Big Trouble in Little China

Despite the general relief which greeted the release of China’s GDP data for the third quarter, as well as the still resilient industrial production data, we could not quite bring ourselves to join in the cheers.

As we all know, the mainstream is all too ready to treat such numbers as an end in themselves, without paying sufficient attention to the informational content involved in lumping together the sprawling, multifarious, activities of millions of people and boiling it down to one, single number — and that according to a methodology which subjectively combines the raw data in order to fit a pre-conceived concept of how an economy actually functions.

Hayek himself took pains to warn of the limitations of this approach in 1963, when he was discussing the great Methodenstreit of thirty years before:-

…it seems as if this whole effort… to ‘scientificize’ economics… were due to a mistaken effort to make the statistically observable magnitude the main object of theoretical explanation.

But the fact that we can statistically ascertain certain magnitudes does not make them causally significant, and there seems to me no justification whatever in the widely held conviction that there must be discoverable regularities in the relation between those magnitudes on which we have statistical information.

Economists seem to have come to believe that since statistics represent the only quantitative data which they can obtain, it is these statistical data which are the real facts with which they deal and that their theories must be given such a form that they explain what is statistically ascertainable.

There are of course a few fields, such as the problems of the relation between the quantity of money and the price level, where we can obtain useful approximations to such simple relations – though I am still not quite persuaded that the price level is a very useful concept.  But when it comes to the mechanism of change, the chain of cause and effect which we have to trace in order to be able to understand the general character of the changes to be expected, I do not see that the objectively measurable aggregates are of much help…

Not only is GDP itself, far too overaggregated  – and far too Keynesian—in its construction, but in China’s case the problem is not only compounded by the suspicion that the numbers are made to tell the story the Party wishes to tell, but also by the fact that where they are not actually incomplete, they are highly inconsistent.

So, for example, we are told that the year-on-year rate of real GDP slowed slightly to 9.1% from the previous quarter’s 9.5%, yet the nominal figures—so far as we can recast them –  seem to have accelerated from 17.9% to 20.6%. Indeed, this last figure would not be inconsistent with the simultaneously reported 23.6% rise in SOE business revenues over the first nine months (of which more in a moment)

If true, this would not only have represented the fastest gain since before the GFC itself intruded, but it would imply a price inflationary component which had accelerated to 10.5% – also the highest in nearly four years and significantly above, and moving in opposition to, the supposedly slowing, 6.1% pace of CPI increase!

In looking for further clues, one finds that, over the spring and summer, nationwide rail freight slowed from its usual 9.5-10% annual rate to a relatively languid level of 6.5%. Electricity usage, too—though more subject to the vagaries of the weather—has been rising at less than 11.5% over the past two quarters, rather than at the more typical 14.0-14.5% registered during recent periods of full-blooded expansion.

But more telling still—and yet another good illustration why the burn-the-furniture-to keep-warm inadequacy of GDP accounting is such a poor gauge of economic well-being—those same SOEs whose revenues we mentioned above have seen an unbroken run of consecutive monthly declines in profit, so far in the second half.

Given that these mighty bastions of the one-party state represent the favoured few, upon whom the available credit is showered, upon whom the best tax breaks and greatest subsidies—as well as the most advantageous resource pricing—is lavished, that is surely a telling statistic, as is the fact that their reported return on equity—of 5.8% – lay below even the official rate of price rises.

So, even as these behemoths have squeezed out their SME competitors—up to four-fifths of whom are reputedly losing money—they have been unable to parlay growing revenues into growing profits, much less yield a positive real return on capital.

On top of this, there have been any number of warnings from among the Party high-ups about the dire state of the export market — sufficient alarm, indeed, having been generated that Premier Wen pledged an ‘essentially stable renminbi’ from now on: in effect, therefore, signalling the end of an appreciation which has led to all sorts of extended currency gambles in places as diverse as Hong Kong’s Dim-sum bond market and the copper warehousing, L/C-manipulating tricks of the shadow importers.

Finally, it should be noted that not only has the stock market closed at its lowest level since the global asset markets began to recover in March 2009, but an accelerated liquidation of industrial commodities is well underway, with materials as diverse as steel, copper, zinc, rubber, cotton, polyethylene, and terephthalic acid all losing 30-40% from their highs, and all setting new multi-month—even multi-quarter—lows in the process.

Far from being ‘ruled out’ by the numbers — as the most credulous of mainstream macromancers have been claiming — China’s hard landing may actually be unfolding as we write, hidden from wider apprehension by the gaudy veil of that one, damnable, statistical fiction which is the stage prop of charlatans and the false comfort of the biddable alike.

China is a prime exemplar of everything we Austrians deprecate, whether in terms of its heavy-handed pretence of knowledge; the fatal conceits of its central planners; its multitudinous suppressions and perversions of the pricing system; or the endemic corruption and influence-peddling which, absent an economically impartial means of allocating means, is the only way to ration scarce resources between competing ends there.

As such, we cannot assume other than it will one day to be revealed to be a heroic disaster; that its attempt to maintain the privileged superstructure of the Party while seeking out a more effective way of marshalling the matériel needed to sustain its all-pervading apparatus will prove to have been the cause of a vast waste of human effort and earthly treasure, even if it has been infinitely preferable to the Maoist horrors which preceded this, the latest grand experiment in socialist Utopianism.

The only professional problem we have with this analysis is the rather crucial one that to be convinced of such an outcome from a grand historical perspective is of precious little use in knowing what or when to buy or sell in the hurly-burly of the fibre-optically fast marketplace in which we operate.

There will undoubtedly prove to be just as much ruin in the Middle Kingdom as there was in Adam Smith’s Britain of the 18^th century. Economic law cannot be repealed, but its verdict can often be long suspended, if usually at the cost of a harsher sentence when ingenuity finally fails those seeking to deny its implacable judgement. If the extended nonsense of our own, last four years of swimming against the tide of inevitability proves anything, it surely proves this.

Thus, while we are convinced that the hard landing in China will be more of an asteroid impact than a mere bender of the undercarriage when it eventually arrives, we cannot honestly say that this will be the inescapable result of the nation’s present constellation of difficulties.

In seeking to avoid such a shattering return to earth, the authorities there may yet hit upon new ruses to hide the losses, to defer the final reckoning, and so to sway production patterns and alter input pricing in any manner of unforeseeable ways before they tangle their ankles in a Gordian knot of their own ravelling and measure their mighty length in the dust of human vanity.

Here and now, however, all we are prepared to say is that this COULD be the Big One, but it might also be a lesser, pre-cataclysmic tremblor—much more severe than many of those constructing investment portfolios out of the straw of China’s invincibility can hope to withstand—but, nevertheless, only an ominous reminder of a mighty upheaval yet to come.

What goes for China, goes for its neighbours around the Pacific, of course, so we should not be surprised to see regional air freight falling into the negative column, or US West Coast container imports dropping markedly short of 2010 levels, nor at Taiwan export orders moving decisively below their pre– and post-Crash levels.

In Europe, all of this is playing second fiddle to the ongoing farce of the EFSF negotiations while, in the US, the fiscal arithmetic remains parlous and the arena for a round of vituperative, but ultimately sterile, infighting.

If the burdens of the first region remain yet unalleviated, at least the impasse shows that there are still those who recognise — albeit dimly — that to earmark trillions of euros of the citizens’ money so as to reward both gross irresponsibility on the part of the member states and the cynical exploitation of moral hazard by the barons of the banking boardrooms is as ethically dubious as it is economically suspect. While all the bien pensants may flood the airwaves and stuff their column inches by decrying this as the fault of the characteristically stiff-necked Germans, we can only sigh that a few more of our glorious leaders do not also disport a suitably Teutonic fusion of the cervical vertebrae.

Meanwhile, the situation in America goes from bad to worse. Indeed, the US deficit now seems almost pre-ordained to grow at $1.3 trillion or so each and every year—around 2 1/2 times the concurrent increase in private sector GDP (that number again!) and unfunded to the tune of a dangerous, potentially intractable and thus highly inflationary 35-40% of expenditures.

Whether or not the Fed is successful in its misguided quest to de-emphasise the so-called price stability part of its mandate in favour of the wild goose chase of trying to reduce unemployment on a permanent basis by monetary means, the lack of continence it has encouraged among an intellectually-vacant political elite—as well as the dire budgetary consequences of any reversal in bond yields from their post-War nominal lows on a full GDP-scale debt mountain—argue against any easy reversal of their joint stance.

It might not go unnoticed that the simplistic, but nonetheless illustrative, measure of the ‘misery index’ — unemployment plus consumer price inflation — currently stands at a 19-year high (even under what many darkly mutter are today much less exacting standards than heretofore prevailed) and is, moreover, pushing resolutely onward into territory only visited in the post-WII era during the dreadful spell between 1973-83 when it seemed as if we had finally driven a stake through the heart of the bloodsucker of Bloomsbury.

This is not just a matter of passing interest, since rising prices amid chronic joblessness is a mix which often widens the split between input costs and output prices—a phenomenon which also tends to go hand in hand with higher levels of CPI itself. Such a combination is usually disastrous for equity multiples, which are themselves the main determinants of stock returns, so — even by his own rather dimmed lights — Chairman Bernanke is again on track to achieve exactly the opposite effect of the one at which he is aiming.

Anyone requiring a further explanation of how this arose should go and read Ron Paul’s cogent rehearsal of the ills that afflict the nation in his recent WSJ editorial, a well-justified Philippic in which he also adopts a view about just what it is that is forestalling the recovery which will be familiar to readers of these pages:-

What exactly the Fed will do is anyone’s guess, and it is no surprise that markets continue to founder as anticipation mounts. If the Fed would stop intervening and distorting the market, and would allow the functioning of a truly free market that deals with profit and loss, our economy could recover. The continued existence of an organization that can create trillions of dollars out of thin air to purchase financial assets and prop up a fundamentally insolvent banking system is a black mark on an economy that professes to be free.

Hear! Hear!

Commodity Corner

Around about this time last year, the market began to shake off its angst and buy anything and everything in sight in an increasingly indiscriminate move which would see commodities, stocks, junk—and just about anything else with the word ‘Risk’ attached—rise for the better part of seven months.

But last year’s rally, however ephemeral its impact either as a prop to asset prices or as a fillip to the real economy, was at least based on something tangible. The Fed was actively monetizing a sizeable fraction of the US budget deficit through its QE-II programme; Chinese real money supply growth—while undoubtedly slowing—was still swirling along in the high teens, in contrast to today’s sluggishly low single digits;  the RBI was only a third of the way through its (unfinished?) tightening phase; likewise, the Banco do Brasil had seemingly paused, half way through its eventual schedule of higher rates; and the European debt crisis was still only a cloud on the horizon — and a cloud which lowered only over the periphery, at that.

In other words, however futile the attempt to print the world back to prosperity, something tangible was afoot and the newly-created monies were flooding into their most immediately accessible outlets in financial markets, en route to effecting their more malign consequence of raising the price of necessaries for the common man.

This time around, the rally was built more on hope and fear than on anything more concrete: hope that the Fed’s Operation Twist would actually mean something other than just the latest act of vandalism committed upon the price mechanism; hope that Europe would issue itself a large blank cheque and have it delivered in wheel barrows to finance ministries and banking headquarters all across the Zone; and the fear of being caught short of benchmark and mired in the slough of negative returns if the year somehow ended in a sustainable relief rally.

Two weeks of that may have been enough to goose the DAX by almost 20% and the S&P and Emerging Markets by close to 15%; it may have jolted base metals 10% and Brent Crude 17% higher; it may have reversed 140bps of the prior steep rise in junk credit spreads, but it does not look like it changed either the fundamental backdrop or the fact that new sources of central bank jungle juice are so far proving very hard to identify.

So, with a nod to the fact that everyone underwater is currently desperate to locate some last remaining, no-brain trade onto which to bandwagon, in order to dress up another year of lacklustre performance and to avoid one more career-endangering embarrassment of charging fees as a reward for losing clients’ money, we must start from the assumption that the rally has run its course, having achieved what all bear market rallies do — to magnify the pain while recharging the powder magazine — and that there is a risk that the current probe lower is met with a further, irresistible wave of panicky liquidation.