Markets, like the individual investors by whom they are ultimately animated, have a tendency towards binary thinking. This week, for example, they decided European Central Bank present Mario Draghi had suddenly and dramatically shapeshifted into a hawk following some mild, inflation-positive remarks Tuesday.
One day later, when Draghi attempted to qualify his statements after a 1.5 Big Figure EURUSD rally, they briefly determined that he is in fact a peaceful white dove and the euro plunged through the 1.13 handle.
Of course, that was ridiculous. Come to your senses! The swing was obviously some sort of crazed overreaction and he is clearly a hawk in his entirety. EURUSD recovered the loss and added 70 more pips to spite doubters. Things are either one thing or they are another.
This is the wisdom of the aggregate, or to phrase it more critically the mob. In liquid markets it correlates closely to reality, but not completely. It is like the Canadian dollar to oil, or the S&P 500 to Federal Reserve policy. It rises and dips along general contours, but there are always gaps or periods of mild disconnection. In these gaps live the sort of investors who turn profits.
As Saxo Bank chief economist Steen Jakobsen pointed out in early May
, one of this year’s most crucial market drivers is the China-driven decline in the global credit impulse. As credit is withdrawn from world markets, so the asset prices driven higher by its prior addition will be led closer to the precipice. But what, precisely, is the context for China’s decision to slow the credit impulse? What is happening behind the headline?
According to Wei Li, Head of iShares EMEA Investment Strategy, investors looking to incorporate the credit impulse slowdown into their strategies need first to understand the facts on the ground in China, and what “slowdown” might mean in practical terms.
“We have certainly seen [a slowing of the credit impulse],” says Li, “but I’d like to put things into perspective. We are not, after all, going from a neutral policy to extreme tightening, but rather from very loose policy to something closer to neutral”.
“The reason for this is because the growth data remain reasonably robust and Beijing feels that there is room to ‘adjust the mixture’”.
Citing an overheated property market as one of the sectors where authorities perceive room for selective tightening, Li points out that “even third- and fourth-tier cities [in China] are seeing prices appreciate too fast and too far, and this is why [Chinese policymakers] are scaling back.”
In terms of this process’ impact on the global economy, Li remains more sanguine than some, stating that “it’s not surprising that we have this selective tightening and the impact on the global economy, once the process is understood, shouldn’t be that dramatic because the Chinese intent to transition has been well-broadcast, at least from a ‘direction of travel’ perspective”.
One of the key factors behind the slowdown seen in the credit impulse is of course Beijing’s desire to crack down on its $9.6 trillion “shadow banking” business, in which banks and financial firms issue high-interest loans to businesses and local governments outside the country’s regulatory framework.
In China, Beijing’s goal is to underwrite stability as it heads into this fall’s National People’s Congress while still pushing back against the shadow banking complex.
Soldiers at the 18th National People's Congress. There is a certain...
desire for precision with these events. Photo: Shutterstock
“Chinese authorities have been quite selective in terms of what part of the curve they will target,” says Li, adding that “ the front-end, seven-day repo [was at] reasonably heightened levels and that’s the part of the market where shadow banking would take place.”
If we look at one-year and beyond,” Li continues, “we haven’t really seen tightening because [authorities] still see a need to remain accommodative on the monetary policy front.”
“It’s happening on a selective basis… it’s more of an “off-setting” or a fine-tuning rather than the sort of across-the-board tightening that would not be received well by markets,” concludes Li.
The centrality of the NPC to Beijing’s current policy moves can hardly be overstated, which is one of several factors underpinning Wei Li’s view that any sort of “hard landing” is exceedingly unlikely at this juncture. As she notes, the NPC “is a half-term scorecard for [Chinese president] Xi Jinping, who is consolidating power in his party…
…I think it is fair to say that nothing big should or can go wrong at this point.”
For Li, there is more to the Chinese economy’s overall solidity than the sheer political will of its leaders, but that does not mean that they do not have some difficult terrain to navigate. “It’s important,” says Li “to remember that while the credit impulse is slowing down, credit is still expanding […] and this has long term ramifications because credit is growing faster than GDP, so the debt-to-GDP level, which currently sits at 260%, will grow even larger in the long term.”
According to Li, “we still need to talk about” how China can “soft land” from this bubble, but she also points out that “in the short term, [the ongoing credit expansion] actually alleviates concerns of a shorter-term hard landing.”
“Delta changes do not necessarily mean we are coming to a stall and we are still talking about a very large economic base, so it’s robust from that angle,” she adds.
It is this question of how best to treat delta changes that goes to the heart of Li’s analysis, and that provides a degree of the gap-exploiting insight required to get beyond the outermost layer of directionality.
The China-driven credit impulse slowdown is having and will continue to have significant global ramifications, placing commodity prices under pressure as demand winds down and deflating overblown sectors as the impact of easy credit withdraws from the landscape.
The trades and investments that this circumstance will favour may at times, however, be counter-intuitive as circumstances depart from trends. Concerning the Federal Reserve for instance, Li says that in her view the US central bank may be shifting its focus ever-so-slightly from a data- to a forecast-dependent stance.
“The latest Federal Open Market Committee meeting was interesting […] we saw, after all, that the weak CPI [release prior to the meeting] didn’t stop talk of balance sheet reduction and rate hikes,” says Li, adding that “it appears that they realise they are behind the curve and if that’s the context, than China slowing incrementally may not be significant in terms of rates or balance sheet reduction”.
Things, then, can be one thing and yet another. A slowdown in Chinese growth may impact commodity prices, exports, and ultimately the US economy without translating directly to Fed policy. A rising Chinese debt-to-GDP reading may risk of a hard handling while protecting, in the shorter term, from same. Disconnections, or opportunities, may occur between assets, between trend and circumstance, and between headlines and market movements.
“It’s important to look where are in the cycle and the consequent asset allocation questions,” concludes Li, “not just delta changes that we react to by getting either nervous or excited… often at rather close intervals”.
This is, in a sense, a volatility chart. Photo: Shutterstock