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SocGen on China

SocGen on China

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Published by Debashis Basu

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Published by: Debashis Basu on Jul 02, 2009
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  WorldGlobal Strategy 
16 June 2009
Global Strategy
Expect new lows in equity markets in H2. Is China the hidden Achilles heel?
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
Equities 30-80 6035Bonds 20-50 3550Cash 0-30 515
Source: SG Global Strategy Research
Equity allocation
 Very OverweightOverweightUSUK 
Neutral Cont Europe
UnderweightJapanEmerging mkts
 Very Underweight
Source: SG Global Strategy Research
Most areas in the markets have now discounted a V-shaped recovery. Any doubt will trigger arapid reversal in prices. I continue to be extremely sceptical and see recent events as part of a1930s-like, long march to revulsion. Talking about long marches, nowhere in the world fills mewith more scepticism than the Chinese economic recovery. The continued enthusiasm for allthings China reminds me so much of the way investors were almost totally blind to the fact theUS growth miracle was built on sand. China could be the biggest disappointment yet.
Whether you look at surging commodity prices or the near 60% ytd run-up in the Metals& Mining sector, one thing is clear; the markets believe wholeheartedly in the Chineseeconomic recovery. We have a long history of sticking our necks
out against theconsensus. In 2001 we repeatedly wrote that the US growth miracle would be seen inretrospect as a sick joke, as it was based on Kilimanjaro-like mountains of debt. It has takena while, but now most concur with that
view. In a few years time, I believe we willlook back on the Chinese economic miracle as the sickest joke yet played on investors.
It is amazing how easily group-think takes a vice-like hold in the financial markets. As theBRIC economies meet for their debut summit, few dare to speak out against the new,
We also saw this same investor mania 13 years ago with the Asian Bubble,which the consensus thought was a growth miracle. But to go that far against theconsensus invites a deluge of hate mail -link. That is why I keep a copy of a World Bankbook entitled
Thailand’s Macroeconomic Miracle: Stable Adjustment and Sustained Growth
 link. It was published in October 1996, less than a year before Thailand
s (and Asia
s)economic collapse. It is all too easy for investors to buy into beguiling
stories whichare in fact utter nonsense. If the bubble of belief in China
s medium-term growth prospectsfinally bursts it will have huge investment implications. I will be writing far more about thissubject over this summer. But one thought, if China is doing so well how come Chinesecompany profits in the year to April are down some 30% yoy (see chart)?
Chinese industrial profits growth (22 regions, year to date, yoy %)
2005 2006 2007 2008 2009-40-30-20-1001020304050-40-30-20-1001020304050
Global Strategy Weekly 
16 June 20092
SG have an excellent Asian economist, Glenn Maguire, who, unlike me, has been totally rightabout the recovery in the Chinese data this year (e.g. for example his Asian EconomicScrapbook
 link ). But it was notable that when the 6.1% yoy rise in Q1 GDP was publishedhe said the real outturn was actually more like 3.5% yoy, but that the authorities
thedata at turning points. Let me put that into plain English. The Q1 6.1% GDP outturn is simply alie
and it helps explain why the Chinese data is derided by so many economiccommentators. Many have highlighted that the GDP seems inconsistent with other data suchas electricity output (see chart below). This latter series remains weak. In May it declined 3.2%yoy and by 3% on the smoothed basis shown below).
Chinese electricity output (3 month mav) and GDP yoy%
Source: Datastream
Yet few dare to point out that the emperor
s clothes might be absent. When, for example, theInternational Energy Agency had the temerity, a few weeks back, to suggest that the Chineseauthorities were inflating the data ( link ), they were met with a robust broadside from theChinese National Bureau of Statistics. The NBS said on its website
It is regrettable that thepoint of view in the original article is groundless
We believe that, for an internationalorganization, this approach lacks seriousness
 link. I think this is a case of
 me thinks thoudoth protest too much
. Nevertheless, an article on Radio Free Asia reported that The NationalPeople
s Congress had found
serious fabrication
in official statistics
 linkandlink. That is not to say that the fiscal stimulus has not had a beneficial effect on Chinese activitythis year. What I question is the quaint notion the markets now seem to have that the Chineseeconomy can grow at a respectable rate when the rest of the world is in a deep recession. TheRadio Free Asia article also quotes Philip Andrews-Speed, a China energy expert at theUniversity of Dundee, Scotland as saying
Whenever you look at Chinese statistics, you say
isit incompetence, is it confusion, is it conspiracy?
He thinks it is a combination of all three.My own view is that to the extent that the renewed surge in commodities and the Metals andMining sectors are based on the Chinese growth miracle, the markets are relying on acombination of hype, lies and wishful thinking. Just over a decade on from the World Bankpublishing
Thailand’s Macroeconomic Miracle: Stable Adjustment and Sustained Growth,
s performance can be best described as unspectacular with an increasinglyunstable and dangerous political backdrop. Personally I believe the bullish group-think onChina is just as vulnerable to massive disappointment as any other extreme of bubble-nonsense I have seen over the last two decades. The fall to earth will be equally as shocking.
2001 2002 2003 2004 2005 2006 2007 2008-10-505101520-10-505101520
GDPelectric output
Global Strategy Weekly 
16 June 20093
s looks at a couple of other things that have caught my eye in recent days. The US FederalReserve have just published the quarterly Flow of Funds data. For data geeks like me this isalways worth a look as it gives detailed financial data for all economic sectors in the US
 link. Among things of note was the second baby-step in the de-leveraging processes of the non-financial private sector. Borrowing declined $179bn in Q1 (annual rate) against growth closerto $1.5tr p.a. for most years prior to the bubble bursting. Interestingly, despite the third quarterin a row of massive fiscal stimulus ($1.4tr in Q1 following $2.2tr in Q4 and $2.1tr in Q3
bluetop bars below), a massive unwind in the balance sheet of the financial sector ($1.8tr, blackbar below) meant that total domestic debt shrunk in Q1 for the first time. One interpretation ofthis is that the de-leveraging process is wholly offsetting massive fiscal stimulus.
US borrowing by sector ($bn annual rate)
Source: Datastream
Finally, I
ve been reading a lot about how the bond markets are now discounting substantiallyhigher inflation (see chart below). Actually as can be seen from the chart, what we are seeingis a reverse of the anomaly that occurred with real yields. A collapse in the price of inflation-proof government bonds in H2 last year was almost certainly the result of investors dumpingthese bonds post Lehman
s collapse. Real yields of 4% at the end of 2008 were an anomalydriven by weight of money selling. My forecast for year-end is that as growth begins to stallout we should look for a return back to 1% real yields and ½-1% implied inflation.
US 10y real yield and implied inflation expectations %
Source: Datastream
2004 2005 2006 2007 2008-3000-2000-10000100020003000400050006000-3000-2000-10000100020003000400050006000
non-financial domestic private sector financial sector federal + state & local governmenttotal domestic
2004 2005 2006 2007 2008 2009-1.00-0.5000.501.001.502.002.503.003.504.00-1.00-0.5000.501.001.502.002.503.003.504.00
implied inflation exp
real yields

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