2019 Economic Outlook: Deflationary Bust Led By China

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China Enthusiast


  • The synchronized global growth experienced for the past 18 months has been driven by expansionary monetary policy in China.
  • Excessively loose monetary policy has resulted in misallocation of capital on an unprecedented scale.
  • As monetary conditions tighten, the tide will go out and the unsustainability of the realized global growth will become clear.
  • China has led the way in disguising weak economic fundamentals with unsustainable credit growth and government sponsored asset bubbles.
  • As this act comes to a close, commodities and emerging markets will feel the brunt of the pain.

Global economic growth and optimism has experienced a significant upswing over the past eighteen months as measured through a variety of metrics (GDP growth, financial market performance, business and consumer confidence and so on). This uptick in growth was not the result of an increase in labor force population growth rates, entrepreneurship, the pace of technological innovation or broad based political and economic reforms.

Instead, it was the direct result of the efforts of the People's Bank of China to breathe life into its economy following the economic malaise of 2015 and early 2016. As China has flooded its financial system with easy credit, a property and construction boom ensued and its demand for commodities and imports began to get back on the path to growth. In an interconnected global economy, where China has been responsible for ~30% of the global economic growth in the post financial crisis era, a boom in China is a boom for the rest of the world's economies as well. And as we will see in 2019, a slowdown in China will be a headwind for the rest of the world's economies as well.

In order to understand the situation China is currently in, it's important to first understand what has happened in the years that led up to this situation. In late 2012, Xi Jinping became the "Paramount Leader" of China, essentially taking responsibility of the Chinese Communist Party, a party that has deep reach into all activities that happens within China's borders. By all accounts, Xi has been a thoughtful, intelligent leader who understands the issues facing China and wants to do what's best for his country.

The situation Xi inherited in 2012 was not an easy one. The Chinese economy was in need of reform after economic liberalization in China and growth rates in the rest of the world had slowed down sharply. Instead of accepting lower growth rates and aggressively pursuing longer-term economic reforms, Xi's predecessor utilized monetary expansion and subsequent soaring asset prices as the primary means of promoting a sense of well-being for Chinese citizens. The charts below highlight how this dynamic played out in China:

Broad Money Growth Outpaces GDP Growth by Wide Margin

Acting as Fuel for Soaring Property Values

Xi Jinping was also faced with the issue of corruption and disloyalty by party members that permeated through all levels of government. Xi experienced firsthand how an absence of strong centralized leadership hindered his predecessor's ability to execute on party directives. Xi vowed not to make the same mistakes. Xi chose not to pursue painful economic reforms such as tightening credit and reining in asset bubbles. These would be a death knell to what he views as a necessity for execution of the party's vision for China: the consolidation of power under Xi.

For this reason, Xi chose to continue on the path of excessively loose monetary policy which gave way to massive growth in mortgage lending:

And fantastic continued appreciation in home prices:

All of which has a very real impact on the political capital of the Communist Party as property now composes ~70% of Chinese household net worth compared to about 15% in the U.S., and as a result, Chinese citizens are extremely sensitive to fluctuations in property values.

Unfortunately for Chinese political leadership, these property values have also become less and less grounded in economic reality, with many major cities with rental yields1 from 1-3%, yields that need unwavering support from fiscal and monetary authorities to be sustained, which is exactly what the Chinese authorities have been doing for the past decade. Beyond simply flooding its financial system with excessive cheap capital, China has turned a blind eye to rampant mortgage fraud by borrowers and the moral hazard that is rampant in the funding of these mortgages.

While these are both typical practices of governments using asset bubbles as an outlet to distract their citizens from a shortfall of tangible growth, China has gone a step further by actually directly buying surplus housing inventory to prop up its housing market. This has had the effect of quelling fears of a property collapse in 2016 and also coincided with the 19th National Congress in which Xi Jinping made a massive power grab to become the most powerful ruler of China since Mao. The Chinese Communist Party has been unwilling to let market forces create short-term pain since any disruption in perceived growth would be an obstacle to its pursuit of consolidated power.

If you have trouble digesting that, just follow the numbers China's own statistical agency produces. China has lost sight of the economic reforms (Privatization, Free Markets, etc.) that led to its economic miracle in the first place as it does whatever it takes to maintain growth rates that were the legacy of a bygone era of reform:

Fixed Investment is a measure of spending on physical assets that are held for more than one year. The recent trend of a shrinking proportion of total fixed asset investment being done by the private sector highlights how China is limiting its future growth potential as the benefits that a strong private sector bring to society are taking a backseat to fiscal directives from bureaucrats in Beijing.

Of course, the question now becomes how long can this go on for. How long will China neglect economic reforms to accomplish political directives? How long can China pump money into its financial system to sustain this asset bubble in property?

The data points to a likely inflection point in 2019.

First, understand that there isn't much authority that Xi Jinping has yet to consolidate within Chinese borders. In late 2017, Xi effectively made himself "king of China" with no end in sight to his tenure. There is no longer the need for Chinese leadership to pursue policies that appease the public, but hurt the long-term economic prospects of China (wasteful fiscal spending, excessively loose monetary policy, etc.) now that Xi has so strongly cemented his power in China.

Chinese leadership now has the political capital to go ahead and embrace the economic reforms that have fallen by the wayside in recent years. It's impossible to tell what will happen when the going gets tough, but right now, it would appear that they are doing just that.

After a period of boosting liquidity to heighten economic sentiment, China is once again aiming to shrink the moral hazard in its financial system and deflate asset bubbles in property. When China did this in the past, there were significant impacts on financial markets around the world, and this time China has less reason to flinch when things start getting dicey, as its leader no longer has any worries about job security.

First indication of economic reform is a decline in Aggregate Financing:

Total Social Financing refers to the volume of funds provided by China’s domestic financial system to the private sector. It's used as a measure of trends in liquidity within an economy. While shrinking liquidity has a negative impact on short-term growth, it also has the effect of deflating asset bubbles and punishing market participants that are over-leveraged and/or engaging in moral hazard.

This tightening of credit in China will have a very real impact on asset prices around the world in the coming 18 months.

We're already seeing it have an effect on China's property sector as can be seen with trends in real estate sales figures.

China's latest property boom peaked around mid to late 2017 and has understandably been following trends in liquidity (Total Social Financing).

As another data point around the health of China's property sector, look at the equities and bonds of China's largest property developers (Evergrande, Sunac, Vanke, Country Garden, etc.). You'll see bond yields rising and equities in free-fall. Clearly, investors are taking note of how sensitive the property boom is to trends in aggregate financing.

Commodities are another asset class that is highly sensitive to these trends in liquidity. China consumes a disproportionate amount of the world's commodities relative to its size as can be seen in the chart below:

And as a result, any slowdown in credit in China has a deflationary effect on commodities, as well as all economies around the globe since all economies consume commodities.

Just consider the chart below which compares the financing data shown previously to year-over-year returns on one of the most followed metals & mining ETFs:

The SPDR S&P Metals & Mining ETF (XME) tracks many of the world's largest commodity producers. The last two times Total Social Financing shrunk on a YoY basis, we saw declines in the value of this ETF of at least 50%.

As a result of China's great influence on the price of commodities, trends in Chinese credit also have a significant impact on interest rates around the world (rising commodity prices -> rising inflation -> rising interest rates & vice versa). Trends in aggregate financing in China have been a great leading indicator for bond yields around the world. Given what's going on in China, an inversion of the yield curve seems inevitable in 2019:

The U.S. 10-Year yield has been lagging credit trends in China in recent years as treasury investors become less optimistic about inflation when commodities are falling in value. An inversion of the yield curve occurs when longer maturity bonds (ex. 10-year) carry a lower interest rate than shorter maturity bonds (ex. 2 year). This often creates fear in financial markets as an inversion in the yield curve is sometimes viewed as a precursor for recession.

It's also important to note that when fear inevitably enters the markets, the Chinese authorities will have less firepower to stimulate its economy back to growth this time around for a variety of factors.

First up: Tariffs. While the dollar amounts of tariffs being discussed are not very significant relative to the size of China's economy, these tariffs are having a very real impact on its currency:

Furthermore, there is some very real monetary tightening going on in the U.S.:

This backdrop is going to make it very difficult for China to open up the floodgates of stimulus like it has in the past when things turn south.

Contrary to what you may hear in the news, Chinese authorities are actually extremely worried about the negative effects a weakening yuan will have on its economy as it limits its monetary tool chest to stimulate its economy when the time comes. The talks of tariffs alone have spurred a sell off in the yuan. As interest rates rise in the rest of the world, China will run into trouble stimulating its economy with easy credit & lower interest rates as such actions will inevitably lead to capital flows out of China and into the currencies of the western world, and consequently put even more pressure on the yuan.

To summarize, China is stuck between a rock and a hard place. The first option is to further stimulate its economy to provide support to a property bubble and the bad actors behind it as the rest of the world raises interest rates, have the yuan plummet in value and the economy eventually enter a period of short-term economic malaise. The second option is to continue to tighten credit and enter a period of short-term economic malaise. Either way we will see a period of lower growth in China, which will have a very real impact on financial markets, and especially so on commodities. For these reasons I am long put options/short the equities of XME, Vale (VALE), Peabody Energy (BTU), iShares MSCI China ETF (MCHI), and iShares MSCI Hong Kong ETF (EWH).

1 Rental Yields are defined as expected rental income/property value. A rental yield of 2% would mean that for a $100,000 property, one could expect to earn $2,000 in annual rent. These yields are used to gauge the valuation of a housing market. Rental yields that are below the "risk-free" rate on treasuries are unsustainable in the short term if housing prices don't continue to rise rapidly and have historically been unsustainable in the long-term despite what other macro factors may be at play.

This article was written by

China Enthusiast profile picture
I am passionate about macroeconomics and financial markets. I focus on economic growth and inflation, and my view of those two variables drives my investment strategy.

Disclosure: I am/we are short XME, MCHI, BTU, VALE, EWH. 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.

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