China’s Foot Is Now off the Accelerator

Chinese Yuan

Markets took a breather overnight. Strength in the US dollar took the wind out of just about everything. A late rally in shares helped the Dow Jones to close down only 0.42%, while the S&P 500 ended just 0.3% lower.

Oil was the worst affected by strength in the greenback. West Texas Intermediate fell 2.6%, while Brent crude was down 2.2%. Gold and copper both fell about 0.5%.

Gold’s correction so far has been pretty tame. After peaking around $1,380 just after the Brexit panic, the subsequent falls have been measured. As I’ve written before, a drop down to US$1,300 would be entirely normal.

In fact, gold could fall below US$1,300 and it wouldn’t concern me too much. As you can see in the weekly chart below, gold has had a strong run since the start of the year; it now needs to correct and consolidate before making another move higher.

Source: Optuma
[Click to enlarge]

I don’t know when the next move higher will start, but I do know that now is the time to build a position if you haven’t done so already. That’s why I’ve written a special report detailing the five best gold stocks on the Aussie market — and the best price to buy during this correction. You can access it here.

Speaking of gold, I’m heading to Sydney this afternoon to attend the ABC Bullion Precious Metals Investor Seminar, which is on tonight at the Ivy Ballroom.

The last time I went to the Ivy in Sydney was for some pre-dinner drinks with my wife a few years ago. I ordered a beer and a glass of champagne. They served the drinks in plastic glasses. We were obviously incapable of consuming alcohol without a) dropping it, or b) glassing someone on the way out.

So we left in disgust…

But I digress…

It will be interesting to get some industry views on the sector (somehow, I can’t see any of them being bearish!), and I will report back to you in Thursday’s Daily Reckoning. If you’re attending the conference, come and say hello if you see me wandering around.

As I mentioned earlier, US dollar strength caused weakness in commodities and stocks today. But the US dollar index has been strong for a while. After bottoming in early May at around 92 points, the index has rallied over 5%.

That might not seem like much, but it is when we’re talking about currencies. The US dollar index measures the performance of the US dollar against a range of other major currencies, predominantly the euro, the yen and the pound. Lately, all of these major currencies have been weak, hence the strength in the greenback.

A major side effect of this US dollar strength is strength in the Chinese yuan. That’s because China loosely pegs its currency to the US dollar. But China doesn’t want a strong currency. It’s trying to squeeze growth out of its debt-addled economy any way it can — and a strong currency doesn’t help.

Which is why the Chinese government continues to weaken the yuan against the US dollar, as the chart below shows:

Source: The Daily Shot
[Click to enlarge]

Here’s the interesting thing, though. To the left of the chart you can see the sharp devaluation that spooked global markets in August last year. Since then, the yuan has continued to weaken, but markets haven’t batted an eyelid.

What’s the big deal behind a weaker yuan?

Maybe there isn’t one. But during last year’s panic, much of the concern centred on the large amount of US dollar-denominated debt held by many Chinese companies. As the yuan weakened, therefore, debt repayment costs increased.

Maybe some debt restructuring has occurred over the last year. Or maybe the recent stimulus-led growth spike has simply papered over the cracks that are in China’s financial system.

If that is the case, we’ll find out how big the cracks are soon enough. A report in Bloomberg, quoting Michelle Lam from Lombard Street Research, highlights that the government’s attempt to blast the economy with liquidity is not translating into broader money growth:

“The divergence between narrow and broad money growth just highlights how difficult it has become for Beijing to generate growth by throwing money at firms that are unwilling to invest. Stimulus has boosted growth but has few second-round effects, and money is just not being passed around.”

In other words, when the stimulus efforts wear off, growth will begin to falter again.

Rowan Callick, China correspondent for The Australian, seems to have picked up on this theme with a series of bearish articles on China lately. In today’s effort, he quotes a couple of Chinese economists who aren’t too upbeat on China’s steel industry. This has major implications for iron ore prices.

Liu Haimin and Song Ligang, writing in the latest annual China Update, published this week by the Australian National University, say China drove up steel production by six times from 2000 to 2015, to 804 million tonnes, almost half global output.

They say: “The scale of that expansion is unprecedented in the history of  industrialisation in Europe, North America and East Asia.”

Last year it exported 100 million tonnes, 50 per cent more than the US’s entire output — though triggering 37 anti-dumping cases.

This is a point I’ve made before, but it’s worth repeating, given China’s latest stimulus efforts have given markets a false sense of security about the health of China’s economy.

That is, Australia was a prime beneficiary of China’s historic steel expansion. And while the iron ore majors will continue to feed China’s steel mills, they will do so at much lower levels of profitability once this stimulus starts to fade.

When will that be?

Who knows? One month, two months, six months?

I’ll keep my eye on certain stocks for clues. Stock prices discount the future, so that’s where you should look. Rio Tinto [ASX:RIO] and Fortescue Metals [ASX:FMG] are the obvious choices. They’ll tell you what’s coming.

Economic management in China over the past few years has been very predictable. That is, the government provides stimulus, then pulls back on the intervention to see how the economy performs naturally.

Soon enough, the economy weakens. When the growth slows to a level that the government deems unacceptable to employment or financial stability risks, it puts its foot back on the accelerator.

Based on this timetable, China looks to be in the ‘foot off the accelerator and see how things go’ phase. This is the riskiest phase for investors, precisely because the perception of risk is at its lowest.

But in a financially repressed and centrally planned economy, perception is deception.


Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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