Failed Correlation Trade Suggest China's Slump Could Be A Pause

Technically yes China's Shanghai index (SSEC) is in a bear market. Losses that reach 20% is technically defined as a bear market.

The SSEC could probably be haunted by the September-October seasonal stock market weakness.

In addition, many have used the Baltic Dry Index (BDI) as a "rational" for a major inflection point on China's stock market aside from the purported policy induced slowdown in credit flows.

Do we share the view that China's stocks will continue to collapse? No.

In contrast to the past where a decline in China's market had prompted for a rise in the US dollar index (for example see April) or our correlation trade, the recent slump have ironically been opposite-the US dollar Index fell!

Our correlation trade extrapolates to falling global stock markets and commodities along with a rising US dollar index (flight to safety) where a higher US dollar index would have signaled 'tightening liquidity'.

But this doesn't seem so. Hence the continued buoyancy in most stock markets.

The US stock markets ended lower last night but hardly reflected on SSEC's crash.

So if the US dollar index persist on weakening amidst sagging global markets, they are likely to signify an "interim pause" and not a major reason for a collapse.

And this should also apply to commodities.

As we see from the Russian experience, where the RTSI earlier fell by 30%, the Russian benchmark have managed to recover most of its loses and now trades above the 50-day moving averages.

This looks likely the paradigm for the SSEC than for a major meltdown.

Warren Buffett’s Greenback Effect Weighs On Global Financial Markets

``If it seems too good to be true, it probably is. Always look at how much the other guy is making when he is trying to sell you something. Stay away from leverage.” Warren Buffett, Three Rules for Average Investors

Hardly has the ink dried from the issues we dealt with last week when events unfolded almost exactly as anticipated, albeit in a fusion [see Will China’s Stock Market Correction Spread Globally?]

US Dollar Leads The Markets

Here is a summary of what we wrote:

1) We expected that China’s overextended markets to have some ripple or leash effect on global stock markets and the commodities markets.

2) The correction in the China’s markets would possibly trigger a correlation trade-where the US dollar would rise in conjunction with falling markets.

3) We also noted of a contingent provision-our suspicion that the US dollar’s rise wouldn’t find firm legs to stand on, ``if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.”

True enough during the early part of the week, global markets crumbled resonating China’s rapid fall. This initially prompted for a short rise in the US dollar index.

However, the US dollar index failed to maintain its bullish composure (can’t get to cross the 50-day moving averages) and eventually faltered steeply going into the close of the week.

Figure 1: Stockcharts.com: USD Dollar Index Leads The Markets

The result-global markets, especially in the US and Europe, came back with a vengeance. (see figure 1)

On the other hand, China’s market (SSEC down 2.83% week on week) appears to have hit our defined bottom range and has fiercely bounced back, while the commodities market caught fire- Oil (WTIC) sped back and drifts at its resistance levels!

And again we see some technical pictures failing to keep up with evolving market events.

All of these hyper volatile actions in just a span of one week! Amazing.

And when the US dollar leads the financial asset markets, it is no less than a symptom of inflation driving markets today.

Warren Buffett Warns On The Greenback Effect

Even the sage of Omaha Mr. Warren Buffett acknowledges the growing risk of inflation as the “greenback effect or greenback emissions”. Last week in the New York Times he wrote

(all bold highlights mine)

``Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

``An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

``The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

``Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

``Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

``Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.”

Here Mr Buffett makes an elementary calculation. I have to admit my admiration for Mr. Buffett’s ability to explain or relate circumstances in very simple “layman connecting” terms.

Essentially, US savers “borrowing from our own citizens” ($500 billion) + Foreign surpluses “borrowing from foreigners” ($400 billion)= $900 billion. US debt initially estimated at $1.8 trillion, which has been scaled down to $1.58 trillion equals a deficit of still at least $680 billion-that would have to be financed out of “a roundabout process, printing money” or central bank money from thin air!

The US treasury is slated to sell $197 billion next week (CNBC). This means that the US sovereign bond markets will likely be tested anew and the US dollar index will likely remain under siege or under pressure.

Analyzing Inflation From A Political Dimension

While many have been saying that because of the deflationary pressures in bubble stricken economies inflation won’t take hold soon, for sundry mainstream reasons of money velocity, oversupply, output gap, excess capacity, liquidity trap, capital short banking systems, Federal Reserve paying interest rates on commercial bank reserves or a combination thereof, we aren’t sure of the interim impact.

We can’t be “timing” inflation because its impact has always been relative.

However we understand inflation to be an epochal problem of human society, which specifically constitutes a series of processes that makes up a cycle.

We can’t simply read through recent events and interpret them as the future.

Since inflation is a political process, it requires the understanding of the underlying motivations of the current crop of political leaders and their prospective actions. After all, politics revolve around economics.

And this has been a phenomenon that has haunted civilizations, kingdoms, governments or empires alike, which has always been expressed through the purchasing power of the underlying currencies.

Mises Institute President Douglas French in recommending cigarettes as an inflation hedge enumerates on such cycle, ``one of Ludwig von Mises's outline of the typical inflation process: prices aren't rising nearly as much as the money supply… phase two of Mises's inflation outline: instead of a rising demand for money moderating price increases, a falling demand for money will instead intensify price inflation. Finally, we come to phase three, where prices go up faster than money supply, the demand for money drops to zero, and government fiat currencies collapse.” (bold highlights mine)

Currently we seem to be drifting in between the phases of “prices aren't rising nearly as much as the money supply” and “falling demand for money”.

Eventually, we should see a transition deeper into “intensifying price inflation” and most probably segueing into “prices go up faster than money supply” depending on the incentives driving policymaking.

And if consumer prices don’t immediately reflect on the impact of the intermediate inflation process, then most of the present political actions will likely be felt or manifested in the financial asset markets.

And so a boom in asset markets is in the first order, as what we’ve been seeing today, and may likely continue as the US dollar index falls.

In short, asset markets are likely to continue functioning as the immediate absorbers of the inflation process.

As Morgan Stanley’s Manoj Pradhan observed of the difference between today’s cyclical patterns with the previous,

``During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery.” (bold highlights mine)

Politically, further inflation is required to sustain the elevation of asset prices, however economically, the risks is that these surges will result to a bubble. So maneuvers for an exit from policymakers seem to be getting trickier by the moment.

Will they take the booze away from the party and allow “normalization” or will they further supply more booze to enliven the atmosphere?

Here, we will bet on another major policy miscalculation.

Yet this boom in financial asset prices won’t translate to sustainable “green shoots” of economic recovery. Instead today’s inflation process will heighten misallocation of resources that would eventually culminate into another enormous bubble cycle.

As Murray N. Rothbard in Money Inflation and Price Inflation wrote, (bold highlights mine)

``Even if prices do not increase, this does not alleviate the coercive shift in income and wealth that takes place. As a matter of fact, some economists have interpreted price inflation as a desperate method by which the public, suffering from monetary inflation, tries to recoup its command of economic resources by raising prices at least as fast, if not faster, than the government prints new money…there is a relative underinvestment in consumer goods industries. And since stock prices and real estate prices are titles to capital goods, there tends as well to be an excessive boom. It is not necessary for consumer prices to go up, and therefore to register as price inflation. And this is precisely what happened in the 1920s, fooling economists and financiers unfamiliar with Austrian analysis, and lulling them into the belief that no great crash or recession would be possible. The rest is history. So, the fact that prices have remained stable recently does not mean that we will not reap the whirlwind of recession and crash.”

So while consumer price inflation may still be currently subdued, this doesn’t exempt us from a prospective bust from the fast evolving malinvestments.

More Inflation Equals Greater Risks

Despite the recent crisis, the fractional banking sponsored debt driven economy conjoint with government policies to rev up the credit cycle has reflected on Mr. Buffett’s admonition of debts reaching record unsustainable levels.

Figure 2: AIER: US DEBT AT RECORD LEVELS

According to Mr. Kerry A. Lynch senior fellow of the American Institute of Economic Research, `` The total debt owed by Americans increased to $51 trillion in the first quarter of 2009. One way to put such a mind-boggling number in perspective is to compare it to the value of what Americans produce. Gross domestic product is roughly $14 trillion per year. Thus, Americans now owe $3.62 for every dollar of GDP. As can be seen in the chart below, this is a record.

``By comparison, in 1980 Americans owed just $1.55 per dollar of GDP. The ratio began to rise sharply in the 1980s, leveled off in the early 1990s, and surged again in the late ‘90s, continuing to do so through the past decade.”

While the recent crisis should have pruned down debt levels to the capacity where the economy may be able to handle it, however, the inherent fear by US and global governments of “deflation”, aside from the implied goal to sustain previous boom days, and the addiction towards inflation has prompted such continued accumulation of systemic imbalances.

As we said in the The Fallacies of Inflating Away Debt, the misleading notion of inflating away such debt levels would make the stagflation era of the 70s a virtual “walk in the park”.

Yet, Mr. Buffett seems quite optimistic on the resolve of the present administration to work this out, which we think could be attributable to the special political influenced privileges acquired from the administration, during the latest crisis, for his personal benefit [see Warren Buffett: From Value Investor To Political Entrepreneur?].

However, Mr. Buffett seems to seriously underestimate the political nature of the inflation process.

The expanded cash for clunkers, the administration’s foisting of its socialized version of health reform (which means another $1.3 trillion through 2019), cap and trade policies and the potential bailouts from the next wave of mortgage resets, the prospective support on FDIC’s eroding funding base as more banks suffer from closure, and the Obama administration’s consideration of future stimulus programs are simply symptoms of MORE (NOT LESS) government addiction towards consolidating power by debt and inflation based solutions.

As Ludwig von Mises on The Truth About Inflation presciently wrote, ``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” (emphasis added)

Hence, the current political leadership adheres to the typical path of leaders opting for the profligate inflation route. Inflation is what they want, then inflation is what we get.

So in contrast to the mainstream who thinks inflation isn’t in the near horizon, we join the outliers who have been warning of the risks of a potential disorderly unwind.

The Newsmax quotes Nobel Prize economist Joseph Stiglitz, ``The "dollar now is yielding almost zero return," Stiglitz said in a speech at the United Nations regional headquarters in Bangkok. "The current global reserve system is fraying. It's falling apart. The issue isn't whether we go to a new system. The question is do we do so in an orderly or disorderly way.” (emphasis added)

Meanwhile, PIMCO’s CEO Mohamed El-Erian says the policy divergence or “disjointed approach” between the US and other global central bankers could risk leading “to volatile financial markets, a damaging drop of the dollar and slower global growth.”

The Bloomberg quotes Mr. El-Erian ``The question is not whether the dollar will weaken over time, but how it will weaken,” said El-Erian, a former deputy director of the International Monetary Fund whose firm runs the world’s largest bond fund. “The real risk is that you will get a disorderly decline.” (emphasis added)

Thus, we won’t underestimate or discount the odds of the growing risks of an inflationary pass through by a lower (or a possible meltdown of the) US dollar on asset, commodity or consumer prices.

Remember inflation isn’t only generated through the credit system but also through fiscal expenditures.

In Zimbabwe, where consumer credit is virtually inexistent, an output gap of -99% (Marc Faber) and unemployment of 94% didn’t stop hyperinflation (89,700,000,000,000,000,000,000% year on year basis in 2008 or a doubling of prices daily)!!!

So the obsession with all sorts of perverse math models by mainstream economics vividly manifest that they don’t have a clue on reality.

That’s the reason why they haven’t rightly predicted last year’s crisis and why they are unlikely to be dependable forecasters.

Will China’s Stock Market Correction Spread Globally?

``We have seen that according to popular thinking, an asset bubble is a large increase in asset prices. A price is the amount of dollars paid for a given thing. We may just as well say, then, that a bubble is a large increase in the payment of dollars for various assets. As a rule, in order for this to occur there must be an increase in the pool of dollars, or the pool of money. So, if one accepts the popular definition of what a bubble is, one must also concede that without an expansion in the pool of money, bubbles cannot emerge. If the pool of money is not expanding, then people — irrespective of their psychological disposition — simply do not have the ability to generate bubbles in various markets.” Frank Shostak, How Can the Fed Prevent Asset Bubbles?

It looks likely that we may have reached a turning point for this cycle.

I’m not suggesting that we are at the end of the secular bull market phase, but given the truism that no trend moves in a straight line, a reprieve should be warranted.

To consider, September and October has been the weakest months of the annual seasonal cycle, where most of the stock market “shocks” have occurred. The culmination of last year’s meltdown in October should be a fresh example.

Although, this is not to imply that we are about to be envisaged by another crisis this year (another larger bust looms 2-4 years from now), the point is, overstretched markets could likely utilize seasonal variables as fulcrum for a pause-or a window of opportunity for accumulation.

A China Led Countercyclical Trend

My case for an ephemeral inflection point is primarily focused on China.

Since China’s stockmarket bellwether, the Shanghai Index (SSEC), defied “gravity” during the predominant bleakness following last year’s crash, and most importantly, served as the inspirational leader for global bourses, its action would likely have a telling impact on the directions of global stock markets.

In short, my premise is that global markets are likely to follow China.

True, the SSEC had a two week correction, which have accounted for nearly 11% decline (as seen in Figure 1) but this has, so far, been largely ignored by global bourses.

Figure 1: Stockcharts.com: The Shanghai Index Rolling Over

Nevertheless, the action in China’s market appears to weigh more on commodities on the interim. This should impact the actions in many commodity exporting emerging markets.

The Baltic Dry Index (BDI) which tracks international shipping prices of various dry bulk cargoes of commodities as coal, iron ore or grain has been on a descent since June.

This has equally been manifested in prices Crude oil (WTIC) which appears to have carved out a “double top” formation.

In short, there seems to be a semblance of distribution evolving in the China-commodity markets.

The possible implication is perhaps China’s leash effect on global stock markets will lag.

From a technical perspective, using the last major (Feb-Mar) correction as reference, a 20% decline would bring the SSEC to a 50% Fibonacci retracement, while a 25% fall would translate to 61.8% retracement.

And any decline that exceeds the last level may suggest for a major inflection point, albeit technical indicators are never foolproof.

Moreover, from a perspective of double top formation in oil; if a breakdown of the $60 support occurs then $49-50 could be the next target level.

As a reminder, for us, technicals serve only as guidepost and not as major decision factors. The reason I brought up the failure in the S&P 500 head and shoulder pattern last July [see Example Of Chart Pattern Failure] was to demonstrate the folly of extreme dependence on charts.

As prolific trader analyst Dennis Gartman suggests in his 22 Trading rules, ``To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.”

In short, understanding market sponsorship or identifying forces that have been responsible for the actions in the marketplace are more important than simple pattern recognition. Together they become a potent weapon.

So despite the recent 11% decline of the SSEC, on a year date basis it remains up by a staggering 67%.

Politicization Of The Financial Markets

Some experts have suggested that when global stock markets would correct, such would transpire under the environment of a rising US dollar index, since this would signal a liquidity tightening.

I am not sure that this would be the case, although the market actions may work in such direction where the causality would appear reflexive.

Unless the implication is that the impact from the inflationary policies has reached its pinnacle or would extrapolate to a manifestation of the eroding effects of such policies, where forces from misallocated resources would be reasserting themselves, such reasoning overlooks prospective policy responses.

The US dollar index (USD) has recently broken down but has been drifting above the breached support levels (see above chart).

It could rally in the backdrop of declining stock markets and commodity prices, although it is likely to reflect on a correlation trade than a cause and effect dynamic.

By correlation trade, I mean that since the markets have been accustomed or inured to the inverse relationship of the US dollar and commodities, any signs of weaknesses in the commodities sphere would likely spur an intuitive rotation back into the US dollar.

Some may call it “flight to safety”. But I would resist the notion that the US dollar would represent anywhere near safehaven status given the present policy directions.

However, if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.

So yes, the movement of the US dollar index is an important factor in gauging the movements of the global stock markets.

But one must be reminded that last year’s ferocious rally in the US dollar index was triggered by a dysfunctional global banking system when the US experienced a near collapse prompted by electronic “institutional” bank run.

This isn’t likely to be the case today.

So far, aside from the seeming “normalization” of credit flows seen in the credit markets, our longstanding premise has been that global authorities, operating on the mental and theoretical framework of mainstream economics, will refrain from exhausting present gains from which have been viewed as policy triumph.

Hence our bet is that they will likely pursue the more of the same tact in order to sustain the winning streak. The latest US FOMC transcript to maintain current policies could be interpreted as one.

Why take the party punch bowl away when the financial elite are having their bacchanalian orgy?

As we noted in last week’s Crack-Up Boom Spreads To Asia And The Philippines, ``Where financial markets once functioned as signals for economic transitions, it would now appear that financial markets have become the essence of global economies, where the real economy have been subordinated to paper shuffling activities.”

Where policymakers inherently sees rising financial assets as signals of economic growth, the reality is that most of the current pricing stickiness has been fueled by excessive money printing that has prompted for intensive speculations more than real economic growth.

Figure 2: New York Times: Hints of a Rebound in Global Trade?

For instance, Floyd Norris of the New York Times has a great chart depicting the year on year changes of global trade based on dollar volume of exports.

While there has indeed been some improvements coming off the synchronized collapse last year, the growth rates haven’t been all that impressive.

In short, rapidly inflating markets and a tepid growth in the global economy manifest signs of disconnect!

Yet global policymakers won’t risk the impression that economic growth will falter as signaled by falling financial asset prices. Hence, they are likely to further boost the “animal spirits” by adopting policies that will directly support financial assets and hope that any improvements will have a spillover effect to the real economy via the “aggregate demand” transmission mechanism.

Alternatively, one may interpret this as the politicization of the financial markets.

To give you an example, bank lending in China has materially slowed in July see figure 3. This could have accounted for the recent correction in the SSEC.

Figure 3: US Global Investors: Declining Bank Loans

According to US Global Investors ``China’s new lending data for July may be a blessing in disguise, as the slowdown can partly be attributed to a sharp month-over-month decrease in bill financing. Excluding bills, July’s new loans to companies and households were comparable to May and higher than April. With more higher-yielding, long-term loans replacing lower interest-bearing bill financing, margins at Chinese banks should improve as long as corporate funding demand remains strong and overall loan quality stays healthy.”

While this could be seen as the optimistic aspect, the fact is that aside from the overheated and overextended stock markets, property markets have likewise been benefiting from the monetary shindig- property sales up 60% for the first seven months and where residential investments “rose 11.6 percent, up from 9.9 percent in the six months to June 30” “powered by $1.1 trillion of lending in the first six months” (Bloomberg)

True, some of these have filtered over to the real economy as China’s power generation expanded by 4.8% in July (Finfacts) while domestic car sales soared by 63% (caijing) both on a year to year basis.

So in the account of a persistent weak external demand, Chinese policymakers have opted to gamble with fiscal and policies targeted at domestic investments…particularly on property and infrastructure.

Remember, the US consumers, which had been China’s largest market, has remained on the defensive since they’ve been suffering from the adjustments of over indebtedness which would take years (if not decades) to resolve (see figure 4).

Figure 4: Danske Research: US Consumers In Doldrums

And since investments accounts for as the biggest share in China’s economy, as we discussed in last November’s China’s Bailout Package; Shanghai Index At Possible Bottom?, ``the largest chunk of China’s GDP has been in investments which is estimated at 40% (the Economist) or 30% (Dragonomics-GaveKal) of the economy where over half of these are into infrastructure [30.8% of total construction investments (source: Dragonomics-Gavekal)] and property [24% of total construction investments]”, the object of policy based thrust to support domestic bubbles seem quite enchanting to policymakers.

Besides, if the objective is about control, in a still largely command and control type of governance, then Chinese policymakers can do little to support US consumers than to inflate local bubbles.

Aside, as we discussed in last week’s The Fallacies of Inflating Away Debt, “conflict-of –interests” issues on policymaking always poses a risk, since authorities are likely to seek short term gains for political ends or goals.

From last week ``policymakers are likely to take actions that are designed for generating short term “visible” benefits at the cost of deferring the “unseen” cumulative long term risks, which are usually are aligned with the office tenure (let the next guy handle the mess) or if they happen to be politically influenced by the incumbent administration (generates impacts that can win votes)”

In China, political incentive issues could be another important variable at work in support of bubble policies.

Michael Kurtz, a Shanghai-based strategist and head of China research for Macquarie Securities Michael Kurtz, in an article at the Wall Street Journal apparently validates our general observation.

From Mr. Kurtz (bold highlights mine),

``…far from being an accidental consequence of loose monetary policy, stand out as the purpose of that policy. The fact that housing construction must carry so much of the growth burden means policy makers likely prefer to err well on the side of too much inflation rather than risk choking off growth too early by mistiming tightening.

``Meanwhile, China's political cycle may exacerbate risks of an asset bubble. President and Communist Party Chairman Hu Jintao and other senior leaders are expected to step down at the party's five-year congress in October 2012. Much of the jockeying for appointments to top jobs is already under way, especially for key slots in the Politburo. Mr. Hu will want to secure seats for five of his allies on that body's nine-member standing committee, ensuring his continued influence from the sidelines and allowing him to protect his political legacy.

``This requires that Mr. Hu deliver headline GDP growth at or above the 8% level that China's conventional wisdom associates with robust job creation, lest he leave himself open to criticism from ambitious rivals. The related political need to avoid ruffling too many feathers in China's establishment also may incline leaders toward lower-conflict approaches to growth, rather than deep structural reforms that would help rebalance demand toward sustainable private consumption. Easy money is less politically costly than rural land reform or state-enterprise dividend restructuring. This is especially the case given that much of the hangover of a Chinese asset bubble would fall not on the current leadership, but on the next.”

So the “window dressing” of the Chinese economy for election purposes fits our conflict of interest description to a tee!

Overall, it would seem like a mistake to interpret any signs of a prospective rally in the US dollar on “tightening” simply because policymakers (in China, the US, the Philippines or elsewhere) are likely to engage in more inflationary actions for political ends (policy triumph, elections, et. al.).

Hence, any signs of market weakness will likely prompt for more actions to support the asset prices.