Emerging markets have a debt problem

by Momentum Investments 0

Is the Global Financial Crisis really behind us, or just evolving into a third Emerging Market instalment?

It has been eight long years since the onset of the Global Financial Crisis.  Whilst much has changed over this period, it appears that the ongoing debt saga is destined to plague the global economy for some time to come. 

In late 2007, the significantly over indebted United States housing market was at the epicentre of what would later be described as the most severe crisis in almost a century.  In the fall out that followed, the world economy was dealt a second blow in the form of the European currency union threatening disbandment.  And once again today, just as much of the developed world appears to be on the verge of recovery, the risk of being dragged back into a third leg of the debt crisis has emerged.  In this latest instalment of the crisis, recurrent economic fractures now look to be rippling through emerging markets.

Is the world entering into the third instalment of the rolling debt crisis?

Over the past few years, American households have struggled to work off the excess debt taken during the housing boom which preceded the Global Financial Crisis. 

Today, with unemployment at an impressive 5 per cent, growth this year expected to be in the region of 2.7 per cent and consumer spending accelerating at around 3 per cent, America appears to be well entrenched in a favourable recovery.  Similarly Europe, whilst in an earlier phase of the recovery cycle, today also appears to be a  beneficiary of a gradual resurgence in economic activity.

However, as developed market prospects continue to improve, an all too familiar situation appears to be emerging, namely an unhealthy debt build up in emerging markets.  As growth in these emerging and developing economies continues to slow, it appears that the build-up in debt now overhangs these nations ominously.  This undesirable debt dynamic has seen emerging markets in aggregate fall out of favour amongst investors.

Emerging Markets trading at deepest discount in a decade

Debt Morningstar 

Source: Morningstar

The credit boom in emerging markets was to a large extent a direct result of the credit bust in developed markets. Crisis induced interest rates in the rich world, resulted in an abundance of cheap loans which became available to formerly shunned emerging markets. 

As global investors begin to anticipate policy normalisation and higher interest rates in the United States, many emerging markets are becoming victims of their debt binge which has seen aggregate debt swell from 73 per cent of GDP in 2007 to in excess of 107 per cent as of the end of last year (according to research by J.P. Morgan).

2016 year-on-year GDP growth

GDP Growth

Source: Bloomberg, International Monetary Fund

Today more than ever souring emerging market sentiment spells trouble for the broader global economy.  With the majority of global growth expected to be derived from emerging and developing regions, it seems unlikely that the world economy will be insulated from prolonged stresses in these vulnerable emerging nations. 

Commodity prices record multi-decade lows

Further exacerbating negative emerging market sentiment, lacklustre global growth appears to have been accompanied by a synchronised surge in supply by a wide range of community producers. 

This oversupply of commodity markets is reinforced by the prospect of waning economic growth in China (the world’s largest consumer of commodities) which can be seen having a profoundly negative effect on global commodity prices.  

Commodity prices severely depressed due to oversupply


Source: Bloomberg.  Bloomberg Commodity Index TR (USD)

Plummeting commodity prices, which have traditionally been met by supply cuts (to normalise price) appear to be entrenched in an aggressive price war amongst commodity producers, which is placing further pressure on already suppressed commodity markets. 

Larger commodity producers are betting that increasing their production volumes will enable them to reduce their per unit costs whilst simultaneously raising their market share by forcing less efficient competitors into insolvency. 

Commodity companies one year returns


Source: Bloomberg, one year returns in ZAR as at midday 26 November 2015

What you need to know

As the prospect of higher interest rates in the US continues to lure capital back to America, many emerging markets (such as South Africa) are likely to become increasingly vulnerable to further currency weakness.  This continued currency weakness stokes inflation.  The South African Rand which today is trading at an all-time low against the US dollar has depreciated by approximately 24.4 per cent since the 1st of January 2015.

The higher interest rates which we are witnessing in South Africa to curb inflation and slow the pace of capital outflows places the domestic economy under further pressure and continues to impede growth (which is currently forecast at an uninspiring 1.5 per cent for 2015, according to the South African Reserve Bank). 

With the global economy looking increasingly vulnerable to renewed economic turmoil in the form of emerging market stresses, investors should be reminded of the importance of incorporating the benefits of adequate diversification in their investment(s) strategy.