Market to put yesterday's rout behind after PBOC's rate cuts

Outlook:

We have already had altogether too much commentary on the global equity rout but we can’t resist the cartoon below. Maybe the Schiller adjusted P/E showed the US market overvalued (but maybe not). We say traders got into a selling panic because the prices of their holdings were falling. In any single case, this is not irrational. One should always seek to cut losses, preferably at a pre-set level. Selling by a lot of individuals becomes the semantically-loaded “herd behavior” in the minds of those who don’t have anything at stake. Sometime herd behavior is the wisdom of crowds, as when the herd all jumps back as the crocodile appears.

The herd also returns to the river to drink after the crocodile snags his prey or goes away. As we are seeing with the rapid jump in European equity indices and US equity index futures this morning, traders buy when prices are rising. There is no need to attribute any fancy mental work. Nobody really knows whether the new PBOC measures will work, and in fact, several analysts have already said they will not. But never mind. The market wants to put yesterday’s rout behind it even as it’s perfectly willing to do it again if a Shock appears.

It’s always tricky to try to combine economic analysis with specific instances of trader behavior. We always marvel that when one big market takes a bath, unrelated markets fall in sympathy, even when the connection between the two is so remotes as to be nearly invisible. This is mostly the case with the China rout. For the US market to drop 1000 points because of the Shanghai and Shenzhen rout is ridiculous. Whatever happens in China economically and financially, very few US companies will feel any impact on their earnings. The US exports very little (except for Boeing) to China, so even a major economic slowdown does not much affect US companies. In fact, the devaluation and need to raise exports is probably good for the lower prices US consumers will see.

Cartoon courtesy of a Reader. Source is Senior Technical Strategist at Capital Management. Ed Matts http://marketvisiontv.com/.

All the same, very big moves in the world’s second largest economy are going to have a pinball effect, ricocheting around the global markets. It’s not irrational to worry about the real economic conditions in China, especially when we feel we can’t trust the data, if only because China holds such a large amount of Treasury bills, notes and bonds. We have zero evidence that China will dump dollar reserves, but it’s not nuts to worry about it.

So just how bad are conditions in China? The NYT reports today that Harvard’s Kenneth Rogoff names the key factor in his book (with Rinehart) It’s Different This Time. The key factor is excessive debt. The NYT names the McKinsey study last year saying “The country’s debt load rose from $7 trillion in 2007 to $28 trillion by mid-2014….. At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany…. Several factors are worrisome: Half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable.”

Others agree. Former TreasSec Paulson, a China expert, said “Frankly, it’s not a question of if, but when, China’s financial system will face a reckoning and have to contend with a wave of credit losses and debt restructurings.” Hedge fund manager James Chanos “has been sounding the alarm on China for years, recently declaring, ‘Whatever you might think, it’s worse"

While the global equity effect of the Shanghai meltdown may already be ending, China’s debt problem and growth problem remain. Does that mean the Fed should be forecasting a China crisis that should stay its hand in September? SocGen, Barclay’s, Nomura and Morgan Stanley all say yes, and it may not be December, either. Goldman Sachs has a US economy conditions index showing conditions have already tightened considerably. It’s an incomprehensible index consisting of the riskless interest rate, spreads, equities and FX combined against the one-year forward GDP. Huh? Others say it has to be September. After all, the stock market may seem to “lead” the US economy but in fact, it has very little to do with the real economy.

Today’s data make that point. We get Redbook Chain Store Sales, the FHFA House Price Index, the Case-Shiller Home Price Index, Consumer Confidence, the State Street Investor Confidence Index, the Richmond Fed Manufacturing Index, and New Home Sales. Quick, find China in there.

We expect the euro to resume its upswing after the current correction ends. The yen may recover somewhat as fear subsides, but the old target of 125 is but a dream now.

Note to Readers: We will not publish any reports on Thursday, Aug 27 or Friday, Aug 28. We sus-pect readership is already very low this August and will be near zero by then.