China and oil stand as top priorities from the start of the year

Outlook:

We get important US data today—the Dec manufacturing PMI and the ISM manufacturing index—but unless the numbers are shocking, the day will probably be dominated by the China-inspired equity meltdown and worries about oil.

These two factors were always going to be at the top of the priority list this year, but nobody saw it coming on the first trading day of the year. The Chinese situation is parlous chiefly because we already had two instances of the Shanghai leading the rest of the world down, in 2007 and again last August. This is the classic case of contagion and has very little logic behind it. As we noted last summer, the Chinese participation in equity markets is very limited—the vast majority of Chinese do not trade equities or have the equivalent of pension funds/IRA’s invested in equities.

The end of the ban on large shareholders selling positions may well have started the stampede—more than crummy economic data, which goes to show that over-regulation is a bad idea. Traders live and die by anticipating what the crowd will do. This time they expected big players to take advantage of the first chance to dump positions. The problem is not that some did or were expected to. The problem is the scale—a loss of almost 7%.

If the ban had not been put on in the first place, the sell-off on economic analysis would almost certainly have been a lot less. A drop by 7% might be spread out over a quarter or half-year, not one day. Unfortunately, the government is likely to be as heavy-handed this time as it was in August, which markets outside China have already deemed chilling, if not outright toxic. Let’s note that the equity gang in every country is all too willing to freak out and there is always a crop of data that seemingly backstops the negative viewpoint. The FT has a splendid set of charts today showing various US metrics (P/E ratios, etc.) over a long period. That there is no particular cause for alarm is going to go unnoticed.

The other big deal is oil. Over the long week-end, there were plenty of articles and TV talking heads speaking of the supply glut and how we really can’t expect oil prices to recover, perhaps all year. The Reuters poll has the average 2016 price for benchmark Brent crude at $52.52 a barrel, down a whopping $5.43 below the poll in November. It’s the 7th consecutive monthly Reuters poll to deliver a price forecast cut—in May, the average forecast for 2016 was $70.90.

As for West Texas Intermediate, the average forecast is $49.75 a barrel in 2016, from $53.73 in November. The average in 2015 was $48.90. It’s one of the peculiar aspects of forecasting that just when farther-out forecasts reach a crazy-looking extreme, the price stops moving in that direction. So the question is whether $49.75 for WTI or $52.52 for Brent is crazy enough. We say no, we need to see the forecast range dip down into the $25 region before the market will stop obeying the forecast.

We see the same thing in FX. Every time the big player EUR/USD forecasts go to 1.0500 and 1.0000, the darn euro rises back up to toy with 1.1000 and 1.1500. It seem perverse but it’s a function of over-positioning by those who believe the forecast but can’t hold on long enough. There are always plenty of excuses for the euro to rise, despite diverging yields—more resilient growth, a more focused central bank, global turmoil.

Quite when and why the euro became the go-to currency in times of stress is not clear at all. Why does a shocking drop in the Shanghai cause the euro to go up? The other way to phrase that question is “when did the euro become a safe-haven currency?” This is something that has been brewing for a long time—we wrote about it in The FX Matrix—but today it’s more than confidence that the ECB will manage inflation better than the Fed. For the coming year, we need to watch out for this effect. It may well prevent parity.