2020 Economic Outlook: World Awash With Liquidity As China Fights Deflation

  • As the Chinese Central Bank is forced into unconventionally loose monetary policy to fight deflation, the world will become awash with liquidity.
  • Equities, such as Qudian (NYSE:QD), that are closely tied to liquidity conditions in China have the most upside against this macroeconomic backdrop.

“Domestic inflation reflects domestic monetary policy” Martin Feldstein

Recent headlines and market consensus around inflation and monetary policy in China are in deep contrast with the content of this post. The general consensus is that inflation is soaring and will continue to stay high, which will prevent monetary policy from loosening to prevent the spread of this inflation. While it is true that headline consumer inflation in China is at multi-year highs, diving a layer deeper drives a significantly different outlook on the future state of inflation and monetary policy in China.

Headline consumer inflation reached 3.8% in October of 2019, above the central bank target of 3.0%, which is driving the faulty takeaway that Chinese monetary authorities may have to tighten monetary policy, or at the very least maintain a neutral position, in response to above-target inflation:

This conclusion misses the fundamental truth that Chinese monetary authorities are not particularly concerned with all inflation drivers, but rather the drivers that are actually sensitive to monetary policy.

The recent uptick in inflation is the result of an outbreak of African Swine Fever causing approximately 200 million pigs in China to be disposed of in 2019 alone. This figure represents over 25% of the global pig population and has a significant impact on consumer inflation in China. Pork is the staple meat in Chinese cuisine with an annual consumption of ~90 pounds per person. With the price of pork doubling on a year over year basis, an inflationary impulse was let loose in the country that’s responsible for more than half of global pork consumption.

The below graph shows what the consumer price index shown above looks like, when excluding the impact of Food & Tobacco inflation.

The food & tobacco sub-index is currently responsible for close to the entirety of the headline inflation number, and the rise in pork prices is the driving force behind this.

There’s also reason to believe that this rise in pork prices will cease to have as significant of an inflationary impact in 2020 for a couple reasons:

1. Pig populations are beginning to stabilize after a series of preventative measures have been implemented to halt the further spread of this virus.

2. Prices for pork are reaching a point where consumers are already seeking substitutes.

For pork driven inflation to have as significant of an inflationary impact in 2020, prices would once again have to double to about 80 Yuan (~$11)/kg , while having no impact on demand. This is an unlikely scenario, given that prices are already beginning to fall as consumers seek substitutes to this demand elastic food source.

Regardless of what the future holds for China’s pork industry, it’s clear that the recent inflation being experienced in China is not being driven by an excess of liquidity in the Chinese financial system, but rather factors that are outside of the control of monetary policy.

The inflation driver that the Chinese Central Bank has historically been the most sensitive to in the past is one that is particularly responsive to liquidity conditions: housing.

There is good reason for this. 70% of Chinese household net worth is tied up in property values, and the property sector represents about half of Chinese investment (and investment represents about half of Chinese GDP). Because of this, there is a high degree of political capital tied to the health of the property market, as consumer confidence and economic growth are heavily influenced it.

This explains why housing has historically been the single biggest factor driving monetary conditions in China. If the housing market is strong, there’s room to tighten monetary policy, and if it isn’t, there isn’t. With that in mind, let’s take a look at the current state of of the Chinese property market to assess likely future developments in monetary policy.

One of the best indicators of the strength of the Chinese property market is the growth rate of the floor space of property being sold. The idea here is that adequate liquidity in the financial system should provide consumers and property developers with the needed financing to have property sales grow at a rate similar to the overall consumer economy. That being said, recently housing sales have essentially flatlined, following a generally declining trend that’s been happening over the past two and a half years:

It would be convenient if the data was better so monetary authorities wouldn’t be forced to ease despite their reluctance to do so, but it isn’t, so they will be.

That being said, managing housing sales does not fall into the direct mandate of central bankers. However, managing inflation does. So, that’s likely an even better indicator of what’s going to drive the next round of monetary easing in China. The idea of the cost of housing falling sounds like a good one, but the reality is that, despite what they may say, property led deflation is one of the biggest worries of Chinese authorities.

These monetary authorities are steering an economy with 40% of its banking assets tied up in property, against a backdrop where bank failures are at 20 year highs and economic growth is at 20 year lows. When you take all of that, and add in the constant worry of experiencing a property-bust initiated lost decade, of deflation and economic stagnation, that your neighbor Japan went through, it’s understandable why Chinese authorities manage monetary policy so closely to the cost of housing.

The latest readings on the inflation sub-index tied to housing points to the lowest inflation readings since late 2008:

Once again, it would be great if housing inflation was closer to 2–3%, so China wouldn’t have to go through another round of monetary easing, but it isn’t, so they likely will.

Just consider how responsive monetary authorities have been to past episodes of declining housing inflation. Without fail, the response to declines in housing inflation has been significant monetary easing through money printing, as the spikes above the blue line in Chinese money supply indicate.

When the cost of housing is on the path to deflation, monetary authorities have to stimulate the economy. The alternative is deflation and economic stagnation, and given that the leadership of China has tied their authority so closely to their ability to deliver growth and prosperity to the Chinese people, that doesn’t seem like a very appealing alternative.

So now the question becomes, what assets are likely to perform well in an environment in which central authorities are aiming to fight deflation with a loosening of monetary conditions. There’s plenty of options for the enterprising investor. Chinese companies are generally trading at very low valuations relative to developed markets, and many of these companies have valuations that are highly sensitive to liquidity conditions.

A prime example of this sensitivity to liquidity conditions can be seen with Chinese consumer finance companies, that facilitate small loans via the internet to consumers that are under-served by traditional banking institutions, due to their limited credit history and the nature of their loans.

About 400 million people in China have no credit history and and they often have loan requests that fall below what traditional banks find feasible to underwrite. This is where these consumer finance companies step in. They use proprietary algorithms to assess credit risk on consumers with limited credit history, and essentially create a marketplace whereby banks, other consumers and the consumer finance companies themselves can lend money to these underserved consumers via the internet, using the platform’s algorithm to set terms on these loans. Similar to companies like Ebay and Uber, these companies help match supply with demand with a user-friendly interface.

The three key assets these companies can have are:

1. Regulatory Compliance — This is the most important thing for any company operating in China to have, but particularly so in the consumer finance space where there have been companies plagued by scandal, and the government is taking an aggressive approach to regulation, in response to this.

2. A large user base of lenders and borrowers — This is facilitated by the trust in the consumer finance company’s ability to appropriately underwrite risk, as well as the marketing and ease of use of the platform itself.

3. Algorithms that do an effective job of assessing the risk of borrowers — This is facilitated by having scale and a long operating history, that allows for improved algorithms and better risk differentiation over time.

Qudian (NYSE: QD) is one of said companies that has assets 1 & 2, but it is unclear how effective Qudian, or any of these new consumer finance companies are in managing risk with their in-house algorithms. This is because of the limited operating history of these internet consumer finance companies, which makes it difficult to gauge how these loans would hold up in an economic downturn. That being said, given the valuation Qudian is currently trading at, as well as the likely imminent easing of monetary conditions in China, the upside is significant. Consumer lending is likely to rise, similarly as it did in 2016 in the last round of monetary easing. And furthermore, the regulatory climate for these companies will likely ease as central authorities become more concerned with economic growth, rather than managing economic risk.

What’s currently priced into Qudian’s stock is essentially imminent bankruptcy. The company is being valued at two times the estimate for next year’s earnings and 2.5 times current year free cash flow. While there are legitimate concerns around the long term viability of the companies operating in this space, when you consider how China is likely going to be switching from the tight monetary conditions that marked the past two and half years to a fresh round of easing, it’s unlikely that one year from now, investors are going to be as gloomy as they currently are.

There’s no question how responsive these companies are to monetary conditions. Just look at how one of Qudian’s competitors, Yiren Digital, traded over the past four years.

I bring up Yiren since it was publicly traded over an entire cycle of monetary policy in China, so it is a good reflection of how responsive the valuations of consumer finance companies are to monetary conditions. I would characterize it as having weaker regulatory compliance than Qudian due to its lack of institutional backing, but it’s likely that many of the regulatory compliant companies operating in this space (NASDAQ:QFIN, NASDAQ: LX, etc.) will see their valuations benefit from another round of monetary easing, as lending increases and regulatory concerns ease.

I believe Qudian has a unique combination of regulatory compliance, a large user base, and a severely depressed valuation that presents significant upside in the scenario of monetary easing in 2020, which I believe is a likely one as monetary authorities begin the fight against deflation.




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