Credit Is Inflationary When Taken On

December 16th, 2020

A big picture observation that we have often made is that credit is inflationary when taken on and deflationary when paid back. Over the past decade, the credit impulse in china (the rate of change in credit growth) has been a reliable leading indicator of the mini-cycles in domestic growth. That is, when China has been increasing (decreasing) the pace of credit growth, that has tended to coincide with an acceleration (deceleration) in domestic and regional final demand, particularly for commodities and raw materials that are directly related to infrastructure, investment and real estate.

Given the increased importance of China to global final demand over the past decade, the mini cycles in credit have also had an influence on world growth. The growth scares in 2010-2012 and 2014-15 coincided with phases of deceleration in China’s credit impulse and therefore also had an influence on risk asset prices and premia more broadly. Liquidity is fungible and there is a self-reinforcing or reflexive feedback loop between the credit impulse, activity and asset prices. However, the most obvious influence has been on the commodity cycle which is most directly influenced by Chinese demand (as the largest end user of most raw materials).

The good news and consistent with the widely held prevailing bias is that the global recovery is likely to be sustainable, synchronous and supported by policy. A global expansion phase is also generally consistent with US dollar weakness, higher commodity prices and outperformance of commodity linked assets and currencies. Indeed, the strength of China’s credit impulse since 2018 and the recovery in other leading indicators such as the manufacturing ISM suggest that there is likely to be further upside in commodities and related assets for at least another quarter or two. However, there are a few tactical points to note.

First, China’s credit impulse probably peaked in October. The rate of change slowed to 9% in November from 9.4% in October (chart 1). While commodity prices and commodity linked assets tend to rally for a few months after the peak in the credit impulse, it is a warning that momentum is likely to moderate over the coming quarters. As Morgan Stanley noted in their 2021 outlook, there are also parallels with 2010 and the moderation in the last expansion after the 2008 recession and aggressive policy response. That episode not only saw a moderation in China’s credit impulse after the extraordinary response to the Lehman shock, it coincided with premature fiscal tightening in Europe and the growth scare and risk aversion from the crisis in peripheral European countries.

Second, the good news and the lesson from that episode is that the cycle usually wins out. However, we would not be surprised if there was a phase of volatility in risk assets at some point next year. From a tactical standpoint, if the Democrats gain control of the Senate on January 5th that might raise expectations for more aggressive fiscal policy and an extension of the current trends in markets.

The final point to note is that commodity linked currencies and assets have probably not priced in all of the recent strength in underlying commodity prices and China’s credit impulse. For example, our fair value estimate for the Australian Dollar (which combines interest rate differentials and industrial commodity prices) suggests that the currency is at least a few percentage points undervalued. Similarly, the recent strength in spot iron ore (Australia’s most important export by volume and value) is also probably consistent with a higher fair value for the currency (chart 2). Of course, it is important not to extrapolate spot commodity prices – the best cure for high commodity prices is high prices as it will increase supply. Nevertheless, the current price is well above equilibrium (and breakeven). However, it has also become part of the broader dispute between Australia and China on trade. The good news for Australia is that the only other source of iron ore is Brazil (as an aside the BRL is probably at least 30% undervalued).

In conclusion, the mini cycle in China’s credit impulse has tended to be a decent lead indicator of commodity prices, commodity linked markets and regional asset prices. Given China’s increased importance in global final demand over the past decade it has also tended to

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