Market report: June 2019

25.07.2019 * reading time: 15min


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USA – review of the economic situation

The US economic prospects are positive, but with a high dose of uncertainty. The unemployment rate is low, wages are growing slightly and GDP growth is robust. The internal situation in US policy regarding trade, deficit, immigration and foreign affairs offers a large dose of uncertainty.

In May, weaker data on industrial output and other domestic data prompted some forecasters to present lower GDP growth estimates in the second quarter.

Retail sales fell in April, as did the Federal Reserve industrial production index for the third time in recent months.

With all ups and downs, we estimate the GDP growth rate in 2019 at 2.5-2.7 percent y / y.

We observe growing protectionism, trade wars and their impact on US prosperity and, of course, growing deficit, debt and the corresponding risk of rising debt servicing costs.

In the further part of the article, I present the “what if” scenario, including interest rate increases, to show how difficult it can be to maintain all growing US government services while building more debt.

The President’s D.T administration is gradually shifting the US tax burden from income and profits to consumption. The income tax for individuals and corporations has been reduced and tariffs for consumer and production goods have been introduced. This was done without a congressional debate and without the White House reminder that America now has a growing domestic sales tax based on tariffs.

Personal taxes fell from USD 1,648 trillion in the fourth quarter of 2017 to USD 1,633 trillion in the fourth quarter of 2018, which means a reduction of USD 15 billion – not much, but we must remember that about 43 percent of Americans do not pay income taxes.

Corporate income tax fell to USD 161 billion in the fourth quarter of 2018 from USD 264 billion in the fourth quarter of 2017, which means a drop by USD 103 billion. These are serious sums.

Tariffs or so-called customs fees, in the fourth quarter of 2018, USD 72.3 billion were collected, compared to USD 40 billion in the fourth quarter of 2017, bringing a profit of USD 32 billion. Most probably, not all USD 72.3 billion have been passed on to consumers.

According to a report from the Congressional Budget Office of January 2019, the five main categories of expenditures for federal government expenditures in 2018 were as follows: 

  • Social security benefits: USD 982 billion;
  • Medicare: USD 704 billion;
  • Army: USD 622 billion;
  • Medicaid: 389 billion dollars;
  • Net interest on public debt: USD 325 billion.

Of the top five, interest payments increased the fastest, 19.2 percent in 2018.

Each of the other categories increased by less than 10 percent during the same period.

Suppose the average interest rate paid by the government for debt increases from 2.45%. in 2018 to the level of 3.20%. from December 2008.

American debt interest costs would rise from $ 343 billion to $ 422 billion. To finance this higher cost of interest, the administration would have to make painful cuts in all other categories – the big five and beyond – or borrow even more, which of course would mean more total debt and even more interest costs.

The FED is trying to get out of the situation

At the beginning of June, the FED did not change the reference rate, but also signaled a very high probability of cuts this year. In the past, interest rate cuts were a sign of trouble – usually made in response to slower growth and rising unemployment. However, this time the growth data does not show weakness.

In the past, the FED was waiting for clear evidence that the economy is struggling with difficulties, then it lowered rates. Rather, it was a race to save the economies already in danger, instead of seeking solutions to economic trouble in the bud. This time, the FED hopes to avoid a repeat and opens the door to rate cuts this summer.

What prompted the FED to change its playbook in this cycle?

This is the scar from the last cycle. Then the central bankers around the world lowered rates to zero or even lower during the Great Recession and still had to resort to quantitative easing (QE), yield curve controls and other unconventional political tools to stop depression. Among decision makers, the view today is that unconventional tools were not as effective as expected: a lot of QE is needed to avoid depression.

The rate of the US monetary policy rate varies from 2.25% to 2.50%, which is roughly half of its initial level before the last recession. It is almost certain that the next recession will force the FED to go down to zero again and return to unconventional tools.

The FED will take these steps if necessary, but we are sure that they would prefer not to do so. It is better now to lower rates and, hopefully, prevent a recession than to wait and be forced to react.

Being preventive does not come without risk. Moving quickly at the interest rate can provide too much fuel for the economy, causing a overheated or bubble in the financial market. But inflation is still well below the FED target, so the risk of overheating seems minimal at the moment.

Speculative bubbles in the financial markets are an urgent topic, but the FED believes that better regulation and increased capital requirements have made the banks safer. Banks were, of course, the channel through which the recent crisis spread from the financial markets to the real economy. Time will tell whether the FED’s trust in its regulatory structure is well-placed. We believe that their position in the near future will allow you to risk market bubbles to avoid falling below the economic curve.

Will modern monetary theory (MMT) go to the mainstream?

Spending more money on social programs is a classic priority for populist policy. Tangible help is the easiest way to convince citizens that the government cares about their best interests. MMT offers a theoretical framework that allows you to increase your spending without having to answer a much more difficult question: how to pay for it.

The evidence from the present cycle seems to be in accordance with the above theses. Contrary to what many people thought, so far, the huge increase in public debt in the United States and other major countries in the world did not cause interest rate increases or lead to rapid global inflation. This is the result provided by MMT, but not what economists would be looking for savings.

The immediate concern of MMT is the hyperinflation spectrum that seems to be strained today. Most central banks, including the US Federal Reserve, are trying to raise inflation expectations and inflation. In order for MMT to operate as long as it was theoretically assumed, investors must be sure that the government is able to enter and control the situation. If higher government spending goes too far, policy-makers will have to be ready and able to raise taxes or reduce spending.

Given the stalemate we see today in the US political system, this result does not seem very likely. And if the markets do not believe in the promise of future fiscal discipline, the policy will not be credible. As a result, inflation expectations and intrusion may increase much faster.

Thanks to MMT, which applies fiscal policy instead of monetary policy in order to manage supply and demand, the government is responsible for capital allocation and making investment decisions. In our opinion, this may lead to less effective results than the use of interest rates, to encourage the private sector to allocate capital and make investments.

Of course, some aspects of the economy require government spending. But in a certain simplification, we believe that investment decisions taken by the private sector under the influence of monetary policy will probably be more effective in the long run.

We believe that many in the political system share our concerns, so we do not expect MMT to formally replace the current economic structure. Some of the MMT policy will be very influential because it has grown from a populist impulse. This means that we will probably see permanent budget deficits, growing sovereign debt and, over time, policies to increase social spending and benefits.

Global economy in mid-2019

We expect + 2.5% global growth in 2019 and 1.9% in 2020.

Unforeseen transmission channels have proved to have stronger than expected impact, especially in terms of reaction on financial markets (flight to quality, super-fast central banks, lower prices of goods) and the cost of uncertainty for the economy. Low inflationary pressure can be stopped by stress in the Strait of Hormuz. Consequently, we revised our trade forecasts down in 2019 and 2020 (+ 2.2% in terms of volume this year and + 2.0% in 2020, after + 3.8% in 2018).

Political risk is not reduced.

A trade conflict may include several battlefields besides US and China rivalry. It seems that interventionism, public extravagance and difficult dogmas continue to generate market noise, but limited effects are visible in the case of household and business confidence.

Inflation expectations and the overall tendency to flatten the yield curve reflect worse economic outlook. The consensus of economists has significantly revised its forecasts of GDP growth in recent months, which is accompanied by a loss of confidence in the money market. For now, there is a gap between the foundations and the stock market, which has positively reacted to the dovish signals of central banks. We still believe that a corporate credit event may occur in the United States after a deadlock in budget discussions and a confidence shock. The next downturn will test the ability to do the right things at the right time in the face of a recession, because traditional policy tools and international cooperation are weakened. Private buffers will be very important.

Considering the magnitude of the current shock of global uncertainty (a trade dispute between the US and China, US public debt will be a source of instability from the fourth quarter of 2019), we predict that seven out of ten countries will see an increase in corporate insolence in 2019, on average in every third country the end of 2019 will see a greater number of insolvencies than before the global crisis in 2008-2009. It is expected that the global default rate (created for own needs) will increase by + 7% both in 2019 and 2020, with still noticeable growth in Asia (+ 15% in 2019), Europe (+ 3% ) and gradual reversal of the trend in the US by 2020.

The economic situation in China

We observe the six most important factors determining the state of the Chinese economy at present:

  • the risk of a speculative bubble in the real estate market
  • risk of a credit bubble (M1 and M2 money supply at record historical levels, CNY 56770 and 192140 billion, respectively)
  • the risk of a permanent, high real interest rate (interest rate at around 4.35%)
  • unemployment rate (relatively stable at around 4%)
  • the rate of capital account liberalization and the openness of the economy to threats
  • probability of errors in politics and fiasco of implemented government programs

House prices in the 100 largest Chinese cities increased by 5.09 percent in 2018, which means a decrease of 2.06 percentage point compared to the previous year. This is the result of the China Index Academy, a provider of information services on Chinese properties based in Beijing.

Only in December the average price of new homes in 100 cities monitored by the Academy increased by 0.25 percent month-to-month to 14,678 yuan ($ 2,136) per square meter.

On a monthly basis, housing prices rose in 60 places, six less than last month; 36 out of 100 cities recorded monthly price drops, five more than in the previous month, and four cities remained unchanged.

Last year there was an increase in prices in 97 cities, among which the 14-percent price increase rate exceeded more than 15 percent, by 20 less than in the previous year.

In December, the average price of new homes in 10 major cities, including Beijing and Shanghai, increased by 0.25 percent month-on-month to 26,732 yuan per square meter, an increase of 0.07 percentage points from the previous month. House prices in these 10 cities increased last year by 2.37 percent, by 1.54 percentage points less than a year earlier.

Considering that the average income of a Chinese resident is around USD 12,000 per year, property prices are high. Of course, they can be higher, but we think that higher prices could cause a price bubble phenomenon. We are talking about real estate prices excluding real estate prices of the largest metropolises. According to our assessment, this is the period in which prices should stabilize, with a tendency to several-percent revaluations in minus and a possible increase in prices in the largest metropolises.

Developers should start the process of deleveraging the assets. Chinese developers are struggling to place bond issues on the Chinese market due to government efforts to tighten lending policy to limit speculative capital in the real estate market.

The corporate debt market seems to have stood still in the month of February, when companies did not place new debt on the Chinese continent. According to the Shanghai Stock Exchange, on February 22, Beijing Capital Land suspended its corporate bond offer worth 10 billion yuan (US $ 1.46 billion), which was explained by policy tightening.

Since October, Beijing has tightened the rules, from home shopping to land auctions, trying to help lower house prices in the face of concerns over the emerging housing bubble.

The government is not only tightening the bond issue criteria, but it is tightening all possible financing channels, including bank loans, equity financing, asset-backed securities, trust funds and asset management plans.

The Chinese government hopes to reduce housing prices in major cities by limiting lending to real estate companies.

The risk of insolvency of small developers is growing due to the slowdown in sales due to the tightening of government policy. The developers’ financing costs are likely to increase as they look at the offshore bond market, which exposes them to higher currency and interest risk.

Thirty Chinese real estate companies issued bonds denominated in US dollars from November 2018 to February 2019, compared with 35 in January-October 2016, according to Dealogic.

China Minsheng Investment Group announced on Thursday, 18/07/2019, that it will not be able to repay the principal amount as well as interest on bonds worth USD 500 million in August, after considering the liquidity and financial results of the company.

On Thursday, the asset and financial conglomerate announced that it managed to repay only part of the capital in the amount of 6.5% from 1.46 billion yuan, approximately USD 212 million.

CMIG said in April that cross-default clauses were launched on US dollar bills totaling USD 800 million. These include USD 300 million in debt that China Construction Bank paid off on behalf of the company in June because the bank issued a cash letter of credit. Bonds in dollars payable in August are traded at around 50 cents against the dollar, compared to around 75 cents at the beginning of July.

The global bond market enjoys decent growth since the beginning of the year, with yields of 10Y US government bonds falling even below the 2 percent first half of June, as the market sees the Federal Reserve intending to lower interest rates. However, the Chinese bonds did not join the rally: the yields of 10-year treasury bonds have not changed. As a result, the spread of yields between China and the US in 10-year bonds increased to over 120 basis points, from 40 bps at the beginning of the year.

The real reason for this phenomenon is, I think, the financial crisis faced by small and medium-sized financial institutions in China, whose symptom may be the acquisition of Baoshang Bank. On May 24, the Chinese authorities announced they would take over Baoshang Bank for a year due to serious “credit risk”.

Baoshang Bank is a commercial bank based in Baotou, a small city of about 2.76 million inhabitants. When it was acquired, Baoshang had about 576 billion yuan ($ 83 billion) on its asset books – compare this to ICBC, the largest Chinese bank, with assets corresponding to more than USD 4 trillion.

The market is afraid that more small financial institutions are in serious trouble, which may be caused by a credit event in China. Secondly, the market recognizes that the Chinese authorities will tighten regulations on financial institutions, which may force some banks to relieve doubtful and toxic assets.

More and more often developers face a difficult compromise: cheaply sell homes or wait for relaxation of price and credit line control, huge discounts (up to several dozen percent) try to attract potential buyers who, in turn, have avoided more expensive residential homes.

Questions related to Brexit

The exit “without transactions” in October is possible and even lawful. However, there are several reasons to believe that this will not happen:

a) The current Parliament is not in favor of leaving the EU “without agreement” and may try to prevent it.

b) In return for voting in a vote of confidence, the new conservative leader will have to give assurances to members of the parliament, some of whom will deal with Brexit. An obligation to try to conclude a contract is likely to be necessary to avoid losing the votes of six conservative parliamentarians.

c) Approximately 100 days remain until Brexit. It does not give you too much time to negotiate a contract or implement a “no deal” legislation, which suggests that a further extension of the Brexit deadline is likely.

d) If the general election were on the cards, Brexit negotiations would be a matter of days, which again suggests that further prolongation of Brexit negotiations is likely.

Will we have early general elections?

Perhaps for many reasons:

a) If the new conservative leader loses a vote of confidence and the Labor Party is unable to form a government, this will lead to elections.

b) If the conservative party under its new leadership will do better in the polls, the new leader may be tempted to try to get a majority government to have more control in Parliament.

 The elections could break the deadlock in the current parliamentary arithmetic – a new conservative leader could get a parliamentary majority, which would facilitate the implementation of the policy. The composition of the Parliament may also change – new MPs may be more in favor of Brexit in the shape that the new conservative leader wants to achieve.

Example May showed that elections can be risky. Conservatives are behind the Brexit Party, the Liberal Democrats and the Labor Party are leaning towards polls regarding election intentions. Until recently, survey data indicated that the Labor Party would probably win the most seats in the election, but would not get the majority of votes.

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.