“[H]ope is by nature an expensive commodity, and those who are risking their all on one cast find out what it means only when they are already ruined.” – Thucydides, The History of the Peloponnesian War
“Narrative is linear, but action has breadth and depth as well as height and is solid.” – Thomas Carlyle
Continuing on from last week, we share more market observations that have caught our attention as we think about investment ideas and themes for 2019. This piece, too, will be chart heavy.
Please note this will be this year’s last weekly update, we will be back with our next piece during the first week of January.
China Shadow Banking
China’s leadership, at the end of last year, made it abundantly clear that reining in financial risk was an economic priority for the next three years. With the centenary of the founding of the Communist Party of China (CCP) in 2021, Chinese leadership would be loathe to witness the run up to the milestone be marred by an economic collapse precipitated by spiralling debt.
About the CCP it is sometimes said “to watch what they do and not what they say”. At least in this instance, they have done exactly as they said they would.
Chinese shadow finance has collapsed and there are no signs of reprieve – the drop in shadow finance has not been cushioned by stimulative fiscal policies undertaken by the central government. Monetary policy, too, has remained neutral for much of the year. It is only in recent months that we have seen some loosening of monetary policy at the margin with the reduction in reserve requirements for banks.
According to Reuters, by the end of September, 25 Chinese issuers had defaulted on
payments for 52 bonds worth a total of 60.6 billion yuan. Compared with 20 issuers defaulting on 44 bonds worth 38.5 billion yuan during 2017, and 35 issuers defaulting on 79 bonds worth 39.9 billion yuan in 2016.
The Chinese leadership’s resolve in sticking to its financial de-risking policy is being tested by both the Trump Administration’s hawkish trade policies and, what we suspect is, a much sharper slow down in credit growth and economic activity than anticipated. Despite the economic challenges, we do not think the CCP will relent – at least not when it comes to shadow banking. Too much effort has already gone into scaling back shadow finance and slowly ridding the system of bad actors.
Emerging Markets
The fortunes of emerging markets are closely intertwined with those of China – the Mainland is, of course, the leading trade partner of the majority of emerging markets. With the collapse of shadow financing and economic slowdown in China, we have seen emerging markets fall quickly out of favour amongst investors. At the end of November, the MSCI Emerging Market Index was down 12.2 per cent for the year.
In last week’s piece we highlighted that we are seeing initial signs that emerging markets may well have formed an interim bottom in October and are well placed to outperform US markets in 2019.
How do we then reconcile our expectation of emerging market out performance in 2019 with the continuation of financial de-risking in China?
Consider the following chart, which plots the 12 month moving average of year-over-year Chinese social financing growth with the Commodity Research Bureau (CRB) Spot Raw Industrial Commodities Index. The three instances since 2007 when Chinese social financing growth has bottomed and accelerated have each been preceded by a bottoming of the CRB Index.
The CRB Index peaked in January and witnessed a sharp drop from May on-wards. Recently, however, the index has started to rise again. While it is early days still, the rising CRB Index may be indicative of China once again beginning to stimulate its economy.
Instead of social financing picking up, however, we may have to look for confirmation elsewhere.
In August, China’s Ministry of Finance said local governments should complete no less than 80 percent of their special bond issuance quota by end of September. Local governments in China issue special bonds for such purposes as highway projects and shanty town redevelopment. Local governments were set a quota of 1.35 trillion yuan of special bonds issuance this year. During the first half of the year, however, local governments had utilised less than 25 per cent of their quotas.
We will be monitoring infrastructure investment growth and local government bond issuance closely to anticipate a recovery in Chinese economic activity and by extension to time an entry into emerging markets.
Infrastructure investment and local bond issuance aside, the Chinese economy has received some much needed relief from the recent drops in oil and semiconductor prices. In 2017, China spent US dollars 260 billion semiconductors imports, according to the China Semiconductor Industry Association. In comparison, China spent US dollars 162 billion on importing oil.
US Foreign Funding and US Dollar Implications
In “Is the United States Relying on Foreign Investors to Fund Its Larger Budget Deficit?“, a piece issued on the Federal Reserve Bank of New York’s Liberty Street Economics blog, the authors write (emphasis added):
“Data for the first half of 2018 are available and, so far, the country has not had to increase the pace of borrowing from abroad. The current account balance, which measures how much the United States borrows from the rest of the world, has been essentially unchanged. Instead, the tax cut has boosted private saving, allowing the United States to finance the higher federal government deficit without increasing the amount borrowed from foreign investors.”
Just because the US has been able to rely on higher private savings to fund its deficit this year does not mean it will be able to continue to fund deficits without increased foreign participation. The authors speculate:
Of course, these are early days and it will be interesting to see how the increase in business saving will play out. For example, the increase in that saving component may diminish over time, perhaps because firms pass on some of their profit boost from lower taxes to their customers via a drop in markups. Firms could also use their higher after-tax income for salary increases in the current tight labor market. A third possibility is for firms use the jump in saving to increase their capital stock through higher investment spending. Indeed, this perspective suggests that a deterioration in the trade balance is a sign that firms are passing on the gains from the tax cut to their employees and consumers.
Finally, the additional downward pressure on government saving going forward will be from higher spending. It may turn out that future drops in government saving from higher spending translate more directly into higher borrowing from abroad.
As we have argued in the past, a rising US dollar environment and add to it a shortage of US dollar funding for non-US borrowers, which increases borrowing and hedging costs, are not the conditions under which foreign institutional investors increase their participation in US Treasury instruments. We are already witnessing Japanese institutional investors scaling back their exposure to US Treasury instruments.
The below chart shows the cumulative Japanese portfolio flows into the US:
The US’s current account balance has been unchanged despite Japanese outflows because of higher oil prices. Middle Eastern oil exporters have recycled their petrodollars back into US Treasury instruments as oil prices have exceeded their fiscal break-even levels this year. With oil prices having corrected recently, however, Middle Eastern participation is likely to diminish.
If, indeed, the US ends up requiring foreign participation to increase to fund its deficits we expect one or both of the following to happens:
1. The US Treasury will start spending from its General Account – much like it did in late 2016 / early 2017 in anticipation of a potential government shutdown – and this will release much needed US dollar liquidity into the global banking system.
2. The Fed starts offering foreign central banks unlimited (or very high) quantities for US dollar swap lines much like it did in the aftermath of the global financial crisis. The Fed has the ability to fix the quantity of US dollars available, this results in the price of US dollars rising when demand for US dollars rises, or fix the price of US dollars, this results in unlimited availability of US dollars. Today the Fed fixes the quantity of US dollars available not the price.
Both of the above would be US dollar negative and would provide a signal to short $DXY / go long emerging market currencies.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.