A Surprising Way to Play a Europe Rally
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
U.S. Global’s Portfolio Manager Tim Steinle is usually soft-spoken and mild mannered, so when he belted out “Europe is Rocking!” this week, our ears perked up.
After a lengthy period of stagnant growth and lackluster results, the gradual crescendo of improving economic data that’s been coming out of Europe lately certainly commands attention.
As our resident expert of the European economy, Tim has been listing several economic indicators that were turning positive during the investment team’s morning meetings. While our entire team keeps track of the economic data and political policies of all the developed G-7 and emerging E-7 countries in the world, Tim keeps his finger on the pulse of European countries at all times in his hunt for outsized opportunities for the Emerging Europe Fund (EUROX).
I previously shared how economic releases have been beating expectations, as shown in the eurozone’s spiking Citigroup Economic Surprise Index. GDP is recovering too, with expectations that the year-over-year growth rate will significantly improve over the next year and a half.
Positive surprises and improving economic growth aren’t the only indications that the region’s economy is becoming healthier. Manufacturing appears to be on the mend. The latest reading of the purchasing manager’s index (PMI) was at a two-year high and topped the 50-mark. This indication of expansion hasn’t happened since July 2011. And, the PMI in the eurozone expanded at a faster pace than estimated.
Economic confidence in the region has also been rising. In July, it reached a 15-month high. Generally, when sentiment turns positive, businesses invest more and consumers spend more. We believe this improving confidence will potentially spur positive third-quarter economic growth and help the eurozone to exit its recession.
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The area’s fiscal situation isn’t in dire straights as it has been. According to BCA Research, structural deficits peaked four years ago. As a result, during the 2009 to 2012 period, the biggest fiscal drags as a percent of potential GDP were concentrated in Europe, namely in Greece, Portugal, Spain and Ireland, four of the five members of the group formerly known as the PIIGS. Fiscal drag happens when a government’s net fiscal position doesn’t cover the desired net savings of the private economy.
Looking ahead at the 2012 to 2015 period, the largest fiscal drags are expected to be in other areas of the world. Based on data from the European Central Bank, “the government credit impulse is improving, which should help to lift the euro area economy out of its ‘endless recession,’” says BCA.
It’s no wonder Tim is cheering Europe on, as these economic data points have important implications for global investors.
Consider the area’s PMI, which Morgan Stanley Research found to be a six-month leading indicator of earnings-per-share (EPS). While the EPS for European stocks has remained relatively flat over recent months, it’s expected to follow PMI and move up.
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Here’s another reason to look at the area: Europe has low valuations compared to the rest of the world. Take a look at the normalized price-to-earnings (P/E) ratio, which is trading at “close to a record valuation low,” according to Morgan Stanley Research. Compared to U.S. stocks and world equities, European stocks are trading at a significant discount.
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So as countries including Germany, France and Italy recover, we have solid reasons to believe their eastern counterparts will enjoy a boost as well.
Take the CE3, which are the Czech Republic, Hungary and Poland. These countries are integral to the supply chain in Europe and dependent on domestic demand as well as its export growth.
We aren’t the only ones pounding the table for emerging European countries. Credit Suisse came out with a report this week that had a bold headline, “Going Overweight Europe = Bullish CE3.” The report makes a case for the Czech Republic, Hungary and Poland as the countries have “cheap markets, cheap currencies, which are commodity importers and are not overheating,” says Credit Suisse.
The firm cites numerous positive data, including the CE3’s lead indicators moving together with Germany, an improving outlook for employment, recovering real retail sales, wage growth, and regional credit growth.
Stay tuned for Europe’s much-anticipated return to the limelight. But before Europe plays before a sold-out crowd, you might want to get your portfolio a front row seat.
- Major market indices finished lower this week. The Dow Jones Industrial Average fell 1.49 percent. The S&P 500 Stock Index lost 1.07 percent, while the Nasdaq Composite declined 0.80 percent. The Russell 2000 small capitalization index fell 1.08 percent this week.
- The Hang Seng Composite declined 1.15 percent; Taiwan fell 3.01 percent while the KOSPI lost 2.22 percent.
- The 10-year Treasury bond yield fell 2 basis points this week to 2.58 percent.
Domestic Equity Market
The S&P 500 was down this week, with the materials sector being the only positive sector, up a modest 0.87 percent. Uncertainty surrounding the Federal Reserve’s quantitative easing (QE) program continues to weigh on investors’ minds.
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- The materials sector was the best performer this week as it responded to better economic data out of China, which remains a key driver for this sector. Both steel and mining industries were the best performers.
- In an otherwise down market, the consumer staples sector was able to outperform as Tyson rose 10 percent on a strong earnings report.
- Cliffs Natural Resources was the best performer in the S&P 500 this week, rising 18.32 percent as the company responded to better economic data out of China.
- The telecom services sector was the worst performing sector this week as AT&T and Verizon Communications were weak for the second week in a row.
- The financial sector lagged as large banks and broker-dealers underperformed. Morgan Stanley, JPMorgan Chase and Goldman Sachs all fell by more than 3 percent.
- First Solar was the worst performer in the S&P 500 for the week, falling 13.28 percent. The company reported disappointing quarterly results.
- The current macro environment continues to be positive as economic data remains robust enough to give investors confidence in an economic recovery, but not too strong as to force the Fed to change course in the near term.
- Money flows are likely to find their way into domestic U.S. equities and out of bonds and emerging markets.
- Earnings have generally been well received as earnings season continues into next week.
- A market consolidation could occur in the near term after such a strong year.
- Higher interest rates are a threat for the whole economy. The Fed must walk a fine line and the potential for policy error is large.
- With much of the significant economic data out of the way, the focus will be on the Fed and whether it will taper in September.
The Economy and Bond Market
Treasury yields moved modestly lower this week as global economic data was showing signs of improvement. Chinese economic data was better than expected this week with a slew of data showing improvements in July. Economic data out of Europe is also improving and it appears that Europe may have finally turned the corner. The market seems to have come to terms with the Fed tapering in September, and yields have been pretty stable over the past couple of weeks.
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- Chinese economic data positively surprised across the board. Industrial production, retail sales and exports were all better than expected in July.
- Economic data out of Europe is also on the mend with German industrial production and factory orders showing strong gains.
- The U.S. trade deficit was the narrowest since June 2009 as exports rose and imports fell.
- Back-to-school results for retailers reported mixed, raising questions about consumers.
- The IBD/TIPP Economic Optimism Index fell for the second straight month.
- Oil and gasoline prices remain elevated which crimped consumers.
- Despite recent conflicting commentary, the Fed continues to remain committed to an accommodative policy.
- Key global central bankers are still in easing mode such as the European Central Bank (ECB), Bank of England and the Bank of Japan.
- The recent sell-off in bonds is likely an opportunity as higher yields will act as a brake on the economy and potentially become self-fulfilling, thus postponing Fed tapering.
- Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.
- Trade and/or currency wars cannot be ruled out which may cause unintended consequences and volatility in the financial markets.
- The recent bond market sell-off may be a “shot across the bow” as the markets reassess the changing macro dynamics.
For the week, spot gold closed at $1,314.40, up $2.65 per ounce, or 0.2 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 3.61 percent. The U.S. Trade-Weighted Dollar Index lost 0.96 percent for the week.
- Gold futures jumped the most in two weeks as the dollar weakened, increasing demand for the metal as an alternative investment. The chart below shows the contrast between the Shanghai Gold Exchange (SGE) and the COMEX. Despite the volume traded on the COMEX dwarfing that of the SGE, it is clear that as far as deliveries of physical metal are concerned, the first is solely a paper market and the latter is a real market for physical gold. As it stands, more and more market participants are beginning to focus on Shanghai to measure real demand for bullion.
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- Platinum gained the most in more than 13 months following reports of exports rebounding in Germany and China, while Northam Platinum Ltd, which operates the world’s deepest platinum mine in South Africa, warned that strike action as a result of deadlocked wage talks will impact operations. The signs of improving demand coupled with supply concerns make platinum very attractive. Similarly, silver futures contracts rose significantly on COMEX as the U.S. Mint reported American Eagle Silver Bullion coins experienced their best July ever with a whopping 93.4 percent increase over July 2012 sales.
- B2Gold issued an exceptional second-quarter earnings report with gold production for the second quarter totaling 82,083 ounces. The company also reported better-than-expected operating cash costs, while establishing the carrying value of its long-lived mining assets at June 30, 2013, required no write-downs. In addition, the company increased its reserve estimates at its Masbate Mine from 3 million to 3.23 million gold ounces at an improved grade of 0.97 grams per tonne. Lastly, the company upgraded its gold production guidance for 2013 to between 395,000 to 420,000 ounces compared with the earlier production forecast of between 360,000 to 380,000 ounces. On a different note, Randgold Resources saw a 62 percent drop in quarterly profit attributable to lower gold prices. However, the company reduced cash costs per ounce by 5 percent in the second quarter relative to the first quarter, which helped turn it into one of only four gold companies to post a profit in th e second quarter so far according to Bloomberg.
- Gold investments on exchange-traded products dropped $30.9 billion this year through July, BlackRock said. Gold outflows totaled $2.6 billion in July, extending redemptions of $4.3 billion in June. BlackRock argues the continued modest inflation readings have lessened gold’s appeal as an inflation hedge.
- South Africa released its latest figures on the country’s metals and mineral output showing gold and platinum continue on the decline. The reading is fairly dismal, considering the African nation once had the world’s dominant gold mining sector. Gold production was down 14 percent year-over-year and is now only the country’s fourth most important mined metal. In terms of global gold output, South Africa has been slipping down from the world’s top producer less than a decade ago to number six. Back in 1970, South Africa produced almost 80 percent of global gold production; now it manages only around 6 percent.
- China’s net gold imports from Hong Kong fell 4.8 percent in June as the government curbed the use of bullion in financing deals as part of its liquidity tightening measures. Traditionally, gold has been used in the commodity-finance trade, which was a popular way of taking advantage of the higher interest rates in mainland China relative to Hong Kong. Gold has also been used to back foreign-currency loans from banks in Hong Kong, using the cash to purchase yuan on the mainland in a form of arbitrage. The recent tightening has made these activities more complex, thus reducing their volume.
- Australia’s ANZ Bank is the latest to open a gold vault in Singapore. Other recent vault builders there include Deutsche Bank and JP Morgan, while Switzerland’s Metalor has one under construction. The new gold vault openings evidence the continued flight of gold from West to East. It appears Western bullion banks have misjudged the power that gold retains in the global psyche and as a key financial instrument, especially to Asian buyers. A recent statement by Yao Yudong of the People’s Bank of China Monetary Policy Committee calling for a new system to manage international liquidity is another indication that China is moving toward abandoning the U.S. dollar hegemony. In the future, China may look toward a hard asset backed currency to negotiate, a move that would certainly bode well for bullion.
- Gold is set to gain as output languishes on spending cuts, according to the World Gold Council. Spending cuts by producers and the closure of costly operations will tighten supply in the global market. In trying to estimate mine production for the remainder of the year, it appears gold production will be flat and could even fall this year. Among many others, Barrick Gold, the world’s largest producer, said it may sell, close or curb output at 12 mines from Peru to Papua New Guinea where costs are higher. On the demand side, China is expected to surpass India this year as the world’s largest consumer of bullion, adding pressure to an already tight physical delivery market.
- The TSX Venture Exchange intends to retire a number of temporary rules on August 31, in an effort to adapt to a new capital markets environment, according to Mineweb. The exchange said it will not allow under five-cent private placements, but that it has other measures in mind to make it easier for juniors to meet the regular financing rules, especially those that relate to stock consolidations. With the new policy, the TSX Venture would let juniors do consolidations without shareholder approval when the share-ratio therein is 10:1 and less. Juniors will still have to comply with provincial securities laws, but it will give juniors a way to meet the TSX Venture’s regulations while avoiding time-consuming, expensive procedures.
- Many of the world's gold miners are struggling to keep their heads above water at current gold prices. One of the main reasons is the fact that mines are old and the replacement ounces that are being found are of much lower grade. A recent Mineweb study shows grades have indeed fallen significantly. For instance, grades in the South African gold sector fell from an average of 4.3 grams per metric ton in 2002 to an average of 2.8 grams per ton in 2011.
- The Federal Reserve should reverse a decade-old ruling that lets banks trade physical commodities, Commodity Futures Trading Commission member Bart Chilton said. Banks including Citigroup, JPMorgan Chase and Morgan Stanley were permitted to expand into commodities markets under a Fed decision, according to Mineweb. The central bank said last month that it is reviewing the policy amid Senate scrutiny of whether such involvement allows Wall Street firms to influence prices. The conflict of interest is evident given that the 10 largest Wall Street firms reaped about $6 billion in revenue from commodities in 2012, according to analytics company Coalition Ltd.
- Gold was put under pressure from the release of better-than-expected U.S. nonmanufacturing data at the beginning of the week. The ISM nonmanufacturing index rose to 56.0 in July from 52.2 in June, largely beating the median forecast of 53.1 from a Bloomberg survey. According to HSBC’s U.S. economist Ryan Wang, the ISM nonmanufacturing business activity and new orders indexes both increased sharply, indicating steady growth in economic activity. Following the reading, Dallas Federal Reserve President Richard Fisher commented that the Federal Open Market Committee (FOMC) is now a step closer to withdrawing from its quantitative easing (QE) program.
Energy and Natural Resources Market
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- The price of copper climbed 4 percent this week to its highest level in two months, partially due to July’s industrial output that was better than expected from China.
- China’s copper imports for July rose to a fourteen-month high, while iron ore imports also hit a record high. From a year ago, China’s copper imports rose 12 percent to 410.7 thousand metric tons (tmt), the metal’s third-straight increase. China’s iron ore imports surged 26 percent from a year ago to 73.1 million metric tons (mmt), according to the General Administration of Customs.
- China’s passenger car sales rose 10.5 percent year-over-year in July to 1,237,600 units, according to data from the China Association of Automobile Manufacturers (CAAM). This was a slightly faster rate than June's 9.3 percent. Within that total, SUVs, typically larger than average, rose by 45 percent to 235,000 units. Strong continued growth in China is very positive for palladium, which derived 12 percent of its total demand from Chinese auto catalysts in 2012, which is up from just 4 percent in 2008.
- There is no stopping the shopping in China when it comes to gold jewelry, as seen in July’s government data. Although down from April’s peak and adjusting for seasonal pattern demand, it is firm at a much higher level than a year ago. This is very supportive for the gold price.
- The price of corn fell 2 percent this week to $4.65 a bushel, which is a fresh thirty-five month low. Expectations were that rain and warmer temperatures would further improve this year’s harvest.
- Uranium prices are at their lowest level since late 2005, yet new primary mine supply is still coming on line. North American miner Ur-Energy announced that it started production at its Lost Creek ISL uranium mine in Wyoming.
- Latest data from the China Iron and Steel Association (CISA) shows that Chinese crude steel output fell 2 percent sequentially to 761 million tons per annum (mtpa) during the last eleven days of July. Output for CISA member mills dropped to 611 mtpa, the lowest since mid-March.
- BHP Billiton signaled that it will expand in the shale oil and gas industry in the U.S., forecasting that global commodity demand will jump 75 percent over the next fifteen years. “It’s my intention to make us hugely proficient, if not one of the leaders in the shale gas and oil business,” Andrew Mackenzie, CEO of the Melbourne-based company, said in an interview.
- Oil explorers that are focused on high-margin shale drilling from Texas to North Dakota are set to outperform Big Oil this year. EOG Resources, Pioneer Natural Resources and Continental Resources are poised to reap bigger returns for investors than that of energy titans fifteen times their market value. These explorers will devote almost all of their drilling capital to higher-margin, domestic crude wells, said Gianna Bern, founder of Brookshire Advisory and Research Inc. in Chicago and former BP crude trader. Houston-based EOG is estimated to more than triple their profit in 2013 to $1.92 billion. The domestic price rally “is bullish for U.S. shale development and benefits producers with a high U.S. production profile,” Bern said in a telephone interview. He continued, saying that U.S. shale “is where the growth is.” West Texas Intermediate, the benchmark crude for onshore U.S. oil, has risen 16 percent this year as new pipelines and rail links eroded a supply glut in the Great Plains. London-traded Brent, the basis for two-thirds of international prices, fell 2.2 percent. This undermined major international producers and contributed to second-quarter earnings from Exxon Mobil and Royal Dutch Shell, which disappointed investors last week.
- Chile foresees mining investments of $112 billion in the next eight years, compared to the $104 billion that was estimated in November 2012. This is due to the incorporation of nine new projects for a total of $3.6 billion, along with another twenty initiatives that have updated their investment budgets, according to Mining Minister.
- Hedge funds and money managers nearly doubled their net shorts in copper futures and options last week, which is the biggest increase in bearish bets since late February, according to data published by the Commodity Futures Trading Commission.
- China has once more proved the pessimists wrong, according to Vale’s CEO Murilo Ferreira. The shares of Vale, along with major rivals BHP Billiton and Rio Tinto, rallied following encouraging Chinese trade data released on Wednesday. The materials sector was the best performer across most markets this week, giving a strong boost to materials export-driven Latin American economies such as Brazil, Chile and Peru.
- Poland’s consumer credit rose 0.2 percent in the second quarter, following six quarters of contraction. The reading shows that the Polish consumer is back, adding to evidence that eastern Europe’s biggest economy is reviving. Consumer spending accounts for 60 percent of the country’s gross domestic product and is crucial to reviving the economy. The move comes on the back of better-than-expected retail sales and industrial output in June, while unemployment fell to the lowest level since November.
- China’s consumer price index (CPI) was up 2.7 percent for July, lower than the consensus of 2.8 percent, and remained flat over June’s reading of 2.7 percent. The tamed CPI print was helped by lower vegetable prices and moderating food prices. The country’s producer price index (PPI) was down 2.3 percent, a little higher than the consensus of -2.1 percent, but up from -2.7 percent in June. China’s loosening policy began towards the end of June and should continue to help improve PPI if demand for mid-stream products picks up. China’s fixed-asset investment jumped 20.1 percent year-to-date in July, which was in line with the estimate of 20 percent. Retail sales rose 13.2 percent versus the market expectation of 13.5 percent. Lastly, industrial production for July rose 9.7 percent versus the market expectation of 8.9 percent, indicating stabilized industrial activities.
- During the post-market on Friday in China, the People’s Bank of China (PBOC) released new local currency bank loans for July to be Rmb 700 billion; this is versus the market expectation of Rmb 638 billion and Rmb 861 billion in June. China’s broad money supply (M2) increased 14.5 percent versus the consensus of 13.8 percent and 14 percent in June. This reading is sequentially stable and demonstrates that monetary policy is shifting to a more neutral bias. In July, the PBOC conducted three reverse repo operations in order to inject around $10 billion into the market. China’s total social financing (TSF) stood at Rmb 808.8 billion in July, lower than Rmb 1.04 trillion in June. The lower TSF reading could be due to banks’ efforts in balance sheet deleveraging for wealth management products (WMPs).
- July exports in China rose 5.1 percent, versus the market consensus of 2.0 percent. Imports climbed 10.9 percent, versus the market consensus of a 1 percent rise. In particular, exports to Europe rose 2.8 percent, indicating a recovering economy.
- The Chinese city of Wenzhou loosened real-estate curbs by allowing second home purchases, the National Business Daily reports. Additionally, in the property sector, three A-share developers in China have been allowed to file for share placement in order to raise capital. This is a significant policy shift since developers were banned from raising money in the stock market, or from borrowing from banks in the last three years following China’s tightening in the market. This could also indicate that shadow banking as a source of financing for developers is being reduced to deleverage banks’ balance sheets in wealth management products. In regards to this policy shift towards the banking industry, the government may allow banks to sell loans to securities firms who will bundle them into asset-backed securities, China Securities Journal reports.
- China’s passenger vehicle sales for July increased by 14 percent and rose 17 percent year-to-date for the period of January to July 2013.
- There has been more negative news for the Russian macro-environment. The trend of negative revisions to the 2013 Russian gross domestic product (GDP) reading, which is visible in the chart below, is likely to extend. Early activity indicators show the macro outlook getting worse. GDP expanded 1.2 percent in the second quarter from a year earlier, placing the reading below all nineteen forecasts in a Bloomberg survey. The data suggests a 0.5 percent contraction in the quarter. The unexpected slow-down in the second quarter stokes concern that the world’s biggest energy exporter may be entering a recession. Furthermore, July’s manufacturing PMI surprised negatively at 49.2 from 51.7. Business confidence, new orders, employment and capacity utilization all showed deterioration.
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- The recent sell-off in the Brazilian real is hurting the bid of central bank President Alexandre Tombini to manage inflation expectations. The real has tumbled 13 percent in the past three months. This reading has frustrated the central bank’s effort to bring the annual inflation rate down below the 6.5 percent upper-limit of its target. With monetary policy moving in the right direction for inflation to slow, the question of where the currency is going to settle will continue to be the driver of inflation expectations.
- Malaysia’s June industrial production was stable, rising 3.3 percent year-over-year, but missed the market consensus of a 3.7 percent gain.
- Taiwan’s CPI reading for July was 0.08 percent after rising 0.06 percent in June, but lower than the consensus of 0.6 percent. Investors are concerned the country may be heading into a deflationary environment.
- The Global Composite PMI recorded a strong start to the second half of the year, rising to 54.1 in July from 51.4 in June. This was the highest reading in 16 months, according to HSBC Global Research. The notable improvements in developed markets, led by the United States’ reading of 61.2 and the reading above 50 for the eurozone, are in stark contrast with BRIC (Brazil, Russia, India and China) country data, where there was contraction. However, the expansionary readings in the developed world should bode well for increases in global trade, which should inevitably result in surging export orders across the countries in the key global supply chain. As a matter of fact, July export numbers for China rose 5.1 percent year-on-year, lending support to the aforementioned thesis.
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- Mexican President Enrique Pena Nieto will delay the announcement of his proposal to end Mexico’s 70-year state energy monopoly until next week. The delay comes as political parties extend negotiations, aiming to reach the broadest consensus possible. Pena Nieto is seeking to change the constitution in order to allow foreign companies to pump crude oil in the country. To Pena Nieto’s advantage, a more aggressive proposal was submitted last week by an opposition party, improving chances of his bill being passed by Congress.
- As shown in the graph below, property sales in China remained resilient in July with a 12.4 percent increase year-over-year. New property starts surged to 45 percent in July after rising 14 percent in June, as land sales accelerated by 108 percent. Overall, property activity showed broad-based improvements, which should drive up sales of housing, auto and home appliances.
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- State-backed lending in Brazil has overtaken private loans, adding pressure to the fiscal balance and prompting the country to ask the International Monetary Fund (IMF) to lower its debt calculation in the face of a downgrade threat. Government controlled banks accounted for 50.3 percent of outstanding loans in June, which has eroded the nation’s perceived creditworthiness. Brazil’s Finance Minister Guido Mantega has asked the IMF to exclude treasury debt held by the central bank from its gross debt tally. In June, Standard & Poor’s threatened to lower Brazil’s credit rating if the country’s fiscal position did not improve. Brazil’s 68.5 percent gross debt level, as measured by the IMF, overtook India’s level last year, becoming the highest reading of the BRIC group.
- Disappointment in Russia’s GDP for the second quarter should have set a stronger argument for monetary-policy easing. The central bank however, has dictated that Russian banks will face tougher rules despite being the main drivers of the economy. In Russia, consumer loans are the main source of economic growth. Nonetheless, households face a large burden of 20 percent of their income on servicing loans, according to Herman Gref, CEO and Chairman of the Board of Sberbank. Elvira Nabiullina, who took over as Russia’s central bank governor in June, is attempting to reduce banking risk by limiting borrowing, even as she seeks to bolster growth. Yet, forcing the limitation of consumer credit on banks appears counterintuitive in a situation of very low growth.
- Currently one of the top policies in China is to deleverage the economy by reducing shadow banking and to cut capacity in steel, cements, non-ferrous metals and coals. Since many over-built industrial facilities are running at losses, and therefore rely heavily on shadow banking for the repayment of interest and debts and to operate cash flow, the deleveraging could cause bankruptcies in the next 6 to 12 months.
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