As inflation-deluded markets begin to wake to the China deflation shock that’s been obvious to MB readers for months, I am beginning to wonder if what lies ahead is a little less benign than my original thoughts. There is no cause for panic. If the worst were to come to pass and a market accident to transpire then I’d see it as a buying opportunity anyway. But for the first time in six months or so, I can see a convergence of events and narratives that could cause markets some nasty dyspepsia.
The first factor to consider is the amount of policy tightening that is underway in China.
Broad credit is retrenching very fast. Bank lending is pulling back at the swiftest pace in twenty years and pressure remains on shadow banking:
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Within this, the slowdown in commodity-intensive sectors is particularly severe.
The three red-lines policy for big property developers has slammed the brakes on Chinese floor area starts, 10% below 2019. Indeed, they running about the same level as 2011!
Making matters materially worse, later 2020 starts were inflated by both stimulus and catch-up growth which doubled activity. As authorities tighten now, the two will come off simultaneously as the construction “pig in the python” passes and a steel output cliff appears.
But wait, there’s more! In the first four months of 2020, Chinese local governments splurged on debt to fund infrastructure stimulus. In the first four months of 2021 that borrowing is down 80%. The quotas were only reduced slightly so there is some mystery as to why. Perhaps local governments have run with the Beijing deleveraging message rather than the quotas. Whatever the answer, if the borrowing strike goes on much longer, a giant air pocket will develop under infrastructure as well as realty for H2.
But wait, there’s more! Don’t forget Huarung and the bond market deleveraging:
- Some Huarung bonds are now trading at 40 cents on the dollar.
- The market is rapidly losing confidence in it and it does play a role in all kinds of counter-party deals.
So far the broader junk bond market has held up OK though spreads are trending the wrong way:
It is possible that Chinese authorities will slip up and a counter-party risk shock rock junk debt.
But wait, there’s more! In addition to all of this credit tightening and slowing catch-up growth, China has also been getting more and more irrational about skyrocketing commodity prices, as well as losing its trade war with Australia. I don’t want to overplay this point. But, right now, it’s fair to say that little would please Beijing more than seeing Australia clubbed like a baby seal with a $50 iron ore price.
This enmity is probably not large nor pervasive enough to pervert Chinese macroeconomic policy, but it may well be sufficiently intense to persist with commodity-crushing policies a little longer than might ordinarily be the case.
And right now may be a case in point.
When we put all of this together, my number one risk for markets this year, policy error, shapes as a plausible outcome for China in H2, 2021.
Not everyone is concerned. Macquarie is reassuring:
“In the past, the inflection point of industrial metal prices often coincides with that of China’s credit cycle,” said Larry Hu, chief China economist at Macquarie Group Ltd. “But that doesn’t mean it will be like that this time too, because the U.S. has unleashed much larger stimulus than China, and its demand is very strong.”
Hu also pointed to caution among China’s leaders, who probably don’t want to risk choking off their much-admired recovery by sharp swings in policy.
“I expect China’s property investment will slow down, but not by too much,” he said. “Infrastructure investment hasn’t changed too much in the past few years, and won’t this year either.”
Hmm, I don’t think so. Biden stimulus is NOWHERE NEAR as big as Chinese for commodities. Only $600bn is for hard infrastructure and that’s over ten years. China spends more than that every single year. And a lot more in 2020, that is now being withdrawn.
Morgan Stanley recently forecast that the Biden stimulus would lift demand for steel by 10mt per annum. That isn’t much more than a few Chinese apartment blocks.
This is where the market plot really thickens. The second round of $4tr Biden stimulus won’t be approved until September 2020 via the Budget Reconciliation process. It won’t be deployed until mid-2022.
In the meantime, the US economy will be rolling straight off a fiscal cliff. Because the 2020 fiscal stimulus was so enormous mid-pandemic, the fiscal headwind in H2,21 is colossal as public spending falls year on year.
This will be offset by the rampaging private sector reopening that is underway. But it will also coincide with the passing of US catch-up growth.
The FOMC sees US growth falling to 2% in Q4 before reaccelerating in 2022 as the fiscal cliff passes. But some see Q4 growth falling even further. David Rosenberg is pointing at zero:
The scary bit
Now put these two forces together:
- A Chinese growth shock into year-end with a falling CNY.
- A US growth scare into year-end with a rising DXY.
In that event, commodity prices won’t just correct in H2, they’ll crash in a rerun of the post-GFC stimulus drawdown. As was the case in 2012 and 2015, such a rout will be enough to drag in EM junk debt, especially given EMs are still hammered by virus, and then wider stock markets will be drawn in.
Readers will recall that a similar 2015 negative feedback loop was short-circuited by what became known as the Shanghai Accord. The Fed backed off its tightening cycle and China ramped up its debt engine again.
This kicked off a new growth spurt in 2016/17 as we enjoyed the global synchronised growth moment on a global inventory rebuild. That was about to run into trouble with renewed Chinese slowing and Fed tightening when Donald Trump came along and rebooted everything with massive tax cuts in 2017.
We won’t see anything quite so coordinated again this time. Nobody is friends anymore. But the Fed is not stupid enough to taper into a China commodities bust so if markets crack into 2022 it will stall tapering. Or do more QE sending the market into a new crash-up cycle.
China will likely have to kick the debt and construction can again as well. Or not, if it really wants to smash Australia and sees reliance upon it for another stimulus cycle as untenable.
There are mitigating factors that could prevent this shock scenario. Europe will be in full recovery mode with catch-up growth underway. The US private sector will also still be in recovery even if public sector spending is plunging. Chinese local governments should have resumed their borrowing, keeping its commodity demand from falling too fast. There’ll be an ongoing if slowing global inventory rebuild. Global tourism and services will be recovering steadily.
So, markets could “look through” the US growth air pocket to the coming fiscally-led Biden boom. In that event, the Chinese slowdown might be contained to a big commodity correction only. We might see USD keep falling as EUR rises, also offering support to markets. Unusually, AUD would also fall.
The warning is that the recent history of the relationship between inflated markets demanding ever more stimulus from paranoid policymakers is not encouraging in terms of which way it will go.