Another good session for stocks overnight, which means the Aussie market should be in the green again today.
Why are stocks rising again?
The official version is that the Fed is now going to be more patient raising rates, and there has been progress on US/China trade negotiations.
The real reason is that prices fell too far, too fast, given the available information, and now stocks are bouncing back to restore some balance.
In my view, this rally is just about done. The key will be whether the next sell-off holds above the Christmas lows. If so, that will be a positive. If not, it will be a sign that the bear market is getting deeper.
Regarding the trade talks, a statement from the Office of the United States Trade Representative, following two days of trade talks, contained the following:
‘The United States officials conveyed President Trump’s commitment to addressing our persistent trade deficit and to resolving structural issues in order to improve trade between our countries.’
If you’ve been reading the Rum Rebellion this week, you’ll know I’ve written a lot about China and its shift from saver to borrower. Here’s where the current trade talks are very relevant to this topic.
If Trump wants to correct the US/China trade deficit, it will hasten China’s path to borrower status. Remember, China’s historic trade surpluses with the US are a major source of its savings, its foreign exchange build up and its domestic bank reserves and economic growth.
In short, the US/China trade deficit has enabled China’s rise to become a global economic power. A shift in this dynamic also represents a shift in how the post war global monetary system works.
The US, as manager of the world’s reserve currency, and via generating persistent current account deficits, has provided liquidity to the world for decades.
With Trump trying to now shrink these deficits, he is also trying to change the way the global economy works. That he’s doing so at the end of the business cycle only increases the risks.
One of the major implications of this shift is less demand for US treasury bonds. China previously reinvested its surpluses in the US bond market, effectively financing US government spending.
But it’s no longer doing this. China’s holdings of US treasuries peaked in 2013, at US$1.3 trillion. The latest data (October 2018) shows China’s holdings at US$1.14 trillion.
With the US continuing to run huge government budget deficits (forecast at around US$1 trillion this year), China no longer a buyer and the Federal Reserve selling treasuries too, it is hard to see how US bonds yields won’t rise and/or the US dollar won’t decline in the years to come.
What are the implications for Australia?
With fewer savings in the kitty, China has less flexibility to stimulate its economy in ways that have benefitted Australia for years.
China’s stimulus has always been about fixed asset investment. A recent IMF paper showed investment as a percentage of GDP in China being 43%, while private consumption was only 38% (compared to a global average of 60%).
The focus on growth via investment in fixed assets benefits commodity producers — especially iron ore producers, as fixed assets are steel intensive.
You can see this in the chart below. It shows the performance (in percentage terms) of BHP Billiton Ltd [ASX:BHP] in red, and Rio Tinto Ltd [ASX:RIO] in blue, against the ASX 200 index. Both have outperformed over the past year.
Unusually, these stocks haven’t tanked on news of China’s slowing economy. Perhaps it reflects an assumption that the focus on fixed asset investment to drive growth will continue in the short term?
Perhaps it’s in anticipation of an imminent stimulus announcement. Even Fortescue Metals Group Ltd [ASX:FMG], a lower quality iron ore producer (its ores have lower iron content than the majors) is rallying strongly, as the chart below shows. Since the New Year, the stock price is up around 13%.
To give you some context, the low for FMG came in September when China’s fixed asset investment growth slowed to a record low. Note the news was already in the price when it was announced in mid-September.
Now, with the stock up 30% from the lows, it wouldn’t be surprising to hear a stimulus announcement from China.
The market certainly senses something is going on.
And perhaps it’s right.
After all, worrying signs continue to emerge about the health of China’s economy. The Asia Times reports:
‘Sales volume in the world’s largest auto market fell by 6% to 22.7 million units in 2018, the China Passenger Car Association said on Wednesday. That marks the first annual decline in more than two decades.’
That’s enough to have China’s central planners in a panic.
But as I’ve tried to explain in this week’s Rum Rebellion, China’s ability to keep pumping out big bang stimulus programs is diminishing. Perhaps they can get away with one more, I don’t know.
If so, it will likely be the last hurrah for Australia’s historic iron ore production and export boom.