Assessing China Risks

September 23rd, 2015


  • Risk assets have sold off this quarter amid concerns about weakness in China and other emerging markets (EM). While our base case scenario calls for a gradual slowing of China’s economy to 5%-6% in the years ahead, we consider two alternative views that are decidedly less favorable.
  • One view is presented in a report by Citi Research, which concludes China’s growth is likely to slow to 2% next year, which would drag the global economy into a growth recession.[1] The other is an analysis by emeritus Professor Robert Z. Aliber, who contends a bubble in China’s property sector could have even greater adverse consequences for China and commodity exporters.[2]
  • While investors have been fixated on China’s stock market as of late, the performance of the property sector and financial system holds the key to whether China’s slowdown is gradual or abrupt. Unfortunately, lack of transparency makes it difficult to assign probabilities to various scenarios. However, the most likely outcome is the U.S. economy will not succumb to weakness abroad.

Assessing China Risks

Among the challenges investors face in assessing China’s prospects are a wide range of views about the economy and financial system. Many observers discount the official statistics that show the economy growing by 7%, considering that “hard data” such as manufacturing activity, electrical generation, and exports suggest much weaker growth. Capital Economics, for example, estimates growth is between 5%-6%, while Citi’s economists believe the likely number is 4% or less. The counter-argument by China optimists is that the economy is transitioning towards services, which is faring much better than manufacturing. Read the rest of this entry »

Global Growth Scare: What’s Real versus Imagined

August 24th, 2015


  • Risk assets have sold off considerably amid concerns about China and emerging markets (EM) in the wake of plummeting prices for oil and EM currencies. The catalysts were actions by China’s government to prop up the domestic stock market and to liberalize the country’s exchange rate policy.
  • While China’s economy is a “black box” for most investors, evidence of a slowdown in emerging economies is compelling: Growth in Q2 was the weakest since the Global Financial Crisis.
  • Thus far, the U.S. economy has performed very well despite the slowdown abroad, although market participants are nervous about the spill-over to the U.S.
  • Our own view is the U.S. economy is on solid footing; accordingly, we are overweight credit risk in fixed income portfolios. However, we are positioning equity portfolios defensively, as the stock market succumbs to its first correction in more than four years.

Background: Worries about China Spread to Emerging Markets

In two previous commentaries, I discussed concerns market participants had about China’s economy in the wake of government actions to prop up the domestic stock market and to alter the country’s exchange rate policy.[1] My conclusions were that the stock market actions were misguided; however, the decision to allow greater exchange rate flexibility was sensible and consistent with long-standing objectives to make the exchange rate more market-determined. Nonetheless, while I continue to hold these views, there is no denying the change in exchange rate policy was widely interpreted as a conscious effort to devalue the RMB, which, in turn, contributed to pressures on EM currencies, as well as oil prices.  Read the rest of this entry »

China’s Exchange Rate Policy: Separating News from Noise

August 12th, 2015


  • Global markets have reacted strongly to China’s announcement that it will let market forces play a greater role in determining the value of the yuan. News reports have portrayed the action as a devaluation that could lead to a bout of “currency wars.” Such reporting in my opinion is pure noise.
  • The more important issue is how much China’s economy is slowing. Our base case is the economy is on a controlled glide from 7% to 5% growth, which is largely priced into markets. However, China’s economy could turn out weaker, which would send ripples across global markets, especially emerging economies.
  • Meanwhile, we are maintaining our investment strategy of over-weighting credit risk in fixed income and higher-quality names in equities.

Implications of China’s New Exchange Rate Policy

The Bank of China surprised market participants yesterday by announcing that it would allow market forces to play a bigger role in determining the value of the yuan. Previously, the central bank set the value of the yuan against the dollar and allowed it to fluctuate in a narrow range around a central parity. Going forward, the authorities will set a reference rate for the yuan based on the market’s previous close and they will allow the currency to trade in a 2% band around the rate. When the yuan depreciated by 1.6% on the first day of trading, newspaper accounts declared that it was the largest devaluation of the yuan in more than two decades and that it threatened to set off a “currency war” if the yuan continued to slide. The lead story for the Financial Times, for example, carried the headline “China Risks Clash with US”, while the Wall Street Journal’s read “Strains Mount After Chinese Devalue Yuan.”  Read the rest of this entry »

China Watch: Is the Next Bubble About to Burst?

August 6th, 2015


  • A 30% sell-off in China’s stock market in the past two months has left investors wondering about the implications for China’s economy. My own take is that one should not overreact, considering China’s stock market is in an early stage of development and has experienced large fluctuations in its 25 year history with limited consequences for the economy.
  • There would be greater reason for concern if problems spilled over to the property sector, which is more closely linked to China’s economy. Indeed, researchers at the Bank for International Settlements (BIS) have placed China and other countries in Emerging Asia at the top of their watch list, considering the massive build-up of debt and property values since 2008.
  • However the situation unfolds, confidence in China’s policymakers has been undermined by the way stock prices were manipulated during the run-up and the subsequent interventions to contain the sell-off. These actions have puzzled investors and also raised questions about the Government’s commitment to market reforms.


China’s economy and financial system continue to be a focal point for global investors in the wake of a 30% plunge in the Chinese stock market in the past two months. The sell-off occurred against a backdrop in which the two largest markets – the Shanghai exchange and the Shenzhen exchange – had advanced by 135%-150% in the year to mid-June, after having lagged for four consecutive years. Read the rest of this entry »

Greek Accord: A Defining Moment, But Not the End of the Story

July 14th, 2015


  • Markets have rallied on news of a last-minute accord between Greece and its creditors, which lessens the risk of a “Grexit.” A key difference from previous negotiations is the requirement that the Greek government must pass mandated legislation by July 15 to be eligible for a new bailout package. 
  • This requirement, if enacted, would lessen the risk of back-peddling by Greece, and it also sets an important precedent for other countries that encounter debt problems. That said, it’s questionable whether the latest package will prove successful in transforming Greece’s economy.
  • The negotiations are a defining moment for the eurozone, as it marked the first time a member country was nearly expelled. As such, it sets an important precedent for other members, and it remains to be seen whether it has permanently altered the eurozone.
  • Amid these developments we have not altered our investment strategy, as we expect the fallout from Greece’s problems to be limited.

Greek Drama: Down to the Wire (again)

For fans of video thrillers or Greek tragedies, it’s hard to imagine a script that contains more twists and turns (including a surprise ending) than the negotiations between Greece and its creditors. Just a few weeks ago, the creditors were willing to make concessions to the Greek government on a bail-out package that would enable it to service its pending debt obligations. Instead, President Tsipras lambasted the offer and called for a referendum to demonstrate the public support it had to negotiate more favorable terms.  Read the rest of this entry »

Greek Drama

June 22nd, 2015


  • Time is running out for Greece to reach an agreement with its creditors. Without a deal, Greece will not be able to pay the €1.7 billion to the IMF that is due this month. Press reports indicate Greek officials submitted a proposal to European leaders over the weekend that include tax increases and spending cuts to hit budget targets, and markets have rallied on the news.
  • Assuming a deal is reached, it would not constitute a permanent solution to Greece’s problems: The country’s debt ratio of 175% of GDP is unsustainable. A deal would merely postpone the day of reckoning when Greece receives additional debt relief.
  • Should talks break down, Greece would likely resort to capital controls to stem the flow of money out of Greek banks. Ultimately, its fate in the eurozone would rest with the European Central Bank, which provides liquidity to the Greek central bank.
  • Thus far, the markets’ response to the drama has been muted outside of Greece and the euro has strengthened, as investors believe the eurozone is better equipped to cope with a “Grexit” today. However, such an outcome would also raise questions about the long-term viability of the eurozone.

Negotiations Reach a Critical Phase

Market participants once again are focused on Greece, as time is running out for the country to reach an agreement that would unlock funds so it can pay creditors. The IMF and European Commission (EC) are now preparing for the possibility that no agreement will be forthcoming for Greece to meet its obligations that are due at the end of this month. At the same time, Greece’s central bank urged the Greek government to accept a deal offered two weeks ago, or risk an “uncontrollable crisis” that might force the country out of the European Union.  Read the rest of this entry »

Is A Debt Problem Looming in Emerging Economies?

May 28th, 2015


  • Where is the risk of a financial crisis greatest today? This question is being asked in the wake of the 2008 Financial Crisis, and most analyses point the finger at emerging economies that expanded credit aggressively and whose property values and asset prices surged.
  • Market participants have been focusing on countries that are vulnerable to shifts in capital flows in response to weak commodity prices, rising U.S interest rates, and a stronger dollar. Two years ago, the focus was on the so-called “fragile five” consisting of Brazil, Turkey, India, South Africa, and Indonesia. More recently, plummeting oil prices and capital outflows have heightened concerns about Russia and Venezuela, while worries about India and Indonesia have lessened following presidential elections.
  • Meanwhile, researchers at the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) are developing early warning systems to identify countries whose banking systems are at risk. The BIS economists find the financial systems of countries such as Brazil, China, India, and Turkey to be at greatest risk.
  • We believe much of the news about individual economies is already priced into markets, but the possibility of a global or regional crisis is not. Our assessment is the likelihood of a repeat of the experience of the 1980s and 1990s is low today, although problems in China and Brazil could spill-over to Asia and Latin America.

Concerns about Emerging Economies

In the wake of the 2008 Financial Crisis, investors have been on the lookout for the next crisis situation. For the past two years, market participants have been primarily concerned about how emerging economies would fare in a global environment where commodity prices are soft and U.S. interest rates and the dollar are rising. The reason: Emerging economies were the principal beneficiaries of strong commodity prices during the past decade and attracted record foreign capital inflows when the developed economies experienced severe recessions in 2008-09. In the meantime, however, growth rates in the emerging economies have slowed considerably, as commodity prices have softened, and their currencies have come under pressure.  Read the rest of this entry »

Market Reversals: What to Make of Them

May 13th, 2015


  • The past few weeks have witnessed reversals from trends of the past 12 months in European bond yields, the value of euro versus the dollar, and the price of oil. We investigate the factors contributing to them and assess whether they are likely to be sustained.
  • The spike in European bond yields appears to be a correction to markets that had become significantly over-valued after the European Central Bank (ECB) launched its quantitative easing program at the beginning of this year. That said, the situation is very different from the “taper tantrum” that occurred in the U.S. two years ago, as the ECB is committed to buy massive amounts of bonds at least through September of 2016.
  • At the same time, the euro has firmed against the U.S. dollar amid weaker-than-expected economic news in the U.S. and diminished expectations of Fed tightening. However, we believe the softening of the dollar will be temporary.
  • The rebound in oil prices of $15-$20 per barrel for West Texas Intermediate and Brent crude may stem from diminished supply in the U.S. However, U.S. oil production could increase later this year if prices stay at current levels, which would renew pressures on oil prices. In any case, we do not foresee a continued rise in oil prices this year.

Spike in European Bond Yields

Over the past few weeks European government bond yields have spiked by 50-75 basis points, with the 10-year German bund yield rising from a record low of 5 basis points to as high as 80 basis points. It is currently trading around 70 basis points. According to economists at J.P. Morgan, this is one of the largest and swiftest sell-offs of bunds during the Economic and Union Government Bond (EMU) era, and it appears to reflect an unwinding of positions that investors put on when the ECB embarked on a massive bond-buying program at the beginning of this year. Read the rest of this entry »

Fine-Tuning Monetary Policy in the Americas

April 13th, 2015

Remarks delivered at the International Economic Forum of the Americas on April 13, 2015.

Dear Mr. Chairman,

Thank you for the opportunity to be part of this distinguished panel and to share my views on the impact of international economic developments on Latin American economies and policies. My perspective is that of an international economist and global money manager. I am not an expert on Latin America, but I have observed the region over the past four decades both in good times and bad, including the lost decade of the 1980s, the 1994-95 “tequila crisis,” and the problems Argentina and Brazil confronted at the start of the last decade.

As the description to our session notes, Latin American economies proved highly resilient during the 2008 Global Financial Crisis. However, some observers are worried about storm clouds on the horizon stemming from falling oil and commodity prices, a strong U.S. dollar, and the prospect of Fed tightening later this year. Accordingly, the main issue I will address is: How concerned should investors and policymakers be about the external environment and its impact on the region?

An Unusually Complex Environment

In assessing the prospects for Latin American economies, one should first recognize how complex the global environment has become since the second half of 2014. Indeed, most forecasts that were made late last year are out–of-date in light of all that has transpired:

  • Oil prices have plummeted by 50%+, and other commodities have softened.
  • The U.S. dollar has appreciated by about 20% on a trade-weighted basis.
  • Interest rates in many European countries are negative now, as the ECB attempts to lessen the risk of deflation via quantitative easing.
  • At the same time, the Federal Reserve is preparing the market for an eventual tightening of monetary policy.

Normally, any one of these considerations would merit extensive analysis and debate. How, then, can anyone be confident knowing how they will play out in their entirety?  Read the rest of this entry »

Cross-currents in Financial Markets

April 7th, 2015


  • U.S. stock and bond markets fluctuated in broad ranges in the first quarter, as investors assessed a wide range of issues including the prospect for oil prices, the U.S. dollar, overseas interest rates and U.S. monetary policy. Economic news was mixed. Real GDP growth may have slowed to 1% in response to a severe winter, but jobs growth continues to be the strongest since the late 1990s, despite a softer-than-expected showing in March. 
  • The inter-play of forces makes the current situation unusually complex: Lower oil prices benefit U.S. consumers and most businesses, but hurt energy producers, while the strong dollar adversely impacts U.S. exporters and multinationals. Nonetheless, we look for the economy to regain momentum this spring and to sustain solid growth in the balance of the year.
  • At the March FOMC meeting, the Federal Reserve signaled that it is prepared to begin normalizing interest rates later this year. However, Fed officials also lowered their forecasts for economic growth and the path of the fed funds rate. Accordingly, the bond market is now pricing in only a 50 basis point increase in the funds rate this year.
  • We continue to overweight risk assets in investment portfolios on grounds that the economic cycle is likely to be prolonged and the Fed will move gradually in raising rates. 

Lower Oil Prices Are Supportive

U.S. economic growth appears to have slowed to about a 1% rate in the first quarter, but we continue to believe the underlying trend is stronger and view the 50%+ drop in oil prices since last summer as supportive. Some of the factors slowing the economy — notably a harsh winter in most of the country and a West Coast port strike — are expected to be temporary. Consumer spending may have moderated somewhat after growing at nearly a 4% pace in the second half of 2014. However, we expect it to grow at a healthy pace in the balance of this year, as strong jobs growth and low oil prices boost real disposable incomes, and consumer confidence stays high: Prior to the March report, payrolls growth had averaged 275,000 workers per month over the past year, which is the strongest since the late 1990s.  Read the rest of this entry »