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China's warning

A slowdown in Chinese monetary growth is bad news for miners and other cyclical stocks
November 22, 2018

Cyclical stocks might be heading for trouble. That’s the message of figures last week from the People’s Bank of China. These showed that the annual growth rate of the narrow money stock fell last month to 2.7 per cent, its slowest rate since 2014.

This matters because such growth has been a lead indicator of Chinese (and to some extent) global economic growth. For example, M1 growth halved in the 12 months to August 2008, just before a deep recession. A recovery in M1 in 2009 led to a recovery in output; slowdowns in 2010-11 and in 2014-15 led to slowdowns in growth; a pick-up in monetary growth in 2016 led to an economic upturn; and the slowdown in monetary growth since last year has seen China’s growth falter.

Just as monetary growth predicts output growth in the eurozone so it does in China, too, and probably for similar reasons: if companies and households have more liquid assets they’ll be tempted to spend more, and if they have less they'll spend less.

Even the most parochial UK investor should worry about this because it matters for UK stocks. My table shows the point. It shows the annual changes in some FTSE sectors that have been associated with annual changes in China’s manufacturing purchasing managers' index (PMI) since 2006.

Sectors sensitive to Chinese output  
Annual change associated with 1pp change in the PMI
Mining6.0  
Engineering3.9  
Banks3.8  
Transport3.7  
General retailers3.2  
IT3.2  
All-Share index2.2  
Based on annual changes since Jan 2006 

As you might imagine, mining stocks are especially sensitive to China’s economy. A one standard deviation fall in the PMI (the sort of thing that happens one-sixth of the time) is associated with mining stocks falling almost 25 per cent. A big reason for this is that swings in Chinese output cause big swings in demand for commodities and hence their prices. M1 growth has been a good lead indicator of the GSCI index of commodity prices. Since 2006 the correlation between annual changes in M1 growth and annual changes in the GSCI six months later has been a hefty 0.57.

It’s not just mining stocks that are sensitive to China’s economy, however. So too are other global cyclical sectors such as engineering and transport.

For example, China’s slowdown in 2014-15 saw mining and engineering stocks fall especially sharply, while the 2016 recovery saw them bounce back strongly.

Investors in banking and IT stocks should also worry about a Chinese slowdown. This is partly because such an event depresses global investors’ appetite for risk and this hurts risky stocks generally.

Yes, there are some sectors thtat have in the past been insensitive to China. These are mostly defensive ones such as pharmaceuticals, utilities and non-life insurers. Overall, though, the All-Share index itself tends to rise and fall a little with Chinese growth.

Which is a problem, because it’s not just monetary growth that is giving us cause for concern. So too are companies' own words. The latest purchasing managers’ survey showed that optimism about future output growth has dropped to an 11-month low, in part because of fears about the effect of the trade war with the US: the problem here is not just barriers to exports but increased uncertainty, which tends to depress capital spending.

It’s not all gloom, though. So far, the purchasing managers' index and commodity prices have held up reasonably well. That suggests it’s possible that the historic link between monetary growth and subsequent output growth might be weakening. And, of course, we are now in that time of year when cyclical stocks tend to do well.

Nevertheless, the fact that we have very few reliable lead indicators of output growth means we should pay attention to the ones we have. And these are warning us to be cautious about global cyclical stocks.