Picking Up Profits from the Fall of China’s Great Economic Wall

Freedom Financial Archive | Originally posted Oct 05, 2022

The Old China Hand Shows His Pair of Deuces

The Chinese data only strengthens the guidance we have provided about the consumer and general economic headwinds.

The issues proliferate. The CCP official data confirms it.

There have been studies done that show any Chinese data (good or bad) is overstated by 3 to 5%.

This has proven true repeatedly.

Videos coming out of China show unfinished (abandoned) towers being demolished.

As with anything coming out of China, there is a mixture of truth and sensationalizing.

But the fact is pressure in China isn’t going away. I’m talking about consumer pressure. Monetary pressure. Fiscal pressure.

Instead, it’s getting worse as the problems grow and compound on each other.

The CCP (Chinese Communist Party) recognized the importance of creating and developing a strong domestic market over the last decade.

“No Matter What I Do!” The Chinese “Big Short” Story Has Been Written

The problem they have faced is a cultural one. Chinese people save rather than spend, while putting a large part of their wealth into real estate.

On average, the Chinese consumer has 67 – 70% of his wealth tied up in real estate, while the U.S. consumer only has about 27%.

Between savings and illiquid investments, the Chinese domestic market has never materialized the way the CCP envisioned.

They tried to “prime” it with more policy support across the dual circulation strategy and doubled down with common prosperity.

The Chinese government provides subsidies across the board to keep inflation low and limit price increases.

And yet, every meaningful indicator is trending in the wrong direction.

The chart below looks at the last few years of spending and how it is still lackluster.

But I think it misses the broader issue.

Recent data showed the benefit of steep car subsidies to drum up added sales, but even with that support sales fell flat.

But the data also misses how the problems appeared well before COVID.

It lines up perfectly to the shifts in employment when both service and industrial hiring slowed according to PMI and local readings.

Institute for Supply Management (ISM) compiles and releases monthly the Purchasing Manager Index (PMI). The PMI is based on a monthly survey sent to senior executives at more than 400 companies in 19 primary industries, which are weighted by their contribution to U.S. gross domestic product (GDP).

The PMI is based on five major survey areas: new orders, inventory levels, production, supplier deliveries, and employment. The ISM weighs each of these survey areas equally. The surveys include questions about any changes in business conditions, whether they are improving, unchanging, or deteriorating.

The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change.

Real retail sales contracted to a level 16% below trend despite a further rise in car sales to record highs.

China’s economic problems started slowly and have progressively gotten worse.

“July’s economic data is very alarming,” said Raymond Yeung, Greater China economist at Australia & New Zealand Banking Group Ltd. “Authorities need to deliver a full-fledged support from property to Covid policy in order to arrest further economic decline.”

The headlines for July:

  • Retail sales rose 2.7% year-on-year in July, down from a 3.1% year-on-year increase in June.
  • Fixed asset investment rose 3.5% year-on-year in July, compared with 5.8% year-on-year growth in June.
  • Value-added output at industrial firms rose 3.8% year-on-year in July, versus a 3.9% year-on-year increase in June.

Our take in one word:Dire.

The data missed expectations across the board:

  • Analysts had forecasted a 4.6% year-on-year increase in industrial value-added output last month.
  • Retail sales had been expected to increase by 5.0% year-on-year.
  • Year-to-date FAI (fixed asset investment) growth of 5.7% year-on-year missed expectations of a 6.2% expansion.

At the heart of the weak numbers were the twin problems of China’s real estate slowdown and zero-COVID policy.

Households still show no sign of opening their wallets and increasing spending.

China’s in the midst of its worst ever property downturn.

Home sales worsened from a 23% from January to August this year.

Weaker real estate activity dragged down the industrial sector. Floor space under construction in the real estate sector plummeted 45.2% year-on-year in July, the most recent month data is available.

Production of steel and cement were down 6.4% and 7.0% year-on-year, respectively.

In the face of this, stimulus measures are simply not working as intended.

The economic figures were dire despite an increase in government spending. Infrastructure fixed asset investment (FAI) rose a healthy 11.5% year-on-year in July.

he official definition of FAI is investment in construction projects with a planned value of RMB 5 million or more plus the purchase of fixed assets, including land.

Capital expenditure (capex) at SOEs (state owned enterprises) increased by nearly the same amount, 11.8% year-on-year.

Get smart:In the face of the awful economic and lending data for July, officials are already looking to loosen policy. Recently, the PBoC announced a 10-bps cut to its medium-term lending facility.

Get smarter:Things are now so bad that it’s hard to see how conservative 10bp rate cuts are going to cut the mustard.

While reducing rates can help with costs, it will do nothing to accelerate borrowing.

Rates have been in a quantitative easing cycle since well before COVID, and the law of diminishing returns have caught up to Chinese policy makers.

Aggregate financing has rolled over below 2020 levels on the back of slowing adoption even as the “cost” of borrowing stays supportive.

When we scratch below the surface, we can see how the support has been created by government bonds mostly going to SOEs (state owned enterprises).

We broke it down several weeks ago, but this is just more proof that the private sector stays in contraction when it comes to credit impulses.

If we layer in the most recent credit data, China’s impulses are back in negative territory despite the sequential rebound of total loans quarter-on-quarter.

What’s a Credit Impulse?

From Saxo:

The notion of Credit Impulse was introduced for the first time by Michael Biggs in November 2008. The Credit Impulse represents the flow of new credit issued from the private sector as a percentage of GDP. It is the second derivative of credit growth and arguably the largest driver behind economic growth.

The thinking behind Credit Impulse is based on basic Keynesian economics. Since spending is a flow, it should be compared with net new lending, also a flow, rather than credit outstanding, a stock.

The main advantage of Credit Impulse is that it helps to solve a number of conundrums that cannot be explained by an analysis focusing on the stock of credit. In addition, it has been demonstrated that, for many time periods and countries, a strong correlation exists between Credit Impulse and other economic data, especially private sector demand, and financial assets.

Before the Global Financial Crisis, the United States, Japan and Europe were the main drivers of the global credit cycle. But a major shift has happened since 2009 resulting in China becoming the dominant actor. As a result, China Credit Impulse is key to monitor in order to assess the evolution of the global economy.

This supports our thesis that the Chinese private sector is avoiding any new debt while their local governments keep trying to push more debt.

The SOEs are being told to take on more debt. But even with that mandated, it is still muted.

The chart below puts into perspective the added push across infrastructure investment, but it isn’t resulting in new construction.

The infrastructure investments through SPBs (special purpose bonds) are overstated. The money either sat idle or was used for things outside of its intended purpose.

Infrastructure investment normally transitions into construction activity, but we are seeing a big shift in capacity given China’s economic headwinds.

China was able to “bail out” the market multiple times over the last 17 years with added stimulus and by acting as the buyer of last resort.

The capacity for stimulus is muted at best, which is being reflected by limited PBoC activity and driving impacts of the law of diminishing returns.

PBoC is The People’s Bank of China, China’s central bank.

Chinese Property Loans Have Left the Building

Another supporting data point about China Banks’ Property Loans.

Bank lending to the real estate sector dropped for the first time in 10 years and the decline is going to persist.

The limitations affecting the Chinese economy is expanding, and the adage of “just build stuff” is failing.

The below quotes from Trivium just echo our points that expansion will be limited, and the where the added stimulus is heading (infrastructure) is already fully tapped out.

China’s problem right now is still the broad-based and expanding economic troubles.

But their solution is the same.

This is why we talk so much about the law of diminishing returns.

Because the CCP has reached a point where every new dollar has a negative impact.

The GDP Target Is Moving, But the Economy Isn’t Running

The big headline: The economy grew 2.5% in the first six months of 2022 – the slowest rate since COVID first hit in 2020.

  • Recent GDP data, whether Q1, Q2, or H1 – take your pick – looks terrible.
  • Most key growth drivers – the property sector, private investment, and consumption – are failing to fire, under strain from regulatory clampdowns and COVID controls.
  • Exports, which have propped up growth in the past two years, are soon likely to join the list.

The writing’s on the wall.

Recognizing the inevitable, in July, the politburo finally walked back China’s “around 5.5%” GDP target for the year.

That implicitly acknowledges what we’ve have known for a while… that officials will struggle to come even close to the target.

The goal now:Keep the economy running in a “reasonable range,” with the understanding that growth will continue to be sacrificed to keep COVID in check.

Question:How do policymakers intend to keep things “reasonable”?

Answer:Build stuff.

As we type, the government is shoveling a massive infrastructure stimulus package out the door to make up for weak-as-hell domestic demand.

And there are plans to add to the stimulus load in H2.

We look down the barrel of this fiscal stimulus cannon more below, but for now, suffice to say it’s big – big – and it’s going to get bigger.

But despite the size of the H2 stimulus, we argue there are significant barriers that will hamper its effectiveness.

Sure, there’ll be a growth boost, but there are compelling reasons to think it will be smaller than one might expect, given the size of the cash pile.

In this deep dive, we look at Beijing’s stimulus, and why we think it won’t be all it’s cracked up to be.

The bolded commentary is the same playbook for a different and growing problem.

Confidence is Down, So Spending is Down

We have consumer confidence pulling consumer spending lower.

It’s important to reiterate this is what’s been officially released. That means the actual situation is much worse.

The momentum across all points of the economy is ebbing, and once you lose that upward trajectory it takes increased money to keep the wheels spinning.

In the Law of Diminishing Returns, it’s described as every new incremental dollar supplies less and less stimulus until every new dollar has a negative “util.”

Said a different way, additional dollars detract from the economy.

The “too many cooks” thing…

China’s Imports are Leading Its Exports into the Dirt

Exports have been supported by provinces reopening and backlogs getting pushed into the market.

Exports have held flat and beaten estimates.

But imports have fallen through the floor, coming in below estimates.

For those that have been following us, we have discussed how imports are a leading indicator for exports and an indicator of local demand.

As imports drop, they will pull down exports over the next few months.

One counterpoint to that is the fall in local demand. Because as Chinese consumers buy less, companies will try to “dump” more into the international market.

But the fact remains imports are an important indicator of where the underlying economy is heading.

And as Chinese imports weaken, it spells more trouble for Europe.

Europe relies significantly on China’s imports of their goods.

With energy import costs exploding and exports dropping off, the current account balance for the European Union has flipped into a deficit… with more pain ahead.

China supported exports “dumping” their excess into the market, which is only growing as local spending declines and activity falls further.

China’s General Administration of Customs released monthly trade data for July.

The headlines:

  • Exports rose 18.0% year-on-year in dollar terms in July, up from 17.9% year-on-year growth in June.
  • Imports increased by 2.3% year-on-year last month, versus 1.0% year-on-year growth in June.
  • The trade surplus was USD 101 billion in July, compared with a surplus of USD 98 billion in June.

Deja vu:Another month, another better-than-expected print for exports.

Analysts have been calling the end of China’s export boom for the past year, but the sector continues to outperform. The consensus forecast was for a 14.1% year-on-year increase in exports last month.

Part of the reason for the continued strength in exports is that companies are still working through the backlog of orders that built up during COVID-19 lockdowns.

The unending export boom is also reflective of the problems with China’s post-lockdown economic bounce back. While production has recovered, domestic demand is still lackluster.

The still-weak levels of domestic consumption can be seen in the worse-than-anticipated import numbers. Analysts had expected inbound shipments to increase by 4% year-on-year in July.

Another worrying sign of the disconnect between overseas sales and domestic consumption is that China’s trade surplus hit a record high last month.

Strong domestic production plus weak domestic demand has led to firms dumping surplus products overseas. For example, steel exports jumped 41.2% year-on-year last month.

The bottom line: Strong exports are supplying a much-needed boost to economic growth.

But they are symptomatic of China’s problematic economic recovery, where production is rising faster than consumption.

The Inflation Pump is Out of Order

Chinese floor space sold is falling through a floor and is steeply negative, which will drag down the activity indicator even further.

Exports have been able to supply some support for activity, but the trend still is lower as real estate drops further.

The government has tried many ways to stimulate the economy.

But as the economy slows, the deficit grows.

The food situation has turned dire with drought warnings springing up all along the Yangtze River.

Back in 2020, water levels reached 800-year highs.

Now, a mere 2 years later, the exact opposite is happening.

Like the water situation, the CCP is seeing inflation run away from them after years of being subdued.

Even as the CCP tries to manage inflation, it is still creeping higher.

I know you can look at the chart below and think “It’s so far below the U.S. and global averages!”

But to achieve that feat, the government dumped billions into the market.

As Trivium highlights below, China has indeed kept inflation below normal, but it’s nothing to brag about.

Performing that monumental task was expensive. As the coffers run dry, it will be difficult to maintain.

China’s stats bureau released the inflation data for July on Wednesday.

The headlines:

  • The consumer price index (CPI) rose 2.7% year-on-year in July, up from 2.5% in June.
  • The producer price index (PPI) increased 4.2% year-on-year in July, down from 6.1% year-on-year growth in June.

Consumer price growth may have hit a 24-month high, but the increase was very narrowly focused on food. Pork prices jumped 20.2% year-on-year last month.

If there’s one thing the Chinese consumer loves, it’s pork.

With the government springing into action to bring down pork prices, this pace of growth is unlikely to persist.

On the other inflation front, things are looking more positive. Producer price growth fell to its lowest in 18 months in July.

Chinese officials like to trumpet that they have avoided the inflation problems plaguing the West through sensible economic policies.

But that’s only half the story.

Weaker price growth in China is a function of poor domestic demand.

The consumer prices data shows that core CPI (Consumer Price Index) – which excludes food and energy costs – was just 0.8% year-on-year in July. That was down from 1.0% in June and the weakest since April 2021.

Producer price growth is also cooling off the back of weaker economic activity, as China’s commodities-intensive real estate sector is still in the doldrums.

Get smart: China may have avoided the inflation bedeviling other economies, but the reasons for that are nothing to brag about.

Chinese Consumers Are Fresh Out of Bullets

We now shift to the consumer dynamic and its underlying issues.

It’s important to remember the shifting population dynamics and permeating unemployment problems.

But the housing shift is still one of the biggest overhangs for consumer activity.

As investors piled on to the real estate, 70% of China’s household wealth is now tied to properties. The real estate craze was so high that buyers had to pay up to 30% of home value and start paying their mortgage even before the construction started. China’s Real Estate Market is considered the ‘most important sector’ in the world. The total value stands at $60 Trillion – More than the entire US Equity market and 2x our housing market. It’s unraveling now with S&P predicting 30% drop -> 1.5x worse than 2008 crash.

Housing and general infrastructure have been the driving force in Chinese growth since 2008.

The government stimulus has been relentless, dumped several times during periods of global slowdowns.

This has supported the pace of expansion, but also increased the underlying leverage ratios to north of 32x.

To put that into context, when Lehman went bankrupt, their leverage was at 28x.

Within China the least levered entity is at 32x. “Disconcerting” is perhaps the proper word to describe this degree of leverage.

The sheer size of the Chinese market makes its slowdown a huge problem for the global economy.

Residential floor space indicators are collapsing. Because of the sheer leverage, banks and corporations need this ability to change hands.

The way provincial governments finance themselves is by real estate sales.

So as the floor space and general activity nose dives, it creates added balance sheet problems.

Another problem is the underlying value assigned to each asset.

Because as write-downs and bad debt expenses rise, it makes the already heavily leveraged balance sheets look even worse.

The problems have been percolating for a few years now, but they’re starting to rollover.

The chart below puts into context how far things can still fall.

Property sales are falling to 2015 levels but had been on an upward trajectory since 2008.

Consumers and local governments will bear the brunt of any further fall. We believe there’s much more downside in store.

Mortgage strikes have been expanding. What are they?

According to Fortune magazine, hundreds of thousands of homebuyers in at least 80 Chinese cities are refusing to pay their mortgages as property developers struggle to complete their building projects, signaling a new era of turbulence for China’s continued real estate crisis.

While we’ll never get the full picture, what we know is already alarming.

Falling new home prices will only worsen. Chinese local banks will write downs or increase bad debt expense stressing the leverage ratios.

But back to the comment earlier about the shift in demographics and how the local population is changing.

China faces a huge problem as the populace ages, and the population growth rate falls below 2.1 children per woman.

The spike in youth unemployment is going to stress things further as young people can’t get jobs and create a foundation to start a family.

The cost of raising a family has risen exponentially in many Chinese cities.

China is introducing a bunch of different initiatives to increase the birth rate and address the demographic pivot.

Twenty-six Chinese agencies have gotten together to address the population pivot.

But the unemployment data below is a much bigger problem hindering growth.

The surveyed jobless rate for those aged 16-24 climbed to 19.9% last month from 19.3% in June, the NBS said Monday. It’s a new record high.

Compare that to a 5.4% unemployment rate for the entire nation. It doesn’t paint a pretty picture.

Putting It All Together

Let’s summarize everything to dispel some concerns about the pitch around China’s debt bubble.

It’s no surprise China has dumped money into infrastructure spending, with a large part of it funneled into ghost cities.

We’ve known since 2011 China was heading down a path of destruction, but the PBoC and CCP were able to kick the can down the road.

I gave a presentation back in 2011 and said something along these lines:

We know that China is going to face consequences for their spending but is it after 100 ghost cities or 1,000 or 1 million. It will eventually be their undoing, but timing it will take a lot of analysis and patience.

We have now reached the point where the Law of Diminishing Returns comes screaming home… and terrible things happen simultaneously.

Companies are looking to “near shore” or “on-shore” to adjust the supply chain.

Those terms are just euphemisms for “bringing manufacturing back home” and away from China.

It should come as no surprise that firms are leaving China in the largest shift since globalization began.

Apple just announced more products will be assembled in Vietnam and India instead of China.

This pattern will continue.

This pivot will weigh on China’s industrial production. It’s been treading water, but just started to pivot lower.

We believe that this shift will only accelerate over the next few quarters.

We already know that China’s main activity indicators for July were lower than expected and in contraction on a month-on-month basis.

The real estate sector was once again a big disappointment as floor space started plunged to 13-year lows while residential demand fell back to cyclical lows.

Overall construction activity is down 13.6% year-on-year, driving home prices lower (-1.7% year-on-year).

Based on the trend, we don’t see this pivoting anytime soon.

The Chinese picture looks grim that can’t be saved by more stimulus and infrastructure spending.

China’s invisible hand can be kept at bay for only so long… before it comes back around to level the playing field.

Action to Take: Buy the Direxion Daily MSCI Emerging Markets Bear 3X Shares (EDZ) up to $17.73

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