China s Debt Build-up & Oil SELL signals

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1 Longview Weekly No. 3, 18 th February 2013 A Pithy Curio of Sector Strategy, Trade Ideas and Global Macro Written by: Chris Watling, CEO & Chief Market Strategist: dl+44 (0) Harry Colvin, CFA, Director & Senior Economist: dl+44 (0) China s Debt Build-up & Oil SELL signals Summary & Conclusion the credit intensity of GDP in China moved meaningfully above** 1x in 2009 for the first time since 2003 (as a result of the Chinese stimulus during the GFC). More troublingly, though, that wasn t a one-off year - credit intensity of GDP growth has remained meaningfully above 1x every year since 2009 (indeed even in 2011 when China was engineering a slowdown to combat inflation). Clearly growing debt faster than the economy drives a sharp increase in the total economy debt to GDP ratio and at some stage becomes unsustainable (section 1).. a number of our short term (proprietary and non proprietary) oil trading models are either at or close to short term SELL levels (i.e. the short term models are increasingly consistent with our fundamental analysis).(section 2) Table of Contents 1. Section 1: China s Rapid Debt Build-up p Section 2: Oil market outlook update short term oil models p. 4-5 This publication is for the use of named recipients only and is protected by U.K. and International Copyright laws. If you are not the intended recipient, please notify us immediately. It is an offence to copy or distribute this publication, in any form or by any means, except as permitted under agreement with Longview Economics Ltd. All rights are reserved. No license is granted to the user except for the user's personal use. No part of this publication or its contents may be copied, downloaded, stored in a retrieval system, further transmitted, or otherwise reproduced, stored, disseminated, transferred, or used, in any form or by any means, except with prior written permission from Longview Economics Ltd. Important disclosures are included at the end of this report Longview Economics T +44 (0) Market Timing, Macroeconomic, Thematic & Commodity Research

2 Section 1: China s Rapid Debt Build-up Cyclically the Chinese economy appears to be in a clear upswing. Chinese car sales in January broke above their 2 year consolidation range (fig 1); a number of the leading economic indicators (LEIs) have continued to trend upwards in recent months (e.g. see official NBS & Conference Board LEIs); while the expansion of credit following on from the rapid infrastructure project approval in June/July last year is supportive of ongoing economic growth (at least in 2013). Consistent with all of the above, our Chinese traffic light macro indicators (whether leading, credit or coincident indicators) have all become increasingly green & amber and decreasingly red*. FIG 1: Chinese Car Sales (monthly total, mn) Strong January car sales pushed the run rate above the prior 2 years consolidation range Structurally, though, the more we analyse the sources of Chinese growth, the more concerned we become. It s well known, for example, that the investment rate of GDP in China is unusually high. Indeed the IMF in its recent November 2012 assessment ( Is China Overinvesting and Does it Matter? ) found: its investment is significantly higher than suggested by cross-country panel estimation. This deviation has been accumulating over the last decade, and at nearly 10 percent of GDP (Ed: i.e. the deviation means that the IMF estimate that the investment rate of GDP is 10% higher than it should be) is now larger and more persistent than experienced by other Asian economies leading up to the Asian crisis. IMF Working Paper no 277 Longview Weekly No 3, 18 th February

3 Digging into the detail behind that high investment rate of GDP (i.e. which is close to 50% of GDP), it becomes increasingly clear that it s mostly funded by a rapid accumulation of debt, in particular since the onset of the global financial crisis (and most notably through the LGFVs*). By way of illustration, the credit intensity of GDP in China moved meaningfully above** 1x in 2009 for the first time since 2003 (as a result of the Chinese stimulus during the GFC). More troublingly, though, that wasn t a one-off year - credit intensity of GDP growth has remained meaningfully above 1x every year since 2009 (indeed even in 2011 when China was engineering a slowdown to combat inflation). Clearly growing debt faster than the economy drives a sharp increase in the total economy debt to GDP ratio and at some stage becomes unsustainable. Since 2009, system wide lending i.e. traditional SOE bank lending plus all other forms of social financing (NB social financing represents much, although not all, of the shadow banking system***) has risen from around 120% of GDP at the end of 2008 up to 180% on the latest data point (fig 2). On current borrowing and GDP growth estimates, it will reach approx 192% by end FIG 2: Chinese Debt to GDP (system wide lending & traditional bank lending) Total non financial private sector borrowing (including the off balance sheet LGFV) reached 180% of GDP by the end of On current estimates, the ratio will increase to 192% by end 2013 *LGFV = Local government financing vehicles (i.e. off B/S companies set up by local governments to enable them to use leverage to build infrastructure and create economic growth) **NB Credit intensity of GDP that s persistently and meaningfully above 1x, by virtue of mathematics, will eventually become unsustainable i.e. as there s a limit to how much debt an economy can support (as, for example, demonstrated by the GFC and recent EM crises) ***NB system wide lending doesn t include the underground financing which is prevalent in a number of Chinese cities. It also doesn t include official national or local government borrowing (although does include LGFV s borrowing) Perhaps what s most troublingly, however, about this debt fuelled growth is its dependence on off balance sheet financing structures and ever rising land prices. At the centre of this scheme lies the local government financing vehicles (LGFVs) and the Chinese Development bank Longview Weekly No 3, 18 th February

4 (CDB) the largest development bank in the world, with a US$1 trillion balance sheet and no depositors (i.e. funded entirely by bond issuance bought mostly by the state owned banks). This model for funding infrastructure projects via off balance sheet vehicles utilising land as collateral for loans, was devised by the current head of the CDB, Chen Yun. The first project, funded this way, was undertaken in the mid 1990s. By 2007, there were 360 such vehicles (according to the World Bank). When the GFC hit, the Chinese government turned to this approach to fund its stimulus. As such, given its rapid take-up by local governments, by 2010 there were between 6,000 and 10,000 LGFVs in operation (as estimated by the Chinese National Audit office and Central Bank respectively). According to Sanderson & Forsythe in their recent book ( China s Superbank ), about 90% of China s fixed asset investment (FAI) has been at the local government level i.e. close to 90% of China s FAI has been funded by off balance sheet LGFV. With the majority of China s growth driven by FAI and the majority of FAI funded by ever rising debt levels, the limits of this model and with that China s growth model, at some stage, will be reached. More on this topic in our forthcoming Longview Letter: China Follow the Money FIG 3: China s Credit Intensity of GDP growth credit intensity of GDP growth (x) In 2013, total credit is expected to grow over 3x as fast as the economy Longview Weekly No 3, 18 th February

5 Section 2: Oil market outlook update short term oil models Harry Colvin Oil prices have risen sharply in recent weeks (Brent crude, for example, is up 6.8% YTD). That reflects general risk appetite in markets and, more recently, bullish comments from the EIA & OPEC* as well as a breakdown of negotiations in Iran last week**. The fundamental outlook for oil prices, though, remains poor (as we have highlighted in recent months - see Oct & Jan Commodity Monthlies No 37 & 38 for detail). In that respect its of interest that a number of our short term (proprietary and non proprietary) oil trading models are either at or close to short term SELL levels (i.e. the short term models are increasingly consistent with our fundamental analysis). Net speculative LONG positions in Brent futures, for example, are at record high levels (see fig 4 below) and at levels which have historically been correlated with a pullback in oil prices. That appetite for LONG Oil positions suggests that recent news flow has been priced in. Added to that, several other models suggest that oil prices should weaken/pullback, in the next 1 2 months. In particular: FIG 4: Oil price vs. Brent net speculative positions Net speculative positions in Brent crude futures are at record highs (NB records began in 2011) *This week OPEC raised its 2013 forecast for global oil demand (from mbpd to mbpd) while the EIA raised its forecast from 90.1 mbpd (to 90.2). Of note, though, the IEA lowered its global demand forecast this month by 0.9 mbpd. **UN inspectors failed to reach a deal this week in Tehran (while Iran has announced that its installing advanced machines to refine uranium more quickly). Proprietary indicators have a clear SELL message. The Longview Trend model, for example, is on SELL (fig 5) - suggesting that oil is overbought relative to its trend. The Longview oil momentum model (fig 6) has a similar message - signalling that recent upside momentum is now close to being overdone (and should therefore reverse in coming weeks/months). Longview Weekly No 3, 18 th February

6 Sentiment, a contrarian indicator, is bullish and at high levels (see fig 8); while Technical models are on SELL (or close to SELL) including the medium term RSI (fig 7) and the 20 day rate of change model (which is close to SELL). The key risk/caveat to building SHORT oil positions, at this juncture, is threefold: First the Fed is expanding its balance sheet (and therefore injecting liquidity into markets). Prior periods of QE/balance sheet expansion have been accompanied by an oil price rally (see Commodities Monthly Feb 11: Oil Fundamentals vs. QE for detail). Despite a general uptrend, though, oil prices still suffer pullbacks/bouts of volatility during periods of QE (see fig 9). Second, oil prices are typically seasonally strong in March and April (reflecting the inventory build-up ahead of the US summer driving season see Longview Letter No 15 Oil Seasonality, bond & equity markets for detail). Having said that, oil is also typically seasonally weak in the month of February (this February, though, Brent is up 2.1%, MTD); & third the risk of an Israeli strike on Iranian nuclear facilities. FIG 5: Longview Trend model vs. oil prices (US$/barrel) Oil is overbought relative to trend Longview Weekly No 3, 18 th February

7 FIG 6: Medium term oil momentum model vs. oil prices (US$/barrel) Recent momentum in oil prices is now overdone to the upside FIG 7: Medium term RSI (56 day) vs. oil futures price (US$/barrel) Oil is technically overbought (on a medium term RSI indicator) Longview Weekly No 3, 18 th February

8 FIG 8: CONSENSUS bullish sentiment index* vs. oil prices Oil price sentiment is bullish and generating a SELL signal *This is a sentiment index created by CONSENSUS and is based on market opinion published by brokerage houses. FIG 9: Brent oil price (US$/barrel) vs. periods of QE Oil typically trends higher during periods of QE albeit with pullbacks/ bouts of volatility Longview Weekly No 3, 18 th February

9 This Publication is protected by U.K. and International Copyright laws. All rights are reserved. No license is granted to the user except for the user's personal use. No part of this publication or its contents may be copied, downloaded, stored in a retrieval system, further transmitted, or otherwise reproduced, stored, disseminated, transferred, or used, in any form or by any means, except as permitted under agreement with Longview Economics Ltd. This publication is proprietary and limited to the sole use of Longview Economics clients and trial subscribers. Each reproduction of any part of this publication or its contents must contain notice of Longview Economics copyright. This agreement shall be governed and construed in accordance with U.K. Copyright law and the parties hereto irrevocably submit to the exclusive jurisdiction of the English courts in respect of any dispute or matter arising out of or connected with this Agreement. Any disclosure or use, distribution, dissemination or copying of any information received from Longview Economics Ltd. is strictly prohibited, whether derived from the reports or from any oral or written communication by way of opinion, advice, or otherwise with a principal of the company; and such information is not warranted in any manner whatsoever; and is for the use of our clients and trial subscribers only. Longview Economics Limited will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to the accuracy or completeness. All information and opinions as well as any prices indicated are current as of the date of this report, and are subject to change without notice. Some investments may not be readily realisable since the market in securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. Futures and options trading is considered risky. Past performance of an investment is no guarantee of its future performance. Some investments may be subject to sudden and large falls in values and on realisation you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. Longview Economics Ltd. is an appointed representative of Messels Limited. Messels Limited is authorised and regulated by the Financial Services Authority. If you have received this communication in error, please notify us immediately by electronic mail to or by telephone at (0044) Longview Weekly No 3, 18 th February

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