The Downdraft
China, de-leveraging and the Fed
Have you always been crazy?
I dont know. I never was much put to the test before today.
The Crossing, Cormac McCarthy, 1995 (punctuation is as Cormac wrote it)
The balance of risks has shifted toward the employment side of our dual mandate.
Fed’s Waller, today
THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OFTEN PAINFUL. DO YOUR OWN RESEARCH.
Today, China’s de-leveraging and an update on what is next for US monetary policy.
China
This caught my eye:
The story is interesting in two respects. First, China’s central bank is trying to drive interest rates up (selling bonds), when inflation is close to zero. Second, the sources are scared to give their names to reporters. Said differently, some of China’s policy (they pull many policy levers at once) amounts to tightening when market forces are seeking to do the opposite (easing) and people are too scared to talk about it outloud. I suspect you are not seeing a more candid discussion of China’s odd policy choices because many of the people that would normally do so (the press, IMF, asset managers) are wary for fear of pissing off Beijing and getting punished.
The broader context is China is in a devleraging and needs appropriate easing and is not getting it. Debt and de-leveraging are abstract concepts and they don’t resonate the way words describing the natural world do, like “chipped curb” or “mottled sand.” But de-leveraging matters because it forces a series of changes in other asset prices that impact us all and are now evident in China and maybe globally.
What Is a De-Leveraging?
A de-leveraging is the process of reducing aggregate debt. An economy is a series of interlocking relationships. This is what’s so complicated about understanding the economy and why even great investors can at best have a partial understanding of this many variables that make up the financial system. That said, borrowing is spending tomorrow’s money today. The problems begin when tomorrow ends up looking very different than what we thought it would look like. Then you owe a huge amount of cash to service the debt, but suddenly there is not enough.
This is what happened in the US in 1929 and 2008 and Japan in 1990 and what is happening now in China. China built a huge amount of real estate based on an estimate of economic growth that would generate the cash to pay off that investment. But the growth is not there to support the cash flows and so growth goes in reverse.
The only known solution to this problem—print—is one that seems counterintuitive to many people but makes logical sense. It is also what ended the Great Depression, got us through 2008 and ended Japan’s lost decades. The issue is that if one person cuts spending to repay their debt, that is responsible behavior. If everyone reduces debt at once, it is a depression. Debts in China are far greater than income, which means as people pull back en masse total income shrinks. Printing boosts aggregate incomes, short-circuiting this doom looop. The central bank is the only entity that can perform this function. In fact, it’s why they exist.
While I know quite a few investors who are buying Chinese stocks because they are cheap—the P/E is about 1/2 less than the US—I am not touching them. The companies are selling into a a shrinking economic pie. It’s hard to know how fast China is actually growing. Beijing says they are growing at 5%. I find it notable how weak commodity prices like oil and copper are. Below the white is oil and the blue is copper. China is an important consumer of each and their weakness in part reflects China’s reality. If China is growing less than its official numbers, that would also explain both the rally in bonds and grinding bear market in stocks. Sometimes markets are pretty good forcasters but, based on the PBOC’s policy, they don’t seem to share that belief.
The US
On August 26, I wrote that I thought the Fed was going to cut 50 basis points this month. That post is here. I’m now more confident in that outcome and have adjusted my portfolio to reflect that. The market does not yet believe this. That is not an opinion, it is a statement of fact. The Fed is discounted to cut 34 basis points later this month, not 50, despite yet another report today that shows weaker than expected employment data.
The gap between that reality and the market belief is I suspect easily explained as the difference between what the data shows now and imagining what it will show in 6 months if the Fed does not start moving fast. Imagining a future different than the one we are in is always hard. On the face of it, things look fine in the US. Inflation is low and positive, unemployment is around 4%, the stock market is up double digits on the year.
But crucially this assessment misses the momentum of what is going on in the economy. Inflation has fallen from 9% to closer to 2%. Offers for jobs for those who have lost a job have plummeted, as shown below. A recent story from a recruiter detailed significant pay cuts that those being rehired need to endure. The momentum is down and fast.
Imagine how this plays out going forward. Everything gets worse—employment, profits, stock prices, inflation (down). Now add China to this. Then you have the mix going forward. The cash flows of the companies I am still long look solid to me. But we now need to go through a risk-off dynamic until the Fed gets ahead of events. Hopefully, the Fed gets the message.
Below are the asset allocation shifts.