Will the ECB and Fed Follow Where China Leads?
U.S. Global Investors
By Frank Holmes
June 2, 2012
Every month, policymakers track purchasing managers’ indices (PMI) around the world as they consider fiscal and monetary actions. To us, a PMI is a measure of health of companies around the world, because it includes output, new orders, employment and prices across manufacturing, construction, retail and service sectors.
Today, the J.P. Morgan Global PMI for May came in lower at 50.6—just above the level indicating expansion—and China’s HSBC Manufacturing PMI fell to 48.4. Both numbers were below their respective three-month moving averages. Historically, we’ve seen China’s PMI number leading the year-over-year change in exports by three to four months, so when the PMI has increased, a few months later, Chinese exports have historically risen, and vice versa.
China’s HSBC PMI tends to be more reflective of export demand, as it is compiled by private parties, covers a smaller survey sample and is weighted toward smaller businesses. Therefore, a lower PMI number indicates lower export demand.
With Europe’s growth in a deep freeze, China is feeling Europe’s pain. While many think the U.S. is receiving most of the Chinese-made goods, Europe is actually China’s largest export partner. Nearly 22 percent of China’s exports head to Europe, contributing nearly 6 percent to China’s GDP; only 17 percent of exports from China are shipped to the U.S.
With fewer exports to Europe, China’s GDP growth could be affected, but probably much less than one might think. Listeners of our webcast a few months ago heard Andy Rothman from CLSA explain how China has become less dependent on the world for its growth. As you can see from the chart below, CLSA had already assumed net exports of goods and services out of China to be negative this year because of slower growth from Europe and the U.S.
Yet, China clearly has the upper hand in controlling growth. Take a look at what happened in 2009 when exports declined dramatically: The government stepped in with a massive stimulus package devoted to bank lending and infrastructure construction. This effort significantly boosted overall GDP growth and “pushed the Chinese economy out of a deep slump,” says research firm BCA Research.
Despite net exports falling about 4 percent in 2009, GDP actually grew more than 12 percent.
China won’t put the pedal to the metal like it did in 2009, though. Premier Wen Jiabao recently said that the government “should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth,” according to Bloomberg News. China is more like Goldilocks: The government wants the economy to be not-too-hot or not-too-cold.
The important thing to remember is that the government will want to avoid the expansion that was “associated with the earlier plan that led to higher CPI, asset price inflation and a surge in lending to non-priority projects,” says J.P. Morgan. Rather, the focus is on making sure the country shifts to a “more sustainable trajectory of growth,” says the research firm.
With the renewed eurocrisis, “Chinese authorities are currently facing an extremely complex and unpredictable situation,” says BCA. They’ll continue to monitor the situation and not make any drastic moves; rather, “Chinese authorities will stay on high alert and act promptly to rescue growth in case of external shocks,” says BCA.
So what will they be tracking as they monitor the situation? We’ve heard the new Chinese Premier-to-be Li Keqiang is paying attention to three factors: power production, railroad freight volume and new bank loans.
Power production in April was slightly positive on a year-over-year basis, but still remained weak.
On May 31, railroad freight volume was released for April, and showed an increase of 3.3 percent over last year, the same reading as March.
New bank loans are down 7.8 percent year-over-year as of May 11, which we believe was the primary reason that China cut the required reserve ratio (RRR) on May 12. J.P. Morgan agrees, saying that together with the RRR cuts, “the seeming start of a new cycle of public spending and consumer stimulus should help to boost loan demand in the economy.”
Looking at the five year data above, all factors are near their lows and below their 3-month moving averages. In whatever shape or form, we expect policy easing to continue.
What appears to be overlooked by the mountain of negative economic news is the fact that China’s stock market is outperforming. In May, the A shares were the best-performing equities among all the developed and emerging stock markets we track. For the year, China’s investors still hold onto a gain of 7 percent, putting the country among the top half of the emerging markets and above all developed markets. This bifurcation may be signaling that the worst is behind us.
Keep in mind that negative news in the media may be a danger sign to some people; to Chinese policymakers, it’s a signal to act.
We believe the next government policy cycle might be just around the corner. In fact, we’ve already seen indications of stimulus from China, such as giving the “green” light to car buyers. Perhaps the European Central Bank and the Federal Reserve will follow suit to avoid a repeat of the last few summers.
This is just a preview of only a few of the points I’ll be making at the Cambridge House’s World Resource Investment Conference in Vancouver next week. Hope to see you there! If I miss you, look for the presentation on usfunds.com in a few days.
- The major market indices were sharply lower this week. The Dow Jones Industrial Average fell 2.70 percent. The S&P 500 Stock Index decreased 3.02 percent, while the Nasdaq Composite posted a loss of 3.17 percent.
- Barra Growth outperformed Barra Value as Barra Growth fell 2.97 percent while the Barra Value index decreased 3.07 percent. The Russell 2000 closed the week with a loss of 3.78 percent.
- The Hang Seng Composite posted a loss of 0.32 percent; Taiwan rose 0.49 percent, while the KOSPI rose 0.57 percent.
- The 10-year Treasury bond yield fell sharply to 1.46 percent, falling 28 basis points for the week.
Domestic Equity Market
The S&P 500 Index fell 3.02 percent this week as the global economy appears very fragile. Global economic data disappointed and weak employment data here in the U.S. drove the market sharply lower on Friday. Traditional defensive areas such as utilities, telecommunication services and consumer staples were the best performers, while energy, financials and industrials all fell by more than 4 percent.
- The utilities sector was essentially flat, in a very rough week for the market with Pepco Holdings, Duke Energy and Public Service Enterprises among the best performers.
- The telecom services sector was not far behind, posting modest weekly losses. AT&T was able to scrape out a modest gain this week, helping the group outperform.
- The best individual stock performer this week was Newmont Mining which rose 3.4 percent as speculation grew that the Federal Reserve would implement additional monetary easing measures in response to the weakening economy.
- The energy sector was hit hard this week as oil prices fell by more than 8 percent. Cabot Oil & Gas, WPX Energy and Range Resources all fell by more than 11 percent.
- Financials were also hit hard this week on a combination of concerns, such as European banking problems affecting U.S. institutions and extremely low interest rates negatively affecting the life insurers. MetLife and Lincoln National Corp. were the worst performers in the sector with both stocks falling by about 9 percent.
- First Solar was the worst performer in the S&P 500 this week falling 17.2 percent, continuing a dismal run as the stock has fallen 65 percent this year.
- For the third week in a row gold stocks and airlines were among the best performers. Gold stocks were driven by the potential for more quantitative easing from the Fed while airlines are being positively impacted by lower oil prices.
- While much of the news this week was negative the silver lining is that this weakness will likely elicit a response from global policy makers. Government policy actions are often a precursor to change in the financial markets and should be monitored closely.
- Stresses continue to build in Europe and missteps by policy makers could negatively impact the markets.
The Economy and Bond Market
Treasuries rallied this week, sending yields sharply lower across the long end of the curve. Europe was the focal point for most of the week. While Greece still makes headlines, Spain was more in focus as the government planned to borrow to pay for bank bailouts. At the same time, economic data is deteriorating very quickly. On Friday there were a slew of negative data points as May purchasing managers’ indices from around the world disappointed and nonfarm payrolls grew a meager 69,000.
- On June 1, the 10-Year Treasury yield fell to 1.45 percent as investors sought perceived safety. This rate is lower than the Near-Term Tax Free Fund (NEARX)’s 30 Day SEC yield on a tax equivalent basis based on a 35 percent tax rate, even though the fund holds bonds that, on average, mature in less than five years. Click here to see returns.
- Retail sales were surprisingly strong in May with same store sales generally beating expectations.
- Brazil cut interest rates by 50 basis points to a record low 8.5 percent.
- European Central Bank president Mario Draghi supported the idea of a bank deposit guarantee. This would likely help prevent a “run” on European banks.
- May nonfarm payrolls expanded by only 69,000, well below estimates of 150,000. The prior two months were also revised lower by 49,000. Overall it was a very weak report.
- Global purchasing managers’ data released late in the week also disappointed. China was a negative surprise relative to expectation, while European data just confirmed the weakness.
- April’s pending home sales unexpectedly fell 5.5 percent which casts a shadow on the recent strength in the housing market.
- Bonds continue to grind higher and appear to be forecasting benign inflation and slow growth.
- The Fed appears willing to increase monetary accommodation if necessary, which would be a boost to the bond market.
- China’s economy is slowing faster than expected and government policy makers appear comfortable with this dynamic.
- Europe remains a wildcard with austerity programs under pressure, creating significant uncertainty.
For the week, spot gold closed at $1,624.10 up $51.07 per ounce, or 3.3 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, beat bullion with a 3.6 percent return. The U.S. Trade-Weighted Dollar Index gained 0.6 percent for the week.
- Confidence in the gold market got a big boost on Friday as the change in U.S. Nonfarm Payroll jobs number came in at just 69,000, falling far short of the 150,000 expectation, thus increasing the likelihood that the Fed will take steps to stimulate the economy.
- The yield on the U.S. 10-year note plunged to 1.45 percent and two-year German note yields actually drifted into negative territory. Although inflation is pretty tame, real interest rates are negative and gold historically performs well under such conditions.
- John Embry of Sprott Asset Management was certainly ahead of the curve when interviewed for a story on Mineweb this week and noted he doesn’t see a recovery of any substance whatsoever in the U.S. Everybody is just so focused on Europe at the moment. Embry points out that the most shocking statistic that has come out in the last nine months is the fact that last year the U.S. monetized 61 percent of its budget deficit, which is staggering, yet no one seems to care.
- Silver did not participate in the rally this week but with trading in the new silver contracts on the Shanghai Futures Exchange its prospects could improve. Some traders speculate the contracts to be bullish for silver prices, similar to the start of trading in gold futures in China, and that the venue could make market manipulation more difficult. It is believed that this move signals China clearly wants more control over the precious metal’s pricing policy. Historically China has used silver as a currency.
- While Greece has been at the forefront of most of the European woes, the shift in focus to Spain is a real worry as this problem cannot be effectively addressed. Something like 100 billion euros were withdrawn from the country in the first quarter and, much like Greece, there have been issues with citizens taking their money out of local banks. Last week trading in shares of Bankia, the fourth largest Spanish bank which was nationalized earlier this month, was suspended as it became apparent that the bank requires more than 15 billion Euros ($19 billion). Bankia holds around 10 percent of the country’s bank deposits.
- The combined European nations don’t have the wherewithal to bail Spain out from its enormous debt. Implementing further austerity measures to allay its debt problems when a quarter of its people (and nearly 50 percent of its youth) are already unemployed will prove to be very problematic.
- Robert Cohen, a precious metals portfolio manager at GCIC, was interviewed by the Gold Report and pointed out we are at a unique place in history where the metal prices are robust and yet the stock prices are the cheapest he has ever seen relative to underlying commodity prices. Investors have turned up their risk dials resulting in lower stock prices with few willing buyers. Cohen believes it is a good time to accumulate positions before QE3 comes.
- Industrial and Commercial Bank of China Ltd. (ICBC) is the world’s largest bank by market value and is the top player by volume on China’s gold and future exchanges. It was reported that ICBC is seeking membership of overseas exchanges and aims to become a major global bullion market maker. This would allow ICBC to grow its financial products to service the supply chain of the bullion market, including loans to miners and smelters, physical gold leasing, hedging and brokering.
- Ian McAvity noted that gold is increasingly trading like a currency and believes most of the speculative money has now largely been chased out of the gold market. But he states that the attitude of many of the U.S. banks is that what is happening now is very much a European problem. “If a European bank blows up, that problem will cross the Atlantic in a Nano-second because the Federal Reserve was bailing out some of the European banks in 2008-2009 and they’ll be doing it again.” Ian raises the question, how can you borrow your way out of a debt problem? With money coming out of the euro and the dollar not really in that much better shape, Ian believes that some of that money will find its way into the gold market, pushing prices higher.
- Europe is China’s largest export market and it is a very important source of trade finance for its industry. Much like 2008, trade in commodities nearly came to a halt as shippers could not obtain a Letter of Credit from a financial institution. Problems in Europe will roll over to China. Economic growth in India showed its weakest quarter in roughly nine years and inflation is still stinging their confidence.
- In Argentina, the mining business just got a little harder. As of this week, mining companies will have to submit quarterly estimates of their purchasing needs which will need approval by a special working group at the Mining Ministry. It is feared the government review process could delay the deliveries of mining inputs by an additional six months.
- Since February, mining companies have had to obtain approvals from a number of government agencies before they can import goods or buy offshore services. Mining companies have also had to create a separate purchasing department dedicated to substituting imported goods and services with Argentinean products and services. Currently it is estimated that as much as 70 percent of inputs used by the mining industry have to be imported.
Energy and Natural Resources Market
- The Global Resources Fund performed better than its peers and benchmark over the last week, despite weak economic data out of Europe, China, and the U.S. that weighed on stocks and commodities.
- U.K. coal consumption was at a six-year 46 percent high in the first quarter. The exact opposite of what is occurring in the U.S. is happening in the U.K. where utilities switched from natural gas to cheaper coal supplies. The U.K.’s Department of Energy and Climate Change estimated that coal-fired power generation increased by 20.2 percent, or 6.5 terawatt hours, in the first quarter. The U.K.’s gas-fired power generation fell to 25 percent market share, the lowest in 14 years. Britain’s six largest utilities expect difficult market conditions for gas-fired power generation through 2016.
- Utility inventories for coal were up again in March to 196 billion tons or 86 days of supply, 62 percent above the 10-year average of 53 days, according to industry research from Stifel Nicolaus.
- Based on Energy Information Administration data, U.S. monthly coal consumption of 57.6 million tons in March 2012 was a 25-year low. With total power generation down 3 percent year-over-year in March, coal generation was down 21 percent year-over-year while natural gas generation increased 40 percent year-over-year. March utility coal inventories of 196 million tons represent 106 days of supply versus 71 days last year. The monthly increases in utility coal inventories have been declining, primarily due to production cuts across the industry.
- Copper producer China Nonferrous Mining Corp. has pulled its planned Hong Kong initial public offering of up to $313 million due to worsening market conditions, becoming the second major IPO to be scrapped in the city this week and underscoring tepid demand for new listings.
- China made stimulus announcements. The Ministry of Finance announced RMB 98 billion ($15 Billion) in central government funding for social housing projects. This compares to 153 billion spend by the government over all of 2011. Also, the National Development and Reform Commission (NDRC) approved construction of three major steel projects, with combined investments exceeding RMB 130 billion. And on Monday, the NDRC approved the construction of a new airport in Sichuan, joining recent approvals of three other airports.
- GlobalOre, the second major physical iron ore trading platform, and rival to the China iron ore platform, launched this week in a bid to boost its price-setting influence. Vale, BHP and Rio Tinto have also joined the platform, reports GlobalOre.
- BofA-Merrill Lynch warned this week that the global iron ore market may be oversupplied in 2013 due to 100 million tons of additional capacity coming online out of Australia.
- China's Ministry of Commerce reported that domestic thermal coal prices are expected to drop further in the short term. In the week to May 27, domestic crude coal prices dropped 1 percent week-over-week, the sixth week in a row. Weak coal demand from the downstream power generation sector and high stocks at power plants have been behind the downward trend in coal prices. Coal stocks at China's major power plants totalled 88.87 million metric tons on May 20, a record high, up 6.4 percent from the end of April.
- Argentina's Mining Ministry this week ordered mining companies to prioritize the purchase of local products and services, as well as seek prior government approval 120 days before making overseas purchases of goods and services. Since February of this year, Argentina has subjected the import of all goods to a pre-registration and pre-approval regime, called the Declaración Jurada Anticipada de Importación. More than 600 product types must now obtain an import license, such as mining machinery and chemicals.
- The Philippine’s GDP increased 6.4 percent year-over-year in the first quarter this year, greater than estimated, and exceeded the previous quarter’s revised 4 percent. In Korea, industrial production rose 0.9 percent month-over-month in April, the biggest increase in three months, and it saw the Consumer Price Index (CPI) rise 2.5 percent in May, holding at a 21-month low.
- Thailand’s CPI for May rose 2.53 percent year-over-year, in line with expectations.
- Hunan Province in central China announced a provincial investment plan totaling RMB 4.2 trillion for 12th 5-years, or about Rmb 800 billion a year.
- China’s State Council has announced it will provide RMB 26.5 billion in subsidies to promote energy-efficient appliances, one of a series of stimulus measures that the market is expecting from the Chinese government.
- Turkey’s trade deficit was much better than expected in April, down to $6.6 billion from $9.1 a year ago. Exports have been resilient in the first four months of 2012, rising by 10.9 percent over the same period a year ago. The eurozone is Turkey's largest partner, and as a result of weaker demand in the region, exports to eurozone countries fell by 6.1 percent year-over-year in January through April. On the other hand, exports to North Africa rose by 63.3 percent (after falling by 23.9 percent in 2011), and exports to the Middle East increased by 35.5 percent.
- China’s official PMI for May was 50.4 versus the estimate of 52; the reading was also the lowest in the year. The new order index dropped 470 basis points to 49.8 percent, which doesn’t bode well for productivity in the next few months if the downtrend is not stopped. The HSBC final China flash PMI was 48.4 versus 49.3 in the previous month, a consecutive seventh month below 50. A PMI below 50 indicates industrial activities are contracting. HSBC China flash PMI tells more about export contraction at the moment.
- Hong Kong retail sales grew 11.4 percent in April versus estimate 16.4 percent, disappointing the market.
- Korean exports fell 0.4 percent year-over-year in May, exceeding estimates but still declining for a third month.
- The European Central Bank said that Hungary’s amended draft law still fails to address a number of previously highlighted concerns over central bank independence and executive powers of monetary council.
- The Russian manufacturing sector gained further growth momentum in May, with PMI remaining above 50.0 for the eight month running, rising to 53.2 in May. Output and employment are higher, while inflationary pressures remain relatively weak.
- The Philippine’s GDP went up 6.4 percent in the first quarter, illustrating the fact that infrastructure investment and domestic demands are driving economic growth and corporate profits.
- With China PMI in May weakening and key sub-indices reflecting weak demand in the economy, this increases the probability of further policy relaxation and accelerated approval of infrastructure projects.
- Czech PMI fell to 47.6 from 49.7 in April, pointing to downside risk in coming quarters. HSBC survey data and anecdotal evidence suggested weak demand from both domestic and external markets, linked to the crisis in Western European economies.
(c) U.S. Global Investors