China is a big, and often mysterious, factor in the world’s economies. In recent years China has created a massive pile of debt. At this point total Chinese debt is about 250% of GDP, the highest among any large emerging market country. Between 2007 and 2015 they created 63%, or $16 trillion, of the growth in the entire world’s money supply. Why? They were trying to help stimulate their economy and to finance an already large total Chinese debt burden (government, financial, corporate and household debt). The danger is that if people in China or elsewhere lose confidence in the yuan and it devalues rapidly or money leaves China (as has been happening), it’s fairly likely that defaults in China would soar.
A major risk is that there are a lot of unstable Chinese financial institutions that have raised money via debt, helping fuel a credit boom that could go sour pretty quickly. Even among more established banks, leverage has soared, with the average bank four times larger than it was eight years ago. Some of the smaller (pseudo) banks rely entirely on issuing debt (rather than acquiring deposits) to re-lend, increasing leverage and risk even more.
These developments are why China has instituted strict capital controls. As risks increase they are trying to stop capital flight from their economy. It’s also why their hoard of U.S. Treasuries is shrinking fast as they sell Treasuries to protect their economy and currency.
At this point Chinese total debt is growing about twice as fast as GDP and now the currency is depreciating. China represents about half of the demand for global commodities, effectively supporting Africa, Australia, and Brazil. A weaker Chinese economy and a weaker yuan mean less demand for commodities and lower commodity prices.
Is Trump the igniter to this China economic tinderbox? He recently picked Peter Navarro to lead US trade and industrial policy. Navarro is the author of Death by China, a strongly anti-China book. Trump was also elected on an America-first policy and has talked about instituting a VAT-like border tax, which would make imports more expensive. Nothing has yet happened, but everything seems to be pointing against China in what is a big market for them.
Why should we care? Two reasons. First, any time you change a machine, you’re quite likely to create problems. The 1997 Asian credit crisis, for instance, carried with it fears of contagion, causing a downturn in the U.S. market. The world is currently fairly tightly linked. A move to shift current linkages is likely to cause dislocations. Problems in China can quickly become our problems.
Second, thinking about China risks can be helpful for figuring out some of what may be going on in the U.S. The Trump rally has been signaled by a strengthening dollar and higher interest rates. Is the Republican sweep narrative the reason for these changes, or is the reason that China is protecting its currency and economy by selling Treasuries (more selling of Treasuries means lower prices and higher interest rates)?
I’d say it’s both. That’s what Charlie Munger would call a lollapalooza, an occurrence where two events combine to create a multiplicative effect. That’s particularly important because the longer term implications are divergent depending on what is the primary mover. What if the dollar is moving up due to financial stress, not only in China but also in other EM countries and Europe? Every market downturn we’ve had for decades has seen the dollar move up as investors move towards cash and low-risk investments. Conversely, if we’re recreating the Reagan years, the dollar is moving up because the economy is getting better. If we’re headed towards crisis, the correct decision is to stay safe. If we’re making America great again, we want to embrace risk. Tough call.
What to do? First, what are the probabilities of these variant outcomes happening? China clearly has a problem, with capital outflows, a depreciating currency, failed sovereign bond auctions, and increasing business debt defaults. Can they get out of this gracefully? I’m not sure how they could, really, though the timing of a crisis is tough to call. It looks broadly similar to the 1997 Asian financial crisis (worse than that, in my mind.) They also have an added reason why things could go bad quickly in the form of Trump policies that look like they will hurt the Chinese economy.
How about an improving U.S. economy? That’s kind of complicated. We have a situation that I don’t remember ever seeing before. Some late cycle economic indicators are still indicating a worsening economy, while some leading indicators have been showing improvement for a while. That’s odd. Usually the lagging indicators (such as employment, sales and credit creation) have already rolled over to at least neutral by the time we see leading indicators improving. What might these contending indicators be telling us? Well, nobody said the economy is just one big uniform blob. The lagging indicators are generally the bigger parts of the economy (70%, in over-broad terms.) They encompass things like retail and finance. Those areas still look weak. What looks (at least potentially) good? Basically, some manufacturing and related industries. So, just taking the indicators at face value, we should currently be somewhat constructive on manufacturing, but cautious on retail and finance.
Again, what do we do? What happens? Of course I don’t know, but I just try to put the probabilities in our favor as much as possible. I’d also say, why can’t both things be in the process of happening? Right now I think it pays to be cautious, as the China situation is fragile and has an added catalyst to get worse in terms of what Trump may do. At the same time, I think we need to be opportunistic on manufacturing America. The data have been getting better, and there’s reason to believe that can continue (admittedly nobody said it has to happen in a straight line.)
Trend lines for leading indicators, for instance, are relatively flighty versus trend lines for lagging indicators that are relatively stable, and a lot of the improving manufacturing data is due to improving sentiment or diffusion indexes (which are essentially metadata.) (Metadata basically is data derived from multiple other data sources. For example, PMI (Purchasing Managers Index) data is derived from five separate economic indicator surveys – new orders, inventory levels, production, supplier deliveries, and employment.) You could argue (though I wouldn’t) that since hard data hasn’t yet changed, we should discount the improvement in manufacturing. I will admit it’s entirely possible that in three months the manufacturing improvement could be shown as ephemeral, but I’ll cross that bridge when and if we get to it.
Thus, for now we’ll stay generally cautious, but we’ll also look for good risk-reward situations to invest in manufacturing America. And as usual, as the data changes, we’ll change. The world may look very different in three to six months, and, if so, we’ll have to act differently to deal with the (potential) new world.
Lastly, I’d add that (as usual) this is an overly simplistic model. There’s much more going on in the world than China and Trump. China is just the biggest worry among a worldwide stressed economic and financial system. The Trump border tax would affect most emerging market countries because their economies depend heavily on exports. The Trump effect of a higher dollar and higher interest rates is a double whammy for most emerging market countries whose debts typically are denominated in dollars, thus making the debt and interest on the debt more expensive in their local currency. And this problem applies to those in all foreign countries who borrow in Eurodollars.
To summarize a few of the stresses in countries beyond China, there’s the banking stress in Europe, along with all European economies sagging and the refugee situation becoming an economic and political crisis. Britain voted to leave the European Union, and Italy voted to move toward leaving both the EU and the Euro currency. India’s “war on cash” has seriously disrupted the country’s entire economy. All economies principally based on oil are under stress due to persistently lower than expected oil prices, particularly the Middle East and Russia.
What we have is a global wall of stresses. Admittedly, I’d also point out that it’s always easier to point to potential problems than potential benefits. That’s fine as long as you’re aware that the number of problems doesn’t necessarily equal the probability-weight of the possibilities.
It’s too early to say, but if I had to guess, I’d say that 2017 is likely to bring more volatility than we’ve seen in a while. That volatility, dealt with properly, may present some good opportunities going forward. We’ll work hard to do our best.