This week’s financial news cycle has been all about China, and a wacky week it has been. On Monday major global equity indexes experienced their biggest pullback since January as trade tensions continued to fill up the Twitter feeds of the investor class and their trader bots. Not that it was all that much of a pullback: the S&P 500 was off a bit more than two percent, the Nasdaq a bit more than that. Predictably, of course, the mainstream news outlets chose to ignore the relatively minor percentage point drop and put up instead the screaming headline “Dow Plunges 600 Points!” “Six hundred” is sort of a big number, unlike “two percent” and so it had to be thus to maintain the focus of their audience for a few more minutes before they all went back to whatever this year’s Candy Crush diversion happens to be. Anyway, stock markets recovered as the week wore on though in a somewhat jittery state. But a potentially more consequential development was playing out a bit behind the scenes in the bond and currency markets. In numerological terms those developments played around the numbers seven and ten.
Unlucky Number Seven
The seven in question refers to the amount of Chinese renminbi that one US dollar buys. Right now the RMB/USD exchange rate is hovering above that threshold, at about 6.9 renminbi to the dollar. That’s not the lowest level for the Chinese currency since Beijing implemented a managed float system to replace the old fixed rate back at the turn of the decade, but it is close. The chart below shows the currency’s price trend over this period.
In the past, China has been accused of purposely undervaluing its currency in order to make its products more attractive to export markets. If that were the case, one would expect Beijing’s monetary authorities to be perfectly happy to let the renminbi fall below seven. The reality, though, is that currency manipulation of this sort has been out of favor for many years. Since the middle of the present decade China’s currency policy has consisted of two main aims: first, to open up the currency to a more prominent role in global financial flows in a manner more befitting of the world’s second largest economy; and second, to prevent massive capital outflows by domestic owners of renminbi-denominated assets. This second point, remember, was a major concern back in August 2015 and again in January 2016 when economic concerns sparked a wave of outflows. At that time Beijing commenced a sustained program of reducing their substantial holdings of foreign exchange reserves in an effort to bolster the currency – in effect, to keep the currency from falling below that threshold of seven to the dollar.
The Tenacious Ten
Which, in turn, brings us to the number ten, as in “10-year Treasury.” Because when talk turns to China’s store of foreign exchange reserves, the dominant asset in question is US Treasuries, the 10-year benchmark prominent among the spectrum of maturities therein. How important is it for China to support its currency above that seven threshold? Important enough to accelerate the pace of Treasury sales – perhaps goaded on by the parallel role such a move could play as a salvo in the trade disputes?
The good news is that a massive sale of Treasuries is probably not in the cards, at least not given the current state of things where China’s economic health remains relatively robust and the trade war is still more about posturing than actual infliction of damage. For one thing, it’s hard to think of a useful asset China could find to replace US government paper for its FX reserves. Japanese government bonds or German bunds? Those are similar in risk profile, but they also carry negative interest rates all the way out to the ten year maturity band. Nein, danke.
Nor is it even certain that substantial Treasury sales by the asset’s largest foreign holder would have a deep impact. The Treasury bond market is around $16 trillion in total size, of which China holds a bit more than $1 trillion in its FX portfolio. There is vanishingly little evidence of any widespread distaste for Treasuries among investors, many of whom expect Fed rate cuts in the next couple years and a general flight to quality sentiment as the global economy slows. That sentiment would likely attract plenty of buyers to any fire sale operation mounted by Beijing.
So that’s the good news. But it is also pretty clear that Beijing will try and do whatever it takes to prevent the kind of financial instability experienced in 2015-16, and a stable currency is a big part of that equation. The headlines may all be about bellicose trade war tweets (and they will no doubt continue to push and pull short term stock price movements), but there is much more going on with China that could play out in uncertain ways in the weeks and months ahead.
Remember last Friday? Investors were in the sunniest of moods, with another month of robust job numbers on top of a better than expected first quarter GDP reading. Even productivity was improved, as we mentioned in our commentary last week (not that anyone was paying attention to the single most important economic growth measure). It was shaping up to be a merry, merry month of May…until late into the weekend when the Twitterverse called investors away from their barbeques to inform them that the trade war was back on the table. Uproar and consternation! Chinese markets, which were already open, quickly went pear-shaped and financial media outlets set up the talking points for the week.
Trade war? Wasn’t this as close to a done deal as these things get? The presumed cessation of hostilities between the US and China on trade was widely accepted by market participants as one of the two primary tailwinds for the 2019 rally in risk assets (the other being the Fed’s pivot on interest rates). By the time the S&P 500 hit a handful of new record highs in late April, a successful outcome to the long-festering trade dispute was conventional wisdom. The Chinese delegation, led by Vice-Premier Liu He, was due to arrive in Washington on May 9 for a round of talks which, if not necessarily definitive, were at least supposed to affirm the intention of both sides to reduce tensions and maintain support for global trade (through bland platitudes if not much else). Instead, those tweets by Trump late in the day on Sunday put new tariff threats back on the table and upended the conventional wisdom.
Jittery Algos, Jaded Humans
Two years into this administration, most cognitively-endowed human beings have learned a thing or two about digesting news from Twitter, particularly that which emanates from one particular account on Pennsylvania Avenue. The performance art of grandiose pronouncements which eventually dissolve into nothingness has become routine. This wasn’t entirely clear when the trade war first started to spook markets in early 2018. But the absence of tangible actions to match the rhetoric of the tweets, along with this administration’s obsession with where the Dow is on any given day, eventually made it clear to anyone paying attention that there wasn’t much in the way of bite behind the bark.
Algorithms, bereft of those cognitive abilities, are not so sanguine, which partly explains this week’s pullback (a natural pause following an extended bull run also being in the mix). The quantitative models powered by these algorithms make up the bulk of intraday trading volume. Many of them are wired to respond to –yes, really – stuff that comes out on Twitter. So the Sunday tweets begat the Monday blues. But even algorithms have a natural stopping point. As we write this on Thursday morning, the S&P 500 is around three percent off its recent high. That’s not much, especially considering that the blue chip index had racked up gains of almost 20 percent when it set the most recent high on April 30.
It’s much less, in fact, than would be the case if the collective wisdom of human and bot traders alike determined that an honest to goodness trade war was the most likely outcome of the current state of play. Fortunately, the evidence against that outcome remains compelling. It’s performance art, and as long as neither US nor Chinese negotiators want to explain to their constituencies (and, in our case, voters) why the economy collapsed on their watch it will likely remain thus.
It’s the first Friday of the month, and we all know what that means. Jobs Friday! We know, because lots and lots of words get put to paper describing the latest trends in the labor market (which, by the way, continue to be resoundingly strong, with the lowest unemployment rate since 1969). Jobs, inflation and GDP form a sort of holy trinity of macroeconomic performance measures. They are the ones that get talked about the most and, in the popular mind, are the ones that most comprehensively stand in for the performance of the economy as a whole.
The day before Jobs Friday another performance measure came out, to basically no fanfare whatsoever. First quarter labor productivity increased by 3.6 percent from the previous quarter (on an annualized basis), well above expectations and the largest quarterly increase since 2014. The chart below shows the five year trend in productivity.
Growth For Free
It is a matter of perpetual bemusement for us that nobody – by which we mean the chattering class avatars of financial media outlets – seems to cast an eye in the direction of the quarterly productivity report when it comes out every quarter. It’s strange because we are always talking about growth. Growth is the lifeblood of the economy, and there is no end to the discussion about how to get more of it.
Well, the answer to the question about how to get more growth is actually quite simple. You guessed it…productivity. In the thousands of years of human civilization sustainable economic growth has only come about by three means: (1) an increase in population, (2) an increase in the percentage of those engaged in gainful labor relative to the size of the population as a whole, or (3) an increase in productivity, defined as the ability to produce more goods and services for every hour worked. Productivity is growth for free – you produce more stuff with the same amount of inputs. Businesses can use the productivity windfall in all sorts of ways: retain a higher percentage of profits for future investments, hire more workers to expand the business, or pay out more in shareholder dividends. It’s a virtuous cycle.
Put another way, the only way that our economy will grow over the long term is through increased productivity. In the short term it is possible to grow through fiscal and/or monetary stimulus, but those are limited in duration and come at a cost. So, again, it is always surprising to see how little attention is given to the one single macroeconomic data point that is the most accurate proxy for long term growth.
Still Got a Long Way to Go
So what to make of that 3.6 percent productivity boost we got in the first quarter? Well, it’s a nice change from recent underperformance, but still not much in terms of a broader historical context. The chart below elongates the time period to show productivity trends going back to 1990.
As the above chart shows, productivity growth was far stronger in the economic growth cycle of the late 1990s and early 2000s than it has been in the post-recession cycle from 2009 to the present (ignoring the recovery-from-trough quarters immediately after the recession). Economists differ as to why this is the case, with arguments ranging from secular stagnation (chronically low demand) to the delayed economic impact of recent innovations like artificial intelligence. We probably will not have a definitive answer to this question for some time. What will be interesting to see in the quarters ahead is whether the Q1 outperformance in productivity continues or if it turns out to be an anomalous blip. A surge in productivity would suggest a new phase in the current growth cycle. Whether the economy can replicate the productivity gains of earlier innovation cycles, though, remains to be seen.
In these weekly commentaries we periodically float “wild card” theories about the global economy. These are not outcomes we expect to happen, but alternatives with in our view a better than zero, less than fifty percent (more or less) probability. We do this not for the sake of near-term predictions, which are always silly, but as a way to identify potential ways your portfolios could be at risk. Some time late last summer we ran one of these outlier theories up the flagpole: the risk of an unexpected bounce in inflation. Now, you could say that inflation was about the last thing on anyone’s mind last fall when markets went into a funk over the prospects of lower or negative growth and observers worried about the Fed making a bad situation worse with higher interest rates. Since then, though, circumstances have changed. On the heels of a succession of outperforming economic data releases and the Fed’s embrace of dovish monetary policy, it is worth taking another look at the inflation wild card.
Where There’s Growth…
As recently as February, the economic consensus around Q1 real GDP growth was that it would barely scratch two percent, if it even managed to clock in above one percent. Today’s release by the Bureau of Economic Analysis put paid to that idea: the economy grew at a rate of 3.2 percent in the first quarter (this figure will be subject to two subsequent revisions before going into the books). Yes, there are some one-off quirks to this performance: inventory build-up by the private sector, higher exports and sharply lower imports probably won’t be sustainable trends. But personal consumption perked up nicely towards the end of the quarter and nonresidential business investment was also a positive contribution. On the heels of last month’s rebound in payroll gains, along with strong retail sales and durable goods orders, the stage would seem to be set for a near-term growth spurt.
…There Should Be Pricing Pressure
We have already seen pricing pressure work its way into corporate income statements. Companies across many key industry sectors are reporting cost pressure in their supply chains, particularly raw materials and transport costs. Wage pressures are also prevalent, which should not be surprising given the historically long run of positive monthly job creation numbers. The main concern analysts have expressed regarding these cost pressures is the effect on profit margins. If companies can’t pass on their cost increases to end customers, their own profits go down and so do their valuations.
But if consumer confidence, buoyed by rising wages and a still-tightening labor market, feeds into increased end-market demand, then companies have more leeway to pass their own intermediate goods inflation onto consumers. Voila – those consumer price indexes stuck forever just shy of two percent suddenly come to life. Again – we don’t yet see evidence of this happening. But it is plausible.
The Spoiler Argument
And if it were to come to pass…so what? Here’s the rub. Right now markets are priced for anything other than a renewed burst of inflation. The bond market has taken “Fed pivot” and run with it, now projecting a greater-than-not likelihood that the Fed will cut rates at least once before the end of the year. Well, guess what: if this vortex of higher than expected economic growth pushes up those consumer inflation numbers then we’re not going to see a rate cut. More likely we would see a yield curve steepening, leading to a repositioning of equity valuations as analysts go back and plug higher discount rates into their free cash flow valuation models. In the long run the repositioning might be good for markets (if investors think the higher growth is sustainable). In the short run it would likely be disruptive.
To repeat: this is a wild card scenario – a joker in the deck, not a most-likely outcome. But it’s worth keeping an eye on. It’s also worth keeping an eye on the Q1 productivity number when that comes out next week. One way (the only way, really) to marry higher growth with low to moderate inflation is through higher productivity and lower unit wage costs. We haven’t seen much of an uptick in productivity for many, many quarters. Now would be a good time for that to change.
There is a predictable visual theme that accompanies articles covering the quarterly release of China’s GDP growth statistics. Pictures of vast, creepily empty real estate development projects festoon the pages of analytical pieces by the likes of the Financial Times and the New York Times, introducing readers to little-known place names like Luoyang and Tianjin. The imagery helps underscore the central importance of the property sector to China (by some accounts 30 percent of its total economy), as well as the increasingly clear evidence that in this sector supply has vastly exceeded demand.
Feed the Beast
And that trend won’t be changing any time soon. In 2018 China’s growth started to slow noticeably. The stock market fell, fears of the effects of a trade war increased, and consumer activity flagged. As sure as night follows day, Beijing flooded the economy with stimulus, in the form of some $180 billion worth of local government bonds. The effects of that stimulus are evident in the chart below, showing the fixed investment trend over the past five years.
The dramatic uptick in the first three months of 2019 (the crimson trendline) is all about state-owned enterprises, through which that stimulus largesse was funneled. The vast majority of the largesse went right into infrastructure and property projects. There will be plenty more of those sprawling ghost cities for journalists to attach to their future reports.
The spree of property project-bound regional bonds was not the only form of stimulus; there was also a major tax cut aimed at small and midsized businesses to encourage them to invest in their markets. That seems to have had some effect on real economic activity (by which we mean things other than property projects in Nowheresville). Retail sales ticked up slightly in the first quarter after the pace of growth fell dramatically in 2018. This trend is shown in the chart below.
China’s economic authorities for years have been trying to rebalance the economy away from the old infrastructure/property schemata to a more consumer-oriented model. The problem is that every time growth starts to slow, the old playbook comes right back out. Notice in that earlier fixed investment chart the timing of the previous surge in state-owned investment spending: 2015 and 2016, when major parts of the economy seemed headed for a dramatic reversal of fortune. Each time this happens, it expands a credit bubble already of historic proportions. China’s debt to GDP ratio was 162 percent in 2008; it grew to 266 percent by last year. Waiting for the rebalancing is like waiting for Godot, while the debt piles up.
It Matters for Markets
The principal headline in this week’s data release was that the overall rate of GDP growth was somewhat better than expected, at 6.4 percent. The reaction among much of the world’s investor class appeared to take this at face value and chalk up one more reason to keep feeding funds into the great market melt-up of 2019. But those same analytical pieces featuring Luoyang’s empty towers point out that, as much of the economic stimulus was front-loaded in the first quarter, a double dip may well be in store. That may matter for markets at whatever time the equity rally takes a pause from its blistering year-to-date pace. Not everything matters for markets, but the performance of the world’s second largest economy is one of the more reliable attention-getters, at different times for better and for worse. The durability of the current stabilization will be something to watch heading into the year’s second half.