Drivers for the Week Ahead

cash, marc

  • Developments in China have seemed to overshadow other considerations as investors returned from the New Year
  • The shale production and reduction of energy dependency helped pave the way for the omnibus spending and tax bill
  • We downplay reports of competitive devaluations under way because of China’s FX moves
  • In addition to the Chinese equity market and oil prices, a development which commands attention is the yuan
  • US earnings season official kicks off; US data may disappoint

Price action: The dollar is mixed against the majors as markets remain nervous. The dollar bloc and sterling are outperforming, while the yen and the Norwegian krone are underperforming. The euro is trading back near $1.09 after being unable to break above $1.10, while sterling is trading near $1.4560 after earlier making a new cycle low just below $1.45. Dollar/yen made a new cycle low near 116.70 but has since moved back to trade around 117.50. Most EM currencies in Asia and Europe are lower. There are a few exceptions, in addition to China. The Singapore dollar, Indonesia rupiah, the Malaysian ringgit and Thai baht managed some modest gains. Central and east European currencies are lower. It was the South African rand that tested the intestinal fortitude of participants today. After the dollar had closed last week near ZAR16.30, it shot up to ZAR17.91 in Asia, amidst talk of a large unwind of long rand short yen position in particularly thin markets. In the subsequent activity, the dollar drifted back to ZAR16.50, where it consolidated in the European morning. MSCI Asia Pacific ex-Japan was down nearly 2%, with Japan closed for a holiday. MSCI EM is down 2% and making new cycle lows, with the Shanghai Composite down 5.3% and the Shenzen Composite down 6.6%. Euro Stoxx 600 is down 0.1% near midday, while US futures are pointing to a lower open. The 10-year UST yield is up 2 bp at 2.14%, while European bond markets are mostly softer. Commodity prices are mostly lower, with oil, iron ore, and copper all down around 2%.

Developments in China seemed to overshadow other considerations as investors returned from the New Year. The offices were open and desks manned, yet many did not appear to be prepared to re-deploy resources. The lack of participation helps explain last week’s drama. Sellers showed up or were forced through money management practices (e.g. stop-losses or options triggered).

The buyers were not really on strike, but they do not often buy right out of the gate. There was the Epiphany celebration in Europe that allowed many to extend the holiday. There was also the US jobs data at the end of the week, which many had expected would contain important information for the chances of a Fed hike later in Q1.

By most conventional measures Chinese shares are over-valued. Moreover, because of the lack of transparency, and a regulatory regime that shifts quickly, a case can be made that when valuing Chinese shares, there should be a discount.

Often we confuse form and function. China has a stock market like others do. That is the form. The function, however, is different. China’s market is dominated overwhelmingly by individuals. In contrast, institutional investors dominate US equity activity. In the US it is about raising capital (IPOs), distribution of ownership risks, measuring the cost of capital in the price discovery process, and managing savings and retirement funds.

In China, the government encouraged households to buy equities in 2013 and 2014 as an alternative to the opaque wealth management products, and the shadow banking sector, which had grown in importance.  Equity ownership is not widespread in China, as we learned last year, and linkages with the real economy are not very strong. There were reports that the some luxury goods sales fell even though an anti-corruption campaign was in full swing.

Look at China’s retail sales. They slowed from 11.9% in December 2014 to 10.0% in April 2015. During that period, the Shanghai Composite rallied about 30%. The market peaked in June. Retail sales were 10.6% above June 2014.   In November, they were 11.2% stronger and are expected to be even stronger in December when the data is reported on January 18.

It is fine for Fu Ying, the chairperson of the Foreign Affairs Committee of the National People’s Congress, China’s legislative branch, to complain that “the US world order is a suit that no longer fits” in a recent op-ed in the Financial Times. But how does China’s clumsy attempt to stabilize its stock market and decouple the yuan from the dollar fit into the so-called US world order? How does the excess capacity (which China openly acknowledges) that is plaguing some industries relate to this world-order? And on the other hand, how many of the few hundred million people that China has lifted from poverty were made possible by the decline in trade barriers and the freer movement of capital that is associated with that same world order?

Indeed, judging from the markets and the media’s coverage of last week’s financial developments, it would appear that the suit that has proved disruptive was not made in the US, but made in China. It is not clear who first adopted von Metternich’s claim about the implications of a French sneeze to America, but many seemed to think that China’s sneeze is what gave the global investors, if not pneumonia, then heart-burn.

The other major development last week, the diplomatic spat between several Middle East countries, led by Saudi Arabia and Iran is also hardly of the US making. It added to the negativity toward oil, as it underscores the low chances an agreement emerging from OPEC about anything, from a new Secretary General to production quotas.

The market system for the distribution of capital holds in the US, rather than the European and Japanese reliance on a bank-centric model. This, coupled with a particular set of property laws, and with arguably lower regard for the environment (NY state has banned shale production on environmental and health grounds) as well as a regulatory regime that encourages innovation, made possible the US shale industry.   Moreover, the US political culture has put an emphasis on being more energy-independent for forty years.

This position is perfectly consistent with neo-liberalism and its antipathy of monopolies and cartels. It is also perfectly consistent with republican (small-r intentional) political theory and its distaste for concentrations of power. The precipitous drop in oil prices has weighed on aggregate corporate earnings, durable goods orders, investment, and industrial output.   The impact bleeds through headline measures of inflation to soften the core.

These costs are mitigated by several considerations. First, the economic impact is transitory. The big cut in investment and orders was in H1 15. These will drop out of the comparison. When the energy sector is set aside due to its unique drivers, the non-energy producing economy is doing considerably better. This is evident in corporate earnings, strains in the high yield bond market, and investor returns.

Second, Bloomberg quotes the American Automobile Association estimate that the drop gasoline prices freed up $115 bln last year. Four-fifths, or $92 bln, was consumed. When the funds are spent on gasoline, much goes to foreign businesses as the US imports about half of it oil needs. Since overall imports are about 17% of GDP, the shift away from gasoline consumption is a windfall of as much as $76 bln to US producers and service providers (though of course, some is a transfer from US refineries to other domestic sectors).

Third, the shale production and reduction of energy dependency helped pave the way for the omnibus spending and tax bill. This includes the sale of some of the strategic reserves that are perceived to be less necessary than previously. This is to say that US oil output gives policy makers more room to maneuver. The lower price of energy (input) may also help lift the multi-factor measures of productivity. It also helped facilitate the end of the ban on oil exports, which was increasingly hard to justify while challenging other countries’ export controls and the lifting of the Iran oil sanctions.

In addition to the Chinese equity market and oil prices, a third development which commands attention is the yuan. It fell 1.5% last week. It is not a particularly large move, even for a major currency. For example, last week the Australian dollar and the New Zealand dollar fell more than four percent, and the Japanese yen gained 2.5%. The yuan is different. It is a closely managed currency despite the pledges that it will be allowed to be more market-driven. Last week’s move was the largest, second only to the decline this past August, for at least the past two decades.

The yuan is no longer a low vol currency. Indicative prices suggest implied vol finished last week near just below 8.9%. This is higher than last summer. Or consider that the 100-day average of 3-month implied yuan volatility stood at 2.25% at the end of 2014. It is now a little over 5.5% and rising.   This changes a quantitative characteristic for portfolio construction.

Chinese officials instruct us to consider the yuan’s movement against a basket of currencies rather than just the bilateral exchange rate with the dollar. China’s created its own index but does not appear to have provided the weights. Given this, perhaps looking at the yuan’s effective trade-weighted performance can offer a guide. It has fallen 3% since mid-November, but is still near record highs reached five months ago. It had appreciated by roughly 30% since early 2011 and has recouped almost four percentage points. The yuan rose by 50% since the 2005 decision to adopt what seems to have been a crawling peg. China will report December trade figures this week.

China also suggested we watch how the yuan trades against the other SDR currencies. Last week, while the yuan was falling 1.5%, the euro rose 0.5%, and the yen rose by 2.5%. Sterling lost 1.5%. Investors, judging press articles and the larger decline in the offshore yuan, fear China is resuming its depreciation campaign that was put on ice following the summer bloodletting, and ahead of the IMF’s decision to include the yuan in the SDR.

Many emerging market countries and some high income countries, such as Canada and Australia have been hit with a negative terms of trade shock as commodity prices have fallen sharply. For China, it is a positive terms of trade shock. Import prices have fallen more than export prices.   The large current account surplus argues against need for a significant currency depreciation. That said, China will report December merchandise trade figures this week. They are expected to show that exports fell on a year-over-year basis for the twelfth consecutive month. Yet if Chinese officials are seriously trying to engineer a transition toward a more consumer-driven service economy, a marked depreciation of the yuan would be an obstacle.

On one hand, with persistently lower yuan fixes, many conclude China is engineering a devaluation. On the other hand, China’s reserves fell by a record $108 bln in December as the central bank leaned against the tide and sought to moderate the decline.   A number of market forces are at play.

Many Chinese businesses took on dollar loans. Some are now reducing the currency mismatch. This counts as a capital outflow under the same accounting rules that considered the loan a capital inflow. Some of the outflow is not really outflow, but shifting funds from one part of China (mainland) to another part (Special Administrative Region, Hong Kong). Hong Kong’s reserves rose $3 bln in December. Last week the Hong Kong dollar was bid above the highs seen in last August’s turmoil.

Mr. Fu from the NPC may advocate a change in the US-system, but it is becoming clearer that change is even more urgent in China. Since the crisis, the US has changed the rules in finance. There is greater protection for consumer borrowers. There are more rules on banks. There is the Dodd-Frank that many argue went too far in reigning in financial institutions. Counter-party risk has been addressed through a more extensive use of central clearers. There is the Volcker Rule that bars proprietary trading. Many argue that by reducing risk-taking activity, liquidity has been adversely impacted. Whether these prove ultimately effective or not is a different issue. The point is that the US financial rules have reformed.

“Ham-fisted” has become a popular one to characterize China’s official response. As we noted last month, the lifting of the ban on IPOs and large shareholder sales that was imposed last year had exposed a vulnerability. The circuit breakers that went into effect at the start of last week were flawed, and accelerated the market meltdown (~10%). The circuit breakers were abandoned and apparently replaced by intervention. Part of the weakness in capital markets late Friday may have stemmed from uncertainty over what would happen after the weekend in Shanghai and Beijing.

From this experience, Chinese officials will likely draw a lesson that supports their already held ideas, which is the market is not a very stable institution. It should be mistrusted. So while China may announce new measures, such as new circuit breakers but with triggers at a greater distance, its ideological rigidity itself may pose an obstacle to the transition it is undertaking.

Reserve managers are unlikely to be impressed. Unsure of China’s motivation, it is prudent to assume the worst: that it seeks a maxi-devaluation. This will not entice foreign central banks to bolster yuan in reserves ahead of the actual inclusion in the SDR later this year. International asset managers are unlikely to be in a hurry to take on (more) Chinese exposure. And when they do, recent events may strengthen the case for sticking with ADRs or GDRs.

We downplay reports of competitive devaluations under way because of China’s FX moves. As noted earlier, many in EM in experiencing negative terms of trade shocks, and so their currencies are expected to depreciate. We do not think any policymakers in EM want a weaker currency, as most are fighting to lend support via intervention and other means. The multi-year EM boom has ended, and valuations across all asset classes are being adjusted. This process is being made even more difficult as the Fed normalizes rates. Because FX markets in particular are prone to overshoot, that means exchange rates are likely to remain volatile as the adjustment continues.

In addition to the performance of the yuan, Chinese shares, and oil, there are a few economic reports that stand out.

  1. US earnings season official kicks off. According to FactSet, the mean estimate is for a 5.3% fall in Q3 earnings. It would be third consecutive quarterly decline, the first since the first three-quarters of 2009. Revenues are expected to have fallen by 3.3%, which would be the fourth consecutive quarterly decline. The current projection is for Q1 earnings to rise 0.5% on a 2.5% increase in revenues.
  2. US economic data may disappoint. The risk is that unseasonably warm weather and the oil slump weighed on industrial output, even though the jobs data showed an unexpected increase in manufacturing employment. Retail sales may disappoint, with lower gasoline prices and a sequential decline in auto sales weighing on the headline. The GDP components may fare better, even after the 0.6% rise in November. Given that new Fed action is not on the table at the FOMC meeting at the end of the month, the Beige Book is unlikely to move the market.
  3. Eurozone industrial production figures for November are the feature. Germany and France have already disappointed, and this will weigh on the aggregate outcome. German industrial output fell -0.3% compared with a consensus expectation of a 0.5% gain. French output dropped 0.9%, which was three-times larger than expected.   Spain and Italy report. Italy’s economy appears to have picked up some momentum in the second half of last year. It could surprise on the upside, like the manufacturing PMI.   Spain’s economy has lost some of its spring. However, the political impasses appears to be breaking as Catalan’s Mas indicated he will not pursue re-election and this last minute move may avoid a new election, and the resolution there could boost hopes of a breakthrough in Madrid.
  4. The Bank of England meets. It is a non-event. Many have pushed a UK rate hike into the end of next year. There has been one MPC member that has been voting for an immediate hike. It might not make much of a difference if he rejoins the fold. It is not like McCafferty’s vote determines the dovishness or hawkishness of the MPC. The weakness of sterling is likely seen as a favorable development, unwinding part of the past appreciation. The risk is on the downside for UK industrial output. The consensus expects a flat report. Such a report would still seem to drag down the year-over-year rate from 1.7%. Industrial output rose 0.7% in November 2014, and this will drop out of the calculation.
  5. Japan reports November’s current account balance. It is expected to be JPY895 bln surplus, despite a JPY158 bln trade surplus. Japan reported a JPY1.46 trillion surplus in October. The driver is not so much the movement of goods and services, which may have accounted for about JPY350 bln of the deterioration, but the movement capital.   November is a poor month for investment income, which is the driver of Japan’s current account position.   Another component that may be becoming more significant is tourism. The relative weakness of the yen may have been a factor encouraging record tourism in Japan.