Fear of being left out drives China rally

A modest surprise to the upside in China’s survey data prompted a powerful rally in Shanghai Monday morning (+2.6%) and a follow-through rally in New York (+1%).

China’s manufacturing PMI printed at 50.5 (just over 50% of respondents are expanding) rather than the expected 49.6. China’s stock market appears to have anticipated the goods news; the China MSCI index has gained 20.5% this year vs. 14.75% for the S&P 500, by far the best-performing large stock market in the world.

The PMI number validates the view of most observers that China’s growth improved somewhat during the first quarter, in response to easier monetary policy, targeted lending, tax cuts and infrastructure spending.

US PMI data released Monday morning also show a modest improvement within a slowing growth trend. The odd man out is Germany, whose March PMI printed at a miserable 44.1.

Despite the poor reading from Germany, German industrials were among the world’s strongest-performing stocks. Thyssen-Krupp rose by nearly 6%, auto parts maker Continental by 5.2%, and Daimler by more than 4%.

I continue to believe that European firms with strong China exposure represent a cheap way of buying into Chinese growth. Daimler and Volkswagen trade at 7 times earnings and 6 times earnings respectively, versus 9.3 times earnings for Great Wall Motors, one of China’s best performers year to date.

The world has been underweight China, whose bond market was folded into the Barclay’s aggregate world bond index today. If China outperforms, the average money manager will underperform, and that creates a powerful incentive to buy China in order not to be left out.

The biggest winners in the US were the beaten-up financials, whose valuations suffered as interest rates collapsed and the US yield curve flattened. Bank of America, Citigroup and Capital One gained more than 3%, while Morgan Stanley and JP Morgan rose by around 3%. Banks are trading like a bond put, and the sector jumped at the prospect of a halt to the deterioration of global economic conditions.

There are two main sources of demand in the world economy, roughly equal in size (in US dollar terms), namely the Chinese economy and the US consumer sector. The former is improving, the latter maybe not so much. US retail data unexpectedly show a contraction in February (although January was revised upwards). The most consistent measure of retail sales excludes volatile autos, building materials and gas stations; ominously, the six-month average of monthly changes is now negative in nominal terms, and very negative if inflation is taken into account.

US households, I have argued for the past year, represent a bigger risk to the world economy than China. Contrary to folklore, China does not have an insuperable debt burden; it has a great deal of supposed corporate debt which really is government debt (on the books of state-owned enterprises). In return for this debt it got excellent infrastructure that contributes to long-term productivity.

The Chinese government has shown that it has ample tools to maintain growth at 6% or higher. US consumers, by contrast, cannot decide whether they want to spend or save. Consumer balance sheets look strong, but that is in part due to the denial of credit to all but the highest-rated households.

Revolving credit (credit cards and related loans) has been growing much faster than retail sales, and it seems that households grew cautious in December, when retail sales unexpectedly dropped by the largest monthly margin since the financial crisis. Hope that the December report was a fluke disappeared with Monday’s -0.6% decline in retail sales excluding autos and gas stations.

The PMI’s show that the US economy isn’t headed towards recession but simply expanding at a slower rate than last year, while the retail sales data show that the consumer won’t contribute as much to growth as in 2018. I continue to believe that 2019 economic growth will come in at about 1.5, vs. 2.7% last year.