The Global Impact of a Chinese Recession

Most economic forecasts suggest that a recession in China will hurt everyone, but that the pain would be more regionally confined than would be the case for a deep recession in the United States. Unfortunately, that may be wishful thinking.

Kenneth Rogoff  




CAMBRIDGE – When China finally has its inevitable growth recession – which will almost surely be amplified by a financial crisis, given the economy’s massive leverage – how will the rest of world be affected? With US President Donald Trump’s trade war hitting China just as growth was already slowing, this is no idle question.

Typical estimates, for example those embodied in the International Monetary Fund’s assessments of country risk, suggest that an economic slowdown in China will hurt everyone. But the acute pain, according to the IMF, will be more regionally concentrated and confined than would be the case for a deep recession in the United States. Unfortunately, this might be wishful thinking.

First, the effect on international capital markets could be vastly greater than Chinese capital market linkages would suggest. However jittery global investors may be about prospects for profit growth, a hit to Chinese growth would make things a lot worse. Although it is true that the US is still by far the biggest importer of final consumption goods (a large share of Chinese manufacturing imports are intermediate goods that end up being embodied in exports to the US and Europe), foreign firms nonetheless still enjoy huge profits on sales in China.

Investors today are also concerned about rising interest rates, which not only put a damper on consumption and investment, but also reduce the market value of companies (particularly tech firms) whose valuations depend heavily on profit growth far in the future. A Chinese recession could again make the situation worse.

I appreciate the usual Keynesian thinking that if any economy anywhere slows, this lowers world aggregate demand, and therefore puts downward pressure on global interest rates. But modern thinking is more nuanced. High Asian saving rates over the past two decades have been a significant factor in the low overall level of real (inflation-adjusted) interest rates in both the United States and Europe, thanks to the fact that underdeveloped Asian capital markets simply cannot constructively absorb the surplus savings.

Former US Federal Reserve chair Ben Bernanke famously characterized this much-studied phenomenon as a key component of the “global savings glut.” Thus, instead of leading to lower global real interest rates, a Chinese slowdown that spreads across Asia could paradoxically lead to higher interest rates elsewhere – especially if a second Asian financial crisis leads to a sharp draw-down of central bank reserves. Thus, for global capital markets, a Chinese recession could easily prove to be a double whammy.

As bad as a slowdown in exports to China would be for many countries, a significant rise in global interest rates would be much worse. Eurozone leaders, particularly German Chancellor Angela Merkel, get less credit than they deserve for holding together the politically and economically fragile single currency against steep economic and political odds. But their task would have been well-nigh impossible but for the ultra-low global interest rates that have allowed politically paralyzed eurozone officials to skirt needed debt write-downs and restructurings in the periphery.

When the advanced countries had their financial crisis a decade ago, emerging markets recovered relatively quickly, thanks to low debt levels and strong commodity prices. Today, however, debt levels have risen significantly, and a sharp rise in global real interest rates would almost certainly extend today’s brewing crises beyond the handful of countries (including Argentina and Turkey) that have already been hit.

Nor is the US immune. For the moment, the US can finance its trillion-dollar deficits at relatively low cost. But the relatively short-term duration of its borrowing – under four years if one integrates the Treasury and Federal Reserve balance sheets – means that a rise in interest rates would soon cause debt service to crowd out needed expenditures in other areas. At the same time, Trump’s trade war also threatens to undermine the US economy’s dynamism. Its somewhat arbitrary and politically driven nature makes it at least as harmful to US growth as the regulations Trump has so proudly eliminated. Those who assumed that Trump’s stance on trade was mostly campaign bluster should be worried.

The good news is that trade negotiations often seem intractable until the eleventh hour. The US and China could reach an agreement before Trump’s punitive tariffs go into effect on January 1. Such an agreement, one hopes, would reflect a maturing of China’s attitude toward intellectual property rights – akin to what occurred in the US during the late nineteenth century. (In America’s high growth years, US entrepreneurs often thought little of pilfering patented inventions from the United Kingdom.)

A recession in China, amplified by a financial crisis, would constitute the third leg of the debt supercycle that began in the US in 2008 and moved to Europe in 2010. Up to this point, the Chinese authorities have done a remarkable job in postponing the inevitable slowdown. Unfortunately, when the downturn arrives, the world is likely to discover that China’s economy matters even more than most people thought.


Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. The co-author of This Time is Different: Eight Centuries of Financial Folly, his new book, The Curse of Cash, was released in August 2016.

The Desolate Wilderness

A chronicle of the Pilgrims’ arrival at Plymouth, as recorded by Nathaniel Morton.


Here beginneth the chronicle of those memorable circumstances of the year 1620, as recorded by Nathaniel Morton, keeper of the records of Plymouth Colony, based on the account of William Bradford, sometime governor thereof:

So they left that goodly and pleasant city of Leyden, which had been their resting-place for above eleven years, but they knew that they were pilgrims and strangers here below, and looked not much on these things, but lifted up their eyes to Heaven, their dearest country, where God hath prepared for them a city (Heb. XI, 16), and therein quieted their spirits.

When they came to Delfs-Haven they found the ship and all things ready, and such of their friends as could not come with them followed after them, and sundry came from Amsterdam to see them shipt, and to take their leaves of them. One night was spent with little sleep with the most, but with friendly entertainment and Christian discourse, and other real expressions of true Christian love.



The next day they went on board, and their friends with them, where truly doleful was the sight of that sad and mournful parting, to hear what sighs and sobs and prayers did sound amongst them; what tears did gush from every eye, and pithy speeches pierced each other’s heart, that sundry of the Dutch strangers that stood on the Key as spectators could not refrain from tears. But the tide (which stays for no man) calling them away, that were thus loath to depart, their Reverend Pastor, falling down on his knees, and they all with him, with watery cheeks commended them with the most fervent prayers unto the Lord and His blessing; and then with mutual embraces and many tears they took their leaves one of another, which proved to be the last leave to many of them.


Being now passed the vast ocean, and a sea of troubles before them in expectations, they had now no friends to welcome them, no inns to entertain or refresh them, no houses, or much less towns, to repair unto to seek for succour; and for the season it was winter, and they that know the winters of the country know them to be sharp and violent, subject to cruel and fierce storms, dangerous to travel to known places, much more to search unknown coasts.

Besides, what could they see but a hideous and desolate wilderness, full of wilde beasts and wilde men? and what multitudes of them there were, they then knew not: for which way soever they turned their eyes (save upward to Heaven) they could have but little solace or content in respect of any outward object; for summer being ended, all things stand in appearance with a weatherbeaten face, and the whole country, full of woods and thickets, represented a wild and savage hew.

If they looked behind them, there was a mighty ocean which they had passed, and was now as a main bar or gulph to separate them from all the civil parts of the world.


This editorial has appeared annually since 1961.

Inside John Malone’s World

By Andrew Bary 

The Courage and Folly of a War That Left Indelible Scars

During World War I, millions died, empires crumbled, nations were formed and maps were redrawn in ways that reverberate mightily a century later.

By Alan Cowell

Is The Fed Losing The Thread? What May Lie Ahead

by: DoctoRx

- The Fed stood pat Thursday, but equity markets sold off.

- Official commentary from the Street could not explain the (mild) sell-off.

- I present a possible rationale: perhaps the Fed is already too tight and should, therefore, sit tight.


It's raining on one side of the street, but the Fed only sees the sunny side
 

Stock markets reacted badly Thursday to the Federal Open Market Committee's statement, even though Zero Hedge - a haven for short-sellers, gold bugs, and gloom-and-doom purveyors - reported as follows:

While there were virtually no surprises in today's FOMC statement - at least relative to expectations, with Goldman's redline statement laid out earlier a carbon copy of what the Fed eventually published - the oddly hawkish market reaction suggests that the Fed did in fact say something that was unexpected…

 

We'll see what the many Fed "whisperers" and independent analysts come up with, but here's what bothered me, in real time, about the FOMC's point of view. From the part of the statement describing the economy, the Fed sees:

...the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year.

 

The Fed, or FOMC, is seeing a Goldilocks scenario. Even the one parameter it mentioned as weakening, business fixed investment, did so from a previously "rapid" pace. So that's fine with the Fed.

 

I see something different. Yes, there's that sunny side of the street the Fed describes, much of which - employment and inflation, discussed later in the statement, are backward-looking indicators. Consumer spending is more of a coincident indicator and therefore, not very helpful in guiding policies that work with, say, a 6- to 12-month lag. Business investment, however, is more of a forward-looking indicator.

What else is a good forward-looking metric related to the Fed's long march to increase interest rates, which began in December 2015 and has thus lasted longer than any rate hike period in decades?

Here's one: the housing market. Housing stocks (ITB) have taken one look at the Fed's policies and the results on the ground, and given this pattern:

  ITB data by YCharts

 

That's about a one-third haircut in only about 10 months.

 

A further problem is, while ITB is weighted toward the homebuilder stocks, in aggregate, a notable part of the ETF's holdings includes more stable consumer discretionary stocks like Home Depot (HD), Lowe's (LOW), and Sherwin-Williams (SHW). ITB's largest holding is Lennar (LEN), which is down from a January high of $72.17 to close Thursday at $41.90. The second-largest holding, D.R. Horton (DHI), is down from $53 to $34.

 

ITB had not been formed yet when housing stocks peaked before the Great Recession. But a look back at LEN shows a typical homebuilder peak in and around mid-2005:

  LEN data by YCharts

 

When the builders peaked around July 2005, the Fed had raised rates 9 times for a total of 225 basis points, or 2.25% percentage points. Unbeknownst to anyone, that was already enough - or too much.

 

Moving to today, perhaps the Fed's 8 rate hikes, totaling 200 basis points, plus reversal of QE, have already been enough - or too much?

 

And what held true in 2005 for housing also held true for automakers. This pattern is also seen again now.

Moving on to larger stocks, the pattern that began occurring in 2006 is occurring now. That is, the banking stocks most closely dependent on local credit conditions - the regional banks - are performing badly. Here's a chart of a large regional bank ETF (KRE) versus the S&P 500 (SPY):

  KRE data by YCharts

 

Larger banks and asset managers also have been performing in weak fashion.

 

Something similar was seen during the Fed's last two tightening periods, mid-1999-2000 and 2004-2007.

 

All the above are the "rainy side of the street" that the Fed is either not seeing or, as in 2006-2007, not caring about. In that period, it was "too late." But in 2000, it was accepted, and the credit-sensitive housing sector became a source of strength during the dot-com recession of 2001.

 

I'm not predicting a recession.

 

What I'm saying is that there are major parts of the economy where the macro data has weakened and may have turned down, and where the judgment of the marketplace - which is a better-than-average indicator - says the Fed is making a mistake.

 

Strong dollars matter

 

Whether by the trade-weighted US dollar index (TWEXB - not a trading symbol, though) or the trading vehicle known as USDX (or DX) or other measures, the US dollar has neared or reached levels also reached as the boom of the '90s was peaking. A rise in the trading value of the US currency weakens exports and encourages imports, thus hurting US business. It also restrains inflation; and/or reflects waning US inflation pressures. (Note: You can track the daily value of TWEXB at a Fed webpage.)

 

A persistently rising, strong dollar has correlated with bearish-to-bullish reversals in the bond market and bullish-to-bearish reversals in the SPY. It also has correlated with weakness in commodity prices, notably gold (GLD) and crude oil. I've been publicly bearish on gold since August 2016 and on crude oil since earlier this year.

 

 

Some thoughts on cash and conflicting possibilities for stocks and bonds

 

This brief contribution is being written a little after 8 AM on Friday. The S&P 500 futures are at 2795, and bonds are down a couple of ticks in yield with the 10-year Treasury at 3.21%. The only wealthier, large country with a higher 10-year govie yield is Italy at 3.44%. France is at 0.80% and the UK is at 1.53%. Australia, typically a high-interest-rate country, is at 2.76%.

 

I have no particular bearish thoughts on the SPY for now. The November-January period is the strongest 3-month period of the year, and I saw a stat that midterm periods are typically much stronger than average for that period. So seasonality argues against the bears. The "tape" is, however, at best iffy for the bulls, so the dictum of not fighting either the Fed or the tape does not comport with a bullish posture.

 

Seasonally, interest rates should have declined the past 7-8 months, so they have acted badly, and they are soon entering their weakest multi-month period. So seasonality favors stocks and not bonds.

 

However, when the Fed gets "too" tight, at some point, interest rates drop.

 

Thus there are cross-currents for traders.

 

Some thoughts on getting to a personal investment plan follow to end this article.

 

As I've been saying since late January, for me the elephant in the room for the markets is not interest rate policy; it is the Fed's ongoing and now massive reversal of QE. The Fed is doing something unprecedented, and few are talking about it. It is shrinking the basic money supply, otherwise called its balance sheet, by $50 billion every month. It plans to do this probably into 2020 and possibly even 2021. Because the debt that matures is being replaced by new debt offerings from the Federal government and GSEs, effectively the Fed is withdrawing money from the banking system at a $600 billion annual rate. That's a lot of moolah. Bank loans and leases are $9.46 trillion. Thus, this metric may be diminishing by 6.3% ($0.6/9.46). This rate exceeds the current growth rate of loans and leases, which the linked FRED site shows as 4.4%.

Note, I'm not an economist or any sort of expert on these metrics, so I'm not saying these are the only ways to look at the system. But directionally, I'm comfortable presenting the above concepts and numbers for your consideration. Also important to note is that, of course, Fed policy is not everything in market action. It's a big world out there! So I look at this as one piece of the puzzle - but a major one that can be analyzed.

 

Given all the cross-currents and given that the Fed is shrinking the supply of cash, I look at cash as a once-hated asset that is returning toward acceptance as an asset that for now gives a positive yield - roughly zero after inflation - but that allows both traders and long-term investors to keep dry powder.

 

At some point, perhaps there will be clear trading opportunities or better bargains in some asset class.

 

Not long ago, Yogi Berra might have said that cash was the place no one wanted to go because the Fed had made it too crowded. That's changing with reverse QE.

 

All in all, and noting the contention in the body politic, my humble opinion is that these are not easy times to suss out what's really going on and what is coming around the corner. Serious Fed mistake or Fed policy reversal leading to markets soaring? Trade war worsening or remitting?

 

Risk on or risk off?

 

Summary

 

Traders may well be wondering if the Fed is too hawkish and is deciding on policy by looking too much at coincidental or backward-looking indicators, ignoring the worsening fundamentals and price action of credit-sensitive sectors of the economy and the markets. That's one risk to investors in equities. A related risk is that this sort of weakness spreads further through the economy.

 

A possibly bigger risk to asset values is the reversal of QE. Because the Fed did QE to help the economy via a wealth effect, isn't reversing it bearish for the real economy? And since the wealth effect involved driving up equity prices, isn't the major goal of reverse QE to drive P/Es down? If so, why is this not being discussed non-stop in the financial media?

I, therefore, see this as a challenging period in the markets and possibly in the US economy.