When it comes to explaining why the post-crisis world has been defined by lackluster aggregate demand and a deceleration in global trade, all roads lead to China.
Indeed, the country’s attempt to mark a difficult transition from an investment-led, smokestack economy to a consumption and services-led model has contributed mightily to an epic downturn in commodities which has in turn conspired with an expected Fed tightening cycle and a laundry list of country-specific political risk factors to push EM to the brink of disaster.
All of this is complicated by the fact that no one really knows how China’s economy is actually doing.
Everyone knows the “official” GDP prints are a joke and alternative measures such as the Li Keqiang index and the CBB paint a worrying picture of how the world’s engine of global growth and trade is really performing. “National sales revenue, volumes, output, prices, profits, hiring, borrowing, and capital expenditure were all weaker than the prior three months,” the CBB reported just days ago, commenting on the performance of the Chinese economy in Q4. The profit reading is "particularly disturbing," CBB President Leland Miller said, before noting that the share of firms reporting earnings gains has slipped to the lowest level ever recorded.
As we documented last month, the credit impulse in China rolled over and died in October as banks are reluctant to lend in the face of rising NPLs and corporates are reluctant to borrow in the face of an acute overcapacity problem.
Meanwhile, Beijing’s deficient deflator math - which causes the NBS to habitually overstate GDP in times of rapidly falling commodity prices - only adds to the confusion.
So, how swiftly (or not) is China’s economy actually growing? Well, no one knows, but as we noted last week, you can hardly blame the sellside penguin brigade for sandbagging the numbers.
Effectively, Wall Street is forced to produce forecasts they know are erroneous because trying to estimate actual output in China would mean missing the “official” mark every single time.
Be that as it may, UBS has endeavored to analyze what would happen should real Chinese GDP growth (so netting out deflation) hit 4% (where it almost certainly already stands).
“We try to simultaneously determine the reaction to an extremely unlikely China ‘worst case’ shock on China-hit economies in different regions, and on different asset markets,” UBS says. Again, this caught our eye because not only is this not “extremely unlikely,” it’s actually already the case, so we’re all ears when it comes to assessing the cross-market impact.
“We see the government ramping up monetary and fiscal policy support and accelerating growth supportive reforms, which is why our base case continues to see a grind-down rather than sharp plummet in Chinese GDP growth through 2017,” UBS begins, in an effort to justify their 6.2% 2016 GDP target for 2016 and 5.8% outlook for 2017.
However, they go on to note that Beijing could fail to ease monetary and fiscal policy “sufficiently” leading to “a highly improbable event” that would see China's GDP slowing to 4% “with fixed investment contracting (yes, this can happen in China); real imports collapsing, and import prices declining further.”
“In this worst case scenario,” UBS continues, “falling investment and commodity prices will likely drive both producer prices and the GDP deflator into deeper negative growth territory [while] nominal GDP would likely drop to 1.3%, as the government delivers as many interest rates and RRR cuts as is necessary.”
"The most important channel through which the Dragon's Tail scenario can affect other markets is trade, although financial linkages and market contagion could also have a significant impact on some markets and asset prices," UBS says. Here's the visual:
And here's UBS' take on the impact for DM and EM going forward:
Commodity exporters and regional economies with extensive trade and economic links with China will likely be most affected, while the impact through financial linkages is likely to be concentrated in Hong Kong and Singapore. Of course, as this past summer showed, the impact of contagion is hard to predict and quantify, and could spread to markets and asset classes beyond the usual vulnerable countries with twin deficits and high leverage. Developed economies will most likely feel a chill, but not be critically affected.
In EM, Asia-ex-Japan growth would be hardest hit by a Dragon's Tail scenario, especially Hong Kong, Taiwan, Korea and ASEAN. Latin America would be hard hit not only by trade but also investment flows and a simultaneous knock-on impact on commodity prices, with Argentina most affected. EMEA would be more affected by its indirect trade and commodity price exposures.
In the DM world, Australia's 2016 GDP growth should stay positive but drop sharply to almost zero in a Dragon's Tail scenario, as Japan would return to recession and CPI deflation in contrast to our current positive base case forecasts. Europe's 2016 GDP growth should stay positive in a Dragon's Tail scenario, but slip back to only 1% with Germany, Finland, Austria and France the most exposed.
Of all the economies we track, the US would be the most insulated from a China worst case scenario, in which its 2016 GDP dip would likely dip to a still healthy 2.3% level thanks to its more domestically rooted growth engine. With softer global inflationary pressures, US CPI would likely also soften, potentially slowing the Federal Reserve's pace of tightening to leave the Funds rate at 0.875% by end- 2016 instead of our current baseline forecast of 1.38%. In this scenario, the Euro would also likely end 2016 at 1.10 against the USD instead of the 1.20 we currently expect. The USD would gain strongly against EM and commodity currencies, however.
Right. Got it. So once again, we encourage you to bear in mind that this isn't, as UBS says, a "highly improbable" event.
Rather, this is something that's already happened, so if you put any stock in UBS' forecast for how things will shape up in the event that real GDP touches 4% in China, you should probably go ahead and factor in more pain ahead for Argentina and Brazil, a sextuple recession for Japan, and a decisively less steep "flight path" for the Fed.
In other words: if you're the type that's inclined to predict a resurgence in global economic acitivity, a rebound in commodity prices, and a smooth, successful exit from seven years of "unconventional" Keyneisan insanity, you can just go ahead and give it up.