China Beige Book Warns Economic Slowdown Has Begun

When it comes to the global economy, few things matter as much as China, the trajectory of its economy and especially the pace and impulse of its credit creation, which is ironic because virtually all data coming out of China is fabricated and manipulated, and thoroughly untrustworthy, either on purpose or "by accident."

The latest example of the former was highlighted over the weekend, when we discussed that a nationwide Chinese audit found some local governments inflated revenue levels and raised debt illegally, once again making a mockery of China"s credibility on the global stage. As Bloomberg reported ten cities, counties or districts in the Yunnan, Hunan and Jilin provinces, as well as the southwestern city of Chongqing, inflated fiscal revenues by 1.55 billion yuan, the National Audit Office said in a statement on its website dated Dec. 8.

An even more blatant example of the former was highlighted in October ahead of China"s Communist Party Congress, when the local securities watchdog literally "advised" some loss-making companies to avoid publishing quarterly results ahead of the Congress as authorities sought to ensure stock-market stability during the critical gathering of China"s political elite.  As a result, at least 17 Shenzhen-listed companies announced delays to their earnings reports from Oct. 20 to Oct. 24, up from three during the same period last year.

However, now that the Party Congress is long over, China"s recent economic data offer a "warning for 2018" now that Beijing"s leaders are less motivated to prop up fake "growth" for purely optical purposes. That is the opinion of China Beige Book, and its president Leland Miller who said that "Incentives to ensure the economy was growing smartly at the time of the Communist Party Congress do not apply as next year wears on," CBB president Leland Miller and chief economist Derek Scissors said in a report released on Wednesday.

According to a private survey by CBB International, which collects anecdotal accounts similar to those in the Federal Reserve’s Beige Book, Q4 results already show some signs of a transition to slower growth,  The most recent sampling of 3,300 Chinese businesses showed:

• Hiring stopped accelerating due to a strong base of comparison


• Manufacturing orders also stopped accelerating 


• Inventory accumulation "is too fast for comfort"


• Sales-price inflation is weaker than in the second quarter


• Wage gains have stopped accelerating

Come to think of it, the CBB data is not that different from the official Chinese data which showed continued slowdown across most economic verticals:

 

"None of these is genuinely alarming yet, and none would be out of place in a typical quarter," the CBB"s Miller wrote. "But the first results after a CPC are not a typical quarter. If you expect a noticeable slowdown in 2018, the first post-Congress returns support those expectations."

To be sure, even here there is confusion: while at the 19th Party Congress, which marked the start of President Xi Jinping’s second five-year term, top leaders signaled less emphasis on pursuing economic growth at all costs, and greater dedication to deleveraging, during the main economic planning conclave in December which set priorities for 2018, they pledged to focus on "critical battles" against financial risk, pollution and poverty in coming years. Meanwhile, deleveraging - Xi Jinping"s endless crusade - was strangely forgotten. Indeed, as Goldman observed last week, "there was no explicit mention of deleveraging" as "recent policy statements increasingly use the phrase "control of leverage", in our view likely a reflection of increasing realism in policy making." This significant policy reversal prompted the WSJ last week to report that Beijing has effectively given up on its deleveraging pledge.

Leverage or not, the table below - courtesy of Bloomberg - shows CBB’s breakdown of how support for the expansion may erode:

Furthermore, evidence from the retail sector doesn’t support the government’s claims of a consumption boom, CBB said. While some large firms have strong sales and profitability improved this quarter, retail revenue growth finished last among major sectors, Miller and Scissors wrote.

"Retail’s performance is decidedly uninspiring. Revenue, capex, and hiring are inferior to manufacturing, while inventory growth is much higher."

The good news: overall hiring has held up and was generally in line with the prior quarter, with 48% of firms staffing up and 3% cutting workers. "Job growth remained stronger at state firms than private, regardless of company size," CBB’s survey found, although as we will show in a subsequent post, while hiring may remain strong, wages are tumbling in a troubling indication that China"s middle class is set for imminent disappointment and anger.

Meanwhile, inflation in wages, prices, and input costs were also roughly the same as in the prior quarter, and were moderately faster than last year, the report said. Profit growth improved.

That said, despite predictions of gloom as we enter 2018, the world’s second-largest economy proved bears fully wrong this year, exceeding analyst estimates in the first and second quarters, and is now on pace for the first full-year acceleration in growth since 2010, with GDP seen growing at 6.8% this year and 6.5% in 2018. There is a problem: this growth was on the back of a near record credit impulse since the February 2016 Shanghai accord, an impulse which is now over.

Which means that all else equal, and absent another gargantuan credit injection in the coming months, China"s bears are about to have their day in the sun all over again.

Doug Noland: There Will Be No Way Out When This Market Bubble Bursts

Authored by Adam Taggart via PeakProsperity.com,

This week Doug Noland joins the podcast to discuss what he refers to as the "granddaddy of all bubbles".

Noland, a 30-year market analyst and specialist in credit cycles, currently works at McAlvany Wealth Management and is well known for his prior 16-year stint helping manage the Prudent Bear Fund.

He certainly shares our views that prices in nearly every financial asset class have become remarkably distorted due to central bank intervention, first with Greenspan"s actions to backstop the markets in the late-1980"s, and more recently (and more egregiously) with the combined central banking cartel"s massive and sustained liquidity injections in the years following the Great Financial Crisis.

All of which has blown the biggest inter-connected set of asset price bubbles the world has ever seen.

Noland foresees tremendous losses as inevitable, as the central banks lose control of the monstrosity they have created:

This is the granddaddy of all bubbles. We are at the end a long cycle where the bubble has reached the heart of money and credit.

 

There will be no way out. We"re not going to get enough private credit growth to reflate things when this bubble bursts. It"s going to have to come from central bank credit; it"s going to have to come from sovereign debt.

 

When this bubble bursts, it will shock people how far the central banks will have to expand their balance sheet just to accommodate the deleveraging in the system. And they won"t really be able to add new liquidity to the market; they"re just going to allow the transfer of leveraged positions from the leveraged players onto the central bank balance sheets.

 

When you get to that point, when the market sees that transfer occurring, I predict there"s going to be fear of long-term financial instruments. We"ll see rising yields. That"s when things will become problematic.

 

There will be losses. Of this global bubble, I think European debt is about the most conspicuous. Sure, European junk debt is nuts, too. It currently trades at 2%. Why? Because the ECB is buying large amounts of corporate debt. The ECB has kept rates either at 0% or negative. The perception is that the ECB will keep those markets liquid.

 

But look at Italy. It"s rapidly approaching 135% in terms of government debt to GDP. That debt will not get paid back. But yet, the market is willing hold that debt at 1.7%. This is debt that has traded at over a 7% yield back in 2012. But here it is today at 1.7%. I mean, Europe is just grossly mispricing its huge debt market. The excesses that have unfolded in European debt across the board are just staggering.

 

So when we get to that point when the central banks begin aggressively expanding their balance sheets (again) but the bond markets are not happy about it, then the central banks will finally have to decide if they want to continue to inflate or if they"re going to focus on trying to keep market yields down. This will be a very, very difficult situation for central bankers when it unfolds.

Click the play button below to listen to Chris" interview with Doug Noland (54m:31s).

China"s Corporate Debt Unexpectedly Rises At Fastest Pace In Four Years, As A New Risk Emerges

Have you heard the one about the priest, the rabbi and China"s deleveraging? We forget how it goes, but it"s pretty damn funny, especially the last part after a Reuters report that following China"s repeated vows by Beijing it would reduce the country"s unprecedented sovereign, municipal, corporate and household leverage, China"s debt is not only rising, but growing at the fastest pace in four years.

It"s especially funny because for years China’s top officials have - well - lied, touting their ambitious policy priority to wean the world’s second-largest economy off high levels of debt, but there is not much to show for it. On the contrary, the debt pile at Chinese firms has been climbing in that time, with levels at the end of September growing at the fastest pace in four years.

As shown in the chart below, a Reuters analysis of 2,146 China listed firms showed their total debt at the end of September jumped 23% from a year ago, the highest pace of growth since 2013. The analysis covered three-fifths of the country’s listed firms, but excluded financials, which have seen the brunt of government de-risking and deleveraging efforts so far.

The analysis revealed that debt in the real estate sector increased the most over last five years, followed by industrials, with the share of industrials in China"s total corporate debtload going up by 3% psince the end of 2012, while relative real estate debt rose by 7%.

In September, as shown here before, state-owned enterprises also reported a much faster pace of growth in their debt, as the government quietly backstopped quasi-private companies. In addition, last month we reported that as part of China"s latest bailout of the financial sysmte, Beijing was set to buy 24% of all residential real estate offered for sale in 2017. Both mean debt would surge, and sure enough, total debt at 75 of the CSI Central SOE 100 index companies  increased by more than 27 percent from a year ago, the biggest increase in many years.

* * *

However, in addition to rising debt, there is another, even more pressing risk: rising rates. According to Reuters, debt servicing costs - i.e., interest expense - now accounts for a fourth of state-owned firms’ revenues in the last few quarters. The ratio rose to around 27% in the second quarter - the highest in at least five years - before declining slightly to 24.47% in the third quarter due to a jump in revenues. Needless to say, with China"s 10Y government bond yield  and corporate spreads blowing out to 3 year wides, traders will be especially focused on what happens to Chinese interest expense in the coming months.

* * *

There is some good news: an analysis of corporate debt showed that borrowing through the issue of bonds has fallen, however, possibly as the regulatory clampdown has pushed up financing costs.   Additionally, as noted last week, October’s data on aggregate social financing of corporate bonds showed aggregate financing of corporate bonds stood at 18.34 trillion yuan ($2.77 trillion) at the end of October after increasing 4.4% from a year ago, the lowest growth rate in two years.

China Broad Credit Growth (TSF + Local Government Bond Issuance)

Who plugged the gap? Ah yes, the infamous shadow banking sector. Per Reuters:

The gap in funding needs appeared to have been filled by off-balance sheet financing in China’s murky and opaque shadow banking sector. Cumulative total social financing, which also includes shadow banking, stood at 172.2 trillion yuan at the end of October, though the exact size of shadow banking is unknown. Total social financing for the month of October 2017 was 1.04 trillion yuan.

Then again, as some have suggested, perhaps China was just waiting for last month"s comunist congress to pass before finally committing itself to this much hyped deleveraging. As Reuters reports, China’s deleveraging push indeed appears to have intensified after the 19th Communist Party Congress in late October. In its latest salvo on the shadow banking sector, (described in in "A "New Era" In Chinese Regulation Means Turmoil For $15 Trillion In China"s "Shadows") the central bank on Nov. 17 issued sweeping guidelines to tighten rules on asset management business, which the central bank estimates is a $9 trillion market. Just a few days later, fears of the deleveraging push resulted in the biggest Chinese stock market crash in 17 months.

 

And while China’s government debt remains optically contained, at 46.9% of GDP as per latest figures from the Bank for International Settlements, top policymakers have recently raised concerns about a sharp build-up in household debt. Outstanding household consumer debt surged close to 30% since the middle of last year and reached 30.2 trillion yuan as of October.  Meanwhile, outstanding yuan-denominated property loans amount to 31.1 trillion yuan and individual mortgage loans add another 21.1 trillion yuan as of the third quarter of 2017.

There are two parting questions one should consider: the first is whether China has any hope of ever deleveraging without unleashing a depression. With total debt/GDP at 329% as of May 2017 according to the Mercator Institute, we doubt it.

 

The second is linked to the first: with China contributing an unprecedented 33% of global debt growth in the past decade, any slowdown in debt creation is sure to send an economic shockwave across the globe.

 

And one bonus question: when the IMF published the following chart in its latest Financial Stability Report, how long did it say China has left before it implodes?

 

China Deleveraging Hits Corporate Bonds As Cascade Effect Begins

Following the market lockdown during October’s Party Congress, many commentators were disturbed by the continued rise in Chinese government bond yields as we returned to “business as usual”, with the 10-year rising to 4%. At the beginning of this month, we discussed the sell-off (see “China: Shadow Bank Inflows Are Critical To Sustain The Ponzi…But They’re Falling”) and noted a useful insight from the Wall Street Journal.

An important anomaly to note about the bond rout: as government bonds sold off, yields on less-liquid, unsecured Chinese corporate bonds barely moved.

 

That is atypical in an environment of rising rates - usually, bond investors shed their less-liquid holdings and hold on to assets that are more easily tradable, like government debt.

The question was…why had corporate bond yields barely moved? The answer, according to the WSJ, was that China’s deleveraging policy led to redemptions in the shadow banking sector, e.g. in the notorious $4 trillion Wealth Management Products (WMP) sector. Faced with redemptions, shadow banks had to sell something…quickly…and highly liquid government bonds were the “easiest option”. Furthermore…and this is potentially significant…the WSJ noted.

Meanwhile, the nonbanks have held on to their higher-yielding corporate bonds, which at least have the benefit of helping them to maintain high returns.

Not any more (see below).

We agreed with the WSJ’s explanation at the time, but noted that the government bond sell-off was actually a sign of the unravelling of the WMP Ponzi scheme. The Chinese authorities are wise to the Ponzi which is why they announced the overhaul of shadow banking and WMPs last Friday (see “A ‘New Era’ In Chinese Regulation Means Turmoil For $15 Trillion In China"s ‘Shadows"). However, the new regulations don’t kick in until mid-2019, a sign to us that when they looked “under the bonnet”, they didn’t like what they saw.  

We doubt that China can achieve an orderly restructuring of its shadow banking sector, never mind its much larger credit bubble. A sign that we have taken another step towards China’s “Minsky moment” is that the bond sell-off has spread to the corporate bond market. The chart shows how spreads versus sovereign bonds have blown out during the last few weeks.

Bloomberg noted how the 10-year yield on China Development Bank notes, a quasi-sovereign issue, closed above 5% for the first time since 2014 today while, in another report, it put the corporate bond sell-off in a wider context.

China’s deleveraging campaign is finally starting to bite in the nation’s corporate-bond market, a shift that will make 2018 a clearer test of policy makers’ appetites to let struggling companies fail. Yields on five-year top-rated local corporate notes have jumped about 33 basis points since the month began, to a three-year high of 5.3 percent, according to data compiled by clearing house ChinaBond. Government bonds, which have far greater liquidity, had already moved last month as the central bank warned further deleveraging was needed.

With more than $1 trillion of local bonds maturing in 2018-19, it will become increasingly expensive for Chinese companies to roll over financing -- and all the tougher for those in industries like coal that the nation’s leadership wants to shrink. Two companies based in Inner Mongolia, a northern province that’s suffered from a debt-and-construction binge, missed bond payments on Tuesday, in a demonstration of the kind of pain that may come.

Bloomberg tries to put a positive spin on the corporate bond sell-off, defaults are healthy in terms of differentiating good and credits.

In the long haul, that all may be good for China. Allowing more defaults could see its bond market become more like its overseas counterparts, with a greater differentiation in price. And that could mean it channels funds more productively. “The deleveraging campaign and the new rules on the asset management industry will further differentiate good and bad quality credits, and make the onshore credit market more efficient,” said Raymond Gui, senior portfolio manager at Income Partners Asset Management (HK) Ltd. “Weaker companies will find it harder to roll over their debts because funding costs will stay high.” Gui predicts yields will keep climbing. The average for top-rated corporate bonds is already 2.2 percentage points above what investors demanded to hold them in October last year.

The rise comes as authorities show greater determination to shift the economy onto a more sustainable footing, with less debt. The latest move was a plan to discipline the asset-management industry, including banning guaranteed rates of return. People’s Bank of China Governor Zhou Xiaochuan graphically depicted the risk of excess leverage, by evoking a "Minsky moment," or sudden collapse of asset values. Key to that endeavor will be scaling back some of the implicit credit guarantees that have backed a broad swathe of Chinese borrowers. The country only started allowing corporate defaults in 2014. Last year there was a record, coming in at at least 29. It’s unclear yet whether that total will be met in 2017.

Bloomberg spoke to an analyst who also believes the recent sell-off in Chinese bonds is more to do with separating the “wheat from the chaff”, rather than anything more profound.

"We expect the divergence of performance between different bond categories (Chinese government bonds, policy bank bonds and credits) to become more prominent into 2018," Albert Leung and Prashant Pande, rates strategists at Nomura Holdings Inc., wrote in a note Wednesday.

We disagree. From our perspective, it looks like early signs of cascading sell-offs within Chinese financial markets, which have long been abused by excessive leverage and Ponzi characteristics. Talking of which, the Shanghai Composite Index suffered its biggest one-day drop since June 2016.

What caused the sell-off? According to some commentators it was fear that the local bond rout was getting out of control...hence "cascade". We noted last week that traders had been stunned by the official warning from Beijing that some stocks - in this case Kweichow Moutai - had risen "too far, too fast". Zhengyang Shen, a Shanghai-based analyst at Northeast Securites commented.

"The decline in Moutai has triggered selloffs in some of this year"s best performing stocks."

Which sounds an awful lot like another example of cascading selling...

"People Ask, Where"s The Leverage This Time?" - Eric Peters Answers

One of the Fed"s recurring arguments meant to explain why the financial system is more stable now than it was 10 years ago, and is therefore less prone to a Lehman or "Black monday"-type event, (which in turn is meant to justify the Fed"s blowing of a 31x Shiller PE bubble) is that there is generally less leverage in the system, and as a result a sudden, explosive leverage unwind is far less likely... or at least that"s what the Fed"s recently departed vice Chair, and top macroprudential regulator, Stanley Fischer has claimed.

But is Fischer right? Is systemic leverage truly lower? The answer is "of course not" as anyone who has observed the trends not only among vol trading products, where vega has never been higher, but also among corporate leverage, sovereign debt, and the record duration exposure can confirm. It"s just not where the Fed usually would look...

Which is why in the excerpt below, taken from the latest One River asset management weekend notes, CIO Eric Peters explains to US central bankers - and everyone else - not only why the Fed is yet again so precariously wrong, but also where all the record leverage is to be found this time around.

This Time, by Eric Peters

“People ask, ‘Where’s the leverage this time?’” said the investor. Last cycle it was housing, banks.

 

“People ask, ‘Where will we get a loss in value severe enough to sustain an asset price decline?’” he continued. Banks deleveraged, the economy is reasonably healthy.

 

“People say, ‘What’s good for the economy is good for the stock market,’” he said.

 

“People say, ‘I can see that there may be real market liquidity problems, but that’s a short-lived price shock, not a value shock,’” he explained.

 

“You see, people generally look for things they’ve seen before.”

 

“There’s less concentrated leverage in the economy than in 2008, but more leverage spread broadly across the economy this time,” said the same investor.

 

“The leverage is in risk parity strategies. There is greater duration and structural leverage.”

 

As volatility declines and Sharpe ratios rise, investors can expand leverage without the appearance of increasing risk.

 

“People move from senior-secured debt to unsecured. They buy 10yr Italian telecom debt instead of 5yr. This time, the rise in system-wide risk is not explicit leverage, it is implicit leverage.”

 

“Companies are leveraging themselves this cycle,” explained the same investor, marveling at the scale of bond issuance to fund stock buybacks.

 

“When people buy the stock of a company that is highly geared, they have more risk.” It is inescapable.

 

“It is not so much that a few sectors are insanely overvalued or explicitly overleveraged this time, it is that everything is overvalued and implicitly overleveraged,” he said.

 

“And what people struggle to see is that this time it will be a financial accident with economic consequences, not the other way around.”

SocGen On China"s Slowdown In The Making

As we highlighted (see here), China’s macro data for October 2017 was disappointing with retail sales and industrial production missing consensus estimates, fixed asset investment was in line and inflation surprised on the upside. There was some impact from state-driven efforts to reduce pollution, but this issue will be an ongoing headache for decades. In big picture terms, the challenge for the Chinese leadership is to deflate a credit bubble in an orderly fashion, something which we’re not aware has ever been done on this scale. Notwithstanding the reach of China’s famed central planners, we doubt that they will be successful, a view which seems to be shared by the outgoing PBoC Governor who recently warned of a “Minsky moment”.

In the following charts of GDP, industrial production, retail sales and fixed asset investment, we showed that growth rates in key macro indicators are currently around the lowest they’ve been since the crisis or, in the case of the fixed asset investment, as low as they’ve been for nearly two decades.

Commenting after the October data releases, SocGen is getting equally bearish. To wit.

China’s activity growth decelerated more than expected in October for the most part, while inflation surprised on the upside. Supply constraints imposed by the air pollution reduction programme clearly played a role, while demand slowdown emerged only a little. However, the seeds have been sown for a full-fledged growth slowdown in 2018. Housing tightening has bitten deeper into housing sales; persistent cost-push inflation may dampen the private sector’s appetite for capex; and, most importantly, credit growth – which did not really slow much in October – is poised to trend further lower amid the resumption of financial deleveraging policies.

SocGen notes that while the slowdown in industrial production growth in October 2017 was concentrated in higher value-added sectors, traditional areas of upstream strength are locked in a deeper contraction.

IP growth dropped to 6.2% in October from 6.6% in the previous month. The high value added sectors – automobiles, electrical machinery and computers, telecommunication & other electronics (CTE) – accounted for most of the slowdown in the headline figures, although growth rates in these three sectors were still in the high double-digits. The anti-pollution campaign also left its mark on upstream material sectors, where part of the production was suspended during winter. Production growth of coking coals, cement, steel and aluminium were all in a deeper contraction.

The property sector has obviously been white hot in the latest phase of the Chinese credit bubble, although Xi Jinping’s warning at the recent Party congress that “Housing is for living rather than speculation” is beginning to look prescient. SocGen notes that housing acts as a leading indicator and, while it weakened in October 2017, the decline remains fairly most so far.

Housing sales – one of the best leading indicators – indisputably weakened further. Floor space sold dropped 6% in October, after a 1.1% increase in 3Q. Sales revenue growth turned negative for the first time in 31 months, dropping to -1.7% in October from 3.9% in 3Q. While the sales slowdown at the moment is unequivocally bad news for housing construction in 2018, housing supply indicators did not really deteriorate as much as they appeared to in October. Yoy growth of new starts fell to -4.3% in October from 0.4% in 3Q, but the mom rate was largely in line with the historical average for this month. Similarly, property investments slowed to 5.4% from 7.4% in 3Q, albeit against a negative base effect.

The bull case for China rests on rebalancing the economy from investment-led growth to consumption-led growth. While the slowdown in retail sales is a concern, it’s too early to gauge whether October’s weakness will be sustained in the coming months due to this month’s Singles Day distortion.

Domestic demand softened somewhat. Nominal retail sales growth eased to 10% in October from 10.3%, despite stronger inflation. Adjusted for price effects, retail sales grew 8.6% yoy in October, down from 9.2% in 3Q. Automobile sales – the biggest category – saw its volume growth down to 2% from 5.7%, which seemed to be behind the softer production number in the IP data. However, given the strong increase in online sales at the 11 November sales events (the “Double 11” or the Singles’ Day), part of the weakness in October might be due to delayed shopping.

While SocGen notes the October 2017 credit data undershot estimates, it remains fairly sanguine on the immediate implications.

Although the credit and monetary data came in below market expectations, there was little deceleration in credit stock growth, which means that the much smaller monthly increases in bank loans and total social financing (TSF) were mostly seasonal. While new yuan loans dropped by almost half to CNY663bn in October from CNY1,270bn in September, growth in the bank loan stock softened by only 0.1pp to 13%, which a faster rate than in 1H17. Growth in total credit to non-financial sectors (= TSF - net equity financing + net increases in government bonds) ticked up a little to 14.4% from 14.3% in the previous month.

However, the bank sees three driving a looming deceleration in credit growth.

1. Housing-related credit tightening seems to be succeeding. Short-term borrowing by households cooled substantially to CNY79bn in October from over CNY200bn in the previous four months, indicating that regulators’ efforts to weed out the taking out of consumption loans for property purchases has started to work;


2. Formal bank lending is likely to be constrained by loan quotas. Reportedly, big banks have either completely or nearly used up their loan quotas for 2017, and there is widely shared expectations among banks that the 2018 quotas1 are unlikely to be much bigger; and


3. As financial deleveraging continues, banks’ options to extend shadow lending will be increasingly limited. “Equity and other investments” – the asset item of banks that is most closely related to shadow lending – has dropped by about CNY1trn from its peak in February 2017 (after increasing by CNY19trn since 2014).

Most importantly, financial deleveraging is poised to pick up soon. In addition to talks by senior policymakers of more regulation, the Financial Stability and Development Committee, the high profile body in charge of this project and headed by a vice premier, has concluded its first gathering and reconfirmed the policy direction only two weeks after the Party Congress. The expectation of tighter regulations has already driven up bond yields onshore.

After the Chinese leadership permitted the credit engine to be revved up again from early 2016 through to the early part of 2017, most commentators have put fears about China to the back of their minds, preferring to focus on the synchronised global growth narrative. The reality is that massive credit bubbles are not only dangerous, but we suspect, inherently fragile, when central planners try to fine tune them.

Critical Threats To 2017's Bull Market - Part 2: Over-hyped Risks?

With The Donald J. Industrial Average surpassing new record highs every day, questioning this bull market"s continued existence remains heresy outside of dark little corners of the internet.

However, continuing his series, Bloomberg"s macro strategist Mark Cudmore dares to mention a few of the more prescient "known unknowns" that could hamper the meltup for the rest of the year... and in the case of today, some that may not.

Via Bloomberg,

Overhyped market risks provide just as many trading opportunities as genuine ones. It’s crucial to delineate what matters and when.

Yesterday’s piece highlighted threats that could cause a material correction before year-end.

Today’s column argues that other oft-cited concerns can be safely ignored for the moment.

Nafta is prominent in the news and any move by President Donald Trump to abandon talks and exit the deal would have global repercussions. Still, that worst-case scenario won’t be a 2017 issue. Even if Trump jumps, he has to give six months notice and Congress will fight to keep the U.S. in.

Will China increase its deleveraging focus after the Communist Party Congress? Probably, and that may hit domestic financial assets. But officials will not want to significantly hurt the real economy and have an impressive track record of slowing growth without killing it. That reduces the risk of a spillover into world markets.

Global yields breaking higher would have major consequences. With only two months of data to go before year-end, are investors suddenly going to believe in runaway inflation though? Given the skepticism shown by the flattening U.S. curve, a one-off print will be insufficient. There’ll need to be a significant change in the trend and there’s simply not enough time left for that in 2017.

Brexit? With expectations so depressed and in the context of a two-year process, it’s not a major near-term risk. It’s a U.K.-asset story, with minimal contagion elsewhere.

Tax reform failure? It seems unfeasible for this to be resolved either way in 2017 and expectations -- at least in the market -- for a successful passage aren’t high in any case.

A Kurdistan-prompted oil shock? The region just doesn’t provide enough supply to be a game-changer -- not with U.S. shale producers ready to ramp up production whenever prices rise.

A failure to form a German majority coalition? Like Brexit, it’s a regional story. A negative that may be underpriced in local assets but not something global investors will panic about.

So, says Cudmore, excluding a Black Swan event, only North Korea, Catalonia or a U.S. government shutdown have the ability to cause a 10%+ correction in the MSCI All-Country World Index by Dec. 31... and here"s why...

China Announces RRR Cut Of At Least 50 bps; First Since February 2016

In a sign that China"s ongoing attempts to delever (and decelerate) the economy may have gone a bit too far, on Saturday morning China’s central bank announced a targeted reserve requirement ratio (RRR) cut, its first since February 2016 and which will go into effect in 2018, in an attempt to boost lending to struggling smaller firms and energize China"s lacklustre private sector, Xinhua reported. 

The People’s Bank of China said on its website that it would cut the reserve requirement ratio for some banks that meet certain requirements for lending to small business and the agricultural sector. According to the PBOC, the vast majority of China’s banks would be eligible for at least a 50 bps cut to their required reserve ratio. As a reminder, the RRR is the amount of cash as a percentage of deposits that banks must park at the central bank as reserves. The current rate for major banks was set at 17.0% after the last general RRR cut that took effect in March 2016.

The PBOC explained that the reserve requirement rate will be cut by 50 bps for banks whose loans to the targeted groups account for 1.5% of their outstanding loan balance or their newly added loans for the previous year. A much higher bar is set for a further 100 bps cut: 10% of loans must be to the designated “inclusive finance” groups, the PBOC said. Banks that meet the 10%  requirement will see their RRR cut by 150 bps.

The PBOC also said the move was made to encourage more small loans - those under 5 million yuan - to small firms, loans to individual proprietors and lending that supports agricultural production, innovation, the poor and education.

As the following chart show, the targeted RRR cut which is meant to stimulate credit creation by smaller banks comes at a time when smaller bank lending has slown substantially as a result of the ongoing crackdown on shadow banking products.

While the central bank explained that the "targeted" RRR cut is a structural adjustment that does not change the country"s overall monetary policy stance, stressing that it would continue to implement "prudent and neutral" policy to guide reasonable credit and financing growth, analysts at Lianxun Securities said that "the size of the cut is big, it covers all big banks, and 90 percent of small and mid-sized banks. Conservatively we estimate 700 billion yuan in liquidity could be freed up."

Perhaps more notably, analysts observed that the cut was different from previous changes to RRR in that it was a “delayed” cut that will not go into effect until next year, which could lead to disappointment for a banking sector that has already seen significant liquidity withdrawn in recent weeks.

“Clearly, the market will be disappointed as this cut will not help ease the liquidity conditions in the onshore banking system in the short term,” Zhou Hao, a Singapore-based analyst at Commerzbank, wrote in a note after the announcement.

The RRR cut will likely not come as a surprise as China’s cabinet, gearing up for the most important Communist party Congress in 5 years starting next month, had recently flagged a possible move, saying "the government would take a number of measures, including tax exemptions and targeted reserve requirement ratio cuts to encourage banks to support small businesses."

The policy action is in line with ongoing attempts to delever the economy and encourage more targeted lending to more vulnerable sectors of the economy, even as the government tries to cut down on speculative investment in the financial sector and property and rein in a rapid buildup in overall corporate debt. However, the RRR cut is departure from the PBOC"s recent approach of setting policy using new tools such as short- and medium-term lending facilities for a similar purpose....

... as well as daily changes to interbank liquidity via reverse repo open market operations.

Lianxun Securities also said the RRR cut would help to offset negative impacts to smaller firms from strict environmental protection measures and capacity cuts, while also offering some liquidity relief to small and mid-sized financial firms. Additionally, the move comes amid increasingly more aggressive attempts by China to delever its shadow banking system, which has plateaued over the past year.

As Deutsche Bank noted several days ago, in China"s latest monthly credit data report "the financial deleveraging campaign has continued to make progresses: banking assets growth softened further; loan and TSF beat estimates but the overall credit growth actually moderated; shadow banking size was shrinking while loan growth stayed resilient. As such from the financial system’s perspective we see improving transparency and lower liquidity risks. While the deleveraging has contributed to a modestly slower economy, the growth momentum is in line with our house view."

That said, DB said that "we do not foresee policies to ease and we expect the deleveraging to carry on orderly," so one wonders how today"s significant easing will impact the German bank"s outlook on China"s economy.

Separately, to offset the shrinkage in China"s shadow banking sector, in February the PBOC extended a preferential programme that allows financial institutions that support rural finance and small enterprises to apply for a lower required level of cash reserves.  But despite still-strong credit growth nationwide, many small businesses and farmers remain in desperate need of funds and do not have easy access to ample cheap credit that state-run firms enjoy.

Also on Saturday, the central bank said it will maintain prudent and neutral monetary policy and use multiple monetary policy tools to keep liquidity basically stable. The statement, which came after the third quarter meeting of the PBOC’s monetary policy committee, said "China will continue with interest rate and exchange rate reform while keeping the yuan basically stable."

* * *

Finally, also on Saturday, China reported that its manufacturing PMI rose to 52.4 in September - more than the 51.5 expected and the highest print since April 2012 - as big factories ramped up faster than smaller ones, presumably a last piece of window dressing to show host "strong" the economy is ahead of the pivotal Communist Party meeting. The National Statistics Bureau attributed the surge to improving demand from domestic and overseas markets and to consumer-goods makers accelerating production ahead of a weeklong national holiday starting October 1. Some economists also said activity picked up thanks to production from Chinese exporters for the Christmas season and manufacturers bringing production forward to beat a government crackdown on pollution.

Ironically, as China"s official manufacturing survey, which focuses on larger SOEs, came out scorching hot, a private measurement of factory activity, which more closely tracks smaller private companies, weakened. The Caixin China manufacturing purchasing managers’ index slipped to 51.0 in September from 51.6 in August, as new orders and output increased at a softer rate than the previous month, said Caixin Media Co. and research firm Markit.

Operating conditions in China"s manufacturing sector softened in September, dragged down by the weakest rise in new business in three months and an easing in output to the lowest level since June, according to the latest Caixin Manufacturing Purchasing Managers" Index (PMI) released Saturday. The headline manufacturing PMI fell to 51.0 in September from 51.6 in August but remained above the 50 break-even mark for fourth consecutive month, according to data compiled by IHS Markit for Caixin.

Readings above 50 indicate expansion in the manufacturing sector while readings below 50 indicate contraction. The higher the PMI reading above 50, the faster the expansion in the sector. The lower the reading below 50, the faster the contraction.

The slowdown in the Caixin index -- which focuses on smaller and medium-size companies -- was in contrast to the sharp rise in the official manufacturing PMI jointly released today by the China Federation of Logistics and Purchasing and the National Bureau of Statistics. The CFLP/NBS PMI came in above expectations at 52.4 in September, the  highest level since April 2012, due mainly to robust input and output prices.

The Caixin index showed that new business expanded at a slower pace due to the weak demand. "Notably, new export work increased only marginally during the latest survey period," Caixin said.

The chart below shows the latest divergence between the two series:

Lu Zhengwei, an economist with Industrial Bank, told the WSJ that the government crackdown to curb pollution falls heavier on smaller manufacturers, which usually have poorer emissions controls, hence the divergence between the gauges. However, in light of the ongoing plunge in China"s credit impulse and the recent miss and slowdown across all major economic indicators, including industrial output, retail sales, foreign trade and fixed-asset investment, it is clear that the economy has begun to cool. 

In response, the governing State Council recommended this past week that the amount of reserves big banks must set aside with the central bank should be lowered, provided they meet certain criteria on lending to small and private businesses. Zhou Jingtong, an economist with Bank of China , said it was a good time to lower the reserve requirement for some big banks to prevent the economy from decelerating too sharply.

That"s precisely what happened this morning.

"Different Type Of Bubble": Markets, The Sports Illustrated Jinx, And The Dodgers

Submitted by Gary Evans of Macromon

Markets, The Sports Illustrated Jinx, And The Dodgers

Why do stocks and assets markets crash? Why is there is a Sports Illustrated jinx and magazine cover stories often signal a sign of a top or bottom of the subject being portrayed?

Regression to the mean, or, more simply, just moving back to the long-run averages.   

Dodgers Tank After SI Cover Story

After going on a tear of 51-9,  the best 60 game winning stretch in 105 years,  the ink was barely dry on the August 28th Sports Illustrated’s cover, which read, “Best Team Ever,” before the Dodgers went into a major tailspin.

“Best. Team. Ever?” The ink was barely dry the cover of our Aug. 28 issue—which hit newsstands Aug. 23, with a corresponding comparison to the greatest teams in history online—when the Dodgers fell into a tailspin that they have yet to escape. Through Aug. 25, they had gone 91-36 for a .717 winning percentage, which put them on a 116-win pace, good enough to tie the 2001 Mariners for the highest total of the 162-game expansion era. Since then, they’ve lost 10 of 11 to the Brewers, Diamondbacks and Padres, and while they still have an ample cushion to win the NL West and wrap up homefield advantage in the National League playoffs, they’ve shown that even if the infamous Sports Illustrated cover jinx is a myth, this squad is hardly invincible.  –  Sports Ilustrated, September 6

Sports Illustrated Cover Jinx A Myth?

We disagree.

Teams, players, politicians, companies,  markets or, whatever or whoever, always seem to be cover stories either at at their peak or nadir.   For sure,  the Dodgers 51-9 winning stretch was unsustainable, and the law of averages had to kick in.

Black Swans Are Rare

We do admit there are on rare occasions when Black Swans come along that defy all probabilities and shatter age old records.  Rarely.

The 2015-16 Golden State Warriors were one, but couldn’t validate their 73-9 record shattering season, reverting to the mean after executing the biggest choke in NBA championship history.   Blowing a 3-1 lead to the Cleveland Cavaliers.

In other words,  the Warriors lost three games in a row in the NBA finals, 33 percent of what they lost over the 82 game season.  That was one “mean” reversion to the mean!

No more, however.

“The Warriors are going to win forever, if everything stays the same. This season is over. You know, we’re gonna play it out, and the Warriors are gonna win. And then the next year it’s gonna be the same thing.” – Jeff Van Gundy, September 6

Regression To The Mean

What about the [Sports Illustrated] curse? What happens is that some athlete somewhere in some sport will perform way above average. Sports Illustrated has to have something on its cover and so seeks out those athletes who are doing exceptionally well, and picks from among them the one that outperforms them all. In other words, this particular athlete will have performed way, way above average, a rare event. At this point, their picture is shown.

But, lo! In the coming weeks, our poor athlete slumps back to average or even below, disappointing all, and once again proving the validity of the curse.

All that has happened, however, is that the athlete has “regressed to his mean.” The overwhelming probability is for that athlete to perform near his average, which the athlete subsequently does. It’s no slump after all, just a return to regularity.

To say the SI has a “cover curse”, then, is no different than saying a coin has been hypnotized after a “Tail” finally shows up after a successful run of 20 “Heads” in a series of coin flips. – William M. Briggs

What Does The Sports Illustrated Jinx Have To Do With Asset Markets?

First,  markets are not immune to the magazine cover curse.  We can recall many covers that were contrarian calls of market tops or bottoms.

Probably the most famous was BusinesWeek’s August 1979, The Death of Equities, cover.

The stock market had been in a decade long bearish funk.  The cover didn’t mark the end of the bear market as it banged around another seven months with the S&P500 falling another 8.6 percent bottoming in March 1980.  The market didn’t break out into the multi-decade bull run a few years later in August 1982.   Timing is tricky but close enough for government work.

The stock market had performed way below its long-term average performance, everyone was bearish on equities and had sold out, including BusinessWeek.  Ergo, regression to the mean with some overshooting.

Yes,  markets almost always overshoot, not only to the downside but also to the upside.

Current Asset Markets

That brings us to today’s asset markets and U.S. household net worth.

We came across a chart, similar to the one below, which peaked our curiosity and motivated us to crunch the data and come up with our own observations and conclusions.

The Data

The chart is self-evident. We are in another asset bubble.

This one, however, is more complicated.

More of a steel bubble, if you will.

Harder to burst and long lasting as it is created and driven by central bank money.  Credit based money bubbles pop easier and more quickly as they are vulnerable to a lightning fast deleveraging as was the case in the last crisis.

Asset prices, as reflected in household net worth, are once again divorced from economic reality now more than ever before.  In our above analysis, the difference between the time series of household net worth and nominal GDP.

The two series tracked each other very closely for 45 years up until 1997.  Asset prices grow with fundamentals, which, ultimately, are driven by economic growth.

U.S. household net worth is currently 38 percent or more than three standard deviations above the nominal GDP index, where the average difference is only 6 percent for the 65-year sample period.

Greenspan Put

The difference data (net worth less GDP) appears to have become non-stationary – e.g., an unstable mean, etc. — after 1997.

Let’s also not forget the flaws of assuming a normal distribution in asset markets, which have   “fat tails”  and skewed distributions,  which is evident with this data,  post 1997.

It may be the result of many things, including the rise of the internet and moral hazard.

The result of the cumulative effects of 1987 stock market bailout,  the 1995 Mexican Peso bailout, and the 1997 Asian Financial Crisis, where western policymakers immunized investors from taking long-term losses.   Thus, 1997 may have been the year markets finally realized and recognized the “Greenspan Put” was alive and for real.

Deleveraging     

Granted there has been some deleveraging by households since the great recession, mainly in mortgage debt, so some of the increase in net worth could be the result of slower growth in liabilities.  In additon, some may  be due slower nominal GDP growth.

More analysis is needed to confirm these alternative hypotheses but you don’t pay us enough for us to put in the extra effort.

We did construct a nice table for you, however, and our conclusion of the above alternative explanations?  De minimus.

It’s all asset inflation the result of the expansion of global central bank balance sheets.

Pension Entitlements

One of the results that really surprised us most in our analysis was the rapid rise in pension entitlements as a proportion of household wealth.

We don’t view this as positive as about 30 percent of pensions, on average, are currently underfunded.  Either contributions are going to be dramatically increased or pensions will be restructured and future payouts reduced.

Either case will be bad for demand and the economy.

The alternative is to cut current services, which is also already taking place. Again, it will only add to the “clash of generations” and more political conflict.

We eventually believe the pension shortfalls will become so large the federal government will be forced to nationalize and monetize them leading to inflation.  We have a lot of experience in countries that have resorted to such policies.

Unfunded pensions are nothing more than “fake wealth.”

Conclusion

Several times a week I walk with a good friend who could have played center field for the Cleveland Indians.   But he had a higher calling.  Let’s call him Joltin’ Joe (JJ).

We have been friends for years and have seen many asset cycles.

We live in a lovely county in Northern California, which is in the midst of another raging housing bubble.   The median income for the county is around $61,000, up about 16 percent from the year 2000.   The median house price is $639,000,  which has more than doubled from $319,000 in March 2012.

Fundamentals dictate that the median price should be, more or less three and half times the median income, or around $215,000.   Let’s add another $50K for the California sunshine premium,  though it was 111 degrees here on Saturday!

At an expected or fundamental value of $265,000, that puts the current median home price in our county 140 percent overvalued.

In general, housing prices should move with inflation and wages.  Such a large change in relative prices is a massive transfer of wealth from the young to the older generations, who own most of the housing stock.

That is if the young are gullible enough to pay these prices.  Again,  more potential conflict leading to the clash of generations.

JJ’s Observations

JJ likes to talk about the housing market.   He is very astute noting that this housing bubble is different than the last one just ten years ago.  There isn’t the leverage that there was in 2007.

A lack of supply drives this housing bubble

Hedge funds, private equity firms, and other investors swooped in during the crash and bought up many of the modest homes in foreclosure.   They then foreclosed on the buyers and are now raising rents on their newly owned homes.

People, such as “The Foreclosure King”  (and you know who I am talking about), who would be living under a bridge or freeway if they were not bailed out by the U.S. taxpayer and the Fed during the financial crisis, somehow think they deserve and are entitled to their dubiious created wealth.    Now they are gouging the younger renters, some of who they probably foreclosed on,   who are now priced out of the market and can’t afford to buy a home.   These people are the new “welfare queens.”

Wonder why the body politic is so angry?

Economic anxiety will only lead to greater political instability.

A Mean Regression To The Mean

JJ is not an economist.  I tell him to be patient unless he wants to day trade and try and flip houses, which can be very profitable if your timing is right and you get out before the bubble pops.

There are few people who do,  however.  Greed usually overpowers common sense when you’re making that kind of easy money.

Assets, whether it be stocks, bonds, emerging market debt, or houses will eventually regress to their mean or fundamental value.  They inevitably always overshoot, creating incredible buying opportunities.

Just as the Los Angeles Dodgers are now doing, regressing to the mean and overshooting their true potential, while in the midst of their own Sports Illustrated jinx.

Diiferent Type Of Asset Bubble

This asset bubble is different.

It is larger, encompasses almost all asset classes, may inflate much further, will  likely last longer than many expect, and will be harder to burst because the global central banks have taken $13-15 trillion in assets out of the markets, creating artificial asset supply shortages,  and repressed interest rates to zero or below.  Leaving few alternatives but to chase risk assets.

Enjoy riding the bubble.  It is fun making money in bubbles and you can become very rich if you time it and get out it time.

It is getting late, however, and there are an increasing number of events looming on the horizon that can knock the markets for a loop.

Also be careful on the short side.  Wait for the markets to break.

When the bubble does burst, and it may take some time, it will be one helluva “mean” regression to the mean.

Or it could crash next month.  Timing is tricky.

We are waiting for the S&P500 to make the cover of Sports Illustrated.  We may waiting a long time, however, as very few believe these asset markets are driven by real lasting organic fundamentals.

Good luck, comrades.

China Delivers "Surprisingly" Great Economic Data Across The Board, Yuan Yawns

Following more dismal data from the US, hope for global growth remains in China and they did not disappoint. Despite slumping macro data, a major slowdown in real estate, and the nation"s deleveraging efforts in the last three months, GDP beat, Retail Sales beat, Industrial Production surged, and even fixed asset investment was above expectations. The Yuan hasn"t moved.

For the last three months, Chinese data has been disappointing, along with US, as the collapsing credit impulse leaks into reality...

But exports and consumer spending have been pillars for the economy over the second quarter, offsetting the curb on leverage, and tonight"s data shows that none of that matters.. because the deleveraging economy beat across the board

• China GDP BEAT 6.9% (exp +6.8%, prior +6.9%)


• China Retail Sales BEAT 11.0% (exp +10.6%, prior +10.7%)


• China Fixed Asset Investment BEAT 8.6% (exp +8.5%, prior +8.6%)


• China Industrial Production BEAT 7.6% (exp +6.5%, prior +6.5%)

As the charts below show, more of the same well-managed data to show that all is well enough that hope remains...Strong growth again reflects an economy awash in credit, foretold in the latest new yuan loans (1.54 trillion yuan) and aggregate social financing (1.78 trillion yuan).

Enda Curran, Bloomberg"s Chief Asia Economics Correspondent, notes that at first glance there"s not a lot for the bears in these numbers given they appear strong across the board. The backdrop though continues to be one of cheap credit and mounting risks. That"s an issue policy makers say they are aware of but for now, it seems like growth above all else is key.

Iris Pang, greater China economist at ING Bank in Hong Kong:

"Higher than expected GDP growth comes from strong industrial production. That said, the gap between FAI growth and industrial production growth tells the story that it is consumption and export driven growth."

Julian Evans-Pritchard, China economist at Capital Economics, said the strength seen in the data seems unlikely to last:

"The recent crackdown on financial risks has driven a slowdown in credit growth, which will weigh on the economy during the second half of this year.

"What’s more, the National Financial Work Conference that concluded over the weekend has signaled that further regulatory tightening remains on the horizon."

We wonder how long before the lagged response to the credit impulse collapse hits GDP... (NOTE the weaker and weaker reactions in GDP to credit impulse surges)

The reaction in Yuan is underwhelming for now... (after its biggest weekly gain since March)

China"s stock market ripped back higher (after an early plunge) ahead of China"s data dump, and held those gains as the data hit (we wonder if someone got wind of the data a little early?).

As a reminder, Japan is closed for a holiday so we are not getting the usual juice from BoJ shenanigans on any move.