Emerging markets displace Europe as fulcrum of world risk

By Ambrose Evans-Pritchard

8:17PM BST 05 Jun 2013

There is a wicked double edge to the emerging-market boom that has so enthralled us for the past decade. The economies of these rising powers are by now big enough to shake the entire world if they come off the rails.

Performers dressed in the costumes of former eunuchs rehearse their steps during an imperial rites ceremony to be staged as a tourist attraction during the coming Chinese lunar new year holidays at the Temple of Heaven in Beijing, China
China's PMI index turned negative in May, despite 20pc credit growth in the first quarter Photo: Getty Images

The US hedge fund Long Term Capital Management was caught $100bn (£65bn) short as bond spreads surged in Club Med, and equities plunged. The threat of a chain reaction was serious enough to force emergency rate cuts by the Fed. The crisis abated.

Asia’s economy is a much bigger beast today, and so is the emerging market (EM) universe. These countries now account for half of global investment. Gross fixed-capital formation last year by EM powers in the G20 bloc was $6.7 trillion, 48pc of the total. China alone spent $3.85 trillion, eclipsing America at $2.5 trillioneven with the US shale boom.

The Chinese figure will surprise nobody who has seen the forest of high-construction cranes in Chengdu or Chongqing, deep in the interior, or passed through railway stations of “Tier IIIcities that reduce Waterloo to Lilliputian size.

“It is the emerging world that is driving global expansion, so we have to watch very carefully for signs of a turn in the cycle,” said Julian Callow from Barclays.

Indeed we do. My fear is that a China-led BRICS shock will transmit a wave of deflation across the planet, pushing the West over the edge into another downward leg of trade depression.

The eurozone polity cannot withstand such a blow. Youth unemployment is above 40pc in Italy, Spain, Portugal and Greece, and “nominalGDP is contracting across the four countries, meaning that high debt is rising on a shrinking base.

Another twist of the deflation knife will be lethal.

America is in better shape, but it is hovering near stall speed. The ISM manufacturing gauge fell below the “boom/bust line” of 50 in May. The most draconian fiscal tightening in half a century is starting to bite.

Whether or not the EM slowdown is an inflexion point, or just a refreshing pause, is now a neuralgic issue. What we know is that manufacturing PMI indices are flirting with contraction across much of Asia, with Latin America and Africa not far behind.

China’s PMI index turned negative in May, despite 20pc credit growth in the first quarter. The extra GDP generated by each yuan of credit has dropped to a ratio of 0.17 from 0.85 four years ago. The debt cycle is exhausted.

Societe Generale’s Beijing analyst Wei Yao warns that China may be on the verge of a “Minsky Moment”, the tipping point when the debt pyramid collapses under its own weight. “The debt snowball is getting bigger and bigger, without contributing to real activity,” she said.

She claimed the debt service ratio of companies has reached a “shockingly high30pc of GDP – the typical threshold for financial crises. “The logical conclusion has to be that a non-negligible share of the corporate sector is not able to repay either principal or interest, which qualifies as Ponzi financing," she said.

The scale is huge. Fitch Ratings says total credit has grown from $9 trillion to $23 trillion in four years. The increase alone is equal to the US banking system.

The EM bulls retort that China and the rising powers are protected this time by $10 trillion of foreign reserves, 80pc of all sovereign gold and currency holdings. This will indeed shield them against a currency attack. There will be no exact replay of 1998, when debts were in dollars and fixed exchange pegs blew up.

Yet it will not protect them against the deflationary shock as the Fed withdraws global liquidity, or against their own credit busts. These reserves are a Maginot Line. If China tries to repatriate the money to prop up its own economy, it would push up the yuan, aggravating the contractionary squeeze.

Nor are dollar and euro debts trivial, though this time they are private. The IMF’s José Viñals said foreign borrowing “has been growing at a rapid pace, exposing them to currency risk and leverage”.

Standard & Poor’s said EM firms raised a record $301bn in fresh debt this year to April, up 42pc from last year.

The bearish notes are coming thick and fast. HSBC is liquidating much of its EM debt and retreating into US Treasuries, “the least bad apple in the barrel”, fearing that the global credit cycle has rolled over.
“We are out of virtually all our EM bonds. It is the end of the bull market," said Benoit Anne from Societe Generale. He is expectingreal moneyinvestors to follow hedge funds out of the door. “When and if this kicks off, it will fuel another massive wave of correction,” he said.

Behind the fading EM story is a relentless loss of competitiveness as reform slackens and productivity growth slows. Nowhere is that clearer than in Brazil, left high and dry with a half-reformed, dirigiste economy when iron ore prices crashed. It faces stagflation, with growth of 0.9pc last year. Manufacturing output is down 3pc below its pre-Lehman peak.

The stock of foreign capital flows into emerging markets has soared from $4 trillion to $8 trillion since 2008, a big enough sum to cause global ructions if the mood turns. That has clearly begun in such countries as South Africa and Turkey, where there is a toxic mix of political risk and current account deficits above 6pc of GDP.

What has set the retreat in motion is fear that the Fed will turn off the credit spigot, draining the dollar liquidity that fuelled the booms. This is what happened under the Volcker Fed in the early 1980s, triggering the Latin American crisis.

You might well ask why the Fed’s Ben Bernanke would “tapermonthly bond purchases (QE) if there is such a risk of global deflation. But the Fed can be insular at times and is clearly having to pick between poisons.

The latest minutes of its Federal Advisory Council warn of an “unsustainable bubble” if QE continues, and suggest the policy is doing more harm than good in any case. The criticisms are getting under the skin of Fed insiders. Even the Boston Fed’s ultra-dove Eric Rosengren now talks of tapering soon.

Mr Bernanke will not be deterred by a shake-out on Wall Street, for that is what he wants – to curb excess and rein in moral hazard. The rest of the world can only pray that he does not push his point too far.

June 6, 2013 6:48 pm

Finance: Forced into the shadows
With Europe’s banks reluctant to lend, private equity groups are stepping in with loans to struggling companies
A man walks between glass facades of the Bonn Post Tower, the headquarters of German postal and logistics group Deutsche Post DHL in Bonn

After five years battling its most severe downturn since the Spanish civil war, Uralita felt that it was running out of options.

The building materials supplier faced debt repayments this year and next. And with no recovery in sight, Uralita’s banks were not in a lending mood.


In 2007, the family-owned company boasted healthy profits and more than €1bn in sales. But it lost money in 2012, with revenues down 40 per cent, due to the collapse in the Spanish construction market.

Its banks, including Santander, the country’s largest, and Bankia, which was bailed out last year, indicated that they would push back the payments for another year – but only if Uralita sold assets, recalls Javier González, Uralita’s general counsel.

Uralita’s tale highlights the struggles of cash-starved companies in Spain and across Europe to find credit, as banks, under pressure from regulators to meet more stringent capital requirements, cut assets and curb lending.

“The Spanish banks are just not ready to take on any more risk,” Mr González says. “They were pushing us to look elsewhere.”

Left with the unpalatable prospect of selling profitable operations to satisfy its lenders, Uralita looked for alternative sources of funds. To its surprise, it found plenty. Four private equity groups, including New York-based KKR and Blackstone, competed to offer a loan. In April the company borrowed €320m over seven years from KKR to repay all existing creditors. The loan will also help fund new investments at its pan-European thermal insulation business.

Uralita’s loan from private equity is a sign of how shadow banking” – long a feature of US finance – is beginning to take hold in Europe. Across Europe, ailing companies are scrambling for credit, only to discover that their bankers are not picking up the phone except to demand repayment. So funds such as KKR and Blackstone are seeking to fill the void.

For Uralita and other crisis-hit European companies, the shadow banksfinancial groups that do not have to meet the capital requirements that traditional banks do – are offering a valued service at a tough time. But the rise of the new private equity-funded lending raises questions about whether struggling borrowers will be able to bear the cost.

“We are going through a seismic shift in Europe,” says Mubashir Mukadam, the head of KKR’s special situations business in Europe.

“European banks have been amending and extending loans provided before the crisis. But now the liquidity needs of the companies and changing regulation are forcing companies and banks to look for other solutions.”

Last year the US-based Giant subsidiary of Spanish cement producer Cementos Portland Valderrivas found itself in a similar bind to Uralita. It was unable to repay its loans as demand for cement in Spain fell 70 per cent.

With banks reluctant to extend a helping hand, Giant turned to GSO, the $58bn credit management arm of Blackstone. GSO ended up lending the cash-strapped company €325m, charging a high rate of interest and taking a 20 per cent cut of its cash flows. It also took collateral in the form of its three US cement plants in the process.

Still, despite such onerous requirements, GSO has enjoyed huge demand for its moneyso much that it finances just 5 per cent of the requests it receives for credit. Traditional banks cannot structure a loan in the flexible, lucrative way GSO does. It is protected from downside risk, but enjoys upside potential in the form of equity warrants or a cut of cash flows.

“A combination of regulation and the markets have raised the cost of capital for European banks,” says Mike Whitman, who is responsible for the lending business in Europe at GSO’s London office. “As banks shrink their balance sheets, the knock-on effect is companies must diversify their sources of funding away from their historical relationship with lending banks.”

To make the banks safer, regulators in the US and Europe require them to hold more capital. This has made them more risk-averse and reluctant to lend to smaller companies, and they charge more for the money when they do.

In the US, where capital markets and non-bank institutions have long played a central role in financing, banks typically account for about 20 per cent of lending. This explains why companies have been able to offset the reduction in bank lending.

But the funding gap left by retrenching European lenders, which have historically accounted for 80 per cent of lending in Europe, is potentially huge.

Alberto Gallo, an analyst at Royal Bank of Scotland, estimates that European banks have cut €2tn from their balance sheets over the past year, including €850bn of loans, of which €200bn was in corporate loans. He expects lenders to slash another €3tn off their balance sheets and says the lending shortage will continue to affect the periphery more than the rest of Europe.

Société Générale analyst Alain Bokobza estimates that in the French market, small and medium-sized companies need an average $100bn in loans every year. The lending deficit is also affecting European real estate and infrastructure projects, which rely on about $400bn of loans each year, he says.

Adding to the difficulties, about $100bn of European collateralised loan funds – a big source of credit for leveraged buyouts – will expire by 2015, and only a fraction will be replaced, according to Standard & Poor’s.

Moreover, European banks are saddled with bad loans from the credit binge. Those bad debts make European banks doubly risk-averse while reducing their lending capacity.

Addressing the [non-performing loan] problem is likely necessary to unlock bank lending to small and medium enterprises,” notes Nikolaos Panigirtzoglou from JPMorgan in London. In the eurozone’s periphery, these bad debts have surpassed €500bn, he estimates, adding that Germany is the only country where such loans are not rising.

The unintended consequence of all this is that it has become possible for groups such as GSO and KKR to offer capital to the capital-starved. For borrowers, this money is far more expensive than they have paid in the past.

. . .

In the good times that ended with the global financial crisis, banks in Europe funded themselves from cheap deposits and from the wholesale market – generally US money market funds. They could borrow for a rate that was just below the Libor benchmark and then charge their corporate clients at a generous margin above thatsometimes as much as 3 percentage points.

The banks did not seem concerned by the fact that they were borrowing for anywhere between one and three years and then lending money to their customers for five years. This lasted until the global financial crisis hit and the wholesale market disappeared.

The debt binge on both sides of the Atlantic peaked in 2007. Since most corporate loans are for five years, the number of borrowers seeking to repay and refinance has been rising in recent months. In Europe, some of the smaller borrowers, such as Uralita, are getting closer to the so-called maturity wall, a mountain of debt inherited from the credit bubble that has to be repaid in the next few years.

Credit funds such as GSO are happy to help – at a price. For a long time, GSO was the only player of scale in this segment of the business. Its portfolio of non-investment grade loans is larger than that of JPMorgan.

The group provided the first leveraged buyoutrescue loan” in Europe in 2010 when it gave $550m to Almatis, an aluminium maker that is part of Dubai Investment Corp’s portfolio. That enabled DIC to fend off Oaktree Capital Management, which had bought a big part of the debt and hoped to buy the company at a significant discount.

“We were faced with two choices: lose control to a vulture fund or partner with GSO, which developed a solution that enabled DIC to retain control while providing capital for the company to prosper,” says David Smoot, chief executive of DIC.

. . .

Other private equity groups are rushing in, flush with money from pension funds hungry for yield amid record low interest rates.

KKR, which manages about $18bn in credit funds, plans to use its $7bn balance sheet to fund deals. It can also use its capital market operations to syndicate a portion of its deals. “We speak for more than we hold in some cases,” says Scott Nuttall, the KKR partner who oversees many of the credit activities there.

Other groups, including Los Angeles-based Ares Management, London-based Intermediate Capital Group and Stockholm-based EQT Partners, are seeking more than $32bn in total for European-dedicated credit funds, according to data compiled by Private Debt Investors.

New teams are being set up, and more and more buyout fund managers, including London-based CVC Capital Partners and 3i, are diversifying into this emerging asset class.

“It feels like the private equity industry in the late 80s and early 90s. There are a lot of teams raising new funds,” says Jeremy Ghose, head of debt management at 3i. “It is there to stay, there’s no turning back.”

Still, private equity groups are not renowned for their munificence. And the fear is that many desperate companies will not be able to pay off this expensive debt.

In the case of Uralita, KKR’s interest rates are higher than what a bank would have offered, says Mr González. But the interest payments are structured so the company can save cash in the short term. This technique, known as “payments in kind”, was widely used during the credit boom and is risky because it increases the company’s debt load.

Moreover, unlike most of the banks, private equity groups will not be scared to take the keys if the companies default, rather than “extending and pretending”.

“If the coupon is too high, they could see the debt drown both their capital structure and their business,” says one lender. “Some of the deals being done today are just bridges to future restructurings. There is a high probability that many of these deals will end badly.”


Europe: Lending plays second fiddle to safety

Europe’s banks rather than capital markets are the overriding source of credit for companies, a fact that is weighing ever more heavily on policy makers as the EU works through its post-2008 regulatory overhaul, writes Alex Barker.

Michel Barnier, the EU commissioner overseeing financial services, has made unblocking credit flows to the real economy one of his policy mantras over the past year.

The trouble for Europe’s banks is that well-meaning efforts to encourage lending seem secondary to the welter of measures designed to make the financial system saferranging from higher capital requirements for banks and insurers to tighter rules for market operators.

Added to this are the strains of the eurozone crisis, multiple national initiatives, looming reforms to bank structures, stress tests and policy initiatives such as the financial transaction tax, which the financial industry fears will gum up markets and choke off access to capital.

“They are asking us to do contradictory and at times impossible things,” says the head of regulation at a big eurozone bank.
This has left the door open for private equity groups, many of them from the US, to step in and fill the lending gap.

So far, the European Commission and European parliament’s main policy moves aimed at supporting lending – or at least industry concerns – have appeared at the margins of bigger prudential reforms.

Bank capital rules were eased, for instance, to reflect the “diversity” of European banking models and improve incentives to lend to small businesses.

New proposals in the pipelinenotably covering money market funds and shadow banking – are also being tempered to heed warnings that too much regulation will undermine credit flows and liquidity.
Mr Barnier recently shelved plans to propose tougher solvency rules for pension funds, citing the “fragile economic situation”.

More proactive initiatives are also being considered to diversify financing for the corporate sector and improve incentives for institutional investors to join banks in long-term investment projects.

Brussels is also exploring ways to reset the tax system to promote long-term investment.

Copyright The Financial Times Limited 2013

June 7, 2013

Bearish Times for Bonds



As if it wasn’t bad enough for the millions of Americans scraping by on paltry interest payments, now they face another threat: the loss of principal on their bonds and other fixed-income assets.
The month of May, and this first week of June, were terrible for many fixed-income investors who have spent the last few years reaching for higher yields. If there was an index for fixed income with the household-name status of the Dow Jones industrial average or Standard & Poor’s 500 index for stocks, the carnage in fixed-income markets would have been a big story and we’d all be talking about a bear market in bonds.
Consider the damage: mutual funds that invest in long-term United States Treasury bonds lost an average 6.8 percent in May, according to Morningstar, with the loss in principal wiping out years of interest payments. But that’s not the worst-hit sector. Higher-yielding bonds and fixed-income securities, to which investors have turned in droves in recent years, have suffered even more, especially mortgage-backed securities and emerging market debt, as well as just about anything that uses borrowing to boost returns.

To enlarge graph click here. 
Many individual securities and funds were hit much harder than the averages. Vanguard’s Extended Duration Treasury Index fund was down more than 6 percent in the last month. In the mortgage area, Annaly Capital management, a popular real estate investment trust that invests in mortgages, fell 8.7 percent, and an iShares mortgage exchange-traded fund lost 10.4 percent. Pimco’s Corporate Opportunity Fund, which is managed by the star analyst Bill Gross and which invests in a mix of corporate bonds and mortgage-backed securities and uses some borrowing, lost nearly 13.4 percent. Annualized, such declines are off the charts.
“There are many closed-end bond funds and mortgage finds that were just annihilated in May,” said Anthony Baruffi, a senior portfolio manager at SNW Asset Management in Seattle, which specializes in fixed-income assets.
This week, the bond markets’ jitters spilled into the stock market, with major indexes gyrating around the globe. The Dow Jones industrial average dropped more than 200 points on Wednesday, only to bounce back Thursday and Friday. High-dividend stocks, which many bond investors also looked to in their quest for income, were pummeled. Shares of Procter & Gamble dropped more than 6 percent the last week in May.
The severity of the market reaction shows how skittish investors have become about ultralow interest rates. Bond prices fall when interest rates rise, with longer-maturity, higher-yielding and riskier bonds the hardest hit — the very assets that the Federal Reserve’s ultralow interest rate policy has encouraged income-seeking investors to embrace.
Fixed-income funds are where investors have traditionally looked for safety and low volatility, unlike stocks, and such precipitous moves are rare. To put this in perspective, the recent plunge in prices of fixed-income securities had analysts reaching back to 1994, when the Fed began raising rates and 10-year Treasury rates rose two and a half percentage points. That year, Orange County, Calif., had to declare bankruptcy after its bond portfolio plunged in value.
The sudden recent moves in the markets have left many experts scratching their heads, because, on the face of things, not much has changed in the overall economic outlook. This week’s employment number American employers added 175,000 new jobs in May — was the average rate for the past year, suggesting slow but steady growth in the economy. Other measures released in May, like consumer confidence, consumer spending, and personal income, were generally positive, but nothing to suggest any imminent surge in economic growth.
Last week’s sell-off was very indiscriminate,” said Jonathan A. Beinner, chief investment officer for global fixed income and liquidity at Goldman Sachs Asset Management. Added Mr. Baruffi, “I was surprised at how severe the market reaction was.”
After all, the Fed hasn’t actually raised rates, as it did without any advance warning in 1994. But all it took this time was the merest hint from the Fed’s chairman, Ben S. Bernanke, that the Fed’s quantitative easing policy might be tapering off sooner than expected. In the latest round, the Fed announced last December that it would buy billions of dollars of long-term Treasury bonds as well as mortgage-backed securities in an attempt to keep longer-term rates low. With the federal funds rate at 0.25 percent, it has already lowered short-term rates about as far as they can go. The question for investors since then has been: How long will the Fed keep rates so low?
Maybe not much longer. “We’ve been talking about the fact that eventually this interest rate cycle has to come to an end for the better part of six-plus months,” Gary D. Cohn, president and chief operating officer of Goldman Sachs, told me this week.

People need to be reminded of the inverse correlation between interest rates and bond prices. The moves in interest rates may seem small, but they’re pretty powerful. There can be a dramatic impact on prices.”
The sell-off in fixed income began slowly on May 10, an otherwise uneventful day with no obvious catalyst for any change in sentiment. It picked up steam when Fed sources didn’t step forward to calm markets. Then, in comments to Congress on May 22, Mr. Bernanke said, “We could in the next few meetings take a step down in our pace of purchases.”
That set off alarm bells, in contrast with his prepared text, which gave no suggestion that the Fed’s policy would change so soon. And then, the minutes of the Fed’s May meeting suggested that some Fed governors were prepared to start tapering off bond purchases as soon as the Fed’s next meeting, which will be June 18-19. Near-panic selling in some markets ensued.
“When you get a fundamental shift in interest rates, which doesn’t happen very often, the initial move is always pretty dramatic,” Mr. Cohn said. “It’s a move from a lower rate world to a higher rate world, and people try to get ahead of it.”
Mr. Beinner added: “The concern is that the Fed is taking away the punch bowl and taking liquidity out of the market. The increase in liquidity has been a big driver of these markets, and as the market gets its head around these things, it follows that those markets will weaken.”
That said, “The magnitude of the moves was extreme in some cases,” Mr. Beinner said. “It wasn’t based on fundamentals, and may have been a liquidity-driven event, with hedge funds selling when prices fell to target levels.
Whether or not the current sell-off continues, the plunge has startled investors who may not have realized how much risk was embedded in their portfolios. “The only thing I guarantee for sure is that someday we will have high interest rates again,” Mr. Cohn said. “It may take 50 years, but rates are going to go higher. We have an entire generation of investors who have never experienced a rising rate environment.”
Mr. Beinner said investors need to reconsider their traditional fixed-income allocations, nearly all of which carry interest rate risk. “It’s an asset class with a negative expected return without any other positive offsetting properties. So why have it as a part of your portfolio?”
He said the simplest and safest approach is simply to park funds in a low-volatility money market fund and accept near-zero returns. There are also floating-rate funds, which invest in floating-rate bank and corporate loans as a way to protect against rising interest rates, at least in theory. But there has been a recent rush into these funds, and the risks may not be clear to investors. Their track records are relatively brief, and it’s not clear how they’d react in another financial crisis.
Hedging by taking short positions in interest rate futures is too expensive and complicated for most individual investors, and so-called inverse funds, which use leverage and take short positions, are too speculative for many investors. There are also so-called unconstrained bond funds, like Goldman’s Strategic Income Fund, of which Mr. Beinner is a manager. His fund uses hedging strategies to minimize interest rate risk and can seek opportunities around the globe. (He says he thinks emerging market debt is undervalued.) But returns on such funds depend entirely on the skills of their managers.
“I’ve been hearing from a lot of worried baby boomers,” Mr. Baruffi said. He recommends a cautious approach, which means accepting low returns for now in return for safety. “People need to be patient,” he said. “This is no time to reach for yield. What people need is a bomb shelter. There’s no return on those, but if the market continues to drop, you’ll be happy and you can reinvest at lower prices.”