All eyes on China

With the weakness in Emerging Market currencies and commodities well established, the likelihood of China having a hard landing has increased. Inventory de-stocking is clearly underway as is the downturn in exports to China.

Those manufacturing companies that have visited us of late talk readily of having to restructure higher-cost European, namely German, cost bases in order to cope with lower loadings, as Chinese demand abates. The shock of the VW scandal has affected European sentiment as well. The global growth shock has permeated Russia where sanctions and oil’s weakness are hu rting. Latin America is notably weak where in Brazil there is wide current political uncertainty, as the Real and the country’s commodity-orientated exports suffer. Even major capital investment markets, such as North America, are dull. This is despite a generally strong economy, as oil and gas investment weakens and, more surprisingly, corporates opt to divert cash flow to stock buy-backs rather than into capital plant - a curious distortion of the prolonged zero interest rate environment.

This much of a global growth shock has now been priced in although continued weak lending data imply that the downgrade cycle may not yet be complete. Internationally, there is an over-capacity situation, centred around China and their exports assisted by gradual devaluation, which will continue to put pressure on Western industrial capacity, particularly with links to the retrenching commodity and oil & gas sectors. Gauges of international shipping capacity confirm this general malaise.

Markets have been volatile with several notable casualties in the commodity space, from Glencore, the trading house, to the indebted Peabody coal operations in the US, still a major supplier to its domestic energy market. Affiliated sectors are seeing capital expenditure vanish and dividend flows cease. The crucial data point remains whether the ultra cautious Yellen is able to fulfil the Fed’s stated policy of a rate rise in 2015. Events in China will be carefully managed by the Communist regime, with graduated easing of rates and studious downward management of the renminbi peg. The degree of devaluation seen by the Chinese, who will most likely be awarded reserve currency status by the IMF, is likely to be ongoing if tentative, given US electoral pressures over international competitiveness and employment. The initial effects of August’s initial devaluation have already seen OECD growth estimates downgraded for 2016. We anticipate, for instance , that lower Chinese flows and recent increases in Stamp Duty will see a degree of over-development attrition within the previously strong London housing market, along with other centres such as Hong Kong, New Zealand, California, Canada and Australia. Activity levels are widely reported as more subdued.

International support from such bodies as the IMF ought to be brought to bear to assist. The Chinese authorities will surely try to manage the unwinding of a leveraged property bubble that has rolled over into its stock market. The quantum and manageability of the resulting bad debt situation is what concerns central bankers. If the Chinese situation causes a serious recession, global growth may suffer further. It may be that continued and concerted devaluation by China is forced on them by domestic social and employment pressures. One has to recall that China is a Communist command economy where social stability and the employment linkage are paramount to the regime’s survival.

It was noticeable in the Fed’s September minutes that Chinese events were referred to as a factor influencing the failure to hike. However, Yellen must avoid getting boxed in by not having any rate influence over any policy response should there be a deflationary downdraught in 2016, which could affect international economies. Whilst there is the undoubted danger of extreme volatility and further market squalls in the immediate future – the autumn has a preternaturally high correlation with such market storms – there is an ongoing likelihood that much of the deflationary concerns will continue to apply to Western growth rates. Should China’s economic data stabilise from its current dire levels, the Fed might still be able to hike in late 2015 and establish the expectation of a shallow path of rates out into 2016. The October Bureau of Labor Statistics (BLS) jobs report was an impressive 271,000 for the month but we would expr ess some caution on its composition as the high degree of over 55 year olds re-entering the workforce indicated that higher paying jobs, leaving the oil & gas and mining space, are being replaced with less productive menial capacity (see Insights blog: the dark side of the data). Low interest rates achieved on savings appear to be a factor driving older workers back into employment. Whilst the Fed may well now hike rates in December, we would qualify the strength of the underlying economy behind this move.

At present, the Fed’s narrative of steeper rate forecasts is not supported by the futures bond curve – and has not been since we noted this phenomenon in the Spring edition of Prospects. Nevertheless, anything other than a fracturing of markets by weakness in China may permit the Fed to restore a stabilising pattern in December. The forthcoming data flow of the next few weeks will be critical and leaves markets naturally nervous with data from China closely followed. The Fed, under Yellen, will be anxious to raise rates if international conditions allow them to, if only to avoid being identified as having given the markets terrible guidance into 2015 and having committed a significant policy error. One has to await the data flow of coming weeks to see which fork in the economic road events go down.

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