A crisis flaring up in emerging markets poses the biggest threat to global recovery and US Federal Reserve rate rises could be the trigger, warned Robert Baur, chief global economist at Principal Global Investors.

On a recent trip to Hong Kong from the firm’s Iowa headquarters, Baur explained to AsianInvestor why he thinks emerging market equity and debt as asset classes are in for a rough ride.

The growth of credit during the boom years in the early part of this century led to excess capacity, rising wages and squeezed margins, making emerging markets vulnerable to a strengthening US dollar and rising interest rates, he said.

Baur is forecasting that the US will end its large-scale asset purchase programme next month, and that the Fed will raise interest rates for the first time in June 2015, in gradual increments of 25 basis points before ending next year at 0.75%.

He pointed to the wobble that EM currencies and equities endured last year – sparked by former Fed chairman Ben Bernanke raising the prospects of an end to US tapering – as a warning sign of what could happen as the dollar strengthens, commodity prices come under pressure and the Fed removes it’s extraordinary stimulus measures. “None of those are good for emerging markets,” he said.

Baur argued the seeds for structural weakness in emerging markets began to be sowed in the late 1990s, when China’s rapid industrialisation started to pull developing countries along with it.

“There were 12 years of one record price after another for commodities,” he noted. “We had spectacular outperformance of EM equities over DM equities in the 2000s and that boom in China carried on even during the financial crisis.”

In November 2008, China introduced a $4 trillion ($652 billion) stimulus package focused on infrastructure and social welfare spending and kept on growing, again pulling emerging markets along. “That boom began to wind down in early 2013,” Baur observed.

He pointed to countries such as Brazil with its trade and budget deficits as fragile, as well as those that have borrowed heavily in non-local currencies, which he underlined was a major cause of the Asian financial crisis.

Baur observed that the US suffered a financial crisis around five years ago and Europe three years ago, but emerging markets had not endured a deep recession since the Asian financial crisis of 1997/8.

He noted that with the US in self-sustaining recovery, Europe crawling out of recession and EM yet to experience a downturn, these economies were diverging.

But Baur said the long-term growth story of burgeoning middle classes in emerging markets remains intact, singling out India and Indonesia with their young populations. China would see its workforce begin to shrink from next year, he forecast.

In a separate survey released yesterday, Principal Global Investors found that investors had become more discerning about emerging markets. Respondents holding a positive view of EM declined to 20% this year, from 38% in 2012, while those holding a negative view climbed four points to 19% over the same period.

Principal’s report found a majority of respondents expecting convergence of economic cycles between developed and emerging markets, driven by DM asset managers expanding their footprints in Asia.

The survey from Principal and Create-Research, entitled Not All Emerging Markets Are Created Equal, quizzed 704 pension plans, sovereign wealth funds, pension consultants, asset managers and distributors in 30 jurisdictions. Together they manage $29.7 trillion in assets.