Posts tagged China Economic Outlook
It’s been one of those weeks where a virtual hailstorm of headlines overwhelms the normal mechanics of cognitive functioning. So much so, that one could easily turn one’s attention away from China for a brief second and turn it back to find that the currency has plummeted in a manner eerily similar to that of August 2015. The chart below shows the path of the renminbi over this time period, along with the concurrent trend of the Shanghai Composite stock index.
Remembrance of Shocks Past
In the chart above we highlight the two “China shocks” that rippled out into global markets in 2015 and 2016. The first was a sudden devaluation of the renminbi in August ’15, a move that caught global investors by surprise. The domestic China stock market was already in freefall then, but the currency move heightened broader fears of an economic slowdown and eventually pushed the US stock market into correction territory.
The second China shock happened just months later, when a raft of negative macro headlines greeted investors at the very start of the new year. Another global risk asset correction ensued, though the drawdown was relatively brief.
Considering those past shocks, though, investors are reasonably concerned about the implications of this week’s moves in both the renminbi and Chinese equities – which briefly entered bear market territory earlier this week. Pouring fuel on the flames, of course, is the addition of an X-factor that wasn’t present for the previous shocks – the looming presence of a potential trade war. Coupled with renewed concerns about China’s growth prospects – with or without a trade war – there is a strong sense in some camps that a third China shock may reverberate out into the global markets.
Less Is More
We understand the concerns, particularly as they are far from the only news items creating a general sense of uncertainty in the world. But our sense is that China’s growth troubles are actually good – good for the country and ultimately good for the global economy. What has slowed down in China this year – well, ever since last autumn’s Communist Party Congress, in fact – has been leveraged fixed asset investment. This is where state-owned enterprises raise copious amounts of debt and invest in infrastructure and property development projects for the primary (seemingly) purpose of beefing up the headline GDP number.
Beijing’s economic authorities have been trying to rebalance the economy away from these repeated trips to the borrow-and-build trough since 2014, but the turbulent domestic financial market conditions of 2015-16 weakened their resolve. The deleveraging commitment got a new breath of life with President Xi Jinping’s consolidation of power after last October’s party congress. With little to worry about politically, Xi and the party formalized the model of “quality over quantity” in the growth equation. So while fixed asset investment and borrowing have slowed considerably, consumer spending has increased. The service economy is growing as a percentage of overall GDP. In the long term, this is a more sustainable model for the world’s second largest economy than unwise lending for the construction of bridges to nowhere.
The Trade Factor
Yes, but what about the trade war? Well, it’s true that uncertainty about the future of trade in general is a clear and present factor in the state of world markets. The unnerving headlines seem unlikely to go away any time soon – the latest today being Trump’s apparent intention to take the US out of the World Trade Organization (without really understanding what that organization is or how, legally, the US would untangle itself from the organization that is the successor to the General Agreement on Tariffs and Trade framework the US itself architected at the Bretton Woods meetings of 1944).
We haven’t had a global trade war since the 1920s, though, so while it is certainly possible to model alternative scenarios, there’s not much in the way of actual data to support persuasive analysis of potential winners and losers. In the meantime, as regards China, the recent patterns in the stock and currency markets merit some concern, but the underlying story is not as negative as some of the present day commentary would suggest.
Stop us if you’ve heard this one before. As the end of the year approaches, investor attention suddenly focuses, laser-like, on China’s financial system. Share markets stumble on the Chinese mainland and in Hong Kong, leading to excited chatter about whether the negativity will spill over from the world’s second-largest economy into the global markets and throw a spanner into what was shaping up to be a most delightful and stress-free (at least from the standpoint of one’s investment portfolio) holiday season.
It happened at the end of 2015, with the S&P 500 falling apart on the last two trading days of the year and continuing the swoon through the first weeks of the new year. The majority of broad-market benchmark indexes lost more than 10 percent – the commonly accepted threshold for a technical correction – before sentiment recovered and bargain-hunters swooped in to take advantage of suddenly-cheap valuations.
Minsky Says What?
Share prices on the Shanghai stock exchange have fallen about 6 percent since reaching their high mark for the year on November 22. Hong Kong’s Hang Seng index, with a proportionately large exposure to mainland companies, is down by about the same amount. The chart below shows the performance of the SSE and the Hang Seng, relative to the S&P 500, over the past six months.
Financial media pundits were quick to remind their readers of the “China syndrome” that played out, not only during that nasty month of January 2016 but also five months earlier, in August 2015 when Chinese monetary authorities surprised the world with a snap devaluation of the yuan, the domestic currency. It started to seep into the market’s collective consciousness that the phrase “Minsky moment” had been uttered recently in connection with China, drawing parallels to the precariously leveraged financial systems that fell apart during the carnage of 2008 (the late economist Hyman Minsky was known for his observation that prolonged periods of above-average returns in risk asset markets breed complacency, irresponsible behavior and, sooner or later, a nasty and sharp reversal of fortune).
Context is Everything
At least so far, fears of a reprisal of those earlier China-led flights from risk appear to be less than convincing. As the above chart shows, the S&P 500 has blithely plowed ahead with its winning ways despite the pullbacks in Asia. Now, US stocks have shown themselves time and again this year to be resoundingly uninterested in anything except the perpetual narrative of global growth, decent corporate earnings and the prospects for a shareholder grab-bag of goodies courtesy of the US tax code. But ignoring fears of another China blow-up is, it would seem to us, more rational than it is complacent.
For starters, consider the source of that “Minsky moment for China” quote; it came from none other than the head of the central bank of…China. Zhou Xiaochuan, the head of the People’s Bank of China, made these remarks during the recent 19th Communist Party Congress marking the start of President Xi Jinping’s second five year term. The spirit of Zhou’s observation was that runaway debt creation imperils the economy’s long-term health, and that is as true for China as it is for any country. In particular, Zhou appeared to be alluding to what many deem to be dangerously high levels of new corporate debt issuers (and speculative investors chasing those higher yields).
Working for the Clampdown
That message was very much in line with one of the overall economic planks of the 19th Congress; namely, that regulatory reform in the financial sector is of greater importance in the coming years than the “growth at any cost” mentality that has characterized much of China’s recent economic history. Following the Congress, the PBOC implemented a new set of regulations to curb access to corporate debt. These regulations sharply restrict access to one of the popular market gimmicks whereby banks buy up high-yielding corporate debt and then on-lend the funds to clients through off-balance sheet “shadow banks.”
These and similar regulations are prudent, but the immediate practical effect was to sharply reduce the supply of available debt and thus send yields soaring. The spike in debt yields, in turn, was widely cited as the main catalyst for the equity sell-offs in Shanghai and Hong Kong.
If that is true, then investors in other markets are likely correct to pay little attention. China does have a debt problem, and if the authorities are serious about “quality growth” – meaning less debt-fueled bridge-to-nowhere infrastructure projects and more domestic consumption – then the risks of a near-term China blow-up should decrease, not increase. Stock markets around the world may pullback for any number of reasons, and sooner or later they most probably will – but a three-peat of the China syndrome should not be high on the list of probable driving forces.
The big news after last month’s National People’s Congress in Beijing was the announcement by Premier Li Keqiang of the government’s intention to set a range, rather than an individual target, for annual real GDP growth. The range was to be between 6.5 and 7.0 percent, seen as striking a balance between the admission that a steady rate of seven percent, the previous target, was not sustainable, while still delivering enough top-line growth to reach the country’s GDP targets for 2020. Today China released its GDP results for the first quarter of 2016 and – lo and behold – the number came in at 6.7 percent. Observers met the release with the usual skepticism over how much the reported figure varied from what is actually going on in the world’s second largest economy. We’re less concerned about whether the “real” top line is 6.7 or 7.0 or even 5.5 percent, and more concerned about what recent data tell us about the progress, or lack thereof, towards China’s much ballyhooed economic rebalancing.
More Bridges to Nowhere?
Specifically, much of the data released since the March NPC meeting points to an apparently deliberate decision on the part of Beijing policymakers to reach for the elixir of investment-driven stimulus – the key growth driver for much of the past 10-plus years – as a way to head off concerns that efforts to rebalance towards a more domestic consumption-driven economy may be falling short. Those concerns have manifested in recent months in the form of massive capital outflows and a resulting 20 percent decline from peak foreign exchange reserves. Premier Li’s NPC remarks reflected the view that a sugar fix is the best response. Markets took note: iron ore prices jumped by a ridiculous amount on the Monday after the NPC, and commodities generally surged in anticipation of a pickup in China demand. Were they right? Consider the chart below showing other recent key data releases.
Among these four charts, you can see the sharpest reversal of recent trends in industrial production and wholesale prices, both of which came in comfortably ahead of analyst expectations. Fixed asset growth – a key metric for China’s activity in infrastructure and property development – is still nowhere near the levels of recent years, but has actually increased for the first time since 2014. Meanwhile the growth rate of retail sales, an important benchmark of consumer activity, is lower than at any time in the past twelve months.
Corporate Debt – China’s Mountain Dew
Fixed asset investment doesn’t happen without infusions of new debt capital. New bank loans in China are up $351 billion in March, on the heels of an even brisker pace of $385 billion in January new loan creation. That January number represents the fastest pace of monthly loan growth on record. While January is often the busiest month of the year for new loan creation, with newly-approved projects tapping their sources of credit financing, the strong follow-up in March raises expectations that China’s outstanding debt will continue to set new high ground. Bear in mind that China’s total non-financial debt to GDP has soared from around 100 percent of GDP in 2009, at the outset of a new bank lending stimulus program, to 250 percent of GDP today.
The aggregate level of debt is not the only concern; much of the lending is still tied to the so-called “zombies” – troubled state-owned companies whose loans constitute a potentially significant credit quality problem for the banks that originate them. Bankruptcies and loan write-downs are a delicate matter in China, and reminiscent of the chronically inept way Japan’s financial institutions and regulators tried to deal with that country’s nonperforming debt problems in the 1990s.
When the Sugar Wears Off
All sugar highs come to an end, a fact not lost on Beijing’s Mandarins. We do not think it is on anyone’s agenda to try and embark on another decade of hypergrowth fueled by bank loans and fixed asset investment. The Mountain Dew is meant to buy some time and give the urban services sector a chance to establish enough momentum to take over as the economy’s growth engine. This is China’s own version of “kick the can,” a game in which almost every globally significant economy has indulged over the past seven years. For the time being we expect the China story to be net-neutral to positive in its contribution to the overall market narrative, premised on expectations of no imminent hard landing and a stimulative effect on commodities prices. Come autumn, though, policymakers may need to show they have an effective antidote to the sugar high.
There has been almost nothing “happy” about the New Year thus far. It’s probably a good thing that investors had a whole weekend in which to shake off New Year’s Day hangovers before showing up to face a sea of red arrows on Monday morning. Those red arrows, of course, came courtesy of yet another series of bafflingly inept moves by Beijing’s financial policymakers. It would be an exaggeration to say that the world’s second largest economy is in a swoon, but its financial markets certainly are.
But while the dramatic pullback in world equity markets and rising volatility are strong reasons to give pause, we do not believe this is the right time to pull the panic switch. While unquestionably a critically important component of the global economy, China depends on other world markets for its exports more than other world markets depend on China’s domestic demand for their own fortunes. Moreover, the fortunes of US companies still depend more on the US consumer than anything else. This year may provide a decisive answer to the question of whether the US economy can continue to prosper as the world’s growth engine despite increasing weakness elsewhere. We don’t yet know that answer – but based on the data we have on hand, we are not ready to jump into the lifeboats. If today’s environment bears any resemblance to past periods, we think more of 1997-98, and less of 2007-08. It is worth revisiting what happened back then before we conclude with our thoughts on the current market.
Asian Currencies, Act I
The Asian currency crisis of 1997 had an effect on equity markets around the world, including the US. The chart below shows the price performance of the MSCI All Counties Asia Pacific index from January 1997 to December 1998, versus the S&P 500 for the same time period.
The carnage in Asia was fast and brutal, with currencies falling as much as 40 percent against the dollar, and regional stock exchanges losing as much as 60 percent. As the above chart shows the S&P 500 (in green) suffered a rapid succession of pullbacks of 5 percent or greater between the summer of 1997 and January 1998 (the pullbacks are indicated in the chart along with the magnitude of each peak-to-trough drawdown). These pullbacks came on the heels of a near-10 percent correction that took place before the currency crisis. Many investors at the time interpreted this shaky performance – in the context of a deeply troubled global economy – as presaging an end to the bull market that had run nearly uninterrupted since early 1995. Asia was seen as the world’s emerging growth region, with great promise for US companies to manufacture, source labor and materials, and sell to the fast-growing middle class households in the region. The currency crisis threatened to bring a swift end to the good times and to provide a headwind to US companies’ EPS growth.
Russia Unleashes the Bears
As dire as the currency crisis was for Asian markets, which continued to fall through most of 1998, the US channeled its inner Taylor Swift and “shook it off” to rally strongly through the first half of 1998. Investors’ focus turned away from turmoil elsewhere to focus on the strength of the domestic US market, particularly the tech boom riding on the Internet’s penetration into commerce and social life. Then another foreign time bomb went off in August, when Russia devalued its currency and defaulted on its sovereign debt obligations. Another massive selloff took place in US equities – this one approaching the 20 percent threshold for a bear market. Caught up in the Russia collapse was the hedge fund Long Term Capital Management, which over the course of a tense few days threatened to turn this pullback into a genuine pandemic.
After all the drama, though, it turned out that the best way for investors in US stocks to navigate these two volatile years was to…do nothing at all. The S&P 500 registered a 66 percent cumulative price gain from the beginning of 1997 to the end of 1998. It was undoubtedly tempting to sell out at various critical junctures, but patience and discipline were rewarded.
Asian Currencies, Act II
Asian currencies are once again at the center of things. Most fell sharply against the dollar last year, though so far by generally less than they did in 1997. The Malaysian ringgit, for example, is about 23 percent lower versus the dollar over the past twelve months, and the Thai baht is softer by some 11 percent. Of course, this time it is the China renminbi – largely not a factor in the ’97 crisis – that is the center of focus. The RMB has devalued by just over six percent from where it was before the first bout of devaluation last August. What should not be forgotten, however, is that the renminbi was largely flat against the dollar in the first half of 2015, while the euro and other developed and EM currencies were falling.
Also worth remembering is that China as well as its Asia EM neighbors are in far stronger FX reserve positions today than they were in 1997. The threat of a debt default by any regional government is considerably more remote than it was nineteen years ago. China’s policymakers may demonstrate a tin ear when it comes to considering the likely short term impact of their decisions on world financial markets, but it is hard to imagine them making the kind of policy mistake that would trigger a real economic freefall.
And that brings us to China’s real economy. All the drama this week started with a below-consensus manufacturing report representing a fifth month of contraction. At the same time, though, recent indicators of consumer activity have been good – retail sales have been growing at double-digit rates for most of the last twelve months. If China’s economic transition is going to succeed, it is going to succeed thanks to the consumer, so these trends are absolutely consequential to the larger picture.
And if China does export price deflation to other markets through a weaker currency? Well, lower prices for China imports could be stimulative for US consumer activity. As we said earlier, what is good for the US consumer will likely be good for US stocks. Admittedly, this is a rational argument being made at the end of an irrational week. We may not be out of the woods as far as the current pullback is concerned. But we are not panicking.
In what has become an increasingly event-driven year for capital markets, Monday looms large on the calendar with the expected announcement of China’s third quarter GDP growth. Given China’s front-and-center role in the recent stock market correction, investors will want to see what the data say about how things are really faring. Not that the data will necessarily tell them much. The longstanding debate over the extent to which China manipulates its headline data continues apace, with the spectrum of opinion ranging from “a bit” to “entirely.” To grasp what is going on in the Middle Kingdom requires a careful focus on the likely source of whatever growth is in store: the Chinese consumer.
How We Got Here
For an understanding of how central the Chinese consumer is to the growth equation – and by extension to what may be in store for global asset markets in the coming months – it is worth a brief visit back to the path of China’s rise to economic stardom. The chart below shows the country’s real GDP growth for the past fifteen years, encompassing its meteoric rise in the early-mid 2000s, the market crash and Great Recession, and the post-recession recovery.
There are three distinct economic stories to tell over this fifteen year span of time. While the Chinese economy was kicking into gear in the 1990s, it was really in the first decade of this century that we saw it rise to become the preeminent supplier of all manner of goods to the rest of the world. Demand in key developed export markets in Europe and North America recovered after the 2001 recession. China’s growth trajectory was largely export-driven, with soaring industrial production and equally soaring imports of energy and industrial commodities.
The Great Recession of 2007-09 brought an end to those good times, but only briefly. With cooling demand in its major export markets China turned inward, commencing a massive, debt-fueled stimulus program in late 2008 that continued through the early years of the present decade. Construction and investment, focused primarily on property development and infrastructure projects, drove this second wave of growth. Even while the rest of the world struggled with low-to mid-single digit growth, China continued to grow at or close to ten percent during these years. But consumer spending lagged, accounting for an unusually low 35 percent of GDP as compared to 70 percent in the US and more than 60 percent in most European economies. Eventually the investment boom ran into the headwinds of oversupply. Visitors to China are rife with anecdotal tales of sprawling, eerily unoccupied commercial and residential real estate projects. As investment waned, China’s policy leaders explicitly acknowledged the need to rebalance the economy away from its traditional growth drivers towards something else. Enter the consumer.
Let a Billion Consumers Bloom
Stimulating domestic consumption has thus been a top priority for the government of Xi Jinping ever since coming to office in 2012. What do the results to date tell us? Well, the news headlines over the past several months, not to mention the ham-handed debacle of the government’s trying to control the stock market’s rise and fall and the subsequent devaluing of the currency, would seem to indicate that all is not well. But there are some indications that consumer activity is perking up rather nicely.
Overall retail sales are up more than ten percent this year – faster than the economy overall. Key consumer sectors like furniture and home electronics are up more than fifteen percent. Yes – again, one has to handle published China economic data with some skepticism. But there are enough positive appraisals from those close to the country’s consumer markets to give some support to the numbers. Recall Apple CEO Tim Cook’s sanguine appraisal about his own company’s China prospects amid the panic of the late August market selloff. Nike’s China sales grew by 27 percent in the most recent quarter – the strongest market in a very strong quarter for the company.
We are certainly not Pollyannas when it comes to China. There is plenty that could go wrong with its ambitious rebalancing plan, not the least of which is the massive debt overhang that looms over the economy. China’s debt to GDP ratio, already high, grew by more than 80 percent from 2007-14 according to a study by consulting firm McKinsey. And China’s rebalancing has other implications elsewhere in the world. For one, stocking the shelves of department stores and supplying trendy apps and gadgets to discerning young Chinese technophiles will not replace an import base weakened by declining demand for aluminum, zinc and nickel ore. That’s bad news for resource exporters like Brazil, Russia and Australia.
Nonetheless, we do believe the whirlwind of panic that sprung up in August was overblown. We will study Monday’s GDP numbers carefully, but are much more interested in how these consumer trends will continue to fare in the coming weeks and months. So far, two cheers. Let’s hope for three.