Baur, who spoke to FSA on a recent trip to Hong Kong, said the first wave of global financial contagion was the US housing market collapse, the second wave was Europe’s sovereign debt crisis and the third repercussion could come from the high levels of debt in emerging markets.
“EMs have too much excess capacity and [sovereign] debt has risen to high levels, at least in China.
“Outside China it’s mostly corporate debt because most governments learned the lesson in 1998 to have less debt and a smaller trade deficit.
“Corporate debt is pretty high. A lot of capital went into emerging market debt during 2009-2011 because of the huge difference in interest rates. The decline in [local] currencies made the dollar-denominated debt hard to pay back.
“Corporates are seeing profits fall, cash flow dry up, interest rates rise, and liquidity tighten. If it continues over the next 1-2 years, it will be a big headwind for the EM world.”
Other risks this year include high yield bond defaults spreading outside the energy sector and the potential for China’s currency to undergo a steep devaluation.
“With high yield debt, the worry is that if the [energy] sector shows a lot of defaults there will be contagion to rest of the bond market, even if fundamentals of the US economy are good.”
In regards to China’s currency, Baur believes authorities are not interested in steeply devaluating the RMB. “China wants a stable currency during its economic transition and that’s a lot easier with strong currency so consumers can buy from abroad.
“Chinese authorities have not lost control of their currency by any means,” he added. “That’s a market fear we don’t agree with.”
The QE myth
The US Federal Reserve has said it intends to hike interest rates four times in 2016. Baur believes it will be a maximum of two times because wages are growing only modestly in the US.
“If faster wage growth is reflected in actual data, then we will have rising inflation expectations and mildly rising interest rates.”
And speaking of QE, Baur believes the conventional belief that inflation will flare as the Federal Reserve buys bonds was turned on its head.
“In the very long run, easy money probably brings as much potential for deflation than inflation. When money is easy — and we’ve seen it in shale oil — projects with a low internal rate of return get built. The result then is an overbuilt sector, then deflation, as supply more than keeps up with demand.”
Low oil prices are a result of oversupply, not demand, and they have pressured shale oil companies to figure out how to reduce costs, he said.
“They’re reusing water instead of just one time use or drilling in not just one horizontal direction but several directions in one vertical drop.”
“They’re making production cheaper, which means oil is probably not going to rebound. As oil rises to $40 a barrel, shale producers pick back up — putting a cap on any rebound.
“With easy money, producers keep producing. In the long run easy money is more likely to bring deflation.”
