It is Europe not China that is seeking “currency depreciation to stimulate the economy”

30th November 2015 by Mark Tinker

Thanksgiving last week made for a shortened trading session and most books were positioned ‘flat’. What the US refers to as the ‘holiday season’ is now underway and excepting some likely activity around the options expiry on December 18th, it would be sensible to expect declining volumes from now into year end. This is likely to involve some book squaring – taking profits and closing shorts, which may well lead to some short term rotation and increased volatility generally. We have seen a little bit of this in metals, with evidence of short covering in copper and  zinc in the last few days, but ultimately these prices will only truly respond to some supply discipline. Interestingly gold continues to struggle. In equities this lower liquidity tends to manifest itself in more exaggerated reactions to earnings and other news flow.

The general view in the US ahead of the presidential election year is that things are ‘OK’. Not great, but not bad either, which in reality has been the case for the last few years but markets chose to be either too positive or too negative. Now they are ‘actively indifferent’ to US macro. Last week’s Black Friday sales in the US were an opportunity to compare the US consumer to their Chinese counterpart. At first glance the numbers are a fraction, the $2.6bn spent in US stores pales beside the $14.3bn spent on Singles Day in China earlier this month. The difference, however, is one of footfall, the Black Friday events are all about getting customers out and into the stores and shopping malls, whereas Singles Day is far more of an online event (around 70% of Singles Day sales were online). It will be interesting therefore to see how Cyber Monday in the US plays out. Whatever the number, it should start to highlight simply how large the Chinese market now is for consumer goods.

Chinese markets closed last week with a number of the brokerage stocks limit down in response to further crackdowns on insider dealing and short selling. There were also a number of other technical announcements to do with limiting leverage (not using derivatives to provide margin) which, in contrast to many commentators we see as being entirely consistent with the resumption of the initial public offering (IPO) pipeline. As discussed on previous occasions, the IPO mechanism is a necessary part of the venture capital/crowd sourcing funding environment, rather in the manner that new cars need the existence of a second hand car market. The Chinese authorities recognise that this mechanism needs not only to be ‘clean’ but to be seen to be clean, hence the recent anti-corruption announcement on the former head of China IPOs and this latest move on several of the large brokerages.

Other structural changes continue to affect the markets in the region. This week China is set to receive approval for the inclusion of the yuan into the special drawing rights (SDR) basket of the International Monetary Fund (IMF), something that the Chinese authorities have placed a great deal of emphasis on. Indeed, as discussed on many occasions previously, I believe that everything we saw with the exchange rate back in August was about achieving this inclusion. The currency needed to be volatile, otherwise it is nothing more than a US dollar clone, but not so volatile as to make investing in Chinese assets impossible to hedge. It also needs to be strong, a weakening currency will put off long term investors, but not so strong as to generate a destabilising carry trade, as arguably had been happening over the last few years. This is undoubtedly a difficult act to pull off, but so far so good. What it is not about however, is “a currency depreciation to stimulate the economy”. To be honest, I am not entirely clear where this populist meme has emerged from. However visiting Europe last week it is certainly something approaching consensus, although to be fair, the strength of conviction has weakened somewhat in the wake of the latest Foreign Exchange Reserve figures that showed an increase last month. The drop in reserves had been mistakenly described as ‘capital flight’, when as per numerous previous weeklies, the detail showed a far more nuanced mix of currency conversion, divestment of reserves to policy banks and paying down of overseas corporate debt.

This week will also see the inclusion of the Chinese ADR stocks into the MSCI Emerging Markets index. These stocks are essentially ‘new China’ plays such as Baidu, AliBaba etc. and have been known as N shares. When global investors have been seeking to ‘play China’ in recent years, they have tended to largely use proxies, such as 1) mining and energy stocks, 2) luxury goods, 3) emerging markets in general, 4) global consumer companies accessing the Chinese consumer, 5) Macau gaming stocks, and 6) N shares. Now, with the ongoing shift to China Growth 2.0, the N shares are the only decent proxy left. With index weightings on China now shifting from 20% to 26% and also a shift within that weighting away from ‘old China’ stocks (including banks) to ‘new China’, these stocks should continue to benefit from positive flows. So far a basket of these stocks has outperformed the broader Chinese market by around 25% since October.

The failure of the ‘old China’ growth proxies is, I believe,  a key reason for the negative sentiment held by many Western investors over China.  One of the stories for next year will, I believe, be a steady dismantling of this Western consensus on China as a slowing/failing economy with ‘questions over the ability of the leadership about commitment to reforms’ and  need to stimulate growth through cutting interest rates and depreciating the currency. Everywhere we look (if we care to) we see ongoing, incremental reforms,  while  Xi Jinping, China’s president, publicly stated (in Seattle, Washington) that China will not depreciate the currency. This not only tells us what the policy is, but puts strong political commitment behind it. That and $3trillion of reserves. The noise traders are naturally getting very excited about the recent weakness of the RMB against the dollar and the spread between the onshore and offshore RMB, but then getting excited about moves that are too small to impact the real world and which only matter when hugely leveraged in foreign exchange (FX) trading books is basically how these guys make money.

Chart 1 shows the rates for onshore RMB (also known as CNY) in orange and offshore RMB (also known as CNH) in black. The spread between the two is shown on the right hand scale and is currently 3 basis points (bps). Under the previous regime it was basically zero, but the whole point of the new (SDR compatible) regime is that the rates are market set.

Chart 1: Onshore and offshore RMB

Meanwhile, in the real world, if I were to go to HSBC and ask to convert my dollars into RMB, they are currently offering a rate of $1 = 6.32 RMB (the other way around i.e. RMB to dollar the rate is 0.16, or 6.25). That is a spread of 10-18bps below the CNH rate. This is not to criticise HSBC, rather to highlight the importance (or not) of the 3bps spread that is currently exciting the noise traders.

To me, the description of a leaderless economy desperate to stimulate growth through currency depreciation and unconventional monetary policy fits Europe far more neatly than it does China and investments in Europe need that background in mind. The statements by Mario Draghi, President of the ECB, that he would do whatever it takes to achieve the 2% inflation target have certainly been interpreted by the FX markets as a reason to sell the euro now with what the FX traders call ‘a five handle’ and very close to the lows touched in April. Should the US payroll numbers out this coming Friday be strong again, the dollar traders will likely push the pair trade even harder, threatening other major currencies such as sterling (at 1.50 very close to getting a ’four handle‘) and the yen.  A year ago, the consensus was for the US dollar to move higher, even though the US dollar trade weighted index had already appreciated from 80 to 88. In fact so broad was the consensus that many strategists were tempted to call for a pull back. However, mean reversion was trumped by momentum, as is often the case in FX, and the index briefly broke 100 back in March. Now as we close out the year, we are very close to that previous high and look set to book another double digit gain for the US dollar. This experience tends to make international (dollar based) investors think about currency hedging non dollar portfolios, which will further exaggerate the moves. The other trade being put on is the divergence trades between US and European bonds.

The expectation of further quantitative easing (QE) by the ECB has pushed European bond yields down even further in Europe – ironically in some cases to levels that no longer qualify the bonds for purchase. German two year bonds, for example, are now offering minus 0.45%! The ‘QE junkies’ are undeterred, suggesting that the ECB will now buy other expensive paper in order to stimulate the economy. Personally I struggle to see the sense in all of this, as we have seen in the US, this only benefits the existing owners of expensive assets (who naturally are those lobbying hard for the programme) and doesn’t result in any expansion of credit in the real economy. In the meantime you seriously damage the ability of your existing long term financial sector to meet its obligations. It is all very well to use monetary policy to prevent inflation rising above 2%, essentially by limiting credit expansion through price, but the idea that a central bank should encourage credit funded spending – or a run-down of savings balances – in order to clear a supply demand imbalance seems very strange, particularly if, as seems to be the perception, the ECB is focussing on a slowdown in China. As explained elsewhere, China has created a surplus of almost every commodity and no amount of demand stimulus is going to clear that (and push up commodity prices) any time soon. It’s a supply story.

Nevertheless, the story remains that the investors’ playbook for QE is to buy real assets, but hedge the currency.  Chart 2 shows the returns to a dollar based investor from investing in the Euro Stoxx index or a hedged equivalent ETF, indexed to 100.

Chart 2: European stocks – currency hedged

In any event, the lower commodity prices driving the low inflation that the ECB seem so worried about are actually helping European consumers, particularly lower fuel prices, while the fiscal screws are slipping, providing back door fiscal stimulus. In the periphery we are seeing more socialist governments (Greece, Portugal) while even committed austerity governments, France and the UK, seem to be back pedalling and Germany seems to have stopped resisting. Currently, there is credit growth in Europe, which is one reason to be optimistic, although  the risk is that prolonged QE does the same as it did in the US, where money growth and credit growth is now slowing dramatically.

Looking into 2016, the biggest risk remains the Middle East, where the shooting down of the Russian jet by Turkey last week put a different twist on the unfolding  saga, with travel stocks in Asia selling off and (excitable) talk of Turkey closing the Bosphorus to Russian ships. The underlying story remains a Sunni versus Shia struggle played out with Russia and America on the side lines, sometimes aligned, sometimes not. What should not be overlooked is the budgetary issues emerging from lower oil prices across the Gulf in particular. We are already seeing an end to petrodollar surpluses and a divestment phase, which will have implications for the assets held by many of the other commodity based sovereign wealth funds as well . This could be part of the explanation for the gold price.

More prosaically, assuming the Middle East settles, we are looking at a world where the US grows, but profits start to shrink, China continues to grow, but in its new, consumer focussed manner and the Eurozone stumbles, but the underlying consumers remain surprisingly healthy, especially in the ‘Arc of Prosperity’ running from Scandinavia down through Austria, Germany and Switzerland. A shift to real assets, as with Abenomics in Japan, will benefit areas such as property, while smaller and medium sized companies focused on consumers – both domestic and international, have the opportunity to make good profits. As stock pickers we always tend to think that it is about stocks not benchmarks and this year, it looks to be true more than ever.

Meanwhile the divergent monetary policies suggest a continued strong dollar, which will present issues for a number of emerging markets with dollar debt. Technical analysts suggest that a break above 100 on the dollar trade-weighted suggests a further 20% move. If so, then this could be the dominant story of 2016.

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