Conclusion: All parties and asset classes leveraged to the RECOVERY trade (copper, oil, Brazil, Industrials globally) will come under increased pressure if China's latest round of tightening proves ineffective to contain inflation and the country is forced to implement further tightening.
In the last 48 hours, a bevy of inflationary data points out of China have been cause for concern globally and may lead to increased tightening in China, which is negative for global growth. Furthermore, we believe that the Bovespa in Brazil will continue to ride the tide of Chinese producer demand, which is already showing signs of slowing on the margin.
According to recent estimates, China accounts for nearly 13% of Brazilian exports (second only to the U.S. at ~14%). With China’s imports slowing sequentially to +49.7% Y/Y in April and the prospects of further tightening by the Chinese government, Brazil’s export-heavy economy could come under increased pressure on the margin. The chart below outlines the tight trading relationship between the two countries of late.
Furthermore, China’s shrinking trade surplus (-87% Y/Y in April) may limit the size of any perspective yuan appreciation, which is less positive for the Brazilian economy vs. a larger appreciation (FYI: Brazil, India, and Europe have backed the U.S.’s call for a stronger yuan).
Below is a summary of the most important (inflationary) Chinese economic data released in the last 48 hours which took the Shanghai Composite down another -1.9% overnight to -19.2% for 2010 YTD:
- Chinese inflation (CPI and PPI) up again sequentially to +2.8% and +6.8% y/y, respectively - the largest spikes in inflation in 18 months!
- Chinese property prices (70 cities) +12.8% year-over-year representing the largest jump since 2005;
- China's purchasing price for raw materials accelerated 50bps sequentially to +12% y/y;
- Chinese imports came in at +49.7% year-over-year growth;
- Chinese loan growth up +51% sequentially (m/m) in April to 774B Yuan (versus 511B Yuan in March);
- Chinese Industrial Production (April) +17.9% versus +18.1% y/y in March;
- China’s Money Supply (M2) for April slowed month-over-month by 100bps, but is still up +21.5% y/y, which suggest future inflation will be very difficult to avoid (The Central Bank of China has a inflation target set at +3% y/y - just 20bps away from April's reading).
All told, these inflationary data points add increased pressure for China to raise interest rates and allow the yuan to appreciate. Aside from those options, however, China has already taken measured steps to cool its economy, the most important of which are:
- Raising reserve requirement ratios three times YTD; those levels are now at 17 percent for the largest banks and 15 percent for smaller ones;
- China's Banking Regulatory Commission ordered 78 state-controlled companies to exit real estate sector;
- Chinese Banks are now asking for 40%-50% down payments for second mortgages;
- In March, Chinese officials raised deposit requirements for buyers at land auctions to 20% of the minimum price to increase costs for developers; and
- China's State Council raised down payment requirements for second homes to at least 50% and have pegged mortgage rates to no lower than 110% of the benchmark rate.
Despite the latest round of tightening measures being put in place just a few weeks prior, these steps have already had a slight, but measured impact in property prices. Beijing News reported today that property prices in the Capital fell 31% in the past month. While we must be careful to not extrapolate this decline and apply it to the entire Chinese property market, it's important to note that a systemic 20-30% decline in housing prices in China's first-tier cities will ease tightening concerns. It may, however, cause producers to substitute away from investment in property, which, on the margin, is bearish for Brazilian exports and the global industrial sector at large.
In fact, we're already seeing signs of that substitution effect, as Total Planned Investment in New Construction Projects has slowed sequentially from +34.5% y/y in the three-months ended in March to +31.3% y/y in the four-months ended in April. Furthermore, Chinese PMI slowed sequentially to 55.4 in April vs. 57 in March, which raised concerns that Chinese demand for commodities will continue to wane. These are marginal sequential changes, but they matter.
Time and data will tell the full story on Chinese housing prices and whether or not the Chinese government will continue to tighten to prevent further inflation. It is important to remember that the Chinese economy is a managed and controlled market, suggesting that incremental tightening will be at their own pace, in spite of external pressure to revalue the yuan. Regardless, all parties and asset classes leveraged to the RECOVERY trade (copper, oil, Brazil, Industrials globally) will come under increased pressure if China's latest round of tightening proves ineffective to contain inflation and the country is forced to implement further tightening.
According to the below Hedgeye RECOVERY Index, the Indices, Industries, and Asset Classes leveraged to the RECOVERY trade have suffered near-widespread declines YTD, with the notable exceptions of the S&P Building and Construction Index and the S&P Homebuilders Index.