Will the U.S. Pick Up Where China Leaves Off?

by: Erwan Mahe

The answer to this question is truly the key to the behaviour of financial markets in the coming quarters.

Indeed, most of the impact from the massive government stimulus plans ($585bn) and, especially, from loan injections (60% of 2008 GDP in H1 2009) has undoubtedly already been exhausted, with all the latest statements by Chinese government and banking officials pointing to a tightening of quantitative monetary policy.

In July, new bank loans contracted to 52bn, i.e. to one-fifth those of June! Let’s admit that it was time to slow down, given that loans granted for the first seven months of the year totalled 7,730bn yuan, well above the annual target of 5,000bn.

We have been emphasising for several months now the Minsky scale aspect of current Chinese growth. Once growth stalls, what zone will pick up the slack?

Chinese officials, who must have a fairly good idea of the dangers of the current phenomenon, have just clearly identified their major risk: overcapacity, financed indiscriminately by the current liquidity wave.

Here is what Chinese Industry Minister, Li Yizhong, has to say:

Li Yizhong, China’s industry minister, earlier this month ordered the nation’s steel industry to refrain from expanding capacity.

"Chinese mills have capacity to produce 660 million metric tons of steel each year and there’s demand for only 470 million tons," Yi then said.

I would like to call on the industry: No new projects for three years.

As such, we figure that China, although it will do all it can to keep GDP growth at 8% or above, is confronted with a potentially steeper slowdown than currently included in consensus forecasts, which would lead to all the usual consequences for commodity, stock and government debt markets.

An example of the Chinese contribution to the world economy in recent months can be seen in the changes in Japan foreign trade, illustrating once again the contraction of world trade, an issue we examined in yesterday’s Thaler’s Corner.

As you can see in the graph, below, while the Land of the Rising Sun’s imports and exports have more or less stabilised in value terms in recent months, they are still 41% below their levels at the beginning of the year!

Exports remain stuck at their 2002 levels, which gives an idea of the road to hoe before we see a real recovery.

But the most remarkable point is that while exports to the US have declined 39.50% y-o-y, those to Europe have fallen 45.80% (!) and exports to China have retreated just 26.50%, notably, thanks to orders of machine tools used in the infrastructure works spending approved by the government in November 2008.

Japanese foreign trade

Fortunately, there is China

If China will no longer be able to play this role of buyer of last recourse for Japanese manufacturers, as we anticipate, will the United States be able to pick up the slack?

This is clearly what today’s financial markets are betting on, based on a battery of favourable US indicators published in recent days, which suggest that the US economy is stabilising.

The optimists have effectively been given plenty of ammunition, with the housing price curve showing the same sort of turnabout as the above-illustrated Japanese exports, and the surprising hike in durable goods orders (+4.9 vs an expected +3%, and June figures were also revised upward) displaying the same sort of curve.

Hmm, is it worth mentioning that these durable goods orders are still 23% below their July 2008 level?

I am not so sure, because what really counts is the momentum, and not necessarily the absolute figures.

We can indeed look forward to even more favourable economic figures on Q3, in the US and elsewhere, because the basis of comparison y-o-y will itself be a lot more favourable (especially in Q4!) and the impact of stimulus programmes, such as the cash for clunkers, will be making themselves felt during the period.

This measure was, in fact, so effective in stimulating auto industry sales (it apparently helped bring in customers who were not even motivated by the $4,500 price break) that Toys’R Us says it will apply an old toy scrapping measure in its toy stores!

The retail toy chain will offer a 20% price discount to customers who bring in certain used articles.

This is the sort of logic that has pushed us to advise clients for some time now to limit hedging operations on stock indices to low-cost strategies (put ladders and ratios) and to avoid short call, which, by the way, are too cheap in terms of implied volatility.

But the question asked most of me since I adopted a more positive positioning on stock markets is why I do not make the “logical” next step and move to a negative position on fixed rate instruments!

My answer is quite simple: Apart from the flight to quality aspect, which will effectively diminish if the scenario unfolds as anticipated, what counts for government debt instruments is anticipations of (and then actual) inflation as well as carry.

On these two points, we are maintaining a much more trenchant bias than that of the consensus.

In the first place, it seems increasingly clear that the major central banks remain sufficiently concerned about the Output Gap and rising unemployment for them to maintain their exceptional monetary measures for a good while.

Moreover, the more investors get used to zero yields on short-term savings investments, the stronger will be the temptation to extend the maturity of the investments to capture yield, at least, initially for the quasi-structural part of what is often under-the-mattress savings.

Even my bank took the initiative to suggest that I transform my money market funds into a higher yield term “blocked” account.

We continue to believe that, while we have a good chance of avoiding deflation, thanks to the vigour and speed of central bank moves (Thaler's Corner of 19-03-09: BRAVO! Shock and Awe: Achieving Rapid Dominance), the strength of the trend is such that I still do not see how the opposite danger, (hyper) inflation, can represent a real threat today.

Current rumours that the BoE will move to negative interest rates at its depository window (Thaler's Corner of 13-07-09: Orphanidès talked about it, the Riksbank did it!), which sparked an incredible rally of 2-year UK Gilts, testifies to the fact that the deflationist Gorgon continues to scare people …

The example of Toys R Us and its 20% price discount is also revealing.

Check out the graph, below, to observe its ravages, with the publication of services prices in Japan this morning.

Down 3.4% y-o-y, they have hit a new low, including below what the country experienced during its lost decade, which may turn out to be many decades.

Prices of services in Japan

Very worrisome

Still favourable to fixed interest rate debt and cash equivalent, we prefer the safety of capital to yield.

This fundamental position does not stop us from suggesting call ratios (table below) at slightly negative delta to bet on the passing time value and a limited short-term upside potential at these interest rates.

On stock indices, we advise investors to give a tactical preference to put ladder and put ratio option positions which would benefit, for example, from limited retrenchment (see below) at a low entry price.

But avoid the short calls at these low volatility levels!

Advised positions


Call Ratio 123 / 124 October: 2, delta -2%, long theta 0.40 (P&L +4)


Put Ladder 2700/ 2500/2350 Sep09:24 delta -18%, theta 0.15 (P&L -19)


Dec10 Midcurve Call Fly 98.25/98.50/98.75:3

Dec10 Call Fly 98.25/98.50/98.75:3

Disclosure: Long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%.