The biggest worry in the global economy now is emerging markets, particularly China

Last week I wrote about the asset-price fuelled boom fading. Back then the biggest worry for the market was Japan and Abenomics. However, in reality the biggest concern is emerging markets. I gave you some reasons why last week. Here are a few more.

In the US, the Fed’s assessment of the economy is broadly upbeat. They see the economy expanding at a 2%+ pace over the next two years, the fiscal drag from austerity notwithstanding. And while I am more concerned about the economy falling out of bed than the Fed, I think the Fed is directionally right. The US expansion is going to continue on the back of consumption fuelled by a housing rebound. Just today for example, existing home sales hit their highest monthly level since November 2009.

The question here is not about long-term sustainability – i.e. whether the rise in consumption is underpinned by a similar rise in wages and income – but rather whether the cyclical trend has legs. And at this point, the cyclical trend looks well-entrenched. For me, the takeaway is that even in the face of an unprecedented financial crisis and tightening fiscal policy, easy money can induce a cyclical recovery.

In Europe, I have been arguing for a while now that the maximum point of economic contraction is behind us. The economy is slowly moving toward recovery, one that I expect to take hold in the latter half of this year already. The European PMIs today confirmed the trend back toward recovery as output fell at the slowest rate in 15 months. Output is still falling, but I believe it will soon rise as nothing on the horizon suggests the data improvement trend will reverse. To be sure, many economies are struggling – and not just in the periphery; Finland has said it expects its economy to contract in 2013 for example. So we are not out of the woods by any stretch. Nonetheless, second derivative analysis tells me the trend is toward better numbers, not worse.

And we know that, despite market volatility in Japan and doubts about the sustainability of Abenomics, Japan’s economy is expanding at the highest rate by far in the G7. And now even exports are starting to pick up too. Just as in the US, my focus here is on cyclical trends and not secular sustainability where I have my doubts in both the US and Japan.

That leaves emerging markets then.

In Brazil, we have embarrassing street riots during the Confederations Cup tournament, a prelude to the World Cup. These are the biggest in twenty years. So they are a very big deal. The reason: disappointing economic growth mixed with rising consumer prices. The currency is near 4-year lows. The central bank is losing reserves as capital flees the country. And the currency war-induced tax on foreign exchange has been scrapped to dampen the volatility. In India and Russia too, there is a serious deceleration in growth.

The big concern is China. We know from Michael Pettis that the transition to a domestic consumption led growth model will be associated with a downtick in capital investment as the country weans itself off of the export-led model. This necessarily means an increase in non-performing loans and distress in the financial sector that will reduce credit growth. There is no way that China can make the transition without a serious decline in economic growth.

Chinese policy makers are now trying to manage this process. They started two years ago but took fright when the housing market fell out of bed and growth started to collapse in an uncontrolled way. The Chinese then ramped up stimulus again and the economy responded. But now, the Chinese are withdrawing that stimulus again and tightening up on regulations.

The fallout in terms of growth and liquidity is now coming out. For example, Chinese manufacturing just hit a nine-month low, with data suggesting the sector is contracting. Analysts are all cutting Chinese growth forecasts. Fitch believes that banking stress may come sooner than anticipated because of credit drying up in the shadow banks. Moody’s has warned on local government debt and on their financing vehicles. So the financial sector is crying out for the central bank to ease restrictions and keep the liquidity flowing. Authorities haven’t yielded yet because froth in the housing market is still a problem, particularly in second and third-tier cities. That leads some government economists to think that China would have to hit the 7% GDP growth level before Chinese leaders hit the panic button.

The question is whether, like last time China removed stimulus, the economy continues to fall in an uncontrolled way or whether the Chinese can control the fall. My sense here is that we are going to see quarterly growth drop by a lot more than a 7% annualized pace and so the Chinese authorities will be forced to intervene. What happens then is anybody’s guess at this point. But the concern is that Black Swan events develop as the China credit bubble unravels. This is what we should be watching right now. In fact, right now, with investors having gone too far in reaching for yield in EM, emerging markets all around have replaced Europe as the potential flash point for the next global crisis.