BLOG

When discussing how the current market has changed in the past year, Morgan Stanley's cross-asset strategist Andrew Sheets said yesterday that one of the things that stood out to him at recent meetings with clients and conferences is that "China is rarely mentioned as a growth concern (after causing angst for much of this period)."

This could be a significant error in light of the PBOC's recent confirmation - by way of Sunday's latest RRR cut - that the Chinese economy has major problems, above and beyond the woeful performance of Chinese stocks in recent weeks, the blow out in Chinese bond yields for riskier companies, the surprising spike in corporate defaults, the record high and growing leverage and overall economic slowdown.

To be sure, much of China's recent weakness has its genesis in what we noted earlier in the month, namely the sharp slowdown in China's credit creation...

... as a result of the ongoing crackdown on shadow credit creation. 

In other words, it's all about China's credit impulse, once again.

As a reminder, two weeks ago we noted once again that according to most flow-tracking economists (and not their conventionally-trained peers) when one strips away the noise, there are just two things that matter for the global economy and asset prices: central bank liquidity injections, and Chinese credit creation. This is shown in the Citi charts below.

The biggest problem, of course, is that both are set to decelerate.

* * *

We bring up this lengthy intro because in his latest note, Nomura's head of cross-asset strategy, Charlie McElligott, tackles the topic of the "global growth scare" which has gripped markets in recent weeks, and traces its origins not to the traditional market scapegoat, namely Trump's trade rhetoric and actions, but a far more tangible concept: the collapse in China's credit impulse.

Here is how McEliggott explains it in "Downshifting into a Growth Scare"

Tactical “risk (sentiment) downshift” message from last Monday’s note regarding the “market inflection” of the past month takes further hold, as the market trend deteriorates further and indicates a burgeoning “global growth scare”

  • Clear signals of past month to “cut” directional “Cyclical Melt-Up” bets and get “tactical” / “market-neutral” grow even stronger last week / today, as we continue to transition into my expected “Financial Conditions Tightening” phase of 4Q18 / 1Q19—“risks” are accumulating and “red flags” are growing:
    • USTs / Rates rally further despite this month’s strong U.S. data and “hawkish hike” Fed, driving gradual covering in USTs from legacy CTA / trend ‘placeholder short’ positions
    • YTD Commodities rally (Classic late-cycle) now seeing “breakdown:” BCOM Total Return Index -5.1% over the past month / BCOM Industrial Metals TR Index -6.8% over the past month / BCOM Agricultural TR Index -10.5% over the past month
    • “Defensive” Equities now rallying powerfully over prior “Cyclical” leadership, while too we see MTD reversal in “Value” outperforming “Growth” as further signal of this very “late-cycle” market shift / rebalancing / rotation
    • QE-era “easy carry” plays such as Emerging Markets see further redemption unwind pressure, with largest EEM outflow ever last week (-$3.0B) and a -3SD sale of MSCI EM Equities futures by Asset Managers and Leveraged Funds (-$2.8B)
    • “Quant Insight” macro factor PCA model too picking-up on this “regime change,” with 9 of 18 “major markets” –tracked no longer “explained” by their prior macro price-drivers—previously a reliable signal of a potential “volatility event” over next 1-2m
    • Away from market-based indicators of said “risk (sentiment) downshift,” recent “dovish” policy pivots from the ECB and PBoC too signaling “growth downgrade”
  • PBoC “easing” moves looking increasingly “frantic”: just this morning, they have 1) cut the SME loan relending rate, 2) made SME loans eligible as MLF collateral and 3) increased the SME loan relending quota to promote small businesses—all on top of 4) this weekend’s “as expected” RRR cut—and still we see Chinese (& Asian) equities sold overnight
  • Chinese Equities looking increasingly as “patient zero,” with a double-whammy “growth scare” into the larger “QE to QT” regime shift: Shanghai Comp -9.8% QTD, Shenzhen Comp -14.4% QTD, Shanghai Property Index -8.1% QTD
  • Chinese Yuan as another proxy for this “regime change”: the largest 8d weakening in offshore CNY vs USD (3.1 Standard Deviation move) since the “devaluation” shock of Aug ’15 -> PBoC is using the Yuan as their “weapon of choice” in the “tit-for-tat” of trade war rhetoric
  • An escalation of / persistent weakening in the Chinese Yuan has potential to trigger a global “disinflationary impulse” via the supply-chain and contributing to further USD upside as a headwind to EM, Commodities and U.S. growth
  • Asian EM “bleeding,” as “trade war” and overall “growth scare” impacts the psyche and drives “outflow” concerns: CNY, IDR, TWD, KRW and THB are the five worst-performing EMFX tracked by Bloomberg globally over the past week
  • EM Equities underperformance analogs (especially vs Russell 2000) run by my colleague Anthony Antonucci speak VERY negatively over the next 6m period for both EM Equities and U.S. Small Caps, where using the current NDUEEGF underperf vs RTY (-18.2% over the past 3m) is a 1%ile return; prior -15.0% over 3m underperf analogs shows on average an EM Equities return of -7.3% / a RTY return of -5.2% over the following 6m period, respectively
  • Market consensus now utterly focused on 2020 as U.S. “recession year,” with enormous interest from Cross-Asset / Macro funds in forward “Curve Cap” trades (reach out to set up a call on our favorite trade expressions)
  • These curve options play for a “risk-off” UST curve STEEPENING due to inevitable U.S. economic deceleration (plus diminishing “half-life” of late-cycle U.S. fiscal stimulus) which would see FOMC normalization efforts pivot to “easing,” due to the impacts of recession and the much larger “secular stagnation” theme

COMMENTARY:

As noted in last Monday’s critical “phase shift” note, “signals” are accumulating which are indicative of the choppy transition in my “Two Speed Year” thesis: it seems that we are in the midst of the move from the “Cyclical Melt-Up” phase 1 to the “Financial Conditions Tightening” phase 2.

It is increasingly clear to me that China is the source of the this “new front” in the negative “QE -> QT” transition, as it seems we are in the midst of a good old-fashioned “growth scare” on top of the complications of tightening global financial conditions thanks to the Fed normalization effortsThe driver is likely the multi-year “deleveraging” efforts by the PBoC, which in turn is now bleeding into weaker domestic- and global- growth & inflation data.  To my favorite “flow-chart”:

FADING CHINESE “CREDIT IMPULSE” AS THE CANARY BEHIND THIS “GROWTH SCARE”:

Source: Bloomberg

CHINESE 1s10s CURVE TOO INDICATING SAID “GROWTH SCARE” AND SIGNALING LOWER GLOBAL COMMODITIES

Source: Bloomberg

CHINESE GOVERNMENT BOND YIELDS SPEAKING TO “CATCH-DOWN” FOR EMERGING MARKETS EPS AS WELL:

Source: Bloomberg

As confirmation of the “growth scare” concerns, the PBoC’s “easing efforts” of the past few months are looking increasingly “frantic,” as the prior RRR cut (and small biz tax cuts, and MLF collateral rules easing) was escalated over the weekend in response to the total meltdown in Chinese Equities markets being experienced (Shanghai Comp -9.8% QTD, Shenzhen Comp -14.4% QTD, Shanghai Property Index -8.1% QTD).  This weekend’s RRR cut was far more powerful than the prior April-kind with regards to the liquidity injection it can drive via the ‘debt-for-equity’ swap program, which is designed to ease credit strains and boost small business. 

Nonetheless, Chinese (& Asian) Equities STILL sold off…so after the close, the PBoC announced FURTHER easing measures (as they go outright “kitchen sink” route), 1) cutting the SME loan relending rate, 2) making SME loans eligible as MLF collateral and 3) increasing the SME loan relending quota.  Geez.

But the most obvious “easing” tool for the PBoC looks to be the Yuan, in large part due to the escalation of “trade war” tensions.  The current 8 session weakening in offshore CNY vs USD (3.1 Standard Deviation move) is the largest since the “devaluation” shock of Aug ’15.  For this reason, we are seeing  a demand for equities index options downside trades, cheapened significantly by contingent CNY weakening (hit me for more details).

LARGEST WEAKENING IN YUAN SINCE THE PBoC SHOCK DEVALUATION OF AUGUST 2015

Source: Bloomberg

An escalation of / persistent weakening in the Chinese Yuan has potential to trigger a global “disinflationary impulse” via the supply-chain and contributing to further USD upside as a headwind to EM, Commodities and U.S. growth.  As such, we see that over the past five sessions, the five weakest EM currencies tracked by Bloomberg are Asian: CNY, IDR, TWD, KRW and THB.
 
This “rolling EM meltdown” is another expression of the “QE to QT” reality, as the “easy carry” environment of the post-GFC period now “coming home to roost” in the form of “skinny exits” for redemption flows.  Last week EEM saw it’s largest weekly outflow (-$3.0B) ever, while MSCI EM Equities futures also saw a monster -$2.8B outflow combined across Asset Managers and Leveraged Funds—a -3 standard deviation move.  For some context however on how much more “room to go” there is with potential EM “capitulation ahead,” look at this chart of the current outflow vs the 14 year inflow:
 
YOU ARE HERE—EM EQUITIES AND DEBT FUND FLOWS OVER THE PAST 14 YRS:

Source: Bloomberg