Andy Lees Sums up the problems well in today’s morning note from UBS:
A few data points. Today’s Chinese PMI was the worst since March 2009, but the flatness of the 2’s – 5’s swaps curve, now just 3bpts (chart 1), suggests this will only get worse as banks don’t have the ability to support continued credit growth unless the central bank starts easing up on policy. As recently revealed by the central bank, total social spending which is both on and off balance sheet credit, is on track to reach CNY14trn this year equivalent to around 30% GDP (Yes thats right, 30% credit to GDP growth). Certainly the central bank could inject a huge amount of liquidity by lowering the reserve requirements, but until that happens growth will look increasingly vulnerable.
Since April I have voiced concern about the potential for a hard landing in China. Once bubble psychology takes over, it is difficult to dislodge it as people have significant sunk costs tied to malinvestments. Look at the debt-financed investments of Chinese state-owned enterprises for example. Moreover, attempts to tighten by raising interest rates increases interest income, adding to demand in an overheated economy. The Chinese have had to be and will continue to have to be extremely aggressive in combating credit growth for dubious speculative ventures. Eventually, the excess capital investment will cease and the bubble will pop. However, when bubble psychology reverses, it tends to do so quickly. This is why a hard landing is likely.
Andy continues onto the US.
Chart 2 shows the US macro surprise index. The 50 day moving average is -82 highlighting the duration and depth of the high frequency data missing expectations. Consumer expectations are now at near recession levels (chart 3) and we have seen data showing personal finance expectations is also extremely weak. The only positive was the ISM index and yet we also know that the detail of that report shows the difference between the forward looking index (new orders minus inventories) and the overall index is diverging aggressively (chart 4). Previous divergences were in 1973, 1979/80, 1984 immediately before a 175bpt single meeting rate cut and two 50bpt cuts in the following one month (ie two cuts in 1 month). The other dip was last year ahead of QE2.
With 96 of the S&P 500 earnings reported, growth is 13.89% y/y which is the lowest since Q3 2009. The brown goods manufacturers and the white goods manufacturers and semiconductor stocks all seem to have been disappointing.
Q2 and 2011 second half economic growth estimates are already being cut as consumer spending weakness takes its toll. Note Andy’s reference to new orders minus inventories. Channel stuffing is endemic at later stages of a business cycle as companies look to maintain earnings growth despite weakening demand. So this forward looking index that strips out inventory accumulation is a good way to gauge future economic and earnings weakness.
Earnings growth will slow and estimates for the second half of 2011 and 2012 will be cut. By September or October this will be evident, making a major correction in US shares a serious downside risk.
On Europe, Andy writes:
European PMI, both manufacturing and service sector are now the lowest since September 2009 at 51.4 and 50.4 respectively. Europe is China’s largest export market, but as highlighted in the daily today Chinese export growth to Europe is slowing even to Germany. It is only Italy whose import growth from China is strong, which is clearly unsustainable. With Chinese real retail sales growth down steadily from 20.4% in 2008 to 10.4%, this weakness in exports is no longer being made up with a reshaping of the economy. On Tuesday the Herald Tribune was highlighting that Germany may be the locomotive but unfortunately it has left its European carriages behind; whilst it is exporting to the rest of the world, its imports from Italy for example are down 3%.
None of this is new. Ed Hugh wrote about the red lights flashing for eurozone growth last month. Moreover, if austerity cuts demand in countries like Spain, Italy and beyond, it will drag Germany down with it via trade and financial linkages. Germany can only continue decent economic growth by fostering greater internal demand. Unless Germany can get its consumers to start spending more, the Eurozone is going to double dip.
Andy Lees concludes:
None of this slowdown or widening of debt should be a surprise given the end of QE2, which annualised as a stimulus equivalent to 7% of US GDP or 69% of the US budget deficit or 11% of US M2 money supply. Taking this away will clearly change both internal and external terms of trade on an unprecedented scale and thereby the distribution of wealth, asset prices and the ability to support both debt and consumption. Lets also not forget that whilst rolling over the US debt ceiling or transferring more funds to Greece may halt a contagion effect, it doesn’t sort out the real problems, and if we are not going to have the default by monetisation then we really have to look out below as deflation will quickly set in again. Without monetisation, we won’t have the cash flow to ignore the data.