For most of the last 20 years, China has been one of THE key drivers of global growth, supporting demand for industrial commodities as she increased her fixed asset investment on a yearly basis. But in 2018, that began to top out. Investors however, are still expecting the old inflationary impulse from China to pick up again, but a tightening of regulations against tech stocks is yet another indication that China has changed direction.
In just three sessions, the Hang Seng China Enterprise Index listed in Hong Kong, fell 13% on an intra-day basis, to within 5% of the lows achieved during the depths of the pandemic rout of last year, as China’s technology sector continues to come under regulatory scrutiny. Even China’s mainland CSI300 fell over 9% during the last four sessions, taking out a significant support level on the way, providing further signs that policy makers are accepting some collateral damage whilst they rebalance the economy away from size towards sustainability. The difficulties faced by China Evergrande Group, where both the equity and credit have come under severe pressure, is another sign of this shift in policy. Companies which have over-levered themselves are no longer receiving unqualified support.
China could well return to previous levels of GDP growth, but if that 6% is focused on domestic consumers and energy transition rather than fixed asset investment and exports, then it has very significant implications for the rest of the world. And yet many international investors still expect China’s investment and growth to return to its former mix, despite China’s policy makers and regulators making many statements in recent months about their intentions to move the economy onto that new path.
Take the recent decision, for instance, to cut the reserve ratio requirements for banks. That was almost universally seen as a loosening of policy that will boost growth. Tavi Costa of Crescat Capital, however, notes that the direction of the ratio has often led the direction of the Chinese currency. At the moment, the Chinese currency looks too strong versus the trajectory of the triple R. Further cuts in the ratio would put downward pressure on the Chinese currency and upward pressure on the dollar.
And as we have seen before, a stronger dollar is a tightening of global financial conditions. A cut to the ratio, therefore, is not necessarily a good thing for the rest of the world. It will benefit some of China’s beleaguered corporates, but there will be very few external benefits from this move. So in simple terms, China is not fueling an inflationary impulse. She targeted copper last year when prices were low but has since railed against the surge in commodity prices that are starting to erode corporate margins. Inflation without growth will have a limited life span. In fact, there are signs from around the rest of the world that prices have got so far ahead of themselves that demand is taking a hit.
US new home sales fell 6.6% in June versus expectation of a growth in excess of 3% and this was despite a downward revision to the previous month’s figure. Demand for large consumer discretionary items has been under pressure as prices increase and furlough schemes start to roll off. US household debt has continued to rise. The combined level of US student, auto, credit card and mortgage debt briefly declined last year, but then continued to march higher and now stands at over $50,000 per capita. Total household debt in the US is in excess of fourteen and a half trillion USD. US household savings over the last year have been at a much higher level than the historical norms, but they are still significantly below these debt levels. And although the potential for deleveraging exists, that would be at the expense of consumption. Even if consumers turn their savings into demand, there remains little appeal for corporates to borrow and help boost consumption. US loans and leases have now fallen back to below the trend after last year’s surge.
In the Euro Area, loans to non-financial corporations have been declining since the great financial crisis, as the over leveraged banking system tries to fix its long-standing balance sheet problems. The trend has accelerated in the last year. European banks can’t lend, and US banks don’t want to lend. In the US, this process is exacerbated by the lack of quality treasury bonds that borrowers can use as collateral. For banks to make loans, they need borrowers to post treasuries, but the market has been starved of bonds by the Fed’s operations and by hoarding.
When the Fed buys bonds, it credits the commercial banks reserves, but these carry a charge on their balance sheet and so they have been offloading them back to the Fed. Overnight reverse repo balances remain around the one trillion dollar mark and higher for their 15 day variant, reflecting a dearth of lending opportunities. It’s not the delta variant or a hawkish Fed that has seen bond yields fall, but positioning and a lack of opportunity. Higher yields in the first quarter may have been little more than Japanese selling. But equally, the messaging from the bond market today may not be as disinflationary as the head-line yields implies. Scarcity may be driving yields lower, though arguably that scarcity is a result of low growth which is itself a result of central bank distortions.
Those central bank intervention are themselves the result of a multi decade disinflationary cycle that may now be coming to an end. But, that is a key difference between today’s inflation and the inflation of the 1970’s. High inflation levels of the 1970’s were the end game of a multi-decade trend in which wages had been in the ascendency over capital. It came to a head with the Nixon shock that ended the dollar peg to gold and the OPEC oil price rises themselves. Entrenched trade union pressure that had persistently pushed for higher wages started to reverse with the switch to free market policies in the early 1980’s.
Today, we may be at the end of a multi decade disinflationary period, and that should make it harder for high and lasting inflation to properly take hold. Clearly there could be a combination of excessive fiscal policy with supply chain bottlenecks. Many people are anticipating a policy error. The Federal Reserve, however, are relatively evenly balanced between hawks, doves and neutrals. The July FOMC is the last one before the summer recess and most people will be looking for guidance from the Jackson Hole symposium in late August. The next FOMC after July is not until the 22nd of September. During the period between now and then US growth momentum should start to wane.
Andreas Steno Larsen of Nordea Bank notes that the year-on-year change in the US ten year plus two year yields, leads the change in the ISM manufacturing survey by about 18 months. US yields here are inverted versus the ISM. When the combined yields are falling on a yearly basis, that loosens financial conditions, setting up a platform for future growth. Last year’s rise in yields now suggests that ISM should drop from current levels. Now that shouldn’t be an issue for equities, unless the ISM drops below 50, but it could be a headwind for the reflation trade.
Furthermore, the Chinese growth cycle usually leads the US growth cycle, and this looks to be slowing. US banks are not lending, and borrowers have been frozen out from borrowing due to those collateral issues. European banks they aren’t lending either. Combine these three major trends plus commodity base effects rolling off and, absent a significant US fiscal response, there should be downward pressure on prices in the second half of 2021. Now obviously there is no doubting that the US has been incredibly generous so far. The depths of the US recession was undoubtedly one of the fastest and deepest on record, mirrored in many other regions such as the UK and Europe. It was however, one of the shortest on record. The National Bureau of Economic Research may have only recently recognized the end of the recession, but most observers knew that it had ended by the middle of last year. Despite that, central bank balance sheets have continued to rise as if the crisis is still in full swing. But is this because the impact of the COVID was so shocking or is it because the underlying economy before COVID was already deeply inefficient?
You may recall that corporate debts were at record levels before the pandemic hit and the Fed was already intervening in the funding markets to support stocks into the end of 2019. Prior to that, central banks had failed year after year to hit very modest inflation targets. Today, persistent supply and demand imbalances could eventually translate into higher wages – there were bottlenecks in the decade after the second world war, though unlike then, today’s productive capacity has been impaired but not destroyed, and today’s higher prices will help ignite increases in supply.
Many investors in the US equity market hardly care anyway. The last time the S&P500 experienced a 10% pull back from a peak to a trough was back in September last year. There have been a few scares along the way, but volatility has generally moved relatively more than the underlying market. The cost of buying protection does not look attractive anyway. Investors have been better off selling their index positions and buying calls, if they want to reduce their risk profile.
On a global stage, the DAX remains a proxy for reflation and emerging market growth. It has performed well in absolute terms, but when we view the DAX performance relative to the S&P and compare it to the US yield curve (which acts as a proxy for global growth) we can see that this index has performed quite poorly.
Therefore, with China continuing to shift its demand profile, which is hurting many of the other emerging markets that were destinations for German exports, the DAX will, for many, be a more attractive downside play than the US.
Now over the years, the DAX has generally displayed a higher down beta to the S&P. That means that when markets fall, the DAX normally falls more than the S&P. The actual cost of a 3 month 95% put on the DAX and the S&P500 is about the same at around 2%. These are not quite the same types of indexes because of the way dividends are treated in each – but the global headwinds to growth are real and if that means lower yields, that’s good for US tech and not so good for the industrials of the DAX. So, the point is that we are entering a 2-month window after the July FOMC in which the Fed will be away. China is continuing its rebalance of the economy and that is a drag for global growth. And commercial banks in Europe and the US are reluctant to lend and that is another headwind for inflation.
Yes, the inflationary story remains in play, but it is dependent on a fiscal surge from the US and supply chain bottlenecks across the rest of the world. The US administration is discussing further support, but that’s very well flagged. However, the market still has to take on board that China is slowly changing course to a different type of growth. All these mini risk-off incidents we’ve seen may appear like idiosyncratic events, but in reality they are part of an ongoing process of change that will have prfound implications for global risk assets.
If you have any questions about this episode or anything about the world's financial markets, please put those in the comment section, and we'll try and answer those in future episodes.
