US Recovery Awaits Corporate Investment Rebound…

26th October 2013

‘First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions in the shortest possible form are, “no, no and no.”  Incoming Fed Chair Janet Yellen speaking in 2005

Dovish comments like that from Ms. Yellen as well as the soft September payrolls report are driving investors to assume Fed tapering has been postponed toward Q2 next year, if not the indefinite future. The key issue remains very low levels of investment in the US economy, which correlate well with job creation – if private investment remains moribund, escape velocity for the labour market and wider economy will prove elusive. As covered in previous notes, overall investment as a share of GDP is trending down over time for demographic reasons as the economy matures and also as it becomes more IT driven; sustained deflation trends in computer software and hardware give companies more bang for their investment buck, while faster inventory turn via ecommerce has reduced the need for warehousing etc. (think Amazon versus WalMart sales per square foot). Nonetheless, we are several percentage points short of trend investment levels and a key issue for 2014 is whether corporate boards from the US to Japan decide that they have sufficient visibility to justify capacity replacement and/or expansion. Markets face a pivotal moment in coming months; either the unprecedented stimulus since 2009 has failed to ignite a self-sustaining recovery, despite the energy windfall, in which case the Fed is pushing on a monetary string and earnings momentum   will roll over in a manner painfully familiar to GEM investors.   Alternatively, we finally get the last cylinder of growth firing and corporate investment pushes US growth toward 3% (and the fiscal drag will ease considerably next year), in which case the Fed will have to expedite its balance sheet normalization. I’d still bet on the latter outcome, but  either way as the S&P grinds toward 1800, it would be wise to finally begin paring US exposure. Record net cash levels for the S&P  500 certainly support an investment rebound thesis, with the caveat that  the tech companies who are the clear winners in the new ‘asset lite’  economy are generating the bulk of that cash, and hoarding it overseas out  of reach of the IRS.

It was odd that the Nobel Prize in Economics was split three ways this year and focused on market theory; most market observers are oblivious to a bubble inflating around them, but none  more so than academic economists with their beloved general equilibrium models. Among the winners, the one you might trust with your money based on  his track record is Prof. Shiller (of US house index fame) who suggests that prices are currently “high” in the US equity market at current levels of his estimated cyclically adjusted PER. This implies that objective measures of the risk premium (expected returns) are lower than average that is, expected  risk premia must inevitably rise. 1990’s, when of course Alan Greenspan  echoed Janet Yellen’s housing comments in relation to the tech boom   although he has since partially recanted). The real  contrast between Shiller and his co-winner Prof. Eugene Fama, originator  of the Efficient Market Hypothesis, is that he remains agnostic about what  risk premium is sustainable. In other words, he doesn’t accept that  there is a ‘fair value’, and so has no room for the prediction that prices  will fall. In the current circumstance, he might say that investors are  highly tolerant of risk i.e. they are willing to accept low expected  returns for taking on US equity risk.

The S&P 500 price/revenue ratio of 1.6 is now 2x its pre-1990s historical norm; the 1987 peak occurred at a price/revenue ratio of less than 1x, but of course margins are considerably higher now. A key support remains LT interest rates at historically low levels and share buybacks as companies use record net cash flow relative to GDP to shrink their equity base. Back in the 4th September weekly, which looked in detail at the CAPE and other long term valuation methodologies, I noted that: ‘Some investors take a macro view of corporate profits using the Kalecki equation (Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends) and thus argue that the large US deficit has been the big source of (excess) corporate profits. With the deficit now declining and both earnings growth and sales growth on the S&P decelerating, there will be a  double whammy of less fiscal stimulus on demand and a shrinking source of profits that needs to offset that impact, preferably by corporate investment. Overall, after the outperformance seen YTD, US equities no longer look compelling, although a push to my original 1800 S&P year-end target is still feasible on inflows from bond/GEM fund refugees.Those inflows as much as the rally in 10-yr Treasury yields are a key support near-term; data from EPFR Global shows that $69.7bn was withdrawn from money market funds in the week ending 16th October while equity funds captured net inflows of $17.2bn as the debt ceiling crisis was resolved.


China Turns on Investment Tap to Offset Liquidity Trap

The tendency of Asian rich brats from Bangkok to Singapore and Beijing to treat city streets as racetracks (frequently crashing their Ferraris spectacularly, and often mowing down pedestrians and fleeing the scene) is a disturbing insight into the sense of elite entitlement which is exacerbating political risks from historic levels of wealth and income inequality. That backdrop complicates the very predictable transition underway in China not only to a lower trend growth rate but with a very different incremental composition (despite the current Pavlovian policy response of state bank funded infrastructure stimulus). Back in the 27th  July Weekly, I concluded that: ‘Every traditional policy lever will be pulled in coming months to restore momentum, and we’ll soon find out whether they’re still attached to anything in the real economy’.

The August lending data suggests that they are, and we should consequently get a ‘dead cat’ bounce in some cyclical sectors this autumn. However, beyond the current slowdown, recent well publicised events suggest that the party probably faces a legitimacy crisis to rival 1989, when Beijing students were more worried about being crushed by tanks than Italian sports cars. Cancelled Macau junket trips, Burberry coats left on the racks and slumping steel and other commodity prices all reflect the aftermath of the deflating 2009-11 credit bubble which much as many commentators seem to wish, can’t be resurrected.

The downside risks in the Chinese steel sector were obvious early last summer as the policy squeeze began, and covered in a note at the time; prices for hot-rolled steel fell to an almost two decade low in recent weeks, the latest sign of deflationary forces engulfing the heavy industrial parts of the Chinese economy, reflected in a still slumping official PPI. The China Iron & Steel Association has said the situation is “disastrous”, with even the strongest groups such as Baosteel losing money. Even before the impact of inflation and GDP growth since, the latest RMB1trn investment package compares poorly to the RMB4trn stimulus after the Lehman crisis, although is combined with a provincial spending spree of dubious funding; Chongqing and Tianjin have each unveiled $240bn programs.

Having been bearish since last summer on the whole construction related heavy industrial area of the market, if I had to bet on one cyclical Chinese sector as a Q4 trade it would be cement, simply because the product is inherently perishable and hence not subject to the vast inventory overhang in say steel and non-ferrous metals. It’s also distinctive in that output trends are already stabilising. Overall, the headwinds on the cyclical part of the market should abate in coming months, although that doesn’t help the longer-term rebalancing narrative. The biggest question for global investors right now is whether China is fully invested in terms of its physical capital, and the answer depends on how you view the data. On a per-capita basis, the country’s capital stock remains a fraction of that in more developed Asian economies such as Malaysia or Thailand, let alone the US and Germany. However, relative to the country’s GDP (or indeed GDP per capita), things look more ominous for industrial commodity bulls.

The bottom line is that while you can make a cost-benefit analysis argument for urban mass transit etc., the number of truly economic infrastructure projects in China at its current level of per-capita GDP/household income is probably tiny after the fast-forward rollout of projects previously planned to 2020 and beyond funded by the post-crisis stimulus. A 200km race track around Beijing for those Ferraris would be a nice multi-billion project appreciated by the party princelings and which would technically add to GDP as it absorbed steel and cement, but it would also add to an economy wide debt burden heading for 200% of GDP. There is a widespread misconception that China has overturned the dismal laws of economics and doesn’t face financial constraints because of the 50% of GDP in foreign reserves etc., but that is simply deluded as the FX inflows those reserves represent have already passed through the economy when sterilised by the PBoC.

Investors are as addicted as Beijing policymakers to the investment ‘fix’, and when last week the NDRC approved 60 new projects, led by railways, roads, harbours and airports; the Shanghai Index jumped 3.7% (although the ECB news was at least as important on the day) and even steel shares bounced, despite chronic overcapacity and unprofitability. Between January and July, China churned out 419mt of crude steel, still up 2.1% y/y despite crumbling demand. The fragmented industry’s gross margin was as low was only marginally positive  and sector wide profits sank 49% y/y to 66bn RMB in H1 according to data from the NDRC.

Sentiment if not financial reality should benefit from project approvals and new investment picking up with bank lending and total credit growth, consistent with a more proactive policy stance in recent months (and signs of life in real estate, a very mixed blessing).  Of the new loans in August, medium- to long-term loans accounted for RMB286bn, versus RMB210bn in July, with their share of total new loans rising to 40.6% from 38.9%, suggesting that banks are funding the pickup in infrastructure investment from announced new projects in Q2. While this will help draw a line under the recent free-fall, it’s constructive only in the literal sense. Banks are supporting the government’s move to fast-track infrastructure projects (not that they had much choice when those red phones rang).

The cash flow squeeze throughout the corporate sector remains intense, but there are signs of credit life; China’s total social financing aggregate, a broad measure of liquidity in the economy, rose to 1.24trn RMB in August from 1.04trn in July. Soft M2 growth was probably due to a transfer of RMB savings to deposits in USD on expectations of further local currency weakness, a trend I covered in the 24th  August Weekly. Outstanding deposits in foreign currencies rose 62.1% y/y at the end of August to $415.1 billion while RMB outstanding deposits rose only 12.2% y/y to 88.31trn at the end of last month.

One positive from the slowdown in FX inflows is that the PBoC is becoming a more ‘normal’ central bank, freed from the straitjacket of relentless FX sterilisation and increasingly reliant on the policy tools of its global peers such as reverse repos in its open market operations to support interbank liquidity growth; that also implies that the period of explosive M2 growth in China is now over. Looking ahead, in H2 only RMB275bn of bills and RMB40bn of repos are set to mature, counterbalanced by the RMB300bn of reverse repos outstanding, limiting the ability for open market operations to boost liquidity further. That makes a belated further reduction in the RRR more likely. Added to some form of export support scheme in the works, it all should goose animal spirits at the margin but 7.5% growth is the ‘new normal’ for China and would actually be a good result.

Value-added industrial output in China rose 8.9% in August from a year earlier, down from 9.2% in July, and the slowest growth since May 2009. The slower industrial production growth was likely due to continued destocking of inventories in cyclical sectors as well as weak domestic demand. This destocking process is likely to continue until late Q4 or early Q1 next year. The country’s CPI rose 2% y/y in August, up from July’s 1.8% rise; the main driver was the price of food, which rose by 3.4% from a year earlier, compared with a 2.4% rise in July. China’s inflation always looked likely to pick up in the coming months due to the upswing in global food prices caused by drought conditions in the US, which alongside a stubbornly resilient real estate market is restricting the opportunity for aggressive stimulus measures. Meanwhile, China’s PPI fell 3.5% y/y, compared with a 2.9% decline in July, and a sustained debt deflation across heavy industrial sectors plagued by chronic overcapacity is another threat to bank NPLs. Fixed Asset Investment growth stabilised at just over 20% growth y/y. Even before the latest spending plans were announced, the fiscal deficit was widening; fiscal expenditure growth accelerated from 17.7% y/y in June to 37.1% in July but revenue growth slowed from 9.8% y/y in June to 8.1% y/y in July.

The level of economic activity in August looks consistent with economic growth of about 7.5% for this year, against the 9% plus consensus forecasts coming into 2012, and no significant rebound should be expected next year. Headwinds from excess capacity and inventory build-up, corporate deleveraging, subdued investment, and banks facing rising NPLs mean that the best hope is that with appropriate policy easing growth will stabilise in a 7-8% trend range. In the February 2011 monthly on China’s sobering historical parallels, I concluded that: ‘The key is a rational capital allocation system which finances projects based on marginal economic returns…that economic ‘reboot’ will inevitably mean a major dip in growth to maybe 6% for 2-3 years before it reaccelerates toward a trend 7-8% on a more sustainable services and consumption led basis. If the current distorted and increasingly wasteful model is pursued much beyond 2012/13, a hard landing is likely soon after which will depress growth for the rest of the decade and have destabilising political implications.’

As foreign investment banks scramble to downgrade 2013 growth estimates toward 7.5%, it’s still plausible that a multi-year growth dip to as little as 6% is in prospect as the economy deleverages amid huge asset write-offs (whether than number is ever reported as such is a different matter). If that leads to productivity rather than input driven growth amid wider reforms/deepening of capital markets, it should ultimately be very positive for long-term China investors. After all, crude GDP growth has never correlated well with EM risk asset returns, and nowhere less so than in China…