Stocks fell hard over the past month, with the U.S. indexes are off around 25%, while London (EWU) is down 30%, China’s market (FXI) is off 35% and Latin America (ILF) is down 45%. Yes, that’s one month.
It’s tempting to be glib and say that Halloween came early, but unfortunately I do still think that there is more of the same on the near horizon. The debt and currency fiasco brewing in Eastern Europe and Latin America is just barely beginning to nick the consciousness of U.S. investors to the extent that it has already freaked out European investors, and the implications are painful.
The blowup of bad loans in the emerging markets of Russia, Ukraine, Serbia, Hungary and elsewhere in the old Soviet bloc, as well as in Latin America, is likely to be worse than anything we saw from U.S. subprime loans.
Most of the exposure in Eastern Europe was held by banks on the Continent in border economies like Austria and Germany, but there is a mess of exposure to Argentina, Brazil and other South American basket cases in Spain and the United Kingdom, as well as in the United States. It’s hard to believe that these emerging markets have gone from perfect world citizens in raging bull markets 10 months ago to lepers now, but that is the nature of a de-leveraging contagion.
As I’ve mentioned before, in a slightly different context, what we’re seeing is the effect of feedback loops: What started as a residential construction slowdown in the United States has led to lower commodity demand and prices; a decline in industrial activity; a plunge in Chinese growth rates and global shipping rates; a cut in the cash flow available to pay off loans in mining projects in emerging markets; and distress among banks, hedge funds and pension funds that have lent them money. All result in a contraction of credit to everyone, which exacerbates all of the above. Rinse and repeat.
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This is the old problem in financial circles. If I owe $1,000 and can’t pay it’s my problem. If I owe $1 million and can’t pay it’s the bank’s problem. If I owe $100 million and can’t pay, it’s the problem of people who lent money to my bank.
That’s why we can’t look at pending debt default in the Ukraine or Iceland and say it’s not our problem. It is. Data from the Bank for International Settlements shows that Western European banks account for three quarters of the $4.7 trillion in loans to Eastern Europe, Latin America and emerging Asia in the credit boom. That figure is far larger than the scale of U.S. sub-prime.
Europe is also staggering with losses in Iceland of $74 billion, of which $22 billion came from Germany. Yes, that’s just Iceland!
The Telegraph newspaper of London quoted Stephen Jen, currency chief at Morgan Stanley, stating that the emerging market crash is a vastly underestimated risk that threatens to become “the second epicenter of the global financial crisis”, this time unfolding in Europe rather than America.
Austria, Germany, Spain on the hookThe Telegraph noted that Austria’s bank exposure to emerging markets is equal to 85% of its GDP, with heavy concentration in Hungary, Ukraine, and Serbia, all now queuing up for rescue packages from the International Monetary Fund. The paper reports that exposure is 50% of GDP for Switzerland, 25% for Sweden, 24% for the United Kingdom and 23% for Spain. In contrast, somehow the United States managed to sideswipe this crash with exposure of just 4%.
Where could matters worsen? Well, BIS statistics show that Spanish banks alone have lent $316 billion to Latin America — twice the lending by all U.S. banks combined. So even though the Spain exchange traded fund (EWP) is already down 50% this year due in large part to Madrid banks’ exposure to their own domestic property crash, it has room to fall further as Argentine and Brazilian stocks, debt and property all plunge into a death spiral.
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While London and Wall Street have largely sat out the exposure to Eastern Europe, their greatest exposure is to Asia. The Telegraph reports U.S. banks’ exposure to emerging Asia a s $329 billion, or as much as the U.S. and Japan combined. So the next time you hear that Malaysian air carriers or Indian steelmakers are under threat of default, chances are that a lot of exposure lies in British citizens’ pension portfolios.
In summary, rapidly weakening emerging market debt and currencies are the new subprime, but on a global and much larger scale. I do not think this is fully discounted in bank analysts’ models. If that’s so, then more write-offs lie ahead — not from U.S. residential real estate, but from Serbian steel mills.
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This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.