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The Big Conversation

Episode 65: Will China kill inflation?

This week we look at China’s key role within the reflation narrative and how it’s been driving some commodity prices higher. Is this a sustainable move or was this a stop-gap effort to stimulate supply in response to the pandemic? What now happens to all those finished goods and will China rotate back to domestic consumption? This could wrong-foot the reflation trade. In the Chatter this week we talk to MarketPysch CEO Richard Peterson about the growth in meme stocks and the general trend toward buzz investing.

  • [00:00:00] With all the recent inflation focus on US fiscal and monetary policy, it's easy to forget that China has also been extremely influential in the outlook for global risk assets. She was at the center of Asia reopening its factories last year and the reflation surge that saw Taiwanese and Korean equity markets make new all-time highs, whilst Japan reached its highest level in 25 years. Throughout much of last year, China was driving demand for many key commodities and was happy to see its currency strengthen against the dollar whilst it was hoovering up these key industrial inputs. China used supply side policies to deal with the pandemic, which meant focusing on industrial output rather than consumer demand. China had combated the pandemic by turning to a supply-side and export response. And despite the typical dip into China's New Year celebration, exports today are much higher in dollar terms than comparable periods in previous years. But as the world attempts to normalize, China will try to pivot back to domestic growth. This could mean less demand for raw materials and simultaneously more finished goods dumped onto the global market. This could put pressure on the current reflation narrative. We'll be discussing China's impact on growth in this week's Big Conversation. 

    [00:01:16] Investors have correctly identified that policy makers have crossed the Rubicon into a world of permanently high public sector deficits supported by aggressive central bank monetization that many believe is part of a shift towards embracing Modern Monetary Theory. And as the latest round of stimulus have shown, this is not just a short-term response to the pandemic. The planned U.S. infrastructure package is expected to run for up to a decade. This super expansionary policy is here to stay until policymakers are forced to reverse course. Much higher inflation could well be the end result. But by going all in on that bet now, investors have probably gone too big, too soon and are now exposed to a downside surprise. And China might be signaling that this surprise might not be far ahead. The Chinese PMI alone, which tends to lead the US ISM, suggests that a slowdown could be around the corner. So we have to keep a close eye on China. China matters because through the commodity complex, it has been a key driver in the reflation story. Some of China's imports of bulk commodities have been on a tear, and this has helped shift the spotlight to those equity markets with a healthy cyclical base like the Dow Jones Industrial, which has made a new all-time high in recent weeks, even as the Nasdaq was rolling over. But there are signs that a slowdown might be coming. China's seemingly huge year on year expansion in its economic activity during the first two months of 2021 mainly reflects the base effects due to the draconian but effective measures that were put in place this time last year to prevent the spread of Covid-19. We can contrast this rebound in productive activity with retail sales, like most of the China data points, year on year retail sales rebounded from the shock of the pandemic, but when we look at month on month activity, sales growth has struggled to hold those pre-Covid levels. This shows just how lopsided and unhealthy the recovery continues to be. The consumer sectors that Beijing wants to see growing are barely limping along, whilst its 'growth at any cost' strategy is again seeing the wrong sectors growing too rapidly. There are only three ways China can resolve the continuing growth imbalance between production and consumption. One way is to produce less, and so let unemployment rise, which is something Beijing will want to avoid. The other two ways require either yet another increase in the country's trade surplus, which Beijing will accept but the rest of the world will oppose, once the pandemic fades, or an increase in its domestic investment, which nearly always means yet more non-productive infrastructure and real estate development. Either way, the response to the pandemic represents a continuation of the lack of balance within the Chinese economy, which remains heavily weighted towards capital investment rather than consumption. China's ratio of fixed investment to GDP has been more than 40 percent for several years now. Whilst the trend rate for GDP has been falling due to declining labor growth and productivity. 

    [00:04:12] This CapEx number compares to around 20 percent for the US. Now, obviously, these are economies in very different stages of their life cycle, but China's number is large based on any historical comparison. Now, some would argue that the global problem of CapEx over investment is a product of low global interest rates, but in China's case, it's also the product of the economic model. China's economy essentially rests on three legs. The first is the old communist command style economy, which is still roughly half of China's GDP. This is comprised largely of the old white elephants, the state owned enterprises. The second leg is where the state directs investment into particular areas, mainly by private enterprises. Is the old Japanese MITI model targeting priority sectors like clean tech and solar, using the state's investment to drive down input costs to make the resulting product cheaper and cheaper so it can then be sold into global export markets. The state acts as a loss leader as it tries to develop national champions. The third leg is the Wild West capitalism, which you've seen in things like property speculation, wealth management products and the shadow banking system, which has surged in size since the great financial crisis. This has also been visible in the recurring bubble like activity of the benchmark CSI 300 Index, where until recently the rise was fueled largely by margin debt. In these credit expansion fueled booms, individual investors and households borrow and speculate in overvalued assets. Therefore, the old blunderbuss approach to credit expansion not only leads to fixed investment problems, it also leads to households getting deeply into debt using inflated assets as their collateral. Pre-Covid China was trying to curb these excesses and focusing on controlling the balance sheets of the shadow banks and the SOEs. But if they regulate the speculative sectors too aggressively, it risks setting in motion a huge debt deflation dynamic. And this is especially dangerous given how high capital expenditure as a percentage of GDP has been for decades. Therefore, as internal pressures build up on China's domestic economy, there will again be a desire to export deflation to the rest of the world so that China's policymakers can focus on the transition away from the industrial complex towards internal consumption to help create a whole new growth dynamic. The classic model of postwar growth used fixed asset investment to drive the business cycle, and the multiplier effect led to an even larger change in output. It is only after this multiplier effect has run its course that consumer spending can take over on that growth charge. And this is the stage that China had reached before the pandemic. She was already battling with the need to deflate its huge capital expenditure bubble while shifting the baton seamlessly to the consumer. This transition was already weighing on global growth before 2020, and it's only been made harder now that the rest of the global economy is struggling to rebound. Now, it's early days, but in the midst of our current reflationary euphoria, markets are ignoring some of the warning signs from China. When China's policymakers last year deployed fiscal and monetary stimulus to aggressively ratchet fixed investment higher and juice the supply-side recovery, when the rest of the world was going into lockdown, they effectively doubled down on the very policy they've been trying to transition away from. And this rejuvenated some of the trends toward speculation. Non-performing loans have continued to grow even after a small pullback in recent months, although as a percentage of official GDP estimates, they have remained under two percent. Similarly in equities, a cautious outlook has appeared. Since the beginning of March, the nation's benchmark CSI 300 index has dropped 14 percent from a 13 year high, despite evidence that state backed funds had intervened to shore things up. Now, that news did help the market bounce by the end of the week, but conditions remain volatile, so it makes sense for us to take heed of an economic repositioning in China. The extreme fiscal stimulus introduced in the US has largely been discounted by strong performance of risk assets in recent months. If we do, however, get more signs of China stepping off the supply side gas in order to return to stimulating domestic consumption, then these one-sided reflation bets may find themselves wrong footed by China's growth that was never more than a stopgap measure through the worst of the pandemic. So in recent months, that reflation trade has been bolstered by a surge in numerous uncorrelated meme stocks. In the next section, I talked to Richard Peterson of Market Psych, who studied the buzz that ebbs and flows behind these names. 

    [00:08:49] Buzz investing in which GameStop was the poster child has surged. Last week, the stock soared again back towards its January levels, but this time with much less fanfare. So what's driving this recurring price action and is it sustainable? I asked Richard Peterson of Market Psych, who looks for investment opportunities within media trends. 

    00:09:08] So what we are seeing in our data is the steady rise in buzz about certain stocks. And we do have some videos where we can even track over time the buzz of certain stocks and you can see them percolating along and then some will take off and become more and more popular. So whether it's Dogecoin or GameStop or AMC or Silver or any number of assets it's really how infectious is the idea behind it. So how emotionally resonant is it and how enthusiastic and charismatic are the leaders? And what we're seeing over time is this accumulation of buzz, as you know, in the data that we produce as people are becoming more and more enthusiastic about that meme. So you not only have the emotional resonance, but then you can see it sort of virally infecting people in the social media and watching as they become more and more attentive to that theme. 

    [00:09:58] For investors looking to play these momentum trades there are some key relationships, especially on the downside, as Richard outlines using the GameStop example from January. 

    [00:10:06] We see the price and the buzz together so when the buzz starts to rise and there's this increasing attention, if the price is also rising, that tells us that there's likely to be momentum. So we have done some quantitative studies on this data. And what we see, the best indicator is the steady rise and buzz, almost an exponential curve in the buzz, when that is paired with a price, the similar rise in the price, and in fact generally slightly precedes it, because then the next day, and the next day, we'll see a momentum effect on the price for the price continues. But interestingly, that's also true on the downside, and it's actually a stronger effect on the downside. So when a stock drops dramatically and the buzz rises, then we tend to see that it'll continue dropping for the next few days. So we see this buzz effect both amplifying on the upside and amplifying on the downside as people are complaining and saying 'what's happening?' That also affects the selling on the downside. But once the buzz reaches a very high level and then the price drops dramatically, as you see at the top, obviously, then you know that it'll start to unwind. And that unwinding is more predictable than the upside because a lot of stocks do start percolating and seem to take off. But only a few make it to the big leagues. Right, they gather a lot of attention. And those are those can be tracked, but the probability of catching those is less than catching a top based on a collapse in buzz, or a collapse in the price and a rise in buzz. 

    [00:11:32] This type of investing has brought a whole new audience to the market who seized upon this opportunity, even though many traditional investors expect or even hope that this investment style will ultimately fail. 

    [00:11:43] People are at home. They have time. They have stimulus checks, they have, so they have the resources and the time and often at least the one of the themes that's being run in these message boards is people are disaffected. They're feeling that they don't have a voice or they don't have enough wealth to really get forward in society. And they're seeing this not as a casino, but as a new way to actually get enough resources to establish yourself in society, and especially if the predominant population is young men here rather than, you know, slugging it out in a profession or a long-term career. This may be a fast wave they perceive to become financially stable and solvent and successful long term. 

    00:12:26] One of the big questions around permanence is whether regulators will step in to curb some of this momentum based activity. 

    0:12:33] Well, the big question, I think, with this is, will there be enforcement actions by the SEC, for example? So right now it does seem as if it started small and it's still niche, but it's been going on for decades. It's just that many people were worried about enforcement actions taken against them for stock promotion and insider trading, and that that worry has come up again because in Japan recently, there's a case from 2008 that was prosecuted where somebody was promoting a stock in a similar fashion, and he was well-known online personality and promoted a stock and made money from the obviously the bull run. And when that happens then there is this idea that maybe there's some illegal collusion happening and that is not, of course, allowed to manipulate stock prices. So when the financial authorities get involved, then we may not see this continuing the way that it's been continuing. But if that doesn't happen, if it is allowed to continue, so to speak, then yeah, I think it will be ongoing. And what we'll see is it aggregates around a few charismatic personalities who are very good at promoting certain concepts. So I do think that's yet the likely outcome. 

     [00:13:43] Although we've used GameStop as the example here, it wasn't a one off. And this form of investing has been around for years, but social media has given it an impetus. Regulators may want to curb this activity, but at its heart are the conditions that have allowed individual investors to combine cheap access to data and trading exchanges with the power of social media. And that trend is not going away.