On the EM Crisis?; A China Update; Lower Fat, Higher Carbs Lower Diabetes Risk!

From: aditya rana
Date: Sat, Sep 5, 2015 at 2:40 PM
Subject: On the EM Crisis?; A China Update; Lower Fat, Higher Carbs Lower Diabetes Risk!


It sure has been a tumultuous August, a mantle usually held by the month of September which has shown to be the worst performing month for equity markets over the last several decades. What was very unusual about the recent turmoil was that all asset classes suffered – developed market equities, developed market government bonds, emerging market equities, currencies , bonds, and commodities. The only assets which rallied were the Euro, the Yen, Gold and Greek government bonds (up about 20%)! In particular, EM assets suffered precipitous declines and various news reports carried headlines heralding the demise of the emerging market story. During turbulent times like these it’s best to keep focus on hard analysis and Research Affiliates put out a helpful note which analyses some of the myths currently prevailing about the fragility of EM economies. To summarise:

-The strength of the U.S. dollar and the expected interest rate hikes by the Fed is widely seen as a trigger for further troubles to EM economies. Balance sheet currency mismatches , weak commodity prices and negative market sentiment would put emerging economies at risk of repeating the Asian and Russian crises of the late nineties.

-Like many other stories that economists tell, this narrative sounds credible but the basic idea of a strengthening dollar threatening emerging market economies rests on three myths which are not supported by the data. To examine each further:

Myth # 1: Higher U.S. yields will cause more economic troubles to EM economies:

-Since higher rates can drive the cost of borrowing higher (both in local currency and dollar terms) for non-U.S. companies and governments, it is assumed that they are always bad news for EM economies.

-However, not all interest rate rises are the same and it is important to look at the underlying factors driving higher rate which fall under three types of shocks – money shocks (unanticipated central bank action to tighten monetary policy), real shocks (good news about the economy), and risk shocks (heightened risk aversion amongst global investors).

-An example of a money shock was when the Fed under Paul Volcker tightened monetary policy abruptly in the early 80’s to bring down persistent inflation. This surprise move pushed the U.S. economy into a recession and sent shockwaves to rest of the world. We are unlikely to be in a similar situation today.

-However, if higher rates signal a stronger U.S. economy, the rest of the world is likely to benefit from it as the U.S. is still the largest economy in the world. Stronger growth is also likely to positively impact investor attitudes to risk, and cause them to diversify away from an expensive U.S. market into global markets sparking a rally. Empirical evidence supports this narrative.

-Analysing the impact of higher yields in the U.S. and Europe, research has shown that when this is caused by stronger economic performance they invariably lead to higher capital flows into emerging markets and higher industrial production in the subsequent year.

-Analysing the dynamic relationship between annual changes in 10-year UST yields, changes in risk appetites (as measure by the VIX index) and annual EM currency returns versus the dollar over a 20-year period, it is clear that higher U.S. rates are positively correlated with returns on EM currencies and rising risk appetites (see chart below)..

-Looking at the relationship between volatility (as measured by annual changes in the VIX) and EM currency returns, it is also clear that investor sentiment is a key driver of EM market returns. As the graph below exhibits, the two series have a negative correlation of -.40, and over the last two and a half years the upward trend of VIX implying falling investor risk appetites can partly explain the underperformance of EM markets rather than simply looking at changes in underlying fundamentals.

Myth # 2: A strong dollar will exacerbate emerging market economic woes:

-This myth arises from drawing causal relations from simple correlations – i.e. if the dollar appreciates then emerging markets undergoe a period of stress, as they struggle to repay their dollar denominated obligations. While this may be a possible scenario, there are many alternative scenarios which are equally plausible. For example, in the past emerging markets have benefited from rising commodity prices which led to higher than potential output causing a real appreciation of their currencies. Now with commodity prices lower, these economies have slowed down and currencies had to adjust to balance current accounts, thereby ushering in a new growth phase.

-Given that differing dynamics can be in play at the same time, obfuscating the true drivers of economic performance, it is important to look at empirical evidence to draw conclusions about true predictors of financial stress. Recent research has shown that economic crises (defined as currency, banking and bond crises) have typically been preceded by a robust economy, rapid credit expansion and real appreciation of the local currency versus the dollar. Studying a large number of developed and emerging markets, researchers have found that real currency appreciation can be one of the strongest predictors of financial crises. So it can be plausibly argued that a stronger dollar may not be a predictor of a financial crisis, but simply be a by-product of a necessary adjustment process signaling economic recovery.

Myths # 3: Emerging markets are as likely now as in the past to experience a deep economic and financial crisis.

-The view that emerging markets are now as vulnerable to a financial and economic crisis as they were in the 90’s, belies the reality than emerging economies are no longer a homogenous group but rather a heterogeneous group with differing economic opportunities and challenges.

-Some emerging markets (e.g., Mexico, Thailand, South Korea, Poland, Chile, and Hungary) have actually cut their interest rates over the past year in contrast to the past when EM countries typically were forced to raise rates to defend their currencies. Like in the developed world, these economies are dealing with falling inflation and production with looser monetary policies, and weaker currencies are a part of their policy goals.

-Secondly, emerging economies have built larger pools of reserves subsequent to the 1997 Asian crisis (see chart below). The ratio of reserves to GDP have increased between 50% and 100% over the last 15 years, and most central banks today have reserves equal to at least 15% of GDP. This is particularly significant given that research has shown that higher foreign exchange reserves drastically reduce the probability of a full-blown crisis.

-Finally, emerging economies are today much richer and stronger than in the past, and they have been able to issue larger amounts of local currency debt insulating them from a real appreciation of their debt. For example, during the 2008-2009 financial crisis, they proved to be surprisingly resilient and suffered only a brief fall in output (especially in Asia) while output in the developed world collapsed under their debt burdens.


-1) An improving g economic outlook in the U.S. has typically been followed by stronger growth, rising risk appetites and capital inflows in emerging economies.

-2) A strong dollar is not the cause of problems in emerging markets – quite to the contrary, a stronger dollar is a result of an adjustment process that has typically led to stronger economic growth.

-3) Emerging markets are a heterogeneous group which have over the years built substantial reserves and a local currency debt market, making them less vulnerable to a crisis.

-Emerging market valuations have been dropping, setting the stage which historically has led to a significant rebound. They have uniformly been severely punished by fluctuating market risk appetite, and the old maxim “without fear, there are no gains” is likely to be repeating itself.

-A perceptive piece of analysis which makes a persuasive case to add EM exposure during this time of market stress, particularly in countries which have a sufficient foreign exchange reserves buffer to give added protection against a financial crisis. As I have noted in earlier letters, China and India should continue to form a core part of an investment portfolio, together with non-U.S. developed markets like Europe and Japan. As the chart below from Research Affiliates illustrates clearly, from a 10-year perspective they offer significantly higher expected returns compared to all other asset classes.

China Update:

-China has been implicated as a leading cause of the turmoil in global markets, with sharp corrections in its equity market, a contraction in monthly industrial production activity and a surprise devaluation of its currency. Is the situation really as dire as the financial pundits make it out to be? Unlikely, for the following reasons:

1)Economic rebalancing well underway:

-As the former Chairman of Morgan Stanley Asia, Stephen Roach notes:

-“China is making solid progress on the road to rebalancing – namely, a structural shift away from manufacturing and construction activity toward services. In 2014, the services share of Chinese GDP hit 48.2%, well in excess of the combined 42.6% share in manufacturing and construction. And the gap is continuing to widen – services activity grew 8.4% year on year in the first half of 2015, far outstripping 6.1% growth in manufacturing and construction.

-Services are in many respects the infrastructure of a consumer society – in China’s case, providing the basic utilities, communications, retail outlets, health care, and finance that its emerging middle class is increasingly demanding. They are also labor-intensive: in China, services require about 30% more jobs per unit of output than do capital-intensive manufacturing and construction.

-Largely for that reason, China’s employment trends have held up much better than might be expected in the face of an economic slowdown. Urban job growth averaged slightly more than 13 million in 2013-14 – well above the ten million targeted by the government. Moreover, the data from early 2015 suggest that urban hiring remains near the impressive pace of recent years – hardly the labor-market stress normally associated with economic hard landings or recessions.

–Services are also what make China’s urbanization strategy so effective. Today, approximately 55% of China’s population lives in cities, compared to less than 20% in 1980. And the share should rise to 65-70% over the next decade. New and expanded cities sustain growth services-based employment, which in turn boosts consumer purchasing power by trebling per capita income relative to that earned in the countryside.

-So, despite all the handwringing over a Chinese crash, the rapid shift toward services-based economy is tempering downside pressures in the old manufacturing-based economy. The International Monetary Fund stressed the same conclusion in its recent consultation with China, noting that labor income is now expanding as a share of GDP, and that consumption contributed slightly more than investment to GDP growth in 2014. That may seem like marginal progress, but it is actually quite rapid relative to the normally glacial pace of structural change – a process that began in China only in 2011 with the enactment of the 12th Five-Year Plan.”

2) Fiscal and monetary stimulus underway:

-As the research firm 13 D notes:

-“Ministry of Finance (MOF) made a 180-degree reversal of the fiscal policy from tightening to loosening in mid-May, and ordered banks to make sure local development projects approved before yearend 2014 will have access to funding. Fiscal spending picked-up after the first quarter, and in July, fiscal spending growth was 24.1% year-over-year, the highest in three months. Since March, the MOF launched a bond-swap program, which allows local governments to swap their maturing local government debt for MOF (central government) bonds. These measures suggest that Beijing is reverting back to its traditional stimulus mode (i.e., issuing bank loans and building infrastructure projects).

-The following chart from Capital Economics indicates that the Chinese government’s own budget projections point toward a sizeable fiscal stimulus boost for the second half of this year.

– PBOC cut interest rates by 25 basis points—the fifth cut since last November. Positive real interest rates provide the PBOC with more dry powder to lower interest rates in an effort to boost growth. Moreover, since there is now less need for China to maintain extremely-large foreign exchange reserves, there is plenty of room for the central bank to cut the RRR even further. (The RRR, it should be noted, was created to absorb excess liquidity during the days of large export surpluses.) The RRR now stands at 17.5% after the latest reduction, but it was actually in the single digits about ten years ago, suggesting considerable room for further reductions. In addition, the recent move to break the yuan’s semi-peg with the U.S. dollar provides the PBOC with more flexibility in achieving its goal of stabilizing domestic asset prices and stimulating the economy.

-More evidence of an acceleration of credit growth has emerged since the start of Q2. According to Ambrose Evans-Pritchard, credit growth (i.e., new bank loans issued) jumped to a 31-month high in July, as shown in the following chart. The monetary base has grown at 20% rate over the last three months.”

3) Housing recovery:

-“As Andy Rothman from Matthews Asia argues China’s housing prices are justified by the rising earning power of the average Chinese worker.

-One of the biggest misconceptions about China’s property market is that most buyers are speculators. In fact, the residential market is driven by owner-occupiers. Data collected from sales managers across the country reveal that during the past three years less than 10 per cent of buyers were investors.

-China’s 9 per cent average annual growth in residential property prices over the past 10 years may appear to be the hallmark of a bubble, but that was accompanied by 12 per cent average annual nominal urban income growth. Unprecedented income growth not only supports China’s remarkable consumption story, it also underpins a healthy property market. Over the past decade, both real urban and rural income rose by 7 per cent or more every year. In contrast, over the past decade real income rose at an average annual pace of 1 per cent in the U.S. and 0.3 per cent in the UK.

-Fundamental demand for housing remains healthy. There are around 13 million marriages every year, and new couples account for approximately one third of new home sales. Income continues to rise at a healthy pace and household savings increased by more than 300 per cent over the past 10 years to $8.5tn, greater than the combined GDPs of Russia, Brazil, India and Italy. Chinese are still likely to buy about 10 million new urban homes this year, almost double the number of combined new and existing home sales in the US last year.

-In the meantime, there have been some signs that previous declines in housing prices have either slowed or stabilized. The year-over-year declines in new home prices have narrowed from -6.1% in April to -3.7% in July, which was the smallest decline in eight months. In July, residential property prices rose in 31 of the 70 largest cities. In the first-tier megacities—such as Beijing, Shanghai, Guangzhou, and Shenzhen—home prices have been posting year-over-year gains for several months since the first quarter (as shown in the following chart). During the first seven months of this year, total value of property sales has risen 13.4% year-over-year.”

4) The Economist bookends the stock market correction:

-As noted in my newsletter dated 6/6: “The Economist carried a cover page in May, 2015 titled “Flying too high: China’s overvalued stock markets” and warned about the “economic dangers of China’s manic bull market”. As the technical analyst firm EWI notes, magazine covers convey conventional wisdom and are seldom (if ever) right in terms of calling an end to a secular bull market, though they can sometimes be right in calling an interim top. So while we are likely to see a correction lasting several weeks (or perhaps even a few months), the next phase of the uptrend should commence subsequent to the correction”.

-However, their recent cover page “The Great Fall of China” (below) was actually bookending the correction in Chinese stocks. As the late analyst Paul Montgomery observed several decades ago that magazine covers often publish cover stories on financial trends just as those trends are near exhaustion. So while the Economist did add to their track record of calling an interim top correctly, its warnings of continued market declines are a classic contrary indicator.

Lowering Fat, Increasing Carbs Better for Type 2 Diabetes

PRCM. Sept 1, 2015:

Vitale M, Masulli M, Rivellese AA, et al. Influence of dietary fat and carbohydrates proportions on plasma lipids, glucose control and low grade inflammation in patients with type 2 diabetes—The TOSCA.IT Study. Eur J Nutr. Published online August 25, 2015.

-Reducing dietary fat while increasing carbohydrate intake is best for type 2 diabetes, according to a study published online in the European Journal of Nutrition. Researchers followed the diets of 1,785 type 2 diabetes patients as part of the TOSCA.IT Study. An increase from less than 25 percent to 35 percent or more in dietary fat intake raised triglycerides, LDL cholesterol, and HbA1c levels, while an increase from less than 45 percent to 60 percent or more in complex carbohydrate intake lowered all of these levels. Increasing fiber and lowering added sugar intakes also had positive effects on cholesterol and blood sugar levels. This is the first study to show that small changes in fat and carbohydrate intake affect metabolic risk factors in a large population of type 2 diabetes patients.

Here’s to increasing complex carbohydrates in your diet, at the expense of fat and meat!




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