The former Deutsche Bank strategist who predicted a crash in emerging-market stocks as early as 2010 says China's economy faces an "irreparable breakdown" that will deepen losses for investors.
The Chinese government is becoming more authoritarian even after proving itself incompetent in dealing with volatility this year in its stock market, John-Paul Smith, who left Deutsche Bank last year to start an independent research firm, Ecstrat, wrote in a report published Tuesday. The shift will leave the country less capable of dealing with "massive and increasing levels of overcapacity across much of Chinese industry," he wrote.
"We regard the Chinese growth model as in a state of almost irreparable breakdown, the implications of which have yet to become fully apparent to investors and policymakers alike," Smith wrote.
Emerging-market stocks and currencies have plunged in the past year as concerns about slowing growth in China and a multi-year recession in Brazil dovetailed with concern that interest rate increases by the Fed might trigger an investor exodus from higher-yield investments in riskier countries.
The current sentiment differs markedly from that in 2010, when the dominant financial and economic theme was that growth and wealth creation would be led by Brazil, Russia, India and China.
Too many investors bought into the narrative that emerging economies were "unstoppable," creating a bubble that is still unwinding, Smith wrote.
"Investors tend to extrapolate the dominant academic and political theories to an extent that feeds the levels of excessive enthusiasm for particular assets, which eventually lead to market crashes," Smith wrote.
With the Chinese, Russian and Brazilian models of "state capitalism" tarnished, the countries need to move quickly to liberalize their economies, Smith wrote. Instead, they're going the wrong way.
"If Beijing were to launch a real as opposed to a rhetorical drive to overhaul governance practices, then the emerging-market convergence trade would be resurrected," Smith wrote. "But policy is moving in the opposite direction at present, that is, towards a more authoritarian governance regime."
The investment conclusion now is that Chinese manufacturing overcapacity will put deflationary pressure on prices, which in turn will keep interest rates and U.S. Treasury yields low for the next five years, he wrote.
"When the dust settles, U.S. Treasuries will cease to be a safe-haven trade, and the stage will be set for a revival of more cyclical equities and asset classes, but this is unlikely to be the case before 2020," Smith wrote.