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 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, is plaguing some industries,
relate to this world-order? And on the other hand, how many of few
hundred million people that China has lifted from poverty was 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,
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, rather than the
European and Japanese reliance on bank-centric model, coupled with a particular
set of property laws, and arguably lower regard for the environment (NY state
has banned shale production on environmental and health grounds), and 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 pace way for the
omnibus spending and tax bill, that includes 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 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 it 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 next
week.
China also suggested
to 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 next 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 the market is
not a very stable institution. It should be mistrusted. So while China may announce new measures, such
new circuit breakers, likely 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.
In addition to
the performance of the yuan, Chinese shares, and oil, there are a few economic
reports that standout.
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 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.
Last Week's Drivers Still with the Whip Hand.
Reviewed by Marc Chandler
on
January 10, 2016
Rating:
Reviewed by Marc Chandler
on
January 10, 2016
Rating:
