SocGen: China's Massive Credit Misallocation Will End In A Painful Burst

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The Markets Are Facing Some Major Headwinds

Alex Davies / Business Insider

The stock market has staged a relief rally over the last three days as various Fed officials have tried to walk back Bernanke’s statement that implied a tightening of monetary policy.  In addition the first quarter GDP revision that indicated a slower economy gave investors hope that a Fed withdrawal of stimulus would occur later rather than sooner.  Adding to the mix was China’s injection of funds to various lending institutions in response to soaring short-term lending rates.  However, we believe that a slower U.S. economy is nothing to cheer about, while China’s economic and financial problems are too deep-seated for any instant cure.

Although others talk about an improving U.S. economy, it is not happening.  The second revision of first quarter GDP reduced the annualized growth rate to only 1.8% from a previously reported 2.4%.  Although the data in the report is now a few months old, it signifies that the economy entered the current quarter with slackening momentum that has continued.  Most of the reduced growth rate was a result of consumer spending growth dropping to 2.6% from the 3.4% reported in the first revision. Moreover, final domestic demand grew a meager 1.3%, compared to the prior estimate of 1.9%.  This is a distinct slowdown from the average growth of about 2% that had been the case since mid-2010.

The slowing momentum has carried over into the second quarter as well.  Real consumer spending dropped 0.1% in April and rose 0.2% in May.  As a result, even a 0.2% increase in June would bring second quarter spending to only a 1.6% gain for the quarter, compared to 2.6% in the prior quarter.  Since consumer spending accounts for about 70% of GDP, it now appears that GDP in the current quarter will not even match the meager 1.8% rate of the first quarter.  While this outcome will likely mean a delay in the Fed’s plans to pare their bond-buying program, we doubt that an even further slowdown of an already inadequate economic growth rate will be looked at kindly by the market.

In addition, China’s economic and financial problems are also likely to impact the U.S. and the rest of the world.  China’s massive stimulus over the last few years into industry and infrastructure has built hugely excessive capacity that is generating little or no returns.  Soaring debt associated with the buildup was hidden by new loans, much of it done through the shadow banking system. 

The Chinese central bank, fearing a credit bust that would hit an already slowing economy, has recently attempted to rein in runaway financing.  But the attempt resulted in short-term lending rates suddenly soaring into double digits from the 3.5% in force for most of May.  This happened at about the same time that Bernanke raised the prospect of curtailing QE, and contributed to the decline in the U.S. stock market.  China’s central bank was then forced into injecting funds into some financial institutions to ameliorate the sudden credit squeeze that threatened the economy.  This also coincided with the Fed’s attempt to walk back some of its previous tightening talk, and contributed to the bounce-back rally in the stock market.

In our view, China’s move to temper the credit squeeze is only a temporary Band-Aid.  The nation’s corporate debt alone is almost 200% of GDP.  Massive overcapacity exists in a wide number of major industries such as chemicals, cement, steel, autos, aluminum, shipbuilding, and metals smelting at a time when its export growth rate is declining.  As a result they have also had to cut purchases of raw materials from the rest of the world, creating slowdowns or recessions in nations dependent on sales of commodities.  All in all, this is a situation that cannot end well for either China or most other nations.   

In sum we believe that the deteriorating economic and financial situation in the U.S. and the rest of the world will result in a major market decline.  Although investors now view any delay in the Fed’s plans to cut back QE as positive, we think that the opposite is the case.  An economy that is too weak for the Fed pare back their bond-buying program would be highly negative for corporate earnings and probably push the economy into undesirable deflation as well.  This is not a situation that is conducive to a robust stock market.  

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STOCKS RALLY, GOLD TANKS: Here's What You Need To Know (DIA, SPY, QQQ, GLD)

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REUTERS/Peter Andrews

The stock market is now on a nice three-day winning streak.

First, the scoreboard:

Dow: 15,024.2, +114.3, +0.7%S&P 500: 1,613.2, +9.9, +0.6%NASDAQ: 3,401.8, +25.6, +0.7%

And now, the top stories:

Overall, the economic data today was encouraging.Personal income jumped 0.5% in May, beating expectations for a modest 0.2% gain.  Personal spending climbed by 0.3% during the period, which was right in line with expectations.  The saving rate improved to 3.2% from 3.0% in April.Initial weekly jobless claims fell to 346,000 from 355,000 a week ago.  The reading was right in line with expectations, and it was a welcome improvement.Pending home sales surged 6.7% month-over-month in May, crushing expectations for a 1.0% gain. "Even with limited choices, it appears some of the rise in contract signings could be from buyers wanting to take advantage of current affordability conditions before mortgage interest rates move higher," said the National Association of Realtors' Lawrence Yun.As the stock market rallied in the wake of the encouraging economic data, gold extended its epic meltdown.  Today, we saw gold fall below $1,200 for the first time since 2010.  It got as low as $1,198 before recovering some of its losses.Don't Miss: MORGAN STANLEY: These Are The 7 Most Attractive Stocks In America »

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