The Return of the Treadmill to Hell

Wednesday, 1 July 2020
Melbourne, Australia
By Greg Canavan

Today’s Insider will take a longer-term view of the world.

Over the past month or so, we’ve focused on short-term events. Has the rally run its course? Will the market turn back down? Who will win the arm wrestle between liquidity and economic reality?

We’ve covered that ground comprehensively. 

But let’s just wrap it up, given yesterday marked the end of the financial year and end of the second quarter.

In short, liquidity won. Rather, it won the quarter. From The Wall Street Journal:

The S&P 500 finished the second quarter up 515.70 points, or 20%, to 3100.29, its biggest percentage gain since the last three months of 1998. The Dow Jones Industrial Average added 3895.72 points, or 18%, to 25812.88, its best quarter since 1987. The rally has cut the indexes’ losses for the year to 4% and 9.6%, respectively.

The Nasdaq Composite, which is heavily weighted toward big tech stocks including Apple Inc. and Microsoft Corp., has fared even better, up 31% in the past three months and 12% for this year. Stocks wobbled to start Tuesday’s session before surging higher into the closing bell.

In Australia, the ASX 200 finished the quarter up 16%, while the Small Ordinaries Index rallied a solid 23.5%.

Over the financial year, the ASX 200 lost 11.2%. The Small Ords fell 10.85%. It was the worst financial year performance since the 2011/12 financial year.

Hmmm…what was the contributing factor behind that poor year for the stock market?


It was the beginning of a rather large hangover. China enjoyed a massive credit binge to get itself out of a hole created by the global credit crisis. It was a brilliant party. Aussie iron ore miners, and resources in general, had a great time.

But as inevitably happens, parties end and hangovers kick in.

The effects of this hit the Aussie market hard in 2011/12.

Which brings me to the point of today’s Insider.

China. And our relationship with it.

Things have changed a lot since those heady days.

China was our largest trading partner (it still is). But most considered China as a benevolent power.

That view has now gone completely out the window.

China is an authoritarian power. It is growing increasingly aggressive. And, I would argue, desperate.

I’ll explain why in a moment.

But first, just to emphasise the point of the changing relationship…

No doubt you’ve probably heard the news today. Scott Morrison is set to announce a $270 billion, 10-year defence plan aimed squarely at combating China’s growing influence and aggression in the region.

From The Australian:

It will include the development with the US of a missile defence shield against ballistic missile attack as well as potential long-range missile technology of up to several thousand kilometres to protect shipping lanes across the region.

Anti-submarine warfare, space-based intelligence and battlefield capability and underwater surveillance technology will also be developed.

The move will be seen as a direct response to the increasing Chinese militarisation north of Australia and the accelerated strategic and economic uncertainty fuelled by the coronavirus crisis.

“What I know is that the world has changed,” Mr Morrison told The Australian. “The world hasn’t known a time of economic and strategic uncertainty like this since the 30s and 40s. This has required us to sharpen our focus on our region and enhance our capability. We need to hold our potential adversaries to a greater distance. Part of our repositioning is to hold them further away and to work with multiple partners to achieve our goals of regional stability, peace and security.”

And, as commentator Greg Sheridan writes:

Australia faces this danger in a moment when everything has been thrown into disarray by COVID-19. It has exposed our vulnerable supply chains and it has accelerated every negative trend in the region.

COVID-19 is indeed a game changer. For the world, obviously. But for China, especially.

Suspicion of the origin of the virus and the management of it following the initial outbreak has changed the way the world views the Middle Kingdom. The world no longer sees China as an opportunity to sell to the world’s largest market and (until then) fastest growing large economy.

It is now a threat.

It is a ruthless, dictatorial regime that has infiltrated our institutions and has tried to buy political influence.

It is the source of most of our manufactured goods, and, in many cases, the supplier of a huge array of strategic goods.

In my view, this will create a structural shift away from the West using China as its primary manufacturing source.

If I’m right, this poses massive problems for China.

You might remember years ago, China bear Jim Chanos said that China was on a treadmill to hell. He was referring to its debt-fuelled growth path. That was 10 years ago.

And guess what? China is still on that treadmill. Only now, things look much grimmer.

At the end of May, total social financing (TSF) debt outstanding hit just over US$38 trillion. The size of China’s economy at the end of 2019 was $14.2 trillion.

So its total debt-to-GDP ratio is nearly 270%.

For a middle income, communist dictatorship, this is a hefty level of debt.

And it’s also potentially conservative. The Institute of International Finance, for example, includes debt not counted by Chinese authorities and put the debt-to-GDP ratio at the end of 2019 at well over 310%.

TSF debt is likely to increase by at least 15% in 2020, while GDP growth will be lucky to grow 3% this year. So the debt-to-GDP ratio will blow out even more.

The treadmill is speeding up. China has no other option than to run faster.

That means it will continue to churn out increasingly unproductive debt.

The optimists will say that it’s all good. China only owes this debt to itself.

That’s true.

But, in order to stay on the treadmill, China has a managed currency. It’s pegged to the US dollar. In order to manage this peg, it must impose capital controls. That means the huge volume of yuan-denominated debt it creates cannot escape.

But, like an overflowing dam, excess yuan will eventually want out.

The result will be a break in the currency peg. This will wreak havoc in global markets. It will be a deflationary shock. It will hit the resources sector particularly hard.

I don’t know the timing. I just know that it’s pretty much inevitable.

COVID-19 did indeed change the world…in ways we are yet to even see.