Thursday, March 29, 2012

Berlitz: China Pocket Guide

The markets appear to be a game of three halves at the moment. The US markets are resilient with equities holding their highs, Europe is gently slipping but the leader is currently China where equity markets have tanked over the past few days. To many, China has become the cradle of the next crisis. With little else going on in the world the amount of airtime and speculative attention that China is getting has already spilled into its secondary markets. Now whilst Australia may indeed be struggling with its own Dutch Disease the current China concerns are giving the Aussie bears more ammo to load up on positions that can only be described as "covering the table" - short AUD/USD, long EUR/AUD, short AUD/ZAR, BRL, CAD, you name it and the number of structured basket term sheets TMM are seeing relating to shorting Aussie are indicating Tabloid positioning. And we didn't even mention Copper or Chinese H-Shares. Yet much of this new wave is based upon China not paying top dollar for Australian commodities much longer.

The assumptions on China we will come back to in a minute, but the thing that strikes us most is the regionality of the opinions being expressed. US and leverage accounts are particularly negative on China and Australia, whereas Europe and real money accounts are more balanced. As usual though, the Chinese and Australian views remain overall pretty up beat on themselves. As ever TMM will try and explain this with a simple chart:

And it seems that even those with more optimistic views on China (Asia-based investors) have finally caught the "China is slowing sharply" bug and capitulated as February's export data (that TMM have already addressed here, concluding they weren't as bad as they seemed) and most recently the HSBC Flash PMI have provided new bear food, driven particularly by those in the US that view China as a Ponzi scheme. Now, TMM have mentioned before that they sit more in the middle of the two Jims (Chanos & O'Neill), neither of the opinion that China is to spectacularly crash nor become the world's growth engine (at least, not anytime soon). And they don't deny the fact that the banking system is full of NPLs related to the 2009-10 stimulus, and these will certainly be an overhang for the next couple of years. But that is in the price and, when considered upon the backdrop of being largely state owned & directed, TMM find it hard to get too excited about both the impact upon the economy more broadly - unlike in the West, loss-recognition and balance sheet repair (which would likely impede credit creation) are not exactly the priorities of either bank managements nor policymakers.

One thing that has puzzled many China-watchers has been the lack of expected policy easing in response to the weaker activity data and slowing inflation. The trouble is that Chinese data is very difficult to read, and TMM constantly receive somewhat, err, "lazy" analysis from both analysts and punters. A brief list of issues: (i) Lunar New Year plays havoc with January and February, and even can have an effect upon March due to the moving around and distortion of seasonal effects, (ii) the quality of the data is poor due to collection (and "massaging") issues, (iii) the data is not easy to understand as much of it arrives in "YoY Cumulative YTD" format, a relic of earlier central planning (see chart below of China Value Added of Industry YoY Cumulative YTD - a chart that is impossible to interpret in this form), (iv) seasonal adjustment factors have dynamically changed as China's economy has changed in composition over the past several years, and (v) there is an important difference between nominal and real figures (for example, the combined Jan/Feb nominal export growth of 7% was poor, but in real terms, was rather stronger than would have been expected given lagged US/EU orders). Any analysis of Chinese data is only complete when the above are considered - and most of the junk that both the Street & Blogosphere have pumped out on this neglect at least one of the above.

E.g. - What the heck does this mean?

So that's TMM's whinging out the way (and we profusely apologise for whinging at all!).

We digress. Reconstructing the above data, the below chart shows the YoY change in Value Added IP (purple line) and the 6m/6m seasonally adjusted annualised rate (saar, green line). The YoY rate is essentially flat, and while the economy clearly slowed in the latter half of 2011, the weakness appears exaggerated by base effects. The 6m/6m saar (green line), which is essentially a measure of growth momentum, clearly bottomed in December and has begun to move higher. The official China PMI also bottomed late last year (more on this below). Chinese policymakers observing the same data may well have come to the conclusion that easing is not really required - TMM would concur.

Of course, growth is only half the story - inflation is the other ingredient to the Growth/Inflation mix. But this too has fallen since the oil/food price-driven increase last year. Putting these together in a very simple model, there is a reasonable correlation between relative equity moves (see chart below, of the relative performance of Chinese H-Shares vs. SPX [Red line], vs. this naive metric [blue line]). No single driver can explain market moves, but broadly, TMM reckon that (as macro guys) the growth/inflation mix is a principal component. Obviously there are divergences related to the 2007-9 failed Decoupling Experiment, the world not being linear (and neither are returns) etc, but TMM think this is a useful way to think about China.

So, back to TMM's PMI model. This has reasonable error bounds that have caught them out before, functions of dynamic seasonal adjustments, but is nevertheless of some use at least. The top line model reckons a PMI of 52.7 - TMM are sceptical of this given the HSBC Flash PMI was so poor - but stripping out the seasonal produces 51.2, which is a smidge above consensus. TMM, however, are less concerned about the absolute level, and more about the direction. Specifically, should the number come out close to consensus, it would confirm that activity bottomed in December in line with the Value Added IP momentum above. A disappointment, on the other hand, would likely be met with eventual policy easing.

Putting all of the above together with bearish sentiment and interesting technicals in H-Shares (see below chart), TMM have begun building a long position both here and in AUD ahead of this weekend's PMI number, and would look to buy the dip into any knee-jerk sell-off should the number disappoint by only a tad. Again, the trouble here related to Lunar New Year and the other complicating factors mentioned above mean that the turn in momentum that TMM reckon is ongoing will not necessarily show up in the hard data for a couple of months. This is a risk TMM will have to take...

And with that, TMM brace themselves for a ravaging in the comments and wish their readers a profitable Q2.


Игры рынка said...

Agree. As long as the US government is running a 1 trln+ loss .. sorry deficit ... a year and should end up somewhere. China and Australia are prime destinations even if absolute volumes of $$$ are not that impressive.

Nic said...

Great read. And 1 trln x cheaper than Smutley.

Amplitudeinthehouse said...

That's chart screams..YOURS.. pal!

Anonymous said...

C says'
I'm afraid I'll have to be the odd man out and hold back my congrags. All your chart confirms for me is why there are two sides to a market.I think you need to get back on my couch and rest until you get over the urge to get your crayons out and draw lines .

Next week I shall be in Mayfair so please drop my bench in Berkeley Square and bring your crayons with you and we'll put them to good use.I've always wanted to see if the pigeons really will swallow anything.

Lykean Capital said...
This comment has been removed by the author.
Anonymous said...

That matrix picture was 100x more efficient than any 100pages strategy report. Thanks for your effort guys


WellRed said...

Alright I'm donning the dunce here. Could you explain to me what exactly that green line represents (the title isn't clear to me..). It's saar, but looks awfully, errr cyclical..

WellRed said...

Alright I'm donning the dunce here. Could you explain to me what exactly that green line represents (the title isn't clear to me..). It's saar, but looks awfully, errr cyclical..

cpmppi said...

It's effectively a 2nd derivative, so it moves up and down depending upon the rate of IP growth - i.e. momentum. If you look closely, you'll see it is not a seasonal component.


Leftback said...

Changing the topic from China to US credit, the pink blog has a long discussion of US credit today that is quite thoughtful, but a lot of it is the old "reverse decoupling" (aka Morning in America) argument, and then there is this from Bloomberg:

"Corporate bond sales hit a record $427 billion in Q1, according to Bloomberg. Companies are borrowing as much as they can before interest rates start moving higher. Higher rates will mean a stronger dollar, especially against funding currencies like JPY and CHF."

This is absolutely standard textbook economics. It is also WRONG. This is the usual post-recession reflationist, growth recovery argument, but one has to wonder if this person has a functioning cerebral cortex, and whether they have been paying attention since 2008? - this analysis is not well suited to our bizarre world of ZIRP, TARP and LTRO. So we beg to differ, and offer instead our version:

Companies are INDEED borrowing as much as they can - before SPREADS start moving WIDER (as US earnings and jobs data begin to weaken). LOWER rates (US and German long end) will mean a stronger dollar and a STRONGER YEN, especially against commodity currencies like AUD and ZAR.

(Cue ritual abuse from recoveryists, inflationistas of various ilk, Treasury bears and fans of US Exceptionalism)

HistorySquared said...

Interesting piece and I’m not sure where to begin, or end. I do not like to be on the same side as negative sentiment naturally, but you’re only a contrarian at the ends; in the middle, you’re a trend follower. Nothing close to panic and capitulation has occurred and we have only just turned down from a massive 30%+ short covering rally.

Beginning with expectations, GDP growth expectations have come down from 8.5% to the most bearish forecasts of 7% - negative sentiment is a forecast for 3% growth or even a recession perhaps - and why can’t they have a recession – the US averages one every seven years. The answer from bulls like Stephen Roach boils down to some version of “because they are a communist country and they know what they are doing.” ~ whatever. Government officials and efficient spending is a conflict in terms. It’s really simple – they have a massive credit bubble - the number one predictor of crisis according to a half a dozen papers – as it has been throughout thousands of years. It’s worse than the US and Japan, not just because it’s empty cities rather than condominiums in Miami and Las Vegas, but because it includes infrastructure as well – trains to nowhere, empty highways, unused bridges, and ridiculous vanity projects – like government buildings emblazoned with gold. They even built a Dubai-esque man made island.

HistorySquared said...

It’s not a Ponzi scheme, like sovereign debt is – borrowing more debt to pay off previous debt owners – but more akin to Enron’s accounting fraud. Today, a billionaire Hong Kong property developer was just indicted; another HK clothing retailer delayed report amid auditing problems, and we haven’t even touched the real frauds – the mainland companies run by government officials like SOEs and the banks. It started with frauds in ADR’s, they are now starting to hit Hong Kong, and only because the accounting standards are tighter in these places. Meanwhile, the IMF deemed accounting standards within China “unfit for international use.” Notice the trend towards the eye of the storm. “The timing of crises is lagged by the degree and length to which the numbers are lied about by governments and banks.” ~ Professor Bill Black. The Hong Kong monetary authority says State-Owned Enterprises would not be profitable if loans were not forced from banks at below market rates, which they have historically not even wanted to pay back, like amid the 1997 Asian Flu. Meanwhile, the bank withdrawals have begun, 800 billion in yuan deposits withdrawn last month. They can ease credit all they want; they can’t lend as non performing loans are going to spiral while their deposit base fleeing. Inexplicably, the central government is thinking of easing restrictions and let their people invest overseas – great idea, awful timing. Financial liberalization is a leading indicator of crises – according to Rogoff and Reinhart.

Australian Miner BHP finally had it’s first negative earnings revision lower; plenty of studies prove out the cockroach theory – where there is one, there will be many. A report on copper yesterday said 90% of the copper being imported sits idle in warehouses. “All we know is that we are selling a tremendous amount of [copper] to China for reasons that don’t appear to be logical.” Bank of America. The reason: people can’t get any more property loans following the crackdown, but they can get copper on margin, which they in turn lever up again to use as collateral to speculate in property, FX, and commodities.

HistorySquared said...

Australia is wholly dependent on China demand and have a massive housing bubble of their own, which rivals only those in China, Hong Kong, Canada, Turkey, India, Singapore, Sweden, etc, in scope. It’s 40-50% overvalued according to economist mag, worse than the US was. – down from 1/3rd of gdp to less than 1/10th. Capital has been flowing in amid the carry trade - borrowing Euros and Dollars to invest in their higher yielding currency – strong FDI is also a leading indicator of crisis, as it flows out just as fast as it flows in. It’s not stuck in plants and equipment, as the manufacturing data show.

On top of it all, China has an oppressed society and is the 11th most likely to experience violence against the government according to the Mincord model. I could go on for a year, but let’s just say I've done a bit of homework on this.

Of course, if you're a short to medium term trader, anything could happen in the next few months amid when run by the fiat currency cartel and government manipulation. For example, i expect the authorities to ease the financial repression with a cut in import taxes.

May the better trade win. Cheers.

Leftback said...

A China skeptic might be tempted to add that 7% is just what they SAY their growth is, and that their data are the smoothest and least noisy data series in the history of data.... a glance at electricity consumption and other associated and less manicured statistics suggests that Mr Pettis might be closer to the mark at 3%.

As for stability and the rule of law, financial or otherwise, under a communist/fascist regime, well, good luck to brave investors in the event of a deep credit crisis. China is a very large and still largely very poor country led by a corrupt elite who have hollowed out an increasing fraction of the country's wealth using techniques well known to Western crony capitalists. Australia, having set itself up as a huge mining shaft connected to Beijing, will reap what they sow.

Four legs good, Two legs better!

Anonymous said...

while Oz may face a nasty 'reaping' when China cools, at least as a small open economy it will be fast and furious. With the exchange rate probably back at 30c the tourists from overseas will flock to our sunny shores to stare in awe at our vast idle open pit mines with rusting drag lines and stay in the penthouse suites formerly owned by the apprentice electricians when they earned $250k a year.

WellRed said...

For what it's worth, I am definitely throwing my lot in with Leftback and HistorySquared here. China's system is a nightmare. Whether there's a short-term trade there or not is a debate for people smarter than me, but I remain convinced that China will miss 8% growth expectations probably just about forever from here on out.

Off-topic here, but it seems like the mood is definitely turning in US markets. Treasuries are regaining a lot of the ground they lost, homebuilders and financials are taking a beating, and most recently the grand bellwether of this market has underperformed (granted this is last bullet is not a trend but worth mentioning nonetheless). Maybe most importantly, the market just cannot seems to rally on good news. Now all we need is for the US to close lower today and the case will be closed (ie US sells European rally)...

Leftback said...

This is the way the quarter ends...
Not with a bang but with a whimper.

Was it good for you too, Macro fans?

MacroDave said...

I have started to think the same thing over the past week or so. Unless the word blows up I think that China has, or is very close to, bottoming. The Shanghai index topped back in 2009 and is down about40% peak to trough.

Anything is possible and the economy could just %%%% the bed but I doubt that happens.

Long way of saying I like the idea of being long.

MacroDave said...

The official PMI liked your post :-)

Anonymous said...

Don't be fooled by China PMI.

Raugh out roud!