We have written extensively about the evolving nature of the US-China relationship. There are multiple dimensions to this – including political, trade policy and defence policy. But it is also important to keep an eye on the aggregate health of the respective economies. These are the two largest economies in the world (indeed, the Chinese economy is about the size of the combined Eurozone economy) and collectively account for around 40 percent of annual global economic output.
The US economy has not been this strong for more than a decade. US unemployment is at its lowest level in 20 years, industrial production is growing strongly and interest rates remain at historically low levels. In the minutes released by the Federal Open Market Committee on July 5, 2018, the staff outlook for the US economy was as optimistic as your author can recall seeing in recent history:
“In the US economic forecast prepared for the June FOMC meeting, the staff continued to project that the economy would expand at an above-trend pace. Real GDP appeared to be rising at a much faster pace in the second quarter than in the first, and it was forecast to increase at a solid rate in the second half of this year. Over the 2018-20 period, output was projected to rise further above the staff’s estimate of its potential, and the unemployment rate was projected to decline further below the staff’s estimate of its longer-run natural rate.”
In China, on the other hand, the supply of money in the economy has slowed significantly over the last two years (see below). Similarly, growth in fixed-asset investment continues to slow, as does growth in consumption.
Chinese Money Supply (M2) Growth, Annual Percentage Change
One measure we like to track is what we call growth in Chinese “excess money”. One way to define the rate of growth of this excess money is to subtract from the growth rate of overall money supply (M2), the growth rate of nominal GDP expectations – which we proxy with the Chinese 10-year bond yield. We believe resulting growth rate gives a sense of the change in excess liquidity in the Chinese economy that has typically found its way into speculative investments, such as property.
We can see from the red line in the chart below that growth in Chinese excess money has slowed dramatically over the last two years (after accelerating during the 2016 stimulus); and has not been this low in recent history.
We also overlay the change in LME metals prices (represented by the LMEX). We believe that Chinese excess money is a key demand-driver for commodity prices. And based on the trajectory of Chinese excess money growth, we believe that the risk in Chinese demand for hard commodities is skewed to the downside over the medium term.
Source: Bloomberg; MGI
In such an environment of a warming US economy and cooling Chinese economy, we would expect to see short-term US interest rates to continue to rise; while Chinese monetary policy will likely remain relatively stable. The net result of these relative policy differences would suggest relative upward pressure in the US dollar, relative to the Renminbi – something we have been observing in recent months. (We do believe, however, that there are other political forces at play relating to trade negotiations that also help explain the recent depreciation of the Renminbi).
Montaka’s current positioning is consistent with our medium term macro views. Montaka’s largest currency exposure is to the US dollar; while we currently have negligible exposure to the Renminbi. Montaka’s long portfolio owns a number of high-quality financial services businesses, such as Wells Fargo (NYSE: WFC) and Travelers (NYSE: TRV), that are currently under-pricing the positive impact of rising US interest rates. Finally, we have recently increased our short exposure to mining companies that are pricing in unrealistic long-term commodity price expectations. Based on our analysis above, we believe the risk in the prices of many commodities is skewed asymmetrically to the downside.
Andrew Macken is Chief Investment Officer with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.