Since President Trump started the trade tariff dispute, China has launched quite a bit of fiscal and monetary stimulus to offset any of the tariff impacts to help keep its economy going. With the yuan falling to 6.85 vs. the dollar, it is no surprise that the CPI and PPI for August released Monday morning showed a positive surprise. Both came in higher than expected as consumer prices rose 2.3% (vs 2.1% expected) and at the top end of the projected range of 1.6%-2.3%. The number was above last month's 2.1% and the highest since February this year. PPI also came in stronger at 4.1% (vs 4% expectations), but below July's 4.6%. What does this all mean?
Given the macro backdrop of slowing potential demand, higher CPI and PPI prices point to stagflation, an environment of higher inflation and lower growth. This is never a positive for risk assets or equities. However, this may be just a temporary phenomenon of higher inflationary prints. Commodity prices ranging from copper, aluminium, zinc, and even prices of computer storage and flash storage have been declining since the start of the year. There is no doubt that the future prints will be more "deflationary." So, we can assume stagflation is temporary, and the bigger risks are of deflation in the system, not only in China, but filtering into rest of the world. The U.S. is not immune.
Goldman Sachs released a report last week modelling their proprietary indicator plotting China's credit impulse which leads commodity prices by 15 months It pointed to further weakness in base metal prices ahead. It also suggests a recession could hit China as early as the first quarter of 2019, not the second half of next year! The dire forecasts in the Goldman Sachs report show a sharp collapse in Chinese consumption ("deflationary"), and potentially the worst credit print this decade. China's economy is now more consumption driven and GS plots various consumption driven data to reach their conclusion rather than follow the "official" figures. China's National Bureau of Statistics retail sales figures slowed in the second quarter and also in July. Plotting the Chinese consumption goods tracker and taking the average of 100 major retailers' sales estimates points to a more bearish picture, showing a year-over-year decline in July.
How things have changed since fall of last year when the National Chinese 19th party congress set President Xi Jinping's place in the constitution in stone, and the economy was firing on all cylinders as stimulus pushed prices far above their trend growth.
The slowdown since then has been achieved, as China's main objective is always to revert to the mean of 6.5% GDP growth. No one knows what the official figure is, as it stays constant around 6.5%, but we can tell from other indicators how momentum ranges to between 5.5%-7.5% growth based on commodity prices and other indicators. If Goldman is right, the higher debt service costs from a rising dollar will eat into consumption growth in China, and this is something that China will not tolerate.
It is do-or-die time for the Chinese economy as the current U.S./China Trade War impasse overwhelms the investment community. Either they try to reach some sort of a settlement -- even if by headlines -- to appease the market and Trump allowing him to claim a "victory" ahead of the November mid-term elections, or they stimulate the economy as they have done in the past, and support the yuan, which they are doing now. After all Trump wants a weaker dollar, it is in his interest. If one were to actually price in the notional impact of these tariffs, one could assume a hit of 0.8% to GDP at the worst. But the perception and the never-ending dilemma that we are in currently, means there is no certainty, and that is worrying investors.
Semiconductor stocks have been underperforming as pricing for flash storage and memory chips has been falling since the start of the year. One can argue these names have value, but their pricing trends are going in the opposite direction. Copper and steel prices are actually close to year-to-date highs, in the case of steel holding up and in the case of copper down only 15%, yet the corresponding mining stocks are down closer to 30-40%. Now that is a clear discrepancy.
As always investment is more about psychology than about fundamentals, especially at times of extreme bullishness and bearishness. Investor behaviour helps pricing revolve around the mean level of "fair value." Until there is some resolution of China's dilemma, it seems assets will continue to get cheaper, across the board, like a domino effect of one market hitting the next, from the low quality most leveraged ones to the higher quality least leveraged ones. Rest assured, when things normalise, quality will always rally first. Value traps take time to close the gap. Cheap can always get cheaper. Stick to where the fundamentals are the strongest and there is the most visibility, but where prices have been distorted due to exogenous factors.