"Living at risk is jumping off the cliff and building your wings on the way down."- Ray Bradbury
Since Q4 2014, we have been explaining why China had little option but to devalue its currency (Rcube Macro Portfolio 20/11/2014). Last week’s move is just the early step of a much more meaningful devaluation. Authorities always choose to devalue as opposed to reforms when a crisis hits. China is currently dealing with deflating housing and equity bubbles, but also debt and economic restructurings all at the same time. The odds that in such difficult environment they choose reform over devaluation are extremely low in our opinion.
On a trade weighted basis,August devaluation puts the yuan only back to where it was in May. Since mid‐2011, the real effective exchange trade weighted yuan has appreciated by 43%. It is no coincidence that it is precisely since then that economic conditions have started to worsen. The Yuan needs to weaken much more.
Chinese equities will keep plunging as long as the currency is not devalued more meaningfully.
Capital outflows are intensifying.
Authorities are tapping reserves which have fallen by $350bln to prevent the yuan from falling sharply, which de facto tightens financial conditions. FX reserves as % of M2 is crashing.
Authorities had to cut reserve requirements to offset the unintended monetary tightening. As the inflation rate is falling faster than the PBOC can ease, monetary policy easing is hard to achieve.
The China Momentum Indicator (CMI) weights together information on electricity consumption, rail freight volumes and credit growth. Based on those three 'easy to measure' indicators preferred by Premier Li, the indicator tells us where growth is heading over the next year or so. Based on the indicator, Chinese GDP is estimated to be below 3% and still falling.
As a result, the Chinese government could be facing both a crashing equity market and a weaker currency in the medium term. The perception by Chinese people that the government advertised so strongly investing in equities creates a political risk if the market were to crash. This could be the catalyst for a more meaningful currency move.
The MSCI emerging market has finally broken below its key support (900). An acceleration is underway. 2008 low is our target.
EM corporate bond spreads do not reflect current risks properly, they have barely started to widen. EM financial conditions are tightening, EM corporations have borrowed almost 5trn of US dollars, and their currencies are plunging together with their cash flows (commodity crash). At the same time because the US twin deficits are shrinking, there are less dollars in circulation. This is a recipe for disaster. It is now unfolding.
EM corporate bonds have massively outperformed equities over the last 5 years, we think this is unsustainable given the EM credit channel tightening, weakening cash flows, capital outflows, and the substantial refinancing needs coming to maturity.
The current disconnect between credit risk and equities in the US (Rcube Macro Portfolio 27/07/2015) relies on the belief that there will be no contagion from the energy sector credit risk to the overall market. We believe otherwise.
Furthermore, deteriorating corporate credit health is visible across all sectors. US financing needs are going through the roof. As a result, corporate credit spreads remain extremely mispriced. The energy story only adds risk to this phenomenon by intensifying outflows. Equity volatility will spike higher and close the gap with credit risks soon.
Additionally, bullish sentiment is falling from historical highs as fast as in 2007. This is a major new development since we strongly believe that it is a prerequisite condition for risky assets to fall further. As John Hussmann regularly says, “the difference between an overvalued market that becomes more overvalued, and an overvalued market that crashes has little to do with the level of valuation and everything to do with the attitude of investors toward risk.”
Diminishing risk seeking attitude visible through sentiment measures, widening credit spreads, and negative market internals represent clear warning signs for global equities.
EM assets have entered a panic/liquidation phase that will end when EM corporate bonds will have priced in correctly the risks facing the asset class. We are still far away in terms of valuations.
Investors should watch carefully EM corporate bond spreads as well as US high yield ones for clues about potential risk aversion contagion. A break below 2040 on the SPX will confirm a medium term top is in.
"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot