In the aftermath of last week’s shocking devaluation of the Chinese currency, markets remained focused on fragility in the broader emerging market complex. The ripple effect of increased uncertainty over the China outlook is not only impacting many other emerging market economies. It is also a key driver of supply-demand expectations in commodity markets and is taking its toll on  many other parts of the global economic system. Asset prices related to the energy or materials sectors, or to export-oriented regions in developed markets, like Germany or Japan, remain especially sensitive to shifting expectations about China’s future.  

The most fundamental challenge to the outlook for China and EM is the dangerous cocktail of a remarkably persistent decline in growth momentum and the lingering lack of structural reform. The growth weakness is partially a consequence of the macroeconomic imbalances that have built up in the EM region, specifically, excess credit that now needs to unwind. These same imbalances have meanwhile increased the urgency to act on the reform front.

Reform action is obviously needed in a broad range of areas. Readjusting an export-oriented growth model to make it more focused on consumption and the service sector, improving the institutional fabric by reducing clientelism and increasing the independence of policy-making, enhancing competiveness in product and labour markets and reducing rent-seeking opportunities through effective oversight and regulation are some key elements of the EM reform menu, but  different meals might have to be served in different countries.     

In China’s case a lot of the reform ingredients will have to be used to solve all of its current economic challenges, but policy-makers’ fading credibility seems to have fueled the fire recently. Against a backdrop of fundamental fragility, market perception of policy-maker credibility can be a key swing factor because it strongly influences the risk of negative feedback loop from markets to the underlying economy. Once FX, bond and equity markets start selling off because of falling policy-maker credibility, Chinese/EM financial conditions will tighten and add additional headwind to the growth outlook.  

This is a clear example of a shift in causality between fundamentals and markets, whereby  the economic outlook could become a function of current market behaviour rather than the other way around. This is also why the global economic system is a complex adaptive system. All components of this massive network influence one another, and information and causality can run both ways between the agents in the system. As a result, a path-dependent state of the overall system might emerge that mainly reflects macro fundamentals but adapts over time as new market forces come into play.
In such an economic ecology it is very difficult to determine when a bout of market volatility will calm down. The future path of the market will partially be determined by the extent to which current feedback loops from markets into the real economy change the growth outlook, and the outlook itself will again have become a function of the persistence of the current market turbulence. Causality can not only shift, but also run both ways at the same time. The relative weight of these cross-currents of economic information then becomes the dominant determinant of the future state of the overall system.  

Besides being complex and confusing, this underscores the importance of analysing the market itself and the behaviour of its participants. With respect to the EM and commodity volatility in recent weeks, it is noteworthy right now how large the consensus is, amongst active players in the markets, to be negative on these asset classes. Investor surveys show close to record underweight in emerging market equities, commodities and energy related sectors. Moreover, technically speaking, many of these assets have now reached “over-sold” levels.

Generally, these type of indicators can provide a contrarian signal, so a short-term bounce from the bottom cannot be excluded in these market segments at this point. How long these dynamics will last is also very difficult to assess ; some of the China/EM ripple effects into the underlying fundamentals can easily come back to haunt markets in the more medium term. For us, current investor behaviour is actually only a reason not to increase our underweights in the EM and commodity-sensitive areas as we keep fixed income spreads (large EMD/US HY weight) and commodities at medium underweights and remain underweight in both equity and fixed income space in the EM region.


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