As the midterm election very slowly fades into history, the trade dispute with China is again a primary market focus. This week stock prices swung back and forth on every rumor about a potential meeting between Chinese and U.S. officials. 1 1 Close Markets seemed particularly excited that negotiations were happening “at all levels.” We already knew senior officials were negotiating. Were investors worried that there was one level of government that wasn’t included? Source: Bloomberg: “China-U.S. Trade Talks Taking Place ‘At All Levels’, Says Trump Adviser,” 11/12/18. If you scroll down below the trade headlines, you’ll find some articles about the Chinese economy. A few months ago these articles were usually either cautious or puzzled, but recently the tone has shifted to somewhere in between fear and panic. Big Chinese tech stocks, known as BATs, which were once high fliers, have been in a bear market for most of the year. 2 2 Close The initials for BATs come from Baidu, Alibaba and Tencent. They make great headlines, such as “BATs Get Battered” or “Someone has taken a bat to the BATs.” 3 3 Close Or if they didn’t, they should have. As far as the real economy goes, the headlines have been less clever and more confusing. They tend to be factually accurate, but a closer examination of the text of the articles reveals a very different picture from what the headlines purport to say. 4 4 Close According to the dictionary that is actually what irony is. It’s not like rain on your wedding day. You could call these the “true myths” of the Chinese economy. 5 5 Close Not quite an action movie. Much better than calling them the terminator or commando. Let’s take a look at some of them.
The first is that China manages its currency. The authorities control the settle and often place it far from where the last trade of the day was executed. They also intervene heavily to reduce volatility. Some would say the intervention is also used to achieve economic or political goals. Back in 2015, the authorities tried a freer exchange rate mechanism, but it was followed by some fairly large down moves in the currency and equity markets, so they reversed course. Earlier this year, when the trade dispute started to worsen, many analysts speculated that China might weaken the currency to offset some of the effects of the tariffs. Sure enough, the yuan has fallen against the dollar. Reports indicate that the authorities have been involved in the foreign exchange markets, but it appears as though Chinese authorities are actually trying to prevent the yuan from falling further rather than being the cause of the decline. As evidence, the official yuan settle has tended to be towards the high end of the day’s range, which suggests a desire for a stronger currency. Their monthly foreign exchange report has shown a steady decline in reserves since the beginning of the year. If authorities had been weakening the currency they would have bought dollar assets and that would have increased their reserve holdings. 6 6 Close There are other factors that affect the amount of reserves. They are measured in dollars, but not all of the reserves held are in dollars so fluctuations in the FX market matter.
China has an incentive to want a weaker currency to improve trade competitiveness, but there are limits. If the currency falls too sharply it could encourage capital flight. Chinese nationals might start moving money out in large quantities to avoid future devaluation. While some of this can be plugged with capital controls, it is almost impossible to completely halt it. China may be intervening to strengthen the yuan to prevent a potential currency crisis.
China runs a large trade surplus with the U.S., which might suggest that China’s currency is weaker than market fundamentals. There is no question that, at over $30 billion per month, the bilateral trade surplus is sizable. 7 7 Close Sources: Bloomberg, U.S. Census Bureau. But there is something peculiar: China’s trade surplus with the U.S. is almost exactly equal to its total trade surplus. This is simply because China does not have much of a trade surplus with the world, excluding the U.S. 8 8 Close You can count on a quant firm to do arithmetic. In fact, China’s total current account surplus (which includes trade and interest payments) as of September has fallen to 0.4% of GDP. 9 9 Close Sources: Bloomberg, State Administration of Foreign Exchange of China, National Bureau of Statistics of China. This does not mean that China is necessarily playing fair in trade, but it does mean its economic growth is not purely based on exports or that it is an outlier among nations. In contrast, Germany runs a current account surplus of almost 8% of GDP while Switzerland’s is over 10%. 10 10 Close Sources: Bloomberg, German Federal Statistical Office, Swiss National Bank, Switzerland State Secretariat for Economic Affairs. China’s shrinking surplus tells us that it may be having some success in transitioning to a slightly more consumer-oriented economy. 11 11 Close Three qualifications. Not really, exactly, such a strong statement.
Chinese stocks have had a terrible year and it goes well beyond the BATs. Both Hong Kong and Shanghai indexes have been steadily declining this year and have underperformed most of the indices in the U.S. and Europe. Some commentators have used this as evidence that investors are expecting a dramatic slowdown in the Chinese economy. In the U.S., a stock market drop of that magnitude is often (although not always) associated with a recession, but the connection between the stock market and the economy in China is not as clear. China had incredibly fast growth without a recession for decades, but this has not led to equally spectacular returns for investors in Chinese stocks. Chinese officials have worked hard to earn a reputation for unreliable data, but even if the data has been smoothed, there is little doubt that the Chinese economy has grown quickly over the past twenty years. The reasons for the disconnect between equities and growth may be that investors doubt corporate governance and are more driven by sentiment than hard data. Whatever the cause, it is difficult to use the behavior of Chinese stocks as a leading indicator of the economy.
While it may be a myth that the stock market is pointing to a slowdown, other signs are. 12 12 Close That hair has been successfully split. The term “slowing” has a bit of a different meaning for China than it does for many other places. When an economy is growing at over 6% (or whatever pace alternative measures may say China is actually growing at), a slowdown can still mean growth at levels that would be exceptional for most other countries. 13 13 Close China’s latest official GDP data showed YoY growth of 6.5% as of Q3 2018. Source: National Bureau of Statistics of China. China is facing external pressures from the trade conflict, which is starting to affect domestic data such as retail sales. Because China’s reliance on trade has been shrinking, it may be better poised to deal with a trade war than many people expect. But it is not invulnerable. While authorities probably have the tools to maintain high growth, they seem wary of using them, perhaps fearing credit excesses of past cycles. 14 14 Close This month, China’s aggregate financing and new yuan loans were below Bloomberg’s economist survey median forecasts. They are trying to be sensible and take measures to improve long-term growth rather than help cyclically. Many forecasters expect Chinese growth to slow over the next few years. There is nothing mythical about such forecasts. We’ll see if they’re true.
What We Are Watching
U.S. Durable Goods (Wednesday) According to preliminary data published last month by the Bureau of Economic Analysis (BEA), U.S. GDP rose at a robust 3.5% QoQ annualized pace in the third quarter. While this headline growth figure was impressive, the details of the report showed a surprising -0.3% decline in fixed investment spending. 15 15 Close This component of GDP is made up of a few major categories: non-residential structures, equipment, intellectual property, and residential investment. This may indicate that headwinds such as tighter monetary policy, slower foreign growth, and uncertainty over trade policy are leading to a slowdown in capex. The monthly durable goods report is perhaps the best high frequency indicator of capex trends. Data for October will provide an update on demand for capital goods such as machinery and computers. If orders continue to show a loss of momentum, it would add to concern that investment activity is becoming a weak point in the economy.
Eurozone PMIs (Friday) The Eurozone Manufacturing and Services PMIs published by Markit reached very strong levels around the start of this year, but both indexes have fallen steadily since that time. This deterioration in business sentiment has been matched by worsening official growth statistics, with GDP slowing from 2.8% YoY in the third quarter of 2017 to just 1.7% YoY in the third quarter of 2018. 16 16 Close Source: Eurostat. The reasons for this slowdown have been somewhat unclear. Auto sector disruptions due to a change in E.U. emissions standards likely depressed third quarter growth to some extent, and heightened political risk and market stress in Italy may also have played a role. Whatever the reason for deceleration to date, any further slowdown could mean that the eurozone economy is stalling out. Softer than expected results for the PMIs to be published this week might lead to weakness in the euro and regional equities and a rally in perceived safe havens such as German government bonds.
Canada CPI, Retail Sales (Friday) The Bank of Canada (BoC) has raised rates three times this year, most recently in October. In the statement accompanying that last rate increase, the central bank sent a hawkish signal by removing language indicating it would “take a gradual approach” to future hikes. While this move fueled speculation that the BoC could raise rates at back-to-back meetings, recent volatility in global equities and a sharp selloff in oil prices 17 17 Close Canada is a major oil producer. may inspire a more cautious policy trajectory. If key data releases such as CPI and retail sales surprise to the downside, markets could scale back their expectations for BoC rate hikes moving forward. This might weigh on the Canadian dollar and support domestic fixed income.