PBoC Struggles to Cope with China’s ‘Bottom Up’ Rate Liberalisation…

China’s 7-day bond repo rate traded at an average of 8.2% on Friday, nearly double its level a week earlier. Interbank borrowing rates also surged, although not to the double digit levels seen in June. After markets closed, the PBoC announced that it had injected a total of Rmb300bn via special liquidity operations (SLOs), and in a sign of panic, has even used social networking service Weibo to declare its actions, rather than waiting a month as usual. In one way, both this spike in interbank rates and the one in June reflect incompetent PBoC technical management of a fast evolving financial market, as bank deposits disperse in a ‘bottom up’ form of interest rate liberalization. 

The bank will provide more liquidity this week to cap rates if needed to calm the year-end liquidity squeeze; while durations of a month and less have surged, those three months to one year have remained much flatter (albeit liquidity is overwhelmingly at the short end). However, Chinese financial markets are evolving rapidly via the shadow sector and competition for deposits is becoming intense, making it harder for the PBoC to micromanage the supply of liquidity. The PBoC hasn’t yet moved to a monetary policy framework targetting benchmark rates, as in developed economies.

On the operational level, the PBoC was complacent because it expected the central government, which has more than RMB4trn of commercial bank deposits and has traditionally allocated a large amount of that to local governments in December, to follow the usual script. That pattern appears to be much more muted under the new regime of official frugality. The key underlying structural issue is deposits have been fleeing the banking system for higher yielding wealth management products and online money market funds, reducing transparency. Additionally, the pressure on banks to secure deposits is always intense at the end of the year when they have to satisfy the regulatory requirement that their outstanding loans total no more than 75% of deposits on their balance sheets. The central bank crackdown in H1 on speculative forms of financing which used the interbank market and WMPs to fuel a property and investment bubble has been successful; monthly total social finance growth peaked back in March and had halved by July.

New total social financing in November stood at RMB1.23trn and total outstanding RMB loans were up 14.2% y/y, the same as overall M2 growth. However, total credit in the economy will grow almost 20% this year.Raising the cost of capital is the only effective way to encourage companies to borrow and invest more efficiently, as part of still very early stage efforts to restructure the economy away from its credit-intensive model that the government admits is unsustainable. The volatility in credit markets this year is a signal of just how difficult and disruptive that process will be.

Both now and in June, the bank refused to inject liquidity until signs of stress were generating panic headlines. The difference is that shadow finance has been reined in since Q2, so using interbank rates as a crude weapon to beat excess credit growth into submission makes even less sense, but also that the 1-year bond yield has been trending higher for months and has reached an almost decade high. It seems that more by default than design, China is now irreversibly shifting to positive real funding costs which will further pressure headline growth rates next year but also boost rebalancing momentum.  Overall, the diversification of China’s deposit markets and rising funding costs are healthy developments medium term but while the immediate money market squeeze will subside, I’ve always maintained that the Chinese economy would ultimately suffer a ‘margin call’ in slow motion from its own bank depositors as they conducted their own version of the global reach for yield.

Ultimately, the onset of demographic decline will see total deposits within the bank and shadow sectors peak through mid-decade as savings start to be run down. In the near-term, while interbank rates will subside and Chinese financial stocks rally into early 2014, 5-year generic credit default swaps look cheap at under 70bps and an increasingly desirable hedge for many investors in 2014, as these episodes of credit market instability are likely to recur and place the spotlight again on the challenge of stabilising overall systemic leverage growth.

UK Economy Reverts To Type…

Like a Christmas pantomime show, the actors might change, but the UK economic script has been painfully predictable in recent decades. The economy has seen productivity collapse versus global peers since 2008, private investment is still 20% below levels five years ago, and yet the consensus which in Q1 feared a ‘triple dip’ recession is now scrambling to upgrade 2014 growth forecasts to 2.5-3%. The delayed impact of the BOE’s liquidity schemes, the controversial government mortgage guarantees as well as a frenzied London housing market creating a ripple effect largely explain the sudden change in fortunes, but even a brief consumer led growth spurt risks highlighting the country’s unresolved structural imbalances.

The UK, which has already seen remarkably sticky cost push inflation since 2008 well above the 2% BOE target, may be the first major economy to make the transition to the excess demand variety of inflation, as domestic credit demand and availability rebounds. Mortgage lending is flat lining in y/y growth terms, but that is distorted by on-going debt reduction by existing mortgage holders –  gross mortgage lending hit a 5-year high of £17.6bn in October, a five-year high and up 9% m/m and 37% y/y; total gross lending looks set to reach £170bn this year. No other major developed country aside from Australia has experienced sustained residential price inflation of the magnitude seen in the UK over the past 20 years, and that boom has been focused on the capital and wider Southeast corner of the UK. London prices have risen 120% in 8 years and roughly quadrupled since the late 1990s; depending on whose data you use, London prices are now 20-25% above their 2008 peak. Prime London real estate has joined the collectibles and bullion hoarded in free ports and bank vaults globally by the super wealthy elite as a tax efficient repository for surplus capital. While on a national level there is no sign of overheating, prime London has attracted global excess liquidity flows, particularly from Asian investors, and is increasingly vulnerable to a reversal if local funding costs or UK capital gains taxes rise (as planned and/or local currencies weaken versus the GBP.   On ONS regional data, several peripheral UK regions are seeing flat to falling prices and prices in the North are still 10% below their 2008 peak. House prices fell 14% from the end of 2008 to the middle of 2009 across the UK but have now returned to their previous peak nationally.

The ratio of household debt to incomes is now projected by the independent Office of Budget Responsibility to rise to 160% by 2018. Households are already running down precautionary savings and revolving credit appetite is picking up, and the OBR expects that trend to continue, one forecast I’d unreservedly agree with. Meantime, corporates are hoarding cash (in the case of banks, by regulatory diktat), and the declining ROE on the FTSE 350 index helps explain its underperformance against developed world peers this year.  Is a current account deficit likely to be in excess of 4% next year GBP positive?  As I’ve noted before, the UK has a lot more in common with India than a taste for curry including very weak corporate investment and productivity trends. At some point, investor perceptions will shift and focus on the structural macro imbalances reflected in sustained twin deficits rather than cheering the high frequency data, with adverse implications for sterling and gilt yields.

‘Internet of Things’ Set to Drive a Connectivity and Industrial Capex Boom…

5th December 2013

A key structural theme this year (see April monthly ‘The Rise of the Intelligent Machines’) has been to overweight global industrial capex/automation plays, in anticipation of a belated cyclical rebound in global factory investment, China’s growing automation trend but also a new wave of connectivity which is adding previously ‘dumb’ standalone hardware to the Internet and will drive an upgrade cycle. The jargon and acronyms in this emerging tech cycle can be confusing, but the bottom line is that makers of sensors, smartphone components such as radio chips and batteries, electric motors and automation equipment are all in an investment sweet spot over the next few years as technologies from the consumer mobile and gaming sectors are embedded within the industrial and urban infrastructure There are a number of new technology cycles gaining momentum, but this one will probably have the widest economic and market impact.  The so-called ‘Internet of Things’ (IoT) isn’t just about household appliances that can be remotely controlled, but a new generation of sensors and actuators embedded in physical objects from pipeline valves to factory machine tools that are for the first time networked.

These networks (of which Machine to Machine communication or M2M is an industrial/infrastructure subset of the IoT) then generate huge volumes of data for analysis and far more precise control of energy use, supply chain optimization etc. While investor/analyst focus has been excessively on smartphone sales to consumers, it’s crucial to understand that the wireless ‘ecosystem’ is rapidly expanding to encompass physical objects, whether household durable goods or parts of the industrial infrastructure, and this new market will be a key driver of incremental revenue growth for mobile component manufacturers (and indeed network operators). The combination of advanced gyroscope/visual/temperature etc. sensors plus wireless technology to create an intelligent network with real time feedback will gradually have huge economic impact, ranging from productivity growth to corporate margins and trend unemployment rates as more functions are automated.

More than 9bn devices around the world are currently connected to the Internet, including PCs and smartphones but that number will explode, with over 12bn M2M devices alone connected by end decade and upwards of 180-200bn devices in total from gaming consoles to fridges, cars and personal healthcare monitoring devices will have some form of internet connection on IDC estimates. Only a small fraction of those will use existing 3/4G wireless rather than wide area fixed WiFi networks and various short-range communication technologies. They will all need RF chips, MEMS based sensors etc. to function. Forecasts vary widely as to the market opportunity given a variety of regulatory and technology issues that need to be resolved (e.g. we will need far more IP addresses on the web) but with the cost of adding communications functionality to a device having tumbled sub $10, the classic tech ‘J Curve’ volume tipping point is in sight.