GLC Insights - China's Year of the Pig

An inverted yield curve, a pig that can fly, and the tail end of a bull market. Three big market themes happening right now, what to make of them and what to do next.

Part 2: China’s Year of the Pig

Is the economy ready to fly again? Will the U.S. be aligned or at odds with China’s economic and market outlook?

If you haven’t read Part 1 of this 3-part series, the inverted yield curve, we suggest you start there.

To view the full outlook report with all accompanying sections, tables and charts, please see the attached PDF reports at the bottom of this article. All data is current as of April 15, 2019.

If you wish, you can also listen to a podcast about this article:

Amin: Hello, I’m Amin Barakat, Vice-President at GLC Asset Management Group. Welcome to the second in our series of three podcasts we are bringing you on three big market themes happening right now, what to make of them and what to do next. The three themes are the inverted yield curve, the outlook for the US and Chinese economies and the anatomy of a bull market.

Before we get started, I want to mention that listeners can access all of GLC’s podcasts through our website or subscribe to the podcasts through Apple’s app, Google Play and Spotify by searching GLC Asset Management.  You will get new episodes automatically when they are released.

I would like to welcome our featured speaker for all three of our series of podcasts, with me is Brent Joyce GLC’s Chief Investment Strategist. The first podcast delved into the story around the recent yield curve inversion. In this installment we turn to the outlook for the U.S. and China.

Brent, markets have been trying to assess for the better part of the past year the extent and implications of a slowdown in China’s economic growth. In addition, the U.S. seems to be having a bit of a growth scare at present and what these issues mean for the trajectory of global growth. 

You’re feeling more constructive when it comes to China these days – what’s the reason for the shifting stance?

Brent: One of the things we need to recognize is that central bank policy makers have actually been trying to engineer slower growth in both China and the U.S. by taking steps to tighten financial conditions, which is were we find ourselves now. Both of these central banks along with many others, the European Central Bank and our own Bank of Canada included are currently stepping back from these restrictive policies. 

For China specifically, the about-face in their policy approach is pretty dramatic. After three years of reigning in credit expansion, China has shifted into pro-growth mode - embarking on a substantial set of stimulative economic growth policies, they have reduced the interbank lending rate to extremely low levels; they have cut the required reserve ratios for banks 5 times reduced taxes across a large swath of the economy – persona taxes, sales taxes and taxes on small and medium enterprises. They are increasing government fiscal spending; and lastly, the People’s Bank of China announced a new program aimed at strengthening the banking system, some are referring to this as a form of quantitative easing.

Early evidence of the impact of these steps can be seen in a surge in overall bank lending and shadow banking so far in 2019.

The kind of credit boost we are seeing in China is consistent with what we have witnessed twice already since the financial crisis, where an uptick in Chinese credit conditions has coincided with every global expansion since 2009.  We believe this will be the third time since 2009 that a rebounding Chinese economy will reinvigorate global growth and trade. This will justify the moves we are seeing in equity markets and lift bond yields in the latter half of 2019.  

Amin: China’s outlook partly depends on healthy economic relationship with major global partners, particularly the U.S. – what your thoughts on that dimension?

Brent: The trade situation has not helped either economy and the slowdown is likely being exacerbated by the trade frictions, but the US and Chinese economies were set to slow even without the trade frictions. I think the trade file is getting too much of the blame for the weakness. It really is more about what central banks have been doing to slow the economy and there are mini-cycles underlying the trade dispute that have more to do with the slowing than trade alone. What I am talking about is the credit cycle in China that we just discussed, but we also believe a significant portion of the slower U.S. growth profile is a result of two issues, both of which we believe are fading: namely, higher borrowing costs, and the normal U.S. inventory cycle and here is where trade frictions likely made things worse. 

Amin: OK, talk to me about the higher borrowing costs first.

Brent: So, higher borrowing costs were the result of 9 rate hikes by the US Federal Reserve over the past three years. This had the intended effect of slowing overall household consumption, especially for big ticket items like housing and automobiles. Higher borrowing costs also eat into corporate profits and dent corporations’ appetite for future investment. With the Fed now on hold and bond yields retreating to 18-month lows, these headwinds are now becoming tailwinds. Many housing-related indicators are showing improvement and U.S. auto sales just matched their best month in over a year.

Amin: And what about this inventory cycle…

Brent: The U.S. has a fairly predictable inventory cycle, which is basically the natural ebb and flow of varying volumes of production, then warehousing, before final sale to the consumer. These cycles have historically lasted 3-4 years from peak-to-peak and we are at the bottom of one such cycle now. The downside of these cycles are marked by weaker readings from the economy. Due to the myriad of trade threats overhanging the global business supply chain, the current inventory cycle slowdown was exacerbated by sharp inventory stockpiling in the US in Q2 and Q3 of 2018, businesses accelerating purchases of inputs fearing the companies the purchase from in China might be targeted by the US government wither by tariffs of outright bans – remember the Chinese company ZTE was blocked from doing business in the US. As we know, they are in a fight with Huawei, where Canada is taking collateral damage. So, the fears are understandable. Incidentally, we also observe similar ‘inventory stuffing’ behavior in the U.K. and Europe, due to uncertainty around the future openness of the border and customs regulations brought on by Brexit.

Amin: What does this mean for the future?

Brent: Swings in the inventory cycle are largely a movement of production between time periods. The result is excess growth in one period (first half of 2018), followed by weakness later (late 2018 and early 2019) - as there is no need to order new, until previous inventory is worked off. The good news is this inventory cycle is showing signs of turning and this should relieve some of the recent weakness witnessed in the U.S. economic data. 

Amin: Obviously with an economy as large as China, there are a number of moving parts, and one uncertainty is timing – how long it will take for some policies to have their intended impacts, and how other issues such as trade policy are resolved. Overall though, you feel that the strong market performance so far this year is a reflection of expectations that the global expansion still has room to continue?

Brent: Yes. I think there is a lot of good news currently priced in, so moves higher from current levels might be difficult in the near-term and it has been too much of a straight line up for equities for my liking, so a mild pull back wouldn’t surprise me. I would see that as a buying opportunity because I do think there will be enough good news by year-end to justify these equity market levels and perhaps a few percentage points more. The signs lately on the trade file point to some sort of deal between the U.S. and China, although that isn’t a lock. And even if that does happen, the Trump Administration seems keen to pivot toward Europe and of course the USMCA has yet to be ratified – and that shouldn’t be considered a forgone conclusion either. So there are still risks. The bond market isn’t really signaling gang-busters growth.

Amin: Yes, let me interject there Brent, just to remind listeners that if they want to hear more of your thoughts on the bond market and inverted yield curves to listen to part one of our Podcast series.

Brent: Yes, in that podcast I conclude that the current brief episode of partial yield curve inversion is more a symptom of current central bank policy, and less a harbinger of recessionary outcomes. So, when we combine all of the risks and potential rewards we continue to see a roughly balanced approach as being appropriate for long-term investors. Maintaining a neutral position across both equities and fixed income (in proportions that align with your risk-tolerance and time horizons) appropriately takes into account both the opportunities and risks that the current market backdrop presents.

Amin: Thanks Brent, I look forward to chatting with you in the third instalment of our series of podcasts covering the anatomy of a bull market.

This is China’s Year of the Pig, symbolizing good fortune and prosperity. We see a lot of reasons why this is the year the Chinese economy will once again take flight, leading to our play on the idiom “when pigs fly”. In fact, we believe this year will mark the third time since 2009 a rebounding Chinese economy will reinvigorate global growth and trade and lift equity markets and bond yields during the latter half of 2019. In addition to a recovery in China, we expect the U.S. economy to improve during the same period.

China’s pro-growth moves

After three years of China reigning in credit expansion, bringing about a slowing domestic economy that has spread to the rest of Asia and Europe, they’ve shifted into pro-growth mode – embarking on a substantial set of reflation and economic growth policies by:

  • Reducing the interbank lending rate to extremely low levels;
  • Cutting banks’ required reserve ratios five times since January 2018 (four in 2018, one in 2019) for a total reduction of 3.5%;
  • Reducing taxes (on sales taxes, personal income and small and medium enterprise business taxes) totaling 2 trillion Rmb or 2% of GDP;
  • Increasing government fiscal spending;
  • Front-loading special construction bonds to increase the amount allowed for 2019 and allowing local government bond issuance to start earlier;
  • Creating a January-February surge in overall bank lending and shadow banking, implying less restrictions and less regulatory clampdown on shadow lending;
  • Announcing a new central bank program aimed at strengthening the banking system (whereby banks can swap perpetual bonds with the central bank to improve their capital buffer) as a form of quantitative easing.

Unfortunately, these policies take time to work their magic on the economy and markets, during which time a détente or deal between the U.S. and China on trade would also help to reignite economic growth. Every global expansion since the financial crisis has come in concert with a reflating Chinese economy (see Exhibit 2.1).

2.1 │China’s Credit Impulse

The post-financial crisis global equity cycle has been heavily influenced by China’s flow of credit.

Diagram of Bloomberg Economics China Credit Impulse Index showing periods of global equity strength (2012-2013, 2016 and current) and weakness (2011-2012, 2013-2015 and 2017).

With North America, Europe and Japan all showing signs of slowing, the timing couldn’t be better for China’s economy to exit its slowdown sooner rather than later. We don’t expect the timing to line up conveniently and 2019 may be subject to bouts of fear that the global economy is slowing.

U.S. economic growth issues are starting to fade

Coupled with the China slowdown is a U.S. economy whose growth rate has moderated from the high-flying days of 2018. A significant portion of this lower U.S. growth profile is a result of two issues, both of which we believe are fading:

  • Higher borrowing costs; and,
  • The normal U.S. inventory cycle that’s likely been exacerbated by trade frictions.

Higher borrowing costs have the intended effect of slowing overall household consumption, especially for big ticket items, such as housing and automobiles. Higher borrowing costs also eat into corporate profits and dent corporations’ appetite for future investment. With the Fed on hold, and bond yields retreating to 18-month lows, these headwinds are now becoming tailwinds. Case in point, many housing-related indicators are showing improvement and U.S. auto sales just matched their best month in over a year.

Why inventory ‘stuffing’ happens and how we’re getting over it

The U.S. economy has a very predictable pattern of inventory cycles – basically the natural ebb and flow of varying volumes of production, then warehousing, before final sale to the consumer. These cycles have historically lasted three to four years from peak-to-peak with the downside of these cycles being marked by weaker readings from the economy.

We’re at the bottom of one such cycle now. The current inventory cycle slowdown was exacerbated by sharp inventory stockpiling in Q2 and Q3 of 2018, due to the myriad of trade threats overhanging the global business supply chain. The U.K. and Europe experienced similar ‘inventory stuffing’ behavior due to uncertainty around the future openness of the border and customs regulations brought on by Brexit.

Swings in the inventory cycle are largely a movement of production between time periods. Excess growth in one period (such as the first half of 2018) is followed by later weakness (late 2018 and early 2019) as there is no need to order new inventory, until the previous level is worked off (See Exhibit 2.2).

2.2 │The ups and downs of U.S. inventory cycles

The U.S. has a natural inventory cycle that lasts on average 40 months peak to peak.

Diagram of ISM Manufacturing New Orders Less Inventory showing pattern of upswings (economic strength) and downswings (weakness) since 1993.

The current inventory cycle is showing signs of turning and should relieve some of the recent weakness witnessed in U.S. economic data.

Addressing economic growth fears

Fears over the extent of the global economic slowdown are driving the current decline in bond yields – the heart of the current inverted yield curve. These events may spark periodic equity selloffs, but we see the worstcase scenario around growth fears as being over-blown.

The rise in equities thus far in 2019 will come to be justified by better global growth in the second half of the year. Investors need to be properly positioned to weather these periodic episodes of “growth fears” without panic. If corporate earnings results are better than expected, and/or the data from China signals that their new policy measures are taking hold, we see any equity selloff as a buying opportunity.

Bottom line:

A positive turn in both the U.S. and Chinese economies will likely prolong the global economic cycle, making the recent ‘inverted yield curve’ signal a false alarm, or at the very least, too premature to warrant a nearterm change in investment strategy. We see no reason to change our recommendation of a broadly neutral stance (risk tolerance aligned) between equities and fixed income.

Putting views into action:

Aligned with our GLC 2019 Capital Market Outlook that suggests a neutral stance for investors, you may need to rebalance back into market areas where selloffs may occur to find yourself back at a neutral, long-term, risk-adjusted investment positioning.

Stay tuned for the last article in our series: Riding the backside of the U.S. bull market!

Copyright 2019 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).

This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.