Is Bad News Good News Again? Guest Poster: Jeff Coggshall, Tiburon Partners

If you hadn’t noticed the recent price volatility in commodities and
commodity currencies, China’s recent PMI and industrial production
numbers already shouted it loud and clear: Growth concerns could come
back to fashion after a long period of worrying about nothing but
inflation.

I personally don’t spend much time worrying about China’s medium-term
growth prospects – mainly because many of China’s growth constraints are
self-imposed (i.e. property market restrictions and other tightening
measures). These can easily be rolled back, and on a 1-3 year timeframe
I find it very hard to envisage a scenario in which Chinese
policymakers are either unable or unwilling to underline growth at a
“reasonably fast” level of – say, 7 or 8%.

However, we cannot deny that some of China’s macro numbers (PMI &
Industrial production) have been pointing to slower growth. As the focus
of monetary policy has been even more quantitative than usual, this has
exacerbated China’s perpetual bias towards easy funding for large
state-owned enterprises, and tight liquidity for small and private
enterprises. Curb market rates in Wenzhou, China’s informal lending
market, have been recently been trending higher.

And as of a month ago, it was probably market consensus that China would
soon be loosening policy as inflation will probably be peaking in the
summer, and easing throughout the second half of the year. This may be
true, but current data is pointing in the opposite direction, with
China’s April inflation figures still high at 5.3% despite a drop in
food prices, which have been, mathematically at least, a major driver of
China’s recent high inflation. This opens up the field for more credible
speculation about structural inflation (from the service side of the
economy, for instance) that might not fade so quickly over the course of
the year, despite the very strong base effects that everyone knows about
already.

There are also a number of medium-term developments like accelerated
wage increases, and power shortages (due to slow capacity growth
stemming from an imperfect electricity price adjustment mechanism in the
face of higher coal prices) that make it easy to believe that China’s
non-inflationary “speed limit” for economic growth is probably 1-2
percentage points lower than it has been over the past few years. I
don’t think it will be possible to stop these concerns from growing over
the course of the next few months.

China is at most times focussed on stability, and shows a strong
preference for policy that promotes stability as an overall end-goal in
the economy and society, often as a preference over the achievement of
other longer term development goals.

It is also, of course, a political transition year in China, with the
new leadership getting phased in and seeking to consolidate power over
the next 8-18 months. In this context, the focus on stability -
certainly from the existing leadership which wants to consolidate their
track record and post-leadership power base – is heightened. This is
ultimately why China has been content to run meaningfully negative real
interest rates, and been more inflation-reactive than pre-emptive
despite strong growth. It has also, at least in the recent past, been
possible for some policymakers to argue that inflation is “peaking”
since June’s inflation will, at least in year-on-year terms, likely be
this year’s peak, with base effects adding considerably less pressure in
subsequent months.

The credibility of Chinese policymakers is currently at a near-term
peak, in our view. They have successfully managed China’s economy
through a few volatile years and their credibility has skyrocketed, to
the point where they are now viewed with (at least grudging) respect by
global financial markets, and are not expected to make “unforced errors”
in the management of the economy.

But given increased evidence of “structural” inflation at the same time
as growth constraints appear to be poking their head above the parapet,
markets have taken to doubting again. In this context, it was easy for
last Tuesday’s CFTC data, which highlighted a number of one-sided
positions (i.e. long Silver, Gold, the Aussie dollar and “risk”
generally and short the US dollar) to spark market volatility. The
anticipatory “pricing in” of QE2′s completion is also probably not yet
finished.

For Chinese markets specifically, positioning is not stretched, and most
cost-driven margin pressures are now baked into numbers. China
investors’ concerns have centred around inflation-driven tightening -
and the potential is for these concerns to deteriorate into generalized
confusion as growth disappoints somewhat and inflation remains elevated
- at least for another few months. This should still present fairly
fertile ground for stock-picking strategies.

For markets where systemic concerns may be less expected, and more
potentially worrisome, I can’t help wondering about commodity-driven
places like Brazil and Australia, where any such concerns have been
dwarfed by a structural view on a commodity story that will continue
“for ever and ever” and does not seem to take into account potential for
a change in China’s “speed limit” of economic growth and political
cross-currents that will make Chinese economic policymaking a lot
trickier in the coming months.
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About Jeff Coggshall
Jeff’s 20+ years of experience in financial markets and Greater China includes work as an analyst, head of research, prop trader, and fund manager. He has been with Tiburon Partners as their head of China investments since 2006.