China is in the midst of a poor-quality rebound, says Geraud Charpin, Portfolio Manager, BlueBay…
Risk assets were trading weaker in the past week amidst volatility in currencies, an unconvincing earnings trend dotted with notable misses and the realisation that asset prices have gone up again while global economic conditions are getting more stretched rather than stronger. A number of themes were discussed across desks and it is macro themes rather than bottom up stories occupying the minds of our analysts.
There are a lot of discussions across the firm about whether China should matter in the here and now or only later in Q3. From a top down view, our analysts are stressing that the large debt funded stimuli that was pumped by authorities into the system has so far only been directed to state owned enterprises (the old economy) and has not filtered through to other sectors. This constitutes a U-turn from the previous policy of shifting from a production driven economy towards a service driven one. It is a poor quality rebound therefore with no obvious spill over into the broader economy yet.
Therefore we cannot establish yet if the effects will endure or fizzle out very quickly. From a bottom up perspective, stress is visible in the financial sector. Deutsche Bank research pointed out that credit has gone into financial institutions for investment rather than to corporates or households loans. This is bad because investments are less transparent and more risky than loans.
In real estate, while tier 1 property prices have seen an upsurge, it has not filtered down to tier 2 and 3 segments. We see this more as a sugar rush than a proper, sustainable uptrend.
While newspapers have been pouring through worrying debt statistics about China, what also caught our attention was the traded volumes on commodity futures’ exchanges. Morgan Stanley research showed that 18 of the top 25 most traded commodities futures contracts (by daily value traded) are on Chinese exchanges with an average contract holding period of just a couple of hours. On the other hand, we note that shipping rates have not increased anywhere near as much in Q1 as the surge in commodity prices would have suggested they would. How much is market speculation versus real demand then?
The temptation is to consider that the size of the credit injection that just occurred should ensure positive short term spill overs for the next couple of months at least. However, our analysis so far gives us no tangible elements to substantiate this and build a strong conviction that this will indeed happen. What we always come back to is that this has all the signs of poor quality and unsustainable growth that only increase existing imbalances in the medium term. Don’t be complacent and ignore potential volatility from China in the short term.
Industry experts seem to rally around the idea that oil’s equilibrium price is around USD45. This price is derived from a lot of assumptions about the pace of global demand, production assumptions from the Gulf states and US shale production.
Several of these assumptions are likely to be individually reasonably accurate but most of these events will happen in a desynchronised manner which means that USD45 is most likely to be a rather unstable equilibrium level. Reuters has pointed out that Iran and Iraq production output have risen faster than expected (Reuters – US OPEC oil survey) while floating inventory of crude is building up (Reuters – US oil storage) across our oceans.
Meanwhile, Saudi Arabia went ahead with a large cabinet reshuffle over the weekend and replaced its pragmatic oil minister as the young prince asserts a more radical stance towards Iran.
In a sign of undeterred optimism though, the market has focussed on the wildfires in Canada as an event that could help put oil markets into equilibrium in the short term. The barrel is stable for now, in a very unstable market.
Markets are exhibiting all the signs of angst and increased nervousness to us. A stronger dollar over the week put a dent in the positive tone that had prevailed across assets recently and the weaker than expected NFP on Friday failed to bring the expected reaction with both 10year rates and the dollar ending the day higher.
Supply is going to test investors’ appetite in coming days and weeks in the corporate bond markets on both sides of the Atlantic. We note, and caution, that the supply from European sovereigns over the past week has sent Italy spreads 14bps wider.
We believe investors have already extended positions in corporate credit but several broker surveys indicate that this is not the case in currencies nor in rates where positioning is not extreme. We stay contrarian in our approach and have no desire to chase valuations in any of the assets we look at