Grant's Almost Daily: China Impulse Control

Earlier today, we said that the primary driver behind Caterpillar's unexpectedly gloomy guidance cut and spectacular price drop, which dragged the Dow Jones as much as 600 points lower, was the ongoing decline in China's credit impulse, something we have been warning about for months.

A few hours later, one of the few remaining respected analysts, Jim Grant, writing in his Grant's Almost Daily daily wrap confirmed out observations, and also attributed CAT's rolling over retail sales as well as disappointing outlook on China's credit impulse.

Grant's full note is below.

Impulse control

Two debt-laden ships pass in the night. As rates in the U.S. mostly ride the escalator, Chinese government yields have enjoyed visible downward momentum in recent months.  The 10-year Chinese government bond yield currently sits just under 3.58%, down from 3.9% on Dec. 31, 2017. The move at the short end has been even more pronounced.  China’s one-year yield has dropped below 3%, down from more than 3.8% at the turn of 2018. More broadly, Bloomberg notes this morning that “Chinese bonds are the top performers so far this year, among 70 markets in the Bloomberg Barclays Global Aggregate + China index, calculated in dollars.”

While lower rates are surely welcome news for a country as highly leveraged as China (total banking assets represented 305% of GDP as of year-end 2017) the prospects of slower economic growth bear close watching. This morning, a separate Bloomberg report notes a communique from Chinese media seemingly girding its citizens for tougher times ahead:

China’s leaders are giving their strongest signal since 2015 that growth in the world’s second-largest economy could slow – and that they’re prepared to tweak policy if trade or financial risks threaten a sharp deceleration.

Hard work is needed to meet this year’s economic targets amid an increasingly complicated geopolitical situation, according to a statement released by state media Monday following a Politburo meeting led by President Xi Jinping.

There’s a deep sense of risk underlying the calm surface, and the leadership’s attitude has changed greatly,” Deng Haiqing, chief economist at JZ Securities Co. in Beijing, wrote in a note. “The attention attached to stabilizing growth is the greatest since 2015.”

Indeed, this morning, China-levered global construction and mining equipment firm Caterpillar, Inc. reported stronger than expected first quarter results, extending gains its recent skyward stock price. Those intraday good times were emphatically reversed during the conference call, after chief financial officer Brad Halverson predicted that the first quarter “will be the high watermark for the year.”

So what ails the Middle Kingdom?  Waning credit appears to be taking a toll on growth. The Chinese credit impulse (growth in borrowing as a percentage of GDP) dropped to 25.39% as of March 31, the lowest since the 2015 yuan devaluation.

Chinese credit impulse, 10-year view. Source: The Bloomberg

The decline in credit impulse colors both China’s slowing economic growth and downward pressure on interest rates.  An April 16 report from J Capital Research summarizes the situation thusly:

Less credit means that companies will be unable to pay their outstanding loans and will instead rely on rollovers. That means more issuance of short-term bonds, wealth-management products, and central bank repos to make sure the system has enough liquidity.

Lower credit growth also tends to be deflationary and to make for slower fixed-asset investment growth. Indeed, the Producer Price Index, while still growing, was up just 3.1% in March and has declined every month since February 2017. As we noted above, the first quarter of 2018 witnessed commodity and asset deflation broadly. \

Author Anne Stevenson-Yang summarizes the predicament facing China’s leadership as flagging growth and skyscraping debt levels seemingly argue for opposing policy responses:

The only way to generate growth is by jacking up investment levels, but authorities seem to believe they can generate a more efficient allocation of capital by using tight command-control tactics. When command-control doesn’t work, we expect the government to try stimulus again, and that will threaten the RMB. Q2 will tell us whether the borders have been sufficiently sewn up against capital flight that authorities can engage in another round.

Could another Chinese currency devaluation be in the cards? Recall that the August 2015 yuan deval was followed by a severe bout of global risk aversion, culminating in a 9% intraday decline in the S&P 500 on Aug. 24, 2015. On that day, a trading halt in eight S&P 500 stocks cascaded into an ETF pile-up featuring major dislocations to net asset value and stoppages of 42% of all equity ETF’s. Will this time be different? The bulls hope so.