James Bevan: Equity markets, sentiment, German data, China & fund flows

James Bevan

Headline data may be cause for optimism but the underlying issues give cause for concern

Just a few weeks ago, regardless of whether the signals were true or note, some indicators from Asia, indeed the rest of the world, had shown  some signs of a possible stabilization or even improvement – and reasonably markets could be optimistic.

Since then, we have apparently seen some confirmation from Mrs. Yellen and the US Federal Reserve that the global economy may have become less of a concern to them, although this week Mr. Carney offered the opposite opinion while Mr. Draghi seems to want the best of both worlds by suggesting that the economy is getting better but that he still needs to ease more.

Japan’s a similar story to Europe, but for markets, confirmation that there may both be a recovery and QE has seemed almost too good to be true – and perhaps this explains why they haven’t performed even better given this notionally supportive cocktail.

What’s clear is that following the rise in equity markets, which will have tended to support the very leading indicator indices that markets like to follow, many market commentators are talking up the economic numbers.

For example, the strength in this month’s German ifo index was taken as proof that the Volkswagen Group debacle had not adversely affected confidence in Germany’s industrial sector. But VW’s own sales numbers point to a falling away of sales and there’s been a significant hit to the company’s reputation. Meanwhile, despite this news, the (hugely important) auto sector component of the ifo was reported to be at close to a record high.

We can only assume that either VW respondents know something that we don’t, they are smoking something  (the emissions of which are also illegal) or most likely the ifo data was collected before the scandal broke. If this is the case, then the next ifo reading may yet provide an unwelcome surprise to markets.

US markets

In a similar vein, we find that this week, markets were apparently ‘pleased’ with the US ISM (Institute for Supply Management) index. Alas, since the global financial crisis, the correlation of this index to actual out-turns and its predictive power have been  modest (although its relationship with financial market sentiment remains as strong as ever).

Certainly, financial markets were cheered by the apparent increase in new orders relative to inventories embedded within the ISM data but we can argue that when looked at over any reasonable  timespan, neither the new orders data nor the overall index level seem particularly inspiring at present. There may have been relief that the ISM stayed above 50 but it would be difficult to suggest that the data was indicating a strengthening economy.

While on the subject of inventories, we can be surprised by markets’ reaction to the latest US GDP data. There seems to be a view prevailing that the ‘weak’ headline number can be ignored because  the rate of inventory building was only half that which had been witnessed in H1 2015.

In fact, although the rate of inventory accumulation was lower, it was still positive and still sufficient to push  the economy’s various inventory/shipments ratios into ‘recession-warning levels’ (as the industrial data  subsequently confirmed – IP has fallen for three straight months).

The fact that the inventory ratios rose despite weak production and continued modest import trends would seem to suggest that sales must have been even weaker and that had the US corporate sector been ‘more aware’ of its excess stocks, then the inventory term might have been negative. Indeed, if the inventory term had been -$50bn rather than +$50bn, then reported real GDP  growth would have been around -1%.

Clearly, there are still pockets of growth in the US – the housing market, parts of the consumption complex and even some parts of the capital expenditure component are   expanding (transport in particular) but at present we can see downside risks to even 2% GDP growth forecasts for this. Having been positive in Q3, inventories could deliver -$100bn (at 2009 prices) next quarter, which could leave growth over the course of 2015 at just 1.5%.

China credit boost

Whilst it’s easy to be gloomy, we can always find something that looks better in the real economy, and we may suspect that markets are in the mood to continue doing this for a while longer.

Thus given the tendency for analysts to attempt to justify recent market moves ex post by reference to economic data that fit the case, we may well see some self-reinforcing moves in markets and broker forecasts and this may be facilitated by the liquidity created by central bank quantitative easing and the immense capital flows from China.

But we should be concerned that the hard objective economic data that markets will eventually receive in early 2016 may turn out to be softer than expected, undermining the optimism, with the particular risk that news from China is especially disappointing.

In terms of the data on China that we do have, with a certain amount of trumpet blowing, China released its September industrial production (IP) data a couple of weeks ago and although the numbers were surprisingly incomplete, the thrust of the numbers added weight to the notion that North Asia’s economy might be  stabilizing.

But now the full data and some revisions to the original data have been released, and the picture’s less good. Taken on its own, September looks to have been quite a poor month for the industrial sector on a sequential basis, although in terms of year-on-year (yoy) rates of change, China’s IP seems to have only become a little weaker and arguably the yoy rate of change chart has become a little less alarming.

The flipside is that many had expected China’s IP data to have been stronger in September following the easing of fiscal and monetary policies and given the scale of stimulus, the progress has been underwhelming.

Thus, it looks as if China’s aggregated budget deficit has moved from around the equivalent of 8% of annual GDP to around 12% of GDP in just the recent months.

In theory, this should have provided  the economy with a sizeable boost but it does seem, just as happened with Japan in the mid-1990s, that much of the proceeds of the increase in government spending is simply being saved by the recipient corporations.

Put simply, we can regard Japan’s much maligned “bridges to nowhere” as really just a corporate subsidy, designed or intended to keep highly indebted construction and manufacturing sector companies afloat. We can suspect that much of China’s fiscal easing has been of a similar nature with limited impact on headline growth.

As for monetary policy, in the 12 months to June, China’s credit had increased by at least $2.75tn but over recent months credit growth has increased to an annualised rate of $3.5tn or more.

Much of this growth in credit seems to have been associated with the discounting of corporate receivables, the refinancing of cash flow negative companies, and even the capitalization of interest expenses.

Nevertheless we could hope that the addition of so much credit ought to be having some effect on the economy and it’s scary that China’s nominal GDP has only increased $568bn in exchange for perhaps eight times as much new debt.

One aspect of a credit boom is that it must be funded and, in the usual course of events, a bank usually ‘funds’ its credit growth by creating deposits.

The problem with or for China is that it may have already created “too many deposits”, with China accounting for 12% of global GDP but laying claim to 25-30% of global deposits, whilst the “asset allocation” of China’s household sector, looks long of domestic deposits and very short (by $3tn-$5tn) of foreign assets.

Against this backcloth, it could be argued that by allowing another leg to its credit boom, China is creating trillions of dollars’ worth of new deposits in a system that is already bloated with deposits, and we may expect the recipients of any newly created deposits to want to    diversify away from them into other assets, most probably abroad and there’s evidence that China’s private sector is at present attempting to export (gross) around $2tn of savings/excess deposits at this time.

These flows would seem to represent a powerful source of ‘liquidity’ and funds flow for the world’s financial and property markets and Chinese liquidity may have played an important role in the recent asset market recovery.

As for how long China can afford to export such a huge amount of money, given the likely rate of growth of China’s banking system at present, China’s private sector could seek to export $1.5tn-$2tn per annum for the next few years, and if sustained this would exhaust China’s ability to intervene in FX markets perhaps as early as within the next 9 months.

We can argue that China can only support its economy with credit so long as the domestic population is prepared to hold the extra deposits and other funding instruments that are being created.

However, the balance of payments data suggest that China’s population is at best only prepared to hold half to two thirds of the  new ‘deposits’ and that the rest are being used to acquire assets offshore.

For China’s authorities, this situation gives them only three possible courses of action.

First, the government could simply stop intervening, and let the RMB fall to such a level that China’s savers could no longer ‘afford’ to buy overseas assets. Such a course of action would solve the excess money supply problem but it would be deeply embarrassing and hugely deflationary for the global economy.

The second option would be to re-impose capital controls despite but while this might stabilize the external purchasing power of the RMB, it would risk residents selling their RMB for gold and other physical assets. In circumstances such as these, inflation rates are prone to rise sharply, as they did in Eastern Europe in the 1980s, and China’s creditors and overseas markets in general probably would not welcome this course of action.

Thirdly, China could defend the currency via a tighter monetary regime that restored confidence in the RMB as a store of value. But such action could trigger recession/depression in China.

In theory, Japan could one day face this same unhappy situation – it too has “too much money” that is backed by some potentially unappealing assets (i.e. JGBs) but the difference between Japan and China is that the former’s population has a long history of suffering in silence for the good of the nation (with the result that at times the MoF/BoJ has not been able to generate the levels of private sector capital outflows that it would have liked to have witnessed), while in China the population already seems to be attempting to export huge sums of money.

Indeed, we can suspect that with China, unless the authorities find a way to plug the breach over the next few months, 2016 could prove to be a very difficult year for Xi and China sensitive parts of the global economy.  Investors would  do well to keep a close eye on China’s now IMF-audited FX reserve data (including the forwards) – if  the recent three figure draw downs do not abate than China’s policymakers will have to choose one of the  three unappealing options described above.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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