Emerging Markets Haven’t Hit Bottom Yet

Twenty percent drops haven’t made EM stocks cheap. Fixed income looks better, but be wary. Three bond ETFs.

By Craig Mellow       . 

China’s arrested development is visible in dozens of “ghost cities” like this one in Chenggong, thrown up in the boom years and still awaiting inhabitants. Photo: ChinaFotoPress/Getty Images 
When Mark Mobius urges caution on emerging markets, you know they’re in trouble. The septuagenarian executive chairman of Franklin Templeton’s emerging-markets group has been boosting the asset class for decades, exhorting investors to pile back in after crises and meltdowns.
Now, not so much. “Things have changed since the 1998, 2008, and 2011 downturns,” he says.

“It would be dangerous to make an overall or categorywide judgment.”

The dean of Franklin Templeton is not alone in seeing longer-term shifts behind the latest debacle of his beloved asset class. Emerging-market equities have crashed by 20% over the past year after treading water for two years, as measured by the widely held iShares MSCI Emerging Markets exchange-traded fund (ticker: EEM). The raw growth that cleansed all sins in times past has tapered significantly. Average economic expansion for developing countries has fallen below 5% annually, from 8% in 2007. Their growth advantage over developed economies is at its lowest since 2002—about 2.5 percentage points.

All of that looks like the new normal, says Rashique Rahman, head of emerging-markets fixed income at Invesco. “We’re looking for a long, drawn-out period of subdued economic growth. It will feel like there’s no end in sight,” he says.

Emerging markets are in part victims of their success. China’s gross domestic product has more than quadrupled since 2001, when Goldman Sachs’ Jim O’Neill coined the phrase BRICs for Brazil, Russia, India, and China. That makes a growth slowdown a mathematical certainty.

But the developing world is also “living through the impact of global rebalancing,” says Jorge Mariscal, chief investment officer for emerging markets at UBS Wealth Management.
IN THE GOLDEN AGE of emerging markets, before 2008, rich countries borrowed at a hectic pace, partly to gorge on poorer countries’ goods and commodities. In the silver age—2009 to 2011—deleveraging Western consumers were replaced by a hyperleveraging China, and by global investors eager to lend to faraway companies rather than accept near-zero interest at home. Bond issuance by emerging-market corporates has more than doubled since 2009, to $2.4 trillion.

Those powerful props have fallen away over the past year or two. China tightened its stimulus tap, and growth is slumping there, from 7.8% in 2013 to an expected 6.8% this year and 6% in 2017, according to the International Monetary Fund. China’s arrested development is visible in dozens of so-called ghost cities that were thrown up during the frenetic boom years and now await inhabitants.

China’s slowdown, combined with subpar recovery in the U.S. and Europe, has slashed demand for the wares of other developing countries. Emerging-market exports have stopped growing after posting 10% to 20% annual gains throughout the 2000s, Mariscal says. The Federal Reserve meanwhile ended its quantitative-easing program and signaled, again and again, that it will raise rates eventually.

Funds rushed back to the U.S., emerging markets’ currencies crashed, and their new mountain of debt began to look much more ominous. A Bank for International Settlements report earlier this month found that a half-dozen big markets—led by China itself, Brazil, and Turkey—have ratios of credit to GDP that historically have been associated with “serious banking strains.”

Emerging-market governments and companies did little to prepare for leaner times. National leaders stopped trying to privatize the massive state-owned banks, utilities, and resource producers that clog the heart of many developing economies. Private corporations grew complacent on easy credit.

Average return on equity and capital has declined for the past four years straight, says Chuck Knudsen, an emerging-markets equity strategist at T. Rowe Price.

The resulting drop in profits means emerging-market stocks are not as cheap as you might expect. The average forward price/earnings ratio across the asset class is about 10.6, about the same as it was three years ago. “Equities are not quite yet at capitulation levels,” Mariscal says.
“There are still some positions to be sold.”

But emerging markets have also improved in some ways over time, and these improvements make fixed-income investment more interesting than equities after the latest wipeout. Nearly two decades have passed since the last full-blown emerging-market crisis, in 1997-98, marked by a wave of sovereign defaults and currency collapses. Governments have learned fiscal discipline since then, save for a few outliers like Venezuela and Argentina.
Bigger debtors should keep paying their bills through the current slowdown, despite jarring downgrades to junk this year for once-prized issuers like Russia and Brazil. “Our base-case scenario is no sovereign defaults among mainstream countries,” says Invesco’s Rahman. That could create opportunity in funds like the iShares Emerging Market USD Bond ETF (EMB), whose price has fallen 6.5% since April, a dramatic move by bond-market standards.

Another change stabilizing emerging markets on a macro level has been a mass shift from pegged to floating currencies, which act as a shock absorber in tough times. Instead of the abrupt meltdowns that afflicted the Korean won, Thai baht, or Mexican peso in crises of yore, EM currencies have lost altitude gradually since mid-2011, scraping 15-year lows against the dollar.

THAT PAINFUL ADJUSTMENT may bottom out soon because cheaper currencies are doing what they are supposed to, cutting import appetites and shrinking the current account deficits that drove devaluation in the first place. That is particularly true for oil importers, which are also getting a big break on fuel prices. India has shown dramatic improvement, its accounts gap shrinking from 4.8% of GDP in 2013 to 0.2% in the first quarter of this year. Turkey and South Africa, which joined India on Morgan Stanley’s much-publicized Fragile Five list two years ago, are also improving steadily.
Against this background, brave investors might want to take a punt on the Wisdom Tree Emerging Currency Strategy fund (CEW), which has fallen 17% over the past year. An indirect way to bet on firming money is through a local-currency bond fund like the iShares Emerging Markets Local Currency Bond ETF (LEMB), which looks suitably beat up with a 21% decline over the past 12 months. Even the more bullish pros warn against betting the farm, however. “We do see value in EM debt, but when one realizes that value remains to be seen,” says Edwin Gutierrez, head of emerging-market sovereign debt at Aberdeen Asset Management.

EMERGING-MARKET EQUITY diehards say they can isolate pockets of the old explosive growth within the larger lackluster landscape. The Chicago-based William Blair Emerging Markets Small Cap Growth fund (BESIX) has been an anomalous outperformer, rising some 30% over the past three years, though it is down 7% year to date.

Fund co-manager Todd McClone says he’s piling into fertile market niches like Chinese pollution-control and alternative-energy firms, or mortgage lenders and private hospitals in India. T. Rowe Price’s Knudsen points to the global growth potential of sectors like insurance and food retailing, even as the emerging-market raw-materials and manufacturing engines sputter.

But few investors will wager heavily on an eclectic portfolio whose liquidity risk is hard for the layman to gauge. McClone’s fund boasts modest assets of $281 million. The dominant EEM ETF holds $21 billion by comparison. It is weighted toward Chinese state banks and mature industrials like Samsung Electronics (005930.Korea) and Taiwan Semiconductor (TSM), which show little promise of outgrowing the macro backdrop. “The rapid growth of ETFs has increased herd behavior as investors focus on beating or at least following the index,” laments Mobius, whose own Templeton Emerging Markets Small Cap fund (TEMMX) has gained 6% over the past three years.

Emerging markets’ greatest strength going forward may be the weakness of competing investments, with multiyear bull runs in the U.S. and Japanese stock markets looking tapped out and the Fed’s restraint indicating that fixed-income yields will remain low in the developed world. The toxic mixture of low growth, high debt, and lagging reform make emerging-market equities unattractive, anyway. But try EM bond markets first, and be careful.

Review & Outlook

Central Banks Below Zero

Serious voices are floating the idea of punishing cash.

Governor of the Bank of England Mark Carney on Sept. 16, 2015. Governor of the Bank of England Mark Carney on Sept. 16, 2015. Photo: Anthony Devlin/Zuma Press

The main monetary news last week was Janet Yellen’s decision not to start a modest liftoff in U.S. interest rates until, well, whenever. So it might have escaped broader notice that the Bank of England is inching toward the same conclusion, despite Britain’s recent success as the fastest-growing developed economy.

The central bank’s chief economist and a member of its policy board, Andrew Haldane, warned Friday that instead of thinking about its first rate increase in years, the BOE should figure out how it can cut rates further than near-zero in the next slowdown.

“The case for raising U.K. interest rates in the current environment is, for me, some way from being made,” he said. “One reason not to do so is that, were the downside risks I have discussed to materialize, there could be a need to loosen rather than tighten the monetary reins as a next step to support U.K. growth and return inflation to target.”

Mr. Haldane is one of the BOE’s doves, and commentators have played up a perceived conflict between his statements and those from bank Governor Mark Carney suggesting a rate increase could come next year. But Mr. Haldane’s remarks, especially those pointing to an economic slowdown in China, echo a theme recently picked up by central bankers in Washington and Frankfurt. And Mr. Carney isn’t exactly a hawk. In June 2014 he warned there might be a rate hike “sooner than markets could currently expect.” We’re still waiting.

Britain is getting caught in the same zero-interest-rate policy, or Zirp, trap that we’ve described in the U.S. Sustained low rates have kept many low-productivity businesses afloat instead of forcing them into bankruptcy; favored larger companies at the expense of smaller, more disruptive firms; and diverted investment into low-productivity areas such as property and construction. The longer this policy persists, the greater a drag it places on investment as businesses start to worry about when a rate rise might come.

This helps to account for the gap between economic growth and lagging productivity that perplexes Britain’s central bankers and leads them to delay a rate increase. The Tory government’s policy reforms, especially a cut in the corporate tax rate to 18% by 2020 from 28% in 2010 and welfare reforms that boost work, exceed most of the rest of the developed world and account for Britain’s growth. But abnormally low rates increasingly undermine those reforms by distorting the allocation of the investment the reforms encourage.

Mr. Haldane’s speech shows that rather than learning from this experience, central bankers are looking for ever more creative ways to continue their low-rate bets. Quantitative easing, in which central banks purchase sovereign bonds and other assets, was an early response to economies’ failure to respond to policy-rate cuts. Imposing negative interest rates on bank deposits with their central banks is the next step, which countries such as Switzerland already are trying.

Mr. Haldane ruminates on how the Bank of England could break below the “zero lower bound” during the next recession—especially the difficulty central bankers would face in reducing rates below zero when people can hold cash. Today’s negative rates can be imposed only on deposits at a central bank, but they can be avoided by withdrawing money from banks and putting it in a home vault.

Mr. Haldane says central banks need to find “a technological means either of levying a negative interest rate on currency, or of breaking the constraint physical currency imposes on setting such a rate.” In lay terms, he means diminishing at command the value of the cash people use every day. He mentions several options, from a stamp tax on cash to issuing digital currencies such as bitcoins instead of paper money and then depreciating the “exchange rate” between cash and the government’s electronic money.

All of this may sound far-fetched, but Harvard’s Kenneth Rogoff has also questioned whether paper money is still fit for a modern economy. Mr. Haldane says economists at the Bank of England are researching how a central bank could issue a digital currency.

This would be revolutionary for a developed economy: If monetary policy stops working, change the money. The fact that a respected policy maker is thinking along these lines makes us wonder if central bankers will everadmit that Zirp has become counterproductive.

Mother Angela

Merkel's Refugee Policy Divides Europe

Chancellor Angela Merkel has shown a soft side in the refugee crisis.DER SPIEGEL Chancellor Angela Merkel has shown a soft side in the refugee crisis.

Germans long knew their chancellor as a rational, deliberate decision maker. But in the refugee crisis, a new Merkel has emerged, driven by empathy. Increasingly, it is looking like the emotion-driven Merkel is prone to error. By SPIEGEL Staff

We can do it. That's the message Chancellor Angela Merkel has been giving her country ever since she pledged in late August to provide refuge to anyone coming from Syria in addition to others seeking protection from violence and warfare. The initial euphoria in the country was significant, with tens of thousands of everyday Germans joining the army of helpers to try and cope with the huge influx of needy refugees.

But there have since been signs that the initial elation is fading. The most obvious, of course, was Berlin's reintroduction of border controls on the German frontier with Austria a little over a week ago. But there have been others as well: Frustration in German states about insufficient federal assistance; grumbling within Merkel's party about her open door policy; and conflicts with the Social Democrats within Merkel's governing coalition.

Indeed, Germany is struggling to maintain its composure and to ward off panic despite all the rising doubts.

Can it be done?

Monday morning a week ago. Senior members of Merkel's conservative Christian Democratic Union (CDU) are meeting to discuss the refugee situation. They talk about the Syrians and Afghans who are filling gymnasiums and moving into container villages that are springing up outdoors. The governors of Germany's 16 states report on shortcomings, from the lack of beds to the lack of doctors and teachers. For Merkel, it is but the bleeting of naysayers.

And it doesn't take long for her to lose patience. When Jens Spahn, state secretary in the Finance Ministry, shares his own story of desperate volunteers asking him how things are supposed to continue in their current state, the chancellor interjects.

Merely describing reality and talking about feelings isn't enough, says Angela Merkel. "Those who bear the responsibility of being in government like we do have a different role. We have to provide the people with answers and solutions."

Can We Do It?

Courageous words, perhaps, but also a bit concerning. Can a report focusing on real conditions on the ground really be seen as an attack on the government line? May truths not be uttered just because they don't align with Merkel's indestructible optimism? As many as a million refugees will come to Germany this year. Can we do it?

Yes, Merkel says, of course we can. It was only three weeks ago that the chancellor said Germany was an amiable country -- and that people fleeing war and political persecution are welcome here. Such statements, free of tactic and calculation, are new for the chancellor.

Her words traveled at lightning speed. They were shared over Facebook and Twitter, via email and SMS, prompting tens of thousands of people -- maybe hundreds of thousands -- to make their way to Europe. In Hungary, refugees are being fought off with water cannons and tear gas. Police officers are back at the German border with Austria to at least try and channel the flow of desperate people pouring in.

Did Merkel miscalculate? Does she still have the situation under control?

The Merkel era began exactly 10 years ago, on Sept. 18, 2005, when she beat out Gerhard Schröder in the general election. It was the beginning of a chancellorship that was at first precarious. She didn't only have to defend herself against Schröder, who lectured her like a schoolchild on the evening that he lost the election, but also against the many enemies within her own ranks who were just waiting for the right moment to knock her off her pedestal.

But that moment never came. Merkel was an unlikely presence in German politics: a woman from East Germany in the male-dominated, West German CDU. Her secret weapon, though, was caution.

She used it to shove aside all of her opponents. Only Merkel is left.

It is now being said that, after all those years of hesitation and procrastination, Merkel has finally found her issue with the refugees. But that is a rather one-dimensional approach. There is, in fact, much more at stake. Merkel is trying to transform Germany into a moral superpower in Europe. It is an aim that is not entirely free of hubris.

Shifting Mood

Despite periodic bouts of bluster, German chancellors have always strived for consensus in the EU. But Merkel has now embarked on her own special path. And when it comes to refugees, she's on her own, cursed by the Eastern Europeans and abandoned by the Brits. Neighboring Austria applauds politely, but the country is happy when the refugees continue on to Germany.

Within Merkel's own party, the mood is shifting. Many think she is slowly losing her grip on the situation. They believe she made a generous gesture, but now she is failing at administering the crisis. And there is some truth to that. After all, like Interior Minister Thomas de Maizière, she spent months blithely ignoring multitude warnings about the rising refugee numbers.

Merkel has long been one to respond to criticism with gentle conviction. But that sanguinity appears to be gone, replaced by gently irascible bluster. Last Tuesday, for example, when she said she would not apologize for Germany showing a friendly face -- because otherwise it "would not be my country" -- she was doing more than just rebuking her critics. It was an unveiled threat: If you don't follow me, you're going to have to look for a new chancellor.

What has gotten into Merkel? The Germans thought they knew their chancellor, whose popularity was largely attributable to her predictability and her at times tiring prudence. Now there is suddenly idealism flashing forth and the world isn't quite sure what to make of it.

Israel and the US are celebrating Merkel. The New York Times gave her a "bravo." Israeli historian Tom Segev says Germany is being "noble and commendable." Among Germany's European partners, however, the enthusiasm is much less effusive. And it's not only Hungarian Prime Minister Viktor Orbán who is openly rebelling against the Merkel approach.

Merkel's invitation to refugees, after all, wasn't just in Germany's name. She was effectively speaking for all of Europe -- her words put the onus for accepting all the refugees who heeded Merkel's call on the entire Continent. Europe is bursting at the seams and it's Merkel who is responsable.

Losing a Sense of Proportion

But Europe isn't interested in aligning itself with the German understanding of humanity. The British government can barely conceal its horror at Merkel's new course. Home Secretary Theresa May said last Wednesday that it was important to help people living in civil war-torn regions -- "not the ones who are strong and rich enough to come to Europe." She categorically rejected Merkel's plan to distribute refugees among European Union member states.

French President François Hollande, whom Merkel has made an ally in the refugee crisis, has kept his distance. Hollande said he wanted to take 1,000 refugees off Germany's hands. A paltry number, to say the least. But these days, Merkel should be grateful even for that. "We never raised unrealistic hopes," says one adviser to the French president.

German Interior Minister de Maizière is already in the process of altering Germany's approach to asylum-seekers. He plans to provide so-called "Dublin refugees" with a small "subsidy to cover the costs of unavoidable travel necessities" and deport them back to their first EU country of arrival. This doesn't fit the image of the merciful Merkel at all. Germany "cannot accept everyone who comes from a crisis region," says de Maizière.

Merkel's transformation is telling of the difference between politics that are good and politics that are right. The distinction is as old as political philosophy itself. German political philosopher Max Weber identified the distinction as being between the ethics of conviction and the ethics of responsibility. In other words, the difference between politics that are guided only by morals or by the likely consequences policies might produce.

What person with a heart would condemn a policy seeking to help refugees who make their way, children in tow, from Greece, through the Balkans and on to Germany? But where is the right balance between humanity and reality? And: Is it more important to save refugees or to save the EU, which itself embodies an answer to the horrors of war. A closer look at the drama of the last few weeks shows that Merkel has lost her sense of proportion.

Berlin, Tegel Airport, August 19

At 1 p.m. on this beautiful summer day, Merkel sets off to Brazil, joined by a large delegation. Before she makes her way to the plane, however, she speaks with Interior Minister de Maizière on the phone. He tells her about the rapidly rising number of refugees and says he plans to announce a new full-year forecast that afternoon, a figure that has been upwardly revised from 450,000 to 800,000.

Merkel is alarmed. The number 800,000 is significant -- large enough, in fact, to dominate the public discussion. And Merkel knows how fragile the situation is. On the one hand, the German economy is booming. In contrast to the early 1990s, when hundreds of thousands of refugees came to Germany from the Balkans, Germans aren't worried about their jobs. On the other hand, Merkel is all too familiar with the often irrational fears harbored by Germans. It has long been important to her that the government not do anything that might inflame the situation further. And she is confident that the CSU won't add fuel to the fire. The Bavarians, she believes, know exactly where the line to right-wing populism lies.

Merkel, though, is still unsure of how to tackle the crisis. The calls for the chancellor to visit a refugee hostel are growing louder, but she doesn't want to show up empty-handed. A political leader must offer solutions and not just complain about the circumstances, she says. It is a sentence that will come up often in the next few weeks.

Nuremberg, Federal Office for Migration and Refugees, August 21

Angelika Wenzl, a senior official at Germany's Federal Office for Migration and Refugees, writes a momentous paper bearing the reference number 411-93605/Syria/2015. It states that the elaborate Dublin procedures will be suspended for refugees from Syria. That means that whoever makes it to Germany from the civil war-town country will no longer be sent away, even if another EU country is technically responsible for them. The memo, never meant to go public, was supposed to provide some bureaucratic relief.

But once Wenzl's message ends up in the inbox of the aid organization Pro Asyl, it's not long before it goes up on their English website. Any doubts about the document's authenticity were brushed aside by the Federal Office for Migration and Refugees on August 25. At 1:30 p.m., the Nuremberg-based agency's social media team tweets: "We are at present largely no longer enforcing Dublin procedures for Syrian citizens." Most of the time, the federal agency's tweets only get shared three or four times.

This particular tweet, however, gets retweeted 156 times. Even the BBC picks up on it. One Twitter user asks whether the new guideline only applies to Syrians who were already in the country. The organization replies that the decision is not pegged to any specific date of entry.

In Berlin, the Interior Ministry goes into damage-control mode. "But that's not a legally binding act, so to speak -- no requirement, no suspension of Dublin -- it's much more a guideline for administrators," a stammering Thomas de Maizière tells journalists. But word has long gotten out to the world. The British daily Independent runs the headline, "Germany opens its gates." Syrians post pictures of Angela Merkel to Facebook emblazoned with the words, "Wir lieben dich," or "We love you."

Heidenau, Hauptstrasse 10, August 26

As Merkel's motorcade rolls onto the parking lot of the former Praktiker DIY store in Heidenau, two groups of people are waiting for her. One is quiet, the other is furious. The quiet one is made up of refugees and their helpers. The other is comprised of irate Heidenau natives.

Merkel winces as she hears the cries. "Traitor!" some roar, along with: "We are the pack!" Merkel looks confused, then she waves because that's what she's used to doing, and disappears behind a barricade.

The choice to visit Heidenau is a response to the violent clashes between right-wing marchers and police in front of a newly opened refugee hostel on August 21 and 22. It was an incident that made global headlines and Merkel is eager to show a different face of Germany.

She tours the new refugee accommodation for more than an hour. Outside it's hot, with the sun beating down on the crowd, and the mood heats up as well. As Merkel reappears, the noise becomes deafening. Horns are blown and one woman yells in a shrill voice, "You cunt! Get back in your ugly car!"

For days to follow, Merkel's people continue to speak of their astonishment at the lynch-mob atmosphere in Heidenau. As chancellor, they say, Merkel is used to insults. But what should the people do who are out to help the refugees? They don't have bodyguards, yet they still must face "the pack." At the Chancellery, the belief solidifies that Merkel must set an example.

Merkel has never had sympathy for the far-right. In 2003, she ejected Martin Hohmann from the conservatives' parliamentary group because he had played upon anti-Semitic clichés in a speech. Over the years, Merkel's position has become more entrenched. In internal discussions, she has rejected any attempts to posit a psychological explanation for far-right extremism in Germany's East. She has no understanding for it whatsoever.

Vienna, Hofburg, August 27

Merkel is in town for a conference on the Western Balkans. Right in the middle of the meeting, news arrives of a truck parked on the A4 autobahn near Vienna containing dozens of suffocated refugees. Merkel goes before the press and says: "We are all appalled at this horrifying news."

Berlin, Federal Press Conference building, August 31

Merkel gives her annual press conference in front of the Berlin press corps. But this time, it isn't just a routine appearance. The word "proud" comes up often in her comments. She is "proud" of the humanity displayed in the German constitution and she is "proud" of the many Germans who are helping the refugees. "The world sees Germany as a country of hope and opportunity," she says. It quickly becomes clear that she wants to send a clear message: Those who are oppressed and those who are fleeing from a civil war are welcome. It won't be easy, she says, but "we can do it."

They are the kind of sentences that have never before been spoken by a chancellor. She is inviting Germans to follow their hearts rather than their interests; she is asking them to invest their energy and money into the reception of refugees. The chancellor gave an oath to devote herself to the good of the German people, but she is now risking her entire political capital for Syrians, Iraqis and Afghans who are in need of help.

Merkel has made risky decisions in the past. In December 1999, for example, she wrote a letter to the influential German daily Frankfurter Allgemeine Zeitung saying it was time for a leadership change in the Christian Democratic Union. The party's head, Helmut Kohl, had become enmeshed in a party donation scandal and Merkel's letter served as the coup de grâce.

Another came in 2011, when she rapidly sounded the death knell of nuclear energy in Germany in the aftermath of the Fukushima meltdown in Japan.

But those decisions were driven by fear. Merkel didn't want to be dragged into the donation scandal that ultimately slowed or ended the careers of several top CDU politicians, so she distanced herself from Kohl. And the "Energiewende" -- Germany's shift away from nuclear and toward renewables -- went so quickly because Merkel was afraid that the CDU could lose support as a result of the Fukushima catastrophe.

It is difficult to say what prompted Merkel, long seen as a sober practitioner of realpolitik, to become the refugee chancellor -- or, as some conservatives call her, "Mutti Teresa," a sharp-tongued reference to her nickname in Germany: Mutti.

Merkel's people vehemently reject the psychological explanations that are currently being posited in German newspapers. One theory, for example, holds that Merkel, who has no children of her own, was deeply moved by the crying refugee girl she encountered during a town meeting in Rostock.

Emotion in politics is dangerous. Those who gain a reputation for being guided by their feelings are seen as being open to manipulation. Still, there are several indications that Merkel's refugee policy is driven more by her sentiment than she is willing to admit. One person who has known her for a long time says that it really did get to her that, during the Grexit crisis, she was portrayed as the second coming of the Nazis. Plus, her popularity gives her plenty of leeway.

Not unlike the super-rich, she is at a moment in her chancellorship when she can spend political capital on things that don't turn a profit.

Luxembourg, European Convention Center, September 4

The situation in Hungary is becoming serious. Thousands of people are surging toward the border and refugees begin breaking out of the camp at Röszke, near the Serbian border. Meanwhile, 2,000 refugees stranded in Budapest begin making their way on foot to Austria. They walk along a highway as cars speed past.

In Luxembourg, EU foreign ministers have gathered for a meeting and Austrian Foreign Minister Sebastian Kurz takes his German counterpart, Frank-Walter Steinmeier, aside. The conditions in Hungary are catastrophic, he says, and Germany and Austria must act.

Steinmeier calls the chancellor, who is at a CDU anniversary event in Cologne with 500 guests. Merkel makes them wait for an hour. After the celebration, she speaks with Austrian Chancellor Werner Faymann, German Interior Minister de Maizière and again with Steinmeier. Then, she makes her decision: The refugees will be brought to Germany in special trains.

Officially, no German ministry is opposed to the decision, but ministerial experts nevertheless issue strong warnings. Officials in both the Interior Ministry and the Foreign Ministry warn that the decision will attract even more refugees to come to Germany.

Merkel doesn't care. She is more concerned about Europe's reputation. What kind of message would it send if images went around the world showing elderly refugees and pregnant women collapsing in exhaustion while marching to Germany?

At 11:30 p.m., Merkel's office tries to reach Horst Seehofer, the powerful governor of Bavaria and head of the Christian Social Union, the Bavarian sister party to the CDU. But the CSU boss is on vacation and has turned off his phone's ringer. Maybe he didn't hear the call; maybe he didn't want to hear the call. In urgent situations, Seehofer can always be reached by way of his bodyguards. But Merkel doesn't make the effort. She has already made up her mind anyway.

Consistent with protocol, however, Chancellery Chief of Staff Peter Altmaier calls Seehofer's chief of staff, Karolina Gernbauer, a short time later. Gernbauer sends Seehofer a text message, which he also doesn't see right away. But the message is how he learns of Merkel's decision the next morning.

Munich, September 5

At 4 p.m. on Saturday, top CSU politicians receive a text message saying "important appointment." They are asked to join a telephone conference at 6 p.m. to "vote on a joint position." Seehofer reports that the chancellor has unfortunately unilaterally "decided in favor of a vision of a different Germany." Seehofer, it is clear to all of those in the meeting, hopes to derive political capital from the refugee issue. His message: Merkel wants to turn Germany into a vast refugee hostel.

Merkel would have loved to have kept the issue out of the political debate. But now, that is no longer possible. In contrast to the chancellor, Seehofer has no political capital to give away. His last significant political defeat, the failure of his plans to implement a highway toll system, is still fresh. It was a mistake for Merkel to believe that the CSU would be able to withstand the temptations of populism. Bavarian Interior Minister Joachim Herrmann tells journalists after the meeting that Merkel's decision "sends exactly the wrong message within Europe."

Berlin, Chancellery, September 7

Merkel and her vice chancellor, Social Democratic Party head Sigmar Gabriel, report to the press about the results of their refugee crisis meeting. A reporter asks Merkel what it feels like to be the face of friendly Germany in the world.

It is a seductive question as it is aimed at Merkel's vanity, but she could easily have brushed it aside with a couple of sound bites. Instead, she says: "I am happy that Germany too has become a country that gives many people hope outside of Germany. And if you look at our history, that is something of tremendous value. So, I definitely do find it moving."

Berlin, Interior Ministry, September 12

The numbers that are now arriving daily on de Maizière's desk are becoming dramatic. Some 40,000 new arrivals are forecast for the weekend alone. German states are insisting that they can't take any more.
De Maizière sets up a conference call with conservative state interior ministers and, after about 15 minutes, Bavarian Interior Minister Herrmann takes the floor. The influx has gotten out of control, he says. "From my perspective, only the temporary introduction of border controls can help. The situation is so critical that we won't violate the Schengen Code by doing so." The Schengen agreement allows members states to introduce border controls in crisis situations for an initial period of 30 days.
De Maizière says that Germany's federal police force would need seven hours' notice to take such a step. At that moment, it becomes clear to everyone that the minister has already thought about introducing border controls. "Is anyone in this meeting against it?" asks Herrmann. Nobody says anything. Lorenz Caffier, the interior minister of Mecklenburg-Western Pomerania, proposes an emergency conference of all interior ministers to discuss the idea of border controls with their counterparts from the Social Democrats. Herrmann rejects the proposal. It would, he said, be counterproductive to exert public pressure on the chancellor.
De Maiziére promises to tell the chancellor about the group's discussion. Herrmann, for his part, immediately calls Seehofer to urge him to pressure Merkel. At 1:26 p.m., Seehofer sends a text message to the chancellor, ending with the words: "I can only urgently ask you to act in accordance with the severity of the situation."
At the same time, the leadership of the SPD meets. Gabriel has already been informed of the changing sentiment within the CDU. He complains: "From the very beginning, I didn't trust the euphoria." The SPD is concerned that the message just sent out about Germany's openness will be immediately countermanded. But Gabriel ensures that the Social Democrats support the decision made by the conservative interior ministers. A tele-conference is set up for 5:30 p.m. for leaders of parties belonging to Merkel's governing coalition. Merkel, Gabriel, Seehofer and several federal ministers join the call. At the end, it is clear: border controls will be introduced.
It is a paradoxical situation: Merkel wanted to show Europe as a paragon of humanity, but now, the rule which, more than any other, stands for European freedom, is being suspended. Across the Continent, border controls are quickly reestablished.

Berlin, SPD Party Headquarters, September 15

SPD party head Gabriel meets with the governors of SPD-led states to prepare for a meeting with Merkel that evening and the SPD governors complain about the federal government's inadequate crisis management. "Why was there no information?" they grumble. "Why are we only talking now about money? Our municipalities can't take it anymore." Party head Gabriel is irritated. He doesn't want refugees to become an issue of conflictual between the SPD and Merkel's conservatives. He defends Merkel and says: "I don't know either." Gabriel is now closer to the chancellor than she is to her own party allies.

Berlin, Chancellery, September 15

At 6:30 p.m., Germany's state governors meet with Merkel. The chancellor has brought along Interior Minister de Maizière and Chief of Staff Altmaier. Gabriel is there as well.

Merkel tries to loosen things up with a joke. She learned from Seehofer, she says, that warm words and slogans don't really help. There is laughter, but the debate that follows is nonetheless unpleasant and the meeting quickly becomes bogged down in a disagreement centering on money and distribution quotas.

Because Gabriel has made it clear that the SPD governors are to go easy on Merkel, they focus their ire on Interior Minister de Maizière, who is already the object of intense critique. De Maizière explains what he has in mind when it comes to helping the German states and says that capacity for 40,000 asylum-seekers will be made available. But when he begins to list unused police stations and empty military barracks, the governors quickly interject. "They are already full," they say. The chancellor says: "Looks like that will have to be reevaluated by next week."

When the governors issue a demand for the Federal Interior Ministry to finally take over responsibility for the distribution of the refugees, de Maizière initially balks. The federal government, he says, has no jurisdiction over the issue.

Some shake their heads. It's not about questions of responsibility, they say, but about concrete assistance. Ultimately, de Maiziére gives in: "Okay, then we'll start on Monday." But by then, Seehofer says, Oktoberfest will have begun. It's too late. Merkel intervenes and says: "Okay, we'll do so starting tomorrow."

In the end, the meeting participants agree on creating space for 40,000 asylum-seekers. Seehofer, though, warns that this shouldn't be understood by the refugees as an invitation. "We can't create the impression that, because we have created 40,000 spaces, they must be filled," he says. Merkel promises that it is only about relieving pressure on the states, which is what she also says in the press conference later.

The meeting in the Chancellery reveals Merkel's weaknesses in the refugee crisis. Normally, Merkel shies away from symbolic action and prefers immersing herself in the details. This time, though, the opposite is the case. How the country should handle the huge numbers of new arrivals is completely unclear.

In Search of a Better Life

Can we do it? One thing is certain: Merkel underestimated the inviting power of her words and how attracted people would be to come to Germany in search of a better life.

But the refugee crisis has also changed Germany's image in the world. Suddenly, it is no longer burning asylum hostels and chanting neo-Nazis that are dominating the headlines. Rather, it is people welcoming refugees at German train stations with water and pretzels.

There are many who are now looking at Germany full of admiration, liberal America first and foremost. "Germany's road to redemption shines amid Europe's refugee debate," was the headline on a Washington Post op-ed written by Fareed Zakaria, one of the best known commentators in the US.

But among Germany's neighbors, Merkel's policies could also provide a significant boost to right-wing populist parties. In both France and Austria, the right wing has developed into a significant threat to governing parties. The right-wing Freedom Party of Austria leads the public opinion polls in the country at the moment while in France, it is far from impossible that Front National leader Marine Le Pen will become the country's next president.

One of the lessons from the euro crisis was that there is no longer such a thing as domestic policy in Europe. When the economy stagnates in France and pensions climb in Greece, it has consequences for everyone. The same is now true of Merkel's refugee policy. When she says that Germany's right to asylum has no upper limit, train stations in Vienna and Salzburg fill up and Hungary moves to build a razor-wire fence on its border with Serbia.

Merkel hopes that altruism can be infectious and that no European country can afford to continue standing by as refugees drown in the Mediterranean. Merkel has transformed the refugees into a gigantic political drama and has declared the crisis to be existential for the European Union. That was a mistake. Europe can't be allowed to break apart just because agreement can't be reached on the distribution of refugees.

A Small, Ugly Compromise

Merkel, of course, knows that, which is why her position has taken on an air of insolence. On Wednesday, European leaders will head to Brussels for a meeting to discuss the situation.

Indications are that a small, ugly compromise will emerge. It will encompass razor-wire fences, registration centers on Europe's external borders and money for countries like Lebanon and Turkey so that they might prevent refugees from heading westward in the first place.

And there will be a debate about Germany's basic right to asylum. Merkel says that one of the greatest challenges facing Europe in the coming years is that of agreeing on a unified, European right to asylum. But how should such a right look when countries like Hungary and the Czech Republic see providing shelter as little more than an act of mercy? Just as Germany was not able to create the euro in the exact image of the deutsche mark, Berlin will not be able to export its precise moral vision to the rest of Europe.

Still, Merkel's brief summer of humaneness was not in vain. It shamed politicians whose first reflex was to explain why help, once again, could not be extended. It showed that it is possible to break with political routine and it encouraged all those Germans who, absent instruction and invitation, followed their human instincts and welcomed the refugees.

That will remain. It made an impression far beyond Germany's borders, also in countries that have reason to look at Germany with some degree of skepticism. Born of the Holocaust, Israel was created as a guarantee that Jews would never again have to travel around the world in the search of protection from their oppressors and murderers. But now, a debate has erupted there too as to whether the country has an obligation to take in Syrians, regardless of their religion.

Prime Minister Benjamin Netanyahu has thus far categorically rejected the idea. But the Jewish historian Segev says: "We should learn from the Germans how to treat refugees."

By Nicola Abé, Melanie Amann, Hubert Gude, Peter Müller, Ralf Neukirch, René Pfister, Barbara Schmid, Christoph Schult, Holger Stark and Wolf Wiedmann-Schmidt

China Cannot Let This Happen

By: John Rubino

After borrowing -- and largely wasting -- $15 trillion during the Great Recession, China now looks like a typical decadent developed-world country, complete with slow growth, anemic consumer spending and unstable financial markets.

But it's not France, Canada or the US, where recessions happen and voters peacefully replace one major party with the other. China, within living memory, has seen civil unrest beget open rebellion beget multi-decade civil war.

Just as Germany is never going back to hyperinflation, China will not tolerate mass protests.

Which means it somehow has to find jobs for the tens of millions of citizens who aspire to middle class life. This need for growth at any price explains the borrowing/infrastructure binge of the past five years. And soon it will explain a massive devaluation/QE program. From Monday's Wall Street Journal:

China's Workers Stumble as Factories Stall

XIGUOZHUANG, China--For decades, an army of migrant workers drove China's boom times, flocking to its cities to sew T-shirts, assemble iPhones, or build apartment blocks and Olympic stadiums.  
The arrangement helped millions of poor, rural Chinese join a new consumer class, though many also paid a heavy price. 
Now, many migrant workers struggle to find their footing in a downshifting economy. As factories run out of money and construction projects turn idle across China, there has been a rise in the last thing Beijing wants to see: unrest. 
In Xiguozhuang, a village among cornfields some 155 miles south of Beijing, it had been rare to see working-age men for much of the year. This year, however, many of the men are at home, sidelined by a fading property boom. 
"Times are tough now," said Wang Hongxing, a 39-year-old father of three who has worked at building sites across China's northeast since his teens, but who has spent the past two months tending his farmland plot. "There are too many workers and wages are dropping." 
But for other migrants, especially those of a younger generation who took jobs in factories along China's coast, a return to farming isn't an option. Nor do they necessarily want to join the service sector China sees as a cornerstone in its shift to a new economic model. 
Wang Chao dropped out of school when he was 15 and left his home in Anhui province. After a series of jobs up and down China's east coast, he felt he had struck gold with a job in a textile factory near his hometown. 
The factory closed in July. Mr. Wang, now 19, and other workers gathered recently outside the factory premises to demand back wages. He says he is owed two months' pay, or about 2,000 yuan, or $320. The owner of the factory, which produces cheap trousers, told workers he is in deep debt and can't afford to pay them. He couldn't be reached to comment. 
Mr. Wang hopes he can find another factory job. In Shanghai, he worked in a restaurant but doesn't want to do that again. "Factory work is so much more comfortable in comparison, and better paid," he said. 
As a result of a rural-to-urban flow that many scholars say is likely the largest in history, roughly 55% of China's 1.37 billion people now live in cities, compared with just under 18% in 1978. 
The migrant workforce now numbers some 274 million but the pace of its expansion has slowed, and many economists believe China now faces a shortage of unskilled labor in urban areas. A mismatch of workers' skills and aspirations with actual labor demand has exacerbated the problem. 
...In August, after the factory a which made Power Wheels cars and other toys for Mattel Inc., shut its doors, hundreds of workers protested to demand unpaid wages.
Such unrest has become more common. China Labour Bulletin, a Hong Kong-based watchdog, has tracked more than 1,600 labor protests and strikes in China since January, already exceeding last year's overall tally of 1,379. 
The malaise has even affected workers at major state-owned enterprises. In May, thousands of workers staged protests over proposed layoffs at China National Erzhong Group Co., a debt-riddled machinery maker in Sichuan. Workers shared images on social media of banners criticizing company officials. One read: "360 yuan! How can we live on that!" 
In response to such disputes, local authorities have at times adopted harsh tactics, including sending police officers to break up strikes and detain protesters. But in some cases authorities have also sought to appease workers. 
The recent unrest is still far from the massive protests that swept over China in the late 1990s and early 2000s as state-owned enterprises laid off tens of millions of workers and local governments expropriated farmland around emerging cities for development. 
But the rise in frequency of strikes and protests has caused concern in Beijing, which in March urged bureaucrats across the country to prioritize "harmonious labor relations."

Take a surplus of young men (the result of China's one-child policy which put a premium on male children), combine it with a shortage of good jobs, and the obvious result is instability.

The equally-obvious solution? Easier money designed to get people borrowing and spending. So now it's just a question of which central bank is first to address its country's crisis (slow growth and a massive influx of refugees for the eurozone, slow growth and a demographic implosion for Japan, slow growth and global chaos for the US, and now slow growth leading to civil unrest for China) with a massive devaluation. China, given its history, might be the odds-on favorite.

Citibank Calls for Helicopter Money Drops across Globe

 By: Stefan Gleason
A quietly panicking Janet Yellen and the Federal Open Market Committee (FOMC) decided the U.S. economy still isn't ready for an interest rate hike last week and left the Fed funds rate at essentially zero - the same level to which the Fed's credibility has now sunk.

After incessantly hyping the notion an economic recovery would allow the "normalization" of interest rates, the decision not to act suggests the economy is much weaker than they have attempted to persuade us.

And it may be getting worse.

Injecting monetary stimulus is easy - any old fool can do it. Removing the extraordinarily easy money after cultivating an addiction in bond and equity markets over most of the past decade, turns out to be hard. Maybe downright impossible.

In any event, precious metals, which were shunned in the futures markets throughout the summer, finally got some love. Silver gained nearly 4%, and gold prices rose nearly 3% for the week.

Stock prices also rallied initially on the Fed's decision not to hike rates. But equity markets relinquished all of those gains on Friday. Wall Street has begun grappling with the possibility of a worldwide recession.

Citibank Fears a "Global Recession" Looms

The Chinese economy is sputtering and close to an outright stall. Brazil, Russia, and India - the other BRIC nations - are already in serious trouble. The malaise in emerging markets may well spread to Europe and the U.S.

Queue up the Keynesians...

According to Willem Buiter, chief economist at Citibank, "A global recession starting in 2016 led by China is now our Global Economics team's main scenario. Uncertainty remains, but the likelihood of a timely and effective policy response seems to be diminishing."

Here in the U.S., investors are once again taking note of storm clouds on the horizon. The S&P 500 fell 8% from its highs this summer. Buiter would like to see central bankers pouring on more monetary stimulus. In fact, he is calling for central bankers to pull out all the stops this time:
"Helicopter money drops in China, the euro area, the UK, and the U.S. and debt restructuring... can mitigate and, if implemented immediately, prevent a recession during the next two years without raising the risk of a deeper and longer recession later."

Central Bankers Looking for Cover to Implement Extreme Measures

But, for the moment at least, it appears unlikely central planners will act before recession strikes in developed economies. Perhaps officials need cover from a sharp economic downturn, and the attendant screams for help, before they can once again ride back out to the rescue.

With interest rates already at zero, the next step - be it negative interest rates, a renewal of quantitative easing, or dropping cash from helicopters - is a doozy.

Not something officials can do casually.

With central bankers across the world already weakening their currencies in a race to the bottom, investors should not be surprised to see the consensus for rate hikes in the U.S. completely vanish in the coming months.

Particularly if America plunges into another recession. That consensus could be replaced by expectations of a brand new stimulus program, either by Congress or the Fed. Or both.

Perhaps the central planners will even start mailing us all checks - early tax rebates or the like - so we go out and spend. Buiter's call for shoving money down everyone's throat is representative of the philosophy that pervades the Federal Reserve and Washington DC: There can never be too much stimulus or money creation. If stimulus is failing, it is simply because it is inadequate. It is time to double down.

Couple Buiter's request for "helicopter money" with his recent modest proposal to abolish cash - an idea gaining real traction with policy makers and the major banks - and you have everything you need to know about why it is important to hold physical gold and silver.