Tracey Chen

Tracy Chen, Portfolio Manager and Head of Structured Credit, at Brandywine Global, an affiliate manager of Legg Mason notes that Chinese consumers are suddenly feeling quite positive about the economy and their prospects according to recent confidence data (see Chart 1).

Ms Chen reports: This surge in optimism is particularly evident among the wealthy. A recent survey conducted by Hurun Report of individuals with net worth more than 10 million yuan (USD 1.57 million) found that roughly 94% of respondents are optimistic about the Chinese economy’s prospects in the next two years, up 3% over last year. Nearly half of this group expressed strong optimism on the Chinese economy, compared with just 28% in 2017—a jump that represents the biggest uptick in sentiment in 14 years. The bullish consumer confidence data can be attributed largely to several factors: the wealth effect of the property boom cycle in 2016 and 2017, a reduction in pollution due to environmental cleanup efforts, the robust gross domestic product (GDP) rebalancing stemming from President Xi Jinping’s national rejuvenation dream, and the emergence of a new economy.

1. The Wealth Effect of the Property Boom

The importance of the property market in China cannot be overstated. The Hurun Report survey confirmed that real estate remains the preferred investment among the rich in China. However, the Chinese property market’s prominence is a double-edged sword. While inflating consumer wealth, it also makes the Chinese economy extremely vulnerable to a property market downturn. The old administrative measures to cool down the property market have not been very effective. Policymakers have started using long-term mechanisms to stabilize the property market, calling for property taxes and housing provisions across multiple sources and channels, including commodity housing, affordable housing, and rental options.

The massive wealth effect from the property boom in 2016 and 2017 is unique. The majority of wealth gains in 2017 were in Tier 3 cities as opposed to the dominance of Tier 1 and Tier 2 cities in the past. As a large economy with uneven regional development, China typically sees changes occur in two or three waves, led by the rich coastal area before spreading to less-developed inner regions. In 2017, the total value of residential properties jumped to RMB 49 trillion (see Chart 2) with a significant wealth effect from property boom gains seen in Tier 2 and Tier 3 cities. Since Tier 2 and Tier 3 cities make up the majority of China’s population and GDP, the impact of the spread of disposable income growth due to property gains from Tier 1 to Tiers 2 and 3 is significant. This wealth effect has spurred a boom in household consumption which helps purchases of luxury goods and Chinese imports. As a result, China’s current account surplus should continue to shrink.

2. The Improving Environment

Due to the government’s anti-pollution campaign for the past several years, which has included a variety of measures such as converting coal heat to gas, pollution in Beijing and in 27 other cities in northeastern China has fallen sharply. The harmful pollutant indicator PM2.5 that measures air quality in terms of particulate matter dropped precipitously in Beijing (see Chart 3). Greenpeace estimated that lower pollution levels resulted in 160,000 fewer premature deaths across China in 2017.

3. The Great Rebalancing

While investors mostly focus on China’s debt and overcapacity issues, the rebalancing of GDP is quietly happening at “China speed.” The expansion of tertiary, or service, industry has been impressive at 8% nominal growth, a much faster rate than secondary industry (see Chart 4). As a percent of GDP, tertiary industry already dominates with a 52% share (see Chart 5).

4. The New Economy

It is also interesting to look at China’s fixed asset investment (FAI) growth as the country shifts from an old economy focused on low value-added manufacturing to the new economy characterized by high value-added manufacturing, services, clean energy, and technology. In this new economy, China has seen FAI in the environment, healthcare, entertainment, technology, and transportation all grow above 10%, whereas FAI in metals and mining has experienced negative growth (see Chart 6). The Chinese government focuses on promoting innovation as evidenced by increasing patent applications (see Chart 7). China, which has been surpassing developed countries in its move toward a cashless society, has seen its mobile payments grow to about the same size as the U.S. credit card market in terms of annual payment value (see Chart 8). Thanks to government subsidies, abundant data, and a large talent pool, China is leapfrogging the U.S. in the digital economy, or at least shrinking the gap, in terms of mobile payments, ecommerce transaction volume, and computing power.

5. The New Connectivity

Investors also have been cautioning against China’s wasteful infrastructure investment, like “bridges to nowhere.” Undoubtedly, there are some wasteful projects, but the immense connectivity network of China’s infrastructure will surely have long-term benefits, such as boosting productivity or supporting the rise of more mega-cities. By the end of 2017, the total high-speed railway operating length reached 25,000 km, connecting over 180 cities and 370 townships. This expanded reach shrinks the concept of time and distance and supports the concept of “China speed” by providing better connectivity among cities and regions, transporting people, goods, and capital. Resources will be reallocated to promote closer economic connectivity inside and across China. The new way of life and commuting, supported by transportation and infrastructure improvements, also increases the mobility of the labor force.

Conclusion

As a leading economic indicator, exuberant consumer confidence usually is a harbinger of stronger economic growth and even higher asset prices. Will the above five confidence drivers—wealth effect from the property boom, improving environment, great rebalancing, new economy, and new connectivity—be able to sustain this confidence at such a high level in 2018? I would not hang my hat on that yet.

Liu He, the prominent advisor to President Xi, elaborated on China’s “One Goal, One Theme, and Three Battles” at the Davos World Economic Forum. The one goal is to transition Chinese economic growth from a focus on quantity to a focus on quality. The one theme is to continue pushing forward the supply-side structural reform. The three battles are dissolving and preventing systemic risk, reducing poverty, and cleaning up environmental pollution. With those missions in mind, policymakers will carry on with financial deleveraging, supply-sidedecapacity, and pollution control. We expect both monetary policy and fiscal policy will stay neutral and prudent with a tightening bias. In all likelihood, financing costs will move higher along with more coordinated financial regulation while the property market will continue its cooling process. Therefore, those short-term pains will moderate China’s economic growth in 2018 in exchange for a longer-term gain. Due to the high leverage of property developers and certain local governments, we likely will see the pressure from financial tightening on both, reflected in higher defaults and more consolidations. Government’s implicit guarantees will be tested. As a result, consumer confidence will be tested as well. However, robust and synchronized global growth, exports, consumption, and the new economy should provide some offsets to the moderate slowdown.

The post What is driving the exuberant confidence in China? appeared first on AdviserVoice.

Richard Lawrence

The German Election

Last June, after the “Brexit” referendum—the U.K.’s unexpected vote to leave the European Union (EU)—market participants began to worry that Brexit signaled the beginning of the end of the great EU integration project. However, consecutive election failures by the anti-EU parties in the Netherlands and France led to a sharp reversal of EU break-up fears; instead, the market narrative turned to one of reinvigorated European cohesion and solidarity, led by Emmanuel Macron and Angela Merkel at its core.

That narrative was arguably intact until the September 25 German election, which once again reignited concerns that populism remains a potent influencing force in global politics. While polls forecasted a range of potential outcomes, the broad consensus was for a comfortable win from Merkel’s center-right Christian Democratic Union (CDU) along with its sister party the Christian Social Union (CSU), allowing her to continue her coalition government with the Social Democratic Party (SPD). Polls were mixed on the potential for a strong showing for the right-wing, nationalist Alternative fur Deutschland (AfD) party. The outcome was a modest surprise, Merkel’s CDU/CSU winning 33% of the vote (down 8% from 2013), the SPD suffering its worst result since World War II with 20% (down 5%) and the AfD winning almost 13% of the vote (up 8%).

Since the election result, the SPD has said it will no longer participate in a coalition government, leaving Merkel with the less desirable option of forming a coalition with the Green party and the liberal Free Democratic Party (FPD). Amusingly this is termed the Jamaica coalition, the party colors of black, green and yellow being those of the Jamaican flag! This coalition may not even be successful given the parties’ differing views on further EU integration, immigration, energy and defense spending, amongst other topics. Notably we would expect the FDP to continue their strong opposition to EU fiscal integration.

Why the Populism?

The more troubling aspect of the election outcome is with regard to the AfD. The AfD platform was clearly anti-immigration and focused on domestic security, but manifested itself in a controversial campaign where the AfD seemingly targeted topics that garnered media attention, and then claimed that it was the victim of a manipulative mainstream media which it termed Lügenpresse, the “lying press.” Sound familiar?

We have been thinking about the underlying cause of this resurgence in populism. Is this a one-off? One conclusion we have reached is that many voters who cast their ballots for the AfD did so because they simply didn’t see their views reflected in the platforms of the mainstream parties. Crime and terrorism, immigration, and pensions were some of the issues that deeply mattered to AfD supporters.

These reasons seem to rhyme with Brexit and Trump’s victory. The lesson learned is that if mainstream parties can’t somehow broaden the appeal of their core messages, they are likely to disenfranchise more of the support from their base constituents. It seems once again that the political establishment has underappreciated the degree of discontent within the voter base. A look at where AfD voters in the 2013 election previously affiliated tells this story—almost a quarter of support came from voters who previously cast ballots for the CDU and CSU parties, and another 14% had supported the SPD and Left Party.

Implications for Asset Markets

Meanwhile, our job is to think about the implications for asset prices. At the margin, the German election seems to weaken the case for continued appreciation in the euro. We might look for President Mario Draghi and the European Central Bank (ECB) to take a slightly more cautious view on its announcements regarding quantitative easing (QE) tapering given the new information. Up until the German elections, we—along with most of the market—expected Draghi to address the future of QE at the ECB’s October meeting.
Conversely, this event probably helps the U.K., albeit slightly, in its Brexit negotiation as the election’s outcome modestly softens the case for a galvanized core Europe. We would therefore expect the British pound to outperform the euro. So far, eurozone bond markets appear to have shrugged off the news, and we would expect core yields in Europe to remain caught in a tug-of-war between the ECB’s QE program—which continues to keep yields lower and highly overvalued—and the continued pickup and broadening out in eurozone economic activity, which should push yields higher. Longer term, we see the potential for yields to move higher.

What’s Next in European Politics

We are sorting through the results of Catalonia’s independence referendum, as the wealthiest region in Spain voted for its independence on October 1. Although nearly 90% of ballots cast were in favor of independence, less than half of eligible voters took to the polls, while the Spanish high court preemptively declared the referendum illegal. This is yet another highly complex political event that could take months—if not years—tounfold. The euro and safe-have Bund yields did not significantly move in response to this referendum; the spread between Bunds and Spanish bonds remained below average and Spanish equities were down 1.8% the day after the vote. What makes the Catalan referendum different than say Brexit or Germany? We believe this particular issue in Spain is more about national identity than populism—the struggle between Catalonia and Madrid has spanned centuries.

The next major national election takes place in Italy in the first half of 2018; the latest date would be May 20. Given the success enjoyed by AfD, we expect the markets to begin to climb a wall of worry about the risk of Italy’s populist euroskeptic Five Star Movement (M5S) enjoying a stronger-than-expected showing. The most recent polls show M5S polling at around 25%, just behind the incumbent Democratic Party and comfortably ahead of other challengers. We will be watching with interest.

In summary, we see the result of the recent German election as a continuation of a broad global repudiation of politics as usual. The real question is what catalyzes such resentment for the political establishment, particularly as voters from more and more countries believe their traditional political parties no longer represent their interests. The answers to this question are complex and varied, but it is likely the root of discontent lies partly in income inequality. This year, our view has been that the global economy is in a phase of modest, low-inflationary synchronized growth. This environment has been constructive for labor hiring, as measured by declines in unemployment rates globally, yet wages are still not picking up even as economies operate at or near full employment. Consequently, many labor market participants feel left out of the post-crisis economic recovery. Furthermore, many of them have not seen any meaningful increase in household wealth, either through appreciation in property values or financial assets.

Perhaps the chasm in income equality has been driven by 25 years of policymaking in favor of economic liberalization, and we are finally starting to see an opposing reaction as a countermovement crystallizes. The genesis and persistence of income inequality is certainly complex, but the fact that the resurgence in populism occurred in Germany—a paragon for economic strength—should put policymakers on notice.

By Richard Lawrence, Senior Vice President, Portfolio Management

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Dorothee Rainis

Historical patterns are among many indicators that can be helpful in the analysis of financial markets, since they can reveal valuable information of drivers or patterns pertinent to assets or events. It should be self-evident however that history only rhymes, so any historical analog has to be treated carefully in order to not jump to conclusions, which can be a costly mistake in financial markets.

One thing that caught our eye last year were the pronounced movements in oil prices, which dropped by over 50% year-over-year in 2014, only to retrace nearly all their losses starting in the first half of 2016. It was indeed an interesting movement, given that a 50% drop followed by an almost complete retracement of the losses has happened only once outside a recession over the last 35 years, namely between 1997 and 2000. Without going into too many details of what drove oil prices in the late 1990s—remember, history only rhymes, so we have to stick to the big picture—we looked at other indicators to better understand the consequences of such a move, including the “grease” in the financial system: liquidity.

The undisputed “central banker of the world” in the 1990s was the United States, whereas now the marginal provider of liquidity might very well be China, as my colleague Anujeet Sareen pointed out.

So how do liquidity conditions of those two periods compare? Taking the fed funds rate as an admittedly coarse proxy for the U.S., and the credit impulse consistent of changes in total social financing and local government debt for China, we can see that those two liquidity measures overlap fairly well—they “rhyme.”

Armed with the assumption that oil prices themselves are strongly related to liquidity since oil producers are paid mainly in U.S. dollars, we can deduce how those liquidity impulses worked their way through the financial system in an ebb and flow of deflation and reflation.
With a contraction in liquidity, demand for commodities tends to decline, and we see that the contraction in both time periods was meaningful enough to cause a pronounced drop in a whole range of commodities. Note that we are looking for similar patterns, not similar price levels; after all, the global economy has changed dramatically since the 1990s, but general economic relationships should still bear strong resemblance.

Receding liquidity shouldn’t only have an impact on commodity prices, but naturally on imports and export orders around the world. As a matter of fact, producer prices responded to the moves in orders and commodities just how we’d expect them to: a distinct correction, followed by a strong reflationary rebound once the liquidity impulse turned firmly positive.

Now, considering that a marked contraction in orders, production, and prices was followed by a clear-cut expansionary period, businesses reacted exactly like we believe they should once work starts pouring in after a dry spell, with skyrocketing optimism, plans to increase capital expenditures, and stronger hiring intentions.

Here’s a Chart of the Moment we issued on U.S. business confidence earlier this year.

Not surprisingly, asset markets also behaved in a similar way. It becomes clear that emerging markets were bound to profit vastly from the inflationary impulse that was waiting to happen in the second half of 2016—and while we concede the timing of markets to rally to the Trump election—we’d have to point out that higher demand was already in the pipeline, ready to burst higher. Calling the recent rally a “Trump trade” might hence only be marginally correct.

Curiously, the ebb and flow of the reflationary impulse happened at a very similar point in the business cycle of the United States, with unemployment, wages and profit growth seeing comparable developments. Cause and effect of this observation are harder to assess.

Further, it would be a poor research practice to avoid pointing out differences in this analogy.

Apart from markets that have changed in composition or size and are hence less prone to the same reactions, the biggest difference can be seen in financial stress indicators. Generally, interest rates are where demand for and supply of credit clears. However, if we can observe that the household sector is still reluctant to borrow despite unprecedented low interest rates, it might be an indication that consumers got burned so badly in the Great Financial Crisis that they are simply unwilling to borrow, no matter how low interest rates are. As a consequence, interest rates can at least partially lose their signaling function we’re so used to, which in turn, would cause spreads and financial stress indicators—which are in large part determined by interest rates and spreads—to behave differently this time around, and is exactly what can be observed.

This analogy begets the question: Do we believe the global economy is awaiting the same fate we saw play out in the early 2000s? As stated in the beginning, we’d advise anyone to not jump to any conclusions.
We’re pointing out in our latest macro outlook that there is plenty of evidence of a much more favorable backdrop for the global economy. Correlations never persist. It is really the task of an investment manager to determine when and how those correlations might change, and also the prime reason why the study of financial markets is both challenging and extremely engaging at the same time!

Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

By Dorothee Rainis, Research Analyst at Brandywine Global, a fixed interest affiliate of Legg Mason 

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