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The Big Conversation

Episode 81: Will China drag down global growth?

This week we look at the soft macro data coming out of China that could be a prelude to a decline in world growth. With many investors still positioned for reflation, the impact from China could wrong foot many investors. Bond yields have been flagging weaker growth for a few months and a break higher by the dollar could create a significant headwind for reflation assets. In this week's Chatter, we talk about the growing carbon emission markets.

  • Speaker 1 [00:00:00] Over the last week, we've had the latest round of global purchasing managers survey data. One of those which stood out was the Chinese Caixin Services PMI. It missed expectations by a long way, marginally holding on to expansion territory, but 50.3 was a big miss compared to the forecast for over 55. In this week's Big Conversation, we'll look at the implications for global asset prices if China continues down the path of rebalancing away from growth at any cost.

    [00:00:31] So China appears to be slowing down, but why does that matter? Well, China still sets the tone for much of the global growth outlook. Many had expected Chinese policymakers to juice their economy into last week's 100th celebration of the Communist Party. Instead, they continue to address many of the past imbalances. And this points to a future in which the U.S. will have to do far more of the heavy lifting if reflation is going to go truly global. The Chinese credit impulse has moved into negative territory because we've seen a big decline in the year-on-year availability of all system financing. When we look at the 12-month moving average of total social financing over the last decade or so, most of the downdraughts have coincided with events such as the Eurozone crisis in 2011, the commodities and profits recession in 2015 and the soft patch of 2018 to 2019 which saw yield curve flattening prior to the pandemic. The shadow banking system has even seen a withdrawal of social financing since 2018. This is all part of policymaker's attempts to clean up some of the speculative excesses and bloated balance sheets within China's corporate sector. Non-performing loans have soared in absolute terms, even though they've remained relatively small as a percentage of GDP. Most analysts however, suspect that the real numbers are much higher. The authorities are even testing the credit waters with China Huarong Asset Management and China Evergrande Group constantly threatening defaults. Policymakers are trying to wean the economy off its credit addiction. Citi's Chinese Economic Surprise Index is deep in negative territory. Outside of the pandemic last year, this is now getting close to the lows of the last decade and beyond, reflecting the ongoing shift in policy. More recently, China has been struggling with the impact of higher commodity prices, which has had a severe impact on margins. There have been attempts by policymakers to rein in some of the excesses in commodities. Margin compression has been a global problem. Inflationary pressures have moved higher at a faster pace than growth. Corporates have started to protect margins. Capital is being hoarded or held for buybacks rather than used for growth. Another sign that China is not providing much global support is the underperformance of EM equities. The ratio of the S&P versus the MSCI Emerging Market Index is closing in on the decade highs once more. And that's despite the dollar being on the back foot for much of the last 12 months. EM equities should have significantly been outperforming over this period. Emerging markets have not experienced the benefits of China growth because China has pointed its engine of growth in a different direction. But the JP Morgan Emerging Market FX Index is testing the uptrend and looks like it will break to the downside. Part of the EM equity weakness is due to a change in the composition of the indices. The old dominance of commodity and heavy industry has been supplanted by the rise of technology shares, and this has been a drag because of the underperformance of Chinese internet names when compared to the tech-heavy Nasdaq 100. The recent shock at the clampdown on ride share service Didi, which recently listed in the US, should be tempered with the fact that increased oversight and regulation has been ongoing across China's technology sectors for a while. But the timing was still unfortunate. One of the big questions for U.S. investors is whether the clampdown by China is actually a prelude to a wider clampdown on a global basis or simply a regional issue that will continue to undermine the relative performance of EM equities. EM investors had been hoping that reflation would help these equities outperform, but that's failed to occur. China is not only stepping back from outright growth policies, but it's also reining in consumer companies that appear to be getting too powerful. China's PMI's have been showing global leadership. Usually they are largely coincident with the US ISM, but during the pandemic months, cycles in the Chinese economy have generally been ahead of other regions by a couple of months. Global inflation is unlikely if China's taking its foot off the accelerator. U.S. fiscal policy is dramatic by recent standards, but it's still relatively small versus the overall economy and small in absolute terms when compared to China's efforts. Over the last 10 years, China's gross fixed capital formation, the world's largest as a percentage of the global total, has started to slow. During that time, other major regions have seen their shares fall. The US share has stabilised, but even with a multi-trillion fiscal package, the global impact will be relatively limited, especially when spread over many years. Additionally, policymakers in North America and Europe have started to contemplate less accommodation, even if that is at the margin. Policies that were driving the reflation narrative are now reversing and putting those assets under pressure. The Australian dollar is testing its key support level of a topping formation. Although the Australian dollar has been underperforming the rally in copper, the Aussie dollar is still a barometer of global growth, and it's close to breaking down. Where copper and the Australian dollar goes, so goes the global mining sector. The ratio of the European-based resource sector versus the broader-based European market, the Stoxx600, has recently rallied back to test its breakdown level. A failed retest then opens the door to significant underperformance from that sector. One of the key questions within resources will be whether oil and gas sectors can outperform in an environment where reflation is under pressure. The simple answer should be yes, because oil and gas has a lower beta to growth, but we continue to see regulatory pressure bearing down on the energy sector. If the ratio of the European oil and gas sector versus European basic resources can break 0.47, then we should get outperformance from energy. Some people may prefer to look at copper outright after its incredible run from last year. Copper should be part of a new megatrend that taps into the development surrounding green technology, but China has already started to build up inventories in anticipation of that opportunity. Copper is therefore vulnerable in the short term to a stronger US dollar, and China stepping back from its need to rebuild. The other area to watch its continued flattening of yield curves. Long-dated yields have been falling since the end of the first quarter this year, and the US government 10-year yield is now testing the 12 month uptrend. We've already seen a sizeable move in the 5 year to 30 year portion of the US curve. Since the June FOMC, we've also seen a move higher in yields at the front end of the curve. There are many distortions at play here, including issues around the dramatic rise in the reverse repo operation, where the Fed has made it more attractive to pump money with them rather than hold short-dated bills. The Fed are offering five basis points on funds, which might sound like not much, but it's better than the zero yield that investors were receiving in three-month paper. Eventually, if money is drained from money market funds into the Fed facility, we could again see another dislocation that causes a flattening, but this time due to higher front-end yields. 15-day reverse repo has reached 1.25 trillion US dollars, led by the overnight facility reaching one trillion dollars at the end of June. So whilst US equity markets have recently made new all-time highs, China's tightening the screws. The US Fed has become slightly more hawkish, whilst the plumbing in the US market is touching extremes. Now the plumbing won't be a catalyst for any breakages, but it could be an accelerant. We should, however, watch what China does and watch the assets that have a strong relationship with China's growth. Many have been starting to roll over following the softening in the Chinese macro data. U.S. equities as ever are ignoring this for now, but historically a slowdown in China is usually a prelude to a slowdown across the rest of the world. And the US fiscal package is not yet big enough to reverse that. There is one market where China is about to make a big splash, and that's its entry into the carbon trading markets. In the next section, I talked to Refinitiv's Yuan Lin about the size of this coming opportunity.

    Roger [00:08:16] The European Carbon Market has been one of the year's best performing assets, and these markets are going global, China's launching its own facility. China has the world's largest emissions and therefore, this will also be the world's largest carbon market.

    Yuan [00:08:28] China launched its national carbon markets this year after decades in the making. The national ETS will cover about 40 percent of the country's total emissions. So it will be the world's largest carbon market. It includes its power sector and it starts covering more than 2,000 enterprises. The annual emissions of these enterprises will be 4.5 gigaton per year. The sector will be covered by the scheme, so the national ETS will cover about 70 percent of China's emissions by 2025.

    Roger [00:09:13] Many of the features of China's carbon market will be the same as those in other regions.

    Yuan [00:09:17] Yes, the ETS is a core policy instrument for China to achieve its carbon pick and carbon neutrality pledge. The overall design of this ETS is similar to existing ones around the world, such as the UK, EU and California, etc.. However, the Chinese carbon market is much larger in terms of the covered entities, three times of the EU markets and compared to the EU ETS that has been in operation 16 years ago, China's new national ETSs will adopt the intensity based targets, there's no absolute cap and yet trading is also limited to spot trading at the beginning.

    Roger [00:10:12] Initially, participants will be limited to corporate entities, but it's expected that greater depth will be added later.

    Yuan [00:10:17] Yes, trading in the national ETS is expected to start during this July or August. Shanghai Environmental Exchange will host this national allowance trading. At this stage, only compliance entities, meaning the emitters can join the trading. Financial investors will be allowed at a later stage. There's also discussion on the carbon future trading which is likely to take place on the newly established Guangzhou Futures Exchange.

    Roger [00:10:53] The price of CO2 emissions in Europe has skyrocketed in recent months after a slow start. Prices on the Chinese market are expected to rise at a gradual pace.

    Yuan [00:11:02] Refinitiv's Carbon Research Team has developed its own in-house model for China ETS, which provides supply, demand and price forecasts until 2030. We expect the allowance price to average 4 yuan per ton in 2021, so roughly 5 euros and gradually rising to 20 euros in 2030.

    Roger [00:11:29] Investors can follow the development of this market and the evolution of carbon prices in China via Refinitiv's new China Carbon app.

    Yuan [00:11:37] Refinitiv has just launched the new China Cap app icon, the application will give you access to news, data, live prices, insights and analytics, including our supply, demand and price forecast for China's carbon markets, as well as the access to our carbon research China team.

    Roger [00:12:00] Carbon markets are only going to grow from here, but how they develop will be key. If prices rise too quickly, which some might say is a success, then companies could be discouraged from opening new facilities in that region if the regulatory charge is too high and Europe's prices may be moving too quickly. The Chinese carbon market will have regulatory oversight as well. Initially, it will only be for companies emitting carbon. Speculators will be allowed to join once domestic carbon futures are launched. If prices rise gradually, it will give companies time to adjust. Given the size of the emissions in China, that will be an essential part of China's energy transition strategy.