I certainly understand why the headlines focus on Thursday’s 7% drop in 29 minutes in Shanghai or the worst ever start to a new year by the U.S. Standard & Poor’s 500 or the plunge in oil to a 12-year low for West Texas Intermediate crude.
All this short-term stuff is very scary.
But frankly it’s not what worries me most at the moment. From a slightly longer perspective–six months or so–the current plunge in China’s Shanghai market is Stage 2 in what looks like a crisis of confidence for Chinese traders and investors.
After years and years stock markets would reliably rally from any plunge on actions by the People’s Bank of China and the Beijing government to support markets, in this Stage 2 the Chinese government isn’t having much luck with measures designed to rally stocks. Today, for example, government moves that would have in the past led to a rally recouping half or more of the week’ 12% plunge have brought the Shanghai Composite a gain of just less than 2%.
It’s clear that the Chinese government is getting less stock market bang for its intervention yuan.
Some of that is because of the truly inept policy decisions being implemented by the Chinese leaders.
And part of it is that Chinese investors and traders have come to recognize just how inept, badly designed, and self-contractory these policy decisions have been. In fact, on the evidence of early 2016, in the eyes of (some? many?) traders and investors the Chinese government has moved from the solution to market woes to the cause of plunging stock prices.
The financial markets look like they’ve lost faith in the institutions–regulators, the People’s Bank, the central government–that have in the past come to the market’s rescue.
If that’s the case we’re looking at a crisis in the Chinese stock markets that isn’t fixable by suspending circuit breakers or adding $20 billion to the money supply (as the People’s Bank did this past Tuesday) or announcing another list of new investments in airports or rail lines. And if that’s the case then we’re looking at a crisis that is capable of hamstringing China’s efforts at economic and market reforms that are essential to move China through the middle income trap that so frequently stalls developing economies.
And to the degree that this crisis is a crisis of confidence in China’s central bank (and associated financial institutions in China), then what we might be seeing is actually just the most visible signs of a global crisis as investors and traders lose confidence in the ability of all central banks to manage financial systems and economies. It sure doesn’t help global confidence that the policies of the Bank of Japan and the European Central Bank have been unable to achieve the goals announced by those banks.
Let me start with what I see happening in China and explain what I call Stage 1 and Stage 2 in this crisis.
Stage 1 starts with last summer’s plunge in the Shanghai market. The Shanghai Composite Index peaked on June 12 at 5166 and then plummeted to 2927 on August 26. That’s a drop of 43.3% in two-and-a-half months. The Chinese government responded with a familiar mix of policies almost immediately announcing, for example, a cut in benchmark lending rates and a reduction in the amount of reserves that banks need to keep against outstanding loans. That latter step is equivalent to adding cash to the financial system; the People’s Bank also directly injected yuan into the system using its open market operations. A few days after the initial moves, the central bank also announced that it would roll over 130 billion yuan in loans to bank, extend the maturity on those loans to six months from three months, and cut the interest rate on those loans by 0.15 percentage points.
Those moves were more aggressive than the efforts the bank has taken in earlier market plunges. And what’s important is that, this time, they didn’t succeed in ending the sell off.
To do that the People’s Bank and other regulators had to promulgate some very coercive commands directly to the market itself. Brokerage firms were ordered to avoid negative comments on the market. All scheduled IPOs were put on hold in order not to drain funds from already listed stocks. Owners of stakes bigger than 5% in a company were ordered not to sell. Investigations into brokerage firms and employees were launched the focused on conspiracies to forcing stock prices lower.
By August 26 all these efforts had succeeded in stabilizing the Shanghai market at 2927.
The recovery from that bottom took the Shanghai market back to 3642 by December 21. That’s rally of 24% and a retracement of more than 700 points of the 2200 points Shanghai stocks had lost from June 12 to August 26.
But the rally didn’t hold. And the market went back into a slump even more volatile that the June to August plunge. From December 21 at 3642 to the close on January 7, 2016 at 3125 Shanghai stocks gave up 500 of the points gained in the 700 point rally from the August bottom. The December 21 to January 7 drop added up to 14.2%.
Why call this Stage 2?
First, because the drivers of this drop are much the same as in the June to August drop.
Second, because the policy response by the Chinese government has, so far, been largely the same as in the June to August plunge.
And third, because this drop marks an escalation of some of the worries about the competency of China’s market regulators at the country’s central banks.
Let me go through the first two reasons quickly since I think you’ll be relatively familiar with this turf and so I haven’t moved too far into “eyes-glazed-over” territory by the time I get to reason three.
First, the causal connection. Remember that back in June-Augut the worries were the China’s growth rate was slowing; that a slowing global economy was depressing China’s exports and export-based economy; that a renminbi/yuan linked through the exchange rate set by the People’s Bank was causing China’s currency to appreciate (and again hurting exports); and that efforts to add necessary market reforms to China’s economy risked bankrupting some of the country’s biggest employers.
I think the current plunge has been based on a strikingly similar list of worries–with the addition of worries about the huge drop in China’s foreign exchange reserves as cash flees China in search of better or safer opportunities and as the People’s Bank burns cash in an effort to prevent the renminbi/yuan from falling too far, too fast. An uncontrolled drop in the currency would unnerve financial markets and make cash flow out of the country even faster. China’s foreign exchange reserves dropped by $513 billion in 2015 to $3.33 trillion. (And despite efforts to prop up the renminbi/yuan, $843 billion left China between February and November, according to Bloomberg.
Second, the policies being use to support the financial market in January include many of the same policy tools run out in June through August. That’s become extremely clear this week as the People’s Bank has added cash to the financial system–just as it has done in every previous bout of market turmoil and as it has pulled back on removing some of the measures it took in June-August to support the market then. The most obvious example of that was the decision to lift a ban on selling shares owned by investors holding 5% or more of a single company’s stock. That ban, left over from the June-August crisis was originally scheduled to be removed today, January 8 but regulators decided to leave it in effect for now.
And third, this time around investors and traders are seeing the incompetencies and policy failures of the People’s Bank and other regulators, which were present in the June-August sell off– exposed as never before. Think it makes trader feel confident about the markets and the people who run them when the country’s security regulator says about the new circuit breakers that made the plunges so much worse this week that it had imposed the policy despite having “no experience” in using this tool. (And when market rules already said no stock could fall more than 10% in a day.)
I’m seeing more and more questioning too–from financial professionals at companies inside and outside China–of basic policies at the People’s Bank. For example, how can the People’s Bank explain injecting cash into system in order to increase liquidity (and spur the economy) at the same time as its efforts to support the yuan remove cash from the system? (The People’s Bank buys renminbi/yuan to support the yuan which removes currency from the financial system and the economy since the bank finances those purchases with bonds.)
There’s a growing body of economic commentary that argues that by maintaing a managed link to the dollar, using the trading range established each day by the People’s Bank, China is effectively importing the Federal Reserve’s program of economic tightening into a situation where other officials are focused on loosening spending, lowering interest rates, and boosting growth.
Is anybody really in charge? Does anybody really know how to run this economy?
Those aren’t the kinds of questions that are good for a stock market trading at a median price to earnings ratio above 60. (The U.S. market, for reference, trades near 20.) Market valuations in China’s financial markets, dominated as they are by individual investors, have always priced in an assumption of effective government support for stock prices. If investors and traders start to lose confidence in their central bank and it’s policies, we’re likely to be looking at a long period of downward movement as that “confidence premium” is removed from the market.
It’s important to remember that no trend goes straight up.
Today we’re seeing a continuation of profit taking in the dollar and a move up in benchmark U.S. oil prices on bets for a short term bounce.
The dollar is now down 2% in December as traders who made money from the strength in the dollar earlier this year sell. With the Federal Reserve’s December 16 increase in interest rates behind us, there really isn’t a big event to push the dollar higher until the market starts to anticipate the next interest rate increase from the Fed. The U.S. central bank signaled a potential four rate increases in 2016. Right now the consensus in the market says that the first of these won’t take place until April. That leaves plenty of time to take profits now, avoid any weakness in the dollar in January and February (maybe even short the dollar) and then get back on the long side in late February and March.
The reverse is true for oil. After West Texas Intermediate broke below $35, the best short-term trade is likely to be to the long side. The danger is, however, that any bounce will be very, very temporary if inventory numbers due for release tomorrow show a build in inventories. A survey of oil sector analysts by Bloomberg shows that they’re expecting an increase of about 1 million barrels in Wednesday’s report from the U.S. Energy Information Administration. That would leave inventories about 130 million barrels above the seasonally adjusted five year average. Anything more than that could quickly erase any upward move in oil prices.
I don’t see much conviction in either move today. This is the time of year when trading volumes start to dry up and traders close profitable positions ahead of Christmas and New Years.
On my paid site CURRENCIES week has ended with a post “3 strong dollar, weak euro (and Brazilian real) picks”
For the last week or more on my paid site JubakAM.com I’ve been writing about currencies.
How long will the dollar rally go on?
What’s the bottom for the euro and what route will it take to get there?
Is the biggest looming danger in global markets right now a potential devaluation of China’s currency?
Today, I ended this string on currencies with a post giving three picks for a strong dollar/weak euro market. You’ll recognize one of the three–it’s the iShares Hedged Currency MSCI Germany ETF (HEWG) that’s in my Jubak’s Picks portfolio. The other two are Luxottica (LUX), a member of my long-term 50 stocks portfolio and (surprise) BRF (BFRS), a Brazilian producer of chicken and beef and packaged foods. The post offers some timing advice on when to purchase and, of course, much more detail on why these picks make sense to me now.
For that, though, you’ll have to subscribe to my JubakAM.com site. Tomorrow on that site I’n going to take a brief trip through the banking sector–remember bank stocks are supposed to do well when interest rates are going up, and then I’ll start a string on oil (with an explanation of what the Saudis were thinking when they led OPEC to do away with production quotas.)
That’s what I’m working on at my subscription JubakAM.com site. I think there’s some value to you in passing on the direction of my thinking about the market on that site. Hope so anyway.
Of course, there’s an ulterior motive to sharing this with you: If you decide that you’d like more detail on my JubakAM.com posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
Certainly the headline is important: In November China’s foreign-exchange reserves declined to the lowest level since February 2013 as the People’s Bank of China sold dollars to prop up the renminbi/yuan ahead of the International Monetary Fund’s decision on adding China’s currency to the very exclusive club of global reserve currencies along with the dollar, the yen, the euro and the pound.
But the commentary on that headline is more likely to move financial markets in the short term: In order to maintain adequate liquidity, while reducing its currency interventions, the People’s Bank will cut bank reserve requirement ratios four to five times in 2016, according to an email response from Standard Chartered Bank to questions from Bloomberg.
China’s currency reserves dropped by $87.2 billion to just $3.44 trillion at the end of November, the People’s Bank reported today, December 7. That brings the reduction for 2015 to $405 billion, as far as outside analysts can tell. The bank also uses the forward futures market to support the renminbi/yuan and that may or may not be reflected in these numbers. (The IMF approved adding the renminbi/yuan to the fund’s Special Drawing Rights basket in a change that will take effect on October 1, 2016. That decision is likely to spur buying of the Chinese currency by central banks and other institutions that track the IMF’s currency portfolio in their own holdings.)
While the pressure to buy renminbi/yuan and sell dollars ahead of the IMF decision is now over, cash outflows from China are likely to continue into 2016 as individual Chinese test the limits of new rules on moving money out of the country and as Chinese investors and individuals look for higher returns in the United States after the Federal Reserve starts raising interest rates. Bloomberg reported today that Macquarie Securities is projecting that China’s reserves could drop to $3 trillion by the end of 2016.
A slip in the renminbi/yuan would likely be welcomed by the People’s Bank and China’s economic leadership since a lower renminbi/yuan against the dollar would provide a boost to China’s exports and to a flagging economic growth rate. In offshore trading the yuan fell 0.32% to 6.3671 to the dollar today in Hong Kong.
But a few international investment houses, such as Goldman Sachs, are predicting that the “normal” decline in the renminbi/yuan won’t be enough and that China will force an actual devaluation of its currency. A devaluation of the sort that China pursued this summer would send shock waves through the currencies and economies of other Asian exporters.
Of course, it is frequently hard to tell what policy China is pursuing in the financial markets until well after the fact. Which will make it hard to interpret the greater volatility in the renminbi/yuan that is likely to accompany the reduction in currency interventions promised by the People’s Bank as part of discussions about the IMF’s decision letting China into the currency club. Is that volatility simply a reflection of a less aggressive People’s Bank or a sign that China is pursuing a stealth-devaluation of its currency?
You can expect any slippage in the renminbi/yuan against the dollar to bring that question to the fore—at least until the markets decide they understand the new rules at the People’s Bank. (Whenever that might be.)
On Thursday December 3 the European Central Bank will send deposit rates even further into negative territory, increase the amount of bonds that it buys each month, extend its program of asset purchases, and expand the range of assets that it buys—or maybe all of the above.
The financial markets will be waiting to see if central bank President Mario Draghi throws the kitchen sink at the EuroZone’s combined problems of slow growth and even slower inflation or if he keeps some policy options in reserve.
You should watch to see how the currency markets—especially that for the dollar and the euro—behave. Will we see the euro rally and the dollar drop on a sell on the news reaction? Or will the dollar keep climbing against the euro on a belief that a strong dollar is about to get even stronger after the U.S. Federal Reserve raises interest rates?
The euro fell another 0.3% against the dollar today to close at $1.0565. The EuroZone currency fell 4% in November and finished the month down 12.65% for the year.
To me it looks like the market has priced in much of the kitchen sink program and if that’s the case I think it’s likely that we’ll see a bounce in the euro here. There’s strong support for the euro near $1.04, a level that marks the March low for the euro. If Draghi gives traders much of what they expect on December 3, I’d expect to see the euro move up slightly on the theory that all the likely news is priced into the currency pair and that the move to $1.04 isn’t enough to stick around for.
That makes sense to me in the short term, but in the medium to longer term a euro bounce assumes that Draghi’s new dose of the same medicine that hasn’t worked very well to increase inflation and or growth will work this time. That seems questionable to me at best—why should more of the same work now when it hasn’t done much of anything over the last six months?
I’d expect to see a renewed downward trend in the euro not too long after any bounce as the dollar resumes its climb after the Federal Reserve finally raises interest rates in December (current odds better than 70%) or in early 2016.
If you’re looking to put on weak euro/strong dollar trade, I’d wait to see if we get a bounce on the news after Thursday and then look for a resumption of the euro’s decline and the dollar’s rise.