Conclusion: Chinese demand continues to decelerate. An analysis of the fundamentals suggests we could be headed for a global correction across a variety of asset classes.
I’ve said it before and I’ll say it again: as risk managers, it is our job first and foremost to help our clients protect capital. To do so, we have to take a duration agnostic approach to our research – which is exactly what we are doing in this report. Even though we have a long term bullish bias on China, we understand there will be a lot of money made and lost along the way (the Shanghai Composite, down 21%, is the 2nd-worst performing major equity market globally). To that tune, we dive deeper into Chinese trade and property data released over the past 48 hours to help decipher what it may mean to equity markets and asset classes globally.
China’s trade surplus grew to an 18-month high in July on the heels of weak exports and an even larger slowdown in imports. Exports rose 38.1% Y/Y to $145.5B, down from June’s 43.9% Y/Y increase. Imports fell off the table: up 22.7% to $116.8B vs. an increase of 34.1% in June. This is the smallest Y/Y gain in Chinese imports since growth resumed in November ‘09.
So what does this all mean? The Chinese deceleration story is nothing new to global markets, but what is new is the REFLATION we’ve been seeing in commodities absent Chinese demand. In 2009, REFLATION worked because of a simple two-factor model: 1) dollar down; and 2) Chinese demand accelerating. Now, one of those factors has been removed from the engine, yet we’re still seeing the same result.
On yesterday morning’s Daily Macro Call (available to our institution subscribers at 8:30 am each day – email us at if you need a live dial-in), I asked Keith: “Chinese demand continues to decelerate, yet we’ve seen commodity reflation over the last several weeks. How long could this continue to happen in spite of waning Chinese demand as investors look to commodities for yield and inflation hedging?” His response, in short, was simple: “until it stops. Then the crash comes.”
In further detail, a combination of treasury yields at or near all-time lows and a bearish intermediate term outlook for U.S. growth (and likely U.S. equities), suggests we are in a period of heightened yield seeking and once prices start to deflate, we could see an expedited move to the downside across commodities and equities globally (fearful selling). The catalyst for this move, as it was in summer of 2008 could be a sharp appreciation of the dollar. The dollar, which has been down for nine consecutive weeks, is likely oversold in the near term. If the dollar rallies, it could trigger a massive down move in many commodities – an asset class that is becoming increasingly autocorrelated with more and more speculative interest from money managers globally. Furthermore, U.S. equities are also near historical peaks in autocorrelation (see chart below), so an expedited up move in the Dollar Index could spell disaster for 3Q fund performance.
In the table below, we show correlations between commodities and select equity indices and the Dollar Index across multiple durations:
In the table below, we show correlations between commodities, the dollar, and select equity indices and the S&P 500 across multiple durations:
While we understand that no two crashes are the same, we are in a similar precarious setup as 2008. Then, the accompanying catalyst (alongside a sharp ascent in the dollar) was a freezing in the credit markets. In our view, that catalyst could be the private equity reliquefication pipeline. In 2007, there were a plethora of L.B.O.’s priced at peak multiples that are now looking to get liquid as debt ratios rise and interest coverage declines. To do so, they’ll either have to IPO increasingly at the low end of the range or hold tight for bankruptcy. Either result (more equity supply at lower prices or rising unemployment) is negative for U.S. equities.
So why might the dollar rally? The answer is quite simple: if the Fed shies away from any further meaningful quantitative easing, the dollar will likely get a boost from a much-needed dose of fiscal austerity (mid-term elections could also prove to be a catalyst with Republicans gaining steam nation-wide). If the current administration finally realizes that QE2 and MEGA Refi. won’t fix our structural, 10 percent unemployment, then U.S. equity investors could be in for quite the surprise.
As with any investment thesis, there are risks embedded in these conclusions. The main risks are: Chinese demand reaccelerating and the Fed opting to pursue further stimulus. While both very valid, we stand counter to both – particularly Chinese demand reaccelerating. Chinese property prices slowed sequentially on a Y/Y basis in July (10.3% vs. 11.4% in June), but, much to the dismay of the Chinese government, they held flat on a M/M basis. This suggests that they will continue to enforce tightening measures, which is bearish for Chinese demand over the intermediate term.
Another data point which affirms this is yesterday's news leak that China’s banking regulator has ordered banks to transfer off-balance sheet loans back onto their books and to make provisions for those that may default. Furthermore, because large and small Chinese banks have to maintain capital ratios of 11.5% and 10%, respectively, there will likely be less lending on the margin – particularly to property developers. Before, banks were able to circumvent the tightening measures by repackaging loans into CDO’s. Fitch estimates these assets to be worth 2.3 trillion yuan ($339 bil.), so in the event they are unable to raise enough capital to cover the load (only $60 billion planned for 2010), they will be forced to clamp down on lending even further – which may wind up sending Chinese demand for raw materials and energy to new lows within this current cycle - which are already depressed. July data (released overnight) affirms this: Chinese Industrial Production came in at the slowest growth rate in 11 months (+13.4% Y/Y); July crude oil imports dropped 14.7% from June; and crude steel production fell to a five-month low - down 3.9% from June.
As for further stimulus, we’ll rely on 200+ years of data to suggest that the U.S. government does not want to cross the Rubicon of Sovereign Debt. As Reinhart and Rogoff’s 2009 study shows, there is a sharp slowdown in average growth once advanced economies breach 90% debt-to-GDP. Sure, the Fed could decide to continue to bail out the markets in the near future, but that will come at a steep cost for the not-too-distant future growth prospects. The is no question U.S. economic data will continue to slow from here, so Bernanke will have plenty of chances to keep firing the QE gun going forward, but at what cost to global growth?