A global slowdown in 2019 – is it already in the price?

A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

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How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

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Macro Letter – No 104 – 09-11-2018

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

  • Despite US tariffs, China’s September trade balance with the US reached a record high
  • A number of China’s Asian neighbours have seen a deceleration in growth
  • The Shanghai Composite has fallen more than 50% since 2015, the PE ratio is 7.2
  • Government bond yields have eased and the currency is lower against a rising US$

During 2018 Chinese financial markets have been on the move. 10yr bond yields rose from all-time lows throughout 2017 but have since declined: –

China bonds 2006-2018

Source: Trading Economics, PRC Ministry of Finance

Despite this easing of monetary conditions the negative impact US tariffs, continues to weigh on the Chinese stock market: –

China shanghai index 1990-2018

Source: Trading Economics, OTC, CFD

Despite being a leader in frontier technologies such as e-commerce (China has 733mln internet users compared with 391mln in India, 413mln in the EU and a mere 246mln in the US) the recent decline in tech giants Alibaba (BABA) and Tencent (TCEHY) have added to financial market woes. However, as the chart above shows, Chinese stocks have been in a bear-market since 2015. Some of its Asian neighbours have followed a similar trajectory as their economies have slowed in response to a US$ strength and US trade policy.

The notionally pegged Chinese currency has also weakened against the US$, testing it lowest levels in almost a decade: –

China currency 2008-2018

Source: Trading Economics

Meanwhile, President Xi has now announced plans to rebalance China’s economy towards consumption, turning it into an importing superpower. Surely something has to give.

The IMF expects Chinese GDP to grow at 6.6% in 2018. They continue to point to signs of economic progress: –

The country now accounts for one-third of global growth. Over 800 million people have been lifted out of poverty and the country has achieved upper middle-income status. China’s per capita GDP continues to converge to that of the United States, albeit at a more moderate pace in the last few years.

The authors go on to predict that the country may become the world’s largest economy by 2030. However, there are headwinds: –

Despite the sharp rebound in nominal GDP and industrial profits, total nonfinancial sector debt still rose significantly faster than nominal GDP growth in 2017. While the corporate debt to GDP ratio has stabilized, government and especially household debt is rising, driven by continued strong off-budget investment spending and a rapid increase in mortgage and consumer loans.

It is debt that concerns Carnegie Endowment’s Michael Pettis – Beijing’s Three Options: Unemployment, Debt, or Wealth Transfers – as the title suggests he envisages three paths to adjustment.

Raise investment. Beijing can engineer an increase in public-sector investment. In theory, private-sector investment can also be expanded, but in practice Chinese private-sector actors have been reluctant to increase investment, and it is hard to imagine that they would do so now in response to a forced contraction in China’s current account surplus.

Reduce savings by letting unemployment rise. Given that the contraction in China’s current account surplus is likely to be driven by a drop in exports, Beijing can allow unemployment to rise, which would automatically reduce the country’s savings rate.

Reduce savings by allowing debt to rise. Beijing can increase consumption by engineering a surge in consumer debt. A rising consumption share, of course, would mean a declining savings share.

Reduce savings by boosting Chinese household consumption. Beijing can boost the consumption share by increasing the share of GDP retained by ordinary Chinese households, those most likely to consume a large share of their increased income. Obviously, this would mean reducing the share of some low-consuming group—the rich, private businesses, state-owned enterprises (SOEs), or central or local governments.

Although fiscal stimulus appears to be rebounding it is a short-term solution. There have been many example of non-productive public investment: as a longer-term policy, this route is untenable: –

If Beijing does not rein in credit growth in time, it will be forced to do so once debt levels reach the point at which debt can no longer rise fast enough to maintain the country’s targeted economic growth rate. This adjustment can happen quickly, in the form of a debt crisis. Or (what I think is far more likely, at least for now) it can happen slowly, in the form of what is subsequently called a lost decade (or decades) of slow growth, similar to what Japan experienced after 1990.

Increased unemployment is a dangerous route to take, debt levels are already stretched, which leaves wealth transfers to the private sector.

A forced contraction in China’s current account surplus must be counteracted by either an increase in unemployment, an increase in the debt, or wealth transfers to Chines consumers (rather than savers).

Looking ahead Chinese growth is likely to slow. Here is Focus Economics – China Economic Outlook for October: –

China Economic Outlook

Available data suggests that economic growth decelerated in the third quarter, mainly due to lackluster infrastructure investment and negative spillovers from financial deleveraging. Surprisingly, export growth remained robust in Q3 despite the ongoing trade war between China and the United States. The September PMI survey, however, revealed that external demand is softening, which suggests export figures are likely to worsen in the next few months. In response, the government has reverted to old tactics, boosting lending and increasing fiscal stimulus. Although these initiatives are effective in supporting the economy in the short-term, they threaten the effort made in previous years to reshape the country’s economic model and allow the country to avoid the “middle income trap”.

China Economic Growth

Looking ahead, economic growth is expected to decelerate. This reflects China’s more mature economic cycle and the impact of previous economic reforms, as well as the tit-for-tat trade war with the United States and the cooling housing market. However, a looser fiscal stance and a more accommodative monetary policy should cushion the slowdown. FocusEconomics panelists see the economy growing 6.3% in 2019, which is unchanged from last month’s forecast. In 2020 the economy is seen expanding 6.1%.

Countering this view Peterson Economics – Who Thinks China’s Growth Is Slowing? Suggests that China may be holding up much better than imagined: –

A widespread consensus has developed around the view that China’s economic growth is slowing and that the leadership in Beijing will have no choice but to capitulate in the tariff war with President Donald Trump to avoid a further slowdown. Leading US news organizations (here and here) have sounded this theme as a kind of late summer siren song to lull people into thinking that Trump’s confrontational approach is bound to succeed at some point. The reality is that, as has been the case for the last few years, the case for China’s imminent economic difficulties is overblown.

The most widely cited piece of evidence for the new conventional wisdom, for example, is that fixed asset investment is slowing dramatically. Unfortunately, this assessment is based on a monthly data series released by China’s National Bureau of Statistics (NBS), which is currently revising the method used to calculate fixed asset investment. The method that was used so far involved considerable double counting, which the authorities are paring back. The slowing growth of this metric, thus, tells us nothing, and assessments based on existing data are no longer meaningful. 

There are three sources of growth in any economy: consumption, investment, and net exports. The problem is that data on China’s fixed asset investment, which include the value of sales of land and other assets, have increasingly overstated the expansion of the economy’s productive capacity.  Nonetheless, financial analysts and others have relied on this series because it is the only high-frequency data available on investment.  China’s data on gross domestic capital formation, which accurately measures the expansion of productive capacity, are available only on an annual basis and with a lag of five months.

According to NBS data, fixed asset investment grew by only 5.5 percent in the first seven months of 2018, the lowest in decades. In the first half of the year (January to June), fixed asset investment grew by 6 percent. But the price index for fixed asset investment rose by 5.7 percent, implying that real investment barely grew.  This, however, is inconsistent with the more reliable NBS data, which show the expansion of capital formation, properly measured, accounted for about one-third of the 6.8 percent of China’s GDP growth.

When the NBS releases final data for 2018 (probably in about nine months), we are likely to learn that the growth of capital formation, properly measured, exceeded the growth of fixed asset investment, just as it did in 2017.

The full article is in three parts – part 2 – taking a closer look at domestic consumption – is here and part 3 – charting the steady rise in imports – is here.

Conclusions and Investment Opportunities

According to analysis from Star Capital (28-9-2018) the PE ratio for Chinese Stocks was just 7.2 times – the second cheapest of the 40 stock markets they monitor – although its CAPE ratio was a more exalted 15.7. Since June 2015 the Shanghai Composite Index have fallen by 53%, peak to trough, whilst since January it has retraced 32% to its low last month. The downtrend has yet to reverse, but, as the second chart above shows, we are testing a support line taken from the lows of 2005 and 2014.

The Q2 2018 Monetary Policy Report the PBoC revealed a moderation in the rate of growth of loans to households to 18.8%, other areas of lending continue to expand rapidly. M2 growth has been steady at around 8%. I believe they will allow interest rates to remain unchanged at 4.35%, or reduce them should the need arise. Last month PBoC foreign exchange reserves fell slightly (-$34bln) but they remain above $3trln: enough to moderate the RMBs decline. China’s real broad effective exchange rate (trade-weighted) is still in a broad, multi-year uptrend due to its soft peg to the US$. Here is the chart since 2006: –

fredgraph (4)

Source: Federal Reserve Bank of St Louis

I expect China to reach a trade deal with the US within the next year. The recent slowdown in growth rate of debt formation by households will reverse: and the Shanghai Composite Index will form a base. The RMB may weaken further as the US continues to raise interest rates. Provided the US stock market maintains its nerve, an opportunity to buy Chinese stocks may emerge in the next few months. It may not yet be time to buy but there is little benefit in remaining short.

Canary in the coal-mine – Emerging market contagion

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Macro Letter – No 100 – 13-07-2018

Canary in the coal-mine – Emerging market contagion

  • Emerging market currencies, bonds and stocks have weakened
  • Fears about the impact of US tariffs have been felt here most clearly
  • The risk to Europe and Japan is significant
  • Turkey may be the key market to watch

As US interest rates continue to normalise and US tariffs begin to bite, a number of emerging markets (EM’s) have come under pressure. Of course, the largest market to exhibit signs of stress is China, the MSCI China Index is down 7% since mid-June, whilst the RMB has also weakened against the US$ by more than 6% since its April low. Will contagion spread to developed markets and, if so, which country might be the ‘carrier’?

To begin to answer these questions we need to investigate this year’s casualties. Argentina is an obvious candidate. Other troubled countries include Brazil, Egypt and Turkey. In each case, government debt has exacerbated instability, as each country’s currency came under pressure. Other measures of instability include budget and trade deficits.

In an effort to narrow the breadth of this Macro Letter, I will confine my analysis to those countries with twin government and current account deficits. In the table which follow, the countries are sorted by percentage of world GDP. The colour coding reflects the latest MSCI categorisation; yellow, denotes a fully-fledged EM, white, equals a standard EM, green, is on the secondary list and blue is reserved for those countries which are so ‘frontier’ in nature as not to be currently assessed by MSCI: –

EM Debt and GDP

Source: Trading Economics, Investing.com, IMF, World Bank

For the purposes of this analysis, the larger the EM as a percentage of world GDP and the higher its investment rating, the more likely it is to act as a catalyst for contagion. Whilst this is a simplistic approach, it represents a useful the starting point.

Back in 2005, in a futile attempt to control the profligacy of European governments, the European Commission introduced the Stability and Growth Pact. It established at maximum debt to GDP ratio of 60% and budget deficit ceiling of 3%, to be applied to all members of the Eurozone. If applied to the EM’s listed above, the budget deficit constraint could probably be relaxed: these are, generally, faster growing economies. The ratio of debt to GDP should, however, be capped at a lower percentage. The government debt overhang weighs more heavily on smaller economies, especially ones where the percentage of international investors tends to be higher. Capital flight is a greater risk for EM’s than for developed economies, which are insulated by a larger pool of domestic investors.

Looking at the table again, from a financial stability perspective, the percentage of non-domestic debt to GDP, is critical. A sudden growth stop, followed by capital flight, usually precipitates a collapse in the currency. External debt can prove toxic, even if it represents only a small percentage of GDP, since the default risk associated with a collapsing currency leads to a rapid rise in yields, prompting further capital flight – this is a viscous circle, not easily broken. The Latin American debt crisis of the 1980’s was one of the more poignant examples of this pattern. Unsurprisingly, in the table above, the percentage of external debt to GDP grows as the economies become smaller, although there is a slight bias for South American countries to continue to borrow abroad. Perhaps a function of their proximity to the US capital markets. Interestingly, by comparison with developed nations, the debt to GDP ratios in most of these EM countries is relatively modest: a sad indictment of the effectiveness of QE as a policy to strengthen the world financial system – but I digress.

Our next concern ought to be the trade balance. Given the impact that US tariffs are likely to have on export nations, both emerging and developed, it is overly simplistic to look, merely, at EM country exports to the US. EM exports to Europe, Japan and China are also likely to be vulnerable, as US tariffs are enforced. Chile and Mexico currently run trade surpluses, but, since their largest trading partner is the US, they still remain exposed.

This brings us to the second table which looks at inflation, interest rates, 10yr bond yields, currencies and stock market performance: –

EM Markets and Inflation

Source: Trading Economics, Investing.com, IMF, World Bank

In addition to its absolute level, the trend of inflation is also an important factor to consider. India has seen a moderate increase since 2017, but price increases appear steady not scary. Brazil has seen a recent rebound after the significant moderation which followed the 2016 spike. Mexican inflation has moderated since late 2017, posing little cause for concern. Indonesian price rises are at the lower end of their post Asian crisis range. Turkey, however, is an entirely different matter. It inflation is at its highest since 2004 and has broken to multiyear highs in the last two months. Inflation trends exert a strong influence on interest rate expectations and Turkish 10yr yields have risen by more than 5% this year, whilst it currency has fallen further than any in this group, barring the Argentinian Peso. For comparison, the Brazilian Real is the third weakest, followed, at some distance, by the Indian Rupee.

India, Brazil, Mexico and Indonesia may be among the largest economies in this ‘contagion risk’ group, but Turkey, given its geographic proximity to the EU may be the linchpin.

Is Turkey the canary?

The recent Turkish elections gave President Erdogan an increased majority. His strengthened mandate does not entirely remove geopolitical risk, but it simplifies our analysis of the country from an economic perspective. Short-term interest rates are 17.75%, the second highest in the group, behind Argentina. The yield curve is inverted: and both the currency and stock market have fared poorly YTD. Over the last 20 years, Turkish GDP has averaged slightly less than 5%, but this figure is skewed by three sharp recessions (‘98, ‘01 and ‘08). The recent trend has been volatile but solid. 10yr bond yields, by contrast, have been influenced by a more than doubling of short-term interest rates, in defence of the Turkish Lira. This aggressive action, by their central bank, makes the economy vulnerable to an implosion of growth, as credit conditions deteriorate rapidly.

Conclusion and investment opportunities

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I concluded in respect of Europe that: –

…the [stock] market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Over the past few months EM currencies have declined, their bond yields have increased and their stock markets have generally fallen. In respect of tariffs, President Trump has done what he promised. Markets, like Mexico and Chile, reacted early and seem to have stabilised. Argentina had its own internal issues with which to contend. The Indian economy continues its rapid expansion, despite higher oil prices and US tariffs. It is Turkey that appears to be the weakest link, but this may be as much a function of the actions of its central bank.

If, over the next few months, the Turkish Lira stabilises and official rates moderate, the wider economy may avoid recession. Whilst much commentary concerning EM risks will focus on the fortunes of China, it is still a relatively closed, command economy: and, therefore, difficult to predict. It will be at least as useful to focus on the fortunes of Turkey. It may give advanced warning, like the canary in the coal-mine, which makes it my leading indicator of choice.

 

 

China – leading indicator? Stocks, credit policy, rebalancing and money supply

China – leading indicator? Stocks, credit policy, rebalancing and money supply

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Macro Letter – No 88 – 08-12-2017

China – leading indicator? Stocks, credit policy, rebalancing and money supply

  • Chinese bond yields have reached their highest since October 2014
  • Chinese stocks have corrected despite the US market making new highs
  • The PBoC has introduced targeted lending to SMEs and agricultural borrowers
  • Money supply growth is below target and continues to moderate

Chinese 10yr bond yields have been rising steadily since October 2016. They never reached the low or negative levels of Japan or Germany. 1yr bonds bottomed earlier at 1.76% in June 2015 having tested 1% back in 2009.

The pattern and path of Chinese rates is quite different from that of US Treasuries. Last month rates increased to their highest since 2014 and the Shanghai Composite index finally appears to have taken notice. The divergence, however, between Shanghai stocks and those of the US is worth investigating more closely.

The chart below shows the yield on 10yr Chinese Government Bonds since 2007 (LHS) and the 3 month inter-bank deposit rate over the same period (RHS):-

china 10yr vs 3 m interbank - 10yr

Source: Trading Economics

From a recent peak in 2014, yields declined steadily until October 2016, since when they have begun to rise quite sharply.

The next chart shows the change in yield of Government bonds and AAA Corporate bonds across the entire yeild curve:-

China_Government_vs_Corp_AAA_Yield_Curve

Source: PBoC

The dates I chose were 29th September – the day before the People’s Bank of China (PBoC) announced their targeted lending plan. The 22nd November – the day before the Shanghai index reversed and 6th December – bringing the data set up to date.

The general observation is simply that yields have risen across the maturity spectrum, but the next chart, showing the change in the spread between government and corporate paper reveals some additional nuances:-

China_Government_vs_AAA_Corp_Spread

Source: PBoC

Spreads have generally widened as monetary conditions have tightened. The widening has been most pronounced in the 30yr maturity. The widening of credit spreads may be driven by the prospect of $1trln of corporate debt which is due to mature between now and 2019.

Another factor may be the change in policy announced by the PBoC on September 30th. Bloomberg – China’s Central Bank Unveils Targeted Lending Plan to Aid Growth provides an excellent overview:-

Banks will enjoy 0.5 percentage point RRR cut if eligible lending exceeds 1.5 percent or more of their new lending in 2017

Deduction will be 1.5 percentage point if eligible lending reaches 10 percent or more of new lending in 2017, or if “inclusive finance” loans take up 10 percent of total outstanding loans in 2017

Rural commercial banks who meet an earlier requirement that at least 10 percent of new lending is local can receive a 1 percentage point reduction

The RRR is the Reserve Requirement Ratio. This is a targeted easing of lending requirements aimed at directing credit to small and medium sized enterprises (SMEs) rather than state owned enterprises (SOEs) and encouraging lending to the agricultural sector. It also favour banks over the shadow banking sector. This policy shift was a rapid response to a trend which has been evident this year. Whilst credit continues to expand the percentage of credit directed to SMEs dropped from 50% in 2016 to 30% in 2017 – this policy aims to rebalance the supply of credit.

Despite expectations that the first half of 2017 would be strongest, the Chinese economy continues to grow above official forecasts, Q3 GDP came in at 6.8%. M2 money supply growth, by contrast, was only 8.8% in October versus 9.2% in September. The chart below shows the declining pattern over the past five years:-

China_M2_Money_Supply_5yr_growth_rate_CEIC

Source: CEIC, PBoC

8.8% M2 growth still looks high when compared with the US (6%) the EU (5.1%) or Japan (3.9%) but with GDP increasing by 6.8% it does not look excessive. It is worth noting, however, that the PBoC target for M2 growth in 2017 is 12% down from 13% in 2016.

What impact has this had on stocks? Not much, so far, is the answer:-

Shanghai Index - 5yr

Source: Trading Economics, Shanghai SE

Chinese stocks, as I have mentioned previously, do not look excessively expensive by several measures, however, this is not to suggest that they will not fall. According to Star Capital, at the end of September the PE ratio for China was 7.6 but the CAPE ratio was a much higher 17.3. The Dividend yield (3.9%) offers some comfort nonetheless.

Conclusions and Investment Opportunities

Chinese economic growth remains spectacular but the authorities are interested in promoting inclusive growth rather than encouraging individual speculation. Official interest rates have been 4.35% since October 2015, which is the lowest they have ever been, however, the reverse repo rate was increased in January from 2.25% to 2.45% and the standing loan facility rate increased in March from 3.1% to 3.3%. The bond market expects this mild tightening bias to continue. Meanwhile, inflation, which was 1.9%, up from 0.8% in February, is hardly cause for concern.

Chinese stocks can be divided into SOEs and Non-SOEs. Since the beginning of 2017 the sectors have diverged sharply, as this chart of the WisdomTree China ex-State-Owned Enterprises Fund (CXSE) versus the MSCI China Index (NDEUCHF), indicates:-

Wisdomtree_ex-SOE_ETF_vs_MSCI_China_YTD

Source: WisdomTree, MSCI

Even since the end of November, when stocks fell abruptly, the outperformance of, what some are calling new-China, has been maintained. This is not to suggest that PBoC policy is deliberately designed to support the new-China economy, but when the interests of the Chinese people and that of enterprises align it can be a winning combination.

It is still too soon to predict the end of the rise in Chinese stocks, the authorities, however, are determined not to allow a repeat of the speculative bubble of 2015. The combination of a continued decline in the pace of money supply growth and higher bond yields, may see Chinese stocks decline in response to monetary tightening before those of developed nation countries. Chinese stocks trade differently to those listed in more open markets, nonetheless, the importance of China should not be underestimated: it might even be the leading indicator for world markets.

Is Chinese growth about to falter?

Is Chinese growth about to falter?

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Macro Letter – No 83 – 15-09-2017

Is Chinese growth about to falter?

  • The IMF revised Chinese growth forecasts higher in July – were they premature?
  • Retail sales, industrial output and fixed investment have slowed
  • The Real Estate sector is still buoyant but home price increases are moderating
  • Narrow money supply growth has slowed, other parts of the economy will follow

China has long been the marginal driver of demand for a wide array of commodities. In an attempt to understand the recent rise in the price of industrial metals, the strength of Chinese demand is a key factor. The picture is mixed.

The chart and commentary below is taken from Sean Corrigan’s August newsletter – Cantillon Consulting – China: Is the tide turning?:-

China_Money_Supply_-_Cantillon_August_2017

Source: Cantillon Consulting

As Corrigan goes on to say:-

As the deceleration has progressed, the PMI has shown its expected downward response. In due course, company revenues – and ultimately profits – will follow if this is long maintained.

Greater recourse to receivables financing (funded partly by recourse to shadow finance) can delay full recognition of this awhile, but it cannot fail to impair either the magnitude or the quality of earnings as it works through the economy.

At the heart of the credit equation lies the Real Estate market:-

China_Real-Estate_and_M1_-_Cantillon_-_August_2017

Source: Cantillon Consulting

During 2016 property prices in China increased by 19%, new homes by 12.4%, the fastest since 2011, but the market has cooled of late due to government intervention to subdue its speculative excess. New-home prices, excluding government-subsidized housing, gained from the previous month in 56 of 70 cities in July, compared with 60 in June. New Home Sales for August were the weakest in three years at +3.8%, however, investment in Real Estate development increased 7.8% last month – this is hardly a collapse. House prices are still forecast to rise by 6.8% in 2017 with growth driven by continued increases in second and third tier cities:-

China house prices - 2nd and 3rd tier cities - Bloomberg

Source: Bloomberg

There are concerns that the property market may crash later this year but Chinese authorities seem to be cogniscent of this risk. They lifted restrictions on international bond sales in June, allowing cash strapped property developers to tap international markets. Bloomberg – Indebted China Developers Get Funding Relief as Bond Sales Soar – covers this story in greater detail.

With Real Estate contributing around 15% to GDP this more moderate pace of expansion is expected to temper the pace of growth for the second half of 2017. In Q2 GDP was estimated at 6.9%, the same level as Q1 – this puts nominal growth near to a five year high.

The tide appears to have turned; Industrial output, fixed investment and retail sales all slowed during the summer. Industrial output rose 6% in August, the weakest this year. Retail sales rose 10.1% down from 10.4% and 11% in July and June. Fixed-asset investment in urban areas was up 7.8% in the year to August, the slowest since 1999:-

China growth indicators - Bloomberg

Source: Bloomberg

In a paper published at the end of August The Kansas City Federal Reserve – Has China’s Growth Reached a Turning Point? provide further support for expectations of a slowdown in Chinese growth. As they note, judging whether the recent rebound in China’s growth is temporary or more sustained, is a complex issue:-

The Chinese economy is undergoing a transition in which economic growth is rising in some sectors of the economy but declining in others. At the same time, China’s official quarterly GDP figures have been criticized for being overly smooth and less informative. Moreover, Chinese government policies have stimulated or cooled the economy at different times, further muddling the signal from economic data.

The authors construct a factor model but find that:-

…no single common factor explains the majority of the variation in Chinese activity. This is consistent with the view that the Chinese economy is in a transition, so different sectors are less synchronized. Indeed, our analysis shows that the five most important factors together account for about 75 percent of the total variation in the selected Chinese data.

The heat-map matrix – darker colour = greater importance – is shown below (apologies for the poor resolution):-

KCFR_Factor_model

Note: “M” corresponds to manufacturing, “I” corresponds to investment, “T” corresponds to trade, “C” corresponds to consumption, “S” corresponds to services, “R” corresponds to real estate and finance, and “P” corresponds to policy.

(Sources: Wind and authors’ calculations.)

Source: Kansas City Federal Reserve

Here are the weightings which the authors assigned to each factor and the cumulative total:-

KCFR_-_Factor_weights

Source: Kansas City Federal Reserve

In conclusion the authors look in detail at the evolution of the drivers behind their principal factor – Factor 1:-

KCFR_Factor_1_breakdown

Source: Kansas City Federal Reserve

As China is transitioning from an investment- and export-driven economy to a more consumption-driven economy, the recent improvement in the manufacturing, investment, and trade group is likely to be temporary. Indeed, this improvement may reflect the rebound in global commodity prices that led to higher industrial profits and production; an increase in fiscal spending, which supported investment; and improvement in global growth coupled with the depreciation in the Chinese currency at the end of last year, which boosted Chinese exports. These driving forces may prove to be temporary, casting doubts on the sustainability of recent strength in the manufacturing, investment, and trade group.

This suggests that the increase in commodity demand outside China has led to increases in prices and that this has helped boost Chinese GDP growth.

Indian, an economy with a large enough GDP to tip the scales, has been slowing since Q1 2016 so the KCFR conclusion seems like the cart leading the horse, it’s little wonder they express it tentatively.

Which brings me to a recent article from Mauldin Economics – or, more accurately China Beige Book – China: Q2 Early Look Brief in which Leland Miller takes issue with the idea that Chinese growth has peaked, corporate deleveraging is the cause, and that the commodity sector is in slowdown mode.

Here’s an extract which gives a flavour of Miller’s contrarian perspective:-

Why Rebalance When You Can Have Both?

The second quarter saw minimal progress in moving away from manufacturing toward services leadership in the economy. This was an excellent failure, however, since services performed well and manufacturing almost as well. Manufacturing tapered but extended its powerful rally since the first half of 2016. Revenue, hiring, and new orders were all higher on-quarter and sharply higher on-year. Still, services outperformed manufacturing in revenue and profits. Hiring in services has been uneven, but Q2 was solid.

Commodities Surprises to the Upside.

Defying early signs of a slowdown, our biggest Q2 surprise was another robust performance in commodities. Make no mistake, the warning signs look like Times Square: the second quarter saw huge across-the-board jumps in inventory, sliding sales price growth in three of four sub-sectors, and rising input costs. Yet, more firms again saw rising sales prices than input cost hikes, sales volumes accelerated, and cash flow moved from red to black, bolstering balance sheets.

Away from Markets’ Gaze, Aluminum Shines.

Commodities’ unsung hero: aluminum. CBB data show aluminum firms wildly outperforming the current market narrative, seeing broad Q2 gains in revenues, profits, volumes, output, and new orders, as well as cash flow, which jumped into the black for the first time in our survey’s history. The why is less clear than the what, but one obvious possibility is aluminum is the latest recipient of some of China’s excess liquidity. The #moneyball may have struck again.

Miller goes on to admit that Real Estate has slowed, credit conditions have deteriorated (outside the property space) and inventories in manufacturing, retail, and commodities hit all-time highs. By one estimate China’s unused steel capacity equals the output of Japan, India, America and Russia combined. Personally I only take issue with Miller’s spelling of aluminium!

China Beige Book remain more optimistic than the majority of commentators but they end their review on a note of caution:-

China’s attempt at deleveraging has been discussed to no end, but its implications are not well understood. In Q1, corporate reporting to CBB showed credit tightening was limited to interbank markets. In Q2, it hit firms: bond yields and rates at shadow banks touched the highest levels in the history of our survey, and bank rates their highest since 2014. So why did borrowing not collapse, denting the broader economy? One reason is what we call the “Party Congress Put.” While borrowing did see a mild drop for the third straight quarter, companies’ six-month revenue expectations remain robust in every sector save property. Companies assume deleveraging is transient, likely because they are skeptical the Party will allow economic pain in 2017. It will not be until 2018 when we find out whether deleveraging is genuine – because it won’t be until 2018 that it will actually hurt.

This brings me back to the question, what caused the initial increase in commodity prices? Part of the impetus behind the rise has been a deliberate curtailing of supply by the Chinese authorities, however, investors should be wary of equating a rise in prices with a sustainable recovery in demand. The Economist – Making sense of capacity cuts in China described it thus:-

Stockmarkets have been on a tear over the past 18 months. Shares are, on average, up by a third globally. Commodities have rallied. And the optimism has infected corporate treasurers, who, for the first time in five years, are spending more on new buildings and equipment. Plenty of factors have fed into the upturn, from Europe’s recovery to early hopes for the Trump presidency. But its origins date back to a commitment by China to demolish steel mills and shut coal mines.

On the face of it, that is an unlikely spark for a change in sentiment. Normally, growth comes from the investment in new facilities, not the closure of those in use. In fact, China’s case is a rare one. By taking on extreme overcapacity, its cutbacks have provided a boost, for itself and for the global economy. The risk, however, is that the way the country is going about the cuts both disguises old flaws and creates new ones.

In early 2016 China announced plans to reduce steel and coal capacity by at least 10% over five years – equivalent to around 5% of global supply. By 2020 they aim to reduce coal output by 800m tonnes – 25% of Chinese production. Steel capacity is set to be slashed by 100m-150m tonnes – 20% of total output – and aluminium, by 30%.

This is not the first time China has attempted to manipulate global commodity markets, yet previous forays disappointed. This time it’s different – a dangerous phrase indeed! Higher prices for steel are likely to encourage domestic investment in new supply. Iron Ore stocks at Chinese ports have reached record levels. Meanwhile the underlying problem – oversupply – has not been addressed. Signs of a roll-back in policy are already evident in the coal industry, where mines which had their production capped at 276 days in 2016, have been permitted to revert to 330 days production this year.

Conclusion and Investment Opportunities

Returning to my original question – is Chinese growth about to falter? In his recent article for the Carnegie Endowment – Is China’s Economy Growing as Fast as China’s GDP? Michael Pettis writes:-

… I would argue that “the end of China’s stellar growth story” has already occurred, and occurred quite a long time ago. Growth in the Chinese economy has collapsed, but growth in economic activity has not collapsed (let us assume, with Grenville, that somehow the reduction in GDP growth from over 10 percent to 6.5 percent does not represent a slowdown in economic activity). The growth in economic activity has instead been propped up by the acceleration in credit growth and by the failure to write down investments that have created economic activity without having created economic value. In that case, high GDP growth levels simply disguise the seeming collapse of underlying economic growth in a way that has happened many times before—always in the late stages of similar apparent investment-driven growth miracles.

The question which springs from Pettis’s article is, when will the non-performing investments be written off? Given the relatively modest government debt to GDP ratio in China (69%) there is still scope to postpone the day of reckoning, but in the shorter-term, trade tensions with the US and a certain reticence on the part of major Central Banks to embrace infinite QE, risks interrupting the current rebound in global growth over the next two years.

The IMF WEO – July 2017 update left global forecasts for global GDP growth unchanged at 3.5% for 2017 and 3.6% for 2018, but their forecasts for China were revised higher by 0.1% and 0.2% respectively. The increasing levels of debt, inventory build and buoyancy of the Real Estate sector may be sufficient for China to avoid a slow-down in GDP growth, but this will be the result of a further inflating of their debt bubble.

Chinese stocks, which continue to trade on single digit P/E ratios, look inexpensive, but this is how they almost always look. Chinese government 10yr bond yields have risen by more than 1% since October 2016 to 3.67% (14-9-2017). Despite the rhetoric emanating from Washington DC, the RMB has retraced much of the ground it lost during 2016 – since January the RMB has strengthened by 4.7% against the greenback.

An economic slowdown in China will prompt the authorities to provide liquidity, this in turn should feed through to lower interest rates, which in turn will help to support domestic stocks. US pressure, such as economic sanctions or the imposition of regulatory constraints, is likely to lead to a renewed weakening of the Chinese currency. A process lower domestic bond yields will help to accelerate. Chinese equities remain in a technical up-trend, as does the currency, while the direction of bond yields is upward as well. This favours remaining; long stocks, short bonds and long the RMB.

When might things change? It is difficult to forecast – I am a trend follower by inclination. The, possibly apocryphal phrase, attributed to Keynes, that ‘The markets can remain irrational longer than I can remain solvent,’ is etched firmly on my heart. The Chinese edict limiting coal production was, perhaps, the catalyst for present rally. I prefer to trade leaders rather than laggards and will therefore be watching the price of Chinese coal closely. Below is the five year chart:-

ICE_South_China_Coal_-_5yr

Source: Barchart.com

There is room for a downward correction – to fill a technical gap – but I see no reason to sell industrial commodities on the basis of this price pattern. Notwithstanding Pettis’s more nuanced view, I believe growth, as we understand it on a month to month basis, may slow. If it occurs the slowdown will be gradual, moderate and, if the government intervenes, might be deferred: though, in the long run, not indefinitely.

The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

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Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.