Following the defeat of the new U.S. healthcare bill, investors have begun to rethink the likely time frame and extent of the Trump administration’s other top priorities, such as fiscal stimulus. Equity markets stalled and bonds rallied as investors toned down their expectations for global reflation recently.
None of this is horribly surprising, but by focusing so intensely on U.S. political developments, investors risk missing a silent shift in what has arguably been the strongest driver of global reflation in the last five years: Chinese credit. This driver is now moving sharply in reverse.
China’s “credit impulse,” the change in the growth rate of aggregate credit to GDP, bears close watching: It has tended to lead the Chinese manufacturing Purchasing Managers’ Index (PMI) by a year (see Figure 1) and the U.S. Institute for Supply Management’s (ISM) manufacturing index by 14 months.
The relevance of the Chinese credit impulse to global reflation cannot be overstated (see Figure 2). China’s massive credit stimulus starting in 2014 initially put a floor under commodity prices and emerging market (EM) growth. Then, the unexpected acceleration in Chinese real estate investment drove both commodity prices and volume demand higher. EM growth subsequently bounced, and with it, global trade volumes. The key driver of realized global reflation, then, has been China – not the promise of fiscal stimulus and deregulation that has helped boost confidence and other soft data in the U.S.
When will China’s credit drop affect growth?
The sharp downturn in the Chinese credit impulse starting in 2016 portends a material drag on Chinese growth in the year ahead. Looking back on the past three years, the Chinese credit impulse turned positive sometime between late 2014 and mid-2015. Given China’s exchange rate volatility in August 2015, it took longer than normal for credit to gain traction. The Chinese credit impulse peaked in March 2016 and slowed sharply after the second quarter. It is only now that the impact of that reduced stimulus should be felt. PIMCO has already factored credit-related drag into its Chinese growth outlook, but the decline in the credit impulse has been sharper and more extreme than many expected.
The question now is not if China slows, but rather how fast. Equally important perhaps is the extent to which commodity prices will correct lower, especially in light of the current enthusiasm about the potential strength of the global growth cycle. The impending slowdown in China could be compounded by ongoing government efforts to rein in shadow bank credit; the cost of policy mistakes rises once the credit impulse goes into reverse.
Expectations for slower Chinese growth cannot be separated from China’s overarching political desire to underwrite stability ahead of the 19th National Party Congress this autumn. Chinese growth is not likely to fall off a cliff between now and then, regardless of what happens to commodity prices. Just as a less hawkish Federal Reserve is the backstop to market volatility, the Chinese growth “put” ahead of the Party Congress is ultimately the backstop to EM- and commodity-related credit risk.
Nonetheless, the complacency over China’s potential deceleration, combined with the greater likelihood that strong U.S. confidence indicators will now move more in line with the lackluster real economy data, suggest that some of the froth will come out of the most growth-oriented segments of the global markets.
Gene Frieda is a global strategist based in PIMCO’s London office.