China: Red Flag Rising

Photo by Alejandro Luengo on Unsplash

Despite a quick reopening, a crack in the Chinese currency suggests things are about to get worse for the world’s second-largest economy.

Written May 24, 2020

The Chinese yuan finished last week near its lowest level in more than a decade as investors began to bet with their feet, heading for the exits over concern that the country is compounding its economic problems with geopolitical moves that are already generating widespread condemnation and even greater uncertainty.

The post-pandemic economic landscape presents a test for the regime that has long prided itself in delivering on an unspoken bargain where one-party rule is tolerated in exchange for consistent economic growth.

However, a sure tell that the government’s grip is slipping was its failure to set an economic growth target for the upcoming year during last week’s National People’s Congress, the annual planning meeting of the Chinese Communist Party. It might seem like an insignificant detail, but for the first time since it began providing GDP estimates in 1990 the central body declined to be bound by a projection that it may not be able to meet. It is a big deal, and the obvious conclusion is that the economy on the mainland is worse than it outwardly appears.

China’s recalcitrance in dealing with COVID-19 has also turned global public opinion against it. As a result, doing business with the Chinese in the future is going to come under much more scrutiny than in the past.

Despite the allure of 1.4 billion potential consumers, it now won’t be so easy to turn a blind eye to the tilted playing field China has erected to their advantage, as much of the world has done since China’s inclusion into the World Trade Organization in 2001.

The U.S. Senate took the first step last week by passing a bill by a 100-0 margin requiring Chinese firms to adhere to American accounting standards or risk being delisted from our exchanges, also a big deal. Other measures will follow.

The pandemic exposed many countries’ over-reliance on Chinese manufacturing and is forcing most to reconsider basing their supply chains elsewhere. Japan even earmarked part of its economic stimulus fund specifically to help its manufacturers shift production out of China.

The bottom line is, the rules of international trade are being rewritten and China is not going to like the changes.

Further complicating matters, China is lashing out at the west’s insistence on an investigation into the origins and handling of the virus. Within the space of a few weeks they’ve made moves to block certain Australian exports, threatened to cut off the supply of critical pharmaceutical ingredients to the U.S., and imposed their own national security laws on Hong Kong. So much for the idea of “one country, two systems” that was the founding principle agreed to by both parties when the British turned Hong Kong over to China in 1997 and that has allowed the former colony to thrive as an international financial center.

Not content to stop there, the Chinese navy is scheduled to begin live-fire military exercises later this month as part of an amphibious assault training operation on an island controlled by Taiwan. As the Wall St. Journal asked in a May 21 op-ed titled “China Moves on Hong Kong”, is Taiwan next?

At the risk of stating the obvious, political isolation from global trading partners can only be seen as a negative for the economy.

Plan A for Chinese authorities to counteract these economic headwinds is with traditional fiscal and monetary stimulus, along with a heavy dose of infrastructure spending. But the effectiveness of that approach is questionable as the country is already swimming in overcapacity, and debt. It’s the demand side of the equation that is lacking.

Plan B would be a devaluation of the currency, which the market is beginning to sniff out. In theory, this would spur demand by making Chinese-produced goods more competitively priced. In reality, it would propel the dollar higher, unleashing a deflationary wave on a world already under enormous pressure from falling prices.

The Fed and other central banks have done an impressive job of rescuing the credit and equity markets from the depths of the pandemic panic in March, but a Chinese devaluation would slam the lid on any hopes of reflating the global economy.

Our core portfolio positions remain long of the US dollar, front-end treasuries, and gold.

Going Negative

Photo by Ussama Azam on Unsplash

Debt deflation starts the U.S. on a path to negative interest rates

Written May 10, 2020

Last week, for the first time in the country’s history, the financial markets began discounting the possibility of negative interest rate policy.  

On Thursday, the December Fed Funds futures contract settled above par (100.00), implying that traders have moved beyond talking in the abstract about negative interest rates and started betting with real money that the Federal Reserve will be forced by events into crossing a line they’ve long insisted they would not step over. 

Japan, Europe, Switzerland, Sweden, and Denmark currently have negative interest rates, policy legacies left over from fighting the last recession in 2008. The theory was that people would be so repulsed by having to pay a bank to hold their money that they would gladly spend it instead, stimulating the economy in the process. It hasn’t exactly worked out that way.

Rather than driving consumer demand, negative interest rates have resulted in a minefield of unintended consequences. Besides the lack of confidence it conveys to the public on behalf of impotent policymakers, it has clogged the banking system and perverted the lending process.

Count us among those who previously thought there was little chance that the Fed would follow the rate policies of its Japanese and European counterparts. But as we recently wrote in “The L-Shaped Recovery“, the pandemic has exposed and accelerated the threat of debt deflation that could end up triggering waves of bankruptcies.

The deflationary scenario was brought into stark relief after we recently came across a chart overlaying the Economic Cycle Research Institute’s Weekly Leading Index (WLI) with the US consumer price index (see below). As the name suggests, the WLI anticipates economic activity 2 to 3 quarters in the future. If the correlation with the CPI holds, it means prices could begin dropping later this summer.

Just as the value of debt falls in real terms in an inflationary environment, it rises in deflationary times. The problem is compounded by declining cash flows as a result of weak economic activity, making it harder to service that debt and potentially creating a serious problem for highly leveraged economies like ours.

The other moving part in the relationship between debt and deflation is the U.S. dollar. If the Fed’s policy rate is anchored at zero and market yields can’t keep pace with falling prices for goods and services, real yields (the nominal yield minus the rate of inflation) will rise, driving the dollar higher and depressing the price of imports domestically and commodities globally. As we said in “The Biggest Trade in the World“, “the risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.”

As has been the case with every rate cut in this cycle, the market will lead the way for the Fed’s next move. And given the risk that rising real yields could pose to the prospects for a recovery, investors are concluding that the Fed may have no choice but to take rates negative.

Besides being long-time proponents of the U.S. dollar and front-end treasuries as core investment themes, we recently recommended adding a position in physical gold. Gold may be subject to bouts of selling if the dollar continues to rise, as many traders still reflexively see the two as inversely correlated. But because there doesn’t seem to be any limit on central bank money printing, gold will shine as the ultimate store of value in a world of increasingly negative interest rates.

Economic Cycle Research Institute Weekly Leading Index vs US Consumer Price Index. Chart courtesy of Real Vision.
December 2020 Fed funds Futures, trading above 100 for the first time ever and implying negative policy rates in the U.S.

Powell Plays for Time

The Fed’s unspoken hope is that lower rates will keep the credit market from crumbling.

Photo by Adi Goldstein on Unsplash

July 15, 2019

Something doesn’t add up. Last week the Fed chairman Jerome Powell went before Congress to say that while the economy remains on “solid footing” it might need some assistance in the form of lower interest rates. It was barely six months ago when he was using similar language to advocate for higher rates. It makes no sense to pitch for easier monetary policy amid a hot labor market and record highs stock prices, but that’s exactly what Powell did.

The Fed chairman referred to economic headwinds blowing toward the US from abroad due to weakening global growth and disruptions in international trade. These pressures are real but hardly justifies the abrupt U-turn in Fed policy this year. It has to be something more than that.

Although Powell didn’t address it directly, the simplest explanation is growing concern over the state of the credit markets. As we wrote in “BBBe careful” one of the unintended consequences of easy money policies has been the explosion in debt, especially among weaker credits (lower-rated companies.) Despite a decade of massive monetary stimulus, the aggregate corporate credit profile has fallen well short of growth trends in the economy. In fact, half of the $5 trillion investment-grade bond universe is now rated just BBB, one notch above junk status.

It’s an understatement to say that this is an accident waiting to happen. It is quite literally a cliff edge, where even a handful of ratings downgrades could quickly create a feedback loop of forced liquidation by funds that are prohibited from owning junk, spreading outward and turning a simple economic slowdown to into a financial crisis.

The only option the Fed has is to play for time, massaging investor sentiment with the prospect of lower rates, maintaining ample liquidity and hoping (!) that growth will recover enough to feed through to corporate balance sheets. But considering that the current expansionary cycle is now already the oldest on record the odds are against it. Second-quarter corporate reporting season begins this week and will give us a look at whether the Fed-inspired exuberance in equities is matched by actual earnings.

Don’t underestimate the downside potential for interest rates. The Fed knows the credit market is the monster in the closet and is preemptively setting the stage for rate cuts despite the lack of any significant stress on the system. They are teed up to ease quickly and aggressively at the first outward sign of trouble. Whether the Fed has enough ammunition to alter the outcome under that scenario remains to be seen but given that the starting point on this next rate-cutting cycle begins with a policy rate at just 2.4%, we have our doubts. There is not much room between here and zero.

In April, we recommended owning short (2-3 year) treasuries. See “The dollar and deflation“. It’s still the best trade on the board and has much more to go.

HYG, the high-yield bond ETF. Despite a lot of heavy lifting from the Fed the bounces are getting smaller.

The Dollar and Deflation

Written by Bruce J. Clark

April 29, 2019

Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.

It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.

The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.

Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.

As I mentioned in (See “Good news, bad news) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.

The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).