Blain's Morning Porridge - But what about China?

Blain’s Morning Porridge – May 30th 2017

“It’s important to be comfortable with uncertainty…. ”

Last week was thin on volumes and activity, but this week may be even quieter. Bank-holiday shortened, mid-term, and the end of the month, leading into June – never a good thing. It feels the pretty directionless feel to markets remains in prospect. It might be the start of summer, but there is a definite whiff of “seen-this-before” in the air.

The ECB will opine everything is fine, but no policy changes yet. The UK election looks slightly less the coronation processional we initially thought it would be: Theresa May is on the back foot, and Corbyn is apparently picking up votes – my twenty-something kids are very excited. US growth may look stronger, but Trump has flown back into further criticism on his family. The £10 double on Corbyn In, Trump Out I proposed last week is certainly looking less a joke!

And, as if to remind us… the news this morning includes US banks waking up to the fact the credit quality of auto-lending is distinctly sub-prime. No S*** Sherlock awards to them all for realising the credit quality of consumer lending on cars, student loans and credit cards is looking wobbly and unsustainable.. again..

As an extra treat I’ve attached a chart from my Macro chum, Martin Malone looking at Global Equities – now $10 trillion plus…. He remains a bull. Not so sure myself.

Meanwhile.. how much should we worry about China?

Headlines predicting imminent China debt default are hysterical nonsense - Moody's cut the credit rating a single notch to A+ (which remains very much investment grade). I most definitely am not a China expert, but in some respects it does look like they are going through a credit "event" somewhat analogous to the Global Financial Crisis of 2008. Whatever happens re Chinese debt in coming months, it’s going to create financial pain and change - but not necessarily end-of-the-world financial cataclysm.

There are aspects of the pace of China growth over the past 30-years that make the current circumstances unique. In just a single generation we've seen a totalitarian regime haul itself from famine and revolution to become a rich and wealthy nation. It’s succeeded on the back of a clear contract between government and the people: as long as the Government delivers jobs and prosperity and there is little in the way of political dissatisfaction. That compact will not be risked.

The structure of Chinese finance is complex - but boils down to the last 30-years of growth and construction financed through increasing debt. The debt market has become increasingly nebulous and complex as the economic expansion has required new sources of capital to be prospected and mined. A host of unregulated shadow banking institutions and mechanisms have emerged alongside the established banks. They have partially funded themselves by selling dubious "structured wealth management" products. A portion of that "unwise" is lending and financing now looks unsustainable - analogous perhaps to the sub-prime/structured debt crisis in the west last decade.

There is going to be considerable pain as it unravels - prompting three questions:

The first is how much will it be an internalised China issue? Could there be destabilising global spillover implications? My gut feel is it’s largely going to be a domestic crisis as the state "sorts" out solutions, and Government puts the economy back in order to sustain high growth. Solutions won't come over night - the next few years will see plenty of news about correcting imbalances in China, and regulation to keep the Growth/Society compact intact in place.

However, wobbles in China could we have damaging implications on global sentiment – perhaps causing the kinds of fear and panic that triggers correction/rout on stock markets?

Second is how can the Chinese Government address the issue without causing shock? While the government continues to manage the narrative, shocks will probably be avoided.. but clearly it will generate a reassessment of China value - one for the EM specialists to ponder.

The Third question is can a long-term solution be found to the Growth vs debt conundrum facing China? It’s been remarked before that China is growing old before it gets rich. That includes payback for single child policies is a rapidly ageing and unbalanced population. Add in further social issues such as the perilous state of the Chinese environment and rising social inequality, and it makes the government's long term task of keeping the lid on social unrest more difficult - and strongly suggests the state will have to borrow more to enhance their side of the social compact in terms of amenity and state provision.

China has not only got old, but has become an economy facing all the demographic issues of an ageing population. Can it meet these challenges long term? Again, my gut feel is the government will adapt and swim with the current. But as the globe’s No 2 economy – its got exert a considerable financial gravity on the rest of us..

Watch that space…

Finally, my crew and I completed our second qualifier for this year’s Fastnet Yacht race – a race to Deauville in France and back. Fantastic conditions on the way over, but gusting winds, thunder and lightning, and driving rain on the way back. Remember, I’m doing all this for charity – check the link: http://www.sail4cancer.org/fastnet-2017-bill-blain