TT discusses whether investors are right to be worried about US rate rises and a Chinese slowdown, and considers which is the bigger risk.
The lodestars of the global economy are giving very different signals. America’s recovery is gradually gathering pace, bringing us closer to the first rate hike in nearly a decade, while China’s Red Giant economy is rapidly losing heat. This divergence is dangerous for the world economy, particularly for those Emerging Markets that prospered from China’s investment boom and an astronomical amount of cheap credit from America. But what should worry investors more – US rate rises or a Chinese slowdown?
Countdown to lift-off
The American economy is approaching escape velocity. It grew at a 3.9% annualised pace in the second quarter of 2015, a feat made all the more impressive by a 13% appreciation in the dollar over the past year. US businesses have been creating jobs at a rate of about 3 million a year, causing unemployment to fall steadily to 5.1%. And with broad money supply growth running above 6%, buoyant economic conditions seem set to continue.
On the face of it, the case for a Fed rate hike is clear. Yet the gravity of such a move would be felt around the world, especially in Emerging Markets. External debt in these countries has risen by $2.8tn to $7.5tn since the Lehman collapse. This leaves them looking vulnerable as each 50 basis point rise in official US interest rates historically leads to a 16 basis point rise in Emerging Market bond yields. Moreover, because higher rates in the US will act like a black hole, drawing foreign capital towards America, the dollar would likely continue to strengthen against Emerging Market currencies, further increasing the burden of dollar-denominated debt.
By making imports cheaper, dollar strength would also add to considerable deflationary forces in the US. Indeed, poor productivity and stagnant wage growth point to ongoing slack in the labour market, suggesting that wage-driven inflation is still some way off, while weaker commodities continue to weigh on consumer prices. Thus if rates rise, very low inflation could quickly become deflation, potentially derailing the US recovery.
US core inflation (%, YoY)
Source: TT International, Bloomberg
But it is precisely this lack of inflationary pressure that should limit the impact of US rate rises because any tightening cycle is likely to be extremely gradual. A number of other factors also suggest that this cycle will be the loosest tightening in history. Firstly, the developed world recovery remains sluggish, weighed down by excessive levels of debt. Combined public and private borrowing in the rich world has risen 36% since the peak of the previous credit cycle in 2007 to 265% of GDP. Secondly, the slowdown in Emerging Markets will affect the US far more than in the past. Whereas in previous tightening cycles the US dominated the world economy, Emerging Markets now account for 38% of global GDP on a nominal basis, and 52% when calculated by purchasing power parity. If US rate rises are as gradual as we expect, emerging and developed economies should be able to take the strain.
The impact on financial markets could be equally uneventful. It seems as though the Fed has been edging towards lift-off for light-years. In fact, this is the most telegraphed rate rise in history. Anticipation of the event is one reason for the recent equity market correction, Emerging Market currency rout, and spike in Emerging Market bond yields. As these adjustments have already largely taken place, there may be some traditional ‘travel and arrive’ share price behaviour once the first hike occurs, with the removal of a big source of uncertainty potentially triggering a relief rally. Several Emerging Market central bankers appear to agree, having urged the Fed to end uncertainty by raising rates.
Chinese economy: coming down to earth
If concerns about US rate rises seem overdone, fears of a slowdown in China are far more justified. After decades of stellar growth, the economy is losing momentum as it rebalances away from investment and towards consumption. Exports are tumbling, factory gate prices are falling, and fixed investment is climbing at its slowest pace since 2000. While official figures claim, somewhat suspiciously, that Chinese growth is right on target at 7%, other measures suggest that the actual rate may be much lower. For example, China’s Keqiang index, a proxy for heavy industry growth comprised of 40% electricity production, 40% outstanding bank loans and 20% rail freight volume, implies far lower GDP growth.
Keqiang Index is near record lows (%)
Source: TT International, Bloomberg
China has been the engine room of global economic growth over the past decade. So the knock-on effects of a Chinese slowdown on the rest of the world would be significant. JP Morgan estimates that a 1% GDP shock in China would reduce global growth by 0.5%. With the massive economy sucking in about half of the world’s aluminium, nickel and steel, those Emerging Markets that have prospered by shovelling commodities China’s way look extremely vulnerable, particularly countries such as Brazil with current-account deficits that are becoming increasingly expensive to fund.
Impact of China growth shock on real GDP, VAR analysis
Source: JP Morgan, Sample 1Q00 to 2Q15
Developed economies have less to fear. American exports to China accounted for less than 1% of GDP last year, while lower commodity prices would actually be stimulatory for Western consumers. But the rich world is far from immune. Since about a third of global investment occurs inside China, imports of capital goods look set to decline, affecting manufacturers from Japan to Germany. Moreover, rich-world policymakers would struggle to offset any spillover effects as interest rates are still at rock bottom, while debt and deficits remain at levels that inhibit fiscal expansion – even if there were much appetite for such spending, which there is not.
With this in mind, China’s economic slowdown is concerning, but there are plenty of reasons for guarded optimism as well. Property is a key pillar of China’s economy and its value underpins the banking system; in recent months, prices have stabilised across much of the country and started to rebound in major cities. What’s more, China’s future lies with its shoppers, not its exporters, and services, incomes and consumption are all proving resilient. Finally, Beijing still has plenty of rocket fuel in the tank if it wants to reignite growth. Benchmark one-year lending rates remain elevated at 4.6%, while required reserve ratios are 18% for big banks. Both are likely to be cut, reducing funding costs for borrowers and freeing up more money for banks to lend. Further stimulus should come in the form of fiscal spending, which was cranked up by 26% in August year-on-year.
In conclusion then, a Fed rate hike poses substantial risks, particularly to Emerging Markets. But a gradual tightening cycle would limit the impact, and fears that developing economies will suffer a rerun of the 1997 Asian financial crisis seem overblown. Indeed, most Emerging Markets are more financially sound than back then. Many currencies are no longer tethered but float freely, leaving them less vulnerable to a disruptive collapse of currency pegs. Most countries in Asia sit on large FX reserves and current-account surpluses, and their banking systems are less reliant on foreign creditors.
Compared to US rate rises, China’s slowdown is a darker matter. But again the doomsters go too far. Economic growth is almost certainly lower than the rate reported by the government. However, it appears to be within the range of a soft landing and there is evidence of improvement in important areas such as property. Even 5% growth this year, the low end of reasonable estimates, would add more to world output than the 14% expansion China posted in 2007 because the economy is so much bigger. Once we have seen the first US rate hike, and China begins to stabilise as stimulus measures take effect, equities should regain their composure.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).