Fiat Economics

In a sign of China’s slowing economy passenger car sales in the country grew at the slowest pace in 15 months, moving off historic highs stoked by the country’s unprecedented fiscal stimulus. As the attached chart highlights, the spike in car sales was highly correlated to strong consumer lending growth catalyzed by the government’s stimulus package—bad news for the sector, and expectations of Chinese economic growth exceeding 10%. The Chinese government has already started, and is expected to accelerate, implementing tighter fiscal and monetary policies, which will have an adverse impact on new lending, auto sales, and general economic growth.

Chinese Car Sales vs. New Consumer Lending

Source: Bloomberg

As everyone is aware—excluding possibly the IMF— the Chinese government has begun tapping the brakes on the country’s economic engine to prevent overheating and curtail inflationary fears.  With this in mind, the IMF surprised quite a few people yesterday increasing their 2010 growth forecast for China to 10.5% y/y from 10.0% in April; well above the current Bloomberg consensus forecast of 10.1%, which I believe holds more downside than upside risk.  Even more surprising was a downward revision to its 2011 forecast to 9.6% from 9.9%, which is likely also too optimistic, especially compared to the 9.25% Bloomberg consensus forecast.  The IMF seems to be underestimating the impact of government restrictions in the country’s real estate sector, the effect of European austerity on the country’s exports, and various other domestic lending restrictions.  Highlighting the downside risk facing the Chinese economy both this year and next, the government’s chief statistician was recently quoted as saying, “In a complex and changing world economic environment, domestic economic conditions are getting more uncertain and complex.”  The lesson here is don’t be surprised to see some disappointing numbers from China over the months ahead.  Keep your eye on the country’s weakening Purchasing Manager Indices, for clues toward future growth.

China’s plummeting real estate transactions could spell trouble for domestic steel and cement industries.  The average number of real estate transaction in China’s 15 largest cities fell 75% on an annual basis according to the most weekly June release according to Goldman Sachs.  On a ytd basis transactions have declined -29%.  The Chinese government has been attempting to cool the overheating sector, in the face of mounting inflation and a more hawkish tone on monetary policy.  According to the China Daily, quoted by Bloomberg, “Apart from one villa development, no residential project obtained a sales license last week and no new residential buildings were put on the market over the weekend.”  One of the primary reasons for the decline is more stringent government policy making it more difficult to receive a second mortgage, coupled with concerns over future policies that have buyers taking a wait and see approach.  The government relied on the domestic economy, including the real estate sector to strengthen growth during the global financial crisis. 

One potentially significant international implication of a slowdown in the Chinese real estate sector is that the country’s construction industry consumes half of the nation’s steel and 36% of its aluminum.  China’s insatiable demand for natural resources has been a major crutch for the commodities industry as demand from the remainder of the world remains tepid at best.  For example in 2009 China consumed 65% of the world’s iron ore exports.  Therefore, any slowdown in Chinese demand for natural resources could have an adverse impact on the commodities sector, and continue to depress shipping companies still at the mercy of China’s whim.  To get a visual on just how significant Chinese demand for natural resources has been please see this piece from Bloomberg’s Interactive Insight team: http://bit.ly/bnCYQz

“Dear all: One Chinese official apparently leaks May macro data According to Reuters, a senior Chinese government official leaked some key macro data during an internal investor conference. If confirmed, it will be one of the largest leakages in China in two years. Official numbers are yet to be released. Relevant numbers are for CPI, PPI, Industrial production, FAI, Exports, new loans, and M2. The most surprising number is the 52% export growth, though people are deeply (in our view, not so necessarily) concerned about the 3.1% CPI inflation which for the first time this year surpassed the targeted annual target at 3%.”  -Ting Lu (陆挺), Ph.D., CFA (Bank of America – Merrill Lynch)

Global markets may be converging on a new ‘volatile’ norm as investors revalue risk, as governments begin the painful process of deleveraging to more sustainable debt levels.  Thus far fears of sovereign defaults have remained contained to the usual suspects—fundamentally weak nations—leading investors to flock to the safe-havens of the U.S., Japan, and Germany.  Risk aversion has pushed 10Y German Bund yields down to a multi-decade low of 2.632%; while 10Y U.S. Treasuries are yielding 3.113% from nearly 4% in April.  Yet, safe-haven debt levels are in most cases worse than their weak counterparts, especially in the case of Japan, meaning deleveraging is a unilateral prescription.  I won’t beat a dead horse on who could be the next Greece, but I do want to emphasize that deleveraging is a painful process, which can adversely impact growth.  Eventually, in the U.S. tough austerity measures coupled with substantial tax increments will be necessary, transforming the fuel of the nascent economic recovery, fiscal stimulus, into fiscal drag.  Japan’s likely the most at risk of the safe-havens with a vast amount of its debt financed domestically, by what is now a shrinking and ageing population; meaning external financing will ultimately be necessary.  This could cause investors to reassess Japan’s stability.  The good news is while tough measures in the US are necessary— creating significant economic headwinds— it should allow the nation to avoid the fate of Greece.  Meanwhile, I recommend monitoring investor sentiment toward Japan as the canary in the coal mine for the U.S.

As of this morning, not only have US equities (as measured by the MSCI)outpaced their global counterparts, but on a year-to-date basis it’s the only index still showing gains, albeit somewhat modest.  Interestingly, as of this week the spread between the MSCI US and MSCI World index reached its highest spread of the year, mostly due to losses in Latin America and emerging Europe. 

MSCI Indices:

Source: Bloomberg

The AUD/JPY exchange rate, commonly used as a carry trade to take advantage of stark interest rate differentials between the two countries, is also a measure of investor risk.  For that reason it may surprise some of you to learn the cost of the Australian Dollar in terms of the Japanese Yen is tightly correlated with the S&P500’s performance.  Both trades invovle risk, and as investors appetite for risk diminishes so to does demand for equities, while demand investors rush into the Yen to quickly unwind their potentially highly levered carry trades.

Risk aversion has also kept the USD/JPY trading relatively range bound, but improving U.S. fundamentals coupled with Japan’s fiscal weakness could be setting the cross-rate up for a bounce.  I expect that recovering investor sentiment, which will eventually lead to a decline in U.S. government bond purchases, will also coincide with a sharp depreication for the Yen in terms of U.S. Dollars.  The chart below highlights how the relationship between the AUDJPY cross-rate against the USD/JPY rate has broken down since the start of 2009.  I expect that USD/JPY rate will gradually increase to 100 from the current level of 93.25 as confidence returns to the market, and investors begin to digest the extent of Japan’s fiscal weakness.  In fact, with the preface that Japan is no Greece, the country’s finance minister recently announced they wanted to extend the average maturity of Japan’s government debt to reduce its refunding risk.  Japan’s debt to GDP ratio is expcted to hit 227% of GDP this year; Greece 110%… 

AUD/JPY, USD/JPY, & the S&P 500

As the chart below illustrates, Chinese inflation has risen above levels where over the past five years Chinese authorities reacted with significant hikes in the country’s benchmark deposit rate.  Yet, Chinese authorities may delay a hike, at least for the moment, to measure the effectiveness of targeted policies at the property sector and several increases to China’s reserve required ratio, now just below the series high of 17.5% at 17.0%.   Nevertheless, even larger gains in producer prices will provide significant tailwinds to Chinese inflation in the second half; likely resulting in higher inflation and slower growth as the government is forced to react.  This outlook will likely continue to weigh on Chinese equities, with the MSCI China index already down roughly 7% since the start of the year.

Chinese Year-Over-Year Inflation Vs. Benchmark Rate

Source: Bloomberg

In the mean time, China’s real estate sector will likely continue to face the brunt of China’s ‘targeted’ tightening policies as authorities try to avoid the type of bubble experienced here in the U.S.  The MSCI Chinese real estate index has lost 15% since its introduction on March 5^th.  Given mounting cost pressure—combined with a recovery in the country’s export sector—there is also a fairly good chance that the Chinese RMB will re-initiate its course of gradual appreciation.   This may become a very sensitive topic given U.S. mid-term elections and recent rhetoric between the two countries.

Europe’s rapidly escalating out-of-control debt crisis has brought about a rare occurrence, solidarity amongst its members; an elusive attribute in the European experiment.   Eurozone members, who have worked tirelessly over the weekend, appear to have agreed on creating a $645bn loan package to help defend its currency and stymie fears of Greek contagion to other countries.  It is still too early to tell whether or not Europe’s new found cooperation will be enough to restore investor confidence, but the Euro has regained some ground in Asian trading.  The true test will come in its ability to bring down skyrocketing yields for Portuguese and Spanish debt, which has come under the microscope of investors due to each countries’ weak fundamentals.  Portugal’s close mirroring of Greece just prior to that country’s breakdown may have been a major catalyst to the creation of this unprecedented loan package—along with a free falling euro.

If this package fails to bring down yields for Spanish or Portuguese debt or stabilize the Euro this situation will very quickly escalate out of control with the potential of tearing apart the Eurozone.  Many already believe the best solution for Greece with but to withdraw from the EU, and return to the Drachma, which only a few months ago would have been an unspeakable idea.  However, historically these types of programs tend to work, or at least stabilize the situation and buy more time for a more permanent solution if necessary.  Nevertheless, a bigger risk may lie ahead for Europe in the form of a double dip recession brought on by austere fiscal policies necessary to repair most member nations ailing budgets.  The EU’s weakest members, commonly referred to as the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) could find it extremely difficult to survive another recession.  Think about someone who has maxed out all of their credit cards, and is about to take a large pay-cut at work.  The only difference here is these countries are indebted to more than just a few credit card companies…

The next twelve hours will be critical for Europe, however, investors mustn’t forget about the next 12 days or 12 months either as this package could prove to be a Band-Aid for a much deeper wound.

Early comments from Paul Krugman raise some good points, but aren’t promising for either Portugal or the rescue package. But, I think the precipitous drop in the euro is indicative of plunging confidence in the region, and both aspects need to be addressed simultaneously.

“I’m not encouraged by the remarks of some of the leaders, who keep talking about protecting the euro as if speculation against the currency were the problem. Actually, a weak euro helps Europe. Speculation against the debt of weak nations is another matter; will they have any real answer to that problem?”  -Paul Krugman

Krugman’s Blog

The wheels of tightening may be gaining momentum in China, after February’s higher than anticipated inflation release.  High inflation leading to negative real deposit rates may entice investors to withdraw deposits and invest in more speculative assets, potentially spurring what is arguably already a bubble in the country’s housing sector.  I believe that China has been avoiding an increase in its deposit rates, at least before tightening by the U.S. Fed, in order to avoid further spikes in hot-money inflows (from investors looking to take advantage of interest rate differentials and anticipated appreciation in the RMB).  But, China’s inflation may have passed a threshold forcing the government to act.

Chinese Consumer Prices on an Annual Basis:

Source: Bloomberg

So what does further tightening in China look like?  First off we will likely see China continue removing excess liquidity through open market operations, increasing the yields and issuance of PBOC paper.  As the chart below illustrates, China has already begun this process, but thus far has proven to not be enough.

China People’s Bank of China 1Y Reference Yield:

Source: Bloomberg

China will most likely continue raising its reserve required ratio (RRR), which they have already increased to 16.5% from 15.5% since the start of the year.  I expect the RRR will move to it’s historic high of 17.5% over the next several months.

Chinese RRR:

Source: Bloomberg

A recovery in Chinese exports and inflationary concerns should reignite a gradual appreciation in the RMB, which was suspended at the onset of the global financial crisis.  (For more on this please see my recent piece on the RMB NDF curve).

RMB/USD:

Source: Bloomberg

Finally, the coup de grâce in Chinese tightening will be any hike in the country’s reference deposit/lending rates.  This would be a clear indicator that Chinese authorities mean business, and the country’s tightening cycle is approaching full swing.  Many analysts suspect we could see a hike in this rate within the next three weeks. possibly as early as next week.  Reverberations from this move would be felt globally, especially in the material and global transport sectors.  Easy money and large increments in new lending spurred almost insatiable demand from the country for raw materials for both final use and speculative purchases.  But, let us not forget, despite creating short-term volatility, these moves are necessary to guarantee China’s future economic growth.  Therefore, China’s tightening cycle will likely lead to quite a few buying opportunities both inside and outside of the country going into the future.

Chinese 1Y Deposit Rate vs. Fed Funds Target:

Source: Bloomberg