“Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.” — Joseph Schumpeter (1883 — 1950)
A quotation filled piece today as we first revisit the discussion on the near-term prospects for a spike inflation. Followed by a few charts and discussion on China’s macroeconomic context.
In March, we argued it was premature to worry about inflation:
“For as long as demand, specifically consumer demand, remains capped by the drastic measures being taken to “flatten the curve” and we do not reach a stage where demand far outstrips supply, we consider any discussion over fears of a sudden spike in inflation to be premature.”
Then a few weeks ago discussing the six to twelve month prospects for gold, we wrote:
“When liquidity creation and destruction is led by the private sector it is generally in response to rising or diminishing prospects for economic activity. Whereas government led liquidity creation and destruction usually occurs when market transmission mechanisms are failing or being corrupted.
Diminishing economic prospects typically lead to an increased demand for savings (falling velocity) while rising economic activity typically causes velocity to rise.”
This week the Financial Times reported (emphasis added):
“Bank deposits are surging across Europe as people respond to the economic and social upheaval of the coronavirus pandemic by saving more, fuelling fears among economists that consumers will not come to the rescue of the continent’s shrinking economy.
Savings rates in four of Europe’s five largest economies rose sharply to well above long-run averages in March, according to recently published data from the European Central Bank and the Bank of England.
French savers put aside nearly €20bn in March, well above the long-run average monthly change in bank deposits of €3.8bn. Separate figures from the Banque de France show that by mid-May, the total had risen to more than €60bn since the country’s lockdown began — indicating that the growth of savings accelerated as the crisis deepened.
Italian savers put aside €16.8bn in March, the ECB data show, compared with a long-run monthly average of €3.4bn, while Spanish households saved €10.1bn, up from an average of €2.3bn. UK household bank deposits jumped by £13.1bn in March, a record monthly rise, according to the BoE.”
From A History of Interest Rates by Sidney Holmer (1864 — 1953) and Richard Sylla:
“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.”
As long as savings continue to rise, inflation, and by extension bond yields, will remain in check. As we emphasised last week, the developed market bond bull market is far from over.
At the risk of belabouring the point, we turn to the US, where, even as corporations have drawn down credit facilities, banks’ loan-to-deposit ratios hit the lowest level since the 1970’s. Deposit inflows from the Fed’s security purchases as part of quantitative easing measures have more than buffeted demand for credit.
That is, only a fraction of the ‘liquidity’ being created by the Fed through asset purchases is making its way into the real economy.
China’s Macroeconomic Context
According Co-CEO Patrizio Bertelli, Prada SpA’s sales in China rose “significantly” more than 10 per cent in May. The haves continue to prosper even as the suffering of the have nots knows no respite. This is a global, not a geographic, phenomenon.
On to the discussion on China.
The above chart compares the annual absolute change in Chinese foreign reserves to the annual rate of change in the producer price index for iron and steel.
To state the obvious, the commodity super cycle between 2001 and 2012 was driven by the infrastructure boom in China. A recovery in commodity prices is not going to manifest on its own and, given advances in technology, supply side reform is probably not going to be enough — something that OPEC can attest to.
The world broadly, and the commodity complex specifically, needs a new source of demand — there are only so many roads to nowhere Beijing will be willing to fund to bailout the rest of world, especially as the rest of the world is becoming increasingly hostile towards China.
In the chart above, the annual changes in the value of Chinese exports and imports is plotted against each other. The chart visualises how tightly the Chinese leadership manages the flow of capital into and out of the economy.
Imports, the outflow of US dollars, are financed, as it appears, almost exclusively through the inflow of US dollars from exports. With the rise of trade protectionism and introduction of import tariffs, Chinese export growth is expected to dwindle. This is not just bad news for China but also for the rest of the world. Any economy — Australia, Brazil, Germany, etc. — structured around exporting to the Mainland will inevitably suffer from a reduction in demand for goods and services emanating from China.
“For every country, the current account and the capital account must balance to zero. To put it another, every dollar that enters a country, either in payment for that country’s exports, in the form of royalty or services receipts, on the form of foreign investment in domestic assets, must leave that country, either in payment for imports, in the form of royalty or services expenditures, or in the form of outward investment.
Why? Because if an economic entity in any country other than the United States is in possession of an American dollar, earned either by selling an asset to an American or exporting goods to an American, either it will use that dollar to purchases something from abroad or to make a foreign payment, or it will save the dollar by purchasing a U.S. asset.” — The Great Rebalancing, Michael Pettis
In value terms, Chinese exports far exceed Chinese imports. By tying together import and export growth, the Chinese leadership, much like other Asian export-oriented economies, has instituted a policy that forces the accumulation of savings which are then funnelled into foreign assets.
With rising protectionism and the COVID-19 pandemic accelerating the trend away from globalisation, this Chinese policy prescription is now stale. Is the Chinese leadership willing to take the short-term pain necessary to pivot towards the Chinese consumer? The answer hitherto has been a resounding no.
Financial repression taxes savers and subsidises borrowers. Chinese consumers are the savers and the state-owned enterprises (SOEs) and local governments the borrowers.
Until and unless the Chinese leadership stops penalising savers for the benefit of SOEs, any claims of rebalancing the economy towards the consumer is little more than lip service.
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.