Medellin Capex

Can You Hear the Fat Lady Singing? – Part III


I love what I do! A recent get together filled with blonde stick insects and cologne covered chinos found me subjected to talk about “work at the office”:

“What did you do at work today?”

“Oh, nothing much, tried to look down the new girl’s top for a bit then I made some phone calls, you?”

“Oh, much the normal, searched the web for our next vacation and found I can get a Filipino bride for a grand.”

After only 10 minutes I was ready to leave.

I then received a call from a friend which snapped me back into my world and cemented my decision to leave. This friend has been extremely successful trading Asian credit and I was eager to get his perspective on emerging market debt and in particular China.

This brings me to my thoughts on emerging market currencies and debt, which I’d like to share with you today.

It all starts with the dollar bull market which we’ve discussed previously at length. As Brad mentioned earlier this year:

So while the US current account deficit continues to narrow there is absolutely going to be a shortage of USDs. There is $9 trillion of dollar denominated debt outstanding, well considering that it took a number of years to build up this debt, it is going to take more than just a few months to unwind, more likely a couple of years at least. If the US Federal Reserve were to raise rates this year it sure wouldn’t help the cause, rather it would throw accelerant on the smouldering liquidity fire!

After a brief breather, the dollar looks set to take out new highs:


This time around the dollar looks set to take out 100 on the Dollar Index. My thoughts today lie in what this may mean for various emerging market asset classes.

Take a look at the MSCI Emerging Markets ETF:


Support sits at 36 and we’re getting close!

This is a function of a stronger dollar. The larger question lies in where the leverage in emerging markets may lie, remembering that the unwinding of the carry trade will be particularly severely felt where leverage is highest.

Taking a step back for a minute and thinking about the events in Europe recently and the events we’ve just witnessed in China, it’s clear to me that central banks are out of control.

Risk lies in with the fact central banks believe themselves omnipotent. This is only half of the problem. The majority of investors believe the central banks are actually omnipotent and that is the other half of the problem. Central bank omnipotence is at an all time high… or is it?

If we look back in history, it’s littered, not with successful central bank intervention, but with central bank failures. For every action there is a reaction. Everything is connected. You can’t throw a stone into a pond and not get ripples. Similarly you can’t have central banks buying assets, or slashing interest rates or any other such action, without consequences for those actions.

Last week I looked back at how the Asian crisis unfolded. That particular crisis was only 18 years ago, yet market participants seem to have forgotten the lessons. We know that central bank intervention in the face of a levered market which is unwinding can often be the precursor to an outright rout.

I then spoke about China earlier this week and how easily and quickly the Chinese central bank stepped in to attempt to stabilise the stock market. That they acted so aggressively is far more concerning to me than the actions themselves. The consequences of this are ultimately a weaker remnimbi, and a weaker remnimbi threatens to exacerbate losses for investors that have been participating in the USD carry trade.

Furthermore, as Chinese growth slows the temptation to slash interest rates and devalue the remnimbi, should it happen, puts additional pressure on competitive emerging market currencies. Countries such as Korea, Malaysia, Thailand, even India. Once again, a stronger dollar vis-à-vis these respective currencies threatens any levered capital invested in the bond markets to seek first to reduce exposures. This means selling the respective currencies and buying back dollars. This self-reinforcing cycle can quickly force margin calls and the global carry trade unwind threatens to get particularly “exciting”.

It’s not difficult to imagine a scenario where as the dollar bull run gathers steam we may well see more and more emerging markets looking like Greece.

Right now a number of emerging market currencies are looking like they’re getting ready to roll over. The repercussions could well be an emerging market bond rout. As such, we’ve been dipping our toes into shorting the iShares JP Morgan Emerging market bond ETF (EMB) with some long dated options.

If nothing else, it’s a heck more interesting than boring cocktail parties…

- Chris

“It amazed her how much people wanted to talk at parties. And about nothing in particular.” – J.D. Robb, Holiday in Death

Can You Hear the Fat Lady Singing? – Part II: The China Connection


Greece is connected to China by the very same thing which has been connecting sex, drugs, and rock’n’roll since Bretton Woods – dollars.

Last week I shared some thoughts on the unintended consequences of actions taken in Europe and why Greece may matter as a result. There is zero chance that the actions taken will result in a stronger Europe, a stronger euro, or an economic strengthening in either Greece or the wider eurozone. Zero!

As interesting as Greece and the euro is, my attention today is on China and how China may well be forced by events taking place globally to make some far reaching choices.

Two scenarios have been widely discounted by the market with respect to China. The first is a remnimbi devaluation and the second is a hard landing for a slowing Chinese economy.

We know that the Chinese economy is slowing. We know this because Beijing tells us it’s so. Their last numbers were that the economy has slowed to their growth target of 7%. Bang on their target rate. How convenient! Now of course these numbers are rubbish, but it’s telling that they’re acknowledging a slowing economy.

We account for these government numbers in the same way we account for any government numbers: by acknowledging that underneath all the pompous sophistication of bureaucrats everywhere pulsates the brain of a tree shrew. The important takeaway is that they’re acknowledging they’re slowing.

China’s Market Crash

As everybody now knows, the Chinese stock market lost over 30% in 3 weeks wiping $2.8 trillion off the books. The only way to lose that much money in such a rapid period of time is by getting caught by your wife having hanky panky with her best friend.

Shanghai Stock Exchange Composite Index

Sure, investors who bought at the top are hurting, but consider that the stock market is up roughly 80% over the last 12 months, and this is AFTER the crash. Viewed with that timeframe and taken into context this is hardly problematic.

This correction is nowhere near as big a concern as it would be if we had a similar occurrence take place in the US due to who is participating.

80 – 90% of the domestic A-share market is made up of retail investors. Novices. This was a bubble waiting to burst as retail investors flooded the market with a record 40 million new brokerage accounts created in the last year. Not only were novices entering the market but they were entering it on margin. By June of this year margin lending as a percentage of market cap ran as high as 20%. While these investors make up the majority of the market they represent a small part of the population. The free float of China’s markets is about a third of GDP, whereas in the developed world this number is over 100%. A soaring stock market and a crashing stock market will have little effect on the vast majority of Chinese households. This is unlike the developed world.

Essentially, this is a tiny portion of the market that got burned. It really needn’t be a problem unless someone does something stupid and causes unintended consequences. Sadly this is exactly what Beijing is doing.

Is China or the US the Next Greece?

Perhaps it’s simply a matter of timing and what’s racing across the news feeds but I’ve read quite a few articles about how the US and China are next after Greece. Debt levels are cited along with a host of other similarities. This is – how do I put this politely – rubbish. The US and China are NOT Greece. Even if the debt levels were the same the similarities end there. Greece cannot issue its own currency. In last week’s missive I mentioned that:

Greece, however, no longer issues its own currency and as such there exists no release valve. Trapped in a deflationary spiral the economy continues to contract: 0.2% in the first quarter of this year following a 0.4% in the last quarter of 2014. When Greece joined the euro, they ceded monetary sovereignty to Brussels, and in doing so stuck a plug in its currency release valve.

That makes Greece unique. The US, on the other hand, can print all the currency they want and pay their debts at par. Greece can’t do that. The bonds of the US, Japan and even China are not at all to be likened to the bonds of Greece. One needs to make a distinction between debt denominated in the country in questions own currency and debt denominated in some other currency.

For countries sporting high debt levels and where simultaneously those debts are foreign denominated this can become a huge problem. Just ask that crazy woman in Argentina…

The Asian crisis, which I discussed last week, is such an example whereby debts denominated in USD became unsustainable. Once the rout started a self-fulfilling trend developed whereby as the currencies in Southeast Asian nations moved lower this added multiples to the payments required on leveraged assets. A vicious unwinding of the carry trade.

China’s Reaction

What I find the most fascinating is not the correction in the Chinese stock market but the actions taken by the PBOC subsequently.

This can only be described as outright panic. Consider the following actions taken.

  1.  China Securities Finance Corp has lent $42 Billion to 21 brokers instructing them to buy blue chip stocks
  2.  A $40 billion stimulus plan to “foster growth”
  3.  Speeding up infrastructure spending.
  4. Capital controls by another name: controlling shareholders and board members are locked up for 6 months from selling stock.
  5.  All new IPOs stopped
  6.  PBOC slashed rates and eased reserve requirements.
  7.  Chinese investors are now allowed to use their properties as collateral to buy stocks.

Aside from the fact that they are doing exactly the opposite of what should be done I find it telling that they are so willing to slash rates and devalue the yuan.

As mentioned, this needn’t be a problem if they simply let the market correct and find its equilibrium.

They haven’t done that and this is what has caught my attention more than anything else.

The Debt Component and What This May Mean for the Yuan

Debt is important to understand as debt is the “gasoline” added to any trade. Debt, or more correctly put, leverage amplifies gains and losses and as such is both the prozac as well as the viagra of global markets. I wrote extensively about the US carry trade in our USD Bull Report but will summarise an important point.

China boasts an estimated US$3 trillion borrowed and invested in various Chinese assets. A decline in those assets values materially affects investors who’ve leveraged their positions, but what really really matters is when the funding currency appreciates and those investors who are short dollars are forced to buy back their dollar positions.

Now this is where Greece and China are interconnected. Greece, as mentioned, threatens to be a poster child of Europe and the euro. This is naturally bullish for the euro in the same way that spandex pants look good on Angela Merkel – not so much!


The euro against the USD

In Europe we have intervention in the markets by Brussels. They may save Greece from introducing the drachma and devaluing it, and having German banks forced to realise losses but they can’t stop the market from devaluing the euro. Risk off is “on” and the dollar is moving higher.

In China we have Beijing intervening in the markets and we have to wonder what those US$3 trillion in the USD carry trade are invested in and what they look like right now.

Consider that globally we are seeing liquidity drying up and global capital flows moving into shorter term paper – US paper.

Two months ago I wrote about capital moving into shorter maturity paper:

Bond yields are rising sharply on the long end of the curve (long duration bonds) in favour of the short end. This is a rational move. Liquidity is crashing on all the long dated maturities and as you can see yields are breaking out. It makes perfect sense to sell the long end of the yield curve given the fundamentals. What we’re witnessing is that cash flooding into the shorter duration maturities.

When looking to understand China I believe that the probability of of a devaluation of the yuan has just risen markedly.

About the Yen?

I would be remiss in mentioning the yen from any discussion on global capital flows. The yen goes lower. We’ve been saying that for 2 years now and I won’t rehash thoughts here. Few seem to understand that the devaluation of the yen exacerbates the probability of a Chinese hard landing and that increases the risks of a devaluation of the yuan.

A rising dollar is globally deflationary. What happens when we get deflation in China?

China absolutely cannot have deflation and will be stuck between attempting to maintain a strong currency and stimulating their economy. This threatens to rapidly become a situation where they run out of “palatable” options and the least painful will be to devalue the yuan. Both politically and economically it will be acceptable. Most importantly it will allow those in power to stay in power.

To summarize, China has:

  • A huge USD carry trade which threatens to unwind
  • A trigger happy PBOC who have shown no restraint in slashing interest rates in order to support the market.
  • Increasing pressures being put on domestic competitiveness due to a strong currency

Soros famously said to “find the premise which is false and bet against it”. When the market’s premise is false, coincidentally the pricing of assets reflects this. Looking at the futures and options markets right now the market is NOT expecting a Chinese devaluation. We think this is a mistake.

The market typically has the collective mentality of a hive, and a pool hall understanding of the global interconnectedness that drives global capital flows. At the local level it believes in the ability of central bankers to forever prop markets. It believes in imposing rules and laws to circumvent free market forces, and it believes this because it views the world through the microcosm of an extremely limited timeframe and geography, much like a field mouse in a corn field surveying its landscape, unable to see the harvesters warming up.

I will leave you with one last thought. This time from the brilliant Albert Edwards of SocGen

We have long believed that China’s growth and deflation problems will necessitate a devaluation of the renminbi in a strong dollar environment. There is mounting evidence that this process may already be underway as the currency falls to a 28-month low against the dollar…

In the current deflationary environment the Chinese authorities simply can no longer tolerate the continued appreciation of their real exchange rate caused by the dollar link.

- Chris

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