Whatever happens in China, the US, Europe or emerging markets, one thing is absolutely certain: the global economy is slowing and with it, corporate earnings. Now that is a real terror
 
For most of the worlds’ markets the summer has been quite kind. Traders departed for the mountains or the beaches and left the machines in charge. Since algorithms have only Zen-like concentration, they never worry about the future. They only concentrate on the present. Which way is the momentum moving? Where is there an arbitrage? Markets also benefitted from both the threat by Ben Bernanke of the US central bank (Fed) and the most recent attempt by Mario Draghi and the European Central Bank to put a floor under the bond markets. But are these actions going to prevent the real problems from rearing their ugly heads. Probably not, for there are five very strong reasons to “Fear the Fall”.

The first and most obvious problem is Europe. The bond-buying program announced last week by the ECB might help save the euro, but it won’t help save the European economy. The program is subject to certain ‘conditions’. No doubt these will require more austerity, which is guaranteed to exacerbate the present recession. The ECB was also very clear that their program would not provide any additional stimulus. It is supposed to remove as much money from the system as the bond buying creates. So although the bond buying program will bring some temporary stability, it may prevent changes necessary to return the Eurozone to growth.

The second issue concerns the United States. In a rather bizarre effort to deal with a bitter partisan divide, the US Congress created a process where disastrous automatic budget cuts would occur if comprise wasn’t reached. Compromise wasn’t reached. These budget cuts along with the expiration of tax cuts will occur automatically on 1st January unless something is done. The combination of a plunge in government spending and a rise in taxes will push the US into recession. The problem can really only be solved by the November election. There is little doubt that some solution will be found, but only at the very last minute. In the meantime the uncertainty will weaken the present anaemic growth.

The third and potentially most devastating is that the promised “soft landing” in China has become harder with every data point and may evolve into a crash. Years of state capitalism have created an economy that is so distorted that it is difficult to find a sector that is not subject to over capacity, over supply or a credit bubble. Real estate restrictions are unlikely to be removed, because the real estate market hasn’t died. What have died are the land auctions that support local governments and their ability to repay massive loans or provide the promised stimulus. Economic weakness in the rest of the world makes it unlikely that the Chinese export market will return to health. Without buoyant export and real estate sectors, the credit pyramids and shadow banking systems create a huge possibility of a systemic failure.

But what happens in China won’t stay there. China’s booming economy was the crucial factor in the growth of most of other emerging markets. China dependency is a real issue especially in Asia and Latin America, but also for 135 companies in the S&P 500 index. Large profit expectations did not come from US or Europe, but from the emerging markets.

The fourth problem is that the overleveraged credit issues thought to be the preserve of developed countries have migrated en masse to the emerging markets. China is not the only emerging market with credit issues. Although many of the large banks, the ones that reach most analysts’ radar screens, in emerging markets are generally considered healthy, almost without exception there are parts of the financial systems of each emerging market that are in serious trouble. Like smaller institutions in Europe, many of these have major transparency issues. So a collapse will come as a surprise.

The fifth issue has to do with inflation. Inflation in developed countries isn’t an issue, at least for now, but the same cannot be said of other countries. A major drought in the US and India coupled with problems in Russia and the Ukraine and infrastructure issues in Brazil all add up to higher food prices. The recent spike in energy prices also doesn’t help. These issues weigh proportionally greater on emerging markets, since food makes up a larger part of consumers budgets and fuel subsidies drain national budgets.

The probability for each of these events is certainly high, but it is not the events themselves that are relevant to investors. Investors invest in companies, not countries. Whatever happens in China, the US, Europe or emerging markets, one thing is absolutely certain, the global economy is slowing and with it, corporate earnings. So the real fear is the reaction of the market when expectations of double digit growth dissipate. Now that is a real terror.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected].)