The Dragon affects every market
In a week that global indices were down by over 2% and EUR hit 21-month lows, central bankers continued to confirm a slowing down of global economic growth. We saw this particularly from the BoC and ECB, and the consequent hits on their currencies. Most importantly, we saw a reduction from 6.5% to ‘6%-6.5%’ (for which read the lower figure) by Chinese premier Li at the National People’s Congress on Tuesday. This was coupled with a disturbing report report from the Brookings Institute think-tank that Chinese existing GDP may be overstated.
We continue to see economic data deteriorate whilst stock markets continue to go up. Why? Because of optimism over the trade war between the US and China. China is the lynchpin. China is probably the answer to 2019. If China recovers due to the trade war, then the stock markets can blow out finally to the upside. If China continues to decline, and it’s stock market with it, then this bodes badly not just for China but for the world. Why is China so important?
China’s importance to the global economy is clear. It has the second largest economy in the world and could overtake the U.S in the next few years. It is the largest supplier of goods, the largest buyer of oil and copper, and is by far the biggest buyer/holder of US bonds.
Yet China’s impact on various global markets is not always as clear. Some markets are closely linked, some less, some have a delayed correlation. The Chinese economy acts as a macro fundamental driver and markets can move for many other reasons. Fundamentals (F) are only one part of our FITS (Fundamentals, Inter-market, Technical, Sentiment) model. Additionally, the US stock market’s focus is largely US centric: US economic growth, inflation and corporate earnings are generally more important in the near-term. It is therefore tempting to discount China’s importance, but as we saw in late 2018, this would be a mistake. If China sneezes the rest of Asia catches a cold and the world gets a fever, if only a short-lived speculative one.
You could say the same about curing the ailments; how and when the trade war is resolved not only affects China but also, in turn, the rest of the world. However, this “fix” may only be a short-term driver given the maturity of the economic cycle and the fact that any trade deal may not undo the tariffs. The damage may already be done.
China and US Stocks
China is important to the US stock market for a number of reasons. Often these are not immediate and U.S. stocks can ignore problems in China until they get critical. This could be seen in the first half of 2019 and also in 2015 when Chinese stocks fell over 30% before the rest of the world really started to take notice.
But Chinese stocks do not necessarily reflect the Chinese or world economy (as demonstrated by the 2015 sentiment driven bubble) so are not always a reliable indicator. The link between the US stock market and China is not through correlated markets, but more a fundamental one related to global growth and the reliance of US companies on US-China trade and manufacturing. This was made very clear in the latter part of last year when the IMF cut its growth forecasts in an update to its World Economic Outlook. This happened in early October and spawned a narrative of slowing growth which got louder as stocks crashed in December. The blame for the slowdown rested squarely on the trade war.
More than 65% of the U.S. trade deficit is with China. The $375 billion deficit is created by $506 billion in imports, mainly consumer electronics, clothing, and machinery. Many of these imports are actually made by American companies who ship raw materials to be assembled in China for a lower cost. They are then counted as imports even though they create income and profit for these U.S. companies. Increasing tariffs therefore leads to increasing costs to US companies, which in turn are passed on to consumers.
The first round of tariffs in Q1 2018 actually had very little effect on the US consumer or markets as they focused on metals such as steel and aluminum, and then on industrial materials such as bulldozers or large factory equipment. This only affected a small amount of companies in the S&P 500. However, the September imposition of a 10% tariff on $200 billion worth of Chinese goods had a long list of casualties as it focused more on consumer goods. CEOs from Coca-Cola, Pepsi, Walmart, Gap and Costco were some of the first to warn of raising prices. But the real effects were felt in Q4 earnings where growth noticeably slowed and CEOs were queuing up to blame the trade war as the source of their problems. With the threat of an increase of the tariffs from 10% to 25%, there is the real risk of significant damage to U.S. companies and U.S. consumption. The importance of a resolution to the trade war is not to be underestimated.
China – Oil
The link between oil and the SPX has been very strong since the December lows and for much of 2018. This correlation comes and goes; the oil crash in 2014-2016 is not immediately comparable to the price moves in SPX in the same period, even if both markets were weighed down by similar concerns. When the correlation is unusually high it tells us that both markets are very focused on growth, which in oil’s case is linked to demand.
China’s link to oil is often overlooked, but shouldn’t be. It not only has the second largest economy in the world, it is also the second largest oil consumer after the US. It is the number one importer in the world with volumes hitting a record 10.48 million b/d in November 2018. To put this in perspective, Saudi Arabia exported 7.1 million barrels per day (bpd) in February, down from 7.2 million bpd in January. The link is clear.
As the trade war directly affects the two largest consumers of oil, it acts as a major driver. OPEC reduced its forecast for oil demand in 2019 four months in a row in late 2018 to reflect this. The IEA kept forecasts unchanged, but only because oil prices fell by 30%.
China and Copper
Copper, the essential component of all electrical cable, is often seen as a barometer of global growth, and China's massive power and infrastructure sectors are the main drivers of demand. China's demand represents over half of the total world demand.
China’s economy is therefore very important to copper and other base metals to the extent that data series such as Chinese manufacturing PMI correlates very closely.
Chinese stock markets also correlate closely at times and it is interesting to note that both China and copper were holding supports in late 2018 while US stocks crashed. This kind of relative strength can be a useful tell.
China and the US dollar
The trade war has been good for the US dollar.
Simplistically put, tariffs increase costs and this pushes up inflation which forces rate hikes which pushes up the dollar. And as the trade war hurts other economies more than it does the US, it also makes the US dollar more attractive versus other currencies. In this regard, China has been accused of intentionally devaluing the yuan to offset the impact of tariffs.
With a trade deal on the table the US dollar is likely to fall. Which makes it slightly odd that Trump and the administration is all of a sudden concerned with dollar strength when there has been little overall movement for months. Perhaps talking it down is actually because they anticipate it falling and want to take credit and want it seen as a good thing.
Certainly the USD/CNH looks like it could fall further after making a decade-high in 2018 and then reversing lower in a trend sequence.
A trade deal hinges on China agreeing on a currency provision and the US has asked China to keep the value of the yuan stable to neutralize any effort to soften the blow of US tariffs. Details are still sketchy despite Mnuchin’s announcement in late February of one of the “strongest” currency deals. Left to its own devices, the yuan should undo the 2018 move and push USDCNH to around 6.3.
We can safely assume that any trade deal will be a market positive, but the impact could depend on the exact details. This is what we know so far, from a Bloomberg article this week (our bold type):
“The U.S. and China are close to a trade deal that could lift most or all U.S. tariffs as long as Beijing follows through on pledges ranging from better protecting intellectual property rights to buying a significant amount of American products, two people familiar with the discussions said.
Chinese officials made clear in a series of negotiations with the U.S. in recent weeks that removing levies on $200 billion of Chinese goods quickly was necessary to finalize any deal, said the people, who weren’t authorized to talk publicly about the deliberations. That’s the amount the Trump administration imposed after China retaliated against the U.S.’s first salvo of $50 billion in tariffs that kicked off the eight-month trade war.
One of the remaining sticking points is whether the tariffs would be lifted immediately or over a period of time to allow the U.S. to monitor whether China is meeting its obligations, the people said. The U.S. wants to continue to wield the threat of tariffs as leverage to ensure China won’t renege on the deal, and only lift the duties fully when Beijing implemented all parts of the agreement.”
We doubt Trump will agree to immediately remove all the tariffs he implemented. The immediate effect of a trade deal would therefore be more driven by sentiment than fundamentals which could take months even years to recover.
China is important. If you find the answer to how their economy will fare over the next six to 18 months, and consequently their stock market, then we probably have the answer to many other inter-related markets. If history is our guide, we may have to wait quite a considerable time before the Chinese economy and stock market comes out of the doldrums, and evidenced by the Japanese NKY in 2009-2013.
As we have said, if China catches a cold, the world sneezes. If China falls asleep, the rest of the world may experience nightmares.
Here’s to making the very best.