It’s hard to ignore the slowdown in China, but it is hardly news. China’s GDP came in last week, as expected, at 6.7%. Over the past 30 years, the strongest growth rate of 14.3% was recorded in 1992, although in 2007 GDP did hit 14.2%. 6.7% is less than half the peak reading - however it is hardly a disaster and is way above growth rates in the G7. Quite why “only” 6.7% GDP growth is universally viewed as a negative remains one of the puzzles of modern finance.
Equally, given the importance of China in the world economy, it remains a mystery as to why investors with a pessimistic view on China, are not more downbeat about global economic growth prospects. Last week, yet again, the IMF downgraded their global growth estimates to 3.2% for 2016 and 3.5% for 2017. Their policy prescription is more proactive use of fiscal policy and structural reform in conjunction with already supportive monetary policy. Indeed a criticism of current policy is its over-reliance on central banks and that the prolonged use of QE and negative rates bring unintended consequences. Olivier Blanchard, now at the Peterson Institute in Washington, but formerly the Chief Economist for the IMF, said he is wary on the use of negative rates saying “I don’t like it, I think it interferes with the business of banks in ways that are very complex” instead “I much prefer what we now call regular QE.”
In a world of elevated debt levels our view is that QE is deflationary. When global aggregate demand is weak, the risk is central bank easing becomes a game of competitive devaluation with no real winner. The danger is that QE is seemingly having better success in promoting risk taking in financial markets rather than stimulating growth in the wider economy as evidenced by the declining velocity of money. Estimates suggest there are close to $7tn of bonds trading at negative yields. But corporate investment remains weak and for the average consumer wage increases are important drivers of confidence and increased discretionary spending: but even in the US, which has been performing better than Europe and Japan, US real median household income has declined since 2007.
The global backdrop of weak economic growth will inevitably impact demand for goods generally and oil in particular. As the oil glut continues to weigh heavy on black gold dependent economies, countries such as Mexico have employed spending cuts as a way to shield themselves from the ongoing pressures. A couple of weeks ago, the country’s Finance Ministry announced it will be slashing spending by an additional MXN 175bn ($10bn) in 2017, this is on top of the ~$7.5bn worth of cuts this year; or 0.7% of GDP. The spending cuts in 2017 assume crude will be priced at $35pb, this is above the pessimistic $25pb estimated for 2016, crude ended the week at just over $43pb; however unlike other oil producing economies, the government has the safety net of the ~$50pb revenue hedge this year.
According to sources, in recent years the government has depended on revenues from state-owned oil giant, Petroleos Mexicanos (Pemex) for roughly one third of the federal budget. As such, the country’s Finance Ministry announce last week that it will grant Pemex support totalling MXN 73.5bn ($4.2bn). This liquidity boost is said to be made up of ~$1.5bn in capital and a credit facility worth ~$2.7bn; allowing the pension and retirement liabilities to be paid off this year. In return the government will require the oil-monopoly to reduce its debts and liabilities in-line. Last month the company had begun taking such steps announcing it had secured credit lines with three of the the country’s development banks to facilitate ~85% of debt owed to suppliers, and provide additional liquidity.
We are exposed to Pemex, via the 6.625% issue maturing in 2035, the bond rallied almost 4 points in the days after the announcement to close the week at a spread of ~455bps over Treasuries, or a yield of 6.72%. The bond has gained ~18 points since the lows in January and continues to remain attractive. Our proprietary Relative Value Model (RVM) calculates that, on average, BBB+ rated bonds with a ~10.5 year duration trade at roughly 220bps over. This suggests that the bond will need to tighten ~235bps to reach fair value, or more simply put, will have to rally a further 28 points to match its peers.