Dr. John Rutledge: Far from Equilibrium Economics, Finance and Investing

Summary: I had a wonderful time working with Kelly Evans on CNBC’s The Exchange last Friday. I had a great conversation with Kelly and guest Andres Garcia-Amaya about the Fed, the economy, earnings, and the trade war; I ran into my dear friends Sue Herrera and Bill Griffiths in the make-up room; and I was able to bring visitors from Japan on set to watch the show being made. Doesn’t get better than that. You can click here to see the short video of our hit.

Last week was a hoot. I had three days of meetings with the top people at Aoyama, select advisor to Japan’s ultra high net worth families, got to spend time with my colleagues at Safanad, and do a CNBC hit on set with Kelly in New Jersey.

I like doing Friday shows because the topics are a little broader and there is more room for thoughtful conversation. Today, we talked about the fed, the economy, the earnings announcements that started this week, and news from the front in the trade war. In this post, I will talk about the Fed and trade war and deal with the economy and markets in the next one.

The Fed story that everyone is talking about is whether or not the Fed will lower the funds rate target by a quarter point later this month. Powell testified last week and has dropped hints this week that it’s confusing out there but the Fed is inclined to play nice. I can certainly understand the confusing part. PMIs are falling everywhere, as shown for the G7 countries below. The June US number (51.7), shows that manufacturing is still growing (the index is more than 50) but it’s down from 52.7 in May and the lowest reading since October 2016. But, as Kelly points out in her report today (you should get it) the June jobs report (+224K), retail sales, the Philly Fed report, and Industrial Production (+0.4%) were all positive surprises.

My colleague, Hisam Sabouni, and I have written a paper on the subject that I will post in the next day. We use Monte Carlo analysis of an estimate of the Fed’s reaction function known as the Taylor Rule to argue that Mr. Powell is right to straddle the fence at this point; the case for lowering the funds rate is not crystal clear.

But the Fed funds rate is the small story. The large story is the growing frequency and aggressiveness of attacks on the Fed’s independence. Central banks must be as independent of political pressure as possible for a simple reason–politicians always have incentives to print money. The next election is never more than 2 years away. It is always a good idea to stimulate spending.

The result is always the same–accelerating price increases. That was true when I worked in the White House in 1981 and inflation and bond yields were both 15%. It is just as true today when we the economy is operating at full capacity and the government is predicting a one trillion dollar budget deficit (that’s a one with nine zeroes after it) next year. Contrary to the opinion of economists who were born after 1980, inflation is not good for you and there is nothing to stop a central bank from inflating the price level and eroding the real value of government (and private) debt.

Turkey is this year’s poster child for thug politicians corrupting central banks. Erdogan has fired the head of central bank so he can set policy himself. (Remind you of anyone?) He has announced he is going to lower interest rates. The inflation rate is already 16%; the 10 year bond yield is 17.2%. Both are going higher as a result of Erdogan’s move.

As a final point, I want to restate a point I made in a recent post. US tariffs are not having the effect on China’s economy that is being claimed by the White House. A 10% tariff on a specific list of Chinese goods will, in principle, raise their prices to US consumers by about 10%. But the Chinese currency (the RMB) is roughly 10% lower against the dollar than it was before the tariffs were announced, which lowers US dollar prices of the same goods by 10%. The net impact is zero. But the drop in the RMB also lowers the prices of all the other Chinese goods that were not on the list by the same 10%. The result is the net drop in US import prices that you see in the chart below.

But the RMB prices of all US goods sold in China will rise to reflect the 10% rise in the dollar (fall in RMB) and the prices of the specific US goods that are now subject to the 10% Chinese tariff will jump by 10% + 10% = 20%! Thats why, in the June trade report, China reported a small drop in exports (-1.3%) and a huge drop in imports (-7.3%), especially from the US (-31.4% LTM). For clarity, the drop in the RMB was not engineered by the Chinese central bank (PBOC). They have actually been trying to hold the RMB up. It was caused by global investors decisions to pull capital out of China. There are, however, serious problems in China’s economy as I explain to Kelly in the video. The top problem is a credit crisis for small, private firms who are starving for working capital. I’ll leave that to another post.

JR

Summary: China grew at a 6.2% annual rate in Q2/19. With a single exception (The Financial Times), every financial news source I checked covered the story by running alarming and misleading headlines. Journalists–you can do better than this.

A sampling of headlines from major sources of financial news talk about the GDP number as “27 year low”, “weakest pace in 3 decades”, “hammered by tariffs”, “trade war stings”, and the winner of the soap opera prize, “…its economy probably can’t go on like this.” (Swoon!) These headlines may catch eyeballs and sell advertising but they are grossly misleading for investors.

Bunk. This is the story journalists should have written.

This morning, China reported 6.2% GDP growth for Q2/19, as shown by the blue line in the chart below from the Financial Times. That’s in line with analyst expectations, lower than the 6.4% reported for Q1/19, and consistent with the gradual cooling of China’s growth over the past seven years. Nominal GDP (the red line in the chart), a good proxy for average income growth in urban areas, grew at just over 8% per year.

Retail sales grew 9.8% in June, up from 8.6% in May, driven by robust auto sales (17.2%) and strong sales of furniture and household appliances. Industrial production grew 6.3% in June, up from 5.0% in May. Investment in fixed assets, property development, infrastructure and manufacturing firmed, as shown in the second chart below from Bloomberg.

The weakest sector was traded goods. Exports declined by 1.2% in June (-2% expected); imports were down 7.3% (-4.5% expected). Exports to the US were down 7.8% in June (the first full month of increased tariffs on both sides); imports from the US were down much more sharply (-31.4%).

These trade numbers, of course, don’t fit the rhetoric that the trade war has brought China to its knees. Chinese imports are actually down a lot more than its exports, even though Chinese incomes are still rising. There is a simple reason for that. The RMB is down by about 10% against the dollar since the trade war began. For US consumers, a 10% tariff imposed on some Chinese goods was roughly offset by the 10% drop in the RMB so the price of Chinese goods in dollars was unchanged. (Chinese goods not impacted by US tariffs are actually cheaper today, in dollars, that before the trade war.) That’s why China’s exports to the US have not fallen much. But for Chinese consumers a 10% tariff on US goods and a 10% increase in the price of the dollar (drop in the RMB), together, increase the prices of US goods exported to China by roughly 20%. That’s why Chinese imports have fallen so much.

The bottom line is that China’s growth was not great but better than a sharp stick in the eye. Real growth of 6.2% is still a huge number–3x US, 5x EU, and 6x Japan growth rates–as you can see in the chart below from this week’s The Economist.

Trade hawks in the White House will argue that China has been cheating by devaluing its currency. But the fact is, the RMB was pushed down by global investors pulling their capital out of China due to the trade war. The PBOC, for its part, was trying to hold the RMB up, not push it down.

The trade war has caused damage to China’s economy, of course, just like it has in many other places. Most notably, companies are working hard to reconfigure their supply chains to avoid shipping products directly from China to the US. I say directly, because trade statistics count the full value of an item (like an iPhone) shipped from China to the US as a Chinese export, even though most of its value may have been produced in the US, Korea, or Taiwan. If they ship the iPhone to Timbuktu and paint it brown there, the whole value of the export will now show up as a Timbuktu export to the US with the resulting trade surplus. Of course, fundamental supply chain changes are taking place too as companies move assembly operations from China to Vietnam, Cambodia or some other more favored location.These supply chain changes don’t happen overnight, but they will go on for a long time.

China does have growth problems; they are caused by the inability of its banking system to provide capital to small, private companies and by its heavy debt burden. The shutdown of the shadow banking sector last year has wiped out most bank lending to small, private companies, known in China as SME’s. In May, regulators seized Baoshang Bank, which sent shock waves through the interbank loan sector. The government has thrown everything they have at the problem, including massive liquidity injections by the PBOC and heavy-handed mandates to brokerage firms to lend money to small banks. But the SME capital shortage is structural; it won’t go away. And then there is the debt problem. That won’t go away either.

Given these problems, today’s GDP report was actually surprisingly good. Of course, no country can grow at 7, or 6, or even 5% forever. To a first approximation, we should expect growth rates to decline every quarter for the next couple of decades as Chinese living standards approach developed country levels.

Scary headlines attract readers; readers attract advertising dollars. That means every quarter you will see headlines that China’s growth is the slowest since 1992. Just don’t confuse the headlines with the facts.

JR