After the Federal Reserve announced its decision not to begin selling securities, UBS sent a note to clients declaring “Hooray! Nothing Has Changed!”. Meanwhile, Deutsche Bank put out a piece of celebratory research citing the fact that “liquidity will be ample and cheap for longer”.
Nowhere were the sighs of relief more audible than in the emerging markets of Asia. Indonesia, among the hardest hit by the prospect of less liquidity, rose 4.8 per cent, the Australian market over 1 per cent and the Philippine market over 3 per cent. Hong Kong, ever sensitive to developments across the border, has been up almost 20 per cent since the end of June when a combination of a sudden spike in Chinese rates and the Fed’s open mouth policy took their toll on confidence.
But the sighs of relief will prove temporary for emerging market investors in Asia.
That is because the liquidity in emerging markets has disguised the extent of leverage in the region and has obscured the fact that the underlying fundamentals are far more sobering than the return of optimism warrants. As Deutsche Bank added, beneath the rally in asset prices is the reality of overconsumption, a property bubble in many markets and excessive credit growth.
If liquidity was all that mattered, the rally in emerging markets might go on for a long time. The Fed’s statements seemed to support the argument that quantitative easing can never end because the moment the Fed appears to reverse course, however slightly, financial conditions will tighten, Treasury yields will move up, bringing mortgage rates up in their wake, equity prices will tremble, and the weakness of real economic activity will become visible once more.
It is clear that the Fed’s large scale securities purchases have far more influence on asset prices than on the real economy. What is being acclaimed as a victory for the doves actually means that bearish views on domestic economic prospects have prevailed.
Real incomes in the US have been in decline for five years. Far more temporary jobs have been generated than high quality, permanent ones. New mortgage applications continue to lag behind housing starts, suggesting that much of the demand for housing is not driven by homebuyers but by institutional investors and financial speculators.
For the rally in Asia to be driven by more than just liquidity, Asia needs to get its corporate act together and deal with its leverage problem. Corporate balance sheets in the region are the most levered in the world.
In its quarterly report on September 15, the Bank for International Settlements noted that loan quality in both emerging Asia and Latin America has dropped sharply, pointing to a rising volume of bad loans.
That follows a dramatic $267bn rise in cross-border credit to emerging markets, the largest quarterly increase ever, in the first quarter.
Start with China, where a current account surplus and capital controls mean there is less immediate pressure, but caution is advised nevertheless. Investors are confused about the intentions of the People’s Bank of China and whether it is tightening credit as it did at the end of June or continuing to relent after instilling fear in the banks and shadow banks. In August, M2 money supply was up 14.7 per cent, new loans rose Rmb71bn and total social financing, which captures most of the shadow banking activity, also rebounded. Housing, exports, industrial production, electricity usage and consumption – and most importantly, the expressed wishes of China’s leadership – all point to growth that is expected to come in between 7-8 per cent.
There is talk that the government will sanction new listings come November.
But that is on a macro level. On a micro level, the image is not nearly as bright as a result of overcapacity and intense competition. Debt to operating cash flow is 7.7 times, according to work from Hong Kong-based Forensic Asia, “well up from the danger level of six times”, says analyst Gillem Tulloch. “Companies are already over leveraged.” In the industrial sector, payments problems appear widespread, with accounts receivable rising to between 90 and 110 days on average – and his universe is that of the listed companies, suggesting the situation might be worse further down the corporate food chain. That also suggests that to invest in banks as a proxy for economic growth is not wise, since their corporate clients are going to have an ever harder time paying their debts.
Moreover, China is slowly shifting to a new growth template, beneath the mini stimulus programmes with their traditional “let them build railroads” template. That means Australian and Indonesian mining companies may also have a dimmer future.
If Asia had better policies, the liquidity that ends up in this part of the world might stick around for longer. But until it does, investors would be wise to also be flighty.