This is an excellent summary by our good friend David Malpass a noted Wall Street Analyst formerly with Bear Stearns, and now with his own firm – Encima Global.
After its Tuesday market close, China announced a joint cut in interest rates and reserve requirement rates (RRR). That buoyed U.S. markets in the morning, but they weren’t able to hold gains. The S&P 500 fell from 1928 at 3pm to 1868 at the close, a 3% drop in the final hour.
For an analogy, the current equity market slump reminds us of the summer correction in July-October of 2011 (S&P 500 down 20.8%.) The decline was driven by a concrete set of negative fundamentals (severe euro crisis and a U.S. debt ceiling stalemate that disrupted the short-term Treasury market) compounded by August vacations. The fundamentals were ultimately resolved, involving four major steps by the ECB that allowed the growth outlook to stabilize. For context, the July-October 1998 equity correction was also 21%, limited by the Fed’s bailout of LTCM, but we think the fundamentals were worse. The 2008 bear market was 57% due to a much broader range of irreversible factors.
We think the latest equity selloff and the negative year-to-date sag (Dow -12%, S&P -9%) has priced in a big slowdown in world GDP and corporate earnings. That’s probably enough based on the fundamentals, but the market is having major trouble with liquidity concerns, bond market uncertainty and fears of cascading margin calls. The Fed’s September 17 rate decision (either outcome) will reduce the uncertainty, but that’s still a long time off. It’s conceivable that the Fed or ECB will take activist steps before September to renew the Bernanke/Yellen/Draghi put. However, China’s rate cuts underwhelmed the market. That sets a higher bar for the other central banks.
China’s Targeted Cut Was Too Little
On Tuesday, China reduced the reserve requirement rate (RRR) by 0.5% to 18% (see graph) and made larger RRR cuts for certain institutions. There was a 3% RRR reduction for finance companies such as auto financing. China’s M2 money supply growth has been accelerating due to the previous cuts in the reserve requirement, and we expect the latest cut to also add to the M2 growth rate. China also cut its one-year lending rate to 4.6% from 4.85%, its deposit rate to 1.75% from 2% and its effective ceiling for the deposit rate to 2.63% from 3%. See graphs in the attachment and details regarding the RRR targeting process and the contrast with Fed tools.
As growth slows below 7%, we expect China to increase its stimulus, but it’s moving too slowly for the market’s taste. It has major monetary, fiscal and exchange rate policy tools and a large pile of international reserves that can be used if global growth slows further.
China auto sales fell 3.4% on a year over year basis through June. Electricity production fell 2.0%, merchandise exports 8.3% and retail sales 10.5% year-over-year through July. China’s bank lending was up 15.5% year-over-year through July after hitting a low of 13.2% in October 2014. These indicators are often used to create models showing much slower China GDP growth, but we note major shifts in the composition of GDP toward services and away from these measures. China is clearly slowing below 7% real as the global slowdown takes hold, but China’s growth is still fast compared to other emerging markets and very fast compared to developed countries. After bottoming at 6.2% year-over-year in the first quarter of 2009, real growth surged to 11.9% yoy in the first quarter of 2010. Since then it has slowed to 7.0% in the first and second quarter of 2015. The Bloomberg consensus for China’s third quarter growth is 6.9% and 6.7% for 2016.
Devaluation Going OK
We think China is better prepared than most of the rest of the world for a strong dollar if the U.S. hikes or a prolonged disinflationary slowdown if the U.S. stays trapped in ZIRP (now likely). China will slow as long as global growth is sinking into the “new norm” established by Fed policy or below it, but China will probably be able to come out ahead once global growth resumes.
The yuan has weakened 3.2% against the dollar over the last 11 days (from 6.21 to 6.41 yuan per dollar) without causing major disruptions. There has been substantial criticism of China’s debt and the risk of capital flight as the yuan weakens, but the currency transition has been relatively smooth. China explains the yuan devaluation based on the real trade-weighted yuan, which has been appreciating sharply in recent years (see graphs); and on market forces, where China’s international reserves have been declining. We expect daily selling pressure on the yuan that invites a slow, crawling devaluation until the government and exporters decide that further devaluation would be inflationary or destabilizing.
We think the yuan liberalization will be good for China in the long run, but the immediate issue for markets is the global slowdown, the deep uncertainty surrounding the Fed, and market illiquidity. Assuming current Fed policy continues, we expect weak growth in private sector credit along with weak GDP growth in the U.S. and most of the world – the “new norm”. China’s latest policy flop (too small an RRR cut) lowers the odds of Fed hike and keeps China at the center of world concerns, explaining the late-day U.S. equity sell-off. As in 2011, we think fundamentals could still come back together, but the liquidity problems are preeminent. The graph in the attachment shows the dramatic losses in dollar-based ETFs for China (FXI), Japan (EWJ) and emerging markets (EEM).
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