Macro: The Chinese New Year

The gyrating market this week so far has more than done its bit to jolt people out of their holiday stupor. The Chinese equity markets and the law makers kept everyone, well, engaged. Late this afternoon we have seen some respite after the Chinese authorities repelled the stock circuit breaker rules. Equities rallied from day's low and bonds sold off. All fine and good. The question is, is it time to fade the market full of confused and panicked investors? Or should you panic yourself instead.

 

Whether the Chinese episode is something to worry about depends on the opinion about how in control the Chinese policy makers are, and what is their line of thinking. Chinese Yuan devaluation is not necessarily such a risk-off thing in itself. Arguably the Chinese authority looks at CNY against a trade-weighted baskets and not only dollars. And also in terms real effective exchange rates, Yuan is far from cheap, and a bit of regression to the mean (at whatever the authorities think it should be) should not cause so much pandemonium. Then again, it is not clear how much control the authorities have in executing these changes. Last year, and this year so far, most of the Yuan "devaluation" has been rather abrupt. This may be the communication policy of PBoC. But apparently that did not go well with the market. The re-balancing problem in China is a real thing. And it is just that, a re-balancing problem. If it can be controlled, with controlled devaluation and a smooth transition from investment based to consumption based GDP, and most importantly manage the debt from blowing off in between, this will be an adjustment.

 

If it is not controlled, it will be a crisis. Some are already calling it so. I tend to think it is not. Referring to someone who knows more about China than perhaps anyone else, there are encouraging signs in this rebalancing effort. The Chinese foreign exchange reserve is a hot issue in near terms. But more importantly, it is how they maintain the balance in the economy (low enough unemployment and no mass-bankruptcies) before they adjust to the new GDP paradigm is the most important question. And FX devaluation is a pretty smart and cheap way to achieve that. At a milder cost of a negative pressure on global inflation. Unless that creates a panic and becomes a self-fulfilling crisis.

 

Market seems to be focused on the second point of FX devaluation, fed by researches on where the level official reserve is and how much outflow it has seen in recent time. Remember how the Chinese market sold off massively in the June and rest of the world hardly noticed? And when that reversed in August when the PBoC revised CNY fixings. The question is how justified this fixation on FX is. The political economy in China is pretty much different than the developed nation or what we have seen in case of the Asian tigers or LatAms under sudden stop, The authorities, in principle, has much wider control on the economy. And if they do succumb to the sudden stop problem and that blows in to a full scale crisis with a collapse of asset prices, it will be felt far more geopolitically, than economically (apart from a certain global deflation, again). I would tend to assume so far what we have seen from the policy-makers are more likely to be mistakes and experiments than a sign of loss of control.

 

In the meanwhile, coming back to the original question, should to panic or fade? Statistically speaking, the odds are something like below (click to enlarge).

 

The charts shows the conditional upside and downside in representative equities after a given amount of weekly sell-off (the opportunity is the difference between upside and downside). It captures the next week's percentage move (vertical axis) given a percentage sell-off this week (x-axis). As we can see, with extreme moves come extreme opportunities. Equities so far sold off around 4% to 5% this week across markets. As you can see the time to jump in to wanton bullishness is still a couple of percentage points away, statistically speaking.

 

Note: these data sets excludes the wild days of 2008, but including them does not change the picture much.

Trading Places: The Eagle and the Dragon

The question is: if China becomes US in 2008, can US play the role of China in 2008?

What are the bazookas the Fed left with that would really impress the market in such an event? Buying risky assets (i.e. equities) is a potential candidate. What else?

Move Over Greece: The Down-Under Version

Since the surprise start of the week, and large rally in rates, rates are almost back to the levels it lost, with steeper curve, especially in Euro. Break-evens are little budged (except a sort of swing in sterling) and dollar marginally stronger and Euro marginally weaker. Only equities still nursing the wounds so far.

I think my optimism about UK turned out to be justified so far. Data-wise US, UK continue on strong data flow. At the same time, I think we are focused on Greece more than it deserves and missing other big thing in the bargain - the unraveling of the Chinese stock markets. This will definitely have a strong influence on the Australian rates markets. I have argued before that the AUD curve is to steep and has to flatten. Since then it flattened from 100+ to 70bps level and now back to 105 (in 5s30s).

We can propose a simple model of the factors that drive the slope in line with similar models for Euro and USD. The explanatory variables are the terms of trade (CTOTAUD Index on Bloomberg), RBA policy rate, and the China current account balance (GDP is also somewhat significant, but not included, inflation not much significant). The estimates are as below.

The model fits as below (click to enlarge)

Post-crisis there is a change in unconditional expected level of slope, which is higher that what it used to be before 2008. But also a couple of changes interesting: a higher sensitivity to China current account balance (as percentage of GDP) and RBA policy measure. The RBA part is as expected. On the China sensitivity, one conjecture can be that current account balance shrunk in China primarily as exports reduced, along with a reduction in imports. That directly impact Australia, and builds in pressure for bull flattening.

This, along with the current directionality of rates with slopes means a very asymmetric positioning for a AUD flattener. If we see a strong return of job growth and commodities inflations, we will see a more hawkish RBA, leading to a flattening. If we see a further worsening in sentiments from China, but no deterioration in inflations, the correlation should lead to a bullish move. A separate estimates shows for each 1 percentage point reduction in China current account balance (% of GDP) leads to a 30bps rally in 5y and 17bps in 30y in AUD.

Given this, and the recent steepening and sell-off in AUD rates, it is a good opportunity to enter a trade. It can be either a flattener (probably balanced by a 5y point to take care of the directionality) or it can be a 5y or 5y5y outright receiver. And all of this will have a positive carry. Which can be used to pay for a sell-off protection in either EUR, GBP or USD long end.

All good, then there is this one possibility of course.

This is NOT Nuts, Where is the Crash?

The secret of making money in the market is to bet against it and then be right as well. As a far-fetched corollary, we can also say when everyone is worried about a market crash, that is perhaps not the best time to actually position for a crash. Even if they are central bankers warning of over-valuation of certain stocks or warning of outright market crash. Central bankers have not shown particular excellence and consistency in timing the markets. Keywords charts for "asset bubbles" and especially "market crash" bursting through the roofs here!

So here we take a look at the global market valuation. We have all range of valuations, from downright moribund Russian stocks to upbeat Mexico. And these excludes much of emerging and frontier markets. As good as a time to stay invested for long term, as any other time. And look for value.

And the markets seem to understand. We have hardly seen any great shift in momentum in equity flow. We have seen recent outflows in emerging market debt, high yield and developed markets equities. And also some increased flows in to US and core Europe bond funds. But before you listen to financial analysts and talking heads, there are very little evidence of flight to safety here. On longer term, what we are seeing is NOT rotation, rather a reflation, i.e. money continues to flow in to both bonds and equities. This is corroborated by central banks flows of funds accounts, as well as other higher frequency flow data. The amount of recent outflows from US equities is dwarfed by the amount pumped in since the financial crisis.

There are reason to believe these latest rounds flows in to bonds has little to do with safe heaven demand. The unforeseen consequences of changes in regulatory landscape (BASEL 3, SOLVENCY 2, all leading to higher bonds demands) and austerity and stress on balanced budget (leading to lower supply) may be the major driver. Clearly yield chasing has been significant as well, but there is some amount of caution out there - see the recent outflows of high yields. The real dangers are the developed economies getting in to the next recession following a natural business cycles from a much lower peak than past recoveries, and a China problem. But none of these present an extreme tail scenario to me. And if your expectation is a total Chinese melt-down, then heaven save us! So unless we see a central bank induced shock therapy gone wrong, a crash may never come anytime soon. At least not when everyone is looking for it! 

And even if it does arrive, probably it will be safer to stay in equities than in fixed income

And, oh, if someone tells you the evidence of irrational exuberance in the equity market is the insane levels of margin debt on NYSE and/or the cheapening of put skew, just sigh and shake your heads.

Yet Another India Vs China Story

A very interesting piece from IMF Direct blog!

It captures how the trade integration within Asia has phenomenal compared to other regions globally for last two decades, centered on the China growth story. And it also highlights how this has resulted in increased synchronization, and increased propagation of growth shocks between regional partners. This, is claimed, has given rise to a high correlation among Asian economies, as they provide this chart for quick evidence

And when I look at this chart, I find India has a pretty interesting position. In fact some might argue, based on this chart, that betting on a Chinese shocks can be structured through short Australia and Korea and long India and Philippines, adding statistical leverage.

Although I am doubtful this negative correlation in economies will translate to the correlations in markets in the event of a severe chines slowdown. Irrespective of how good or bad the economic story is, India will face consequences on international financial flows if we see a real serious slow down in China. The question is what happens when the dust settles down. India is a net importer from China, with some overlaps of export to other developed countries. So certainly will suffer much less directly through a slowdown in China. In fact can even benefit from reduced competition in global markets. But by any means economic downturn of the second largest trading partner is no good news, even if it runs a net trade deficit.

But if the slowdown in contained, I think there will be some focus on this issue and India will see some part of the flows from the Asia focused funds, trying to limit Chinese exposure

In fact, long-term market correlation supports this. NIFTY has been much more correlated to S&P 500 ...

... than Shanghai Composite