Time to put the brakes on Chinese exposure

Amid mounting evidence that China’s economy is on the verge of a slowdown, it is time to reduce commodities exposures, writes Chris Watling.

There is an increasing risk that China’s economy will slow more than expected. Its yield curve is close to inversion (ie, signalling a meaningful growth slowdown) and official short-term interest rates have also moved meaningfully higher in recent months (while unofficial shadow banking rates are reportedly many times higher than official rates).

Leading economic indicators are slowing: PMI surveys continue to slow, while car sales are contracting and copper imports are falling. Inflation is also yet to be brought convincingly under control – although the debate on this is mixed. 

Of particular note, Chinese Premier Wen Jiabao said in the Financial Times in June that: “The overall price level is within a controllable range and is expected to drop steadily.”

In contrast, the China Securities Journal (a government-sponsored publication) “believes that inflation in June is very likely to exceed 6 per cent year on year” while other sources, including Reuters, have cited Chinese central bank officials as stating that “The People’s Bank of China will continue to increase interest rates and bank reserve requirement ratios until it sees three consecutive months of decline or stability in consumer prices”.

Meanwhile, the bubble-like nature of China’s housing and construction boom enhances the risk that the slowdown will become unmanageable.

A more significant than expected slowdown in China would undoubtedly have knock-on effects for commodities, given China’s dominance in most global commodity markets.

It would also have meaningful knock-on effects on a number of key emerging market commodity producers (Chile, Peru, South Africa and Kazakhstan, among others) as well as a handful of developed world commodity producers – in particular Australia, Canada and Norway.

In contrast, though, while the Western economies would not be immune to a Chinese slowdown given its major contribution to global growth each year, they are much better placed to weather that slowdown than key emerging market commodity producers. In particular, the likely sharp fall in the oil price that would accompany such a slowdown (and is currently accompanying it), will benefit the US and other western households.

We believe it’s prudent to reduce commodities allocations on a one to two year view (in our model, from 15 per cent to 5 per cent) with most of that in gold as a hedge against major policy error and continued long-term money creation, and redistributing some of that commodities weighting into equities (up 5 per cent to 57 per cent in our model) – especially western equities – as well as cash (up 5 per cent to 10 per cent). 

Commodities will fare poorly

Liquidity is less plentiful

Our analysis suggests that a key driver of commodity prices in recent years has been money creation (ie, quantitative easing programs in the US in particular, but also the UK, Japan, China in its own form, and the Eurozone).

With the end of the second round of quantitative easing (QE2) in June, liquidity is less plentiful. As such, a key support for the recent upward price momentum in commodities is removed. 

QE3 is unlikely any time soon

In particular, in its April 2011 economic projections, the Federal Reserve removed much of its tail-risk deflation forecast.

That, coupled with economic weakness, had been a key justification for its QE program. In its June 2011 forecast update, the Federal Reserve maintained those higher inflation forecasts.

Added to that, as discussed below, there is increasing evidence (despite the recent economic soft patch) that the US recovery is self-sustaining.

The Chinese economy is slowing

Given it is the key consumer of most commodities – especially base metals and some agricultural products – a slowdown in China’s economy will impact global commodity prices.

For example, China accounts for most of the growth in global copper demand this past decade. The same can be said of steel, aluminium, lead and tin.

Added to that, there is strong evidence of a bubble in Chinese residential and commercial construction (where much of the base metals are consumed).

Further evidence, for example, of Chinese ghost cities (constructed but empty) continues to emerge while property valuations are excessive and bubble like, and supply is plentiful.

Western equities are attractive

Economic expansion is set to continue

Despite recent soft economic data, key macro indicators continue to support an expectation of an ongoing economic expansion. In particular, the US (and western) yield curve remains steep, credit and monetary conditions remain loose, and US car sales continue to trend higher while companies continue to throw off plentiful cash flow – all conditions which point to economic expansion and not recession (and all indicators which have correctly forecast, ahead of time, all US recessions these past 40 years). 

Other near-term indicators also suggest that this US expansion has become increasingly self-sustaining. For example, after contracting from July 2008 through September 2010, US consumer credit grew each of the next seven months.

US consumer intentions to buy a car and house have increased sharply in the first half of 2011 and US job creation, as well as chief executive officers’ intentions to increase their employment in the next six months, have also both improved over the past six to nine months (despite recent poor US non-farm payroll data).

Added to that, the oil price spike in February and earlier this year, has, in large part, eased in recent weeks.

Equities are cheap 

While valuations, per se, are not the best forecasting tools for equities on a one to two year view, they are of interest if the economy is expanding and relative valuations are compelling.

In particular, US and other western equities are very attractive relative to government bonds, US high-grade corporate bonds, US high yield corporate bonds and cash.

Against US government bonds, and given the recent weakness in equity markets and strength in bonds, the yield pick-up (that is, equity risk premium) is back at record high levels (in excess of 7 per cent).

US equities currently yield more than US high yield (ie, junk) corporate bonds. Against real cash rates, equities are also very attractively priced.

Medium-term models are at key buy levels

Over and above the valuation message favouring western equities, there are also a number of medium-term models which suggest a meaningful equity rally is likely from around current levels, highlighting this time as a key tactical entry point for adding more equity risk. 

In particular, a number of sentiment indicators, which had been bullish and therefore on contrarian sell a number of months ago, are back at key buy levels.

The AAII sentiment bullish index, for example, is back at the low levels last visited in September 2010. Consensus sentiment and equity advisory optimism are also both at multi-month lows.

Equities are also meaningfully oversold both on an absolute basis, and also relative to bonds – against bonds, for example, equities are two standard deviations oversold (note, that typically occurs once a year). Other medium-term indicators are giving a similar message.

Relative to emerging equities, western equity markets are cheap, are still benefitting from minimal or no monetary tightening (unlike Asia) and are less vulnerable to falling commodity prices.

In contrast, a number of the emerging markets are vulnerable to falling commodity prices and a temporarily slower Chinese economy.

Chris Watling is chief executive officer of London-based Longview Economics and a regular speaker at the PortfolioConstruction Forum Conference each August.