Most people would explain the rally in global risky assets since mid-February as being primarily down to the spectacular volte-face from the Federal Reserve, where Janet Yellen (and others) dramatically toned down their narrative that the Fed would be hiking rates as many as four times in 2016. This explanation makes a lot of sense, although I would argue that the underlying reason for the sudden dovish outburst was possibly more to do with the dramatic weakening in the US economy that had occurred since December (which we discussed here) than the still-prevailing belief that the Fed has suddenly somehow become globally aware.
But the jump in risk appetite hasn't all been about the utterance of a few words from policy makers in the world's biggest economy. The world's second biggest economy has also played a major role.
China's economy was staring into a very deep hole last year. Real estate prices were tumbling in almost every city. The economy was stagnating, with the Caixin China Composite PMI having slumped to 48 in September last year, the lowest since January 2009. The Renminbi came under severe pressure, not helped by its semi-peg to the soaring US Dollar, and huge and destabilising capital outflows were the consequence of this.
The authorities in China have responded to last year’s slowdown by unleashing a monetary stimulus that on one measure is greater than the expansion of 2009. The chart below shows that the ratio of M1 money supply growth to M2 money supply growth, which has historically been a good indicator of economic momentum, has reached the highest level since data began in 2005. The M1/M2 ratio is a measure of liquidity in an economy, where M2 money supply is a broad measure consisting of cash, savings and deposits flowing through an economy (therefore including loans and securities investments, which is why M2 is equivalent to credit growth), while M1 money supply is a narrower, more liquid component including only cash and demand deposits.
The Chinese economy has picked up on the back of this stimulus, with the composite PMI bouncing back from its September low and returning to its average of the last five years. Together with the depreciating US Dollar, the cyclical rebound in China has also helped fuel the commodity price rebound, which has in turn provided a much-needed boost to emerging markets and commodity exporters.
But while the quantity of China’s growth may have stabilised, the quality of growth has sharply deteriorated. China’s huge monetary easing resulted in real estate services jumping 9.1% in Q1 from the previous year, while construction rose 7.8%. It appeared that China was back to its bad old ways, and gunning for short-term gain, where the expense is surely long-term pain.
What’s perhaps even more disconcerting is that the economic rebound in China hasn’t been considerably greater, given the scale of the stimulus. Official growth numbers in China are notoriously unreliable, but China’s economy grew only 1.1% in Q1 from the previous quarter, the slowest quarter to quarter expansion since 2011. The chart above suggests that China’s monetary stimulus should have resulted in a far greater growth rebound. It’s also curious that the surge in M1 hasn’t been accompanied by a surge in M2.
And the most recent monetary data releases, together with wide reports that the PBOC has (perhaps in response to recent warnings from the IMF) asked its banks to cut down loan underwriting, suggest that the cyclical recovery in China may already be over. After a surge in new Yuan loans in Q1, Thursday’s release showed a sharp fall as China’s banks underwrote 555bn yuan in new loans in April, down from 1.37tn in March, and well below market expectations of 800bn.
If the brake truly is being applied to China’s cyclical bounce, then it won’t be long until China’s severe structural problems re-emerge. I (and others) have written many times in the last five years about why China’s growth rates are set to plunge (for example see here); China faces a daunting challenge, where private debt levels are in excess of many developed countries’ pre-2008, where the working age population is now falling (relaxation of the one-child policy came 20 years too late), and where China is now suffering from a competitiveness problem on the back of years of real exchange rate appreciation, but can’t depreciate its currency without causing a re-emergence of destabilising mass outflows. Running higher and higher credit leverage in an effort to hit an unsustainable growth target can only end one way.