Donald Trump has been making headlines lately with his rants over China’s currency, but there is a lot more to the global picture – What Trump doesn’t know…
A little over a week ago the Netherlands Bureau for Economic Policy Analysis reported that global trade shrunk in the first six months of 2015 at the fastest pace since global trade collapsed in 2009 following the financial crisis, down 1.5% in Q1 and another 0.5% in Q2. This is big, very big, yet very few are talking about it! Which is why we are. According to a report from the Economic Cycle Research Institute, the last time export price deflation was this intense every G7 economy was in a recession.
The Eurozone’s growth wasn’t as strong as expected in the second quarter, with overall GDP rising by 0.3%, (barely above stagnation) and slower than the 0.4% in Q1. The two largest economies in Europe disappointed with Germany growing 0.4% versus expectations for 0.5% while France didn’t grow a bit versus expectations for 0.2% growth. Italy eked out 0.2% growth versus expectations of 0.3%. The Netherlands was similar with 0.1% versus expectations for 0.3%.
Despite the massive efforts by the Bank of Japan to get the economy roaring, Japan’s Q2 GDP didn’t give us much to cheer about either, declining at a 1.6% annual pace. Brazil also surprised to the downside, its economy contracting by 1.9% versus expectations for 1.7%, the biggest contraction for the nation in over six years!
So what may be happening here? Well, about 45% of the world’s GDP comes from commodity producing nations, and commodity prices have been taking a serious beating as is illustrated in the next chart. If a nation can’t sell as much of its own stuff (commodities), it isn’t going to be able to buy as much stuff from the rest of the world… pretty simple! (You can see a bigger version of the image below if you click on it)
Across the board, save for a few unique standouts such as tea, (traumatizing to your Irish author here) olive oil, (thanks to a nasty bug attacking trees throughout Tuscany) and uranium, (Japan is getting its reactors back up after the horrors of the tsunami) commodity prices are falling dramatically across the board. Even the world’s biggest producer of diamonds, De Beers, announced on August 24th that they would be lowering their prices by 9%. Apparently, diamonds are a little bit less of a girl’s best friend. These prices are down so much for two main reasons: the strengthening dollar and growth rates are well below historical norms, both here in the U.S. and abroad, which means commodity producers need to continue to cut back on production.
The slowing global growth story shows up in many places. While the US may be the world’s largest economy, China is second and it is the world’s largest goods-producing economy. When it is slowing, that’s telling you a lot about global demand. For one thing, all those commodity-producing countries aren’t buying as much stuff from the Chinese. Germany is a big exporter to China so when China slows, Germany feels it and that affects the rest of the Eurozone. The decline in oil prices coupled with sanctions has seriously hurt Russia, which in turn is hurting Germany as German exports to Russia decreased by almost 31% on an annual basis in the first half of 2015. Getting hit by declining demand from both Russia and China is putting a lot of pressure on Germany, the nation that has long been the engine of growth for the Eurozone.
Now what’s the story behind the dollar’s strength? Remember all those quantitative easing programs? QE1, QE2, QE3…? For those the Fed bought up tons and tons of “longer-term securities issued by the U.S. government and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac” in an attempt to inject more and more money into the economy thinking that would spur demand and get the economy back on its feet. The next chart shows the magnitude of the program. From January 2003 to today, the Fed’s balance sheet has expanded 511% as it purchased trillions of Treasury bonds and mortgage-backed securities. U.S. GDP today stands around $18 trillion, so this means the Fed tried to increase the amount of money in the economy by nearly 20%! Yet we didn’t see crazy inflation, which at the time seemed a likely possibility.
Where did all that money go? Mostly into asset prices…the ending of QE saw the dollar strengthening versus other currencies and the fall of commodity prices… with more likely to come.
While the Fed was buying up Treasuries in order to put more money into the economy, China was continuing its unprecedented reserve-accumulation exercise which, starting in 2003, amassed almost four trillion of foreign assets! That is more than all of the Fed’s QE programs combined. So what we really experienced on a global level was hyper-QE.
Today the story in China is a little different with the economy suffering from both a decline in exports due to the global slowdown and a shift from a primarily goods-exporting and manufacturing driven economy to a more service-oriented and internal demand driven one. The nation’s economy has evolved into one in which about 20-25% of its citizens have a middle-class lifestyle while much the rest of the country lives more on par with Nigeria. This is an untenable situation and Chinese leadership knows it, but is under a mountain of pressure from every angle. Chinese state and private debt is estimated to be around 300% of GDP, if you can believe the GDP numbers. If you think, like we do, that they are likely less than those reported by the government, then the situation is even worse.
So what’s all this about China’s crashing stock market kicking off the correction here? The next chart shows the massive run up that China’s main index experienced, rising over 130% from last August to early June and the correction it’s suffered since those highs. By August 26th, the Shanghai Composite had fallen over 43%. By the close of last week it had recovered a bit to be was down 37% from the highs.
The enormous run up in China’s stock prices over the past year was not due to improving fundamentals, as its economy has been slowing.This run up was based more on the assumption that the government would do whatever necessary to keep the market moving up combined with increasing use of leverage, (meaning people borrowed to buy more stocks). Not exactly a unique phenomenon these days!
Understandably, Chinese officials took steps to rein in the use of leverage. In January, they raised the minimum amount of cash needed to trade on margin, which would restrict the practice to wealthier investors. They also took steps to punish companies that had been lax on enforcing the margin rules with their clients. In April, Chinese regulators cracked down on “Wealth Management Products,” WMPs which are similar to U.S. money market funds, but in some cases WMPs were being used to generate funds that were then used to finance individual and corporate stock market investors at ratios of up to 10:1! They also banned “umbrella trusts” which helped clients evade the margin trading limits. The market still went up.
Dissatisfied with the results of their tightening, on June 12th regulators then reduced the total amount of margin lending stock brokers could do, while also reiterating forcefully the ban on illicit margin trading through mechanisms like umbrella trusts. This time investors listened, the market bull run broke and the plummet began.
In early July regulators pulled an “Our bad” and did an about-face, reducing the amount of money required to open a margin-trading account. Yep, first lowered this a few years ago and then raised it back up again in January and after watching a gut-wrenching slide in stock prices they reversed yet again! Since July, the government has taken a variety of steps to try to pump the market back up. Last week the market reversed its downward spiral only when the government announced it would engage in a large-scale asset purchase program in order to keep up stock prices. The markets in China and around the world rallied on the news. Then in yet another about face, (dizzy yet?) Sunday China announced that it had decided to abandon attempts to boost the stock market and will instead intensify efforts to find and punish those it suspects of “destabilizing the market” by “spreading rumors!” Over the past two months, state-owned investment funds and institutions have collectively spent around $200 billion attempting to prop up the market, with limited success.
This weekend 197 people were arrested for “spreading rumors” and “false information” online about the recent stock market crash and the explosion in Tianjin, including a journalist and stock market officials. On August 24, Wang Xiaolu, a leading journalist at one of China’s most widely read financial publications was arrested, and admitted to causing “panic and disorder” in a public confession aired on state television. Unsurprisingly, the Committee to Protect Journalists has condemned his arrest and subsequent “confession”. I thank my lucky stars every day that I was born where I am free to say what I think. Those who know me have assured me that I’d likely be six feet under if I’d been born under a different regime!
One final thought on China’s economy. When we take a deeper look, we see that according to official figures, gross fixed investment was 44% of gross domestic product in 2014. While figures for investment are more likely to be correct than those for GDP, does it really make economic sense for an economy to invest 44% of GDP and yet grow at only 5%? We think not! Talk about horrible returns. If these figures are to be at all trusted, investment could fall sharply going forward. That would mean further weakness in demand from China for commodities used to the enormous infrastructure projects for which it has become famous.
We’ll wrap up with China’s yuan and currencies across the world. As we mentioned in our May issue, China is attempting to be included in the International Monetary Fund’s Special Drawing Rights, which means it needs to let its currency float more freely. Earlier this month it took another step towards that end by loosening its hold on its currency, which resulted in the yuan falling some 3-4% versus the dollar. The following chart shows the performance of a wide range of currencies from across the globe versus the U.S. dollar over the past year. (You can see a bigger version of the image below if you click on it)
The one in red is China’s, (couldn’t resist!). As you can see, almost every major currency in the world has dropped in value relative to the dollar over the past year. Here are a few numbers to go with the chart above:
- Australian Dollar down 31%
- Canadian Dollar down 22%
- Chilean Peso down 20%
- Euro down 16%
- Japanese yen down 15%
- Indian Rupee down 9%
- British pound down 7%
- Swiss Franc down 4%
- Chinese yuan renminbi down 4%
Keep these numbers in mind as you hear Presidential candidates tossing insults at one another and at other countries around the world. China isn’t the only nation whose currency has declined in value against the dollar. Furthermore, if the argument is that China has been “artificially” keeping its currency cheap relative to the dollar in order to make its exports more attractive to the rest of the world, then why did its currency immediately decline in value the moment the government loosened its hold, proving that the government’s intervention has been keeping its currency higher than it would be were it allowed to float freely? This also makes intuitive sense. China pegged its currency to a band around the dollar. The dollar has been strengthening significantly while China’s economy has weakened. It is unsurprising that the market’s pressure is to push China’s currency lower. Yet another example of how headlines and TV talking points are often misleading.
For a broader historical perspective, the next chart shows the performance of a slightly smaller set of currencies against the dollar from 2010 through the end of 2013. The weakening of the dollar against these currencies is directly related to the various quantitative easing programs, the termination of which was announced when the Fed released the June 2014 FOMC (Federal Open Markets Committee) notes in early July 2014. (You can see a bigger version of the image below if you click on it)
Here we see that during those three years it was actually the dollar that was falling relative to global currencies. In fact, during this time China’s yuan actually strengthened versus the dollar by 11%. You don’t hear any candidates ranting about how the dollar devalued versus other currencies for years! There is a lot more to the situation in China than is discussed in the popular media, and it is something that could have a very big impact on the global economy and if affects the Fed’s decision on raising rates.