Wondering if we're seeing another redux of an Asian currency crisis? Or if the world will catch China's cold. Or for the meeker of us, how the hell does one actually trade and speculate in the current market. All these are burning questions that are better left for the charts to answer.
Key themes that presently revolve around the podium include: A full fledge currency war in the East; the U.S. Fed's interest rate liftoff; a protracted bear super cycle in most commodities; and China's conundrum.
If 2014 was Nirvana for global risk markets, 2015 is solidly shaping up to be a Valhalla for chasers of returns. The immensity of events, be it on the micro or macro scale, should usually lead to directional moves which should make logical sense over time. This is not what we're seeing.
As traders, we have to say that it has been an incredibly difficult haul generating profits be it in currencies, equities, or bonds. Prices are now mostly either in convoluting ranges, or in overextended trends. The S&P 500 has gone just about no where year-to-date, the Dow 30 is red for the year, while stocks in most emerging markets are much lower.
There's Nothing Like Statist China
If it doesn't ring to you like state-controlled siren everytime a minor hiccup happens, then you're not paying attention. The Chinese are living in economic denial, and the government wants that to continue. It does this by rapid and frequent interventions in the banking sector, outright manipulation in the financial markets, and messing with its currency.
First it was that draconian rout in China's stock markets, which was covered in our latest Guest Post. That was met with unprecedented state intervention from the Chinese government, which always believed that it had overarching reigns over how its markets traded. As it turns out, the politburo is quickly loosing credibility in its ability to tame the animal spirits of China's massive pool of retail investors.
Chinese stocks are still extending their decline but Wednesday saw another state funded liquidity injection into the banking sector, to the tune of $80bn. Stocks rose. Mission accomplished for now.
But just when the markets thought that was all there is to it, China sent shockwaves across the world in yet another surprise move. 8 days ago, the PBoC devalued the yuan by fixing it much lower against the U.S. dollar. USDCHN (offshore yuan) spiked more than 3000 pips from low to high. It was the largest 2-day devaluation in history.
Very few were able to predict this move of desperation by the Chinese government. 3 days before its shocking move, China's trade balance printed dismally, missing analysts' expectations. It was logical that Beijing moved to act, especially in light of an appreciating greenback (thanks, Fed). The economic costs associated with maintaining its previous yuan fix continue to mount, until enough was enough.
The Chinese apparently think a 'weaker' yuan equals more exports, which equals better growth figures. Economists however understand that economics isn't a linear science...
There is no where else in the world, where any economy commensurate with China's level of development, can such a degree of intervention be found. It is almost every other month that the CCP either steps in directly to control (a nice word for manipulate, which is what it really is) the markets. Proof is in the details.
The easy reason to justify the move is of course to put it on trade. Since a weakening trade balance is the last thing China needs to ensure it caps 2015 with a solid '7%' GDP growth rate, it needs exports to rise. Interestingly, the government never mentioned trade as an official reason for its yuan revaluation. But we fully expected that...
The government has for now remained muted on the future path of yuan fixing, saying that any revaluation will be gradual. Economists are however calling for a 10% depreciation for a sizable effect on exports. Let's see who's lying.
Which Translates To An All Out Asian Currency War
It is naive to think that China's yuan shocker would be an isolated event. It was Japan in 2010 that first launched the first bout of currency wars in modern financial history. Back then, the BoJ went bonkers on its own programs of QE (which has still not worked their charm on its economy till today), monetizing just about everything it could both to ease monetary conditions and to kill any last shoots of yen strength.
Just like China today, Japan was confounded with a rapidly strengthening yen (for different reasons). The yen was seen as the world's safest haven in times of financial turmoil, much like the Swiss franc was and still is. A strong yen hurt Japanese exports, probably not a nice thing when its economy was still stuck in a decades-long deflationary spiral. The inevitable devaluation ensued. So following in the footsteps of Japan, China seems to be on the same path of weakening its currency to gain export competitiveness.
However, the real drama actually begins when other econimies react. And how would they react? Well, by too devaluing their currencies. Look no further than Vietnam.
To be fair, reaction by foreign countries has so far been relatively mild. What's more disturbing to us is that the currencies of most Asian countries (China, S. Korea, Indonesia, India, Thailand, Hong Kong, Taiwan, Singapore, Malaysia, Philippines, ect...) have been in their own routs against the U.S. dollar. On a trade weighted basis, the same observation exists.
The starkest example being the Malaysian ringgit. A massive political scandal involving Malaysia's long standing Prime Minister Razak Najib and his trust entity (1MDB) is said to involve some $270mn in embezzled funds. Approval ratings are plunging, confidence in Malaysia's reigning political party is slumping, fund outflows are rising. The ringgit has fallen to record lows against the U.S. dollar, breaking the big figure of 4 to the dollar, with little sign of stoppage.
And it doesn't end there. Malaysian stocks are crashing as foreign investors are pulling out en masse. The latest official CPI inflation of 3.3% smashed estimates, and is a painful reminder of the consequences of depreciating currencies.
It's not just Malaysia that is feeling the brunt of what we like to call a global wave of derisking. Most Asian stock markets are in the red for 2015. China's main index is down almost 30% from its highs and remains as stable as a top spinning at half speed. Even South Korea's Kospi Index is in the cusp of entering a bear market. But what's all this derisking for? Cash on the sidelines?
The combination of crashing commodity prices, global economic growth uncertainties, and a strong U.S. dollar has weighed hard on EM currencies such as the Indonesian rupiah. USDIDR has surged in recent weeks and remains close to record lows as with many others.
An important fact to understand is that most Asian currencies are either managed floats or completely pegged to a reference benchmark. The result of this is strong impetus to weaken one's currency should the benchmark strengthen too much. Naturally, if the benchmark falls, inaction would convey the same for the managed currency.
It just so happens that the Chinese yuan is a key component in many of these benchmarks, meaning a weaker yuan would translate into many weaker currencies.
Emerging Market Currencies Crucified
The real action is not in stocks or bonds but in emerging market (EM) currencies. The top contenders for the ultimate widow maker seems to be the Turkish lira, most recently. Not tailing too far behind are the Malaysian ringgit, Mexican peso, Brazilian real, Indonesian rupiah, Indian rupee, and the Russia ruble. A lot of these EM currencies are Asian, but their are exceptions.
While the U.S. dollar is broadly weaker post July's disappointingly hawkish FOMC minutes published on Wednesday (again leaked before standard press time), EM currencies have persistently been weakening against just about every other non-EM currency that is trades in the markets. The ferocity of these moves does remind us of the Asian Financial Crisis of 1998.
As it turns out, politics, economics, and a swath of other global headwinds have caused a concerted depreciation of EM currencies for much of 2015. While the macro drivers have been instirmental in their part, what is lesser talked about in the mainstream media is the aversion to emerging markets altogether.
Most emerging markets have seen widespread retail and institutional fund outflows since the Fed ended its QE program in September 2014. Almost a year later, the effects are painfully brutal. Starved of easy money, funds have been repatriated to where they initially originated from - developed markets.
While developed markets were easing monetary policy and exporting inflation, emerging markets were tightening policy to control rising prices which had a lot to do with the hot money inflows the printing presses had endowed the markets with.
Much of the outperformance seen in EM markets were not a function of internal fundamentals but were supported by the constant streams of capital seeking returns abroad.
The reverse is now true. As developed markets start transitioning to tighter monetary policies, EMs have started their own phase of easing. The West has been exporting deflation to the East for more than a year now, dampening growth and spuring currency wars as we've just seen China snap.
What goes up artificially will come down in reality...
Growth Concerns Are Very Real
It seems like there are real things to fret about. The global economy is not in the best shape it has been over the last 3 years or so. Each economic cycle has become more truncated and difficult to forecast. China remains the fastest growthing major economy of the world, at least according to state-controlled official data.
Shenenigans aside, the diverging directions each and every economy of the world seems to be traveling in makes being an adept economist pretty challenging. Divergent economic cycles spell divergent monetary policy cycles, which ultimately means lots of chop in the financial markets. Which is exactly what has happened as you will see further down.
And of course econimies that are heavily dependent on traditional manufacturing industries, and conmodities tend to suffer the most. Notable ones are Australia, Brazil, India, many of the Persian states, South Korea, Russia, Turkey, and so on.
Inflation is another factor that weighs very heavily on the minds of central planners. Inflation is raging in some parts of the world (thanks to their routing currencies), while there is a total lack of it in many parts of the developed world.
The contrast cannot be more pronounced. We're seeing developed economies such as Switzerland, Norway, Sweden, the U.S., Canada, Japan, the UK shivering from disinflation or outright deflation; central banks there are keeping monetary policy easy and interest rates very low. On the other extreme, we have developing and third world economies the likes of most Eastern ones seeing hard to contain inflation with monetary policies directed towards managing upside price risks. Wow!
Making Markets Ever Harder To Trade
We've been ranting about this for quite some time now. Overall market conditions have made it very unfavorable for speculators and investors alike. The volatility we're seeing isn't the type most are accustomed to. The VIX (fear index) remains at extremely suppressed levels, but that hasn't translated into the typical melt up in equity prices as it would normally have been.
Active participants in the market get a sense that everyone is waiting for everyone else. Adamant on taking on excessive amounts of risk, we hazard that many institutional funds are heavily overweight cash as we seem to lean back on the liquidity presence.
The dichotomy between fundamental valuations and multiples has also continued to bully investors into believing that sub-15 P/E are now a thing of the past. If something isn't sustainable, it won't continue forever. Be forewarned.
Things are also different underneath the surface. So called "black swans" are now becoming a commonality. Mega moves occur regularly even in highly liquid asset classes such as currencies, equities, and commodities. Of course the easy scapegoat would be high frequency traders (HFTs), but we tend not to believe that HFTs should take all the blame. For another story...
The most important take away from all this is, how do we trade in such harsh and unforgiving conditions. Reiterating what we said earlier, in such a scenario, it is difficult to loose a lot but also difficult to make a lot. A long-short portfolio has done better YTD, judging by hedge fund returns classified by strategy. Equities and fixed income remain lackluster while the real action is in currencies and commodities.
But Trends Are Also Overextended
The chops may be strong, but the trends are even stronger. It is harder for the layperson to jump onboard a speeding train hoping to emerge unscathed. Such is the case with the double faced markets - a poker face on one side, a delirious face on the other. You can't make this stuff up!
Crowded trades, as we like to call them, are plentiful. Anything from being short EM currencies, oil currencies, commodity and industrial currencies, and being long the U.S. dollar in contra is definitely a crowded trade. Shorting most commodities puts you on the same wagon, while shorting oil makes you a real hippie. Energy, industrials, materials, and EM are the biggest shorts across multiple asset classes.
If everyone is short, then who's long and long what? The only markets that are large and deep enough to accommodate all that counter weight without spilling over hysterically are the bond and currency markets. The U.S. dollar is the obvious most longed asset right now, while we suspect treasuries are either neutral to slightly shorted.
Which does make us very worried indeed. Worried that once this boat tips over, an epic capitulation would almost certainly ensue. We already saw the first glimps of that in April when the U.S. labor market posted a shocking NFP figure of 130,000. Long positions in the dollar were instantly reeled back, and it happened all at once. We've never really eclipsed April's highs in the dollar index (DXY) since.
Some crowded trades are however justifiable. Trades such as the proverbial short oil play remain a big winner for those convicted enough to stick to a consistent theme of a supply glut in the physical market. Crowded trades can however stage violent and abrupt moves from time to time. Our experience with mega trends has taught us that trends tend to get stronger before they die out; and die do they either in whimper or a bang.
Which still ultimately causes more hardship for chasers of returns. It's a tough play jumping abroad protracted trends, especially when one considers the potential risks involved with entering at the top or bottom. 2015 is shaping up to be a nightmare.
All Because The Fed Is Holding Everything Hostage
At least the Fed knows better than to pull an SNB. Nevertheless, markets have never been more reactive every word emanating from the FOMC, like lithium is to water. For a long time, ever since it announced tapering down of QE3, the world's most potent central bank has been trying hard to guide market expectations towards a gradual interest rate liftoff.
Almost all of the dollar strength we've seen this year has been because of expectations of a rate hike later in 2015. The consensus is clearly calling for a September liftoff, with December coming second.
However as we've clearly stated in April, we expect at liftoff to be in October's FOMC meeting at the earliest. 3 options are available for the committee's selections: September, October, or December. We're almost certainly going to get a liftoff in 2015. That's clear.
But that's not the point. The point is the apparent seizure the markets seemed to have developed in response to the Fed's language and posturing. To be honest, we're irked. Very irked by this nonsense - the markets are now a blender machine with Yellen at the controls.
Any implied hawkish tone and risk aversion befalls everything. The opposite holds true. If the Fed had a third mandate of maintaining financial market stability, it would have failed miserably.
But Is the U.S. Economy Any Good?
We'll leave this one for you to decide. The Fed says labor market conditions are trending towards full employment but aren't there yet. The bright spots: The labor market, housing (relatively), consumer confidence and sentiment. The dim spots: Inflation (core and broad), corporate profits, manufacturing and industrial activity.
The Fed continues to place emphasis on 2 pivots - prices and employment. A tug of war between differing idealoges and market vectors has proven too tricky to call.
Despite factoring out falling energy prices and volatile food prices, core inflation has slowed to just above nil. July's core CPI inflation printing at 0.1% has stoked concerns that the Fed will not hasten towards lifting off as soon as the markets expect. The mandated 2% Keynesian inflation target has not been met for more than 5 years running.
To us, prices should only start rising once real wage growth accelerates. We believe this can only happen after the Fed's zero interest rate policy (ZIRP) is lifted and borrowing costs are allowed to rise throughout the U.S. economy.
This chicken and egg enigma seems not to have caught the eyes of Princeton economists. We wonder why.
The quantity aspect of employment in America's labor market have been mostly addressed. When focusing on the quality aspect of it, one should discover that many job additions come in the form of part-time employment, and low skilled labor in blue collar industries such as F&B and hospitality.
The number of skilled jobs has actually gone down over the last year, but for every one skilled worker fired, 2-3 part-time and lower skilled ones are hired. Go figure...
Regardless of how optimistic or conservative these extrapolations get, one thing is for certain. The transmission will always be through the Fed and its interest rate policies. Markets will therefore continue to be heavily dependent on data until the rates have officially been raised.