News In Charts: Big Trouble In Little China

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

Since we published our previous Global Economic and Markets Outlook, the US has emerged from its weather-related soft patch. US manufacturing has rebounded, payrolls are again averaging close to 200k per month, and consumer confidence, though still low, continues to improve. Stronger data on economic activity in the euro area, particularly France, have caused us to revise up our projections for growth in the single currency bloc. But in terms of global growth, that is more than offset by news from China, which is slowing more quickly than we, and certainly the consensus had expected. This matters for our forecast, and for our asset allocation – perhaps materially. In our central scenario, global growth rises to 3.6% this year, and 3.8% next year. In our risk scenario, where a series of bank failures in China cause the world’s second largest economy to suffer a hard landing, global growth is much weaker than that.

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The aftermath of the failure of Lehman Brothers aside, which produced a collapse in the prices of oil and other commodities, global inflation is as low as it has ever been. And with one or two exceptions, including notably the UK, we expect it to remain low. On our central view, inflation averages less than 2% across the advanced economies both this year and next. In the euro area, it remains below 1%. But the slowdown in China means that risks are to the downside. In a world where China lands hard, the euro area, alongside many other advanced economies, suffers outright deflation.

Our asset allocation has shifted slightly over the past three months. We have a bigger underweight on commodities, reflecting China’s slowdown. We still believe that now is not the time for the Great Rotation out of bonds and into equities. Deflation fears will keep a lid on yields. But markets are shifting towards our view that the ECB will soon engage in a programme of full-blown, unsterilised QE. This supports European equities throughout the forecast horizon, and it explains why our overall equity underweight is a little smaller than it was back in January.

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China’s slowdown

That China is slowing is beyond doubt. In March, its manufacturing PMI (HSBC) came in at just 48.0 – the weakest of the lot. The question is how hard will it land? To combat the slowdown, we expect that China will fall back on what it knows as policy makers turn on both the monetary and fiscal taps. That means easier credit, more (wasteful) government expenditure, and further substantial gains in ‘social financing’. In our central scenario, to which we give a weight of 85%, this strategy ‘works’ in as much as it facilitates a soft landing. But it also aggravates China’s long-term structural imbalances. Growth slows to a little below 7% next year, on the official measure at least.

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According to Fathom estimates, and helped by the emergence of a large shadow banking sector, non-performing loans (NPLs) in the Chinese banking system have more than doubled as a share of GDP, from 7% in 2001 to 17% in 2013. By late 2015, the stock of NPLs is likely to hit $3 trillion, more or less regardless of the growth outlook. In principle at least, the Chinese authorities have the resources to deal with this – net external assets alone would cover around two thirds of these bad debts. But in our risk scenario, to which we attach a 15% probability, the authorities fail to react quickly enough. Contagion spreads rapidly through China’s banks and shadow banks, causing one or more of the ‘Big 4’ to fail. Bank lending collapses. Private investment and household consumption drop off rapidly, as do imports and property prices.

However, the consequences are not confined to China’s borders. As China is the world’s foremost consumer of energy and raw materials, commodity investors will be hit hard in this scenario. So too will those countries that are heavily dependent on exports to China. These include both developing economies, such as South Africa and Malaysia, which together export between 10% and 20% of all that they produce to China, and advanced economies, such as South Korea, which exports 15% of its GDP to China.

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In our hard-landing scenario we see the RMB falling by some 20% against the US dollar by the end of next year, and oil dropping to around $70 per barrel. That would represent a significant global disinflationary shock at precisely the wrong time.

It is a question of when, not if for the ECB

Euro area inflation has fallen dramatically in recent years. From a peak of 3.0% in late 2011, it dropped through 1.0% last October and, according to the Flash Estimate, reached just 0.5% in March. Headline inflation is substantially below target in every single country, including the core countries. Europe’s healthiest economy has not been spared – Germany’s inflation rate plunged to 0.9% in March. Against this backdrop, China’s economic slowdown should be of great concern to the ECB.

When we first called upon the ECB to enact a policy of full-blown, unsterilised QE back in January, we were less concerned about GDP growth being sustained, or about the threat of outright deflation, than we were about the dangers stemming from a persistently low inflation rate. This alone would be enough to imperil debt sustainability for a number of European sovereigns – including both Italy and France. Although, on our central view, euro area inflation may already have troughed, it is unlikely to rise materially throughout our two-year forecast horizon. And in our risk scenario, the euro area as a whole faces outright deflation. That is why we maintain our call for the ECB to act, and we do not view pressure on Frankfurt as having diminished just because the PMIs are recovering. Following this month’s policy meeting, the door to QE is more than ajar. When push comes to shove, the ECB will deliver. It is simply a matter of when.

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