Asia and the global bear market
The global bear market has started. It will knock the stock markets of the mature economies back 20% off their peaks, and emerging-market debt and equity by much more.
Contagion is the current buzzword. There's nothing wrong with buzzwords if they describe accurately what's afoot. A decade ago, Asia "going under" would have been a small gash in the hull of global markets. The water-tight doors of capital controls and protected markets in the rich world would have avoided sinking the ship - not so today.
Sure, if you compare exports and bank lending to Asia with the GDP of rich countries, they're a drop in the ocean, and pretty insignificant even in the case of Japan - the most exposed country in the region. But we are all conditioned like Pavlov's dogs to watch the "real" economy for events that will affect financial markets. This time around it will be different. It is events in financial markets that will hit the real economy - the current has reversed in the financial circuitry.
Nor is it right to look for an entirely rational justification of why the Asian crash should roil Wall Street. The fall of the butterfly in the still air of Hong Kong may just be the catalyst for the hurricane in New York. The Hong Kong equity collapse could just inspire investors to think again about global equity-market risk.
There are two alternative roads for investors. They both head more or less in the same direction and lead to the same city: the Gomorrah of the bear market. The first is that equity markets head south now. So do speculative debt markets, particularly those of emerging economies. This cuts the peak off the mountain of the global economic cycle because so much consumer spending in places like the US and the UK is based on the wealth effect of households owning so many equities.
The second road is that financial markets in the US and Europe regain "irrational exuberance". This could be reinforced by capital fleeing the emerging economies to safe havens. Bonds suffer for a while. Global liquidity dries up. Central bankers tighten as the "new paradigm" dies and wage inflation pushes up in the US. Equity markets crash later. The world economy slows.
The crash could be worse in the case of the second projection than in the first. But it would come later. Under both, safe-haven long bonds (UK gilts, German Bunds and US treasuries) end up as winners. But under the second scenario they would suffer first.
The real nightmare is when both scenarios happen simultaneously. Wage-cost pressures in the US force the Fed to raise interest rates, making it impossible for emerging economies to stem capital flight. The Bundesbank does likewise in the name of Emu convergence - it still has to cover a 130 basis point short-term interest-rate gap with overheated Spain and nearly 300bp with Italy. Soaring interest rates in emerging economies, needed to stem capital flight and stop currency collapse, inflict a series of 1929 crashlets, lighting up like flame-spots around the world.
There is a common thread. Emerging economies with big external deficits, both past and present, and a stock of unproductive domestic assets financed by formerly "cheap" capital inflows (which permitted the current-account deficits to get out of hand), are only entering hell right now. Capital will flee. The most vulnerable are those countries with managed exchange-rate regimes that are not backed by sound economic fundamentals. They will be automatic targets of hedge funds. That's Korea, Brazil, Argentina and Hong Kong, although Hong Kong has an asset bubble rather than an external deficit problem.
A fixed exchange rate acts like a straight drainage pipe linking currencies and financial markets. When there's pressure on the currency at one end of the pipe, capital is instantaneously sucked out of the financial system at the other end. Asset prices deflate immediately. Then the economy tanks. That's because exchange-rate and monetary policies aren't allowed to act like suspension units on a bumpy road surface. Asset prices, and through them the real economy, bear the strain of adjustment.
My road map to the bear market looks like this. Korea goes bust. It is the most overgeared economy in Asia, with debt-to-equity ratios of 300%. It has a domestic credit bubble almost as big as Malaysia's, at 155% of GDP. Much of it is financed by the short-term foreign borrowings of Korean banks, the highest in Asia. Korean corporations have covered the cost of debt only once in the past seven years and currently earn a 3% return on assets against a cost of debt of 13%. The country's net external liabilities are booming and understated, as the Korean banks' external assets have probably been lost in the emerging-market turmoil. And it has the worst ratio of maturing foreign debt to reserves in Asia. In short, Korea is bankrupt. It is unlikely that the IMF can finance the Korean crisis without massive multilateral assistance.
Korea is also a natural flash-point on the geopolitical map. A collapse will raise global and Asian insecurity dramatically. It makes the impending collapse of North Korea unfinanceable by the South. And who knows what the North's reaction to turmoil in the South would be? That means that China and the US will come face to face over US involvement in stabilizing the Korean peninsula. Aside from the massive cost of doing so, China would be hostile to either US or Japanese involvement.
The Korean crisis is also going to unsettle Japan. That could cause the fragile Japanese consumer to pull back and Japanese investors to accelerate capital outflows to the US (and maybe Germany) and the Japanese economy to plummet. The yen would dive to ¥140 against the dollar. The won will collapse to at least W1,400 to the dollar as the crisis unfolds.
Korea is the world's 11th largest economy - its annual GDP is more than twice Indonesia's. Its exports account for 3.1% of world trade, almost as much as China's share. But Korea's exports are the high-value stuff that competes directly with the autos, electronics, steel and chemicals exports of Japan and Taiwan, as well as with western producers. So it means cheaper exports will invade western markets.
A collapse in the won will trigger a global fall in corporate pricing power and a deflationary impact that China's massive exports of low-end products could never achieve. That matters to the world, because Japanese and Korean exports will be competing on price as their currencies collapse. The pricing power and profitability of Japanese, US and European corporations will suffer.
The collapse in the won could take the Nikkei to 13,000 and trigger another Japanese banking crisis. That, in turn, could cause either banking collapse and capital flight from Japan, or capital repatriation to shore up Japan's domestic financial system.
The US stands out as the supreme safe haven of the world. Capital will flow there. But US equities are unlikely to outperform for long. The massive stock of US foreign direct investment will earn no real money in Latin America and Asia over the next two years. Throw in some sizeable currency losses and EPS growth for Dow Jones index companies is only likely to be 5% next year. Paying 21 times earnings for that sort of growth is too much.
Indeed, the collapse in foreign earnings of US corporations is likely to hit the big flagship names more than most, and get wide media coverage that will affect sentiment badly. Take Boeing - markets have been punishing the stock for not being able to produce enough aircraft right now. By this time next year, Boeing will be penalized by markets because demand is slack. Other sectors will not go unscathed either. European banks have 4%-10% of earnings in Asia. And emerging markets are where operating margins are highest, on products like PCs and mobile phones.
David Roche is president of Independent Strategy, a London based research firm.