Another day, another warnings about China's fading credit impulse (see here in February, and Pimco most recently), and market complacency about what the recent monetary tightening and drop in commodity prices in Chinese markets means for global markets, this time from Citigroup.
In the latest note from Citi's cross-asset strategist, Jeremy Hale, titled simply enough "China: Caution Ahead", he highlights the long-standing trend lower in the EMRA, or Emerging Markets Risk Aversion Index (CIGMEMRA Index on Bloomberg) which is Citi's measure of aggregate risk aversion in developing countries, which in turn has led many investors to ask the bank whether "investors are getting complacent on EM."
While Hale fails to answer directly, he does point out that while forward returns are mixed across the asset classes, "risky assets don’t usually fare that well when EMRA is low."
In this context, China is key, and much of the peace of mind for investors has been based upon broad sympathy with the view that 2017 will be mainly a year of “steady boat” economic policy from the Chinese Authorities as we head into the 19th Party Congress this autumn.
Hale notes that one potential factor that could threaten the "steady as she goes" status quo is the informal rule that China's leaders retire if they have reached the age of 68 when the congress takes place. If President Xi has the clout to get the age limit waived (not to yet be assumed) then the Xi-Wang duo could continue to run China for another five years, if not longer. As such, heading into the plenum, stability has been an EM positive.
Politics and the 19th Congress aside, Citi notes that certain, more mundane Chinese macro indicators "are starting to wave red flags", among which:
- The Markit PMI is starting to turn over
- China's Inflation Surprise Index - a leading indicator to global inflation metric - has posted a recent sharp drop
- China's import trade has likewise tumbled after surging recently
- Chinese Iron Ore imports into Qingado port have plunged
These are shown below:
Adding another "red flag", Hale also notes that "some market commentators in recent weeks have highlighted that perhaps there is a major risk that consensus opinion is again overlooking the influence of China’s credit cycles, and thus perhaps overstating the potential contribution of future Chinese demand growth to the global outlook (Figure 4). And Citi’s EM strategists think that the recent macro-prudential tightening in China could possibly contribute to more negative spillovers in the coming months."
While we have repreatedly demonstrated various iterations of this all important Chinese "credit impulse" in the past, the following chart of the 12M change in China's credit impulse, this time as created by Citi, deserves to be seen again:
As a result, in order to assess the changes to the monetary backdrop in China, Citi’s China economists have created their very own Monetary Conditions Index (MCI, higher = looser monetary conditions, Figure 5). The Citi China MCI is calculated by using the weighted average of lending rates, M2 growth, and the REER. Interestingly, their caveat to just using a more mainstream credit cycle chart (like the Bloomberg one above) is that there are places where the credit growth deviates from indicators such as the PMI. Moreover, China’s credit system has gradually been moving from a bank loan denominated system to a more diversified financing model (Figure 5, bottom RHS).
The most obvious observation in the chart above is the clear effect of the recent 2015 stimulus. "The MCI index rose sharply from all-time lows, but since November last year this has turned. Four consecutive months of declines in this MCI suggest liquidity conditions are starting to tighten."
Next question: What happens if this tightening continues?
To assess the historical impact of declines in the MCI and thus perhaps forecast as to what may be witnessed in coming quarters, Citi takes 4 previous turning points in the China MCI and then plot what materializes in each cycle and on average in the 24 months post local peak in the MCI.
Citi's bottom line is hardly a surprise:
"as we witness a turn to tighter monetary conditions, this tends to be quite bearish for the hard data as we show above (Figure 6). Across the board, on average, these charts suggest material downside risks to YoY growth in measures of domestic activity."
Hale then breaks down the impact of China's slowdown across various asset classes, as follows:
- Broad FX: On average, both aggregate G10 and EM FX tend to soften around -6% vs the USD, within the first 9 months after a turn in the MCI, although different cycles vary to some degree thereafter.
- Rates: 10y UST yields on average tend to move sideways initially as the reflationary momentum fades. Around 8 months after the MCI turns, history shows that the 10y UST yields fall. Breaking this into its real and breakeven constituents shows the repricing lower in 10y breakevens is most evident (~- 40bps on average in 9 months), as likely disinflationary forces kick in from slowing demand growth. On average, curve implications are biased towards substantial flattening (on average ~20bps in 9 months) as the implication takes grip on the global outlook.
- Equities: Risky assets in EM (local) broadly hold up well until suffering on average a soft patch at around 5-6 months, seeing around a 5% correction in local terms.
- Credit: Here, risks to wider EM spreads are worth highlighting. Current CDX EM spread levels may be too tight by a significant magnitude. Widening of EM corporate spreads is evident in every historical period. Similarly in sovereign space, China CDS on average widens in the first 6 months after loose conditions peak. Both these historical developments are important for trades in our macro portfolio, as we discuss later.
- Commodities: Broader effects quite limited (Figure 11). More China centric commodities see downside risks mainly between 6-9m after the turn in the MCI. Given that’s where we are in the current period, the recent slides in copper and iron ore may not be surprising therefore. Any relationship to gold prices isn’t wholly evident
The next question is should China slow, what - if anything - can the PBOC still do?
If this MCI tightening persists and macro data follow, how can the PBoC react?
More recently, as we have written before, China has focused more on fiscal policy and the RRR, rather than policy rate cuts (Figure 12, LHS). One reason for this is that the PBoC is probably cognisant that they are reaching their “zero bound” and that the room to maneuver in a crisis is becoming limited. As such they are likely preserving some fire power. Indeed, note how the current easing cycle has been much less aggressive (in magnitude and from a time perspective) than in some historic episodes (Figure 12, bottom, middle).
As an aside, what this means is that China now has, by far, the highest real policy rates amongst the largest economies (they actually moved into positive territory again). Together with a still very rich currency, this exacerbates the headwinds for the domestic economy long term. Our hunch is that the PBoC will likely continue using the RRR to manage liquidity – and this is also our economists’ base case. And probably only in a sharper downturn are they likely to resort to policy rates cuts.
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Hale's takeaway is predictable: "tighter monetary conditions in China, if sustained, may mean that the period of unexpectedly strong Chinese activity growth, which started in 2016 Q1, is coming to an end."
Despite continuing to use higher money-market rates to discourage leverage, the PBoC have enough in their toolkit to ease liquidity conditions if needed. But investors should be warned that volatility may not be contained till the end of the autumn. Historically, on average, EM risk aversion has risen from this point in the MCI cycle (Figure 13).
While the jury is still out (crashing commodities notwithstanding) whether China has indeed turned the monetary corner, Hale admits that "the implications for sovereign CDS are clearly negative and thus widening China CDS is one way to hedge portfolios/trade this theme."
Citi's big picture conclusion is actually hardly a surprise, as it recaps what we have said and shown before: China's reflationary spark is fading, and it will now be up to Trump to provide the next global impetus for economic recovery.
Admittedly, China’s contribution to the broader global recovery may be waning. Further legs to the global reflation theme may now rely even more so on the Trump administration’s ability to deliver on key campaign promises.
As discussed in previous Weekly’s, we continue to hold an outright tactical long in 10y UST futures (with a stop on the 10y generic yield at 2.45%), which likely has a high delta to the data momentum that are showing signs of decline from post GFC cyclical highs. We continue to favour our 5s10s $ flattener too, which should also perform should China growth slowdown or Trump delay on tax reform/ fiscal stimulus.
Finally, to all those who still harbor hope that the current administration has a chance of passing any laws that boost the US economy, it may be a good idea to hedge "just in case"... after all, with volatility record low across all asset classes, hedging has never been cheaper.