Most China Bears tend to mention China’s debt without giving details on how it’ll become an issue in the future. Like any highly leveraged company, when growth (or revenue) is increasing, it makes servicing the debt on its balance sheet an easier task. However, once growth slows, the cash flow created decreases and the ability to service even the interest payments can become a serious issue. In the case of China, they have a mounting concern because demand is slowing for its products, globally and domestically, which could lead to numerous problems if this trend continues.
In this post I will discuss:
- A slowing of demand, globally and domestically, for China’s products
- The message being told by China’s credit and loan data
- The impact on equities, commodities, and currency
If the demand for China’s goods continues to decrease, globally and domestically, their government will be forced to change from “managing” the economic slowdown to full on stimulus. As China’s Premier Li Keqiang mentioned recently, they have no plans for “massive stimulus” despite the economic slowdown. Therefore, there is further room to the downside, in regards to demand, before the Chinese government changes course.
A Slowing of Demand, Globally and Domestically, for China’s Products
In last month’s post (https://wp.me/p9vaFZ-8w), I detailed how consumer demand is slowing in US. Therefore, I won’t spend time rehashing it. One item I will mention is that the US is seeing a sudden increase in imports coming from China. As discussed by the WSJ:
Imports into U.S. seaports are surging over usual seasonal patterns in an apparent push by retailers and manufacturers to pull orders forward ahead of a new round of tariffs set to hit U.S.-China trade in January.
Ports in Southern California, Georgia and Virginia reported double-digit growth in import volume from September to October, setting monthly records as furniture, apparel, auto parts and other goods streamed in.
In other words, the potential tariff increase is pulling forward the demand of goods from China. Whether the tariffs occur or not, we should expect to see less demand of Chinese goods in 1Q19 relative to 1Q18 because of demand being pulled forward. After this adjustment period, the demand of Chinese goods will depend upon the strength and demand of the US consumer rather than policies coming out of DC.
US Imports from China
Turning to China’s other large trading partner, we see that demand from Europe began to slow in 1H18. Europe accounts for ~20% of China’s total exports. Unlike the US, there are no tariffs being threatened by Europe so this narrative can not be used as an excuse.
Europe Imports from China
Before moving to the Chinese consumer, just a reminder that I don’t trust the data published by China. This is why I use other data points to confirm my view whenever possible. Keeping this in mind, when it comes to the Chinese consumer, the economic data published by China is telling a concerning story.
When looking at consumer sales, there are two types of data points: headline and enterprise. The headline number (or total) is discussed by the media and, in my view, is adjusted to show a more positive outlook. The enterprise number is based off retail businesses with 5 million CNY (~$750,000 USD) and hotel and catering with 2 million CNY (~$300,000 USD). Meaning, it doesn’t take a lot to be considered an enterprise in China.
Starting with retail sales, we see that Total Retail Sales have gradually declined in 2018 and over the years. However, since the start of the year, Enterprise Retail Sales has dropped substantially from ~9% to 3.6%, which is less than the current growth rate in the US.
Retail Sales Y/Y: Total (white), Enterprise (yellow)
e-Commerce sales have seen a similar decline and helps explain the YTD declines in JD.com and Alibaba.
e-Commerce Sales Y/Y (white), JD.com (JD, green), Alibaba (BABA, yellow)
Auto sales on a 6 month average Y/Y is back to the levels last seen in 3Q15.
Auto Sales (All Models)
Just in case the Chinese have changed their spending preferences from goods to experiences, we turn to hotels and catering. Unfortunately, we see a similar story being told here, a gradual decline in Total Sales and a larger decline by Enterprise since the start of the year.
Hotel and Catering Sales Y/Y: Total (white), Enterprise (yellow)
Finally, if we assume the Total Retail Sales and Total Hotel & Catering Sales are correct, that would mean that small and medium sized businesses would have stronger cash flow generation than enterprise businesses. Meaning, banks would find them more attractive to lend to. However, there are numerous articles, like discussed in the link below, which suggesting this is not occurring.
The Message Being Told By China’s Credit and Loan Data
As discussed in previous posts, China is a credit driven economy. When China’s money supply and loan growth is slowing, demand slows. By itself, declines in interest rates have never been enough to generate an increase for the demand of goods and services in China. Historically, loan growth and the money supply haven’t increased until the PBOC embarked on stimulus to generate growth.
In May I discussed Shadow Banking vs traditional lending from banks (https://wp.me/p9vaFZ-5f). Since then, Shadow Financing has continued to decline and is now negative for the first time ever.
However, bank loans (CNY Loans) have continued to grow steadily at 13%.
The good news, in regards to the stability of China’s financial system, is that the more risky loans (Shadow Financing) are shrinking while the more stable loans (CNY Loans) are increasing. However, CNY Loans are not increasing at a fast enough pace to outweigh the decline in Shadow Financing, which leads to a headwind for demand of goods and services.
Turning to the money supply in China, we continue to see M1 decline. Just a reminder, inflection points on the 12ma Y/Y has historically led turning points in manufacturing data by ~6 months.
For the last 15 years, M1 has done a great job leading the export data of its major trading partners by ~6 months. Since China is the largest consumer of raw materials and manufacturers more goods than the US and Europe, M1 should continue to lead the export data. Unfortunately, this means that M1 is forecasting that the small deviation that we’re currently seeing (similar to 2011 and 2014) isn’t sustainable.
China M1 (black), Exports 6ma, Y/Y lagged 6 months: Australia (blue), Brazil (green), South Korea (red)
Turning to interest rates, we tend to see interest rates in China decline after M1 has rolled over. As stated earlier, lower interest rates by themselves don’t increase demand in China, stimulus provided by the PBOC increases demand.
China M1 (blue), China 1yr yield (red)
Looking at the three interest rates I follow closely in China, we see that after a brief pause in 3Q18, the 1yr and 5yr have begun to decline once more.
5yr Yield (green), 1yr Yield (yellow), SHIBOR (green)
In January (https://wp.me/p9vaFZ-2w), I went into more detail about how the difference in the interest rate spreads can show signs of stress. For me, the initial signal comes from the 5s – 1s spread and the SHIBOR – 1s spread confirms that signal.
Currently, 5s – 1s is above 0.50 but is not accelerating higher. Therefore, I continue to think the stress building in China’s financial system is manageable at this time. If the 5s – 1s spread would suddenly move towards 1.00, SHIBOR – 1s is also increasing, and interest rates are declining, then I would get very concerned about the stability of China’s financial system.
Top Panel: CNY (green), SHIBOR – 1yr Yield (white); Bottom Panel: 5yr Yield – 1yr Yield (yellow)
Similar to previous periods of stress, the PBOC has indicated that it may begin to manage the CNY to prevent it from depreciating further. If this is occurring, than the implied volatility of the CNH should begin to significantly decline from its current level.
CNH (white), CNY (yellow), Implied Volatility of CNH (purple)
The Impact on Equities, Commodities, and Currency
Considering the issues discussed in the previous two segments, this doesn’t give the best outlook for the cyclical components of the market and reinforces why I’ve been negative on them since I started this blog in January.
Using interest rates as a very broad overlay, it supports why it will be best to avoid cyclicals until interest rates, at a minimum, stabilize. There will be counter-trend rallies along the way but the longer term trend will be lower for the forseeable future .
This means, avoiding Emerging Markets…
Emerging Markets ETF (EEM, white), 1yr Yield (yellow), SHIBOR (green)
…avoiding industrial metals…
LME Metals Index (white), 1yr Yield (yellow), SHIBOR (green)
…avoiding oil (or energy)…
WTI (white), 1yr Yield (yellow), SHIBOR (green)
…while being long assets that benefit from a stronger US Dollar.
US Trade Weighted Dollar (inversed, white), 1yr Yield (yellow), SHIBOR (green)
Finally, here’s a breakdown showing the cyclicality of various global indices when looking at the weights of Financials, Industrials, Energy, and Materials.
As shown by the Nasdaq this week, it does not mean that the indices with low cyclical weightings will be safe. It ultimately means that you need to know what’s in the index and understand the drivers behind it.
While this post leaned more to the negative side than normal, I don’t see the concerns highlight by China Bears escalating in the immediate future.
In my opinion, the key to China’s ability to “manage” the economy will come down to the US consumer. There might be declines in demand, like we’re seeing currently, but as long as the US employment data remains strong, then the PBOC can continue as is.
No changes in recommended asset allocation this month.
- Overweight (or long) the USD
- Underweight (or short) Emerging Market currencies
- Overweight (or long) long dated maturing US debt
- Underweight (or short) Emerging Market debt
- Neutral (or 50% exposure) S&P 500
- Underweight (or short) Emerging Markets
- Overweight (or long) US defensive sectors and industries
- Underweight (or short) US cyclical sectors and industries