Over the weekend, New River CIO Eric Peters had a simple and concise summary for events over the past year: "Pretty much everything that happened in 2016 can be explained by two things; China and oil prices,” he said. “Literally, that’s it."
Today, thanks to a research report from UBS titled "Where is the epicentre of the reflation trade?", we have confirmation that Peters was spot on.
In the note by UBS strategists Bhanu Baweja and Manik Narain, the duo said that it was indeed China that has been the central growth driver for the world economy, even though "for a spell in Q4 2016 the US was certainly the flag bearer of the reflation trade" although before and since "it was China at the epicentre of the most significant positive growth shock for the global economy", something we have cautioned since February when we said that the global reflation trade was merely a function of the broad credit impulse coming out of China.
And since said impulse turned negative some time ago, the reflation trade is now effectively over, especially with Trump's fiscal plans failing to achieve any traction in the US.
Here are the key details from the UBS report:
- Having lifted off the depths of secular stagnation, the market seems to be in the early stages of climbing down from the highest altitude of reflation hope. This journey took place so quickly that few have been able to establish exactly what the reflation trade is all about – hopes of lower taxes and regulations, higher inflation, a revival in investment and manufacturing, or merely defeating extreme pessimism? Unless we recognise its driver, and understand its texture, we won't be able to assess whether reflation will prosper, suffocate, or mutate.
- During Q4 2016 the US certainly was the flag-bearer of the reflation trade. US real rates and inflation expectations led a global rise in yields, small cap stocks outperformed the overall market handsomely, and the USD appreciated. However, these forces have since lost steam or reversed.
- Both prior and post that spell of time, the economy at the epicentre of the most significant growth impulse for the global economy has actually been China. Its import volumes rose by just under 15% over the last 12 months, providing a solid boost to global growth. By comparison, US' import volumes grew by 3.5%, while Europe's were nearly flat over the same period. To a degree, political change in the US stole China's reflationary thunder.
- The global economy is an interconnected structure, and it would be incorrect to categorically claim that there is a unique form of reflation, the genesis of which lies entirely in one region or another. As financial and consumer balance sheets have healed, hard data in the US and Europe have also improved, particularly retail sales, housing and labour markets. Inflation expectations too are well off last year's lows. The relative weakness lies in production and capital expenditure, which, while on very gradual positive trend, are not yet strong enough to engineer a response in growth globally through robust imports. Certainly, this 'home-made' variant of reflation in developed economies has been conspicuously weaker than survey data would have suggested.
And here is the visual confirmation of where the global reflation trade has "come" from:
As the chart above shows, while there has been some degree of retail sales and labour market healing in most major economies, when we look for the core of the reflationary stimulus, a region that has also helped growth in other regions through higher imports, China stands head and shoulders above everyone else. US and Japanese import volumes have grown modestly, but nowhere close to China's have. European import growth has really been about higher values than volumes.
So if China was the global reflation drive, how did this inflation spread to the rest of the world... what was the pathway in question? The answer - imports.
And here a problem emerges: usually commodities and sentiment are driven by same positive force – improving demand. But this time in evoking the same correlation as usual, commodities may be playing a trick on sentiment data. Over the last year the Chinese construction and infrastructure-driven demand signal has been polluted by significant noise from supply shutdowns in Chinese coal and iron ore mining. Authorities have actively limited production of upstream commodities as they hope to tackle pollution and reduce overcapacity. A similar dynamic is at play in copper and oil where strikes in Chile and reduced production from US Shale (in 2016) and OPEC (today) are playing an important role in propping up commodity prices. The market is getting sentiment excited nonetheless because, of course (and we are oversimplifying) 'Dr Copper is always right!'
As a result, while the data doesn’t allow us to measure contribution of each product in terms of import volumes, looking at it in values, it is clear that till recently commodity demand has driven China's import pick up. This isn't only driven by higher prices, commodity import volumes have risen strongly too. Manufacturing imports have pushed higher recently as micro data suggest a revival in production.
A more nuanced analysis seeks to isolate where, precisely, in the Chinese economy did this sudden surge in demand for imports come from. According to UBS, it is difficult to quantify precisely the relative influence of demand and supply, but, we do get some clues. Despite the pick-up in import volumes the improvement in Chinese IP has been modest. Mining production has gone down on the back of attempts to reduce supply in overcapacity and polluting sectors. While improved housing demand has been important for China's imports, there is a big influence of the domestic supply curve moving left. "This changes everything" UBS notes, and confirms what we said a month ago, when we said "Why The Fate Of The World Economy Is In The Hands Of China's Housing Bubble."
Which, ultimately, brings us to the one data point we - as "Austrians" - have claimed was the most important of all in defining key market inflection points and periods of relative growth or contraction: China's credit impulse.
After a sharp rise in 2016 that was similar in magnitude to 2009, and launched by the greatest credit expansion launched by China in history, China's credit impulse has become negative. The correlation between credit impulse and domestic demand is less than perfect in China, but this important under-appreciated change can, over the coming 3-6 months, have an impact on Chinese investment and import growth. This is not a part of the popular consensus, which continues to believe that growth will sustain at today's strong levels all the way through till the end of the year.
As UBS further notes, the market seems to be extrapolating recent Chinese strength all the way at least to the 19th National Congress of the Communist Party in autumn. In reality the credit impulse has turned negative, and as officials' focus seems to be shifting from growth to containing leverage. In short, "the best of China's growth impulse for the global economy may be behind us", and while it is unclear if this may spark another capital flight one China's economy again cools off, it would not be at all surprising to see a resumption in tens if not hundreds of billions in Yuan capital flight each month.
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So with China's credit impulse, and therefore both the domestic and global reflation wave now ending, will the US be able to pick up the torch?
As a reminder, early prospects for US tax reform, financial deregulation and infrastructure helped spur a strong re-rating of US equity markets, which also spilt into confidence surveys. However, devoid of further near-term catalysts given the complexities of enacting major stimulus, UBS believes that this element of reflation may also proceed at a far slower pace going forward and have a considerable time lag before being endorsed by hard data.
To answer the question if China can hand over the global growth torch to the US, UBS points out that over the past 2 years US investment has grown at a slower pace than consumption, which typically only happens in recessions. After being a drag for 3 quarters Investment contributed positively to GDP in the last two quarters of 2016. The momentum here will have to build in a big way if US is to take over the reflationary baton from China.
A big if, which leads to UBS' pessimistic assessment that with China growth momentum sliding and the US unlikely to be able to carry the burdern, the outlook for risk assets is problematic, to wit:
Assets have chased sentiment higher, and the clock is ticking for hard data in the US and Europe to take the reflation baton over from China. Thus far, we see few convincing signs that trend growth rates in these regions are changing materially. Again, we will be watching investment, production and capacity utilisation most closely. These need to pick up for Western reflation to bring improved cash flows to global companies. If the healing is limited to the labour market and housing, that home-made brand reflation, we may only get more hawkish central banks without the global growth impulse; an unhelpful mutation of the reflation trade.
The conclusion: "Driven by the twin engines of Fed and China monetary largesse and a positive commodity price shock, the passive trade has run a long way. It is time to pare down some cyclical exposure."
While that may be bad news for the BTFDers (whom JPM advised earlier today to take the next 3 weeks off), it's good for all those who have long scratched their heads to uncover the global economy's true beating heart.