Shanghai Index’s Rally- Impact of Inflation or Indications of Economic Recovery?

``Any market where the Federal Reserve has engaged in purchases – agency securities, mortgage backed securities, providing funding for consumer loans, the commercial paper market, to name a few - the Fed is replacing rational buyers rather than jumpstarting the private sector. Why would a rational person buy securities that are artificially inflated in price? If the Chinese dare to buy these securities anyway, then they must be as guilty as the U.S. of currency manipulation. Indeed, that’s what it comes down to: the U.S. wants to have a weaker dollar and China wants to be in control of when to allow the yuan to appreciate. Insulting China is not the right way to go about it. China has to recognize that a stronger yuan is in its national interest. While the U.S. is accelerating its market interventions with implications for the dollar, China is working hard to allow for more exchange rate flexibility.”- Axel Merk China and the U.S. Play Chicken: Currency Manipulation

Are there signs of financial market divergence or decoupling out there? Probably.

That’s if we read into the performance of China’s Shanghai index as a possible indicator of a potential market reversal (see figure 5).

Figure 5: Stockcharts.com: Does the breakout in the Shanghai Index presage financial market recovery or inflation?

The Shanghai index (SSEC) appears to have been in a bottoming formation since it reached its most recent lows early November.

The SSEC broke through its major bear market trend last December [see December’s China’s “Healing” Equity Markets: The New World Market Leader?]. This despite the downside pressures in most of the world’s major bourses, most especially the US markets.

At Friday’s close, amidst all the gloom and doom, the Shanghai index significantly broke to the upside (red arrow) and way above its resistance levels (horizontal blue line). Since the SSEC is up 25% from its November lows, technically this suggests a transition into the advance phase of the market cycle.

And the SSEC’s pretty impressive breakout comes even amidst predominant consolidation in most of the global markets. Seen at the chart above: the S&P 500 pane below main window, the Emerging Market index-mid pane, and the Asia Ex-Japan index lowest pane.

A Head Fake Shanghai Index Rally?

Some skeptics hastily retorted that the recent recovery in credit growth, (as discussed in Will “Divergences” Be A Theme for 2009?) which may have possibly aided the mighty lift in China’s major index, could have been a function of either “bills discounting” (see figure 6, left window) or maneuvers to please policy makers. In other words, government manipulations aimed at juicing up the market.

Perhaps.

But the same argument has been made before suggesting that China’s government will support “so-and-so levels” as the bear market unfolded. This apparently hadn’t been successful as the Shanghai Index lost 71% from peak-to-trough.

So if the Chinese government failed to prevent its bear market from blossoming why should they succeed today?

Figure 6: US Global Investor: Bills Discounting and Composition of Baltic Dry Index

Anyway going back to the rationalization of “Bills discounting” as driving the markets, according to US Global Investors, ``A recent surge in China’s bank credit growth may have captured, at least partly, an artificial demand spike for short term discounted bills as companies took advantage of borrowing at the lower bills rate to earn the higher bank deposit rate. Commercial banks could have also moved off-balance sheet loans back onto their balance sheets to demonstrate compliance with government mandates.”

Next, we read objections about how short term credit growth will only boost economic growth over the interim, which subsequently could translate to the risks of rising bad loans. In addition, we read that the prospective deterioration of corporate profits amidst an intimidating environment should further weigh on China’s stock prices.

It’s odd to hear such objections when the same parties seem to be in favor of massive government interventions in the marketplace.

The difference is that there seems to be a preference over seeing credit growth happening in the US and NOT in China. This stems from the assumption that the US is the world’s irreplaceable ‘aggregate demand’. For me, such observation reflects a smack of prejudice, linear thinking and denial.

Moreover, the idea that short term credit growth will lead to future bad loans is absolutely correct. But that is the underlying principle behind all these government interventions, because excessive credit growth, whether undertaken by the private sector or the government, eventually becomes a bubble. And as much as it applies to the US, it should apply to China too.

Lastly the toll from bear market in the Shanghai index was a substantial 71% decline on a peak-to-trough basis. This means that the market could have already discounted such profit deterioration.

Shanghai’s Rally A Function Of Home Stimulus?

So instead of looking at the markets burdened with biases or reading today’s grim economic outlook as tomorrow’s outcome, our preference is to try to view markets objectively based on the political setting.

We would like to add that the rise in the Baltic Index which we mentioned last week in What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, appears to have been corroborated (see figure 6, right window). Iron ore shipments from Brazil to China has been surging from the start of the year while the same shipments from Australia to China appears be picking up too.

And since today’s marketplace has been heavily distorted by the massive government “inflationary” interventions, the surge in Baltic Index could likely be a function of the activation of China’s $586 billion stimulus (see figure 7).

Figure 7: US Global Investors: China’s $580 billion Stimulus

Based on the above distribution, China’s stimulus program appears heavily tilted (about 85%) towards infrastructure spending. Thus, the jump in Baltic Index could be deduced as China’s thrust to realize the “pump priming” of its economy.

Remember China (GDP $4.22 trillion 2008-CIA) is a rapidly developing third world economy in contrast to the US (GDP $14.33 trillion 2008-CIA) which is the largest most advanced economy in the world.

Yet, when compared to the US, it is likely that China’s stimulus policies has greater chances to work simply because its economy is still largely inefficient due to significant State control of important sections of the Chinese economy’s capital and production structure. According to Gavekal, “the state sector accounts for about 35% of output, and it decisively controls all upstream and network sectors of the economy”.

And because significant parts of the economy are under state control the issue of “crowding out of the private sector” isn’t much a concern in the same way as it is in the US.

On the other hand, of the proposed $884 billion stimulus package for US President Obama only $137 billion or 15.5% is said to be allocated to infrastructure spending.

Inflation Spillage Effect; Jigsaw Puzzle Falling Into Place

Yet, we can’t also discount the idea that Shanghai’s Index performance may have accounted for as our expected “spillage” from the inflationary actions undertaken by many global governments.

For instance, Brazil seems to be the indirect beneficiary of the US government’s bailout of General Motors.

This from the Latin American Herald Tribune, ``General Motors plans to invest $1 billion in Brazil to avoid the kind of problems the U.S. automaker is facing in its home market, said the beleaguered car maker.

``According to the president of GM Brazil-Mercosur, Jaime Ardila, the funding will come from the package of financial aid that the manufacturer will receive from the U.S. government and will be used to "complete the renovation of the line of products up to 2012."

While much of the money printed in support of the US economy seem to be sucked into a vortex of losses within its financial sector, some of these appear to be sloshing over to parts of the world as in the case of GM-Brazil.

Eventually as the global forcible liquidation subsides the impact of these spillages will become increasingly evident.

And the next thrust would probably see inflation seeping into the commodity sector, on the backstop of a combined global infrastructure stimulus. This should translate to a vigorous rally in the commodity sector which should likewise lead to the resurgence of equity benchmarks of emerging markets, including the Philippine Phisix.

Remember markets aren’t just about the conventional notion of economic demand and supply but importantly about the demand and supply of money relative to the demand and supply of goods and services.

As a caveat, we are not talking here of real economic recoveries but one of the after effects from inflationary policies in the context of the present political setting.

And as we long argued, we believe that US Federal Ben Bernanke will fervently use its inflationary policies to achieve either of the two goals, one to reignite the economic growth engines abroad in order to support the US economy through the export channel, or two, reduce the real value of debt.

The US, in contrast to mainstream views, won’t lift the world this time around. At best, it would be the other way around-the world lifting the US economy. At worst, it would be a manifest decoupling.

And as far as we are concerned pieces of our jigsaw puzzle seem to be falling into place or events are beginning to shape as we predicted them to be.

Prepare for the next super inflation.