The China Correlation

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–Buckle up Australia. You’re along for the ride in a high stakes game of chicken. We’ve written about inflation chicken before. To sum up: the premise is that Ben Bernanke is using interest rates to force China to revalue its currency and surrender its low wage advantage over the rest of the world.

–Of course maybe that’s not Bernanke’s intention at all. He has other issues, like the solvency of the U.S. banking system. But if Bernanke is the leading general in the global currency war, he’s inflicting serious damage. Food riots have led to regime instability in the Middle East and North Africa. Egypt is the latest example.

–But the real target is China. And the situation has changed a bit since we first wrote about it. The simple question is who can tolerate the effects of inflation the most? In the U.S., the Bernanke Fed’s monetary campaign against its own currency (the U.S. dollar) has led a bogus stock market rebound and a furious rally in industrial metals and grains prices.

–What the Chinese really need is a wall to keep out all those Federal Reserve Notes. Instead, you’ve seen increased signs that Chinese authorities are getting a bit panicky about reigning in Chinese lending to prevent further inflation. The China Business News reports state-owned banks in China have made over A$182.81 billion in loans so far this January. That’s 15% of the total for all of last year and twice the amount of money banks lent in January.

–So what, you say?

–The State has ordered banks to hike lending rates by 10–45%, according to some media outlets.  “Particularly worrying,” reports Reuters “are China’s property prices. Housing prices in major cities soared by more than a fifth last year, private research showed in January, raising doubts about the effectiveness of tightening measures announced during 2010.” China is losing the war against inflation (it has a traitor in its ranks with a currency peg that guarantees growth in the money supply).

–But enough about policies and bubbles. Is the stock market telling you anything useful about what’s happening in China? It could be! The chart below tells your editor that China’s inflation problem is going to become Australia’s commodity problem. That is, a credit slowdown in China is bearish for Chinese stocks and the economy, and thus bearish for Aussie companies that export to China.

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–Far be it for us to take over the role of chartist from our resident expert, Murray Dawes. But Murray is on holiday in Tasmania today. So we’ll have a crack. The chart shows China’s Shanghai exchange leading Australia’s All Ordinaries by about five months. Why about five months?

–Chinese stocks bottomed in November of 2008—a full five months before the S&P 500 and the All Ords. Those indices were reacting to the Bernanke Fed’s inflationist policies. For whatever reason, China anticipated/led that move (worth thinking about).

–But you can also see that Shanghai’s rally lasted just about eight months and has since failed to make a new high. The market fell in April of last year, bottomed in July, and peaked in November. Since then, it’s been downhill skiing.

–For most of last year the two benchmarks were well correlated. The only real divergence is that since October, Chinese stocks have priced in something bearish and Australian stocks have not. At least not yet. Could it happen soon?

–Our old friend Dr. Marc Faber gave a rip-roaring interview to Bloomberg news in which he pointed out that most emerging markets have failed to make new highs from their November/December levels. He expects a 20–30% correction in emerging markets and says U.S. equities and Treasuries (in the very short term, as in 10 days and 2–3 months) will outperform emerging market stocks.

–By the way, Faber says U.S. stocks will lose less than emerging market stocks. This is what he means by out-performance. It’s a relative return. They will do less bad, but not well.

–What does this mean for Australian stocks? Well, you could argue that local matters are a bigger influence on stock prices. After all, the flood levy will act as a tax on consumers at some level and will keep the federal budget in deficit longer than expected. But wage and price pressures will keep rising for a variety of reasons.  In other words, domestic factors are also arguing for a hit to stock prices.

–Lead-footed Ben Bernanke could care less that he’s exporting political volatility with his weak dollar policy. After all, QEII has managed to keep mortgage rates relatively low and stock prices high. Banks have repaired quarterly earnings, although they’ve ignored major renovations to their balance sheet structure. Americans have yet to experience the same food and fuel pain easy money has dished out elsewhere on the planet.

–The best way to win a game of chicken is not to not be in the car at all. But Australia’s stock market doesn’t have this choice. The economy is tied to resources and China’s demand for them. And the capital markets are tied to America’s fiscal and monetary lead. Buckle up.

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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