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Schroders fund managers ring alarm bells on emerging markets

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Portfolio managers at UK asset manager Schroders have warned of imminent crises in China and other emerging markets, and their impact on popular investments themes such as emerging market debt and the emerging consumer.

Making the case for European high-yield bonds at Schroders’ International Media Conference on 14 November, senior portfolio manager Konstantin Leidman contrasted Europe’s lack of loan growth through the crisis and recession, which is keeping a lid on both yields and defaults, with China’s annual credit expansion of 30-40% over recent years, to levels approaching three-times GDP.

“I don’t have the words to describe the situation in China, really,” he said. “It is in the emerging markets we see real deterioration, already evident in places as diverse as Brazilian mining, Slovenian banks and the over-extension in Turkey.”

He added: “The next episode of defaults will be in the emerging markets, and the casualty will be the emerging consumer because the rescue will destroy their savings and, of course, the companies that depend on that consumer.”

Leidman’s critique might be dismissed as a European bonds manager talking his own book, were it not for the fact Geoff Blanning, head of emerging market debt and manager of the (long-only) Schroders Emerging Market Debt Absolute Return fund, gave an even gloomier assessment of his asset class in a later session at the conference.

Blanning also likes Europe, where he feels risk has declined “dramatically”.

His fund has been an owner of Greek government bonds since last year – a move that he admitted led to significant assets heading for the door.

He points to its newly achieved current account surplus and the extent to which its stock of traded debt has shrunk thanks to the 2012 restructuring.

He also pointed out that the country is already discussing a return to the bond markets.

By contrast, Blanning sees the long period of underperformance by emerging market equities as the canary in the coal mine for emerging market debt, which he argued, held up until this year only because of investors’ desperate search for yield.

Despite relatively tight spreads, Schroders’ quantitative scoring model, covering 80 countries, has seen its average score deteriorate since 2006, to the extent it is now about as low as it was immediately before the Russian debt crisis of 1998.

“The current valuations are not justified,” he said. “The risk is much greater than many people think.”

He singled-out Turkey’s vulnerability after years of domestic credit expansion and capital pouring in from overseas.

“The worst country in the world today is Turkey,” he said. “Its current score is the worst any country has ever had in our model.”

However, if Turkey is in bad shape, China’s score is deteriorating the fastest.

Like Leidman, Blanning points to the massive bank credit expansion China embarked upon in response to the global financial crisis.

“I was positive on China until as recently as two years ago,” he said. “But now I am persuaded it is going to see a major, major banking crisis. The Chinese authorities have ruined their banking system – people just haven’t accepted it yet.”

When IPE asked what China could do to avoid his predictions from becoming reality, Blanning said the idea that China’s economy is growing at 7-8% is “fanciful” (he put it at more like 3-4%), and that the only solution would be for the authorities to print money to buy-up huge amounts of its banks’ equity.

However, he pointed out that this would be highly inflationary, causing the renminbi to decline sharply and a consequent capital flight.

“The best thing China can do is implement really aggressive reforms to open up its economy,” he said, “but, given the economic metrics we see, I can’t imagine how a crisis can be avoided.”

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