Rebel Traders – Analysis Without The Hype

Despite what is habitually said of Chinese stats, some elements seem to indicate that “growth”  is not abating in the Chinese economy. Electricity consumption is generally considered as the most reliable indicator to check the reality of Chinese production.

According to power usage stats, the September rise was the strongest Y/Y, and October and November energy consumption should also rise strongly to 15 and 20 % according to projections.

China’s power consumption in September rose 10 percent year-on-year to 322.4 billion kilowatt hours, the fastest pace of growth since June last year, the China Electricity Council said on its Web site on Oct. 15.

The increase followed 8 percent growth in August and indicated continued economic recovery, it said.

Power generation in August gained 9.3 percent year-on-year to a record 344 billion kWh, as demand from manufacturing plants soared in line with rising consumption fueled by the government’s stimulus spending. The council did not provide output figures for September.

Power consumption in the first nine months rose 1.4 percent year-on-year to 2.7 trillion kWh, it said.

Grid operators sold a combined 2.2 trillion kWh of electricity in the first nine months, up 3.2 percent year-on-year, it said.

A total of 199.7 billion yuan was spent on construction of power plants in the first three quarters, 83.2 billion yuan of which went on coal-fired projects.

China added 49 million kWt of generating capacity in the first nine months, comprising 32.9 million kWt of thermal power, 12.1 million kWt of hydropower and 4 million kWt of wind power, the council said.

A total of 219.2 billion yuan was spent on grid construction and upgrades, it said.

The 10 percent year-on-year growth rate of power consumption in September was “normal” in comparison with a decline in consumption a year earlier, Yang Zhishan, a power analyst with CITIC Securities Co. Ltd., told Caijing.

Year-on-year growth in power use during October and November will likely reach 15 percent and 20 percent, respectively, Yang added.

Power consumption began falling year-on-year last October amid the global downturn. It began to grow again in June, when it expanded 4.3 percent. Growth rose further to 6 percent in July and 8.22 percent in August.

We all know with what caution Chinese numbers must be taken. However, there generally is a measure of truth in them, even if positive evolution are exaggerated and negative evolutions downplayed. At the very least, they give an idea of the general trend.

And so far, it would seem that the Chinese economy is succeeding in walking that thin line between the stimulus excesses and developing an internal demand.

As some observers tend to believe only year on year numbers as being valid comparisons, the factory output increased by 12.3 % from August 2008. In addition, in what would seem to indicate a success in developing an internal market, the Chinese retail sales jumped by 15.4 % in August, Y/Y, these numbers being adjusted for seasonal distortions (China’s new year holiday affecting the calculations).

At the same time, however, exports fell more than estimated by 23.4 % Y/Y in August.

However, the whole progress is expected to pull the Chinese GDP back up to 9.5 % on a yearly basis, and to pull ahead the whole Asian region.

Output at the nation’s factories gained 12.3 percent from a year earlier, the most since August 2008, the statistics bureau said in Beijing today. Local-currency new loans were 410.4 billion yuan ($60 billion), up from 355.9 billion yuan in July, the central bank reported.

(…)

Economists had forecast an 11.8 percent gain in industrial production, according to the median of 15 estimates in a Bloomberg News survey. New loans were projected to total 320 billion yuan, a separate survey showed.

Retail sales climbed 15.4 percent in August from a year before, the most for the year after accounting for seasonal distortions caused by the lunar new year holiday, statistics bureau data showed today. The median estimate was for a 15.3 percent advance.

Despite this rapid progression, so far, there appears to be no hint of inflation, as the Chinese CPI and PPI both declined, respectively by 1.2 % and 7.9 % Y/Y. However, inflation stays at the heart of the preoccupation of the Chinese authorities.

China’s consumer and producer prices witnessed a fall in August, generally consistent with market forecasts. Consumer prices fell 1.2 percent year-on-year, 6 percentage points lower than the fall in July, the first consecutive seven months of decrease since 2003, according to the data released by the National Bureau of Statistics on Sept. 11.

Producer Prices were down 7.9 percent, 3 percentage points lower than the decrease in July, having reversed a widening fall since December 2008.

In fact, M2, the measure of Money supply which reflects the money in circulation*, appears to have risen to over 57 Tn Yuan, a huge amount which allows for some worries in the Chinese government on its capacity to handle inflation when all this money starts flowing back in the economy.

China’s central bank said M2, the broadest measure of money supply, increased to 57.67 trillion yuan at the end of August, up 28.53 percent from a year earlier. The growth rate was slightly higher than the 28.2 percent forecast by 20 economists surveyed by Caijing. The growth rate in August was also higher than 28.42 percent at the end of July, the People’s Bank of China said in a statement on its Web site on Sept. 11.

A Chinese version of the American problem in the months ahead. For now, the government is only happy that it can find some jobs for the huge Chinese jobless population.

*M2: Equals M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and “close substitutes” for money.^[13] M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation (from Wikipedia)

Update: as some readers seem to have an issue with Chinese numbers and confront them to the stats on power usage (stats released by the same governmental agencies they don’t trust, by the way), it is worth pointing out that the Chinese power demand rose by 6 % in July.

Recently, disgruntled bears have begun pointing to the Baltic Dry Index’s (BDI) fall as a sign that there is a divergence that should lead the markets down. Once again, that translates a bad understanding of the correlations (or lack thereof) between the BDI and economic activity.

For starters, the BDI reflects the cost of shipping dry goods and generally especially raw materials across the globe.In recent months, its value has been hiked by China’s stockpiling of commodities and demand for shipping on short term.

The BDI is also very sensitive to marginal increases in demand and thus can be overreacting to temporary phenomenons such as Chinese stockpiling, if this demand exceeds the supply of ships then present.

This can be confirmed when you relate the BDI to the  very bleak picture of the US Industrial Production painted by this graph:

However, and that’s where a slip is often being made, the BDI reflects more the demand in shipping of commodities at a given moment than some real changes in economic activity. It does not predict or reflect the markets (hence often these reflections about the “illogicity” of the markets). Especially it does not reflect the activity of industries which have a supply of commodities nearby.

The correlation of the BDI to the stock markets is all but clear:

The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates to the stock market, however, is unclear.

Illustrating the point here is an overlay of the S&P 500 and of the BDI:

And any correlation that may have existed imperfectly in the past has been totally turned around:

Over the long term (since 1985), the Baltic Dry Index and the S&P 500 have had a positive correlation of 0.5 (1 = perfect correlation, -1 = perfect inverse correlation). Like everything else recently, though, that relationship has been turned completely upside down. As shown in the chart below, the S&P 500 and the Baltic Dry Index have been moving in opposite directions for most of 2009. As one has risen, the other has declined, and when one falls, the other seems to rise. Looking at the correlation between the two shows that year to date, they have had a negative correlation of -0.4, which implies a significant inverse relationship between the two.

Because the BDI reflects the demand for shpping in cases like the Chinese example, it could go up when the Chinese are stockpiling and fall as a rock thereafter. In addition, in general, an excess supply of ships could very well drop the index as well, as illustrated by Vincent Fernando, a former analyst of shipping at Citigroup.

But essentially one problem with using the BDI for economic forecasting is that the BDI could feasibly go up in an environment where commodities demand was shrinking, if the supply of ships was shrinking even faster. These would be negative economic factors. This is because the BDI’s value is not solely driven from the demand side. To me, it makes far more sense to just look at nominal demand for commodities rather than the BDI since the BDI has the complicating factor of vessel supply growth one needs to consider. The other thing is that the BDI is a measure of spot rates for dry bulk commodities consumers who, generally, are in the near term forced to pay whatever it takes to get their raw materials shipped (A steel plant needs to keep operating despite some higher ore transportation cost). On the flipside, vessel owners are in a similar boat (no pun intended), and in the near term are generally forced to take whatever rate they can get to fill their ships. (A ship sitting around is just a cost, ie. fixed costs are high, thus using a ship at a loss is usually better than not using it at all)

This is excellently illustrated in the example Fernando shows to illustrate his point:

Because of these inelastic characteristics of supply and demand, and since the BDI is a measure of spot rates, the BDI is thus absurdly volatile. I can explain why via the following simplified example, which I used to use frequently at Citi.

Imagine you have 10 loads of iron ore and 9 ships, and that every load of iron ore must be sent no matter what while every ship must be filled no matter what. Imagine the bidding war between those 10 iron ore consumers fighting over just 9 ships. Shipping cost would skyrocket since they all need to ship regardless of cost. Now imagine if a week later two more ships enter the market. Now imagine the bidding process. Suddenly the tables have completely changed. You have 11 ships, that all need to be filled no matter what, and only 10 loads of ore. Shipping rates would plunge, despite a period of just a week passing by. This is, in a simplified nutshell why the BDI is so volatile.

Now, add to this the fact that predicting ship supply and commodities demand has a pretty high margin of error, at the same time remembering how sensitive the BDI is to small mismatches due to the inelastic nature of its underlying supply and demand, and you quickly realize that predicting the BDI is a fool’s game and also that it is not a reliable forward indicator given that it is a spot rate index in a market where both sides are basically forced to close a deal due to high fixed costs. The BDI is measure of supply/demand mismatch at the moment, and can change drastically on a dime. Its little else beyond this. It hit its peak not when the global economy was in its healthiest state, but in early 2008 when things were already starting to come apart, but Chinese commodities demand growth still had some steam and just kept outstripping stagnant vessel supply growth. For a moment. And then it all collapsed. And BDI correlators got annhilated in popular stocks such as DryShips (DRYS). Thus, let’s hope that we put to rest any talk of the BDI as a reliable leading indicator, even if in six months someone datamines some new, latest correlation.

Now, for the final demonstration of the argument. It just happens that Mr. Fernando’s point was illustrated by what happened in August. In fact, with the drop in demand from the Chinese for commodities, the dry bulk ships were in oversupply considering the low level of industrial production around.

Hence, what is driving down the BDI is merely the laws of supply and demand on that specific point. Sure, the stats indicate a recovery of Industrial Production in several countries, but this has mostly been the case of an inventory reduction across the board. While producers remain cautious, they will not stockpile on commodities for now, unlike the Chinese.

Case in point:

The Baltic Dry Index, a measure of shipping costs for commodities, fell for an eighth consecutive session in London as the supply of ships exceeded demand.

The index tracking transport costs on international trade routes fell 83 points, or 3 percent, to 2,689 points, according to the Baltic Exchange. That’s 23 percent lower than before the declines began. Last week’s 17 percent slide was the steepest drop since the end of October.

“Charterers out there seem to be well covered for their requirements, and as such we do not expect any turnaround in the short-term,” Rikard Vabo and Lars Erich Nilsen, analysts at Oslo-based Fearnley Fonds ASA, said in a note. “Congestion is also coming down quite significantly.”

What conclusion to draw from this story? Well, for one, beware of people who think they can draw simplistic correlations. If such was the case, then the traders all around the world would all be successful and rich. Markets play on hopes and fears. They don’t obligatorily relate to the present-day economy and they don’t care about the feelings of the people being trudged upon in an economic recession.

For the future, the demand of commodities will be important to see how the global economy rebounds (if it rebounds). But it is better to use other tools than the BDI to check that demand. Again, Q4 will the quarter of reckoning if the market has not figured it out before.

A lot of animation going up now since the market broke levels that were predicted by Chuck as being technical tops for the market.

However, the really interesting item is considering that debate of whether we have an economic recovery or not.

There have been a number of positive signals the latter times which could indicate a recovery on the fundamental side, for the economy.

A quick review of these:

- French and German GDP have seen a boost in Q2 thanks mainly to a “cash for clunkers” effect; In Q2, the German GDP was mostly pulled by interior demand, although that may also be a clunkers effect;

- German Industrial production rose thanks again to “cash for clunkers” and stimulus plans around the world;

-  Eurozone Industrial Production rose by 3.1 % in June.

-  Chinese Industrial production is up, mainly thanks to the Chinese stimulus plan;

- Japanese exports are up, pulled forward by Chinese demand.

- US Rail traffic has been up.

- US PPI are low (which gives an additional possibility for the economy to grow without being strangled).

- US and German consumers and businesses have expressed confidence in a recovery in relevant studies (although the US consumers also expressed “anxiety” as to being able to wait out the recovery with their dwindling cash). We still need to see the consumer confidence studies of today.

- Consumer staple goods companies have had good results;

1° A Keynesian “recovery”?

Now let us look into detail into these news and what they mean.

A Keynesian policy as already several time explained aims at “relaxing” the economic machine by introducing government-pushed influx of money into the economy in the hope that this influx of cash may be spent and develop on other sectors. Sometimes it “pulls forward” future demand… Sometimes, it creates a need in persons that may not have taken the step without the additional support. At any rate, the effects are present in the economy. The question is whether the effects will transmit to other sectors and whether confidence will carry through, or whether the beneficiaries of the aid will not simply hoard the cash in prevision for harder times. Supply-side theoreticians maintain that stimulating the demand is meaningless.

The interesting part about the Keynesian policy is also that it is heavily dependent on a return of the confidence in the economy. And we will see further how this comes to play.

2° German Industrial Production: Leading indicator or false signal?

German industrial production has risen, but most of it was linked to car production, although a non-indifferent part was also linked to industrial production for external clients. Germany is a big producer of machinery, hence a vanguard of leading indicators, in that investment decisions are generally an indication of a recovery. Here of course, the stimulus plans abroad have had their importance.

This , of course, brought up an increase of 3.1 % of industrial production in the eurozone.

The main issue being that many analysts question the viability of this recovery with regards to the markets for the products manufactured by these investment tools.

“Our general view is that we’re skeptical that it’s going to be sustainable,” said Dominic Bryant, an economist at BNP Paribas. “Without some sort of strong consumer demand from somewhere in the world, where’s the end buyer for all the products that the investment goods will make? That’s not really clear. The U.S., U.K., Spanish consumer are going to be in depression for years.”

We will have a conclusive answer to this question only with Q3-Q4 numbers.

3° Chinese Production:  it does not solve the Chinese internal issues.

Chinese industrial production has been making wonders if you should believe Chinese numbers alone.  Yet, considering the influx of money and the Chinese export numbers, yes, the production has recovered some, although Y/Y it should still be disastrous. In addition, China still has issues with providing jobs for its population. No mystery in those conditions, that their government is taking additional measures to protect against riots. Here again, stronger exports are needed.

As most of the Chinese production is known as “junk” and they have been gearing their economy for additional demand with investment expenses, overcapacity is now going to be an issue.

4° Japanese exports: again, industrial production on the forefront.

Chinese numbers are always viewed with a lot of skepticism, except when they are bad, I joked in an earlier post… However, they are confirmed by other numbers, like for instance, Japanese exports of cable and copper wire which are at their highest since November, despite being down 21 % Y/Y.

These exports managed to raise the Japanese GDP to 3.7 % growth on an annual basis on Q2.

5° US Industrial production and GDP up, rail traffic up, confidence in a recovery and low PPI:  what do they say?

The attempt is here to try to focus on the supply side and on infrastructure, with the hope of starting off an essential cyclical sector. An essential concept, often forgotten by critics of government investment stimulus and similar plans is that of a supply-side recovery. In that respect, it is postulated that pushing forward production may by itself trigger the following demand and that recessions are often caused by inefficient economies.

In this economic theory, it is postulated that what actually drives demand is the production and supply of goods, and not the demand. In short, it is the exact reverse of the demand-side theoretician that populate most of the media. Quite ironically while pushing the demands of most conservative advocates for tax cuts, this also supports some level of Keynesian interventionism.

Their argument is quite interestingly made in a recently published article:

Consumers rarely lack incentives to spend, but producers sometimes lack incentives to produce (i.e., after-tax profits). Households postpone buying new homes or cars when firms are laying off workers and stock prices are falling. Improving the “incentive to production” generates the income and wealth to finance consumer spending.

Unfortunately, those who view such facts dimly through the prism of demand-side economics are habitually inclined to see no way out of recession. The consumer is responsible for over 70% of GDP, they remind us endlessly. Yet unemployment will keep climbing for a year or more, supposedly slashing incomes of the jobless and making others too fearful to spend. To make matters worse, they say, people are saving more (horrors!) and borrowing less.

The fundamental error behind this familiar mantra is what I call “the demand-side fallacy.” It involves confusing the use of income (consumer spending and saving) with the source of income (profitable business).

(…)

Even on their own terms, demand-siders’ skepticism about the incipient recovery is inconsistent with the curiously unreported fact that real disposable personal income has increased since last August. Real DPI increased at 2.7% annual rate in the fourth quarter and 6.2% in the first. Regardless of rising unemployment (a lagging indicator), real consumer buying power is going up not down. That rarely mentioned good news, in turn, is largely due to lower inflation–a welcome cyclical phenomenon demand-siders often decry as deflation. People respond well to bargains, including discounting California’s overpriced homes.

This implies that news like a low PPI are positive for the economy, because the deflation allows to maintain a lax monetary policy, hence avoiding to strangle the nascent recovery. However, this also means that injecting money into the economy is also a useless manner of tackling the issues.

And this being said, practical and effective stats such as rail traffic, Industrial production and GDP show that there is some momentum on the recovery side. Until when this momentum will last and whether it will last or self-perpetuate is a question to be answered in the next quarters.

6° The consumer situation is stabilizing

Sure, I’m going to have a lot of hate mail for saying that… But nonetheless, some aspects of the consumer economy are getting better, with deleveraging following its flow, banks restricting credit, and credit card delinquency slighltly improving.

There appears also to be a mutation in the consumer attitude, where Americans are realizing that they cannot live beyond their means. That could lead to deep and profound mutations with regards to the manner the economy is organized on a global basis. This still remains to be verified, and the coming months will tell us more about the savings rate and thirst for credit.

7°Consumer staples giants are holding their own

P&G, Unilever and other companies have adopted a mixture of strategies to face the recession. P&G, for instance, increased its prices by 5 %, Unilever and Danone chose to lower prices and privilege volume, while bettering their cost profiles through adapting their production tools and profiting of the lower prices of commodities.

On the whole, these companies resist quite well in the recession by finding new ways of facing a decline in demand.

Conclusion: positive signs, but a lot of dangers ahead

While these numbers confirm the overall positive signs of recovery in worldwide economy, there are caveats. The huge shifts from one quarter to another confirm the stimulus effect and its gigantic nature at the global level. However, these are also one-off effects, due to expire in the short-term, should the economy not manage to get back to an autonomous growth.

In that respect, there are many obstacles on the road ahead. We might quote the huge leverage still at work in the US banking system and unemployment as lagging threats on the health of the US economy.

And that is where the all-important aspect of confidence comes up. As we have seen, one of the main needs for the economy to pick up is probably to recover confidence. Confidence to invest and confidence to make decisions involving the future, which is quite a hard thing to do in a recession. Hence the need for the governments to communicate and spin off good news, to encourage a recovery in confidence.

At the very least, if we get a confirmation that the economy is jump-started, we could be in for a very slow and protracted recovery. Time will tell, but for now, due to the unforeseen elements of the current crisis, we are treading on uncharted territories. The biggest challenge for the economy: not to fall into one of the multiple bogs hiding black swans on the “road to recovery”.

And the greatest of these bogs will probably be having to deal with the huge debt the world has accumulated to stimulate its way out of the recession.