How can companies and investors avoid losing money as the global economy goes into a China-led recession? That’s the key question as we enter 2019. We have reached a fork in the road:
The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:
“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”
His words confirm he equates “the economy” with the stock market, as the chart shows:
- The Fed no longer sees its core mandate on jobs and prices as defining its role
- Instead it has become focused on making sure the S&P 500 moves steadily upwards
- Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue
Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards. But now it is very close to finding itself over the cliff edge.
CORPORATE DEBT IS THE KEY RISK FOR 2019
The Fed should have realised long ago that markets cannot keep climbing forever. Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery. As a result:
- Investors now have no idea if are paying too much for their purchases
- Companies don’t know if their new investments will actually make money
We are heading almost inevitably to another ‘Minsky Moment’ as I described in September 2008,:
“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.”
This time, however, the risk is in corporate debt, not US subprime lending. As the charts above show:
- The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before
- Lending standards have collapsed with most investment debt in the lowest “Triple B” grade
Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.
And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:
- Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
- The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.
CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK
As the chart shows, China’s corporate debt is now the highest in the world. Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.
The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017, China’s central bank governor warns of ‘Minsky Moment’ risk. The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:
“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”
Companies and investors need to take great care in 2019. China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:
- Companies with too much debt will go bankrupt, leading to the Minsky Moment
- The domino effect of price wars and lower volumes will quickly hit other supply chains
- Time spent today in understanding this risk will prove time very well spent later this year
Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down.
The world is coming to the end of probably the greatest financial bubble ever seen. Since the financial crisis began in 2008, central banks in China, the USA, Europe, the UK and Japan have created over $30tn of debt.
China has created more than half of this debt as the chart shows, and its total debt is now around 260% of GDP. Its actions are therefore far more important for global financial markets than anything done by the Western central banks – just as China’s initial stimulus was the original motor for the post-2008 “recovery”.
Historians are therefore likely to look back at last month’s National People’s Congress as a key turning point.
It is clear that although Premier Li retained his post, he has effectively been sidelined in terms of economic policy. This is important as he was the architect of the stimulus policy. Now, President Xi Jinping appears to have taken full charge of the economy, and it seems that a crackdown may be underway, as its central bank chief governor Zhou Xiaochuan has been explaining:
- Zhou first raised the issue at the National Congress last month, warning of the risk of a “Minsky Moment” in the economy, where debt or currency pressures could park a sudden collapse in asset prices – as occurred in the US subprime crisis. “If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. We should focus on preventing a dramatic adjustment.”
- Then last week, he published a warning that “China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing. [China] should prevent both the “black swan” events and the “gray rhino” risks.”
We can be sure that Zhou was not speaking “off the cuff” or just in a personal capacity when he made these statements, as his comments have been carried on both the official Xinhua news agency and on the People’s Bank of China website. As Bloomberg report, he went on to set out 10 key areas for action:
- “China’s financial system faces domestic and overseas pressures; structural imbalance is a serious problem and regulations are frequently violated
- Some state-owned enterprises face severe debt risks, the problem of “zombie companies” is being solved slowly, and some local governments are adding leverage
- Financial institutions are not competitive and pricing of risk is weak; the financial system cannot soothe herd behaviors, asset bubbles and risks by itself
- Some high-risk activities are creating market bubbles under the cover of “financial innovation”
- More companies have been defaulting on bonds, and issuance has been slowing; credit risks are impacting the public’s and even foreigners’ confidence in China’s financial health
- Some Internet companies that claim to help people access finance are actually Ponzi schemes; and some regulators are too close to the firms and people they are supposed to oversee
- China’s financial regulation lags behind international standards and focuses too much on fostering certain industries; there’s a lack of clarity in what central and regional government should be responsible for, so some activities are not well regulated
- China should increase direct financing as well as expand the bond market; reduce intervention in the equity market and reform the initial public offering system; pursue yuan internationalization and capital account convertibility
- China should let the market play a decisive role in the allocation of financial resources, and reduce the distortion effect of any intervention
- China should improve coordination among financial regulators”
Clearly, Xi’s reappointment as President means the end of “business as usual” for China, and for the support provided to the global economy by Li’s stimulus policies. Xi’s own comments at the Congress confirm the change of direction, particularly his decision to abandon the idea of setting targets for GDP growth. As the press conference following the Congress confirmed, the focus is now on the quality of growth:
“China’s main social contradiction has changed and its economic development is moving to a stage of high-quality growth from a high-rate of expansion of the GDP,” said Yang Weimin, deputy head of the Office of the Central Leading Group on Financial and Economic Affairs. “The biggest problem facing us now … is the inadequate quality of development.”
Companies and investors should not ignore the warnings now coming out from Beijing about the change of strategy. China’s lending bubble – particularly in property, is likely coming to an end. In turn, this will lead to a bumpy ride for the global economy.
China’s economy has not had a good start to the year. Central bank governor, Zhou Xiaochuan, admitted at the weekend that growth had “tumbled a bit too much“, adding:
“China’s inflation is also declining, so we need to be vigilant to see if the disinflation trend will continue, and if deflation will happen or not”
The chart above of electricity consumption highlights the problem:
- It soared 15% in 2010 as China’s stimulus programme took hold, after 6% in 2009
- It then held at 12% in 2011 before dipping to 5% in 2012
- More stimulus then pushed it up to 8% in 2013, but it fell back to 4% last year (green line)
- And in the first 2 months of 2015, it was up just 2.5% (red square)
Even more revealing is that the January-February data showed consumption by secondary industry (the largest single consumer) was up only 1.5%. Heavy industry actually showed a fall of -0.4%. This confirms there was no recovery after the downturn in November, when 2000 factories were told to cutback output in order that Beijing might have clearer skies for the APEC Summit.
The key issue is that the government is now entering the really difficult part of its transition to the announced ‘new normal’ economic policies. Until recently, many had assumed this would be relatively painless – the government would simply wave a magic wand, and suddenly everything would be going well.
But reality isn’t like that. You have to do the painful bit first, in China’s case by cutting back sharply on wasteful investment. As Premier Li warned China’s parliament last month:
“This is not nail-clipping. This is like taking a knife to one’s own flesh. But however painful it might be, we are determined to keep going until our job is done.”
This is why I have argued for the past year that China’s economy may well see zero growth for a period between now and 2017. President Xi has been very clear about the importance of moving into the ‘new normal’ economy. And he has a number of initiatives underway, such as the new Silk Roads and the Asian Infrastructure Investment Bank, that will produce growth in the second phase of his leadership after 2018.
But in the short-term, it would make political sense for him to take the pain of restructuring in 2015-16. After this, he can then hope to point to ‘green shoots’ of recovery in 2017, in the run-up to his reappointment in March 2018.
Thus Xi argued on Saturday at the Boao Forum: “China’s economy shouldn’t be viewed only by its growth rate“.
The last 10 days have seen turmoil in major currency markets:
- The Swiss National Bank gave up trying to devalue versus the euro, and the franc jumped 30% in minutes
- The European Central Bank (ECB) launched its €1tn Quantitative Easing (QE) programme, causing an immediate 3% fall in the euro’s value versus the dollar
These are major moves by any historical standard, and highlight how earlier ‘currency wars’ have broadened in scale.
Their origin was in 2009, when the US Federal Reserve launched its first QE programme. One of its key impacts (whether intentional or otherwise) was to devalue the US$ – thereby supporting export growth and the US economy. By 2011, after the Fed’s QE2 programme, the US$ Index was down 19% as the chart shows.
But then the Bank of Japan launched its own QE programme. And in October last year, when the US$ Index seemed likely to fall again, it launched its QE2 programme. Last Thursday, the ECB began its own QE programme, effectively joining the war on Japan’s side.
Japan and Europe have ageing populations and so cannot generate domestic growth. By weakening the currency, the ECB and Bank of Japan expect to compensate for this by generating growth in export markets. In turn, however, these competitive devaluations create major risks for the global economy, as the greatest central banker of modern times, Paul Volcker, has explained:
“Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. I think it gets dangerous when they lose sight of the basic function of the central bank. The key issue concerns what this “function” should be. The basic function of a central bank is to defend the value of the currency,” he insists, as his highly successful experience in the 1980s “taught him how limited a central banker’s powers really are”.
CHINA HAS ABANDONED STIMULUS FOR A ‘NEW NORMAL’ APPROACH
The problem is that currency wars are a zero-sum game. Today, Japan and the Eurozone are winning at the expense of the USA and Switzerland. Thus the US$ Index has broken out of a 30-year downtrend, and is at an 11-year high.
Effectively, though, this means that 2 of the world’s 4 largest economies are effectively waging a currency war against the largest economy, the USA, as well as against Switzerland. This cannot end well.
Within a few weeks, the Fed will find that the US recovery is suddenly weakening again:
- The collapse of the shale gas/oil bubble means US jobs growth will soon reverse, and housing starts slow
- US companies will lose market share in export markets as Japan and Europe become more competitive
- The rise in the value of the US$ will also help to ensure that the US slips into deflation.
- And so the Cycle of Deflation will likely move forward another stage, towards protectionism and tariffs
Of course, there is another way forward, which avoids this zero-sum game.
China’s new leadership realised 2 years ago that its previous policies had been a complete mistake. It has since adopted ‘New Normal’ policies, based on an acceptance that ageing populations inevitably lead to lower economic growth. As Zhou Xiaochuan, governor of the People’s Bank of China, told the World Economic Forum in Davos last week:
“If China’s economy slows down a bit, but meanwhile is more sustainable for the medium and long-term, I think that’s good news”
Unfortunately, very few of his peers seem to be listening to his common sense message.
WEEKLY MARKET ROUND-UP
The weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 57%. “Current market fundamentals do not support any significant upturn on benzene pricing”
Brent crude oil, down 53%
Naphtha Europe, down 53%. “Buying appetite in downstream petrochemical markets is thin as polyethylene players wait for the February ethylene contract to settle”
PTA China, down 44%. ”Buyers were mostly purchasing on a need-to basis, adding that the market outlook remains uncertain”
¥:$, down 15%
HDPE US export, down 23%. “Most domestic export prices continued to slip on lower ethylene and energy market values”
S&P 500 stock market index, up 5%
China seems to be trying to tell the outside world something quite important about the impact of its economic policy changes. But to judge by most expert commentary, the outside world is convinced they are bluffing. Thus JP Morgan issued a Buy recommendation yesterday on the Shanghai market:
“Chinese stocks will probably rally as much as 20% as gauges of economic growth stabilize and valuations rise from historic lows. We recommend a trading buy of China equities, based on seasonality and all-time low valuations. We expect a 15-20% market rebound in the coming weeks, once growth stabilizes due to seasonality and the market’s focus switches to structural reforms.”
But state-owned China Daily gave a different view from the prestigious Academy of Social Sciences the same day:
“Surging borrowing costs are threatening China’s economic growth this year. With growth momentum already slowing, Chinese enterprises will find their earnings increasingly insufficient to cover the cost of debt, with loan rates now exceeding 9%. The situation inevitably raises the question of how the credit-dependent economy can keep expanding at the current pace. There’s a dilemma facing the central bank.
“If the People’s Bank of China maintains a tight monetary stance and loan rates stay high, economic growth will be constrained. Cash-starved companies will result in a contraction in business activity, with the Purchasing Managers’ Index for manufacturing likely to slide below 50 in the second quarter. If the PBOC loosens monetary policy to push down borrowing rates, it will have to achieve total social financing – a broad measure of liquidity – of more than Rmb 19tn ($3.14tn) to support GDP growth of 7.5%.
“But that amount of total social financing would represent 12% year-on-year expansion, much faster than last year’s gain of 9%. An increase of that scale will cause massive macroeconomic risk, because non-performing loans will pile up faster and the goal of reducing the economy’s reliance on credit-fueled expansion will recede even further into the distance. To have more sustained and quality growth, we’ve got to let the growth rate go down.
“Yet another risk is the massive debt of local governments that rely on land as collateral. If there’s a setback in the property market and land values decline, it’s unclear how local governments can repay their debt, analysts said. As of June 30 last year, that debt stood at an estimated Rmb 17.9tn.
“People always say China’s economic growth model is export- and investment-driven. But if you look at the data for the past two or three years, it is becoming solely investment-driven. Exports in 2012 made a negative contribution to GDP growth, and if you deduct speculative funds disguised as trade payments, you’ll find that exports were a drag on growth again in 2013. As the economy increasingly relies almost solely on investment, any slowdown in investment could curtail growth.”
And then, as if it wanted to ensure we got the message, it used the chart above in reporting on the coal market :
“China’s drive to transform its economy, which includes reducing the role of energy-intensive industries and paring steel capacity, is driving up coal inventories at key ports as demand across a variety of sectors weakens. Inventories at Qinhuangdao in Hebei province, the largest coal port in China, exceeded what’s widely viewed as the warning line of 8 million metric tons on Feb 6, which was a 10-month high, according to the China Coal Transportation and Distribution Association.
“The rising stockpiles indicate that downstream users at steel mills, cement factories and coal-fired power plants are reluctant to purchase fuel because of weak market conditions.
“Inventories at Qinhuangdao usually hover around 6MT, but the figure has been rising in the past few months. In the past three weeks, the figure soared almost 2MT, reaching 8.28MT on Sunday. Inventories are also rising at the other three major coal ports in North China – Caofeidian and Jingtang (both in Hebei province) and the municipality of Tianjin. Inventories at the four major ports in North China totaled 22MT by the end of last week.
“Given that coal fuels so many industries, weak demand for the fuel also portends a slowing economy.”
“Massive economic risk”, or “trading buy”? Opinions really couldn’t be more opposite.
Time will tell if the outsiders know best – but the blog doesn’t believe that China’s new leadership are bluffing.