US stocks finished lower overnight. Notably, the NASDAQ underperformed again.
I think something significant is going on here. The leader is beginning to falter. It may not be long before you see some big moves taking place in the market.
Like what happened in China yesterday…
Chinese stocks plunged 4.2%.
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That occurred on the ‘good news’ that China’s economy returned to growth in the June quarter. It expanded 3.2% year-on-year, and is now down just 1.6% for the first six months of the year.
But the quality of that growth was poor. As the Financial Times reports:
‘The solid rebound was only achieved with Herculean effort from an interventionist state falling back on the same tools it has relied on since the financial crisis of 2008.
‘Even before the first virus cases were discovered in Wuhan, the economy was struggling with massive over-investment, particularly in redundant real estate projects, mounting bad debt, growing dominance of inefficient state enterprises and chronic underconsumption. The government’s response to the collapse of growth in the first quarter has exacerbated all these problems.’
And the second quarter economic growth data bore that out.
Chronic under consumption?
Retails sales fell by 3.9% in the quarter, while real disposable income was down 1.3%. In other words, the consumer in China isn’t consuming.
That’s bad news for an economy that wants to increase consumption as a share of GDP. Or as the FT puts it:
‘Despite years of official rhetoric on the need to create a consumer economy and reduce reliance on investment as the main driver of growth, China’s household consumption as a percentage of gross domestic product remains extraordinarily low — less than 40 per cent and on a par with countries such as Gabon and Algeria.’
China’s problem, a perennial one, is that state-directed investment is ‘crowding out’ the private sector, both in terms of consumption and private investment.
For example, investment by state-owned enterprises increased 2.1% during the first half, while private company investment fell by 7.3%. The FT points out that the English language data release left this little snippet out.
‘Crowding out’ the private sector is probably the wrong expression. Drowning it might be better. The FT says its all part of Xi Jinping’s three-year plan to enhance the role of state-owned enterprises at the expense of private business.
China may have gone back to the 2008 playbook, but it is virtually impossible for them to replicate it.
This spells trouble for Australia
Back then, China’s response kicked off a three-year resources boom, particularly in the bulk commodities of iron ore and coal. It led to a terms of trade boom, which (if I remember correctly) pushed nominal economic growth rates as high as 10% at one stage.
As a result, the Reserve Bank hiked interest rates to 4.75% by late 2010, and stayed there for a year.
Why can’t China do it all again?
Put simply, it now has too much debt.
According to the Institute for International Finance, across all sectors China’s debt level is on track to hit 335% of GDP, up from 302% at the start of the year.
That’s a huge increase, and tells you that China’s debt-fuelled growth is now becoming increasingly unproductive.
The other reason China can’t continue to pull this lever is a bit more complex, but I’ll keep it simple.
In short, China manages its currency, the yuan, against the US dollar. It’s not a hard peg, but it’s close.
In order to do this, it has to restrict capital flows. To be precise, it has to put up a wall to stop Chinese capital getting out.
As China creates more and more credit to prop its economy up, ever greater amounts of yuan flow through the economy. Clearly, the yuan is being devalued. But it’s not easy to exchange that yuan for US dollars. Capital controls prevent it.
Still, connected money will look to get out and get their hands on US dollars.
This perhaps explains why China moved on Hong Kong recently. It’s the conduit for capital flows in and out of China. To really control capital flows, the government needs to control Hong Kong.
The US knows this. As a result of China’s recently legislated national security laws, the US responded by removing Hong Kong’s special economic privileges.
As Trump said in a recent press conference, Hong Kong will now be treated ‘the same as mainland China.’
If that’s the case, China will be even more deprived of US dollars in the years ahead, putting more pressure on the exchange rate.
Throw in the fact that the West no longer trusts China, and are reconfiguring their supply chains, earning US dollars via trade will become a struggle too.
This all points to a coming break of the currency peg in the year ahead.
What does that mean for Australia and your investments? I’ve been working on a major report on this topic for the past few months.
Keep your eye out for it next week.
Editor, The Rum Rebellion