While many experts are pointing to the Chinese banking system as the primary source of concern in the world’s second largest economy, Riddell (pictured) believes the outlook for GDP growth is much more worrying, and could see it go down the route of Japan, which has been crippled by deflation for more than 20 years. He highlights emerging market debt as an asset class that could come under particular pressure, but also believes the economic performance of a number of developed and emerging economies are at risk.
"Commentators have focused on the drying-up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown," he explained.
"There is much speculation as to why SHIBOR has soared, [but] the spikes are nothing new – there was a near replica of the current SHIBOR spike exactly two years ago."
"A much bigger, longer-term China worry is that market participants still believe that China can grow at 7 per cent-plus ad infinitum, but I can’t see any scenario under which this is actually possible."
Riddell highlights waning competitiveness and poor demographics as the principal reasons for his bearishness.
"China’s wages have doubled since 2007 and its currency has appreciated 25 per cent against the euro and 35 per cent against the US dollar since China dropped its peg in 2005," he explained. "Competitiveness has therefore significantly weakened."
"Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen."
"If you add that an enormous demographic time bomb is starting to go off in China, its long-term sustainable growth must be considerably lower than consensus expectations."
"My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and emerging market debt in particular."
"If you like clichés, China is in effect 'turning Japanese', but unlike Japan, it has grown old before it has grown rich."
Riddell points to acute comparisons between what happened to Japan’s GDP growth rate as it rebalanced away from an investment-led model and towards more of a consumption-based one in the 1970s to 1980s, with what is happening in China now.
As investors will be all too aware, Japan is the worst-performing equity market of the last two decades, in spite of its recent renaissance.
Performance of indices over 20yrs
Source: FE Analytics
"When investment as a percentage of GDP falls, then the GDP growth rate falls too. Everyone accepts that China must reduce investment and increase consumption, but few people acknowledge that this means that China’s GDP growth rate will slow considerably," Riddell said.
"I continue to believe that emerging market and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes – such as Australia, South Africa, Indonesia, Chile, and Brazil – are acutely vulnerable."
Emerging market debt, which had previously had an excellent decade long-run, has seen a sharp sell-off in recent weeks, followed by sharp outflows from its funds.
Performance of emerging market debt funds over 10yrs
Source: FE Analytics
According to FE data, on average, emerging market debt funds have lost around 10 per cent over the last month.
Riddell thinks emerging market debt is now more attractively valued and although he believes an all-out crash in the asset class is still unlikely, he says he remains wary of it.
"In sum, emerging market debt now offers relatively better value than it did a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble. That doesn’t mean I’m bullish," he said.
"It will take a much bigger sell-off in emerging market debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.”
"The recent EM debt sell-off probably isn’t yet The Big One – it is more of a tremor. The Big One will probably need either US growth and inflation surprising considerably to the upside, or China surprising to the downside."
"If that happens, then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in."
"Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978 to 1985, 1995 to 2002) have been coupled with EM crises," he added.
Riddell himself heads up an emerging market debt fund, making his weariness of the asset class all the more telling.
He has run M&G Emerging Markets Bond since February 2010 and has returned a little over 13 per cent since then. This is marginally more than its IMA Global Bonds sector average, though the fund has been far more volatile.
Performance of fund vs sector since Feb 2010
Source: FE Analytics
Riddell also runs M&G International Sovereign Bond and M&G Index Linked Bond.
