1. The Politiburo speaks, the market spikes
Words move markets. Investors, traders, and analysts scrutinize every comment made by the U.S. Federal Reserve. And, how they interpret these comments moves markets. Sometimes up, sometimes down, sometimes both in the same day.
Parsing the Politburo. In China, where policy and economics are even more tightly intertwined, readouts from Politburo meetings are even more carefully parsed for clues that indicate changes in how the economy is going to be managed. And, how these are parsed likewise moves markets.
Getting the Poliburo wrong. Over time, phrases in Politburo readouts become associated with specific policy changes. So, when you see a certain phrase, you interpret this as a signal. Unless...
- The phrase has lost its connotation or taken on a new one, or
- The phrase is mechanically pulled out from a context that strips the expected connotation from the phrase.
- Either way, you get what the Politburo meant wrong.
Case in point. Andrew Polk of Trivium China: 'The Politburo - China’s 25 highest-ranking politicians - held its monthly meeting on April 23 and discussed Q1 economic performance and the policy outlook.'
- ''When the readout from the meeting came out, the markets got really excited because the readout included the phrase, "We need to expand domestic demand."'
- 'Under the Hu-Wen administration that phrase used to be a very clear signal of coming stimulative measures for economic activity.'
- 'So, everyone jumped on that and said, "Oh, it looks like the Chinese top leaders are going back to the stimulus playbook of the Hu-Wen era and are looking to expand domestic demand again."'
- 'And, the Shanghai composite jolted in reaction – up 2% on Tuesday, April 24, the biggest one-day jump so far in 2018.'
The excitement. An example from Bloomberg, April 24: 'China Stocks Get Adrenaline Shot From Policy Easing Signals.'
- 'Chinese stocks got a much-needed shot in the arm Tuesday, gaining the most in two months amid signs the government is willing to ease its tightening campaign to avoid an overly sharp economic slowdown.'
- 'The rally followed a meeting where policy makers mentioned the need to boost domestic demand for the first time since 2015, and dropped a reference to deleveraging.'
- '“The Politburo meeting sends a signal that China may roll out fiscal stimulus and supportive monetary policies to resolve financial risk and stabilize markets,” said Ken Chen, a Shanghai-based analyst with KGI Securities Co. “That has boosted sentiment on the market, especially for blue chips.”'
- Mr. Chen's analysis was echoed by many other equity analysts.
The problem. Mr. Chen and the other analysts were wrong about what the Politburo meant. Andrew explains.
2. How to parse Politburo pronouncements
Andrew: '"We need to expand domestic demand" has been a buzzword or buzzphrase, if you like, in China signaling stimulus is coming.'
- 'Analysts saw it in the Politburo meeting readout and said, "That's what they used to mean when they said this, and so it must mean that again."
- 'They didn't realize the nature of that phrase has changed over the past five or six years.'
- 'The analysts should have done a more careful reading.'
'Careful reading.' How do you do a careful reading? Andrew and Trivium China show you three steps:
- Trace the 'etymology' of the phrase.
- Check the context where the phrase is used.
- Consider what makes sense.
1. Trace the 'etymology' of the phrase
- 'We went back and read through all the Politburo readouts from the economic meetings, which take place generally in April and December, and it was pretty clear by reading those how that phrase had evolved over the past few years.' 'We found that the Politburo hadn't used the term "to expand domestic demand" since late 2013.' 'And, we saw that the last couple of times that they just used the term "domestic demand," or even "increasing domestic demand," it wasn't followed soon by stimulus.'
- 'In fact, the last time the Politburo used that exact phrase - "We need to expand domestic demand" - was in December 2013.' 'The next time 'domestic demand' was mentioned was in April 2014. And, it was still seven months until stimulus started.''Then, in November 2014, the PBoC embarked on an easing cycle that included six cuts to benchmark interest rates over the course of 12 months, for a total reduction of 165 basis points in the key lending rate – and the Politburo never once talked about “increasing domestic demand” during that period.'
- 'By tracing the history of how the phrase has been used, we could see that it hasn't really meant stimulus since Xi Jinping has taken power. So there's no real reason to read that new phrasing as stimulative.'
2. Check the context where the phrase is used
'So, despite the initial stock market reaction, the Politburo statement is much less than meets the eye for several reasons':
- 'The actual key message from the readout was to underscore the “three tough battles” as policy priorities in 2018 – i.e. addressing financial risks, fighting pollution, and alleviating poverty. So risk containment is still top dog.'
- 'The bit about “expanding domestic demand” comes at the end of a long sentence listing a host of priorities, which also included keeping fiscal policy “constant” and monetary policy “neutral.”'
- 'While the Politburo hasn’t used the term “domestic demand” for several years, it has often identified the need to “expand aggregate demand.” They used that phrase four different times in 2016, and once in 2017. Those mentions were not followed by stimulus.'
- 'The replacement of “aggregate demand” with “domestic demand” is all about the looming trade war. Policymakers are rightly concerned that trade tensions may have a major effect on growth. If that is the case, they will try to offset those negative effects.'
'When we saw how the phrase was used in the context of the entire Politburo readout, it was pretty clear that they didn't have stimulus in mind.'
3. Consider what reading makes sense
'Standing ready to support the economy in the face of a potential trade war is a far cry from pump-priming credit and investment to stave off an organic economic slowdown.'
'Taking the entirety of the Politburo statement together, then, it is pretty clear that Xi Jinping was saying “we will support growth in response to a trade war if we have to, but we are mostly still focused on risk containment.”'-'Top policymakers see that the economy is broadly slowing, but so far they are still comfortable with the current growth range, especially on the nominal side.'
'But, even if the Politburo did mean, "We're going to do some stimulus activity," it's unclear to me where exactly that stimulative activity would come from.'
'When analysts were saying, "This is a signal that macro policy is loosening," I ask them, "What would the stimulus look like right now?"'
- 'China is pretty much maxed out on the fiscal side.'
- 'With deposit rates at just 1.5% – already a negative real yield thanks to inflation at 2.1% – the PBoC does not have room to cut on the monetary front.'
- 'Moreover, they're trying to contain the big markets in real estate right now, so there's really is no room to cut interest rates.'
- 'Interbank rates are currently elevated, and there's a tightening cycle in the US, so a marked acceleration in credit growth just doesn’t seem feasible.'
- 'So, with the financial derisking that's going on - and financial derisking was clearly underlined in the Politburo readout - they can't really boost bank lending at the same time that they're trying to get banks to reduce interbank activity and keep bank funding tight.'
'If analysts had stepped back to consider what makes sense, they would have seen that China doesn't have any good options to stimulate the economy now, even if it wanted to.'
The bottom line
'The bottom line: There is no stimulus coming.'
- The analysts and then the market got it wrong.
- Why? 'I think it was a bit of a lazy reading of "We need to expand domestic demand."'
3. 'The art of China-watching':
then & now
Andrew shows the kind of careful analysis needed to approach a correct interpretation of Chinese official pronouncements. But, at least today there are official pronouncements.
When I was CIA case officer in China Operations - that is, a spy not an analyst - I'd see my colleagues in the Soviet/East European Division pulling their hair out trying to figure out what a photo meant.
- Not a picture of a Red Army missile site - a picture of the old guys standing on the rostrum at the May Day Parade.
- What their order in line meant, who was in, who was out, and so on.
- That's one of the ways they tried to get a handle on what was happening in the closed, authoritarian Soviet Union.
- In the trade (and later commonly), we called it 'Kremlinology.'
- China, for 'China watchers,' was just as opaque. Maybe even more so. We didn't have as many revealing photos and speeches.
Here's a quote from the CIA's now declassified, 'The Art of China Watching,' written in the mid-1970's, not long before I joined China Operations.
- 'It is no semantic accident that observers of the Chinese political scene are more often called "China-watchers" than "Sinologists," while analysts of the Soviet Union are frequently referred to as "Kremlinologists."'
- 'The art of China-watching is imprecise at best, and hardly deserves yet to be called Sinology.'
- 'The explanation, or blame, for this often frustrating situation lies mainly with the way the Chinese conduct their affairs. To say the Chinese have a penchant for secrecy is almost an understatement.'
While much has changed in China since then, the 'penchant for secrecy' hasn't. And, 'the art of China watching' is still 'imprecise at best.'
As Andrew has shown, 'China watchers' today, especially in the form of equity analysts, look at words not pictures.
- What does a phrase used in an official pronouncement signal?
- How was it used in the past, and when it was, what happened?
- Has the phrase taken on a new meaning, and therefore has become a signal of some new outcome?
Parsing meaning in this way is just as challenging - and imprecise - as analyzing a photo. And, when analysts get it wrong, markets move just as much as when they get it right.