Global markets face uphill struggle as China, US tighten policy

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Investors had expected to begin the week toasting the victory of former investment banker Emmanuel Macron in the runoff for the French presidency.

Instead the “massive and co-ordinated” hacking of his campaign, while unlikely to alter the outcome of the election, will add to the growing sense of unease that’s been triggered by the latest slump in commodity prices.

Many traders have been stunned by the viciousness of the latest sell-off in commodity markets. Iron ore futures prices, which slumped 7.5 per cent in trading on Friday, are now at their lowest levels since November, having dropped more than more than 30 per cent from their February peak.

Similarly, US crude oil prices tumbled more than 6 per cent last week to US$46.22 a barrel, the lowest level since November, as investors worried that OPEC’s output cuts would fail to ease a global surplus.

And the price of copper has also dropped sharply amid worries over rising inventory levels at the London Metals Exchange.

Many analysts blame Beijing latest efforts to reduce the riskiness of the country’s financial system for triggering this latest bout of turbulence in industrial commodities prices.

The cost of short-term borrowing in China’s interbank market hit 2.85 per cent last week – the highest level in more than two years – as investors worried that Chinese President Xi Jinping has given his blessing to the regulatory crackdown.  According to state news agency Xinhua, Xi told a Politburo meeting in late April that maintaining financial safety was “strategically important”.

As part of their efforts to bolster financial stability, China’s top regulators – including the country’s energetic new banking cop, Guo Shuqing – have stepped up their scrutiny of high-risk, high-yielding investments known as wealth management products (WMPs). The popularity of WMPs has soared in the past few years, with around 29 trillion yuan ($5.6 trillion) – or roughly 40 per cent of Chinese GDP – now invested in these opaque products.

WMP dangers

Typically, banks sell these risky investment products to their retail customers and use the proceeds to buy assets such as bonds, shares, commodity futures and property. Alternatively they lend the funds to outside fund managers who buy similar assets. Both banks and fund managers try to boost their investment returns by using generous dollops of leverage.

But depositors’ faith in WMPs was badly dented last month when it was revealed that a China Minsheng Bank branch had sold WMPs that didn’t even exist. When shocked investors rushed to the bank to withdraw the 3 billion yuan they’d invested in the WMP products, they found that the head of the branch had been taken into police custody and that they were unable to get their money back.

At the same time, falling Chinese bond and share prices (the Shanghai Composite has shed 5 per cent in the past month) combined with higher borrowing costs have made it difficult for banks to generate the high returns that depositors have been promised. As a result, the number of WMPs sold by the Chinese banks dropped 15 per cent in April from the previous month.

What’s more, the expectation of tighter regulation has prompted some Chinese banks to ask external fund managers to repay the money they had entrusted to them.

The risk is that these fund managers must now to liquidate their highly leveraged investments to repay the banks, selling off their holdings, whether they are corporate bonds, shares or commodity futures. And this process could snowball as falling asset prices trigger further selling from highly leveraged investors. Meanwhile, declining market liquidity will make it more difficult, and expensive, for Chinese companies to access funding.

Indeed, there are already signs that China’s tougher regulatory regime is acting as a drag on economic activity. China’s factory sector lost momentum in April, with growth slowing to its weakest pace in seven months, according to the Caixin manufacturing purchasing managers’ index (PMI).

The big question for investors is how far Chinese regulators will go in their attempt to curb financial risk. Some analysts argue that they’ll tread carefully for fear of causing the economy to brake sharply ahead of the important Communist Party congress later this year, where Xi is expected to consolidate his grip on power by appointing allies to key posts.

But other analysts are more pessimistic. They believe that the regulatory changes already underway are likely to cause a significant credit contraction in China, which will inevitably reverberate through global markets.

US markets at record highs

So far, the US share market has shrugged off this risk, with both the Standard & Poor’s 500 index and the Nasdaq ending last week at fresh record highs.

Investors’ spirits were lifted by the April jobs report which showed that non-farm payrolls rose by a seasonally adjusted 211,000 in April, much higher than the 190,000 new jobs that economists had expected. At the same time, the unemployment rate fell to 4.4 per cent, the lowest level in a decade.

Markets saw the robust April jobs report as lending credence to the view of US Federal Reserve that the economic weakness seen in the first few months of the year would prove “transitory”. But the improvement in the US labour market means that it’s now extremely likely that the Fed will raise short-term interest rates at its June meeting.

Some economists warn that a rate hike will force debt-laden US consumers – who have already started cutting back their spending on big-ticket items such as cars and refrigerators – to tighten their belts even further

They point out that despite the improvement in the US labour market, wages growth remains feeble. Average weekly earnings in April rose by 2.5 per cent from a year earlier, but given that US consumer prices have risen nearly as fast there’s been little improvement in real, inflation-adjusted wages.

And consumers are likely to find it harder to borrow going forward, because US banks have already begun to tighten credit conditions on credit cards and other consumer loans because of rising problem loans.

The risk is that US consumers – whose spending accounts for about two-thirds of the US economy – are in too fragile a financial condition to withstand a further hike higher borrowing costs.

By Karen Maley

Financial Times

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