Posts tagged ‘China’
At this time last year, markets were preoccupied by the bear case on China. The stock market had collapsed, the yuan was devalued and the country stood supposedly on the brink of a major banking crisis brought on by bad lending and vanishing growth. So appalling were the consequences of such a crisis that the Fed explicitly linked US monetary policy to the wild ride offered by the Shanghai Stock Exchange.
What a difference a year makes! There is the occasional susurration over the Chinese Peril discernible by those who listen intently, but panic on the subject, having waxed to hysteria last summer, has since waned to nothing.
At the same time, Chinese data has continued to be published as before. So what has it been telling us? Are we being complacent to ignore a threat which only twelve months ago was thought to imperil the world? Or was it all nonsense?
A year ago this blog took something of a sceptical stance on the Chinese Peril. On the subject of devaluation in particular we said that “exports matter to the Chinese economy, devaluation ought to help exporters, and monetary softening elsewhere ought to ease some of the pain in the property market and contribute to lending growth.”
Lo and behold, those macroeconomics textbooks turn out not to be a waste of shelf space after all. Trade figures out from China yesterday showed the pace of decline continuing to slow; both export and import numbers exceeded forecasters’ expectations. It is instructive too that the latest bout of renminbi weakness has passed without much comment: the yuan is just under 3% weaker against the dollar for the year to date, almost matching the pace of its decline last year when it made for headline news. (Just as importantly it is also 6% weaker against the euro and 21% weaker against the yen.) So far there is no sign of this translating into higher prices: CPI inflation was +1.3% on the year to August, towards the bottom of its recent range and well below the levels of 5-6% which provoked a policy response in 2010-11.
Further evidence of economic woe last year came from output indexes. It was seen as more surprising than it should have been at the time that a sharp strengthening of the currency had hurt manufacturing. Similarly, when last week’s manufacturing PMI number came out at 50.4 for August – not earth-shattering, but the highest level for two years – it not only beat expectations but fell outside the entire forecast range.
Another area of concern was the property market. Signs of weakness last year were misinterpreted as a dangerous, balance-sheet-threatening bubble collapse. Yet the market has since steadied following its correction and some cities are imposing ownership curbs in an effort to curb precisely the kind of overextension which so many observers thought they had noticed twelve months ago. As to balance sheets, figures out last month showed that the bad loan ratio for the Chinese commercial banking system actually stabilized in the second quarter at 1.75%. (That’s still a large figure in dollar terms – $215bn – but then China has fifteen times that amount in sovereign reserves.)
Looking at some other indicators, retail sales growth has remained steady at levels of +10% on the year and more throughout 2016, and July’s passenger car sales figure (+26.5% on the year) was the highest posted for three and a half years. On the industrial side of things, electricity consumption came in at +8.2% on the year to July, up from -0.2% back in December and the highest print since February 2014; headline industrial production itself seems to have bottomed out last year and has turned out at +6% and better for 2016 so far.
None of this is to say that China does not have her economic issues, like every other country. Here one might think of SOE inefficiency, frustrations to some monetary transmission mechanisms, over-reliance on particular sources of growth, grim demographics and developing world problems such as questionable building standards and the frictional effects of political corruption. But if we are to find the source of the next global catastrophe it seems we must look elsewhere. The Chinese Peril, if such a thing really exists at all, is still biding its time.
As market bears know all too well, one of the world’s crushing problems at present is China, and everything connected thereto. At the height of the panic which made for such an enjoyable start to 2016, one specific pointer towards China’s imminent and terminal doom was identified as her debt “binge”. Only this Wednesday, this very same binge headlined a blog post from The Economist magazine which warned:
“DEBT in China is piling up fast. Private debt, at 200% of GDP, is only slightly lower than it was in Japan at the onset of its lost decades . . . and well above the level in America on the eve of the financial crisis of 2007-08 . . . The value of non-performing loans in China rose from 1.2% of GDP in December 2014 to 1.9% a year later. . . .”
Specifics such as these betoken credibility. Yet they also invite questions. What does “private debt” mean? Which matters more: the 1.9%, or the 200%? What are the equivalent numbers for the other economies mentioned?
Let us start with the components of “debt” in China. First of all the only one which the bears seem not to want to mention: sovereign debt. This is estimated at 43% of GDP by the IMF on a gross basis for 2015. At the same time, however, China has huge sovereign reserves – about $3.2trn at the moment, again on IMF numbers, which is about 31% of 2015 GDP. With the country targeting a fiscal deficit of 3% this year and reserves trending downwards since 2014 it is true that the country’s sovereign debt position is deteriorating on a net as well as a gross basis but it should be obvious that it is nobody’s idea of a crisis. (UK sovereign debt was 88% of GDP on the same, gross basis in 2014, the eurozone’s over 90%, the USA’s over 100% and Japan’s approaching 250%.)
The “private debt” figure mentioned in the quote comprises a corporate (non bank) debt ratio of 165% and household ratio of 40%. That sounds a lot scarier than 43%. But it is not far off similar figures in other places. Only yesterday the Federal Reserve published America’s balance sheet for last year showing non-bank corporate and household debt of 74% and 82% respectively, making “private debt” of 156% altogether. Lump in sovereign and financial sector debts too and the total comes out at a cool $63.4trn, or 364% of US GDP. (The equivalent figure for China is 247%.)
The UK’s balance sheet comes out even worse than this on a broad basis due to the massively distorting impact from the financial sector. According to our own balance sheet, our total financial liabilities for 2014 came out at a nice, round £30trn, or about sixteen and a half times our GDP that year. Use net figures for the financial sector, however, and this plunges down to a much less startling 487% of output, of which a mere 349% is that “private debt”.
These sorts of numbers are esoteric territory, and not usually visited by relevant parties such as ratings companies. There are reasons for this. Vast swathes of the figures are prone to uncertainty and conceptual artificiality, for instance. We can look at government budgets, and bond yields, and arrive at a view on the sustainability of a country’s debt position. But what is the household sector surplus, or deficit?
Let us draw a line under these “private” or “total” debt to GDP arguments now and move on to non-performing loans. The banking system NPL ratio did rise from 1.5% to 1.6% in 2014 and will have risen further last year. The government is working on new measures to convert NPLs into equity stakes in struggling companies and one can read this bearishly. Whatever the final announcement and accompanying figures on this front, however, we do know that the required reserve ratio for major banks stands at 17% despite recent monetary loosening, up from 7.5% a decade ago. We must, as always, wait and see. The time bomb expected from Chinese trust investments two years ago failed to detonate, but bond defaults have been making headlines. Perhaps this time the country’s banking system, strongly capitalised as it is, will blow up in the face of an NPL crisis the government is already taking measures to manage.
The Chinese economy, like all economies, has its problems. And like the problems of other countries, some of these are local in nature. But in talking up a catastrophic debt burden where none really exists the bear case overreaches itself. There is enough out there to worry us in the real world – we do not have to look for phantoms.
This morning’s leading headline on Bloomberg News read as follows: “Stocks Advance in Europe, Asia Amid China Holiday … ”
Without the peril of the Chinese stock market to contend with, European bourses were up by 1-2% early in the day and are higher at the time of writing. This certainly fits the narrative of those who see the collapse of the supposed equity bubble in China as the source of all the summer’s ills.
(Before moving on, a brief comment on that “supposed”. The Shanghai Composite Index rose by 58% from the start of this year to its peak on 12 June, having risen by 53% in 2014. It hit a p/e of 23.5x in the process – then began to fall. By the bottom on 26 August the drop had reached 43%. If that isn’t a bubble … ?
On the other hand that p/e was well below the 45.5x reached at the market peak of 2007 – a peak which has yet to be exceeded. And it is miles short of the 60-70x levels seen during the twilight of the go-go 1990s tech boom, and below the average level so far this century. In addition, +53% is only the fourth-highest calendar year price return for the index in the last ten years, the highest having been seen in 2006 when the market much more than doubled. Finally, the market was valued at under 10x earnings for long stretches of 2013-14 before the rally began, well below the 14x and 12x reached at the market bottoms in 2005 and 2008.
This is a febrile market which has undergone rapid change but to interpret its rally from the depressed point of mid-2014 as an egregious bubble episode is to make a glaring analytical mistake.)
Some of the actions of the Chinese government have been woefully unhelpful. Direct interventions in the stock market have exacerbated falls and sharpened investor concerns, as tends to be the way of these things. At the same time, special interests in the corporate sector have sought to manipulate the government’s response to their advantage.
Other parts of the world were in exactly the same place very recently. The SEC banned short selling of financial stocks on Wall Street from Friday 19 September 2008 – the week of the Lehmans bankruptcy – in an effort to “protect the integrity and quality of the securities market and strengthen investor confidence.” By the time the ban ended after the close on Wednesday 8 October the S&P 500 Diversified Banks index had fallen by another 22%. Christopher Cox, then Chairman of the SEC, gave an interview to Reuters after Christmas that year which contained the following little nugget:
Cox said the chief executive of one major U.S. investment bank even urged suspension of normal trading rules across the entire U.S. market, likening the situation to how Abraham Lincoln suspended habeas corpus during the Civil War and Franklin Roosevelt sent Japanese-Americans to internment camps during World War Two.
The chief executive said, “that is how America made it through such crises, and we couldn’t be too focused on maintaining the rule of law,” Cox said.
Now that is panic. When it hits markets it is perhaps understandable that policymakers are not immune.
At the same time as the SEC was floundering around trying to put the clock back, however, the US Treasury began to implement measures under the newly-enacted Troubled Asset Relief Program, including the purchase of mortgage-backed securities to assist in the repair of bank balance sheets. On 8 October 2008 the Fed cut its target rate for the first time since April of that year from 2% to 1.5% in a concerted move with the ECB, Bank of England and the central banks of Canada, Sweden and Switzerland. A month later it began its first tranche of bond purchases under QE.
The speed of the banking sector recovery in the US – as opposed to Europe or the UK – has been one of the great relative strengths of the American economy. While some actions of the American government were woefully unhelpful, therefore, others were more constructive.
Exactly the same is true of the situation in China today.
As this blog remarked over the summer, it had been ignored amid all the attention on stock markets that China’s exporters were being hobbled by the quite sudden strength of her currency against the euro (and, for that matter, the yen). Only a few days after that post was published the People’s Bank of China devalued the yuan by 1.9%, its most significant depreciation since the epoch-making 50% shift engineered in January 1994. By the end of the week the yuan was down all of 2.9% at 6.39 and has stayed close to that level ever since. A few days later the 12-month benchmark lending rate was cut, for the fourth time this year, and a further reduction in the required deposit reserve ratio announced for major banks. At this point the PBOC had fired all three monetary weapons in its arsenal in a single month.
Back in the 1990s China came to dominate production in certain low-technology sectors, such as toy manufacture, and remained a relatively small economy (still smaller than Italy by the end of the century). Through continued competitiveness, investment, innovation, and broadening into higher-tech areas such as computers and mobile phones, Chinese exports overtook those of the US in 2007 and of Germany two years later. Today China is the world’s largest exporter by a mile, with the annual pace running at $2.4trn versus $1.6trn for the US; fifteen years ago China exported about a quarter as much as the US did.
So exports matter to the Chinese economy, devaluation ought to help exporters, and monetary softening elsewhere ought to ease some of the pain in the property market and contribute to lending growth. All this is fundamentally supportive. Nonetheless, the devaluation in particular – arguably the least contentious policy response of all – was interpreted as a sign of panic and the stock market continued to fall. In other words the actual direction of monetary policy was ignored in favour of the presumed context for its loosening. This was obviously a bearish response which again has clear recent parallels elsewhere.
What must surely be only a little less obvious are the implications of this response for imminent policy action in other places. Mr Carney at the Bank of England has just dismissed the idea that the kerfuffle within and over China will throw the MPC off their envisaged tightening path for rates. In the US, speculation over the timing of the first hike in the fed funds target since June 2006 has reached fever pitch. Will it motor up to 0.5% in two weeks’ time, as the majority of forecasters currently expect? Or will there be a delay?
Most importantly for investors: would a September hike be taken as evidence of a strong recovery, or would it ignite fears that the Fed is taking away the punchbowl too soon? And would delaying until next month be seen as a welcome reprieve, or betray a conviction that the US economy’s expansion is weaker than was thought?
The consensus from market participants still seems to be that monetary tightening will be accompanied by the upward march of equity benchmarks because (a) tighter money is a sign of economic strength and (b) that’s what happened last time. But as the events of recent weeks have shown, markets can get nervous again very quickly. And the Chinese experience is a reminder that in those circumstances, even positive policy decisions are taken as a sign of something bad.
It is difficult – even, perhaps, irrational – to dislike stocks more today than before they tumbled. There does not appear to be a new recession suddenly lurking around the corner. But complacency over the ability of today’s stock markets to take higher rates in their stride sits uneasily with the reaction to China’s very modest devaluation and other policy manoeuvres.
Well, here is August. Traditionally, though not always a quiet month, we shall be two thirds of the way through 2015 once it ends. So far the summer period has seen pockets of notable activity in markets rather than outbreaks either of optimism or of panic. For the moment things feel pretty calm – so let us have a look at some areas which have drawn attention over the past month or two as we approach the more active autumn period.
China has preoccupied minds for much of the last few weeks. The stock market is down by about 28% from its peak in June, meeting the technical definition of a crash. A Shanghai-based CIO captured the consensus well when he said a month ago: “The market is now falling on the assumption that both China’s economy and financial markets face systemic risk.”
China’s economic growth has certainly disappointed but despite much commentary the supposed systemic issues are not so clear cut. What is clear is that manufacturing activity has cooled materially since the middle of last year and that export growth has fallen away.
It has attracted little comment that since the bottom 15 months ago the yuan has appreciated by 22% against the euro – very slightly more than what the dollar has done over the same period. Consider at the same time that it is Europe which has seen positive growth surprises over the period and the US where GDP has been sluggish.
We know that there are policy moves afoot in China to reform the economy and that the property market has again hit a bout of serious weakness. But it is also likely that more mundane currency factors, of exactly the kind which have been hobbling reported EPS for the S&P 500, have been playing their part. Chinese exports to Europe have fallen by an average of 16% on the year for the most recent three months where data is available (March to May). That’s the fastest drop since 2009 – and stands against a modest rise in exports to the US.
Elsewhere rate hikes have been attracting attention. (The Bank of England vote on the subject split only yesterday of course.) There has however been very little movement in market expectations for central bank action in the UK and US over the last few months – or to put it another way, continued expectations of a very benign tightening cycle whenever the time finally comes.
This is consistent with the behaviour of oil over the last few weeks. The key Brent and West Texas crude contracts fell during July by 18% and 21% respectively, the sharpest monthly decline in the latter case recorded since October 2008. If prices remain at their current lows it will not be until early 2016 that the base effects of cheaper energy on inflation fall away completely. Through the prism of the short term that looks bullish for rates. But from another perspective it could present markets with more of a shock once the effect finally does unwind.
(As a brief aside let us look at the effects of bargain-barrel crude on oil producers. At one end of the scale it has seen Saudi Arabia return to the debt market for the first time since 2007; at the other, life for 30m Venezuelans gets ever more horrific with farming nationalized and starving people rioting over food. OPEC has raised output by about 2m barrels per day since mid-2014. One begins to wonder whether this whole cheap oil policy was really such a clever idea.)
Back to Britain! While not as dramatic as the oil price the strength of sterling has been a noteworthy feature of the landscape for UK investors, and a seasonable boon for those going abroad. On a trade weighted basis the pound is over 7% stronger so far this year and carries its highest value for more than seven years. On a PPP basis it looks expensive to almost everything except the Swiss franc (though not always significantly so). Nonetheless, this will be causing some creative tension in Threadneedle Street – and it also offers an opportunity for anyone looking to diversify away from sterling.
Finally there was a fascinating story about a possible cyber attack a month ago. On 8 July computer problems grounded all flights at United Airlines, stopped trading at the New York Stock Exchange and knocked over servers at the Wall Street Journal. One theory held that this was the work of Chinese hackers. The logic was that the bankruptcy and euro-exit of Greece, then a live possibility, would open the country up to control by China and / or Russia. Fearful of this, the west used cyber tactics to exacerbate the crash in the Chinese stock market.
This blog would ordinarily have dismissed this as conspiracy prattle – but it was then officially denied. There could not have been a cyber attack, apparently, because United suffered a computer problem whereas NYSE closed because of a technical issue. And at the WSJ it was simply an overload. As CNN summed up:
What ties together all three failures? The companies involved are all business operations that rely on massive computer systems. Automated software is complex, sometimes involving millions of lines of computer code. All it takes is a single error — even misplaced text — to grind it to a halt.
Then there was this wonderful quotation from cybersecurity expert Joshua Corman, who must do contract work for the Department of Administrative Affairs:
“Increased dependence on undependable things allows for cascading failures.”
That offers no explanation whatsoever for what happened on 8 July, but it does underscore the vulnerability of modern society to attacks of this kind. Why only a month earlier the payment systems at RBS collapsed, leaving wages and state benefits for hundreds of thousands of people unpaid. This was attributed to “creaking IT systems” by the British Bankers’ Association, which may well be the case; but what would happen if those creaking systems were to get a concerted external push? We already know that significant black swan events, such as major terror attacks, can occur without state support. Geopolitical conspiracies aside: would it be possible for a real cyber attack against key targets to be perpetrated by non-state actors? And what is implied for the next conflict between developed states?
At this point holiday reading begins to take over from financial analysis so let us leave things there for now.
Markets might have been calm, then, but there has been much of interest to observe. Some of this speaks to future surprises, and some to one or two of the themes identified by this blog at the start of the year. All we can do, as always, is to keep our eyes open and decisions clear as we approach its closing months.
The FTSE 100 index hit a new high only a few days ago, closing above 7100 for the first time on Monday. Risk assets have generally had a strong year. There has not even been any visible excitement over the prospect of a secessionist wipeout in Scotland or any of the other shocks which have been postulated by Westminster pundits in the run up to the election next week. But tensions rose yesterday when the US GDP print for Q1 came out almost flat against expectations for a lacklustre but positive +1%. Markets took the number badly. Was it a sign that the global economic motor is slowing – yet again? Has the pricing of risk got ahead of itself?
There have undeniably been signs of pressure on the US. One agent of the weak growth number was a decline in net exports: by the end of March the dollar had strengthened by more than 20% on a trade weighted basis over a period of nine months. Currency strength was expected to weigh on corporate earnings too. As earnings season opened earlier in the month forecasts were for a 6% drop in EPS for the S&P 500 index relative to Q1 2014. And it is not just the US of course. China has come under scrutiny for growth outcomes well below the 9% averaged by the economy over the past 20 years. Towards the middle of the month data for retail sales and industrial production disappointed the market consensus, and there are signs that the manufacturing sector has fallen back into slight contraction.
After the run markets have had so far and the experience of most of the last few years it is perhaps natural to expect a period of retrenchment, if not a modest sell off, over the next little while. If the economy is indeed under pressure then this could catalyse such an event as well as justifying it. The picture is more mixed than it might appear, however. From the US we had stronger than anticipated employment data out only this afternoon, with initial jobless claims down to 262,000 – within reach of the previous low of 259,000 recorded in April 2000. And corporate earnings have not collapsed as feared: with two thirds of the index’s members now having reported, S&P 500 EPS are up by 3% over the previous year and the forecast for the whole index this season has come up to -1%. In China too, foreign investment growth has continued its solid run, service sector activity has accelerated and some progress has been made on structural reform (an area which is often overlooked).
Furthermore, the world’s glass is half full as well as half empty. Given the size of its markets, power of its central bank and global economic influence it is inevitable that the US should occupy much of our thoughts. While the titan across the Atlantic has been struggling a little, however, the weary colossus of Europe has begun to show improving signs of life. Similarly, while the growth rate of the world’s most populous country has fallen back it has been overtaken by stronger than expected economic expansion in the second most populous: India, where GDP growth for 2015 was projected to reach 5.5% at the beginning of the year is now forecast to see 7.4% (using Bloomberg consensus data). This speaks to the continued variability of outcomes identified as a market theme by this blog for the current calendar year, and it should also make us wary of interpreting particular data as evidence of general gloom.
Before leaving the subject of growth behind it is worth looking at the behaviour of the oil price over recent weeks. The collapse in crude was the most significant market event of the last few months of 2014. It generated pronounced volatility in equity markets and its disinflationary impact thrust bond markets higher – especially in Europe, where yields have reached record lows. The price stabilized over Q1 (a cornerstone of the rallies we have seen). Indeed it now appears to have bottomed, with both the Brent and West Texas Intermediate futures contracts up over 20% this month. This has had effects which few might have predicted back in December, such as helping the Russian stock market become one of the world’s top performers over the year to date.
It also means a bottom for oil-driven disinflation, though it is likely to be a few months before this washes through to annual CPI numbers. At the same time, that US labour market data reminds us that underlying pricing pressures will have been gathering strength. Only this morning the Employment Cost Index rose by its highest annual rate – 2.6% – since 2008. Looking forward, it is perhaps here that we might find genuine reason for concern on the macro front, and another source of variability between markets as the year plays out.
China. My goodness but we’re all worried about her at the moment!
There was another splash on the FT this morning about warnings of hard times ahead for some private investors as bond and trust investment defaults are expected to increase (further from zero) in coming months. And of course there has also been much attention given to the Chinese property market, which may be in a bubble; which may be primed to burst.
All this sounds rather worrying. Before commenting further there are three facts we need to observe:
- China approaches any potential bear period in the default cycle from a strong position. The required deposit reserve ratio for major banks stands at 20%, headline real GDP growth of 7.5% per year counts as a recession and managing the strengthening of renminbi in a stately fashion has built up foreign currency reserves of $3.8trn (comfortably more than twice total gross government debt as forecast by the IMF for 2013 – which itself stands at an unterrifying 23% of GDP).
- Commentators cried wolf on the property market ages ago. Two years back – a very bearish time, let us remember – there was a lot of talk abroad about the imminent collapse of Chinese real estate. In fact, even before then (worried about something called “inflation”), the Chinese had been tightening monetary policy via interest rates, exchange rates, and that bank reserve ratio in a deliberate attempt to slow the economy which had already seen the country’s real estate climate indicator fall sharply (it remains well below its ten-year average today).
- Chinese reported EPS, as measured by the CSI 300 Index, have grown faster than earnings for the S&P 500 since the nadir of 2008, grew faster in 2013 and are forecast to grow faster this year too. This is a good reflection of relative rates of growth in GDP. The difference in price behaviour has resulted in a US valuation multiple of 17x, well off the 2009 low and above the ten-year average; and a Chinese earnings multiple of under 10x, well below the ten-year average and lower even than the previous nadir reached in the middle of the Great Recession.
So it seems very unlikely, to say the least, that trust and real estate worries in China will lead to anything like the effects of (say) the subprime mortgage debacle on the US, or if they do, that this is not already priced in.
That is not to discount the possibility of distress entirely of course. The boy who cried wolf, morals about honesty aside, was proved right in the end.
So let us turn to China’s undeniable problem: it is a deeply unfree country. Looking at the World Bank indicators on national governance, China ranks broadly in line with other EM economies such as India and Brazil on measures such as the efficacy of government, the rule of law and the control of corruption. But in terms of popular voice and government accountability she is among the worst in the world. Coming in at the 5th percentile China is less free than Iran, Belarus or the Congo, and significantly less so than Russia (which does appallingly on the other measures by comparison).
This means very limited freedom on investment opportunities for the Chinese (generating disproportionate interest in real estate, for instance, and complex trust structures), coupled with controls on capital movements and profit repatriation with which Western investors are very familiar.
In itself this lends only a limited amount of credence to the idea that the big, bad wolf stands at China’s door. It remains much easier to see Western economies being bankrupted by their banking systems. But for anyone looking for the structural problem with the Chinese economy: that is it.
As a final aside, we should also remember how those trillions in imported reserve dollars are invested. China is the biggest foreign holder of US government debt in the world, and towards the end of last year sold nearly $50bn worth (out of a $1.3trn total). That’s five times the amount of monthly “tapering” being undertaken by the Fed.
In other words, if the bears are right about China being on the brink of some kind of systemic collapse, it is utterly impossible for the world to remain immune; not least the Treasury market, which has had a nice rally this year so far. The decoupling of emerging market and developed-world performance has been an eye-catching feature of recent quarters, but – one way or another – it is not really sustainable.