E Markets: Spigots

Cold weather. The arctic vortex crashes down on the US with my spigots suffering like my fingers. Anyone that has suffered frozen pipes knows the feeling: spigots become freezing ice volcanoes after a thaw. Burst pipes and ongoing cold blasts make the present market melt up look technically bearish, even while the headlines improve over the big worries with China perpetual bond issuance for banks seen as a U-turn on its forced deleveraging of the shadow banks; with Trump blinking on his wall money and reopening the government; with the UK May blinking with the DUP over Brexit and with the ECB blinking over its rush to normalize. Nevertheless, the last week was modest for risk takers with the economic data confirming the 4Q downturn has no real bounce in 1Q and so the gloom set in for the “gliteratti” of the WEF Davos as the IMF cut its WEO growth for 2019 and increased the downside risk. 

So, for the week ahead, the trepidation over Fed pauses or Chinese QE (quantitative easing) should be about the credit pipes and the flooding that follows. Thaws in risk mean less room for the FOMC to pause. Financial conditions are a global affair and between ongoing BOJ, SNB, BOE bond buying, and now the new QE with Chinese characteristics, the FOMC normalization and the ECB talk of doing the same makes QT (quantitative tightening) seem like a frozen spigot. There is a growing danger in this thinking given that short volatility, long carry plays have become the consensus winning game again.  EM flows into debt overwhelm fears about weaker earnings and slower global trade. 

The headlines from last week were just not focused on China stimulus plans after a weaker set of economic data but rather US/China talks stalling over intellectual property, gloom from Davos speakers, North Korea/US summits, NATO/Russia concerns over the new Russian missile defense and the collapsing regimes of Venezuela and ZimbabweThe culmination of the last week came from the US airport slowdowns from TSA and air traffic controllers leading to Trump flipping on his wall showdown with the democrats. This event reopened the government and ensures a deadlock for anything new from the US on fiscal stimulus. 

How the US growth rate plays out in 2019 and beyond rests on the consumer and business spending as the US government appears to be tapped out post the Trump tax reform and given the size of the national debt. The role of fiscal and monetary policy in how nations grow isn’t the only factor with the last week highlighting the role of confidence driving forward business and consumer spending plans. This brings us back to how the FOMC considers financial conditions along with confidence measures and whether the new Powell Fed will be tested accordingly. 

Question for the Week Ahead: Does the China Perpetual Bond plan end growth concerns for 2019?

The connections between US and China, the world and Asia all come to play in the outlooks for 2019. On one hand you have China stimulus and on the other, is the risk for an extended China trade war. The question maybe whether the plan for China back-door QE leads to less willingness to come to a deal with Trump over the stickier issues of intellectual property and open seas (read as the militarization of the South China Sea). Many want to believe that China can re-inflate the economy at the command of Xi. The ability for the Chinese government to issue more debt as it did in 2008 and help spur growth globally is the playbook. China has room when you look at the amount of government debt compared to Europe or the US or Japan. 

However, the larger and more troubling issue about perpetual bond issuance working as a new QE for the world rests on how it drives the Chinese consumer.  Many see the plan a merely a recapitalization of the banks – as they issue perpetual bonds (the big 5 and up to 40 other institutions), the PBOC swaps them for government bills. This move puts their debt on the balance sheet of the central bank. The duration of these swaps, the amount of actual bonds in the pipeline to be issued, the willingness of the insurance sector and foreigners to buy the stuff – all that matters as well. The Bank of China issues about $5.6 billion (CNY40 billion) Friday at 4.5% with 2 times cover – that is better than the 5.2% expected – but still implies even higher pass on costs to the private sector.  The roll-over of private debt is the usual stuff of 1Q and the noise of the Chinese New Year celebration (Feb. 5) in disrupting business and spending makes it hard to tell if all this will work. 

The speed of change in the private sector and household balance sheets makes the present plan for perpetual bonds look a bit like pushing on a string.  Can you get banks to lend to riskier companies and consumers by giving them more liquidity? Supply meets demand and that remains the key fear for China as it shifts into a middle income trap risk like Japan in the 1980's. The present plan for 2019 to hold grow at 6% by government stimulus and this new QE makes the risk for asset price inflation clear, but as the US and EU learned it doesn’t drive the private sector to investment or the consumer to spend more without inflation. Property price inflation is the natural place to expect this money from perpetual bonds to flow. 

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