As a guy, these are the most dreaded four words you can hear when you’re in a relationship. In fact, there are only two likely outcomes following those four words. One is that you find yourself knee-deep in a bottle of bourbon on a guys’ night out. The other is that you personally prop up the stock price of 800flowers.com when you order the “I’m so sorry and I’ll happily deplete my retirement account to show you how sorry” bouquet of roses, with expedited shipping.
For those who struggle to translate the opposite sex, “We need to talk” means she needs to talk and you need to listen.
Well, this week it’s time for a role reversal, because I’m the one saying that “we need to talk” to all the investors out there who think that paying attention to equity markets is more important than focusing on the underlying economic conditions of a given economy. So, grab your passport, put your seat and tray table in their upright position, and let’s take a trip to The Red Dragon.
“Don’t Worry About It”
She’s telling you, “I’ve asked you five times to take the trash out and you still haven’t done it?! You’re undependable.”
However, don’t worry about it if you ignored my call on slowing Chinese growth from two months ago or last month. When I initially brought up the China slowing subject in September, no one was discussing it, and now suddenly you can’t find an article on China that discusses anything else.
Last week, the Big 3 of Chinese data (industrial production, retail sales, and fixed asset investment) confirmed my perspective and caught the attention of investors everywhere.
Industrial production slowed in October, continuing its downtrend since peaking in March. It was clear from the report that the government’s crackdown on pollution is crimping the materials sector of the economy. Production growth across cement, steel and aluminum are all contracting at an accelerating rate.
Retail sales also slowed, continuing the trend that’s been in place since June. Retail sales is one of the data sets most impacted by China’s attempt to shift from an investment-led economy to one that is consumption-led, which more closely mirrors the U.S. economy. Last month’s slowdown was driven by auto sales, which are the largest component of the Chinese retail sales number. Auto sales growth slowed substantially from the September rate and absolutely fed into the slow industrial production growth number I discussed above.
And finally, fixed asset investment growth completed the trifecta by slowing for the sixth consecutive month. For the uninitiated, fixed asset investment is one measure of capital spending and refers to any investment in physical assets, such as real estate, infrastructure, or machinery.
“It would be nice if …”
She’s telling you that everything following the “if” is meant to be interpreted as an unconditional order.
Until recently, China’s property sector has been on an absolute tear, fueled by the nation’s credit bubble.
However, President Xi dropped his own version of “it would be nice if …” when he warned at the recent Party congress that “Housing is for living rather than speculation.” His shot across the bow of real estate investors is beginning to look prophetic.
Housing sales growth turned negative for the first time in thirty-one months. Housing new starts are now contracting for the first time all year, and property investment growth slowed to 5.4% in October from 7.4% in Q3.
If President Xi is serious about curbing speculation in the housing market and pushing through further financial reform, then this initial slowdown in housing could be just the beginning of a much longer downtrend in Chinese real estate.
She’s telling you it’s anything but fine. I’m telling you Chinese equity cheerleaders want you to ignore the data, focus on the 34% year-to-date rally in Chinese equities, and believe everything is fine.
Unfortunately, I’m going to have to take her side in this argument. When Chinese growth slows while inflation accelerates (which is happening right now), Chinese equities are anything but fine.
Since 2010, there have been three regimes lasting at least five months when growth slowed while inflation accelerated: December 2010-September 2011, December 2012-November 2013, and May 2015-April 2016.
During those three regimes, the iShares China Large Cap ETF (FXI) returned -27.3%, +1.8%, and -3.4%, respectively. While the returns are a bit scattered, they are clearly anything but bullishly inclined. On the risk side of the ledger, FXI’s maximum drawdowns registered at -32.4%, -23.8%, and -28%, respectively.
The bottom line is that when the Chinese economic equation is growth slowing plus inflation running, it equals a crash in Chinese equities. Ouch!
This one is not gender specific: every single one of us figured out by the age of four what it really means when someone says “maybe.”
Despite the economic backdrop and the data to support it, a Chinese equity market correction is not a foregone conclusion, it’s a “maybe.”
Historically the PBOC likes to juice the stock market with excess liquidity when they see it teetering. There has been a lot of big talk out of China lately about financial reform. They are actively trying to deflate their massive credit bubble without sending themselves, and the rest of the globe, into an economic tailspin.
If Chinese equities begin to hurl themselves towards Earth, I remain unconvinced the PBOC won’t open up the fire hydrant of liquidity right into the streets of financial markets.
For now, the developments in China remain as a watch-and-wait scenario, but the Gravities are beginning to align for a short bias on Chinese equities and an opportunity to go huntin’ for wabbit.