China and The Money Map

China and The Money Map

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The Money Map helps us understand what types of asset work best in different environments. If you can predict where inflation and bond yields are headed, which isn’t always easy, then the Money Map tells you where to invest. And more importantly, where not to invest.

If inflation is rising, then gold and value assets will outperform. If inflation is low or falling, stick with equities and bonds. Similarly, if the economy is strong and bond yields are rising, then Growth and Value will beat Gold and Quality. It is logical and helps to explain what performs best and worst given the macro conditions. Right now, bond yields are rising, which puts us on the right-hand side, while inflation (future expectations) is broadly flat or falling.

That’s the simple implementation, but we can also consider the diagonals. Real rates, which are bond yields less inflation, are illustrated by the top left bottom right diagonal (orange). High real rates favour growth, while low real rates favour gold.

The other diagonal, bottom left to top right (green), follows the “heat” of the macro conditions. Here we add inflation and yield together and get a sense of market heat, which could be described as a proxy for nominal GDP growth. A very low number is ice cold, such as in 2008 when interest rates were dropped to zero, while inflation was briefly negative. A very high number is fiery and means rates and inflation are getting out of hand, as they are in places like Turkey and Argentina.

I will go through the key rates and inflation in major countries for comparison. It may surprise you that while Europe and the US have an inflation problem, China recently dipped into deflation.

Inflation by Country

Source: Bloomberg

Looking at bond yields, the US and UK are by far the highest, with Europe stubbornly catching up. Meanwhile, Japanese yields remain contained by policy, while Chinese yields are falling. That is, Chinese bond yields have historically been correlated with the rest of the world, but something has changed.

10-year Bond Yield by Country

Source: Bloomberg

Real yields, the bond yield less inflation, is alarming. The real yield in the US is already very high at 2%. The UK is similar because although it appears to be 1.1% lower, that can be accounted for by the indexing against RPI instead of CPI, which is around 1.2% (on average) higher. So the UK and the US are about the same. Europe is still at zero, with Japan at -0.8%. What is remarkable is how China is 2.85%, which is a very high number and is bound to be stalling the economy.

Real Yields

Source: Bloomberg

Finally, I show the heat, where the yield and inflation are added together. The West tears away into the stratosphere, with Japan very low but rising. The standout is China, which has fallen from 8% in late 2019 to just 2.2% today. As I said, think of the heat to be a proxy for nominal GDP growth. The USA touched 2% at the depths of the 2008 credit crisis. Could China’s situation be much worse than we currently realise?

Market Heat

Source: Bloomberg

The Chinese economy is slowing rapidly, and with the major property developers defaulting on loans, the domino effect cannot be ignored. This is a clear risk for global markets because these things are rarely contained. This could spread as exposure to bond defaults tends to end up in all the wrong places around the world. The other development is how China used to be correlated with the global financial system, but that no longer seems to be the case. It is inevitably a cause for concern.

I am very conscious of these developments and am keen to ensure we are prepared for the worst. That is not to panic, but to remain cautious.

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