Frenzied speculative activity in China's equity markets

It's time to take another look at the recent developments in China's equity markets as major indices hover near the highs we haven't seen since 2008.

Source: Investing.com

With property markets in trouble, China's speculative investors are turning to equities. Moreover, increasing numbers of new investors are entering the markets. Last week we saw more than a million new A-share accounts opened, with brokerage firms having trouble keeping up.

Source: @vikramreuter

What's particularly alarming is that many new investors jumping into the market tend to be poor and far less educated. Everyone is all of a sudden an "expert" investor. Anecdotal evidence suggests that "hot" stock tips can be "obtained" from places like your local grocer and the barbershop.

Source: @Callum_Thomas, @TomOrlik 

The most compelling evidence of speculative frenzy in these markets comes from the volume of stocks bought on margin.

Source: @Callum_Thomas, @prchovanec

These developments certainly suggest that a bubble is building in these stock markets - similar to what we saw prior to the financial crisis in China. From the peak in 2007 it took the market about a year to give up 71%. Of course many argue that valuations are far better now and do not warrant such a correction. Perhaps.

According to Patrick Chovanec, when it comes to valuations, there are some issues to consider. Valuations of course depend on the outlook for earnings (which could be tricky given the slowing economy) as well as the credibility of Chinese reported earnings. Chinese banks have low valuations simply because the quality of loan portfolios is expected to deteriorate. Some earnings reports are skewed by vendor financing which is not always properly disclosed. Yet other firms don't disclose their full liabilities, which are often off balance sheet in special-purpose vehicles.

Many of these bets are based on new stimulus expectations from Beijing rather than valuations. The timing, scope, and effectiveness of such stimulus however remains uncertain.

Whatever the case, given the sheer size of the potential new investor pool, this trend can go on for some time. However, Beijing is unlikely to passively watch these developments unfold. An additional regulatory action (and we already had one recently) could cause this market to take a material hit. China could put further limits on margin trading and add other restriction on trading activities. Moreover, such action could take place much sooner than many investors expect. We don't need extreme valuations to see a major correction.

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Is China's growth slower than the 7% consensus?

Further evidence is emerging that China's economic growth is likely to slow further. Even without thinking about growth fundamentals, when you have a 10 trillion dollar economy, a 7% growth is larger than the whole GDP of Sweden or Poland. The sheer size of China's economy relative to the rest of the world will limit its growth rate. China's authorities openly admit the growth challenges the nation faces.

FT: - [Premier Li Keqiang] gave his assurance in Beijing’s Great Hall of the People while warning that China would struggle to meet its annual growth target of “around 7 per cent” this year. “It is true we have adjusted down somewhat our GDP target, but it will by no means be easy for us to reach this target.” Mr. Li told reporters at the end of the annual parliamentary session. “China’s economy has already exceeded $10tn so a 7 per cent increase is equivalent to the entire economy of a medium-sized country.”

The question however remains: could we see growth that is substantially below even this reduced estimate? The latest fundamental economic reports seem to suggest a sharper slowdown than economists have been forecasting. Here are three examples: fixed asset investment growth, industrial production, and retail sales - all below consensus (see "Act" vs "Forecast").

Source: National Bureau of Statistics, Investing.com

Furthermore there is a slew of other indicators as well that seem to support the view that China's slowdown is sharper than originally thought.

1. China's rail freight volume:

Source: @SBarlow_ROB

2. Hong Kong jewelry sales and Macau gaming revenue:

Source: @M_McDonough

3. Hong Kong industrial production growth:

4. Price declines in China's industrial commodities markets. Here is the Shanghai Futures Exchange hot-rolled coil May futures contract:

Source: barchart

When some of these as well as other metrics are combined into the Bloomberg China GDP Tracker, we are looking at a growth rate that is below 6.5%. While still tremendous relative to much of the world, this viewed as a significant slowdown for China.

Source: @M_McDonough

Monetary conditions such as the strong yuan (which has risen sharply with the US dollar) as well as unusually high real rates (discussed here) will further dampen economic growth. For example for certain types of manufacturing, a US firm may now choose Mexico over China as the yuan has become much more expensive relative to the peso (in addition to lower shipping costs due to proximity).

CNY/MXN

Slowing growth would suggest that China's equity markets should be under pressure. Just the opposite is taking place however - the Shanghai Composite is near multi-year highs.

Source: barchart

The reason has to do with stimulus expectations. Economic weakness (relative to historical growth) has been so pronounced, Beijing is ready to provide monetary and fiscal support.

FT: - “Under this ‘new normal’ state we need to ensure that China’s economy operates within a proper range,” Mr Li told Sunday’s press conference. “If our growth speed comes close to the lower limit of its proper range and affects the employment and increase of people’s incomes, we are prepared to step up targeted macroeconomic regulation to boost market confidence.”

How effective such stimulus will be remains to be seen but Beijing will certainly make an all-out attempt to avoid a "hard landing".

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The Fed has an uphill battle on "wage pressures" argument

The Fed is now focused on recent improvements in the labor markets as it prepares for the 2015 rate hike. The unemployment rate is approaching the so-called "natural rate of unemployment". This is the equilibrium state beyond which we should, at least in theory, start seeing wage pressures.

However here are two indicators suggesting that with the disinflationary pressures in the background, the summer of 2015 liftoff may be premature.

1. The US. Bureau of Labor Statistics publishes an index that tracks individuals who are "not in labor force, searched for work and available". It's a good indicator of labor force slack in the US (as opposed to labor force participation rate which is impacted by demographic factors). This may indicate that wage pressures nationally, particularly for unskilled labor, may be some time off.

2. Moreover, instead of seeing signs of wage pressures across the country, wage growth is actually slowing quite sharply, especially for non-supervisory employees.

The Fed may be able to justify a 2015 rate hike by stronger payroll numbers and lower unemployment rate. It can also focus on froth in the financial markets. But for now raising rates due to "wage pressures" will be difficult to justify.

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Global commodities under pressure

Posted by Walter

With the dollar's renewed strength and slower global demand, commodities are under pressure again.

Source: barchart

The situation in Brazil is not helping as the weak Brazilian real encourages producers to dump commodities at lower prices (in dollar terms). And Brazil is one of the largest commodity exporters in the world (from corn to iron ore). Here is the Continuous Commodity Index (broad commodity index).

Source: barchart

While the dollar rally and the weakness across the energy patch are pressuring commodities, other drivers exists as well. One specific commodity to watch closely is lumber. Here's May-2015 lumber futures contract. Is it an indication of slower US housing demand on higher rates ahead? Is the Canadian housing market in trouble?

Source: barchart

And then we have the raw materials prices in China: steel rebar (used in construction) and iron ore (May-2015 contract). The rebar weakness tells us not to expect a housing recovery recovery in China this spring.

Source: barchart

And China's recent growth downgrade is sending iron ore futures to multi-year lows (see story).

Source: barchart

While the focus has been on crude oil, a number of non-energy commodities are also in trouble.

Source: CRB

With the Fed's expected rate hike in 2015 and further dollar strength widely expected, the global deflationary environment is pressuring commodities across the board.


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Debate around the 2015 rate hike intensifies

Posted by Walter

Following Janet Yellen's Senate Banking Committee testimony, the Fed seems to be quite deliberate in preparing for a rate hike in 2015. It's hard to imagine taking such action in the disinflationary environment we find ourselves in, but market participants are increasingly accepting that possibility. That's why we've seen the equity markets pull back somewhat and the dollar continue climbing.

Source: barchart

The problem of course is that the dollar's strength is already pressuring US manufacturing and there is more to come.

Manufacturing orders have fallen sharply, with the dollar contributing to some of the declines.

However it seems the Fed is likely to be less focused on the dollar and instead concentrate on wages, where we are supposedly seeing a few pockets of wage pressures. Here is a quote from the NY District Beige Book report.

NY Fed: - The labor market has continued to strengthen since the last report, with some reports of increased wage pressures. One major New York City employment agency maintains that the job market has tightened considerably in recent months and that it is stronger, across the board, than it has been in eight years. This contact also notes that wages have accelerated, especially for workers with any computer skills. More broadly, business contacts report that they continue to increase employment, on balance, and considerably more firms plan to add than cut jobs in the months ahead. Service-sector firms also indicate increasingly widespread wage hikes.

This hardly qualifies as wage pressures at the national level, but it's something the FOMC will watch closely. As of now the market expects the Fed to hike at fairly regular intervals starting in early Q3-15.

There is quite a bit of debate around the timing of the first hike - especially given the psychological importance of that policy change. For example Morgan Stanley economists argue that the low core inflation will keep the Fed on hold until next year. The core PCE measure lags the headline number and will take some time to recover. It's difficult to see the Fed hiking with core PCE below 1.25%.

Source: @pdacosta, Morgan Stanley

Nevertheless an increasing number of economists and Fed officials feel that a 2015 liftoff is on - if anything as a symbolic exit from the zero rate policy.

MarketWatch: - Kansas City Fed President Esther George said she would support a decision to hike short-term interest rates in mid-year. "While the FOMC has made no decisions about the timing of this action, I continue to support liftoff towards the middle of the year due to improvement in the labor market, expectations of firmer inflation, and the balance of risks over the medium and longer run"

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An update on Brazil's flagging economy

Posted by Walter

Brazil's economic uncertainty continues to worsen. While growth projections for all the BRICS have been lowered, for the first time in years Brazil's economy is now expected to contract in 2015.

Source: Bloomberg, @M_McDonough

We can see the impending recession reflected in the nation's inverted government bond yield curve.

The fiscal situation has worsened materially. As the Economist recently pointed out, wage growth of public sector employees is unsustainable.

Source: @sobata416, Economist.com

The government is now forced to undertake significant austerity measures which will hit the economy hard. Years of mismanagement have come home to roost. With fiscal risks on the rise, the nation's sovereign CDS remains elevated.

Source: @HedgeForMoney

The Brazilian real hit new lows not seen in over a decade, as the economy struggles. Furthermore the Petrobras scandal as well as its potential impact on state banks (who are massively exposed to the firm's credit risk) weigh on the currency.

Source: Investing.com

As the currency depreciates, the nation's dollar denominated debt is becoming increasingly burdensome.

Source: @sobata416,  Economist.com

Some may remember this headline from 2013.

Source: Bloomberg, May, 2013

That $11 billion was 24.5 billion reais in 2013 and now it's 32.8 billion. The company's liabilities have increased by a third while the assets have been hurt by weaker energy prices.

In response to the currency weakness Brazil's central bank hiked rates to the highest level since 2009 to stabilize the currency and fight rising inflation. This will further dampen credit demand and accelerate the recession.  Now all we need is for the Fed to hike rates. That will put more downward pressure on the real and force Brazil's rates even higher. As it is the 10-year government bond yield is already above 12.75%.

It's important to point out that given its significance to the global economy, Brazil's problems can spread way beyond its borders. The Petrobras scandal for example has shaken other Latin American debt markets (see story). The currency weakness in Brazil is now pressuring some international commodity markets. The nation's growers of sugar, oranges, etc. can dump commodities at lower dollar prices and still come out ahead in domestic currency terms. As a result orange juice and sugar futures have fallen sharply (May-15 contracts shown below). A number of other commodity markets will be impacted as well.

Source: barchart

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The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB, Investing.com

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics

Source: Investing.com

Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.

RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.

Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.

Source: Investing.com

But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.

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