Shocks and Surprises, Week Ending Oct 15th

This was a curious week, in that the shock which dominated markets all week only arrived officially on Friday, but had been foreshadowed the previous week. The previous week, China's press had announced that deposits at the Big Four state-owned commercial banks had fallen by around 420bn yuan during the first 15 days of September. For China-watchers this was a massive flashing red light, because twice in China's recent financial history the unwillingness to allow formal interest rates to rise has ended up destabilising the bank deposit base, and forcing a policy change in order to sort out the underlying problems of the financial industry.

By Monday, Chinese policymakers were in action. The most obvious move was the announced arrival in the market of Central Huijin (the domestic arm of China's sovereign wealth fund), buying up stocks of the Big Four. Less obviously, but just as important, the recent focus on the financial complications of Wenzhou – the most active of China's private-lending markets – crystallized into action. China's press reported previously undisclosed details of the role which local officials were playing in the market, and by midweek, Beijing had dispatched 11 teams to the city to mediate a clean-up between the debtors, the SMEs, the 'private lenders', the officials who fund them, and the banks who fund the officials. The very next day, Wenzhou was applying for pilot status as the example-project around which China's next round of financial-system reform could be structured.

Markets in China and Asia rapidly recognized this series of events as a signal that the Chinese authorities, having for much of last year watched, analysed and sized-up the multiple and interconnected problems developing around inflation, local government debts, SMEs, the property market, and China's kerb-market interest rates, had developed a plan and had now concluded it was time to act. I think this is not the signal for a crude reflation, but rather the next stage of the long-running overhaul of China's financial sector. 

So between Monday and Thursday, Shanghai's index rose 4.3%, and the Hang Seng rose nearly 6%, and 5yr CDS rates China Development Bank and Bank of China retreated by 43 basis points. The assurance that the Chinese authorities seemed to know what they are doing of course contrasted with the continued dithering of European politicians.

When China's monetary data finally arrived on Friday, it was just about as bad as one might expect. M1 growth slowed to 8.9% YoY in September, the slowest since January 2009. Worse, it fell 2.2% on the month, which was a sequential disappointment more than two standard deviations below seasonal historic patterns. M2 growth slowed to 13%, which was the slowest growth since January 2002, and a sequential slowdown which also passed the 1SD mark. Not only did the absolute growth of monetary aggregates stall, but together they also signalled the collapse of liquidity preference (M1/M2) of 1.5 SDs below seasonal historic trends, suggesting a rapid retreat of inflationary expectations.

And this found an echo also in China's inflation data. Although there was no surprise in the CPI number (6.1% - as expected), there was in the PPI number, which came in at 6.5%, below the range of analyst expectations, with the retreat showing across all sectors.

Elsewhere in the world, economists are recovering their range in the US, with only modest positive surprises coming from retail sales (up 1.1% MoM), and labour markets (again). What analysts will be looking for in the coming months is, of course, the 'danger' of a 'growth shock' which could reignite both commodity prices and the debate over US monetary policy.

In Europe there were also more positive than negative surprises this week, particularly from the industrial economy. Industrial output rose 1.2% MoM, which was massively better than the consensus had expected, with both France and the UK particularly surprising on the upside. In addition, German trade data came in much stronger than expected, with exports rising 3.5% MoM – economists had expected a rise of only 1.1%.

The obvious thing is to dismiss this better-than-expected European industrial data as irrelevant in the face of the potentially catastrophic problems of the financial sector, and the seeming unwillingness/inability of European politicians to deal with them. And indeed, that is the safer bet. Nonetheless, over the last three weeks, we appear first to have had fairly decisive evidence that the US is not headed for a double-dip recession, and now to have a reasonable assurance that China's policymakers are well aware of the potential frailties of China's position, and are moving across a broad field to deal with them. If the world economy is a tripod, two legs standing is very materially better than none.  The gale is no longer howling in the face of a European solution - rather, it has swung very gently behind them.