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Chinese Data Recap and What it Means for Global Markets, July 18, 2017

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Chinese Economic Data

  • GDP held steady at 6.9% vs. (E) 6.8% in Q2
  • Fixed Asset Investment was 8.6% vs. (E) 8.4% in June
  • Industrial Production rose to 7.6% vs (E) 6.5% in June
  • Retail Sales rose to 11.0% vs. (E) 10.6% in June

Politics - Sevens Report (1)

Takeaway

The headlines tell the story of yesterday’s data dump in China. The reports were universally better than expected, but GDP was the report that warranted the most attention as the headline growth rate held steady at 6.9% rather than pulling back as expected.

Quarter-on-quarter growth jumped to 1.7% from 1.3%, which suggests that the Chinese economy is starting to stabilize towards the top end of the government’s target range of 6.5%-7%.

Looking ahead, the solid growth level seems to be sustainable, and not just a short-lived spike in economic activity. Without getting deep into the details, the growth is consumption driven, and new government policy and reforms are poised to help continue fueling solid growth into H2’17.

Bottom line, yesterday’s strong set of Chinese economic reports were welcomed by economists, as they underscored the positive outlook for the global economy going forward. But the reason the data did not ignite a more pronounced rally in global equities is the fact that growth in China has become more of an expectation, and global growth as a whole is no longer a great concern (as it was back in the summer of 2015).

Instead, very low inflation rates in the US and Europe are the most notable concern, and until those statistics begin to firm, weak inflationary pressures will be a drag on risk assets like stocks in the months ahead.

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China’s Inverted Yield Curve, June 28, 2017

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If A Yield Curve Inverts In China, Does It Signal A Looming Recession?

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China's Inverted Yield Curve

Last week, in our post, “Will Chinese Credit Impulse Impact Global Markets?“, I explained how China remains the largest macro threat to the rally as it begins to deflate its massive credit bubble, a credit bubble that has funded asset bubbles across geographies (Australian property, California property, Treasuries, stocks, etc.).

At this point, it’s just a risk, as there are no concrete signs that the Chinese economy is in trouble, although the Chinese bond market is signaling some caution.

First, it’s well known that inverted yield curves predict recessions. Here in the US, the inverted yield curve predicted the ’81, ’91, and ’00 recession, and the ’08 financial crisis (remember the yield curve inverted in ’05, and stayed that way until the Fed started cutting rates in late ’07).

So, it is noteworthy that the Chinese government bond yield curve is essentially flat, and in some cases has inverted. For instance, as of yesterday the three-year government bond was yielding 3.558%, higher than the 5 year at 3.524%. And, the 7 year was yielding 3.626%, higher than the 10 year, which yielded 3.56%. So, while not a total inversion, it is safe to say it’s flat.

Now, before we go running for the hills and sell stocks, we have to realize this is China, not US Treasuries. As such, liquidity distorts this picture somewhat. For instance, 10-year Chinese bonds are by far the most liquid, so they will move more than other issues. Still, this is not the type of yield curve that implies an economy that is healthy. Again, this matters because the last time we got a Chinese economic scare, it caused the S&P 500 to collapse 10% in a few days… not once, but twice in a six-month period.

Bottom line, I’m not saying get defensive, but I am saying that from a macro standpoint 2H ’17 is shaping up to be more bumpy than 1H ’17, and I want everyone to be prepared. We will be watching China closely for you.

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Will Chinese Credit Impulse Impact Global Markets? June 22, 2017

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Yesterday’s article: Why Credit Impulse Matters.

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One of the reasons I watch China so closely (along with other macro analysts) is because for the last decade, every time China has had an economic scare it’s caused global markets to drop, sometimes violently. The most recent examples were Aug/Sept ’15 and Jan/Feb ’16.

More specifically, those two bouts of recent volatility ended at the same time as China massively re-engaged its credit creation machine (think QE) to support its economy. If you look at the chart below, Chinese credit creation declined in ’13-’14 and was flat through ’15.

But when the Chinese economy started to stall in mid to late 2015, officials massively ramped up the credit creation machine again. Maybe it’s just coincidence, but the US stock market hasn’t had a correction since.

Now, China is once again trying to shrink its massive credit “bubble.” And, they’re removing liquidity from the system, as both charts show.

Sevens - Chinese Credit Impulse

I realize this isn’t the prettiest chart, but the point I’m trying to make is this: This ramp up in stocks started in February 2016 at the exact same time as China re-engaged its massive credit creation machine (i.e. loans and QE). It could totally be a coincidence, as there has been real earnings growth in the US… but that would be a BIG coincidence.

The question for us is: “Will it cause another scare in global markets?”

It hasn’t so far, but that doesn’t mean it won’t.

So, while it might seem odd that I consistently bring up China even when it’s not in the news, this is the reason: Historically when China tries to shrink its credit bubble, bad things happen. And, as they say, history in markets doesn’t repeat… but it does rhyme. So, the focus in the daily Sevens Report will remain on the Chinese economy and credit stats for the next several months.

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Credit Impulse Continued: This is a chart of the cumulative balance sheets of the ECB, BOJ and Fed. With increases of this magnitude, it’s understandable why stocks have rallied. Of course, that begs the question, “What happens when it starts to decline?”

Time to Buy Emerging Markets? March 29, 2017

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The Case for Emerging Markets, an excerpt from today’s Sevens Report. Everything you need to know about the market in your inbox by 7am, in 7 minutes or less.

Time to invest in emerging markets, tom essayeAs expectations for a pro-growth policy based reflation trade (i.e. the Trump trade) fade here in the US, one potential beneficiary is emerging markets. The sector has underperformed since the election due to a combination of

1) Dollar strength,

2) Rising US bond yields, and

3) Fear of trade wars.

But, if we see an extended pause in the dollar and bond yield rally, and continued poor execution on pro-growth policies, then emerging markets offer value in an otherwise expensive market.

Now, I’m not saying I’m a long-term bull on emerging markets, nor does this analysis mean I’m not a long-term bull on the dollar or bond yields… I think both go higher long term.

However, the fact is this market has already priced in a an acceleration of growth in the US. If that doesn’t materialize, we could see a sideways chop in the dollar and bond yields, and emerging markets will likely outperform near term (i.e. the next few months).

The investment thesis behind EM is comprised of three pillars: Valuation, inverse correlation to the US-based reflation trade, and positive exposure to global growth.

Pillar 1: Attractive Relative Valuation. Emerging markets are much cheaper than most developed markets, as several research pieces we’ve read have emerging markets trading 12X forward P/E, compared to 17X and 15X for the US and Europe, respectively. So, there is value there, especially after the under-performance following the election.

Pillar 2: Hedge Against a Reflation Trade Unwind. If we see the reflation trade continue to unwind (which started in earnest last Tuesday) then emerging markets will benefit. Case in point, since the election, our preferred emerging market ETF (withheld for subscribers) has returned 5.9%. But, almost all of those gains have come over the past few weeks thanks to the Fed’s dovish hike, and the healthcare failure.

If reflation trade enthusiasm wanes in the US, emerging markets will continue to benefit thanks to the weaker dollar and lower yields. To put it simply, emerging market returns are highly inversely correlated to the dollar. If we see the dollar continue to grind sideways or continue to fall, emerging markets should outperform.

Pillar 3: Positive Exposure to Global Growth. Finally, emerging markets should benefit from a rising global economic tide. US rate hikes aside, the rest of the world’s central banks remain very “easy,” and generally speaking global growth is on an upswing… and that should continue to benefit emerging markets. There are, however, risks to the trade. First, if we get border adjustments in a corporate tax cut package, that’s negative EM because it effectively puts a tax on all emerging market exports (i.e. raw materials), which will reduce demand. Second, if the Fed becomes more hawkish near term, then the dollar and bond yields will rise, and EM will lag. Third, if China sees another growth scare that will hurt EM. Finally, if the Trump administration begins to levy import taxes or engages in aggressive trade policies, that will obviously be EM negative. Of these risks, we view the most probable as the Fed getting more hawkish. But, near term that just isn’t very likely. So, the risks to this strategy are real, but we don’t view them as imminent.

Finally, I’m not saying emerging markets are a long-term strategy, but I do think EM is something that can outperform over the coming months, especially if we see a lack of progress on tax cuts. As such, EM offers reasonable upside in a market where not much is cheap, and we think the potential reward is worth the risk.

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