China’s Debt Explosion Could Mean Problems For Emerging Market Assets

By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management

Our outlook for emerging market stocks and bonds has dimmed on a risk-reward basis. Our apprehension is focused on the dramatic increase in China’s level of private sector debt at a time when we view emerging market equity valuations as unattractive. We think the risk-reward tradeoff for emerging market stocks and bonds has become increasingly unappealing.

China’s well-documented real estate boom has been fueled largely by an increase in private sector debt. On one hand, the Chinese government is trying to slow the growing debt issue. On the other hand, the Chinese government is encouraging banks to make loans to other countries with low credit ratings as part of their One Road, One Belt initiative. We think that banks are making risky loans to help advance the government’s political agenda, however, this distortion can have severe effects if these risky loans go bad.

Domestically, retail investors in China have been loading up on “wealth management products” (WMPs), which have attractive yields but are backed by risky assets. Recent estimates suggest that nearly 56% of these assets are invested in China’s debt market, typically using leverage to enhance the return. Their market has grown quickly with small city and rural banks participating much more than the large state banks. Here too, the Chinese government has moved to stem this practice, but the burden on these smaller banks has already increased risk.

Our concern is more about the pace of growth in private sector debt, rather than the overall level. According to Capital Economics, a London-based economics firm with offices around the globe, since 1990 no emerging market country has seen the ratio of private sector debt to GDP increase by more than 30% over a decade without experiencing a banking crisis. We think that China is flirting with danger here. While China’s strong fiscal position may help prevent a full -blown banking crisis, the probabilities of increased headline risk, volatility, and a potential economic slowdown, have us concerned. Any economic slowdown from China could hurt countries that export to China, especially those who run a trade surplus with China. In our view, South Korea and Taiwan are especially vulnerable.

Still, China’s relatively closed economic system (not a lot of imports and little direct foreign investment) should keep the damage contained to its closest trading partners, especially those with lofty stock market valuations. We view the potential damage to stock and bond prices across broad emerging markets as significant. That is especially true given these stock markets’ relatively high valuations. Based on price-to-book value relative to history, investors are willing to pay as much for the uncertainty around emerging markets as they are for large U.S. companies as represented by the S&P 500 Index.

These lofty valuations may translate to reduced upside. Factoring in the increasing risks that we see in emerging markets, the risk-reward tradeoff makes little sense to us. Therefore, we are underweighting emerging markets and emphasizing other areas of the global market that we think have more attractive risk-reward potential.

This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.

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