Notes on rebalancing: Chinese consumer demand and the shale gas revolution

We continue to believe that the world is still in need of major rebalancing. 

Global policymakers have faced an onslaught of crises or crisis potential. As such, despite what seems to be happening (a slow market-led rebalancing), they continue to revert to policies that have driven growth (and imbalances) in the past. 

A true rebalancing will bring economic pain, for sure. But the ongoing resistance we're seeing will only mean the pain is deeper and lasts longer whenever it comes.

Of course, China is a big part of the rebalancing puzzle. And they've acknowledged their need to rebalance their economy. They've even taken concrete steps to insure they pull back from the growth path that leads to an overheated economy and an inevitable collapse.

Measures to increase the number of transactions in their own currency, the yuan, are encouraging. The greater the use of the yuan in global trade the more open it must become and the better the market can dictate its value. 

We consider currencies to be the pressure valves of economies that serve to rebalance respective economies as needed. A system with an explicitly managed currency (e.g. China) or implicitly managed currency (e.g. US) cannot be good in the long-run.

But certainly there are risks to China even as it embraces some pieces of rebalancing.

Many analysts and researchers note the demographic hurdle. As much as China is urging its population, directly and indirectly, to become more urban, the needed and expected shift cannot be forced. Consider the real estate market, for example ...

The inventory of housing is in place now, but most of China's rural class and commuting class cannot afford to live there. A significant drop in price is needed to help this along. But with a significant drop in price comes a drop in wealth for those investors who've bought into the housing developments and the real estate market in general. 

When you see a system-wide erosion in wealth you often see contagion in credit markets. China's shadow-banking system (i.e. unconventional loans and wealth management products) has expanded amidst the last couple years of stop-and-go lending policies passed down by the government and the PBoC in response to inflationary pressures. When the value of assets drops and borrowers begin to default, the rest of the dominoes become more vulnerable.

In China's commie-capitalist economy, the leaders maintain their grip on the economic reins. But not only do they claim credit for the good, they must also deal with the bad and the ugly. 

Rebalancing will require reforms that hand over greater control to Chinese households and consumers. This means the policies that brought years of double-digit growth must be sacrificed to some extent. This is why the task of rebalancing China is oh so delicate -- necessary reforms equal lower growth, but lower growth equals socio-economic tensions. Unfortunately, the tension will come a lot more quickly than the benefits of reform.

There is a reason I dug into this today -- I came across two articles this morning ...

The first simply notes some recent improvement in Chinese consumer demand and factory orders. Here is Reuters' takeaway from the numbers that were reported:

Stronger domestic demand helped China's factory activity to rebound in March, with... new orders up sharply in a sign that the underlying economic recovery is strong enough to weather any risks from patchy export performance .

This is certainly a welcomed development amid ongoing Eurozone woes that have kept China's best export customers at bay. But is it enough to keep the economy going if Europe triggers a quake in financial markets?

The second article I came across this morning represents a bigger story that attempts to look further into the future of China's factories. More specifically, the US shale gas revolution is likely to facilitate some rebalancing in China as it reduces the costs of producing goods in the US. This is certainly a long-term data point, but it gives merit to that arguement that "Made in the USA" will make a comeback.

Here is a key piece of the Reuters' column titled, "Will shale gas decimate China's toy makers?":

The advent of cheap natural gas in the U.S. is threatening to displace expensive naphtha in the production of petrochemicals, the key building blocks for plastics, synthetic fibres and solvents and cleaners.

There was a story in The Atlantic earlier this year that talked about GE bringing factories back to the US. The simple reason is that it makes more sense to have a better grip on all stages of production and supply chain management. Consider also the fact that Chinese wages and transportation costs have risen.

And then recently I saw comments from the CEO of a major US company who said the cost of labor is not the primary reason for taking a company offshore; the regulatory and tax environment are the main reasons. If the US government finds ways of lessening this burden, and the shale gas revolution lives up to the hype, America could quickly see a manufacturing renaissance that changes global trade dynamics quite drastically.


-JR Crooks


China got the memo before the Russians

Cyprus is a tiny economy (though their banking system is of meaningful size). And it seems the bailout deal has been finalized, with details on what percentage of the uninsured deposits (rich people's money) will eventually be confiscated.

What matters is not how this will impact eurozone GDP growth, but how it will impact investor confidence in the region and around the world. The potential fall-out is still huge.

While a good amount a Russian money (and maybe British and Greek money too) has probably found a way out of Cypriot banks despite them being closed for several days now, China perhaps saw this risk developing ...

Specifically, the crisis in Europe will be a potentially major outflow of capital. Here's how Jack responded to a reader question wondering why Cyprus is such a big deal:

The knock-on effect to the EU as a whole is two-fold, it seems to me:  1) It further adds to mistrust among member states; 2) it likely leads to more cash hoarding among consumers, businesses, and banks across the zone—that means growth slows even more, unemployment rises, and pressure builds on the currency regime.  Already much of the collateral among the individual countries banking systems has been pledged to the ECB.  This adds considerable risk to both depositors and banks in general. 

That is how it impacts the EU.  And this impact will be real.  If wealth cannot be created, the periphery spirals downward with rising debt levels and rising unemployment.  It is a recipe for an breakup of the single currency and end to the European Project in general.  Cyprus is a symptom of the dysfunction across the banking system—not the cause.  But its demise opens the wounds for all to see. 

Who will want to have their money parked anywhere in Europe after the way officials are handling the Cyprus bailout?

Not China.

Now, albeit after the fact, we know where China is putting its money: back into US Treasuries.

This Wall Street Journal story is from Monday. But read it if you haven't already. I think this points to what has become, and will continue to be, an intermediate-term driver of markets: money moving to the US for safety.

The US Dollar is rising. So are US Treasury prices.

As a side note, capital seems to be flowing back into China after significant outflows last year. At first, this would seem like a positive development, i.e. investors international companies aren't fleeing for fear of a major economic slowdown. But in the shorter-term, these inflows suggest there will be inflation pressure and the government will need to act to contain said pressures. Such a maneuver could halt Chinese growth.

If this idea gains traction and the Cyprus debacle doesn't fade away (because investor confidence has collapsed), the markets (even in the US) will be in for a rude awakening.  

-JR Crooks



Germany: Heroes or Hubris-Filled Control Freaks?

germanyI have no spur

To prick the sides of my intent, but only

Vaulting ambition, which o'erleaps itself,

And falls on th'other. . . .  

- Macbeth Act 1, scene 7. 25–28  


To argue the Eurozone is a two-tier system is to simply restate the obvious. Germany is still coasting along nicely, sucking the remaining wind out of the rest of the pack, all the while seeming to be the financial savior. Some say Germany is attempting financially what it wasn’t able to achieve militarily—complete dominance of Europe. Maybe that’s a bit of hyperbole, but maybe its not.  

The following interesting and provocative comments, which I believe are quite accurate, are from William H. Overholt, a Senior Research Fellow at the Ash Center of Harvard’s Kennedy School (Winter 2012 edition of The International Economy magazine):  

“When the global financial crisis began, the world could be saved by depression only by massive fiscal stimulus.  Because of the size and global engagement, three countries bore responsibility for saving the global economy:  the United States, China and Germany.  The United States and China acted decisively and averted depression.  Germany stood aside and profited as a parasite on the US and particularly Chinese stimulus.  

“…As Europe struggles to avoid collapse of the southern European economies and the Franco-German banks, Germany sought to paint its own role as virtuous and the Greek/Portuguese/Spanish/Italian role as debauched in order to justify forcing most of the costs onto the southern Europeans.  Greeks should, according to this logic, bear almost the whole burden of sacrifice while the German companies and banks who profited for decades from an unfair currency structure and predatory lending should pay minimally.  

“It won’t work.  The burden on Greece and others is too great for them to bear.  By worsening, rather than ameliorating southern depression, Germany ensures those countries failure.  Squeezing Greece the way the allies squeezed Germany after 1918 can only lead to the fracturing of Europe.  

“…Germany is exploiting the euro crisis to impose on Europe a system that will be structured by German rules and dominated by German power.”  

Others see it the same way it seems.  This is from Criton Zoakos, at Leto Research:  

“A collapse of Germany’s export markets in the Eurozone’s periphery has posed a challenge to its commitment to remain the world’s pre-eminent advanced exporting nation. Germany is meeting this challenge in a twofold way: it is making great efforts to develop new markets for its exports among the BRICS, and it is pushing hard to convert the Eurozone periphery from export markets into sources of large amounts of cheap labor. If the BRICS are the future destination of German exports, the PIIGS trapped in the Eurozone will ensure competitive labor costs and a competitive Euro exchange rate.”  

There are major problems with Germany’s grand strategy to grow as the world’s premiere export nation; here are a few:

1) The global demand dynamics have changed considerably as the private sector de-leveraging continues in earnest (i.e. thanks to the balance sheet recession in the US particularly).

2) There may not be enough demand from the BRICS, as they fight for similar portions of the export pie given their export models, in the same vein as Germany.

3) The US and China know the game Germany is playing and will not play the role of patsy as the weak states in the Eurozone have been forced to play.

4) Germany underestimates US capabilities at its own peril.  Expecting a straight-line US decline is a big mistake, I believe, given the rising angst amongst US citizens and voters. A few major policy change dynamics, in terms of either defense policy, i.e. forcing NATO to start paying for itself (which means Germany), or a new US industrial policy that allows US corporations to bring home cash and provide siginificant incentives to build domestically, could change the balance of competition quickly.

5) And a brilliant point from Mr. Zoakos as it relates to the where real sustained growth flows; it is not about exporting of existing supply of goods:  

“As a rule, sustainable growth originates in the supply of new, innovative goods and services provided by entrepreneurial activity – the type of supply that creates ex nihilo its own demand. There was zero demand for telephones before Alexander Bell invented them. There was zero demand for personal computers before the creation of the first PC with a workable operating system, and so forth. Supply of pre-existing goods and services does not stimulate growth once it has satisfied market demand: Once the supply and demand curves intersect, the marginal rate of profit in the given industry reaches zero, meaning that the given industry stops contributing to macroeconomic growth.”  

So far, not even the US government has been able to destroy the innovativeness of most American entrepreneurs.  The US was declared dead on arrival—heading into decline, once before by a major world export power; it was Japan at the time (as Germany and China are declaring the same now).   

I remember vividly a story I read in The Wall Street Journal, it was back in 1986-87 range.  At the time, you may remember, Japan was about to swallow up the globe. It was the world’s second-largest economy and destined to become number one, racing past the US, we were told by those great seers back then a la the usual gang of simplistic regression analysis-thinkers so common among our top global financial types. Mr. Japanese Finance Minister (or Foreign Minister) said: “Europe will become our boutique and America will become our farm.”  Oops!  That didn’t seem to work out so well now did it?  

Germany seems increasingly hubris-filled as the outline of its next grand strategy for total European control seems to be heading toward fruition. But once again, I believe its plans will be thwarted, as many PIIGS captives inside Europe and those with out interests outside are on to the game.  

Happy Friday.  Have a great weekend.


Might copper longs take a bath after the China news?

copper tub"I believe there is something out there watching over us. Unfortunately, it's the government."

- Woody Allen

Fundamentally, copper prices could fall.

Technically, copper prices could rise.

But either way, copper appears due for a big break.

HONG KONG, March 27 (Reuters) - China holds more than 1 million tonnes of commercial stocks of refined copper cathode currently, a level last seen in 2009, due to high imports and weak domestic demand, which may slow arrivals in the second quarter, analysts said on Tuesday.

High stocks may also prompt Chinese smelters to cut refined copper output, the analysts and sources at smelters added.

I’ve kept my premium service members aware of this burgeoning bearish supply glut and the impact Chinese demand will have on the price of copper. But as copper is tugged back and forth between bearish fundamentals and bullish risk appetite sentiment, the technicals are setting up in what is typically a very bullish trading pattern:

032812 copper resized 600

Two things to note:

1)      The narrowing range constitutes a pennant formation that typically resolves itself in the direction of the trend (in this case, up.)

2)      The Bollinger Bands bubbled out and now have narrowed rapidly, typically indicating a large and fast breakout (in either direction) is in order.

Often, especially in the nearer-term, the fundamentals seem not to matter and price action is dictated by sentiment and technicals. If this holds, then copper could be on the verge of a substantial break to the upside.

Today’s price action is not confirming that yet, as copper futures are down nearly 2% on the day.

In addition to yesterday’s latest update on the copper supply situation in China, overnight earnings releases suggest Chinese companies are feeling the pressure from a slowing economy. That is influencing copper prices today.

SHANGHAI, March 28 (Reuters) - China shares ended down 2.7 percent on Wednesday, the biggest one-day percentage drop in four months, as weak corporate earnings reports increased worries over the domestic economy.

Remember: there is no such thing as an obvious or easy trade. Today’s China news is likely hurting a lot of nascent copper longs.


Are stars aligning for a big break in commodities?

mining truck“According to analysts at Credit Suisse, the consensus has "severely" underestimated the amount of housing supply set to hit the market in coming years. Chinese developers own enough land to build almost 100,000,000 new housing units. Together with the sale of some empty apartments, this would be enough to satisfy China's housing demand for up to 20 years, the analysts have warned."  

Financial Times, 22 March 2012  

I woke up this morning and checked my charts, as always. I have been expecting a downturn in risk appetite to manifest in crumbling asset prices, at least until correction happened.  

I’ve been getting a bit discouraged with this call, as most everything has stayed relatively buoyant. But today after looking at the commodities I think we could be getting very close to a substantial and playable drop, technically speaking.  

CRB Commodities Index, daily: a convincing break below critical support at its 50-day moving average today? It seems so ...      

032212 crb resized 600

And the newswire this morning suggests global growth expectations could add pressure and break the camel’s back. Let’s go to Reuters:  

The euro zone's economy took an unexpected turn for the worse in March, hit by a sharp fall in French and German factory activity that even the most pessimistic economists failed to predict, business surveys showed on Thursday.  

The purchasing managers indexes (PMIs), which capture how thousands of companies have fared over the month, effectively quashed any lingering hopes the euro zone might avoid falling into a new recession.  

Most worryingly, the surveys suggested business activity in economic heavyweights France and Germany is starting to flag, with job losses mounting across the bloc at the fastest pace since March 2010.  

Markit's Eurozone Composite PMI fell to 48.7 in March from 49.3 in February, slipping further below the 50 mark that separates growth from contraction and capping the first quarter of the year in disappointing style.  

The “resolution” that secured Greece’s second bailout brought more calm to the market than I expected ... up to, during and after the process. Thus, it seemed it would take a noticeable downturn in growth numbers to change the sentiment ... since all the PR measures will certainly fall short of actually stopping recession.  

Back to Reuters:  

The HSBC flash purchasing managers index, the earliest indicator of China's industrial activity, fell back to 48.1 from February's four-month high of 49.6. New orders sank to a four-month low, an expected rebound in export orders failed to emerge and new hiring slumped to a two-year low.  

Clearly, China has been on a steady and gradual downward growth trajectory. But thanks to eurozone commotion and a gravity-defying US stock market, the slower growth in China has not been met with much scrutiny.  

These PMI numbers, however, are a favorite among analysts considering China’s lasting dependence on manufacturing. PMI reports do not go unnoticed, especially when they are south of 50. Granted, this is the HSBC number and not the “official” number reported by China which usually comes in a smidge higher. Nevertheless, here is a chart that encapsulates it all: 

032212 china pmi stuff

This theme of the eurozone falling into recession followed by lower-than-expected Chinese growth has been part of our fundamental story for some time now. And for those who follow me more closely, and those who subscribe to my Commodities Essential newsletter, know, I expect this dynamic will ultimately hit commodities hard.  

Another take away is the improving US growth differential. With investors of an increasingly international mindset, investing has become very much a relative game at times (note: it’s always a relative game in the FX market.) That said, we could continue to see a relative outperformance in US assets relative to those in Europe and Asia.  

US jobless claims fell to their lowest level in four years, as reported this morning, for what it’s worth.

This means US stocks could continue to outpace foreign stocks on the upside. I am just waiting to find out if US stocks will ever succumb to any downside.   We could be close.


Is this China’s last ditch effort to avoid the hard landing?

shop“We will improve policies that encourage consumption.”

- Wen Jiabao

Let me ask: what have China’s central planners now admitted is integral in supporting sustainable Chinese economic growth?  

  1. New emphasis on consumption-led growth to rebalance the lopsidedness of investment growth that’s currently compensating for softer export growth

  2. The need to cool speculative bubbles within the economy so as to reduce the inflationary pressures and manage social perceptions

I agree. But easier said than done, of course.  

We talk a lot about why the shift to sufficient levels of consumption will be tough for China to achieve with any efficiency. Basically, the consumer faces pressures from inflation and redirected capital flows, from the central government to local government investment projects, which prop up the current system, despite the need for a shift.  

Amidst the puzzle pieces China is using to put together an economic rebalancing, commentators have sought to expose the main obstacles to achieving that goal. Real estate is certainly among the largest obstacles. It is certainly worth watching.  

While we don’t get as much bubble talk as we once did, China’s housing situation is still fragile ... and it is still an important piece in China’s economy.  

It is among the reasons we see comments from the Chinese Premier today regarding a revised growth target lower than the all-important 8% level, a need to stem rising home prices, a commitment to making credit accessible, and:  

He also said the government would defuse rising local government debt, regarded by many investors as the key risk to fiscal sustainability. Government figures show about 10.7 trillion yuan ($1.7 trillion) was owed by local governments at the end of 2010.  

That was from Reuters. So is this:  

China's big four state-backed banks will lend more to qualified property developers to boost entry level housing supply, a statement in the central bank's newspaper on Friday said, a signal that they are ready to ratchet up real estate lending.


According to the statement published on the front page of Financial News, a paper run by the People's Bank of China, the big four banks "will proactively support qualified property developers to develop common commercial housing that is in demand to boost effective supply of common commercial housing."  

There are a lot of conflicting winds blowing through the Chinese economy. Some measures may achieve their intended goal; but much of the policy jawboning amounts to setting perceptions, conveying to the public just what Chinese officials want its people, and investors, to expect.  

When it comes to China’s revised GDP target, it’s anticipated that they are just setting the bar low so they look better once they clear it. Until now 8% marked the floor at which China believed it could achieve growth necessary to keep social concern from boiling over.  

Apparently lowering the growth target offers policymakers room to reform the system and encourage businesses all at the same time. Reuters:  

Lower growth will allow Beijing to reform key price controls without causing an inflation spike, so monetary policy can stay broadly expansionary to ensure a steady flow of credit to the small and medium-sized firms the government wants to encourage.  

In a nutshell, that’s the familiar stop-and-go policymaking Chinese officials have become known for over the last 4 years.  

China has succeeded in recent months to bring inflation down. And CPI out later this week will probably reveal prices are stable around 4%. This opens the window for China to take supportive action aimed at growth numbers, and they know it.  

But one has to wonder if this is China last chance to dance. Besides the internal risks to growth, China continues to tug with a Europe that’s heading into recession and a US that’s fighting to stay above water. If they are able to stabilize investor expectations, their efforts could be supportive for markets through to the end of Q2 or into Q3 assuming there is not some inescapable external shock.  

The Shanghai Composite Index began reflecting the Chinese growth downturn back in the second quarter of 2011; it has since rallied back in 2012. But will we see Chinese stocks foreshadow a renewed downturn in the Chinese economy that is deep enough to disappoint?        

030512 ssec

We might get some near-term selling that is technical in nature. But as I said, China is working overtime to keep things going. That may mean it is still a couple more months before we see real fallout in Chinese stocks and global risk appetite.  

For good measures, here is the Shanghai Composite and the S&P 500:  

030512 ssec spx

Seems like some sort of correction is due.


Can China 'steel' the risk spotlight from Europe?




"The responsibility of tolerance lies in those who have the wider vision." 

-George Eliot


So we have witnessed a roughly streak of risk appetite across the markets. A whopping 10 out of the last 13 weeks the S&P 500 has closed higher than the prior week’s close.  

US stocks have undergone a tight and steady ascent, aided and abetted by optimism (rather, the lack of renewed pessimism) in the eurozone and an ongoing corrective rally in the euro.    

022712 eur

I mean, there has been plenty of real reason to be pessimistic; but it’s almost as if investors have revisited an obviously irrational and fundamentally careless mindset. My diagnosis of this condition goes a little something like this:  

==> I’m fatigued by the slow-speed train wreck of deliberations aimed at rescuing the eurozone ...

==> The amount of coverage lent to the Sovereign debt crisis and Greece is sickening, even if it is warranted ...

==> I don’t want to miss the bus on another global central bank liquidity-induced market rally ...

==> If there is actually a Greek default or some other systemic trigger of global market contagion, I’m sure I’ll hear about it ...

When the time comes I’ll be able to take the needed steps to secure my money efficiently ...  

In fact, I think I’ve written about this ‘mindset’ before ... in explaining the potential for “black swans” post credit crunch 2008. (Of course, it is a contradiction of terms to be able to identify potential black swan events.) Bottom line: investors are willing to take on risk because they have become so saturated with warnings and forecasts that they’ve developed a sense of complacency, a false sense of security.  

Well, consider this another warning!      

022712 vix

Above is the VIX, a volatility index use to gauge investor fear and uncertainty. It’s back to low levels that have marked the floor since the 2008 financial crisis sent the vix into uncharted highs. In other words, investors are about as comfortable (complacent) as they’ve been in this era of risk.  

Moving to economics, consider this ...  

LONDON, Feb 24 (Reuters) - Global steel production is experiencing its sharpest contraction  since the dark days of 2009, when the industry was gripped by the manufacturing freeze that followed the 2008 financial crisis.     

Global output in January shrank by 8 percent year-on-year as the slowdown evident over the closing stages of 2011 accelerated and deepened.  


In the euro zone itself output in January was down by 6 percent year-on-year with that in the region's largest producer, Germany, tumbling by 9 percent.   

Steel – what’s the big deal?  

Obviously, it is a raw material that is critical to so many manufacturing applications. And obviously, contraction in manufacturing is not a welcomed event for investors betting on economic growth. But the steel story alone isn’t going to be a catalyst for risk-aversion that sends investors fleeing the markets.  

It is, however, a China story. And it is an example of the headwinds the Chinese economy (and the rest of the world) faces.  

China is at a point where they must build a substantial consumer class to make up for softening in external demand. Because while we see steel capacity shuttered in Europe as they enter recession, China also wrestles with overcapacity across many sectors that have been artificially buoyed by government investment initiatives.  

And now that the residential real estate bubble is deflating – intentionally or unintentionally – there will be a headwind pressing hard against the demand for steel, among other things. Oddly enough, the hope for the steel industry and continued production rests on the demand from social housing initiatives aimed at providing affordable housing to so many citizens who were priced out of the market as the real estate bubble inflated, despite the massive amount of vacant housing.  

Ultimately, China is experiencing a slowdown in growth and they are pinning growth hopes on the Chinese citizens’ capacity to increase consumption. But when purchasing power is diminished from inflation and a controlled currency, and when households bear the burden of the government’s investment strategy that funnels money into superficial investment projects instead of the consumer sector, the weight of this new responsibility appears even heavier.  

I do think investors are awaiting an actual default in Greece, or hard and irreversible evidence that the Sovereign debt crisis cannot be contained as expected, before they run for the exits. But I also think their complacency or indifference at this stage blinds them to the risk that China will majorly disappoint.  

To wit, there is another mindset out there:  

China always pulls through despite the warnings of imminent economic collapse; I’ll believe it when I see it.  

I hate to be cliché and say ‘this time is different’ ... so I’ll just say ‘keep your eyes open this time.’