HONG KONG/SINGAPORE -- In early October, as investors were dumping stocks in emerging markets from China to Argentina, veteran Wall Street investor Byron Wien sent out a memo to his clients. "The major question confronting investors is whether the U.S. equity market can continue to move higher when the rest of the world is experiencing an economic slowdown, political turmoil and trade disputes," Wien, vice chairman of the Blackstone Group, wrote.
He cited past examples when U.S. investors remained calm even as emerging markets collapsed around them. But then he introduced a note of caution. "If the economies of Europe and particularly China weaken seriously, that could have an impact" on American stocks.
Less than a month later, that "if" scenario was looking more likely. On Oct. 24, major U.S. indexes sank more than 2%, wiping out all of the gains they had made in 2018. By Oct. 29 the S&P 500 Index was down 9.9% from its record high reached in September, as American investors worried about the impact of rising rates, slowing economic growth and trade friction between the U.S. and China.
Such worries had already been tormenting Asian markets for months. Indonesia, the Philippines and India have watched their currencies slump due to the strengthening U.S. dollar, while fears of an economic slowdown have hit South Korea. Chinese stock markets have been under pressure for much of the year, falling into bear market territory as the trade war began to hit manufacturing and consumer sentiment.
After so much selling, many investors will be looking for an opportunity to buy cheaper shares. Indeed, Asian shares rallied Nov. 2 after US President Donald Trump tweeted that he had “a long and very good conversation” with Xi Jinping, his Chinese counterpart.
The two leaders are expected to meet on the sidelines of the G20 summit in Argentina later this month, offering hope of a thaw in US-China trade tensions.
Jim McCafferty, head of Asia equities ex-Japan at Nomura, told the Nikkei Asian Review Oct. 30 that a potential meeting between the two leaders could form the basis of a trade war detente. With the midterm elections behind him after Nov. 6, Trump will be able to focus "on getting some kind of resolution with China," he said.
McCafferty added that the governments of South Korea and China have moved to support stocks, with Seoul setting up a multimillion-dollar fund to buy shares.
Still, some of the catalysts for the recent downward moves may not be going anywhere soon. The U.S. Federal Reserve is expected to continue raising rates through 2020, which could keep pressure on emerging market currencies. The full impact of the U.S.-China trade war has not been felt yet by companies or consumers. And worries about the Chinese economy remain.
The Shanghai Composite Index, one of China's major stock indexes, has fallen by about 28% from the high it reached in January -- a plunge that prompted officials in Beijing to try to reassure the public and ramp up economic stimulus. According to state-run media, Xi offered "unwavering commitment to the private sector," while Vice Premier Liu He said the recent market sell-off was "creating good investment opportunities for the long term and healthy development of the stock market."
Despite their comments, there is a growing view that China has more to lose than the U.S. in an all-out trade war. The Trump administration has imposed tariffs on $250 billion worth of Chinese products, and Beijing has retaliated with levies on $110 billion worth of U.S. goods. This has already cast a dark shadow over the Chinese economy, and there are fears that an escalation of the tit-for-tat tariffs could harm growth further.
In a survey of China economists by Nikkei and Nikkei QUICK News, a "worsening U.S.-China trade war" was the most commonly cited risk factor facing the economy.
AXA Investment Managers Asia estimates that an "all-out trade war" could push China's GDP down by as much as 1.5%. Tetsuji Sano, economist at Sumitomo Mitsui Asset Management predicted that the Chinese government will lower its growth target to 6% from the current level of around 6.5% next March.
The GDP growth rate in the July-September quarter was 6.5%, below forecasts and slightly below the 6.7% logged in the second quarter.
Looming in the background are a number of structural problems in the Chinese economy, some of which long predate the trade friction.
First is its reliance on "shadow banking" -- higher-risk financial products and lending provided by nonbank institutions. This nonregulated financial activity is opaque and has been cited repeatedly as a potential flashpoint for the Chinese economy. Regulators have sought to control it over the past year, but this tightening contributed to a slowdown in real estate investment and other sectors. Moody's has said that the government has recently loosened credit conditions to stimulate growth in the face of slowing growth and the U.S. trade dispute.
Another problem is collateralized finance. In China, companies often borrow money using their shares as collateral. In the current bear market, the value of this collateral has eroded, causing a vicious cycle that has contributed to a further decline in stock prices. For these companies, the result can be dangerous: some have faced margin calls and forced liquidations.
In a report on Oct. 23, S&P Global Ratings noted that the market value of all shares pledged for stock-based borrowing in China stood at 5 trillion yuan at the end of September. Falling stock prices mean that cash-strapped owners "may extract funding from listed companies through higher dividend payments or other means, creating financial burdens on the listed entities themselves," S&P said.
Alexious Lee, an analyst at CLSA, said the sell-off in Chinese stocks shows that investors "are in panic mode over margin calls from pledged shares spilling over into the main board for liquidity" from the Shenzhen Stock Exchange's ChiNext board of small-cap shares.
The stock market turmoil is having an impact on Chinese companies. On Oct. 25, China Life Insurance said its net profit for the January-September period fell 25.9% from last year to 19.87 billion yuan ($2.86 billion), dragged by "significant decrease in equity income in open market due to the dramatic volatility in domestic capital market."
The pressure has also hit China's currency, which on Oct. 24 fell to its weakest level since the global financial crisis in 2008.
Mixed bag for ASEAN
The upheaval in China's financial markets extends to the Association of Southeast Asian Nations. Although the region's economies and markets are seen as relatively stable compared to those of other emerging countries, the risk of capital outflow is becoming increasingly serious.
U.S.-China trade friction is not necessarily bad for Southeast Asia. A number of companies have been shifting production from China to ASEAN countries -- including Vietnam and Cambodia -- to escape new U.S. tariffs. The International Monetary Fund has downgraded its growth rate forecast for emerging and developing countries around the world in 2019 by 0.4 point, while the downgrade for the five big ASEAN countries is just 0.1 point.
Benjamin Shatil, executive director in charge of emerging Asia economic and strategy research at JPMorgan, said, "This region is going to be more resilient even if we have external uncertainties -- trade war, Fed tightening and that sort of thing."
Although such resilience should be an advantage for ASEAN economies, market conditions have still been harsh. In the Philippines and Singapore, stock indexes have declined by more than 10% since the beginning of this year. Even more serious is Indonesia, where the rupiah has plumbed its lowest levels since the 1997 Asian currency crisis.
Concerns about Asian share prices and currencies are rising as the U.S. Federal Reserve continues its rate hikes. The Federal Open Market Committee is widely expected to raise rates at its December meeting, followed by two more hikes in 2019 -- moves that have reminded some investors of the 2013 "taper tantrum" sell-off in emerging markets. Back then, the assumption was that the invested capital would flow out of the emerging countries with low interest rates back into the U.S.
At the time, Indonesia was dubbed one of the "fragile five" -- a collective term for emerging countries whose currencies were likely to be sold. The central bank of Indonesia held its rates steady at its monetary policy meeting on Oct. 23, following five hikes this year to protect the currency. Market participants view a further rate hike as unavoidable.
Katrina Ell, economist at Moody's Analytics, told the Nikkei Asian Review, "The rupiah has already fallen over 12% this year, and a further 1% to 2% depreciation is likely by the end of the year as the Fed continues to tighten, putting upward pressure on the greenback. This would bring the rupiah to the range of 15,300 to 15,450 [against dollar] by the end of the year. We expect at least one further 25-basis-point hike, likely mid-December to coincide with Fed's next hike."
'Every nation for itself'
As the Fed raises rates from the ultralow levels employed to fight off the effects of the 2008 financial crisis, the world must contend with another legacy of the downturn: excessive debt.
Governments, households and -- above all -- companies borrowed cheap money after central banks employed "quantitative easing" policies to stimulate crisis-hit economies. The Institute of International Finance notes that global outstanding debt swelled to 3.2 times world GDP by the end of March, up from 2.9 times 10 years earlier. According to Timothy Adams, CEO of the IIF, a number of enterprises will find it difficult to refinance their debt. "Over the next one to three years, it could have [an adverse] impact on economic activities and future investment."
International cooperation is required at such times, but instead there is friction. During a meeting of G-20 finance ministers on the sidelines of the IMF/World Bank Annual Meeting in Bali in October, countries were so divided that they could not even agree on a joint statement.
Ian Bremmer, president of Eurasia Group, who attended the IMF/World Bank meeting, lamented the lack of urgency in responding to these challenges. He contrasted the current international climate to the financial crisis in 2008, when all of the world's major governments recognized the need to act.
"Today, leading participants at international confabs like the G-7, G-20, the United Nations and the IMF take an 'every nation for itself' approach," he said.
On Oct. 23, Masahiro Ichikawa, a senior strategist at Sumitomo Mitsui Asset Management, reviewed the global risk situation in a memo for customers. He analyzed five risks: the U.S.-China trade war, U.S. midterm elections, Italy's financial problems, Brexit, and the fallout from the killing of journalist Jamal Khashoggi by suspects thought to be linked to Saudi Arabia.
"None of these in the end will seriously damage the financial markets or the world economy, but it will take a bit more time before the market concerns are relieved," he concluded.
While some have speculated U.S.-China tensions will ease after the midterm elections, others believe the trade war is just beginning. "It would last about 20 years," Jack Ma Yun, chairman of China's Alibaba Group Holding, predicted in September. Teruo Asada, chairman of Marubeni Corp. in Japan, has said that "there is a possibility that the trade war between the U.S. and China will last for 10 years to 20 years."
Some are more optimistic. At an investor event in September, Lim Chow Kiat, chief executive of GIC, a sovereign wealth fund of Singapore, emphasized the positive story of demographics and growth in Asia's emerging markets. "Emerging markets are currently going through a bit of turmoil, especially in the financial markets. But technology disruptions can be even more powerful in developing or emerging economies." He continued: "Their populations tend to be younger, and they take to technology in some ways faster and better."
This story was updated on Friday, Nov 2 to reflect market movements following President Donald Trump's comments on his conversation with Chinese President Xi Jinping
Nikkei Asian Review deputy editor Dean Napolitano in Hong Kong and Nikkei staff writer Kentaro Iwamoto in Singapore contributed to this report.