From the beginning of the 1980s, we’ve depended on globalization to expand economic opportunities — first with the entrance of emerging countries into the global workforce and capital markets.

 

Later that decade, the end of the Soviet Union brought another vast population and territory into the global marketplace. Increasingly we’ve looked to China to create new consumers and expand demand for the goods and services produced by developed markets. What are the third-order effects if the world is on a slower trajectory of growth in the longer term?

 

Trade as the engine of global GDP

 

World trade in the 1980s, 1990s and early 2000s had a beta to global GDP that was greater than one, meaning that trade was growing faster than GDP. That relationship was synergistic, with growth creating more trade that created more growth and so on. During the current cycle after the 2008 financial crisis, however, trade and GDP have been growing at about the same pace. Can trade continue as the same engine of global expansion that it used to be?

 

Many factors have created increasing obstacles to trade. Demographics trends are less powerfully positive than in earlier decades. While lower taxes were a hallmark of the 1980s and 1990s, higher taxes may be necessary to support aging populations. Deregulation was once a common global theme, but climate change and financial excesses have brought us into a new regime of reregulation. Where we had been levering up, now credit may still be rising even though the leverage beneath it is declining. Taken together, these conditions put us in an environment of global excess supply with a process of globalization that appears to be on hiatus at the moment.

 

Exposure to China

 

To gauge the direct impact of China’s slowing on growth in the rest of the developed world, we can look at exports, foreign direct investment, banking exposures and portfolio flows to China as well as competition against Chinese products in export markets. With the exception of a resource-driven country like Australia, direct exposures generally seem fairly limited for most developed countries.

 

Where developed markets are likely to feel more impact is through indirect transmission  mechanisms or secondary channels. We have seen that China matters more to other EM

economies than it does to developed markets. In aggregate, however, those other emerging economies do create increased vulnerabilities for the developed world. In addition to Australia, exports to all emerging markets — not just China — represent a notable share of GDP for a number of countries.

 

Bear in mind that this analysis looks only at export exposure. There are also exposures to banking, investment and many other elements of the global markets that can be negatively — albeit indirectly — impacted by China.

 

Consequences for investors

 

Clearly, China’s slowdown has affected global growth and financial markets through a variety of channels. One further transmission mechanism has been China’s exporting of commodity price disinflation as its demand for these raw materials of production has waned. This, in turn, has capped the pressure on central banks — specifically the Fed — to tighten monetary policy to avert the threat of rising inflation.

 

Otherwise, we don’t perceive the direct trade linkages to China as cause for alarm in the developed world outside of Asia. In the United States, for example, trade in merchandise and services has been running at 30% of GDP since 2010. Trade with China has accounted for only 1% of US GDP, one-third as much as trade with Canada. Admittedly, Canada’s resource exposure to China may have put this primary US trading partner into a technical recession, but Canadian imports from and exports to the US have continued to rise.

 

China’s impact on Asia has been greater, especially in Taiwan, Korea and Singapore. And we’ve seen the secondary effects flow through to the countries that are big commodity exporters, such as Russia, Venezuela and Brazil. Given these economic struggles and the poor sentiment about emerging markets, should investors be considering their stock markets as good value plays? In our opinion, even though EM valuations do appear attractive on a top-down basis, returns on equity and capital have been declining and profitability remains relatively low. We have yet to see much of a catalyst to alter the earnings picture.

 

If growth-boosting government policies allow China to stabilize over the coming quarters, might these emerging economies experience a bounce? Many of these countries tend to be reliant on trade and exports, and such second-order effects may take even longer to come about. The emerging world is no longer a simple, binary risk-on or risk-off, but rather a more selective market where it can pay to take an active approach and know the specifics of each country and company. For EM investors who can be patient and cautious, there could be some attractive opportunities after the correction.

 

In conclusion, China is a $10 trillion economy in a $75 trillion world, so it matters. Even if direct exposures don’t look particularly worrisome, we are concerned about the indirect effects that we may not fully understand. The markets failed to recognize where we were all exposed in 2007 and 2008, and we would rather not make that mistake again.

 

So we wouldn’t underestimate the primary, secondary and tertiary effects of a weakening China on the rest of the world. The economic slowdown has created excess capacity in China that has spread beyond its borders. Subdued commodity prices and global disinflationary pressures are unlikely to prove fleeting, and there seems to be no tinder to reignite global growth. What this says to us is that central banks may not be compelled to deviate from the mantra of lower for longer.

 

And there could be upside to this story. In the past, the tertiary effects of slower global growth,  lower interest rates and falling commodity prices have proved beneficial. Muted energy costs in particular have stimulated household spending in consumer-driven societies in Europe, Japan and the US — and potentially even in China itself. 

 

 Erik Weisman, Ph.D., is an investment officer and portfolio manager at MFS Investment Management