Cyclical gloss comes off

With structural problems back in the global economy, China needs a soft landing for emerging markets to catch a bid again.

If something cannot go on forever, it will stop. Stein’s law is particularly applicable to investors who for many months have been wondering just how long the strong cyclical momentum in the global economy can continue in the face of all sorts of structural problems, ranging from excessive sovereign debt to China’s overinvestment boom.
    
Well, the panic over the state of government finances in the Club Med countries and a premature outbreak of inflation in emerging markets has finally ended the Great Reflation trade. The focus is again turning to all the structural issues.
    
The reflation regime that led to a synchronous surge in every asset class across the world starting early 2009 began to show the first signs of cracking late last year with the Chinese equity market losing steam.

Chinese stocks over the past few years have behaved as the proverbial canary in the coal mine regarding the country’s growth prospects, and yet most analysts outside of China surprisingly under-appreciate their signalling power.
    
The pretext of never-ending Chinese demand sustained the rally in commodity prices and other so-called China plays — from currencies of major commodity exporting nations to global industrial stocks — until March 2010.

But the Chinese market had already started to drift lower several months ago in response to various policy-tightening measures aimed at controlling inflation and calming down rampant speculation in the property market where home prices have risen more than 30% nationwide over the past year.

Even now, while the Chinese equity market is back at June 2009 levels, many China plays are still 20-30% above last summer’s readings. The disconnect between Chinese equities and China plays was also apparent in the first half of 2008 when commodity prices carried on surging despite the slump in Chinese stocks.

The global financial crisis later in that year abruptly closed the gap and, this time around, the sovereign debt troubles in southern Europe are bringing about a return to rationality.

It should be of no surprise that tighter financial market conditions again end the disparity as abundant liquidity inflates China plays as much as the fundamental factor of economic growth in China.
    
So what happens after the divergence ends? The probability that China plays are now well past their period of best relative performance is a reasonable one.

China’s capital spending spree undoubtedly fuelled the commodity super-cycle and defined the investment performance of various asset classes over the past decade.

Materials and energy stocks were the best-performing sectors across regions while markets that topped the country league tables were the resources-rich economies of Brazil and Russia among the emerging markets and Australia and Canada in the developed world.
    
China’s economic size magnified the demand for commodities. No country in the history of economic development ran an investment-to-GDP ratio north of 40% for as long China did over the last 10 years.

Its capital spending is now larger than that of US or Europe, and China accounts for 25-50% of world demand for most industrial metals even though its share of the global economy is less than 10%. This equation is way out of line and is set to correct in future.
    
China’s investment boom is indeed showing signs of finally slowing down. After all, the country cannot build roads, rail networks and airports at the frenetic pace of the past few years.
    
Moreover, following the global recession in 2008, Chinese authorities injected a massive infrastructure-oriented stimulus that led to even greater excesses with availability of infrastructure in the country far above levels justified by its per-capita income.
    
Excess liquidity in the system is now finding its way into the property market, making the authorities wary of a property market bubble.

With the more affluent population buying multiple homes amid a speculative frenzy that is, in turn, pushing prices sharply higher, the average Chinese home-buyer is becoming increasingly resentful, as affordability is a major issue.
    
The price-to-income ratio on a national basis exceeds 10. Policymakers in China are well aware of the systemic problems any housing boom-bust cycle can cause after having seen the movie play out in the developed world.

To avoid the problem from getting out of control, they are likely to keep tightening the screws on the property market until prices start to cool.
    
The last time they engaged in such action was in early 2008; property transactions as well as prices fell sharply before the authorities took their foot off the brakes after the onset of the global recession.

The risk this time is that even stronger tightening is required as speculators — emboldened following the short-lived tightening of 2008 — refuse to back off easily. Just as the demand outlook for commodity prices is starting to deteriorate, the supply response is getting more aggressive.

Commodity producers are in the process of adding significant capacity with prices of most of their products trading well above the marginal cost of production — helped in no small measure by the large financial fund flows and the low cost of stockpiling.

The potential problem is that once supply momentum builds, it is hard to reverse as the fixed costs for commodity production are high and the variable costs are low.
    
Supply and demand dynamics at the start of the last decade were very different. New investment was little as commodity prices had been in a secular decline for 20 years and, back then, hardly anyone anticipated the size of the investment demand emanating from China.

The unexpectedly large rise in demand led to a disproportionate increase in commodity prices and in the profitability of commodity-producing companies.
    
The mega trend of one decade rarely extends into the subsequent one. From that perspective, the recent selloff in China plays may just be the start of a significant trend reversal as real estate and infrastructure spending account for a large share of China’s commodity consumption.
    
Apart from the China demand factor, huge amounts of easy money have of late led to a paper demand for commodities, with exchangetraded funds for various commodities attracting record capital inflows.

Nevertheless, the reflation trade has its limits: not all assets can continue to rise simultaneously without the prices of some undermining others.

Beyond a certain threshold point, commodity prices not only boost headline inflation but also usually pass through to other items over time in developing economies.
    
Of course, the proximate cause for the nearterm weakness is the Greek debt crisis. However, the bigger issue for emerging markets is the cyclical momentum is beginning to roll over as central banks tighten policy due to inflationary pressures. This does not bode well for risky assets.
    
It was only natural for some of the cyclical gloss to come off following the very powerful thrust of the past year.

The problem though has been further complicated with part of the liquidity pumped into the system to revive credit growth finding the wrong home, from commodity funds to the property market in places such as China. The debate now is whether China will have a hard or a soft landing.
    
If China can slow its economy down to 7-8% from the unwieldy double-digit pace it is currently running at by letting consumption growth continue at a robust pace while reducing investment spending, its soft landing will result in a structural decline in commodity prices and ease inflationary pressures in countries such as India.

The Chinese market will also achieve a higher valuation if it moves to a more sustainable growth path after the usual initial hiccups related to a somewhat slower growth profile. It’s worth recalling that Japan’s growth slowed from 8% in the 1970s to 5% in the 1980s, yet the stock market boomed.
    
China’s stock market will be the best leading barometer on how the economy is faring in its attempt to engineer a soft landing.

The current message from the market is that slower Chinese growth will be more welcome than the pattern of strong growth driven by overinvestment that leads to higher inflation through commodity prices.

The model of commodity-intensive, hyper growth cannot continue forever and if there is any merit in Stein’s law, then it will stop.