“We have now sunk to a depth at which restatement of the obvious is the first duty of intelligent men.” ― George Orwell
A comment about China’s manufacturing PMI for March before getting to this week’s update.
China’s manufacturing PMI for March came in unexpectedly strong at 52.0, after recording 40.3 in February and above consensus expectations of 42.5. The kneejerk reaction to this data point from a number of market commentators was that China, once again, was fudging its economic data.
The thing about a kneejerk reaction is that it is an emotional response, one that has not been clearly thought through. And indeed, if one considers (a) the PMI is a diffusion index and (b) the statement from Foxconn, the world’s largest provider of electronics manufacturing services, at the start of March suggesting that their Chinese operations should return to normal during the month, the manufacturing PMI coming in at 52.0 is somewhat unsurprising.
The PMI is a diffusion index based on the number of companies reporting an improvement or deterioration in business activity relative to the previous month. A reading little above 50 suggests that slightly more than half of the companies indicated an improvement in activity relative to February’s historic lows. A much higher reading would have been required to suggest that manufacturing activity is back to normal in China.
Anecdotally, in February we contacted a sample of small and medium Chinese manufacturers through Alibaba and found that all were closed for business. We contacted the same sample of manufacturers again in mid-March and found that they were all up and running and accepting orders.
Armed with data and the correct definitions, a lot of noise can be filtered out.
On to the update.
War Like Symptoms
President Lyndon Johnson declared a war on poverty. President Richard Nixon declared a war on drugs. And last month President Donald Trump described the battle to slow the spread of COVID-19 as “our big war.”
Whether it is a war or not is a matter of debate. US public debt, as a percent of GDP, is, however, started to exhibit war like symptoms even before the passing of the largest stimulus package in US history. When it is all said and done, the US’s debt-to-GDP ratio will have blown out the levels hit during and in the immediate aftermath of World War II.
Modern Monetary Theory is here in everything but name.
From the Wall Street Journal (emphasis added):
“With 20% of Americans locked in their homes, nearly all air travel canceled, and the global supply chain disrupted, you don’t need to be a Keynesian to think the government should intervene. But that doesn’t mean the Cares Act—an acronym for Coronavirus Aid, Relief, and Economic Security—is wise. The last thing we need at this moment is a Keynesian stimulus. Since the lockdowns constrain supply, stimulating demand would lead only to a rise in prices.”
As the purveyor and custodian of the global reserve currency, the US effectively has an ‘elastic currency’, the circulation of which can expand and contract to meet the needs of economic activity. Whether the expansion or contraction leads fluctuations in price levels depends on whether the demand for US dollar liquidity is sufficiently keeping pace with the supply of US dollar liquidity.
Pricing conditions, that is inflationary or deflationary pressures, are primarily a function of the spread between the supply and demand of US dollar liquidity. A condition of excess liquidity exists when there is a greater supply of US dollar liquidity than there is demand for it, gives rise to inflationary pressures. When there is an insufficient supply of US dollar liquidity relative to demand, an economy is beset by deflationary pressures.
So, the creation of a large amount of liquidity in an economic system is not immediately inflationary — rather, if the expansion in liquidity occurs in tandem with an expansion in economic activity, then it can facilitate continued expansion of the economy.
From the Bank for International Settlements on 1 April 2020 (emphasis added):
“On the demand side, institutional investors (insurers, pension funds and other portfolio asset managers) play a key role. Such investors have obligations in domestic currency, but they hold a globally diversified portfolio, with a substantial portion denominated in the US dollar. To finance the purchase of dollar assets, they swap domestic currency into dollars, thereby gaining access to dollar funding on a currency-hedged basis. Their portfolios have grown substantially since the GFC, giving rise to greater hedging needs.
On the supply side, dollars are provided by banks and other financial intermediaries, who source their dollars in global capital markets. However, in the decade following the GFC, banks that provide such hedging services have become a smaller part of the overall financial system, reflecting narrowing lending margins due to low interest rates, as well as tighter regulation (Erik et al (2020)).
Against this backdrop, the financial turbulence of recent weeks has led to a sharp decline in the supply of hedging services by banks as they retrench in the face of the shock. In addition, banks have experienced drawdowns of credit lines from corporate borrowers, which have crowded out other forms of lending by banks. Prime money market funds that traditionally supply dollar funding have experienced redemptions, leading to thinner supply. Together, the pullback in the supply of dollars from banks and market-based intermediaries (even as dollar demand has remained high) has resulted in the sharp increase in indicators of dollar funding costs.”
Financial intermediaries are stepping away from their core activities. Thereby circumventing the flow of liquidity in the monetary system despite the Federal Reserve and US Treasury’s best efforts to flush the system with dollars. Supply of dollars is falling short of demand. Outside of pockets of price gouging and price spikes for specific highly demanded goods, the probability of a spike in inflation remains low.
The below is a chart of four-quarter moving average of the Citi Macro Risk Index versus the year-over-year change non-residential fixed investment by the private sector in the US. (A rising magenta line implies declining macro uncertainty while a rising line implies increasing macro uncertainty.)
Non-residential fixed investment declines during periods of macroeconomic uncertainty.
Given that we are in a period of extremely high levels of uncertainty, capital investment by the private sector is likely to remain low — ergo production capacity utilisation in the economy will remain low. Without low levels of unemployment and high levels of capacity utilisation, inflation is unlikely to manifest. Unless of course one expects a complete loss of faith in the US dollar hegemony — something we do not perceive as a near-to-medium term risk.
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.