China Toes a Delicate Balance
By Chris Maxey, Ryan Davis
June 11, 2012
Markets Post Best Week of 2012
Markets posted their best returns of 2012 last week as investors anticipated additional policy action from global central banks. The S&P 500 rose 3.7% and the Dow Jones Industrial Average advanced 3.6%. The yield on the 10-year US Treasury rose 18 bps and ended the week at 1.64%.
A series of events during the week heightened optimism that central banks would once again step in to support financial markets. In a Wednesday release, the European Central Bank did not cut its policy rate, but ECB President Mario Draghi said the bank was “ready to act” in response to the deteriorating state of the Eurozone. Indeed, investors did not wait long for such action as Spanish officials requested aid in the sum of $125 billion for its troubled banking system over the weekend.
On Thursday, China announced it had cut its lending and deposit rates by 25 bps, the first such cut since 2008. China has largely been implementing monetary policy through bank reserve ratio requirements in recent years, making the country’s latest announcement a more explicit attempt at stimulating its economy.
The bigger question remains the Federal Reserve. While Ben Bernanke was neutral on additional quantitative easing in public comments last week, there is a feeling that recent economic deterioration could force his hand. An article by Jon Hilsenrath in the Wall Street Journal, considered by many to be one of the closest sources to the Fed, reported last week that the Fed was considering more action amid the faltering recovery.
Additional action begs the question of whether there is a diminishing rate of return for new stimulus. While QE1 and QE2 saw sustained multi-month rallies, market response to the LTRO program did not quite reach the same magnitude. Without structural improvement in the debt crisis, it remains to be seen how powerful a new QE-induced rally would be.
Source: Thomson Reuters
In a limited week of economic data in the US, there were a few positive surprises. The Federal Reserve’s Beige Book, which summarizes economic conditions across the 12 Fed districts, also painted an encouraging view of the US economy, despite negative results in recent data.
Wednesday’s Fed report noted that overall economic activity expanded at a “moderate pace during the reporting period from early April to late May.” This strength was widespread among the districts, except Philadelphia, which noted slowing growth.
Growth was also widespread by sector. The Beige Book noted expansion in industries such as manufacturing, new vehicle sales, travel & tourism, information technology
services, and energy production & exploration. Notably, the report indicated improvement in residential and commercial real estate, as well as construction activity.
Finally, the Beige Book indicated that consumer spending and hiring activity was stable to slightly better. The report noted that employers continued to have difficulty finding qualified workers for positions. This is a theme echoed in the ISM reports and elsewhere, and singled out as one factor delaying a recovery in the labor market.
On Tuesday, ISM released its monthly Non-Manufacturing index (NMI). The headline index rose 0.2 to 53.7, slightly above consensus expectations. Strength was concentrated in the business activity and new orders indices, which rose 1.0 point and 2.0 points, respectively. This is the 29th straight month the NMI has been in expansionary territory.
One negative takeaway from the NMI was a significant slowing in the index’s employment component. The measure fell 3.4 points to 50.8, just marginally above the point of contraction. May marks the second consecutive month that this index has dropped at least 2.5 points, a troubling development that mirrors weakness in the nonfarm payroll data.
Consumer credit continued to expand in April, albeit less that economists expected. The Federal Reserve reported consumer credit increased by $6.5 billion, with non-revolving credit driving the advance. Revolving credit contracted, indicating credit card use fell during the month. April’s 3.1% annualized rate of credit growth represented a slowdown from the fourth and first quarters’ rates of 6.7% and 5.8%, respectively.
Despite April’s moderation, consumer credit continues to expand at a healthy clip. A large chunk of this is attributable to student loans, but this lending should nevertheless filter through to additional spending by consumers. The trend in revolving credit should be watched, however, as that metric had largely stabilized in the past six months. April’s 4.8% decline was the biggest drop since April 2011, and just the third decline in the past 12 months.
Initial jobless claims improved somewhat in the week ending June 2, as the series fell 12,000 to 377,000. This was slightly below estimates, and even stronger when considering the prior week was revised upward by 6,000. Still, the overall trend during the past two months has been creeping higher. The four-week moving average advanced to 377,750, roughly 14,750 higher than the end of March.
On Friday, the Census Bureau reported that the US trade deficit narrowed to $50.1 billion in April from $52.6 billion in March. Both exports and imports fell in April, with a bigger decline in imports modestly shrinking the deficit. Declines in the imports of goods were responsible for weakness, as service imports were roughly unchanged. April’s numbers may reveal more of a self-correction than anything, however, as March saw a dramatic jump in the US trade deficit from $45.4 billion to $52.6 billion.
Overseas, there were a few important indicators of note. First, the second estimate of Eurozone GDP for Q1 reaffirmed the initial estimate of zero growth. The figure was boosted by an unexpected 0.5% advance in Germany, while France (flat), Italy (-0.8%), and Spain (-0.3%) exhibited significant weakness.
Unfortunately, several measures point to an even weaker quarter in Q2. Industrial production for Germany in April contracted by 2.2%, a much deeper loss than economists predicted. Meanwhile, the Eurozone’s service PMI fell deeper into contractionary territory, while a separate measure of retail sales also fell more than expected.
These metrics and others all but confirm that most of the region is in recession. Harsh austerity and slowing global demand is weighing on already anemic economic growth. Signs that economic deterioration is spreading to Europe’s core economies also paint a bleaker picture for the continent moving forward.
This development is having an impact on companies with foreign revenue exposure. As reported by Bespoke, S&P 500 companies with more than half of their revenue derived overseas are underperforming purely domestic companies by nearly 10% over the past 12 months. Most of that gap has occurred in the past two months as the sovereign debt crisis intensified and the US dollar rallied.
Source: Bespoke Investment Group
China Toes a Delicate Balance
With many of the headlines focused on Europe recently, investors have paid less attention to the ongoing situation in China. Chinese officials, in response to weakening economic activity, are actively moving to reinvigorate the economy. Some believe their actions will prove futile, but with trillions of dollars of reserves at their disposal, there is very good reason to think China will find its way through this tumultuous period.
Over the weekend, China released a deluge of data on the state of its economy, ranging from inflation trends to retail sales. In the lead up to the releases, Chinese officials made some drastic maneuvers, leading many to wonder if things in mainland China are worse than believed. In a certain sense, they were right.
Prior to the weekend, Chinese officials took measures to ease liquidity in the country by reducing the benchmark lending rate to 6.31% and the deposit rate to 3.25%. It is the first time China has cut rates since 2008 and while China has taken measures to reduce the required reserve ratio (RRR) for banks, outright interest rate cuts were not expected for the near future.
Entering the weekend, it was clear that markets would pay special attention to Chinese economic releases for May. It turned out data was not necessarily terrible, but by no means great, either.
Export growth grew faster than expected in May, as growth to Asian counterparts and the U.S. was better than many forecast. May’s export growth of 15.3% Year-over-Year (YoY) led to overall trade data that was a major improvement from April’s 4.9% YoY growth. Economists caution that the one-month spike may be a temporary aberration, but for the time being, it quelled some market concern.
Source: Wall Street Journal
Also encouragingly, China revealed that YoY inflation in May fell to 3.0%, down from its peak of 6.5% in the middle of last year. As long as inflation remains contained, Chinese officials will have little challenge in supplying the economy with liquidity through rate cuts, cuts to the RRR, or other measures.
Initial reaction to news on industrial production (IP) was positive as IP rose 9.6% YoY in May, up slightly from April’s 9.3% growth rate. Unfortunately, the April reading was the slowest in 34 months and economists were expecting a stronger bounce to 9.9%.
Also of concern was news that retail sales growth slowed to 13.8% YoY. That was a decrease from the 14.1% YoY rate seen in April and below expectations of 14.2% growth. On the surface, 13.8% appears strong, especially compared to consumption figures in the developed world.
China appears to be facing two major problems currently. On the one hand, 40% of China’s exports ship to Europe and the United States. On the other, government officials have long struggled to convert the economy from an export orientation to one based on domestic consumption.
Over the past decade, household consumption as a percentage of GDP has declined, while investment has risen sharply. This does very little to provide a buffer for the economy during periods when Europe and other nations are flailing.
Source: Wall Street Journal
China is in a tenuous place at the moment, dealing with weakening economic growth and potential fears of a hard landing. Recent data suggests that a hard landing is out of the question for right now, but any further slowdown in the U.S. or Europe could quickly drag China in the wrong direction. Chinese officials still have massive amounts of dry powder at their disposal in the event they need to stimulate economic growth, which also reduces the likelihood of a hard landing scenario. Long term, however, any additional injections of liquidity raise the risk of inflation and property bubbles.
the week ahead
There are several important indicators on tap for this week, including inflation data and retail sales. The National Federation of Independent Businesses also releases its monthly survey of small businesses, and the Fed releases industrial production data.
European elections should dominate the week’s headlines. Greek elections are on tap for Sunday, which will provide significant clarity on the future of the country and the debt crisis. Success by Greece’s left-leaning, anti-bailout parties could signal the country will abandon its commitments to fiscal reform and potentially lead to a Greek departure from the Eurozone.
The second round of French parliamentary elections is also scheduled for Sunday, potentially giving new French president Francois Hollande and his Socialist party a legislative majority. The party did well in the first round of elections yesterday, indicating the group will likely achieve majority status. This too could undermine fiscal reform efforts.
The US Treasury has scheduled several auctions this week, including $32 billion of 3-year notes on Tuesday, $21 billion of 10-year notes on Wednesday, and $13 billion of 30-year bonds on Thursday.
Central banks meeting this week include Indonesia, Thailand, New Zealand, Philippines, Chile, Japan, and Russia.
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