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16 June 2009

Global Strategy Weekly

Expect new lows in equity markets in H2. Is China the hidden Achilles heel?

Albert Edwards Most areas in the markets have now discounted a V-shaped recovery. Any doubt will trigger a
(44) 20 7762 5890
albert.edwards@sgcib.com rapid reversal in prices. I continue to be extremely sceptical and see recent events as part of a
1930s-like, long march to revulsion. Talking about long marches, nowhere in the world fills me
with more scepticism than the Chinese economic recovery. The continued enthusiasm for all
things China reminds me so much of the way investors were almost totally blind to the fact the
US growth miracle was built on sand. China could be the biggest disappointment yet.

Q Whether you look at surging commodity prices or the near 60% ytd run-up in the Metals
& Mining sector, one thing is clear; the markets believe wholeheartedly in the Chinese
economic recovery. We have a long history of sticking our necks way out against the
consensus. In 2001 we repeatedly wrote that the US growth miracle would be seen in
retrospect as a sick joke, as it was based on Kilimanjaro-like mountains of debt. It has taken
a while, but now most concur with that ‘extreme’ view. In a few years time, I believe we will
Global asset allocation look back on the Chinese economic miracle as the sickest joke yet played on investors.
Index SG
% Index
neutral Weight
Q It is amazing how easily group-think takes a vice-like hold in the financial markets. As the
Equities 30-80 60 35
Bonds 20-50 35 50 BRIC economies meet for their debut summit, few dare to speak out against the new, ‘New
Cash 0-30 5 15 Paradigm’. We also saw this same investor mania 13 years ago with the Asian Bubble,
Source: SG Global Strategy Research which the consensus thought was a growth miracle. But to go that far against the
consensus invites a deluge of hate mail - link. That is why I keep a copy of a World Bank
Equity allocation book entitled Thailand’s Macroeconomic Miracle: Stable Adjustment and Sustained Growth
Very Overweight – link. It was published in October 1996, less than a year before Thailand’s (and Asia’s)
US economic collapse. It is all too easy for investors to buy into beguiling ‘growth’ stories which
Overweight
UK
Neutral Cont Europe are in fact utter nonsense. If the bubble of belief in China’s medium-term growth prospects

Underweight
Japan finally bursts it will have huge investment implications. I will be writing far more about this
Emerging mkts
subject over this summer. But one thought, if China is doing so well how come Chinese
Very Underweight
Source: SG Global Strategy Research
company profits in the year to April are down some 30% yoy (see chart)?

Chinese industrial profits growth (22 regions, year to date, yoy %)

50 50

40 40

30 30

20 20

10 10

0 0

-10 -10

IMPORTANT: PLEASE READ -20 -20

DISCLOSURES AND DISCLAIMERS

-30 -30

BEGINNING ON PAGE 4
-40 -40
2005 2006 2007 2008 2009

www.sgresearch.socgen.com Source Datastream, National Bureau of Statistics of China

 Global Strategy Weekly

SG have an excellent Asian economist, Glenn Maguire, who, unlike me, has been totally right
about the recovery in the Chinese data this year (e.g. for example his Asian Economic
Scrapbook – link). But it was notable that when the 6.1% yoy rise in Q1 GDP was published
he said the real outturn was actually more like 3.5% yoy, but that the authorities “smooth” the
data at turning points. Let me put that into plain English. The Q1 6.1% GDP outturn is simply a
lie – and it helps explain why the Chinese data is derided by so many economic
commentators. Many have highlighted that the GDP seems inconsistent with other data such
as electricity output (see chart below). This latter series remains weak. In May it declined 3.2%
yoy and by 3% on the smoothed basis shown below).

Chinese electricity output (3 month mav) and GDP yoy%

20 20

electric output
15 15

10 10

5
GDP 5

0 0

-5 -5

-10 -10
2001 2002 2003 2004 2005 2006 2007 2008

Source: Datastream

Yet few dare to point out that the emperor’s clothes might be absent. When, for example, the
International Energy Agency had the temerity, a few weeks back, to suggest that the Chinese
authorities were inflating the data (link), they were met with a robust broadside from the
Chinese National Bureau of Statistics. The NBS said on its website “It is regrettable that the
point of view in the original article is groundless…We believe that, for an international
organization, this approach lacks seriousness” – link. I think this is a case of me thinks thou
doth protest too much. Nevertheless, an article on Radio Free Asia reported that The National
People’s Congress had found “serious fabrication” in official statistics – link and link.

That is not to say that the fiscal stimulus has not had a beneficial effect on Chinese activity
this year. What I question is the quaint notion the markets now seem to have that the Chinese
economy can grow at a respectable rate when the rest of the world is in a deep recession. The
Radio Free Asia article also quotes Philip Andrews-Speed, a China energy expert at the
University of Dundee, Scotland as saying “Whenever you look at Chinese statistics, you say ‘is
it incompetence, is it confusion, is it conspiracy?’” He thinks it is a combination of all three.

My own view is that to the extent that the renewed surge in commodities and the Metals and
Mining sectors are based on the Chinese growth miracle, the markets are relying on a
combination of hype, lies and wishful thinking. Just over a decade on from the World Bank
publishing Thailand’s Macroeconomic Miracle: Stable Adjustment and Sustained Growth, that
economy’s performance can be best described as unspectacular with an increasingly
unstable and dangerous political backdrop. Personally I believe the bullish group-think on
China is just as vulnerable to massive disappointment as any other extreme of bubble-
nonsense I have seen over the last two decades. The fall to earth will be equally as shocking.

2 16 June 2009
 Global Strategy Weekly

Let’s looks at a couple of other things that have caught my eye in recent days. The US Federal
Reserve have just published the quarterly Flow of Funds data. For data geeks like me this is
always worth a look as it gives detailed financial data for all economic sectors in the US – link.
Among things of note was the second baby-step in the de-leveraging processes of the non-
financial private sector. Borrowing declined $179bn in Q1 (annual rate) against growth closer
to $1.5tr p.a. for most years prior to the bubble bursting. Interestingly, despite the third quarter
in a row of massive fiscal stimulus ($1.4tr in Q1 following $2.2tr in Q4 and $2.1tr in Q3 – blue
top bars below), a massive unwind in the balance sheet of the financial sector ($1.8tr, black
bar below) meant that total domestic debt shrunk in Q1 for the first time. One interpretation of
this is that the de-leveraging process is wholly offsetting massive fiscal stimulus.

US borrowing by sector ($bn annual rate)

6000 6000

5000 5000

4000 4000

3000 3000

2000 2000

1000 1000

0 0

-1000
federal + state & local government -1000
financial sector
-2000 non-financial domestic private sector -2000

total domestic
-3000 -3000
2004 2005 2006 2007 2008

Source: Datastream

Finally, I’ve been reading a lot about how the bond markets are now discounting substantially
higher inflation (see chart below). Actually as can be seen from the chart, what we are seeing
is a reverse of the anomaly that occurred with real yields. A collapse in the price of inflation-
proof government bonds in H2 last year was almost certainly the result of investors dumping
these bonds post Lehman’s collapse. Real yields of 4% at the end of 2008 were an anomaly
driven by weight of money selling. My forecast for year-end is that as growth begins to stall
out we should look for a return back to 1% real yields and ½-1% implied inflation.

US 10y real yield and implied inflation expectations %

4.00 4.00

real yields
3.50 3.50

3.00 3.00

2.50 2.50

2.00 2.00

1.50 1.50

1.00 1.00

0.50 0.50

0 0

-0.50
implied inflation exp -0.50

-1.00 -1.00
2004 2005 2006 2007 2008 2009

Source: Datastream

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