- The Big Conversation
The Big Conversation
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Published on: December 4, 2019 • Duration: 15 minutes
This week we discuss the slowdown in China despite the trade wars. China is trying to evolve its economy away from a reliance on credit fueled manufacturing, towards services and consumption. The market chatter looks at the ongoing disconnect between data and the US equity market, with its unstable reliance on central banks. And the whisper updates the outlook for UK assets based on recent election polls.
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[00:00:03] Last week, when Donald Trump signed the bipartisan bill requiring an annual review of trade between the US and Hong Kong, it was seen as just another escalation in the ongoing trade tensions between the US and China. But in many ways, those trade tensions are detracting from some very real changes which are taking place within China, ones which are equally important to today's investors as those trade tensions themselves. And that is the big conversation.
[00:00:35] Any discussion on China is polarizing and individual investors are themselves incredibly impassioned. But I want to focus on the current market economic transitions and briefly how we got there over the last 20 years. China's GDP has grown from one trillion to 14 trillion in US dollar terms and is now closing in on the largest single country GDP, the US. However, total GDP is a numbers game and obviously China has a much larger population. On a per capita basis, China's GDP is roughly nine thousand dollars and it significantly lags the US at fifty six thousand dollars. But China's impact on the rest of the world has been huge. As we all know, China has created an unprecedented demand for raw materials, was also adding a huge swathe of cheap workers and consumers to the global labour force and the world benefited from this demographic dividend. But that may now have ended, and the authorities in China have recognized the risks of relying on credit. Whilst debt is a useful tool to kickstart growth, excessive debt is a game of diminishing returns. And is there an optimal level of debt? Well, in some ways, this is the very heart of the current narrative and there's no simple answer. But China has gone from using around two units of debt for every unit of GDP growth to now using seven units of debt for every unit of GDP growth. And that's not really growth. That's leverage. But for the rest of the world, things really started to take off with China's entry into the World Trade Organization on December the 11th, 2001. The Asia crisis, four years previously to that was all about South Korea, Thailand and Hong Kong. In fact, China hardly warranted a mention. But China's entry to the WTO also came at a time of cheap and plentiful US dollars, in the crisis management of that post dot com era. Now, although China's economic rise has been incredible in terms of speed, it is arguably unsustainable. And it's this feature which fuels a vast amount of the current debate. China's greased the wheels of its own growth through judicious amounts of credit over the last 20 years. Chinese credit growth has far exceeded that of the US, even though its overall GDP still lags. The big question is, is that growth, organic growth? China's dilemma is combining GDP targets with financial stability targets. Using excess credit to hit GDP growth targets means that these goals are mutually exclusive and the Chinese economy is also very leaky. Much of this capital made its way out into the global system by their insatiable appetite for raw materials or the issuance of U.S. dollar denominated corporate debt. However, it also escaped by capital flight as wealthy people diversified into other geographies. And the influence on house prices in places like Sydney and Vancouver is very, very well documented. In 2009, when the world was convulsed by the great financial crisis, China upped the ante with another round of credit fuelled demand, which helped kickstart a commodity boom. And again, in 2016, a credit fuelled surge in demand from China helped halt the commodity bust and profits recession that swept the world on the back of a strong U.S. dollar. But already at this point, we had seen the difficulties that China faced in trying to micromanage the economy. If the borders are open, capital can exit as easily as it enters. When the US dollar rallied in 2014 and then the Fed started raising rates in 2015, the gravitational force was for capital to leave China. As the US became relatively more attractive, Chinese FX reserves fell from four trillion to 3 trillion and I think most analysts would suggest that 3 trillion of reserves are left. Ans China has only 1 trillion of liquid reserves and the other two are tied up in illiquid assets and projects. There was an attempt at a mini devaluation in 2015, but this simply accelerated the outflows from China and briefly unhinged global markets. This led to the Shanghai Accord and the aforementioned capital injections in 2016. Time and time again, China was coming up against the issue of a fixed exchange rate, an open capital account and domestic monetary control, which you probably know as the impossible trinity. And you can only have two of those three. And maybe, just maybe, that 2016 is the last time that China uses huge credit injections as a tool to manage economic growth, or least economic growth at all costs. And although the beginning of 2019 also saw a huge uptick in China's new credit, there are two issues for global investors. One's old and one's new, the old one is the diminishing returns. Whilst each new credit surge was bigger than the last in absolute terms, it was smaller in relative terms because of the growth of the economy. And the new one? Well, in 2018, the authorities indicated that credit was no longer being used for growth at any cost, but now for selectively patching up parts of the economy that have become unstable, like the banks or the indebted state owned enterprises or SOEs. China is also in a corner due to the rise in its inflation. Inflation remains a source of fear for the leadership in China. Swine flu may be the catalyst for the high CPI prices, which is in stark contrast to producer price index PPI, which has sunk back into negative territory. But authorities will be reluctant to reopen the credit spigots until CPI inflation has re based. So what are the signs today that this time is different? Well, this time round, unlike 2009 and 2016, we have not seen the surge in commodity prices and commodity stocks with this most recent uptick in Chinese liquidity. Chinese economic profits growth has hit a 10 year low. Revenue for Macao casinos, the growth there has once again dipped into negative territory. Still not as steep a decline that was seen during the corruption crackdown and global profits recession a few years ago. But still, a sign of retrenchment. And GDP is being managed down. Low single digit GDP growth is far more in line with developed economies than high single digit or double digit growth. And whether we believe the absolute numbers or not, the trajectory is clear. China is changing. They are focussing on the internal economy and moving away for investment towards consumption. And this will have a big impact on the outlook for commodities. They are shifting their fixed asset investment into global projects such as belt and road rather than domestic projects. And yes, commodities could receive a boost from these or even the collective efforts of Brazil, India and Indonesia. But these countries will never mobilise resources at the same scale and speed. The year on year change in global commodity prices has been tracking China's PPI which recently went negative again. So yeah, I mean, commodity prices, they are poised to potentially squeeze as markets continue to price for a reflation re rebound and an element of global synchronized growth. Speculative short positioning in copper futures is extreme, so could squeeze higher, but it would be wrong to think that commodities will be impacted as much today as they were during the rebounds that were previously fuelled by China's leaky capital. In terms of currency, the authorities will want to avoid any dramatic moves. Managing transition is about managing volatility. The mini devaluation 2015 was a painful experience and Shanghai is not yet fully developed as a financial centre. To do so would require far looser capital controls. So there'll be a reluctance to push Hong Kong to the brink. And although the media fixation is with longer term US China relationships, in the short term, China is unlikely to return to the growth at any cost model. Commodity demand should stay sluggish. The preference will be for low, not high currency volatility, and within that, trade tensions offer a two way risk of resolution or extension, whilst window dressing ahead of the Communist Party's 100 anniversary in 2021 is a potential upside risk. But that is something for next year.
[00:09:12] There's been a lot of chatter about the equity markets surging into year end and the S&P 500 making new all time highs, even whilst the global macro data continues to struggle. Investors appear to have priced for a turn in the manufacturing data, and yet the majority of that data continues to remain sluggish, even though there are signs of turns in some of the subcomponents. The services sector and the U.S. consumer, on the other hand, still looks healthy. But even that data is now starting to lose some momentum. So on the data front, let's start with IS consumer confidence. This figure was marginally weaker than expected. And yet it was the first time we've had four straight declines since 2012. But what really matters is the speed with which consumer confidence can turn once the trend reverses. And look how steep the declines were prior to the onset of prior recessions. And although the recent number was high, it is testing the 10 year trend. And furthermore, of the subcomponents, the jobs plentiful, minus jobs hard to get as an indicator fell below zero. It has done this on five prior occasions in the last 30 years, and three of those preceded recessions and one of the others was during the recovery phase after the great financial crash. This is the first time it has dipped below zero since 2008. Interest rates on U.S. credit cards have recently been making new all time highs. Now, some of this does represent a wider variety of services on offer, but it's still fairly incredible given the absolute level and direction of us overnight interest rates. Auto loan delinquencies have also been rising back towards the post crisis highs. In dollar terms, because of the rise in auto loans in total, the value of auto loan delinquency today is far higher than in 2010. And what about other global data points. Exports in China, Japan and Korea remain sluggish, as do imports. In fact, we have just seen the fourth consecutive monthly year on year decline in global trade, which is the longest stretch since 2009. And it's clear that the whole of 2019 has been fairly weak. China profits, as we've just seen, are also weak. European and global manufacturing PMIs might have bounced, but remain tied to the recent lows and global auto sales are on the back foot. Daimler has just followed on the heels of Audi in announcing substantial job cuts as they try and adjust to these structural changes. And EM currencies are also on the back foot. The JP Morgan Emerging Market Currency Index has been making new all time lows. In the US,? Well, the Fed is adding yet more liquidity to overnight markets, with operations now in excess of 100 billion and it has usually only operated on this scale during previous recessions. So whilst the behind the scenes data still looks poor, the bets on the equity market, particularly the US equity market, have remained robust and perhaps none more so than the volatility index or VIX futures, where the short position has reached an extreme. But in terms of sentiment, the short VIX futures and the recent all time highs on the S&P 500 show that the market feels that the central banks have their backs. And this is why politics have in many ways superseded economics and corporate profits as the key driver of markets and especially equities. Central banks can subsidize the economy, but not indefinitely. But they have very little influence on tweets about trade disputes. So as long as the politicians are quiet, the central banks continue to manipulate volatility. But remember, we are always just one tweet away from a turn in the equity market.
[00:12:53] At the beginning of November, we covered the UK election and we tried to work out what the outcome would be based on what markets were pricing in. At the time, it looked like a conservative majority. Today, we've seen a few polls which suggest that the majority could be as high as 60 seats. So what should the market be pricing here and what should we expect? Sterling itself hasn't really moved. Its in that 128 to 130 range and I think that part of the reason is because that majority could lead to complacency so the market doesn't want to get ahead of itself. But nonetheless, if the conservatives get a working majority, we should look for 135 to 140 on sterling. It is considered to be a very undervalued currency. In terms of the bond market, we should expect yields to rise. The reason behind that is the Conservatives and Labour are both expect expected to spend more. And I think that that should see convergence between, for instance, the UK and the US 10 year yields. I wouldn't put that trade on in an outright sense because global factors such as global trade may be more of an influence. In terms of the FTSE, the benchmark UK index, they'll actually underperform because it's related to the performance of Sterling. When Sterling goes up the FTSE100, which earns a lot of its revenues overseas, often starts to underperform European benchmarks. So the FTSE100 will underperform, for instance, the DAX. But within the UK I think there’s some really good opportunities. We could look at things like the real estate sector. We should expect things like Brexit to come to a soft conclusion in January. So this should open the UK back up to foreign direct investment and also internal investment, which should be good for both private and commercial property. So the footsie 350 real estate sector should finally start to perform and you could put a short on with the FTSE100 which should underperform given the move in sterling. What are the risks? Well clearly the risks are that from here to December the 12th, we see this majority whittled down in the polls to what is closer to a hung parliament and then we're back to square one. And obviously, if you're long the FTSE350 real estate sector versus the FTSE, that would be under pressure. But Sterling should go up, property should do well, yields should converge and we should start to see a return to pre 2016 levels, if the conservatives maintain a majority and get that through the election itself.
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