Stuck between Europe and China

Rapidly declining world growth has been causing difficulties for stock markets in the emerging world year. In the spring it was US growth that first came under pressure. Escalation of the Eurozone crisis then prompted recession fears in not only Europe but also the US. Just as in 2008, China finally followed suit. Sensitivity to negative world trade growth and doubts as to the options for effectively stimulating domestic demand have substantially suppressed the Chinese stock market in recent months. Concerns for Chinese growth largely explain why emerging markets have underperformed developed markets this year.

While Europe muddles through and appears unable to save the monetary union, China is taking serious steps towards a firm package of stimulation measures. The initial signs are clear. For the first time since the early 1990s, local governments are permitted to issue their own bonds. The capital is destined for infrastructure investments. That decision was made last week and was the first policy move towards stimulating domestic demand. In the meantime, buyer restrictions in the housing market are gradually being relaxed and a support package for smaller businesses has been announced.

For investors in emerging markets, the positive dynamics in China, on the one hand, and the malaise in Europe, on the other, are causing perplexity. Sensitivity to improving Chinese growth prospects is high, given China’s importance as main buyer of emerging markets exports. So when investors gain more confidence in effective stimulation measures in China, that is a strong positive signal for the whole emerging markets investment category.

The trouble is that the positive effect of China could be entirely cancelled out by further escalation of the Eurozone crisis. The risk for banks and the total economy in Europe is high as long as national leaders fail to agree on a sustainable solution to the debt problem. That system risk is so overwhelming that it is difficult to make investment decisions based on other developments outside Europe, such as the recent good news from China.

Generally, when the biggest commodities buyer in the world embarks on a large-scale stimulation policy, then investors immediately look to markets such as Russia and Brazil. Those same two markets are not only sensitive to changes in commodity prices; they are at least as sensitive to investors’ willingness to take risks in general. And who wants to add risk to his portfolio just as the first banks in Europe are beginning to go under and Berlin and Paris have yet to come up with a plausible policy solution?