Emerging Problems

By John R. Taylor, Jr.

Money has been flowing away from the G-10 countries and toward the rest of the world for almost a decade. The outflow, punctuated only by the traumatic fall of 2008, has led to unprecedented asset appreciation and wealth creation in the emerging world. According to the Forbes calculation, billionaires have increased from just a handful 25 years ago to several thousand today, and their combined worth is $2.3 trillion – almost as much as the $3.1 trillion from the developed world. It’s not just the billionaires that have gained so much since the collapse of the Soviet-inspired communist development paradigm around 1990 and the Southeast Asian wipeout at the end of that decade. The emerging-world upper class has financially outpaced the rest of the populace in a very dramatic way. With the collapse in global interest rates and the increased availability of capital, the market value of assets, like real estate and corporate shares, has exploded, making the rich much richer. Of course, the vast majority in these countries own no assets and are dependent on wage levels to survive. While investment has exploded and wealth with it, the asset boom gave most people absolutely nothing. China is the most striking – and surprising – example of the disparity between the haves and havenots. The UN says that 30% live on less than $2 per day, yet a Deutsche Bank study argued that the 70 top lawmakers in China had a net worth of $89.8 billion, while the 660 individuals running the 3 branches of the US government had a total net worth of only $7.5 billion. No wonder there is a pressing need for social leveling in China and that the new regime has made this a cornerstone of their policy. This same dichotomy – maybe not quite as extreme – appears in every one of these fast-growing developing countries.


What happens next in most of these countries won’t be as pretty as the last decade. Although the Arab spring should not be seen as a harbinger of the future for the developing world, there are similar problems that must be remedied to avoid dramatic societal upheavals. Poverty, a new growth model, and the societal investment to move into the future all need to be tackled. Because any increase in the cost of very basic necessities like food or petroleum products can result in political disturbances, inflation is a great fear and government subsidies are more often than not used to blunt this risk. However, these strategies are stop-gaps and even dangerous in the long term. More economically effective and socially conscious is an increase in wages. Whether this policy is chosen by the leaders or forced upon them, it is driving unit labor cost up and cutting the cost advantage these countries need to maintain their export sales. With a slowdown in the developed world, those sales are already in trouble, and with higher wages and more domestic wealth and consumption, the trade and current balance is deteriorating. This implies a funding gap that is being met by foreign capital inflows and, more often, by offshore borrowing. We would argue that the party for emerging bonds is almost over and, if the developed world stays moribund, emerging market growth will collapse. Their equity markets suggest this is starting to happen. Although these countries will eventually develop a model dominated by domestic growth, they are not there yet. In fact, the path to that end is not easy or even clear. Lower currencies will be the answer. Short rates will be under pressure, too, even if longer rates rise to attract
capital.

Europe Isn’t Worried 

By Jonathan Clark

Half of the countries in the OECD are in recession and, as a result, there is tremendous emphasis around the world on economic growth, but there is not much evidence of this in Europe. Although many of the peripheral countries have an employment problem – the worst, Greece and Spain, both registered 27.2% unemployment – there has yet to be a significant move away from austerity. Some countries including Spain are being given extensions to achieve their budget deficit targets, but there is little chance of fiscal stimulus. Part of the reason is that Germany controls the purse strings, and with elections on September 23 there is little chance Chancellor Merkel will be softening her stance towards austerity. After her reelection, we will see. Sovereign borrowing rates in the peripheral countries other than Cyprus have been declining since July of last year or longer. This eases some of the fiscal strains on these countries, as markets are more accepting of new debt issuances so debt rollovers are often at lower interest rates. That is some measure of relief for the entire Eurozone, in recession for five and soon to be six consecutive quarters, but some countries are declining for that many years.


Our preferred measures of risk in the Eurozone are sovereign borrowing rates of the peripheral countries against the core and credit default swaps, both of which show risk appetites are still high. This is typically good for the European countries, as well as their equities and currencies. The chart shows that Spanish 10-year government borrowing costs versus German Bunds have been narrowing since July of last year (shown opposite on chart) and this has caused the euro and most European currencies other than the British pound to strengthen. Provided this interest rate spread continues to narrow, it is difficult to be very negative on the European currencies.


EUR/USD should form a peak during the next few weeks and then resume its downtrend. Our target for this upmove is only the 1.3350 area and if seen this should be a good place to begin selling. Only a close above this level means the uptrend will become stretched and it will rally to the 1.3480 area before peaking, but this is less likely. By the week of May 20 and probably sooner the euro should turn lower and decline for several months. A close below the support at the 1.3020 to 1.3035 area is needed to immediately turn the outlook negative. It is then headed directly lower into the middle of June. Our initial target for this downtrend would become the 1.2550 area. The longer-term cycles argue this overall weakness can persist into August and the euro can fall to as low as the 1.2100 area before bottoming. A widening of the Bund/Bonos spread is a likely to be an early warning that the downtrend is resuming.