All eyes will remain on China and the China fallout

Outlook:

Despite EU Econ Commissioner Mosovici’s denial of a global recession at Davos today, sentiment is shifting to exactly that outlook. That’s the Big Picture perspective. The triggers are falling oil prices and China, and the key outlet is equities. As we saw yesterday, a little seeming stability in oil prices, the yuan and stock markets quickly restores some risk appetite, but the smallest setback trashes it again. Former IMF chief economist Blanchard blames the herding instinct, but that’s a normal side-effect, not the main event.

By now we should know that oil prices are probably going lower and we will not see $50-60 oil again for many moons, possibly all year and into 2017. Every bit of data and analysis points that way, including yesterday’s IEA bombshell on oversupply. You’d think the world, including oil traders, would have accepted it by now. Screaming headlines that the drop in oil to under $28 “causes” stock markets to fall into bear market territory are short-sighted, shallow and just plain wrong. The real reason is slowing growth and fear of global recession.

To slowing growth and fear of global recession we must add uncertainty surrounding China. We find it hilarious that yesterday, according to Market News, a Chinese official asserted “China’s GDP calculation is based on solid and accurate basic data,” an acknowledgement that the rest of the world is skeptical about Chinese honesty. This is not unfounded. After all, China tries to manage the economy in a thousand ways and in addition, discloses national character by stealing everything that isn’t nailed down, especially technology.

It’s not knowing what China will do about its crisis that sets nerves on fire. Some reports today say the absence of any new initiatives was one driver of non-Chinese stock market declines. And even with a few days of relative stability in the yuan, the outlook remains for a big, fat devaluation at some point and sometime soon—within 6 month

Goldman writes that a big one-time devaluation is the least of three options. More likely is a lesser fall against the dollar and a managed fall against the basket. Goldman expects the yuan to rise to 7.00 over the coming year, or a 2% trade-weighted fall. Bloomberg gives us a quote of 6.5793 today, so 7.00 is barely a burp.

But others, including a hedge fund manager named Hart (Corriente Advisors in Fort Worth, Texas) featured in a Bloomberg story, see a one-time devaluation of as much as 50% or more. “Why should China be forced to suffer deflationary effects of defending its currency when everyone else isn’t?" It will cause problems for the Chinese holders of $1.5 trillion in dollar-denominated debt, but too bad. The yuan should not be so strong. “Despite recent weakness against the dollar, the yuan has gained 36 percent over the past decade against a Bloomberg basket of 13 currencies designed to replicate the official CFETS RMB Index.”

Bloomberg goes on, “He’s not the only hedge fund betting against the yuan. Carlyle Group’s Emerging Sovereign Group in New York and Omni Partners in London are also positioned for a retreat in the currency. Crispin Odey, who runs Odey Asset Management, said in September that the yuan should fall by at least 30 percent.”

And Reuters has a story on the non-deliverable forward market (NDF) showing clear evidence the wind is blowing the way of a big devaluation. “The NDF market shows the yuan staying close to the current spot rate of 6.58 per dollar for the next month, then falling 0.9 percent in the second month. The NDFs have priced in a decline of 1.4 percent toward the end of April.” One analyst summed it up: "The market is betting on the yuan fixing flatlining for at least two months and then a big depreciation, just like in August."

China will hold fire until later. One special “weak spot” for the timing might be the lunar new year holiday that starts Feb 8. “One-month NDF points have moved down sharply from 988 points in early January to 400 as speculators priced out any odds of the move happening within a month. Six-month NDFs have also fallen since early January, but far less and are at 2055 points or double the levels in November. The NDF curve spreads narrow beyond six months, indicating markets do not expect a devaluation to be delayed beyond then.”

We have no idea whether China will be able to resist a big devaluation. Clearly it wants to, in order to curry favor with the IMF, which can still take it off the list of “reserve currencies” used in the SDR basket. But equally clearly, the peg to the dollar and even to the new basket does not serve the Chinese economy well. For the moment, the problem is the lack of transparency. To be fair, governments are not supposed to leave a trail of hints that allows evil speculators to take advantage, but the markets would like to see some evidence China has a plan—any plan. Despite official denials, many observers have been expecting new stimulus measures that never materialize. The market is seriously out of sync with the Chinese government and it’s not the market’s fault—it needs information.

Can we blame China for emerging market equities at a 6-year low and European equities at a 13-month low? The S&P hovering near the Aug low and probably breaking it today gives the hint—August was the last Shanghai crash and followed within two weeks by the yuan devaluation. So, yes, we can blame China.

We admit to being a little surprised the crisis mentality returned so quickly and so virulently when yesterday it seemed to be settling down. Under normal conditions, we get a bounce after a big sell-off. We still think the euro is vulnerable to a Draghi Moment, but right now that seems to be the least of our worries. All eyes will remain on China and the China fallout. We advise getting out and staying out until the dust clears.

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