China's Unsustainable Semblance Of Stability And The U.S. Economic Decoupling

| About: Direxion Daily (DUST)
This article is now exclusive for PRO subscribers.


The U.S. economy is going to lead the world from a low growth environment with the Fed raising rates two or three times in 2017 as other central banks ease.

The narrative in the market is a stable China. I believe this is unsustainable and I expect the Chinese economy to slow and financial concerns to heighten.

China must go through an economic reset as their economy rebalances away from an investment led growth model facing diminishing returns and overcapacity towards consumer and export led growth.

This Chinese economic "reset" would involve a depreciating yuan boosting export competitiveness, corporate debt restructuring, and banking system losses leading to the potential need for a recapitalization.

A global reflationary scenario is not a near term event, though I believe in high global inflation long term largely as a result of QE and prolonged low interest rates.

U.S. monetary policy is still accommodative even with gradually rising rates. The Fed funds rate is actually still set below even the Fed's very low estimates of its natural rate. According to the December 2016 FOMC minutes, "Members judged that even after this increase in the target range, the stance of monetary policy remained accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2% inflation".

The main causes of the U.S. financial crisis were the deterioration in household balance sheets and high debt to income ratios. Both of these are repaired as depicted below and this bodes well for the expansion. Many indicators have recovered strongly despite a recent soft stretch in 2016.

I think monetary policy is perhaps too accommodative in the United States. The Fed is right for raising rates (NYSEARCA:TLT) (NYSEARCA:TBT) (NYSEARCA:TMV). The longevity of the expansion will be extended through raising rates earlier and more gradually rather than a late, steep rise which can cause a recession.

Some people are claiming secular stagnation Japan-like scenarios (NYSEARCA:DXJ) for the United States (NYSEARCA:SPY) (NASDAQ:QQQ) and I find this to be imprecise. Japan's total credit to the private sector has completely stagnated since 1990 resulting in deflationary pressures. In the United States since the crisis it has recovered strongly and is above peak 2007 levels. This shows the U.S. has reached escape velocity and that the Fed may be moving too late.

Then we have politics. People's opinions differ on Trump but the result is going to be a more expansionary fiscal policy as Trump will likely widen the deficit with lower taxes and an infrastructure plan. The U.S. will become a very attractive place for business. As Dalio states, "A pro business U.S. with its rule of law, political stability, property rights protections, and soon to be favorable corporate taxes is a uniquely attractive environment".

I have bets on U.S. economic growth and the U.S. leading the world from a low growth environment. I am not that optimistic on emerging markets though particularly China. A rising value of the USD due to higher U.S. bond yields increases the burden of U.S. dollar denominated debt in emerging markets, which is at a high level. This could set off a wave of EM corporate debt downgrades and defaults. Emerging market currencies will be under pressure. Corporate debt in China is already extremely high at 170% of GDP. Although currency depreciation can be a positive for exports, there can be excessive depreciation also known as a currency run which can cause capital flight - an economic negative.

The Fed is no longer on hold. Markets are underpricing the Fed here. Fed Fund futures only assign a 21% probability of 2 hikes in 2017. As the U.S. economy improves, the Fed will raise rates accordingly. The Fed is the central bank of the U.S. and will look after the U.S. The U.S. economy withstood the 1997 Asian financial crisis and will prove resilient as China slows and financial concerns there heighten. I don't expect the Fed to back off again as long as the U.S. economy performs even if there are negative effects in emerging markets.

China is going to experience a rough 2017. An excessively depreciating yuan and lack of ability from the PBOC to defend it could become a cause of concern. Chinese corporate debt is at 170% of GDP and their economy is going to continue slowing. This is compared to corporate debt at around 33% of GDP in the U.S. China's investment led growth model is facing diminishing returns and overcapacity. There has to a higher share in GDP contribution from consumer spending and net exports rather than investment. A depreciating yuan will allow Chinese corporations to regain export competitiveness with other countries who have seen their currencies depreciate. This will help exports in the interim of this rebalancing from investment to consumption. The PBOC may have to lower rates in response to an economic slowdown. This is currency negative. The Chinese banking system will likely have to be recapitalized as their economy slows with non performing loans rising.

With that being said, I think economic and financial conditions will prove manageable for authorities in China. There will be heightened concerns regarding Chinese financial conditions, but it does not amount to a 2008 repeat. China's long term future is bright, but the near to intermediate term could be rough.

I think gold prices (NYSEARCA:GLD) (NYSEARCA:SLV) (NYSEARCA:GDX) (NYSEARCA:GDXJ) look particularly vulnerable if the scenario of an accelerating U.S. and slowing China unfold. An improving U.S. economy and a slowing China would result in U.S. yields rising with inflation expectations declining. Real interest rates would therefore rise which is gold price negative (NYSEARCA:DUST) (NYSEARCA:JDST).

The U.S. dollar (NYSEARCA:UUP) (NYSEARCA:USDU) is likely to appreciate further as well which will also weigh on gold prices. As the Fed moves, many other central banks will lower rates or ease further. There will likely be a shortage of USD especially given a high level of dollar debt in emerging markets. Rising U.S. yields are supportive of the dollar.

A near term rise in inflation could save gold, but given my concerns with China I don't think we'll get major rise in inflationary expectations. China (NYSEARCA:FXI) slowing and an oversupply of commodities will prevent any major rise in inflation for the near term in the U.S. The U.S. labor market, core CPI and growth will all perform though allowing the Fed to raise rates, yields to rise and dollar to appreciate.

Disclosure: I am/we are long DUST.

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.