China rides to the rescue?

The headlines from last week sounded dire. It began when China’s May economic activity report was disappointing, with industrial production, retail sales, and fixed-asset investment missing market expectations. 


Then the Federal Reserve took an unexpected hawkish turn. The statement from the FOMC meeting acknowledged that downside risks from the pandemic were receding as vaccination rates rose. It raised the 2021 inflation forecast dramatically, shaded down next year’s unemployment rate, and projected two rate hikes in 2023 compared to the previous forecast of no rate hikes. As well, a taper of its quantitative easing program is on the horizon.


Collapsing global trade and growth. Rising interest rates. It sounds like the start of a major risk-off episode.


My own reading of cross-asset market signals comes to a different conclusion. China’s slowdown is stabilizing, which may serve to put a floor on global risk appetite and equity prices.



Mapping China’s slowdown

In the past few months, there has been growing concern over a slowdown in China’s credit growth. Total social financing (TSF) has been rolling over as Beijing normalized policy after the pandemic.



These conditions have sounded the alarm over a China slowdown. Historically, this has led to negative consequences for global growth and capital market returns.



China watcher Michael Pettis gave a more optimistic interpretation in a Twitter thread.
TSF will grow 9.3% in 2021. This is roughly equal to consensus nominal GDP growth expectations, in which case we will have seen a stabilization of China’s debt-to-GDP ratio – something Beijing has promised will happen this year. Because we’re all expecting last year’s contraction in consumption to be partially reversed this year – and not just in China – 2021 will be the only year in which Beijing has a real shot at stabilizing Chinese leverage even as GDP continues to grow quickly.


Shehzad Qazi of China Beige Book, which monitors the Chinese economy from a bottom-up perspective, noted that “among firms that borrowed new lending (rather than rollovers/credit extensions) did rise”, indicating that credit is going to more productive activities than just rollovers.


My own market-based indicators appear constructive. The relative performance of MSCI China and the stock markets of China’s major Asian trading partners relative to MSCI All-Country World Index (ACWI) are all showing signs of stabilization. Most markets are holding relative support levels. Taiwan and Australia are exhibiting nascent relative uptrends.



The AUDCAD exchange rate is also a useful market-based indicator of the Chinese economy. Both Australia and Canada are resource-exporting countries of similar size. Despite recent trade frictions, Australia is more sensitive to Chinese growth as most of her exports are either to China or the Asia-Pacific Rim, which are levered to China. By contrast, Canadian trade is more sensitive to the US economy. 



AUDCAD recently bounced off an important technical support level after peaking in March. I interpret this as another sign that the trajectory of Chinese economic deceleration is bottoming.


Another reason for greater stability in Asia is the buffer provided by foreign exchange reserves. Bloomberg report that Asian EM FX reserves have grown significantly, which makes them more resilient to external shocks.


Asia’s emerging economies have accumulated their highest level of foreign-exchange reserves since 2014, offering a powerful buffer against market volatility if the U.S. Federal Reserve changes course. Central bank holdings of foreign currencies in the region’s fast-growing emerging economies hit $5.82 trillion as of May, their highest since August 2014. When China’s cash pile is stripped out, emerging Asian central banks’ reserves stood at an all-time high of $2.6 trillion. In 2013 a signal that the Fed would begin winding down asset purchases sent shockwaves through Asia, an episode that came to be known as the “Taper Tantrum.” Foreign investors fled and bond yields shot up, forcing central banks to burn through their defenses to protect their currencies. 



The Fed’s hawkish turn

The FOMC took a hawkish turn at its meeting last week. Its Summary of Economic Projections showed that participants significantly marked up the 2021 inflation rate, regardless of how it’s measured. However, inflation is expected to decline next year indicating the transitory nature of the price increases. Moreover, it is now expecting two rate hikes in 2023, compared to none in the March SEP.



Translated, the Fed believes that pandemic-related downside risks to the economic recovery are falling. It’s seeing signs of transitory inflation. While it’s difficult to forecast policy very far out, it would be prudent to begin removing monetary accommodation and think about raising rates in about two years.


The economy is recovering and gaining momentum, it’s time to gradually take the foot off the monetary accelerator. The Citi Economic Surprise Index, which measures whether economic releases are beating or missing expectations, is rising again after bottoming out recently.



Across the Atlantic, the Eurozone ESI recovered strongly in the second half of 2020 and momentum is strong. The ECB has also signaled that it intends to stay accommodative for a very long time.



These are signs that the rest of the world has decoupled from China and fears of a China slowdown were not dragging down the global economy.



Equity market implications

Here is what it means for the equity markets. Market valuation depends on two factors, the P/E ratio, which is a function of interest rates, which are expected to rise, and the E in the P/E, which is also rising too.



This environment should be bullish for cyclically sensitive equities. The Rising Rates ETF (EQRR), which is tilted toward cyclical and value stocks, is testing a key relative rising trend line. While I would not suggest investing EQRR because of its low AUM which invites a wind-up of the ETF, it is nevertheless a useful barometer of market factor trends.



In particular, I would focus on the commodity-producing parts of the market. PICK is a global mining ETF that is just testing its long-term uptrend.



Energy stocks are also exhibiting both absolute and relative uptrends with strong underlying breadth.



There are several reasons to be bullish on these stocks. First, they exhibit cheap relative valuation.



These stocks are also enjoying the tailwind of strong demand-supply fundamentals. The WSJ reported that there is little current capacity available to meet rising demand from a global recovery.

Languishing commodity prices led producers to slash capital spending on major resources by nearly half over the last decade, shrinking stocks of industrial metals to two-decade lows and reducing supplies across commodities. The crunch is now converging with a buying spree in key markets to supercharge prices—and there is no quick fix.


Since 2011, investments to develop the energy and mining sectors have fallen 40%, according to asset manager Schroders, leaving many producers unprepared for a recent boom in manufacturing and spending in the world’s two largest economies. Prices of resources from corn to lumber to battery metals have risen sharply over the past year, in many cases to twice or more from pre-pandemic levels, aided by low interest rates, a weaker dollar and infrastructure building in the U.S. and China.
Normally, producers respond to higher prices by increasing supply. In this cycle, mining and energy capital expenditures have languished. In particular, the energy sector is cautious about expanding capacity when forecasts call for falling demand as users shift to renewables.



In the short-term, however, investors are already overweight the cyclical and reflation trade. The latest BoA Global Fund Manager Survey shows that respondents are overweight commodities, banks, and cyclically sensitive sectors like industrials. If a pullback were to occur, investors should regard that as a welcome sentiment reset to gain cyclical exposure.




No market crash

In conclusion, investors should not expect the stock market to crash despite the dire headlines. Real-time indicators such as the copper/gold and the broader base metals/gold ratios indicate a sideways pattern in risk appetite. This should not lead to a major risk-off episode.



From an intermediate-term perspective, the current environment is bullish for cyclical and reflation stocks, and especially resource extraction sectors owing to the lack of a supply response in the face of rising demand. Signs of stabilization and a possible bottom in China’s growth trajectory will also be supportive of commodity demand, as China has been the primary consumer of global commodities. However, investors are already long the cyclical and reflation investment theme, and a pullback would represent a buying opportunity.



16 thoughts on “China rides to the rescue?

  1. Yesterday was triple witching. There was a huge fall in the September S&P 500 contract (ESU 21) between 4 and 5 PM. Was this because of expiration of options on ES or was it because of expiration of S&P 500 call options (that are settled using ES futures)?
    Options (like futures expire) at 5 pm. So, even S&P 500 calls may be settled using futures (?).
    The reason I am asking this is that this may be an important trading strategy on Triple and Quadruple witching days. Thanks.

    1. Yesterday everywhere media headlines say there are $818B worth of single stock options expiring the same day. Very unlikely people would bet on that many options on average single stocks, more likely for indices and mega techs. Look at the weekly volume for DIA, QQQ, SPY. Really big. So it looks like many SPY call options expired worthless. Many option traders also set auto limit on loss/gain (a lot of them using 50%). So there might be some auto early exits.

      Every 3-month the context starts anew. So starting from next Mon we will start a new cycle. Let us observe how this new context unfolds and we will know by Sept how to position for next triple/quad expiry for short-term trades.

      As a general rule, up will be down and down will be up approaching expiry. This is how dealers/MMs profit and screw option buyers. But they don’t always prevail. Sometimes we have overwhelming flows like institutional 60/40 rebalance, like end of 2018. Yesterday this rebalance helps MMs. TLT is up and SPY is down. So yes, this can be one of your tactical moves when you align with MMS/dealers every three months. Add a few other indicators and the win rate increases substantially.

  2. Last week was a train wreck for Value and I’d like to throw out a few thoughts. Before I talk about possible negative scenarios, let me offer a shining ray of light. The Healthcare sector did great. A likely reason is that Obamacare was upheld in the Supreme Court. My perennial favorite ETF, the Medical Devices ETF (IHI) has finally become a momentum buy again. Yippee.
    Titanium hips (elective surgery now possible with Covid down), remote medicine, to robot surgery and on and on for an aging population.

    Now the gloom. What if this break in the markets is the beginning of a bear market and not a normal intermediate correction? I don’t think it is because there are no economic stressors and the Low Vol Factor is not outperforming but what if a bear market is unfolding? Here is a possible reason, the Delta Covid Variant.

    This last week in the UK where the population has had a very high vaccination rate and high amount of previous Covid infections, had 8000 people with new infections (a big jump from a thousand or so) and 800 hospital admissions with the Delta Variant (for my example I’m using round numbers for clarity of concept). Of those, 65% were people who had no vaccination, 25% had one jab and 10% HAD TWO JABS!!. Our local hospital reported four Delta infections in people who had both jabs.

    The Delta Variant is picking up steam in America and around the world. It is more infectious and more deadly. What if the joyous re-opening we are experiencing now turns into a huge fourth wave over the next few months or is even starting now. February and March 2020 saw markets getting a surprise sideswipe when Covid hit unsuspecting investors. Are some savvy people seeing a problem out there?
    Before reading this British statistic I was totally expecting a glorious race to herd immunity and grand reopening of the economy. Most of the population has only one vaccine shot. Seems the Delta Variant laughs at one shot.

    This also begs the question, that if the Delta Variant is so resistant to the vaccines, it will play havoc on the developing world worse than we have imagined. Rich nations are sending out a billion vaccine doses. That is 500 million double doses but I’m sure they are expecting to vaccinate a billion people with one dose. The Delta Variant laughs at one dose. What impact will a global Delta infection wave have on commodity demand and global economic growth in general? Substantial, is my guess.

    This is just a ‘What if’ thought process and not my basic call on the market’s direction. I will say the British news announcement gave me a chill.

      1. Likely we are transitioning back to a slow growth era like 2018 but with viruses always hanging up there globally. So this makes robust growth unlikely. Currently 5y and 10y breakevens are declining. So this is good on inflation front. Indicators copper/gold and lumber/gold are back to 2018 levels. So more or less markets accepted the Fed’s narrative.

        As in any damped system the response always has ringing (local over/under-shoots) when an excitation is applied. Eventually it settles at an equilibrium. So expect resources to bounce back but not aggressively, after techs have their fun. Basically the easy money has been made. It now enters an environment where more trading is needed.

        This virus has opened the door for mRNA technology. Intuitively we should invest in Moderna. But this technology has also opened the door for a biotech boom. We should invest in arms dealer: A, RGEN, TMO, and DHR to lesser degree, then WST.

      1. The key thing about manipulating commodity prices is that it doesn’t work for very long. Unlike stocks, commodities are pure, supply and demand items where end-use buyers load up for the amount they need.

        If demand for industrial metals, especially those in the Green Energy, EV business, rises as forecast, their prices will soar. Agricultural prices will also rebound as the global economy rebounds.

        I expect this pull-back in commodity prices is just a speed bump in the long term upward trend.

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  3. We returned last night from a week in Oahu, our first real post-pandemic vacation. I would say that Hawaii has a good handle on safety measures, whether entry restrictions or compliance among residents/visitors to the usual guidelines. Most people opted for outdoor masking as well, although obviously if you’re hiking/ swimming/ sitting along the beach they come off.

    Life on the island is generally back to normal, even in remote areas along the North Shore. The one drawback? You’ll need reservations for just about every meal. Long lines even for coffee. I think businesses that cater to tourists failed to anticipate the demand and/or are unable to hire enough staff. Car rental rates are sky high (rental fleets were shipped to the mainland during the pandemic, and it will take time to ship them back). We were able to rent a 2016 Tesla Model X, but had to pick up from /drop off to the homeowner that the rental agency subcontracts with. Hiring a cab 6-8 hours a day would have been less expensive. Nothing else has changed – good food, friendly people, and great beaches/hikes.

  4. Hi Cam, Ken,

    Just wonder if you’re at all concerned about the another key beneficiary (banks) of growth to value rotation.

    KRE/SPY broke down key support level with a rounding top (frowning face).

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