August 24, 2015

While in many cases a 38% decline in Equities from their mid-June peak, wiping out 16 months of gains in just 8 weeks, might have had substantial domestic economic effects – not least through the wealth loss in the Private Sector – the consequences of the decline in the Chinese market are slightly more subtle and global in nature.

A little background data might prove helpful; according to the China Household Survey of Finances, about 9% of Households participate in the Equity Market and Equities account for just 1% of Total Household Financial Assets. In comparison, Japanese, Euro and US Households have 10%, 18% and 33% of their Financial Assets in Equities. The loss of wealth and the direct effect on consumption in an economy of approximately $10 trillion and where Household Consumption is just 38% of GDP (versus 52% back in 1990) is, by any measure, modest. Moreover, the top quintile of Households by Income own over 90% of the Equities held by all Households and they have the lowest propensity, by far, to consume. China is just a little bit different.

So, what is the most worrying element of this whole affair?

As we have shown previously, the real problem of China lies in the fact that Manufacturing Productive Capacity Growth still substantially exceeds the rate of growth in demand globally. Domestic demand in the Euro area, UK, Japan and US is growing at just about 2.5% when Chinese Manufacturing Capacity is growing at almost four times that pace.

The gap is narrowing rapidly, and that is the source of the rapid slowing in Chinese growth, reflected in commodity prices, global growth and global inflation. However, it is still substantial and the excess that has been accumulated will take years to run-off.

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The consequence of this huge overhang in potential supply is very clear when you look at the growth rate of Global Merchandise Trade in the last decade:

  • China accounts for a fifth of the growth in Global Merchandise Trade in the 10 years through 2013, with the Asian bloc as a whole at 43% (22% if we strip away Japan and China).
  • At the margin, China (and Asia) have made a hugely disproportionate contribution to the growth in World Trade in the last decade. In that period, global production rose 2.7% annually when trade grew 4.7% annually.
  • In the 5 years up to 2013, China accounted for 27% of the growth in Global Merchandise Trade.

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In short, World Trade Growth has substantially outpaced production growth in the last decade and China has been a disproportionate contributor to that trade growth. China is the marginal provider of cheap goods – it is, in effect, the price setter in the global market for merchandise.

Now, if we add a devaluation to a massive overhang in capacity and the role of China as the marginal price setter globally, what do we get? Disinflation and Deflation.

China’s “out” from this slowdown – driven by years of debt accumulation, bank balance sheet expansion and grotesque over investment – is devaluation. The implication for the West is clear – deflation. This makes an exit from QE and a normalization of monetary policy almost impossible.

What is the impact of deflation on Equity markets?

Well, take a look at the following chart. We took one of the most reliable and commonly used valuation ratios – the Price/Trailing 10 Year Earnings – and looked at it over the last century and more versus US Consumer Price Inflation. You see something very interesting:

  • Over the whole period there is, as some have noted, a “sweet spot” for valuation – the blue bars have a distinct “hump” at the 5th and 6th inflation decile, which is when consumer price inflation is in the range 2.0 – 3.3%.  Note that valuation falls away quite appreciably when we get down into zero inflation and below that in the lower two deciles.
  • There is, however, some relief when we exclude the extraordinary period of the last 20 years and the bubble of 2000. Then we see that the “sweet spot” is, in fact, a consequence of a small number of observations around the 2000 bubble peak. Nevertheless, valuations do fall away noticeably at very low inflation/deflation periods (and at very high inflation levels).

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So, if our analysis is correct and we face a period of intense disinflation/deflation, then a lower valuation for Equities would appear entirely appropriate. In the meantime, reluctant to pin all hopes on a forecast, we continue to “observe and infer” i.e. to respond to changing market conditions rather than try, frustratingly, to anticipate them.

 

MONOGRAM CAPITAL MANAGEMENT