By John Richardson
THE Chicago Board Options Exchange’s (CBOE) volatility index fell to its lowest level since 1993 on 8 May.
But we knew then that the China economy was slowing down – and that very probably, the Trump administration would fail in its efforts to achieve meaningful tax cuts and infrastructure spending.
Financial markets have since then become even more becalmed – and have also reached new record highs – despite another North Korean missile test and, in the space of just one week, President Trump’s dismissal of former FBI chief James Comey and the controversy over claims that the president leaked sensitive intelligence information during a meeting with Russian government officials. These distractions suggest it will be even harder for President Trump to achieve his growth-boosting policy agenda (that’s if you accept the view that his proposed measures, which right now are short on detail, would actually boost growth).
Since 8 May, China’s April trade, industrial production and retail sales data have also further confirmed that China’s 2017 economic growth almost certainly peaked in Q1 at 6.9%. This stronger first quarter performance gives the Chinese government plenty of leeway to allow the economy to cool down over the next few quarters whilst still hitting their annual growth target for 2017 of 6.5%. It also has the leeway, and plenty of popular support, to improve air quality in the big cities. This year’s environmental clean-up campaign is tied-in with lower lending growth – and will add to downward pressure on GDP growth.
What is even more remarkable about the lack of volatility in financial markets is the role that stronger Chinese growth has played in stronger global growth. As a reminder:
- The global economic recovery has had very little to do with a fundamental shift in the underlying growth dynamics in key developed economies such as the US. Until or unless the US and the rest of the West tackles the challenges of ageing populations, a sustainable recovery cannot happen.
- What has instead been behind the recovery has been a mini commodities pricing bubble. In 2016, commodities prices rose as the Chinese economy boomed on a rapid growth in lending. This was the result of the Populist anti-reform political faction regaining control of China’s economy. Global deflation thus turned to reflation as global manufacturers hedged against higher raw material costs by building up their inventories of raw materials.
- But this year’s slowdown in lending demonstrates that the Princeling pre-form political faction led by Xi Jinping, China’s president, is back in control of the economy. Prices of commodities such as iron ore have, as a result, started to decline as credit conditions in China tighten.
So markets should now be pricing-in the strong possibility that the recent strength in purchasing manager’s indices (PMIs) in Europe and the US will start dissipating. What could soon become apparent is that the stronger demand being reported by companies in the West has largely been just the restocking effect described above. PMIs could thus soon weaken, especially if the China slowdown helps drive oil prices lower.
Why are finanical markets becalmed markets then? Mohamed El-Erian, former head of Pimco, the world’s biggest bond fund manager, told the British newspaper, The Guardian:
Investors have been conditioned to think central banks can suppress volatility. They also see that the low growth appears stable.
But the above chart is an important reminder how the central bank that matters more than all the other central banks – the People’s Bank of China – is now in lending contraction mode. Sure, it may change course, but this seems unlikely over the next few quarters and into early 2018. Please be careful out there.