Equity investors across the world are positioned for the nirvana of synchronised and accelerating global expansion led by China and the US.
What they may instead get is a synchronised Sino-American slap in the face. Analysts at UBS say the international credit impulse has already “collapsed”. The two interlocking economic superpowers are both tightening policy into an approaching storm.
The US bond market has been signalling for two months that the US economy remains uncomfortably close to a deflationary relapse, an implicit judgment that the US Federal Reserve is about to commit a policy error.
Bond vigilantes have refused to “confirm” the Trump reflation rally playing out on world bourses. Yields on 10-year US Treasuries have fallen by 33 basis points to 2.29 per cent since early March.
The slump in US economic growth to 0.7 per cent (annualised) in the first quarter suggests bondholders are right. There are now enough indicators flashing recession warnings to take serious heed.
Citigroup’s “economic surprise index” has crashed over the last eight weeks. It has given up all the gains from those first euphoric months after Donald Trump’s election, when markets briefly believed that he would deliver his fiscal blitz.
There has been a steady drip-drip of hard facts that never quite validate the soft surveys. US car sales were supposed to come to the rescue in April. Instead they dropped 4.7 per cent. The New York Fed says 6 million people are over 90 days in arrears on $US1.16 trillion of car loans. This in turn is causing lenders to tighten standards.
The $US12.5 trillion market for US bank credit has sputtered out, with flat growth over the past three months. Commercial and industrial loans are falling at the fastest rate since the Lehman crisis.
Meanwhile, the Fed is in “another galaxy”, to borrow an expression in vogue this week.
It shrugged off signs of weakness as “transitory” at this week’s meeting and seems determined to pack in a clutch of interest rate rises while the coast looks clear.
“The Fed is going to be far more aggressive than people think,” said Adam Posen, head of the Peterson Institute in Washington.
Evercore ISI, a boutique of central bank experts, warns that the central bank will not recoil from further tightening as it did in 2015 and 2016 at the first sign of Wall Street trouble. Rightly or wrongly, it thinks the world is now in better shape. The US labour market is tighter. The dollar has come off the boil.
The greater worry for the Fed at this stage is falling behind the curve as inflationary pressures build. It thinks the “natural” rate of interest is near 2 per cent and will not be deterred by “temporary factors”, unless something awful happens. “Investors should not expect to be bailed out by early and aggressive Fed action if there were to be a mid-sized fall in the stock market,” said the group.
You might say it is remarkable that the Fed is tightening at all given the slump in personal consumption growth to 0.3 per cent in the first quarter, a level that has preceded recession on every occasion over the past 40 years except the one anomaly of 1987.
There must be a risk that they will do exactly what they did at the tail end of the pre-Lehman boom, when monetary indicators had already turned down. Bureaucratic over-tightening caused a manageable downturn to morph into a banking crash.
The relevant point is not whether rates look low – a distraction – but where the pain threshold lies for a dollarised global system that is more leveraged than ever before. The Institute of International Finance says debt has reached $US217 trillion, a record ratio of 325 per cent of world GDP.
There have already been 13 “synthetic” rate rises by the Fed in this tightening cycle, if you include the effect of winding down quantitative easing under the Wu-Xia model. We may already be close to the end.
“The Fed are wrong, just as they were in 2007-2008 when they didn’t recognise the recession risks. Their models simply do not work. They have one more hike left in them and the next move after that will be a cut,” said Patrick Perret-Green from AdMacro.
The big US banks are advising clients to take money off the table as the “Icarus trade” flames too high. “We look to use any further strength over the next weeks as a good opportunity to reduce exposure and lock in some profits,” says JPMorgan’s Mislav Matejka. Key among his six “red flags” is fading stimulus in China.
The latest Chinese mini-boom has been a wonder to behold. The authorities panicked after the economy hit a wall in early 2015 and reverted to extreme debt creation. The Bank for International Settlements warns that the “credit to GDP gap” has reached 30 points, the highest in the world and the highest yet in China. Any score above 10 is a warning sign.
Net fiscal stimulus reached 10 per cent of GDP last year. This matched the post-Lehman surge in 2009, but the circumstances are different and the efficiency of credit has in any case collapsed. It now takes 13 yuan of new debt to generate one yuan of growth.
Beijing began stealth tightening six months ago. This is turning into a full-fledged effort to rein in the $US8 trillion shadow banking nexus.
“The Chinese economy peaked in the first quarter and is set to lose steam for the rest of 2017,” said Danske Bank. Caixin’s manufacturing index is the weakest in seven months. Steel output has dropped to 2015 levels. Planned investment is even lower. Housing curbs are biting with a delay. China’s credit impulse has turned negative.
Saxo Bank says the contractionary forces are so powerful that the Chinese economy may slide towards a “full stop” later this year, with tremors through the commodity nexus and with risk of outright falls in world GDP.
“The markets are pricing in a 20 per cent chance of a recession, but after returning from China, we think it is more like 60 per cent,” said Saxo’s Steen Jakobsen.
“China accounts for half of world growth and it is hard to see what can replace this. Trump won’t move the needle until next year at best. We don’t think any central bank should be tightening right now,” he said.
The business cycle has not been abolished. It invariably ends when policymakers hit the brakes too hard. Judging that moment is never easy. But the risks are rising and there will be nowhere to hide in Europe if and when “Chimerica” buckles.
by Ambrose Evans-Pritchard