Outside the Box: Watch these 3 areas to tell when China’s hard landing is near

We are closer to an economic hard landing in China than the consensus believes, and the price of industrial commodities, crude oil and Apple’s stock will be better indicators of this than many economic statistics released by the Chinese government.

The strategy that worked well for U.S. investors in the first three quarters in 2018 — staying more domestically-oriented and avoiding emerging markets and natural resources — is likely to continue to work in 2019, most likely after a trade deal with China is done. Large-cap domestically-oriented companies in the S&P 500 SPX, -0.01%   may be a great place to be.

First, let’s look at Apple AAPL, -0.98%

Apple is too big not be affected by the ongoing global economic slowdown. When a company creates a premium product — the most expensive and arguably the best phones on the market — it will see slowing demand every time the global economy slows. Ask any luxury brand what happens to their sales in a recession, and you will hear that high-end brands tend to suffer the most.

Moreover, China is a major area of expansion for Apple. The weakening of the Chinese economy was happening before the trade friction intensified, and if one reads Apple’s news release carefully and sees all the Tim Cook interviews, it’s not hard to conclude that the trade war is a catalyst but not a cause of Apple’s sales miss. If China’s economy does decelerate quite bit more notably, it would be definitely hit Apple’s shares harder.

China is so large — almost $13 trillion in GDP — that it would also drag many smaller neighboring economies that Apple is targeting as well as the overall commodity markets.

Industrial commodities have been flashing red for a while

There is no recession to be seen in the United States in 2019, yet there is a very significant ongoing weakening in the global economy. You can see that in the price of industrial metals and the price of crude oil. Last time there was a severe economic slowdown in China, in 2014, the prices of industrial metals, as represented by the London Metals Exchange Index, fell simultaneously with the price of crude oil (see chart).

China is the largest driver of crude oil prices on futures markets. When the price of crude oil falls like a rock from $77 to $42 in a single quarter, it’s not only about supply — and Saudi Arabia has been pumping more — but also demand.

After all, there is no Saudi component of the London Metals Exchange, and the price action of the LME confirms the message of the crude market. The LME Index weakened beginning in June 2018 — much earlier than the crude oil market and before trade tensions intensified. That is evidence the trade friction is merely a catalyst but not the cause of weakening demand for energy.

If a Chinese economic hard landing does arrive, I expect significantly more downside for crude oil and industrial commodities. Revisiting the lows seen in December in both crude oil CLG9, +0.64%   (near $42) and industrial commodities would be an indication that such a hard landing is coming and for investors to to stay away from energy and materials stocks in the S&P 500.

The trade war isn’t China’s biggest problem

The Chinese have created a credit bubble similar to the credit bubble a lot of Asian countries experienced in the 1990s that culminated in the Asian Crisis in 1997-1998. As the Chinese economy has grown from a little over $1 trillion in the year 2000 to likely close to $13 trillion in 2018, the total credit in the Chinese financial system is up over 40-fold, if one counts the infamous unregulated shadow banking leverage. That has taken the total debt-to-GDP ratio from 100% to over 400% in just 18 years. This is a very similar dynamic to what most Asian countries experienced before the Asian Crisis.

The government crackdown on unregulated lending is primarily what has caused the Chinese economy to slow down in 2018, not trade tensions. These tensions merely added to the slowdown and, if they can be resolved, the Chinese would still have serious issues in their domestic economy.

The trillion-dollar question is when will the Chinese recession strike? The reason why so many analysts and strategists have been early (i.e., since 2010) in calling for a recession in China is their lending quota business, which Chinese authorities have perfected in using their economic expansion for 25 years.

More monetary stimulation is on the way

The PBOC issued new lending quotas in November and announced cuts in reserve requirements for Chinese banks earlier this month. The required reserve ratio for banks will drop by 0.5 percentage point on Jan. 15 and a further 0.5 percentage point on Jan. 25. The cut will release a net 800 billion yuan ($116 billion) of liquidity according to the People’s Bank of China. The bet is that with credit multiplier effects associated with fractional reserve banking, this move will have a positive and lasting economic effect. If the result is not as quick as expected, more such moves are likely.

Chinese monetary interventions of the sort we have seen in the past two months are beginning to remind me of the old “kicking of the can down to road”. None of this fixes the problem of too much borrowing in the Chinese economy, but offers another band-aid solution. It does buy the Chinese authorities time to ponder a way out of this mess, which is precisely the way to make the mess much bigger.

History has shown that extreme monetary policy of the type we have in China today is that it tends to lose efficacy over time. The more indebted the system is, the less effective more lending is. A trade war complicates the effects of a less-potent monetary policy.

Lending into a credit bubble certainly has extended the present Chinese economic cycle past 25 years — much longer than anyone could have expected. The reason is the unprecedented control that Chinese authorities have over their financial system, controls that have never existed to such a degree in any capitalist country.

Because of the precarious situation of the Chinese economy, I believe there will be a trade deal with the U.S. as it is in the best interest of the Chinese to focus on more serious economic problems. I do not believe that a trade deal saves China from a recession, but it will give the Chinese time to try their monetary stimulation one more time and perhaps manage to extend their economic expansion yet again.

Still, it has to be remembered that the postponement of a recession with such extreme monetary tactics will only make the recession quite a bit worse when it comes. Whether the hard landing arrives in 2019 or 2020 is impossible to say given that such extreme monetary tactics have never before been used on such a scale.

Since China is a hybrid economy of government control combined with free enterprise, officials there think they can eliminate the economic cycle — but they can’t.

Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier & Associates owns AAPL in managed accounts and/or sub-advised mutual fund. Ivan Martchev does not own AAPL in a personal account.

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