The China Factor

• July 2, 2004
• Mark Boucher

The Joint
US-China Distortion Dynamic

 

The Fed raised rates 25 bp and
continued the “measured” language just as we and the markets were expecting. 
Markets initially responded well, but reversed today on higher volume, a
negative sign.  A surprise on the employment picture to the upside will hurt
stocks and bonds tomorrow, whereas weaker employment growth should allow bonds
more upside and a better market environment for a spell.

 

It is also true, as many have
written to ask about, that our Zweig signals of 9/1 thrust and a/d 2/1 thrust
have both been triggered recently, and that these normally are reliable
indications that a decent rally is underway.  Yet the macro environment leads us
to be more cautious than we normally would following these signals.  Why?  One
reason is our analysis and understanding of a large global economic distortion
being played out in combination by China and the US.  Let’s look at it in brief,
because I believe that it is critical for investors to understand going forward.

 

A-lot of investors are basing
their inflation expectations on the environment of the 1970’s.  There are lots
of similarities — exploding deficits, a war that is costing much more than
anticipated and doesn’t appear to have an endpoint, low real interest rates,
higher oil prices and potential shocks, lots of monetary and fiscal stimulus on
a concerted basis globally, and chronic and massive US current account
deficits.  There are some big differences as well however and the economic
dynamic today seems substantially different.  A major difference has to do with
the global supply/demand balance.  Whereas the chronic current account deficits
of the 1970’s were a symptom of excess demand, today they are more a symptom of
excess supply coming out of Asia.   The interrelationship between China and the
US, the two main engines of growth for the global economy are critical for
investors to understand to have a grip on where to invest and what real risks
are.

 

The emergence and
industrialization of China on the global economic scene is one of the largest
forces to hit global economies in decades.  The Chinese manage to save nearly
40% of GDP, which they use mostly to invest in industrialization, but a
substantial leftover of which is exported to the rest of the world.  The Chinese
current account surplus is actually quite small as a percentage of its savings,
because China is a massive importer of capital goods and resources, mostly from
the rest of Asia.   The entire Asian region has a savings surplus of over 4% of
the regions GDP. 

 

 

The US economy is the only one
large and robust enough to absorb this massive Asian savings excess, while the
US is also the only economy large enough to absorb the exploding supply of goods
coming from Asia, that allows China to integrate and be absorbed into the global
economy.  The American economy with its market-orientation and less rigid labor
market (particularly less than Europe) has been able to re-orient itself
repeatedly to higher-end production such that it has stayed near full employment
despite Chinese displacement of whole industries in manufacturing and low-skill
labor areas.   Europe is large enough but is inflexible and undynamic and so its
growth rate remains muted continually and its unemployment remains high — the
cost of more socialist policies, more rigid regulations, and less
market-orientation (excluding east Europe which is not large enough in and of
itself).  Thus Asia uses its savings excess to fund American interest rates and
keep them artificially low via currency intervention and bond purchases with
excess current account dollars.  The lower than would-be interest rates fan the
fuel of the American consumer, who in turn can better absorb new Asian goods. 

 

Thus whereas the US current
account surplus in the 1970’s led to instability and global inflationary
pressures, the current account surplus today is critical to maintaining global
balance of excess supply coming out of Asia.  But demand created by artificially
low interest rates is not sustainable long-term.  Chinese and US authorities
must team up to try and manage the Chinese absorption into the global economy
without causing inflation in China or the US.  Chinese low-priced goods in turn
keep inflationary pressures in the US down much lower than they would normally
be with this level of fiscal and monetary stimulus.  Yet if the stimulus becomes
too significant it will fuel US-based inflation from excess consumption.   

 

So far neither China nor the US
has reached enough of an inflationary problem to interrupt the virtuous circle
of this Chinese-US dynamic.  And with global leading economic indicators
suggesting a cooling off of growth, investors may well be surprised at how long
it takes for inflationary pressures to grow.  We suspect inflation will not
become a significant problem to force more aggressive policy action until 2005. 
1970’s style inflation is unlikely to develop in any event. 

 

However, once inflation just
begins to be a problem and it prompts further interest rate hikes in the US, it
could lead to a policy error that could easily tilt the world back toward
deflation and recession.  Because the US must have artificially low interest
rates to stimulate demand enough to keep buying Asia’s excess production, it may
take a much more modest increase in short-term rates to have a much more
significant impact on markets than is normal.  And, once interest rates rise
enough to cut consumption significantly, the global economy could fall very
quickly and sharply.  Asia is building capacity for demand that will not exist
at that time.  And the US is borrowing to consume in ways that are not
sustainable long-term.  When the US-China virtuous circle unravels it could lead
to a much more severe recession and deflation risk than the world has seen for
some time.  Chinese tightening could have a similar dramatic effect on global
demand for its imports, which is fueling Asian growth and is mostly responsible
for Japan’s emergence from the clutches of deflation.

 

What interest rate levels are
enough to cause this sharp shift?  It is not clear — though it is likely to be
much lower rates than most economists believe to be neutral.  Note how
significantly the markets responded nearly universally to the prospect of higher
rates in the March-May period.  This may be foreshadowing of market environments
to come once tightening gets to be enough to kill the virtuous circle.

 

^next^

 

 

Investors need to carefully
monitor the above major dynamic.  It’s implications on major investment
asset-classes will ultimately be profound.  The world will eventually have to
correct for distortions caused by this circle — meaning larger than normal
excess capacity  being built in Asia, and more retrenching than normal in the
consumer sector in the US.  The deflation threat is thus not now the biggest
one, but once central banks are forced to actually target lower growth levels,
investors may be shocked at how quickly the deflation threat returns, and how
quickly and sharply global markets decline. 

 

We continue to suspect this is
a playable though volatile rally — we just don’t advise playing it with nearly
normal allocation levels.  There are still huge risks and this is not the time
to bet the farm.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.   This did not
include our foreign stock recommendations that had spectacular performance in
2003. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 109, 98, 97, 57, and 88 with 43 breakouts of 4+ week ranges, no
valid trades and close calls in LCUT and ONYX.  Upside breadth is continuing to
improve, and we are now eagerly awaiting trades that meet our criteria. 
Position in valid 4+ week trading range breakouts on stocks meeting our criteria
or in close calls that are in clearly leading industries, in a diversified
fashion.  This week, our bottom RS/EPS New Lows sunk back to bull market
territory, registering readings of 8, 23, 8, 7, and 3 with 1 breakdown of a 4+
week range, no trades and no close calls.  We’re still not getting a lot of
trading signals in valid breakouts, though the environment is improving.

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training module. Basically,
we have rigorous criteria for potential long stocks that we call “up-fuel,” as
well as rigorous criteria for potential short stocks that we call “down-fuel.”
Each day we review the list of new highs on our “Top RS and EPS New High List”
published on TradingMarkets.com for breakouts of four-week or longer flags, or
of valid cup-and-handles of more than four weeks. Buy trades are taken only on
valid breakouts of stocks that also meet our up-fuel criteria. Shorts are
similarly taken only in stocks meeting our down-fuel criteria that have valid
breakdowns of four-plus-week flags or cup and handles on the downside. In the
U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

Massive stimulus globally is working to create a self-reinforcing recovery.  But
it is based on a weaker foundation and faces more potential risks than any
recovery since WWII.  And eventually its underpinnings will be removed.  Central
banks can only be magicians for a while before reality must come home to roost.

Mark Boucher