Return of the Silk Road Thanks to China

Return of the Silk Road Thanks to China

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Let’s kick off the week by having a look at China. There are a few things going on there right now that are important for Australia. Our economy is really just a derivative of China, so it makes sense to take notice of what’s happening in the Middle Kingdom.

The first thing to note is that the authorities — once again — are trying to reduce leverage within the financial system by tightening liquidity. That means the central bank is basically taking cash out of the system.

This has the effect of driving up short-term interest rates. And that’s starting to impact the interest rate ‘structure’. As the Financial Times reported over the weekend:

On Thursday, the benchmark yield on five-year Chinese government bonds rose above the 10-year yield, the first such inversion since data from the National Interbank Funding Center began in 2010.

What does that mean?

Well, usually, an ‘inverted yield curve’ is a sign of a slowing economy. If it persists long enough, it is often a precursor to a recession.

In the good old days, when interest rates were ‘normal’ (before central banks started playing the role of God), an inverted yield curve set off alarm bells. It was the market’s way of saying that liquidity was too tight. It was a sign of bad things to come.

I’m not sure you can draw the same conclusions in China. Its financial system is different. The central bank manages the flow of liquidity constantly. The central bank engineered this liquidity tightening, and it will reverse it if need be.

For example, the FT article points out that the People’s Bank of China has drained more than US$130 billion from the money markets so far in 2017.

When you reduce supply, and demand stays the same, prices go up. That’s why you’ve seen the price of short-term money (the interest rate) go up in China this year.

And that’s why you’ve seen prices come back in the areas that benefit from cheap money. For example, Chinese stocks. Below is a chart of the Shanghai Composite Index over the past year.

Source: Optuma

Click to enlarge

Starting in April, Chinese stocks corrected sharply. From the high to the May low, they are down around 8.5%. Given what’s happening in the money market, the correction is entirely due to central bank liquidity tightening.

What about commodities?

Below is a chart of the Thomson Reuters/Jefferies CRB Commodity Index. It peaked in early 2017. It hit the lowest point in nearly 10 months in early May.

Clearly, liquidity tightening measures in China are having an impact on global commodities. As you can see in the chart, the index bounced off support recently. If it can hold above this level, I don’t think there is a great deal to be concerned about. But if it falls below here, it tells you that the slowdown in China is deepening.

Source: Optuma

Click to enlarge

My guess — and it’s just a guess — is that China is firmly in control of this slowdown. It’s ‘orderly’ and designed to take some speculative heat out of the market.

There are no guarantees that it will stay in control, but I don’t think there is any need to panic right now.

China is still channelling credit into real economic projects. It’s just trying to rid the system of easy and destabilising speculation.

China is well known for its massive infrastructure projects. This policy underpins demand for commodities. But now China is taking infrastructure to another level.

On Sunday, China kicked off a two-day summit to promote its ‘One Belt, One Road’ program, an immense project designed to bring the old Silk Road trade route into the 21st century.

As the FT reports:

Chinese president Xi Jinping hailed his country’s Belt and Road initiative as “the project of the century” as he announced scaled-up financing for a signature strategy that promises billions in investment and trade benefits. Delegates from more than 100 countries, including 28 heads of state, convened in a $1bn complex north of Beijing for the two-day summit that began on Sunday. Pride of place went to Russian president Vladimir Putin, while the largest economies in Asia and the west sent lower-level representatives.

“Spanning thousands of miles and years, the ancient silk routes embody the spirit of peace and co-operation, openness and inclusiveness, mutual learning and mutual benefit,” Mr Xi said in his opening speech. “We should foster a new type of international relations featuring win-win co-operation; and we should forge partnerships of dialogue with no confrontation and of friendship rather than alliance.”

Hmmm…that stands in stark contrast to the way the US conducts its foreign policy.

According to ABC Online, China will spend up to US$1 trillion on infrastructure projects, with the aim of expanding world trade by US$2.5 trillion. This is China’s attempt to once again become a dominant global power in terms of trade and economic output.

From the Middle Ages through to the 19th century, China was the world’s most advanced economy. The Silk Road trade route flourished. But it all went downhill when the British instigated the Opium Wars.

China got hooked on dope and the economy never recovered.

Xi Jinping’s grand plan is to restore China’s economic might. And he wants to do so through increased trade, specifically with Europe and all points in between.

It’s a vision that will take decades to play out. But it’s a positive one that should ultimately be beneficial for Australia.

Regards,

Greg Canavan,
Editor, Money Morning

PS: Fund manager David Tice is known as the wildly successful manager of the Prudent Bear Fund. He sold the fund to Federated Investors just as the 2008 financial crisis was unfolding.

Tice recently told CNBC: ‘“The market has tended to go down about every seven years. It went down in 1987, 1994, 2001 and 2008. During these periods after the declines, it rallies like crazy. But now bad things are about to happen again.”

Vern Gowdie agrees. He shows you how to bunker down and prepare for those ‘bad things’ today. And how you can capitalise on the coming downturn once the dust settles. To find out more, go here.

Greg Canavan

Greg Canavan

Greg is the Managing Editor for Money Morning. He helps investors preserve their wealth over the long term using a method known as value investing. Lucky for Money Morning readers, he imparts some of this knowledge on them three times a week with editorial spots.
Greg Canavan is a feature Editor at the Money Morning and is the foremost authority for retail investors on value investing in Australia.
He is also the Editor of Crisis & Opportunity. An investment publication designed to help investors profit from companies and stocks that are undervalued on the market. Greg is the former head of Australasian Research for an Australian asset-management group and has appeared on CNBC, Sky Business’s ‘The Perrett Report’ and Lateline Business. He has written articles for The Sydney Morning HeraldThe Australian and www.ninemsn.com.au. Greg’s aim is to help you create a portfolio of stocks based on sound, proven, investing principles. His system for identifying stocks trading beneath their ‘intrinsic’ value combines a big picture understanding of the financial markets with a thorough valuation analysis of individual securities. Greg’s method of investing is not about taking huge risks and rushing into big positions. He investigates highly profitable companies trading at a reduced premium to their net asset value, or ‘equity’ value as he puts it – and passes that research on to his subscribers to incorporate into their financial plan as they see fit. With Greg’s help, you can implement a long-term wealth building strategy into your financial planning, be better prepared for the tough financial challenges ahead and stop making the basic, costly mistakes that most private investors make every time they buy a stock. To find out more Greg’s investing style and his financial worldview take out a free subscription to Money Morning here. And to discover what a company’s profitability reveals about its true value…and more importantly how you can use that knowledge to become a better, smarter investor, take out a 30 day trial to his value investing service Crisis & Opportunity here. Official websites and financial eletters Greg writes for:

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