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Right then, let’s get stuck into it. Yesterday, we got further confirmation that China’s economy is slowing…and the Aussie dollar and stock market jumped higher. How does that make sense? Well, it doesn’t really, but here’s the logic…
Yesterday, the Aussie market spent most of its time in the red. Then, HSBC released preliminary Chinese manufacturing data for March, showing activity in China’s manufacturing sector slowed to an eight-month low. Bad news, right?
Wrong. It’s good news. Apparently, it means China is closer to announcing a large stimulus program. (Because the last stimulus program was so successful.) Once this little rumour swirled through the market yesterday afternoon, the Aussie dollar and stock market pushed higher. Ahhh stimulus, is there anything you can’t do?
Steady on though. Market action overnight didn’t exactly reinforce the stimulus rumours (although the Aussie dollar was strong in US trade). The S&P500 fell 0.5% while the NASDAQ slumped 1.5%. The main action was in the biotech sector, which fell 3% after a 9% decline on Friday.
Maybe that’s what happens when the prospect of continued easy money disappears. The bubbliest sectors panic first. Here’s a chart of the NASDAQ’s biotech sub-index:
Hmmm…it’s doubled from the start of 2013. Now it’s in the process of taking some of those gains back. Hot money – a euphemism for short term, speculative, leveraged funds – is getting out of the ‘hottest’ sectors as the prospect of tighter monetary conditions in the US takes hold.
And recent data releases support this view. US manufacturing is humming along. Last night’s release of preliminary data for March showed a strong reading of 55.5, down from February’s 57.1, which was the strongest month in over 3.5 years. Anything over 50 signifies expansion.
So the US economy continues to show signs of health, which means the Fed’s trajectory of QE reductions and ‘normalisation’ of interest rates (whatever that means when you have a US$4 trillion balance sheet) continues.
Meanwhile, over in China momentum is definitely slowing, driving the calls for more stimulus. As the Wall Street Journal reports:
‘Some analysts expect the People’s Bank of China to cut banks’ reserve requirements, freeing up funds that can be used for lending. Others think authorities will rely on the type of stimulus spending they’ve used in the past.’
Our feeling is that the authorities in China, under the leadership of President Xi Jinping, have a higher tolerance for pain than they did in the past. Previous efforts to provide stimulus only exacerbated economic imbalances and made the task of trying to normalise the economy even harder.
We don’t know how the mind of a central planner works, but we’re thinking that pushing the stimulus button now would not send the signal needed to help reform the Chinese economy. Having said that, the authorities are playing a very dangerous game in trying to gently deflate the credit bubble.
Part of the focus is on ridding Chinese industry of overcapacity. An industry with too much capacity generates sub-standard returns and must implicitly be subsidised by other parts of the economy. Steel and cement are two sectors with chronic overcapacity and the authorities are trying to clamp down in these areas.
China’s Caixin magazine reports on the problems emerging in the steel sector:
‘(Beijing) – The largest private steel manufacturer in the northern province of Shanxi has become ensnared in deep debt troubles as the whole industry struggles with overcapacity.
‘Highsee Iron and Steel Group Co. Ltd. has seen its capital chain broken and creditors including banks line up to try to get their money back, sources with knowledge of the situation said.
‘The exact amount of debt the company owes is not clear. Estimates by industry observers put it between 15 billion yuan and 20 billion yuan. China Minsheng Bank alone may have lent more than 3 billion yuan to Highsee, a source close to the bank said.
‘Minsheng Bank’s president, Hong Qi, declined to say how much the company owes. He said the provincial government has intervened, but that the situation "was not even near a crisis."
‘However, analysts worry a storm is brewing. "Highsee’s problems are typical" in a sector where a huge debt problem is only beginning to reveal itself, an industry observer said.
‘The China Iron and Steel Association, a trade organization, has also sounded the alarm. A recent report it published says many of country’s major steel-producing and trading companies’ debt-to-asset ratios have passed the 70 percent red line.
‘The report also shows that the combined loss of major steel companies in the first two months of the year was nearly 3 billion yuan. Products that had sold well in the past were piling up in warehouses, hurting the ability of companies to repay loans.‘
Hmmm…China wants to get rid of excess steel capacity. This means it must allow steel firms to go under. And judging from the above, they are well on their way. But because most have high debt levels, it also means the banks will take a hit via rising bad debts.
So does the government stimulate to prevent the firms from going under? Or does it allow the restructuring to take place and focus on containing the fallout in the financial sector? If it’s serious about rebalancing, we’d guess it will focus on the latter.
But Aussie investors think it will focus on the former. That’s why the miners and the dollar rallied yesterday in the face of bad news.
On top of that you have the Reserve Bank of Australia mulling interest rate rises, which is why the dollar remains stubbornly over 90 US cents. The prospect of higher interest rates and a stronger dollar, at the same time that our most important trading partner slows down, is not a pleasant one.
But we think it’s only a prospect. Tomorrow, we’ll explain why the RBA won’t increase interest rates anytime soon. And why, if it does, it would push Australia towards recession.
for Markets and Money
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