Source: Lynn Noah, marketrealist.com
I last wrote about the dangers of policy divergence in mid-March, but since then the economic situation in China and elsewhere in Asia has deteriorated significantly. Over the weekend, the PMI data were reported, and it looks like it was a comprehensive miss, according to Business Insider. Manufacturing PMI fell by 0.1 points to 50.1 (indicating weak growth, since this is a diffusion index), and survey components such as production, new orders and new export orders were all weaker than in March. Order backlogs fell to 44.8, almost as low as the scary number (44.4) seen at the start of the year. Dangerously, the employment component fell to 47.4, indicating expanding job losses in the manufacturing sector. Given the rising level of labor-related civil unrest in China, this can't be helping. The services PMI fell to 53.5, which while positive, is still a decline from the 53.8 reported in March, and continues the long decline seen since the 2009 peak of around 59.6. Thus, rather than seeing measurable progress in its goal to rationalize its economy, China is experiencing setbacks. In fact, The Wall Street Journal's Costas Paris has reported that trade through the Port of Hong Kong has fallen 11% in 1Q 2016, and Chinese imports from Europe were down 7% in the first quarter, indicating that despite easy money and fiscal stimulus, China's economy is still growing relatively weakly. Several Chinese provinces (e.g., Shanxi, Heilongjiang) have shown slow growth this year, according to Lucy Hornby of the Financial Times, and Liaoning Province in NE China actually will report a 1.3% decline in real GDP for the first quarter.
The new data add to the pressure on the government to do something, and although monetary and fiscal policy have already been supportive, it is likely that more will be required. Even the well-publicized anti-corruption campaign, which has already nabbed a reported 330,000 people, does not ensure that the government's standing with its workers is where leaders need it to be. Indeed, the absolutely gigantic surge in corporate borrowing in the first quarter (i.e., $954 billion, according to the Financial Times), together with a 2% of GDP surge in government spending and a 13% increase in the money supply, indicate a certain degree of desperation to get things moving. There are reports (e.g., Frank Holmes, 2016, Seeking Alpha) that parts of the Chinese economy such as the industrial, mining and energy sectors are in fact doing better, but there are also concerns (as discussed recently by Rachel Butt at Business Insider) that this cyclical recovery will soon run out of steam.
Morgan Stanley believes that the additional stimulus has been adding to the huge overcapacity in many industries in China, and therefore may be doing more harm than good. This overcapacity has been causing a slowdown in payments in the manufacturing sector, according to Gabriel Wildau of the Financial Times. This means that accounts receivable are growing rapidly over time (having already reached about $1.7 trillion), with average payment delays for listed companies stretching from 46 days in 2011 to 70 days now. Smaller companies are being forced to accept payment via 90-day or 180-day bankers' acceptances. This has led to additional business for the biggest banks, who are busy securitizing and financing the accounts receivables. So we have the biggest increase in lending ever witnessed, but between accounts receivable financing and the very common Chinese practice of rolling over bad corporate debts, one has to question how productive all of this new loan activity in the first quarter could have been. Rachel Butt has reported that it took the Chinese equivalent of $6.40 of new debt to produce $1.00 of nominal GDP in 2015, a clear sign of non-productive debt being used to prop up the financial system.
Source: Bloomberg; ibankcoin.com
The IMF has noted recently that about $1.3 trillion in corporate Chinese debt, or a sixth of the total (and 7% of GDP), is owed by companies with lower monthly revenue than what they need to pay on interest payments alone. Tom Mitchell at the Financial Times has suggested that NPLs at Chinese banks could be much bigger even than this, because many banks have taken on large volumes of opaque wealth management assets that are used as work-arounds to avoid regulatory limits. Naturally, these assets are either off-balance sheet or are not reported properly under current bank accounting methodology. This sounds vaguely reminiscent of the mortgage securitizations rampant in the US in 2006, right before the system collapsed.
The most dynamic sectors showing recent progress in China are directly related to commodity stockpiling. Although some have interpreted this year's surge in commodities trading as a cyclical recovery, others like Tanuki Capital LLP, see it as dominantly the stockpiling of dollar-denominated raw materials like oil, copper, iron ore, gold, silver, rice, cotton and corn. This stockpiling may involve to some small degree a component due to a cyclical recovery, but its scale suggests that it is mainly stockpiling for another purpose. For example, oil is being stored this year in China's strategic reserve facilities at five times the rate seen in 2015, and there are 83 supertankers carrying 166 million barrels of crude now in transit to China, according to Charles Kennedy at the oilprice.com blog. Iron ore and copper imports have surged at the highest rates seen since 2009, but we know that actual overall final demand is in fact still slowing. The people at Tanuki Capital have made a compelling argument supporting the idea that China is preparing for another step-function currency devaluation. One of the most interesting parts of their argument is the observation that Mexico may be a strategic trade threat to China because of its cheap labor, thus putting even more pressure on China's leaders to do something to help their economy.
China's currency reserves continue to shrink at an average rate of $100 billion per month, according to Wolf Richter of the Wolf Street blog. The Institute of International Finance (IIF) believes that this rate may very well accelerate as the government fights off speculators and the outflows related to capital flight. The IIF estimates a reduction in China's currency reserves of another $538 billion this year (after a decline of about $800 billion last year), which would drop the total remaining to about $2.66 trillion. This sounds like a lot, but much of this is assigned a specific purpose in trade and can't be used to offset capital flight. So the Chinese government is slowly being pushed into a tight corner. China's fight against speculators and capital flight makes sense if the goal is to get enough breathing room to make a clean decision without appearing to give in to obvious outside pressure. Since overall economic momentum still appears to be somewhat negative, all of this may raise the prospects of a sudden currency devaluation this summer or fall.
A sudden devaluation would not only make China's exports more competitive, but it would take pressure off the government by increasing the number of manufacturing jobs. However, it would also render much of Chinese corporate dollar-denominated debt (recently estimated at $1.15 trillion) more onerous to deal with, since the relative value of the renminbi would fall. Fear of this turn of events could explain the huge corporate refinancing push in China, in which large amounts of US dollar-denominated debt has been rolled over into Chinese currency-denominated debt. To the extent that this is happening, it reduces the amount of money leaving the country that can be attributed to pure capital flight. This huge debt rollover (while having the same impact on currency reserves) represents people simply anticipating a problem and rationally dealing with it. Still, the debt rollover has had a negative impact on the US Treasury bond market.
If China devalues only mildly this summer, as it did last August, then it will create trouble for the markets, but in itself it should not be disastrous. However, if it is a larger devaluation step, as implied by the massive stockpiling of commodities, then there will be considerable turmoil as a result. But leaving the markets aside for a moment, a step-function Chinese devaluation could produce serious side effects on the global economy. It is possible that since no coordination of policy will likely occur, an intensification of the so far relatively mild global currency war will ensue. Most countries in Asia would be forced to follow suit almost immediately in such an event. For an ominous historical precedent, we have only to look at the aftermath of the U.K.'s abandonment of the gold standard in September 1931, which represented a sudden devaluation in the pound sterling of 20%. In that instance, many countries faced a stark choice: 1) defend the gold standard by balancing their respective budgets and accepting wage and price deflation; 2) impose trade restrictions and capital controls to limit import spending and reduce gold outflows; or 3) abandon the gold standard, devalue their currency, and rescue their banking systems. Soon, dozens of countries left the gold standard behind, but because it wasn't coordinated, those still on the gold standard usually chose increasing trade restrictions as their policy.
But as Barry Eichengreen has shown in his seminal book on the gold standard's role in the Great Depression (1995; Golden Fetters, Oxford University Press, New York, 448p), the lack of policy coordination amongst countries led directly to both a currency war and an intense global trade war that did massive damage to the global economy. If China acts in dramatic fashion this year, the good news is that investors' fears about the demise of the Chinese economy will be diminished a bit in the short run. The bad news is that a policy divergence similar in scope to that in the Great Depression, falling at a time of already diminished global GDP growth, and occurring in the midst of the greatest credit bubble that humanity has ever known, will once again potentially expose the entire global economy to a massively destructive trade war.
The Policy Divergence in the Great Depression:
In March, when I wrote about this issue, I was unwilling to suggest that we were actually committed to such a path, but given all of the disturbing economic events since then in China and elsewhere, I am concerned that a repeat of the 1930s debacle is becoming more and more likely. I am increasingly convinced that markets could be facing a long, hot summer, and that investors need to be prepared for some major shocks. Of course, this prognosis could be wrong, but I think we are looking at a case where the risk is highly asymmetric, i.e., perhaps a small probability of occurrence, but huge losses if it happens. I would favor relatively large portfolio allocations to bonds (Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV), Wasatch-Hoisington U.S. Treasury Fund (MUTF:WHOSX), iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), Vanguard Long-Term Government Bond Index ETF (NASDAQ:VGLT), iShares 10-20 Year Treasury Bond ETF (NYSEARCA:TLH), and iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF)) and cash for all but the boldest investors.
Ironically, in light of the analogy I'm making to the role played by gold in the Great Depression, this time around I would at least initially favor gold (iShares Gold Trust ETF (NYSEARCA:IAU), SPDR Gold Trust ETF (NYSEARCA:GLD), or Van Eck Merk Gold ETF (NYSEARCA:OUNZ)) as a store of value at least. As to investors interested in playing equities, not for all the tea in China would I buy more stocks at this juncture, or take on more risk than the absolute minimum required, until this threat is resolved one way or the other.
Disclosure: I am/we are long TLT, VGLT, TLH, IEF, IAU, OUNZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.