NEW$ & VIEW$ (19 JANUARY 2016): China; Oil.

Did you miss yesterday’s New$ & View$?

Bank of Canada to cut key rate to zero in 2016, Barclays says

JPMorgan: Canada Really Needs a Weaker Loonie

2015 GDP Shows China Wrestling With Slowdown

The growth rate, released by the government on Tuesday, moderated to 6.8% for the fourth quarter and 6.9% for 2015.

(…) President Xi Jinping also urged the officials “to stabilize short-term growth.” Premier Li Keqiang talked of “increasing downward pressure” on the economy, complicated by slack global demand. (…)

Other data released Tuesday traced the deepening slowdown. Value-added industrial output rose a less-than-expected 5.9% in December compared with a year earlier, slowing from 6.2% growth in November. Fixed asset investment in non rural areas climbed 10.0% last year, compared with an increase of 10.2% for the first 11 months of the year. Retail sales, a bright spot in the economy, grew 11.1% in December from a year earlier, a tick down from November’s 11.2% increase. (…)

With the gloomier outlook, Chinese officials have said the government is looking to increase deficit spending this year to generate growth, even if that tactic has limits. Higher spending on infrastructure last year showed signs of kicking in as investment levels grew faster after lending in November and December increased, and the government is expected to spend more heavily on infrastructure this year, but the upturn may be short lived given that investment figures showed weakening in December. (…)

Households and companies now spend the equivalent of 20% of GDP on interest payments, more than the U.S., Japan or the U.K. and equal to Korea, said research firm Gavekal Dragonomics, citing figures from the Bank for International Settlements. (…)

Louis Kuijs, Oxford Economics: “With nominal GDP growth in services exceeding that in the secondary sector by an unprecedented margin, the share of the tertiary sector in overall GDP rose a whopping 2.4 percentage points to 50.5% in 2015. While this suggests substantial rebalancing, it is in part due to severe downward pressure on output prices as many firms in overcapacity sectors are not responding sufficiently to price signals, underscoring the need for bolder reform. In any case, the robust growth in the consumption and services nexus is key for policymakers – they need it to avoid labor market stress.”

Julian Evans-Pritchard, Capital Economics: “The upshot is that while the official GDP figures shouldn’t be taken at face value, growth does appear to have been broadly stable last quarter and the December data, although mixed, don’t suggest that China is now entering a deeper economic crisis. On the contrary, with the tailwinds from recent policy stimulus still gathering we actually expect the data to gradually turn more upbeat over the next few months.”

The worries about China’s slowing growth

(…) no one much believes the numbers. China has long been suspected of massaging data to smooth its growth trend, under-reporting GDP when overheated and over-reporting it during lulls. Judging by the eerie stability of key indicators recently, China’s statisticians appear to have been doing just that. In year-on-year terms, growth over the past six quarters has been 7.2%, 7.2%, 7%, 7%, 6.9% and 6.8%. Such a tight clustering is improbable. Private surveys suggest that growth was much lumpier last year, with the economy initially soft, then picking up in the final months thanks to stimulus policies. Using a composite of alternative data from electricity usage to car sales, many analysts reckon last year’s growth rate was really 5-6%—not bad, though certainly not as buoyant as the government says.

Headline growth is, however, only the first of the concerns. Look under the hood at the composition of Chinese growth, and the picture that emerges is of extreme weakness in certain parts of the economy. Heavy industry is in bad shape, blighted by overcapacity and falling demand. Service sectors from finance to health care are much more robust. But services, by their nature, are mainly delivered locally; China is able to provide more of what it needs by itself, not through imports. That is cold comfort for other countries, especially commodity producers, which had come to count on ever-stronger Chinese demand. Official data are admirably clear on this bifurcation of the economy: services output grew by 11.6% year-on-year in nominal terms in the first nine months of 2015, whereas manufacturing grew by just 1.2%.

The biggest fear about Chinese growth is that much worse is still to come. Total debt has gone from about 150% of GDP before the global financial crisis in 2008 to nearly 250% today. Increases in indebtedness of that magnitude have been a forerunner of financial woes in other countries. Cracks are beginning to appear in China: capital outflows have surged, bankruptcies are occurring more frequently and bad loans in the banking sector are rising. It is all but certain that more pain lies ahead, though quite how much and how it will play out are matters for debate. If there is one thing all can agree on about China’s economy, it is that the gap between official data and market perceptions has widened to a chasm.

China devaluation – a necessary evil?

(…) The key question is whether China can restore confidence in its exchange rate policy, not least among its own citizens. For as long as a renminbi devaluation of unknown size continues to overhang the markets, an abatement in capital outflows, and a return to stability, seems difficult.

It is even possible that the event that markets most fear – a controlled depreciation of 10 per cent or so – might be the only way of restoring calm, if accompanied by other reforms. Until the renminbi is deemed by the global financial system to be at a sustainable level, fear of disruptive change will dominate sentiment.

The PBOC does not seem to agree. Last week, it finally intervened in the foreign exchange markets with enough conviction to halt the recent depreciation, temporarily at least. The new exchange rate regime has now been spelled out in some detail. The central bank has decided to maintain a “relatively stable” renminbi against a basket of foreign currencies, while allowing much greater flexibility than before against the dollar.

But it has also said that, in the longer term, the exchange rate against the basket may be allowed to move, in line with changing economic fundamentals. The central bank clearly wants the exchange rate to become gradually more market determined, as it shifts to a monetary system where domestic money market rates are used as the main instrument of monetary policy.

This makes good sense, except that the present level of the exchange rate does not command market confidence. In part, this is because there is so much suspicion that the State Council, not the PBOC, is ultimately in charge of exchange rate policy. There is continued speculation in the markets, whether true or not, that President Xi Jinping’s economic staff believes a devaluation will be needed to restore stability. This, and the expectation of an imminent tightening in controls over outward capital movements by Chinese households, is leading to a rush for the exits.

The Economist has calculated that if only 5 percent of China’s population decides to take advantage of the $50,000 annual limit on foreign investment, the outflow in 2016 would be equivalent to the whole of China’s $3.3tn in foreign exchange reserves. The reserves have already fallen by almost $700bn since the peak, and the rate of decline is showing no sign of abating.

So is it now clear that the renminbi is fundamentally overvalued and needs to fall? The PBOC denies this, pointing out that the current account of the balance of payments remains in comfortable surplus, and that long term capital flows are also still in the black. Indeed, it describes the possibility of devaluation as “ridiculous and impossible”, concluding that

There is not a basis for the RMB to devalue continuously. It will remain strong among the reserve currencies.

The authorities clearly have no desire to be accused of “competitive devaluation” by the US, especially in an American election year. Nor do they want to increase the cost of foreign currency debt, measured in renminbi. Latest estimates suggest that foreign debt stands at about $1.5tn, so a 10 per cent devaluation could increase its domestic value by about 1.5 per cent of GDP, according to Goldman Sachs. Finally, there little sign of a generalised hard landing in the economy at present, which would make a devaluation unavoidable.

However, there is a severe problem in the shape of the rebalancing of the economy away from old manufacturing sectors towards the new economy. Western economists have tended to see this as a silver lining in the recent economic history of China, arguing that the economy is successfully shifting resources towards the sectors that will dominate its future. But a careful look at the data suggest that this is far from the whole story:

The optimists point to the rise in the share of services in nominal GDP, and the corresponding decline in industrial sectors, as shown in the above left graph. Measured in current prices, the rebalancing appears to be well underway, with the share of industrial sectors falling from 47 per cent in 2011 to 40 per cent now.

However, almost the whole of this rebalancing in nominal terms has occurred because of a large drop in the relative price of industrial products compared to services. In real, inflation adjusted terms (above right graph), there has been no rebalancing whatsoever in the past decade taken as a whole (though there has been a percent or two in 2014-15). The needed shift in real resources – labour and capital – out of the moribund sectors has therefore barely started.

This conundrum is explained by the collapse in industrial goods prices that has occurred as excess industrial capacity has built up in the Chinese economy. Although this has happened in most manufacturing sectors, it has been at its most severe at the low-value added end – ie in heavy goods industries that are probably now making significant losses but are still being propped up by the state.

Most other economies, both developed and emerging, are experiencing negative producer price inflation as commodity prices have collapsed, but the size of the industrial sector in China makes it a particular problem there, and it has been exacerbated by the rising renminbi in 2013-15.

In the Central Economic Work Conference in December, President Xi firmly established “supply side reform” as the new buzz word for policy in 2016. That means that excess capacity will be tackled by plant closures and job losses, offset by easier fiscal and monetary policy.

In a western economy, it would be taken for granted that such a programme would be accompanied by a drop in the real exchange rate as overall monetary conditions are loosened. Flexible, market determined exchange rates can go down as well as up. Perhaps that is also becoming a necessary evil in China.

Europe’s Corporate Bonds Trading at Recession Levels A wave of selling has taken Europe’s corporate-bond market to levels typically seen during recessions, another indication that the turmoil in global markets could spread into the wider economy.

The gap in yields, or spread, between Eurozone high-grade corporate debt and safer government bonds has ballooned to its widest level in nearly three years, according to Barclays bond indexes. Three years ago, the European economy was in recession following the sovereign-debt crisis that had engulfed the continent. (…)

Oil Market Could ‘Drown in Oversupply’ Oil prices could fall further this year as the market faces an “enormous strain” on its ability to absorb new supplies from producers such as Iran, the International Energy Agency said.

(…) The oil markets could be left with a surplus of 1.5 million barrels a day in the first half of 2016, and “unless something changes, the oil market could drown in oversupply,” it said. (…)

The IEA said Iran could add around 300,000 barrels a day of additional crude by the end of the first quarter, and that the return of Iranian crude to the global market will inevitably and largely offset the 600,000 barrels a day drop that is expected in supplies from producers outside OPEC.

Global inventories, which rose by a notional 1 billion barrels in 2014–2015, will see a further build of 285 million barrels in 2016, which will put storage infrastructure under pressure despite significant capacity expansions .

The IEA, which advises developed countries on energy policy, maintained its expectation for global oil demand growth this year at 1.2 million barrels a day, down from 1.8 million barrels a day in 2015 it anticipated in December.

The unseasonably mild winter saw global oil demand growth fall to a one-year low of 1 million barrels a day in the fourth quarter of last year, down from a near five-year high of 2.1 million barrels in the third quarter.

Supplies from OPEC fell by 90,000 barrels a day in December to 32.28 million barrels a day due to lower production from Iraq and Saudi Arabia, the report said, adding that OPEC has effectively been pumping at will since 2014.

Output from OPEC countries is now 1.06 million barrels a day higher than the same period of last year, a major factor in oil prices falling below $30 a barrel

Iranian output rose in December by 40,000 barrels to its highest level since June 2012, the report said.

The IEA cut its forecast for 2016 OPEC crude oil demand by 300,000 barrels a day to 31.7 million barrels per day due to slightly weaker demand growth.

Supplies from outside OPEC, which proved “resilient” for most of last year, shrank on an annual basis in December for the first time since September 2012.

In total, global oil supply grew by 2.6 million barrels a day in 2015 following similar large gains of 2.4 million barrels a day in 2014.

• OPEC Says Weak Oil Prices to Curb Output

(…) “After seven straight years of phenomenal non-OPEC supply growth, often greater than 2 million barrels a day, 2016 is set to see output decline as the effects of deep capex cuts start to feed through,” the producer group said in its closely watched monthly report.

Though OPEC acknowledges more than 2 million barrels a day of new projects are still planned to go ahead this year, the organization still expects non-OPEC output to fall by almost 700,000 barrels a day in 2016 as the effects of lower capital spending are felt.

The U.S. is expected to see the biggest decline in production, with output forecast to fall by nearly 400,000 barrels a day, but OPEC said places such as Canada, the North Sea, Latin America and parts of Asia are also particularly vulnerable.

OPEC’s oil production, on the other hand, remains elevated, despite declining by 200,000 barrels a day last month, according to secondary sources. The group’s output—including newly reinstated member Indonesia—fell to 32.2 million barrels a day in December led by lower production in Nigeria, Saudi Arabia and Iraq. The group’s output still remains above the anticipated demand for its oil though, which OPEC sees rising by 1.7 million barrels a day to 31.6 million barrels a day this year.

• Saudi, Gulf Subsidy Cuts Seen Damping Regional Oil Use in 2016

Saudi Arabia’s decision to reduce energy subsidies will lead to higher fuel prices and limit growth in the country’s consumption of oil in 2016, according to the International Energy Agency. Similar cuts by other Gulf Arab states will further squeeze demand growth in the Persian Gulf region. (…)

Saudi oil demand is forecast to rise by just 45,000 barrels a day to 3.3 million barrels a day in 2016, sharply lower than the 125,000 barrel-a-day expansion in 2015, the IEA said. Subsidy cuts by Bahrain, Oman and the United Arab Emirates will add to the impact on Middle Eastern oil demand, which will gain by only 100,000 barrels a day to 8.3 million barrels a day, it said.

As of Jan. 11, gasoline prices in Saudi Arabia rose to 0.75 riyals (20 cents) per liter from 0.45 riyals per liter for 91-octane fuel, and 0.9 riyals per liter from 0.6 riyals per liter for 95-octane grade, said the IEA, a watchdog agency for the world’s most industrialized countries. (…)

• Cnooc to Cut Spending, Output Amid Crude’s Plunge

(…) The Beijing-based explorer will produce 470 million to 485 million barrels of oil equivalent this year, slipping from 495 million in 2015, it said in a statement to the Hong Kong stock exchange Tuesday. That would be the first decline since at least 1999. The company said it will spend a maximum 60 billion yuan ($9.1 billion), down from last year’s 67.2 billion yuan.

Total spending last year missed the company’s original target, highlighting how producers have struggled with oil’s plunge to a 12-year low. The price collapse hasdelayed $380 billion worth of investments on 68 major upstream projects, according to industry consultant Wood Mackenzie Ltd., and has forced suppliers from BHP Billiton Ltd. to BP Plc to write down the value of assets and fire workers. (…)

Cnooc’s production won’t reach 2015 levels for at least two more years. It’s targeting output of 484 million barrels of oil equivalent in 2017 and 502 million in 2018. The company plans to start four new projects this year while drilling 115 exploration wells, it said. The lower-end of the company’s production target sets output this year at about 1.29 million barrels a day, a drop of more than 68,000 barrels a day. (…)

SENTIMENT WATCH:

David Rosenberg:

(…) The notion that Energy defaults (this is not the same as residential real estate circa 2008, not by a long shot) or the Emerging Market space can tip this $18 trillion beast otherwise known as U.S. GDP into a sustained downturn is hyperbole to an extreme. (…)

The capitulation is in. (…)

Few, however, are willing to call this a buying opportunity. (…)

But lost in the bearish narrative are the cash flow benefits to consumers – whether they spend the cash flow or not is a separate matter, but the real income effect is undeniable.

Regionally, countries like Japan, India, China and much of Continental Europe are huge winners.