Diary of a Financier

On the SPX correction & China

In Capital Markets, Economics on Wed 2 Sep 2015 at 17:40

Everyone trivializing the Fed’s (expected) upcoming rate hike needs to stop being so ideological, stubborn, obtuse, etc…

Yes, in a vacuum, a +25bp increase to our zero-bound Fed Funds Rate should have a de minimis impact on the US economy.  However, economies are not such simple, static, single-factor  machines anymore. Consider…

  1. Globalization:
    Intercourse of trade & capital among nations have created various levels of co-dependence.
  2. Global, coordinated central bank intervention:
    Developed market CBs responded harmoniously to the Global Financial Crisis — albeit lopsided at times. This era is drawing to a close as the BoE and Fed are in the midst of decoupling from the ECB & BoJ.
    In their heyday, participating economies enjoyed asset reflation; uninitiated emerging markets were left to contend with a de facto beggar-thy-neighbor FX war. Subsequent DM inflation was exported to EMs, whose CBs were forced to tighten policy to prevent overheating.
  3. Global imbalances:
    Demographic variance between developed and emerging markets is at historical extremes.
  4. Debt supercycle

This is all good & well, and the Fed’s raising rates had been telegraphed, and markets had discounted it accordingly.  Markets are dynamic machines that should smoothly discount information as it comes (when they’re functioning properly). However, the fly in the ointment here has been China…

The attribution of recent US market woes to China’s market/economic collapse is mainstream.  Yet, everyone’s settling for the easy out, saying the correlation is unjustified given fundamentals: some version of either ‘China accounts for only 5% of SPX revenues’ or ‘the US economy is still healthy.’  All of these pronouncements are accurate, but they ignore sentiment.  So, while I expect SPX will resume its secular bull market in due time, I can’t call it wrong for taking short-term cues from Chinese markets.

~~~~

The most important point is that China’s currency ($CNY) is effectively pegged to the Dollar ($USD). Persistent currency pegs are unnatural mechanisms that invariably cause imbalances and excesses (like China owning a disproportionate share of global exports and therefore becoming an outsize creditor to the US Treasury). That USDCNY peg made for a wild ride throughout the Fed’s unconventional postcrisis easing programs: China suddenly had a currency that was even more artificially depressed, since the Dollar was under QE’s yoke.

Thanks to the world’s most fundamentally undervalued currency, Chinese exports boomed in the fever pitch of their economic miracle.  Since its economy was in its infancy, domestic profits had no other place to go but into domestic fixed investment.

Thanks to all this reinvestment, Chinese assets boomed.

Shortly, the Chinese had a problem on their hands: the fixed investment boom had outgrown its footprint. Buildings and infrastructure were being built for no reason other than there was no alternative use for the capital.  On the other end of the balance, global developed markets hit their sustainable growth rates/debtloads amidst demographic headwinds, so trade partners like the US couldn’t keep absorbing Chinese exports.

China- real GDP components (yoy % change, 2008-14)China needed to accelerate domestic consumption to help its economy accommodate this excess capital in a more productive outlet. This savings surplus can enable a high standard of living, but that process takes a lot of time.  (For example, it logistically requires time to reach the impoverished masses in rural China, and even there were an instantaneous mechanism, the velocity of money has a theoretical limit.)

Unfortunately, expectations of a Fed rate hike sent the US Dollar screaming higher over the last year, and the pegged Yuan followed.  As painful as this currency appreciation has been for US multinationals, it’s hit the Chinese even harder, because China’s far more dependent on exports.  That’s the direct correlation — the causation — that nobody is acknowledging.

The US economy is far more diversified, with a many-pistoned engine.  China isn’t there yet.  What global, coordinated central bank policy response giveth to postcrisis China (i.e. reflation), it now taketh away.

~~~~

Today, China needs a fiscal stimulus: put more cash into the hands of its citizens and incentivize consumption.  This is in stark contrast to its normal prescriptions: monetary stimulus, market intervention, and fiscal stimulus targeting fixed investment.  A consumption-focused fiscal stimulus is tricky to pull-off in China; there are still a lot of hard-t0-reach people living off-the-grid.  It’s necessary, though, to both accelerate its economic reallocation and break its effective USD-peg (giving CNY the competitive devaluation it so desperately needs).

The recent solutions of intervening with direct, open market purchases (and broad, institutional selling prohibitions) is a very naive, destructive approach.  On top of that, the Shanghai ($SHGIDX) is fraught with the fear-of-the-unknown.  Can we trust official Chinese data?  How much debt is there in the system that we don’t even know about?  How large is the shadow banking system?

…but none of that is news to anyone.  These are known-unknowns — bricks in the wall of worry.  In other words, these risks have already been discounted by markets like the Shanghai.

To wit, consider the following:SHGIDX weekly (2000-15)

Shanghai Composite ($SHGIDX)
+93% from crisis low (2008)
+74% from postcrisis low (2013)
-40% from ytd high (2015)
-48% from alltime high (2007)

The point of those stats is that the Chinese market has fallen almost 50% over the past 8 years — almost cut-in-half — across the same period that the economy has expanded more than 194%!  You don’t have to trust the integrity of their reported GDP growth (I don’t), and you can argue that they’ve pulled-forward years worth of growth (with unnecessary infrastructure spending), but their economy hasn’t contracted to that magnitude.  Per capital income and the standard of living have unequivocally increased — even on an organic basis (sans stimulus).

That doesn’t mean that today’s closing price of SHGIDX is fair value, oversold, or the bottom.  What it means is that SHGIDX is an incredible long term buy.DXY weekly

In terms of timing, unless Chinese regulators were to implement the fiscal stimulus I recommended above, I’d expect the worst will be over for SHGIDX by 2016q1, when yoy comps lap the USD’s spike, which launched in 7/2014, but really didn’t reach today’s plateau until 2/2015. So, the buying opportunity in China should arrive in 2/2016.

~~~~

Back to my original thesis now.  Yes, the US economy is still healthy on both a trailing & forward basis (see Q2 GDP & August PMIs).  Yes, direct exposure to China is de minimis (~5% of SPX sales).  Yes, the fundamental outlook is improving (see SPX forward earnings consensus).  No, the correction is not unjustified.  What we’re experiencing is a decline in stock market sentiment — confidence — which has been manifest not in fundamental deterioration, but rather in valuation multiple contraction.  If you’re the type of investor who insists on fundamental attribution, consider that the emerging market/Chinese growth miracle is a central tenant to SPX’s long term growth outlook, and endangering the former endangers the latter.  That hypothesis is manifest in the flattening US Treasury yield curve.

So, while a 25bp increase in the Fed Funds Rate may not be of much consequence to the US in isolation, it’s material within context of:

Decoupling global central bank policies

FX divergence

USD appreciation

CNY appreciation

Chinese slowdown

Global confidence hiccup

None of this is fatalistic.  None of this threatens the secular bull market.  Sentiment is transitory.  It’s the factor responsible for the market being a short term popularity contest, as opposed to a long time weighing machine.  On the contrary, this is opportunity!

–Romeo

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