The End of Monetary Policy Divergence: RIP US Equity Outperformance?

The End of Monetary Policy Divergence: RIP US Equity Outperformance?

The past several months I’ve been pointing out that speculators have been increasingly shifting to one side of the boat, long reflation. And then this week, central banks finally joined the party, tightening monetary policy only after these inflationary base effects had peaked.

I think this development is very bad over the medium term for global liquidity conditions. As noted by Johnathan Tepper in his recent Macrovoices interview, higher inflation and economic growth will pull excess liquidity out of financial assets and into the real economy. Throw in the hawkish shift of the world’s four largest central banks, and global liquidity conditions in the second half of the year should not be nearly as elevated as they are today.

With that said, global liquidity will not be the main topic of this week’s blog post (but I’ll touch on it later). Instead, I am choosing to focus again on yet another wobbly pillar of not just the reflation trade but US equity market’s outperformance these past +3 years as well.

In light of the hawkish shift of foreign central banks, the Fed finds that it is no longer the only game in town. Since 2013, the Fed’s relatively hawkish stance was super charged by the incredibly dovish policies that foreign central banks embarked on. During that time the ECB and BOJ increased their asset purchase programs and adopted negative interest rate policies. The combination of these central banking policies pushed capital into the US and strengthened the dollar.

As the dollar is a major source of emerging market funding, the stronger dollar tightened financial conditions in these countries, and hurt their economies which led to a prolonged period of capital outflows and equity market underperformance (vs the US). During this time, the phrase, “the cleanest shirt in the dirty hamper” was commonly applied to the US dollar, economy and stock market, but is that still true?

From a technical standpoint these trends seem to be waning and on the verge of a reversal. SPY / Europe (IEV):

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Despite the parabolic move higher, US equities have gone nowhere against emerging markets for over 18 months and counting. This week, we saw a break below the 50 week moving average as well as the +3 year trendline. SPY / Emerging Markets (EEM):

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SPY / World (VT):

 

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With the central banking divergence set to converge, we could even see the Fed hold steady or shift to a more dovish policy while the ECB and BOJ further tighten monetary policy. Given that the BOJ and ECB are still experimenting with NIRP there is plenty of room for them to tighten their monetary policy. Could you imagine the rally we would see in European financials if the ECB reduced its NIRP tax on the banks?

The Fed on the other hand may have overplayed its hand. If we look at inflation where it seems everyone (except those holding record treasury short positions) is now aware of the falling base effects associated with energy prices.

But in the US, little ink has been spilt over one of the largest contributors to inflation, rental prices.

In short, the inflationary pressures that the Fed has tried to get ahead of are unlikely to develop before the June meeting. Meanwhile, economic growth is also likely to disappoint or at least not accelerate to the upside as lending growth continues to fall.

Corporations have also put their debt issuance on hold as they wait for Trump’s regulatory cuts and stimulus package to form up.

If Trump and Congress cannot get their act together, look for the Fed to lower expectations of a future rate hikes.

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Which would mean that the Fed is unlikely to defend the dollar, and we could see it fall below the 99.5 level, completing this H&S pattern that I’ve been calling for these past few weeks. More importantly, by not defending the dollar, the Fed is essentially giving the green light for capital to leave the US.

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Lastly, any narrative about capital flight would not be complete without the country who has suffered from capital flight the most these past few years, China. And if there is a country that would benefit more from a falling dollar and falling US treasury yields than China I would not know it.

Previously I noted that the central authorities in China were hard at work to blow another stock bubble, Bitcoin: The Rising Tide Pressures The Biggest Leak:

“The stock market which everyone believes left for dead, may rise from its shallow grave and roar like never before. Pension funds will begin allocating additional holdings to the stock market as soon as this week. This is a pretty serious development. The last thing Beijing wants to do, is torpedo the pensions of millions of workers. On the back of this move, Chinese authorities have cut equity margin requirements from 40% to 20%.”

Just last week, the PBOC hiked interest rates. The reason: to apply more pressure on the nation’s out of control housing bubble.

It is likely that the authorities are trying to funnel China’s big ball of money back into other asset classes such as precious metals and equities. The inverse H&S pattern is quite obvious, throw in a weaker dollar and falling treasury rates and a new bull market could in fact be in the cards.

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It’s worth pointing out, that being bullish Chinese equities does not mean I am necessarily bullish on China’s economy, or global growth for that matter. There’s still plenty of warning signals out there.

And as I noted earlier, the Chinese authorities are actively working to deflate their booming real estate bubble. If successful in their efforts, the deflationary effects, will reverberate across not just emerging markets but the globe. And this in my view would likely mark a great opportunity to be long the dollar. As global liquidity begins to dry up around the world approximately 3-6 months from now, the dollar should bottom and begin to build up a head of steam for all the wrong reasons, There Is No Alternative (TINA).

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

Mirror Mirror On The Wall: Is The Reflation Trade About To Fall?

 

On Friday, Grant Williams announced he was working on a new presentation and asked the twitter-verse what they thought the craziest chart in the world was.

If you haven’t read the responses, I highly recommend that you do. There are a lot of really great charts (although Bitcoin is not one of them, give it a few more years folks). Of course, being somewhat of a reflation trade fanatic, I threw out a rather expected response.

I also forgot to add one very important component to this trade which is for speculators and hedge funds to be very long US stocks and short volatility, but we’ll get to this bit later.

 

Arguably the most overextended, and most talked about leg of this trade is the speculative long oil position. In 2017, we’ve seen speculators add to their net long position by about 200,000 contracts.

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With oil below its 200d ma (dark blue line) and at its lowest point this year, even without counting the cost of rolling these positions over, AT LEAST 40% of these contracts are in the red.

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Students of history will recall that the last time speculative positioning was this extreme oil tumbled over 70% in the following year. During this time (2014), Hedge Funds and speculators operated under the false assumption that OPEC had their back.

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Once again, OPEC has warned the US shale and more importantly the speculators that OPEC does not have their back.

The poor fundamentals supporting higher oil prices only gets worse from here. US oil inventory is at a post WWII record high.

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Meanwhile, US gasoline demand has also been “unexpectedly” soft.

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At the same time, US shale producers currently holding an extreme short futures position making them well prepared for a downturn in oil prices.

 

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On top of being well positioned for a downturn, US shale breakeven prices have collapsed in the last two years.

In order to cripple the growth of the US shale industry we’ll need to see oil prices below $40 for a prolonged period of time. That’s not exactly music to the ears of these record long speculators…

Which brings me to the crux of my argument: If the price of oil continues to fall, hedge funds and speculators will take incredible losses. These losses will begin to weigh on their other positions which they also have levered themselves to the hilt on and force them to unwind these positions as well. Taking into account that the fundamentals supporting their extreme positioning have continued to deteriorate, any potential unwind could become incredibly violent as the markets return to reality.

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In the past month I’ve written counter arguments for two of the reflation trade positions (long US dollar and long US stock market) and given that oil base effects have played a key role in driving inflation higher I believe we are about to see a tremendous amount of pressure applied to yet another one of these speculative positions, short bonds.

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Recall that oil prices bottomed in February 2016. With base effects firmly behind us, and the price of oil set to head lower, we could see oil quickly go from an inflationary pressure to a deflationary one.

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And if we give the recent rise in rates a historical perspective, we find that we are at the top of a 30+ year channel… and people make fun of me for betting against an 8 year trend.

I couldn’t have said the following better myself.

AND YET this is the exact opposite positioning that we see from hedge funds and speculators, who are not only short bonds but extremely long stocks!

Since my bearish post on US equities, the technical deterioration of the US stock market has only gotten worse.

Investor appetite for junk bonds appears to be waning.

At a very key juncture I might add.

Insiders are running in terror from the market.

But don’t worry, hedge funds aren’t alone in their foxholes, retail investors have finally joined the party.

So much for the most hated bull market in history. Retail have responded to higher prices and Donald’s rhetoric. They’ve heard that Donald Trump is going to enact some super stimulus and tax cuts that would transform the US economy into a soaring eagle that shoots laser beams out of its eye sockets.

Of course, the reason retail investors are in the stock market has nothing to do with the underlying fundamentals of the actual reflation trade or US economic health for that matter. I hate to sound like a broken record but here is a quote from The Reflation Trade:

“But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. Or to use another analogy, investors have entered the Jade City, but they have become distracted by the Giant Green Floating Head.”

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If we examine the underlying health of the US economy, we find it is quite weak. Despite this Trumpflation narrative, loan growth over the past two months has actually been negative.

Consumer lending standards are tightening.

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3-month LIBOR continues to hit post crisis highs.

And even with the tremendous growth we’ve seen in US shale, the US economy has continued to slow. Going from 1.9% in Q4 to just 1.3% in Q1.

The accelerating growth in employment we’ve seen, although enough to spook the Fed into hiking, has diverged dramatically from the underlying fundamentals of GDP growth.

And yes, let’s not forget the Fed is prepared to hike interest rates for the 2nd time in just 3 months. This dramatic tightening has put a great deal of pressure on China’s slowing economy.

 

And to top off this cluster fuck of speculative positioning, it is important to note that the VIX has been sold shorter than Tyrion Lannister.

Fortunately as we all know, a Lannister always pays his debts.

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Or just watch and wait for oil volatility to spread to other asset classes.

So while hedge funds and speculators are watching Trump for false bull signals, they are missing the underlying weakness. To make matters worse, investors and speculators have not been this positioned for a move in the global economy since the world was supposed to end in 2009.

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666 becomes 999 which some how becomes 1999 but wait the year zero didn’t actually start till the year 10, which makes the year of the devil 2009!

OK bad Arnold Schwarzenegger movie references aside (I’m optimistic to think that 3 people will get that reference), my point is that investors are levered to the hilt in almost all the wrong places: Long dollar, long commodities, long US equities, short volatility and short US bonds.

Until now, these levered positions were a powder keg in search of a spark. If the price of oil continues to fall we could witness a forced unwind of these extremely levered speculative positions which would come at a time when the market is incredibly fragile and the Fed has been uncharacteristically hawkish.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

Toro: Dollar Bulls Charging At The Fed’s Red Cape

Toro: Dollar Bulls Charging At The Fed’s Red Cape

The dollar story is a very interesting one. As the global monetary system’s reserve currency the dollar does not behave like any other fiat currency. The history of other monetary systems typically lasts around 40 years. At 46 years, our current post-Bretton Woods system (beginning in 1971), is old, rickety and fraught with danger. These instabilities have created powerful structural forces that have propelled the dollar higher. The most recent episode was the 2014 rising dollar story that crushed oil and other commodities as well as the Emerging Markets that depend on them.

These forces are still at work. They haven’t gone away, and neither have the bulls who are aware of their presence, no matter how far in the background they may be. I consider myself in this camp, but at the same time, as I indicated in the previous sentence, I believe these forces to be mostly hidden in the background, waiting to be thrust again into the light.

On the other hand, I see a confluence of bearish dollar forces at work. Despite the amazing soybean quarter of 2016 which almost puts TSLA’s Q3 “positive cash flow” to shame, US GDP growth has been sub 2%. Q1 2017 is likely to come in under 2% as well.

It is important to note that these two quarters will have taken place before the effects of rising interest rates and the stronger dollar will be fully felt. These sub par GDP numbers also include the incredible growth we’ve seen from the US shale industry. Is some other US industry going to magically contribute to GDP going forward? It is hard to imagine a scenario where US economic growth will surprise to the upside.

And yet the Fed still finds reasons to hike interest rates. Janet Yellen, looking through her rearview mirror points to the fantastic economic strength we’ve seen in the larger foreign economies.

First off, China does not look as healthy as Janet Yellen’s rearview mirror suggests. The GDP growth target in China has fallen to 6.5% and, more importantly, M1 growth has rolled over which suggests China’s best days are now behind it.

Part of the readjustment in China’s growth is due to the unstable nature of the country’s real estate boom. Xi’s approach to a tighter monetary policy and more stable growth should slow the real estate boom and have far reaching effects for not just China’s economy but commodities and Emerging Markets as well.

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As for Europe and Japan, yes it is true their economies have responded positively to the reflation trade. Because these economies have been trapped in deflation the longest, it makes sense to see them be the largest beneficiaries of inflation (at least in the short term). Eurozone’s PMI is at its highest point in over 5 years.

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We haven’t seen a Japanese PMI this positive since Abenomics’ heyday in 2014.

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Meanwhile, warning signs have piled up in the US, and the ISM manufacturing survey despite being elevated could peak as early as this month.

But we know the real reason the Fed is prepared to hike. The global reflation trade has certainly given Janet and her ilk a false sense of comfort, but the odds of a fed rate hike were incredibly low until a week ago.

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That is, until The Donald gave his State of the Union address.

There was no US economic news between mid February and now to suggest such a rapid rise in March rate hike odds. Trump spoke, and the Fed panicked. If everything Donald said was in fact going to happen and at the pace he implied, the Fed would have undoubtedly fallen behind the curve. But is Trump really going to get the things he desires as soon as he suggests? From my November blog post, It’s A Trap!:

“In order to win the election, Donald Trump successfully united a diverse group of people and yet he didn’t win the majority vote. And although the republicans may have won congress, Donald is hardly a republican president. Donald Trump is akin to a battle commander who has charged too far ahead of his troops. He will need to wait to gather the army before he can launch an effective attack.”

However, eloquent and well spoken his State of the Union address may have been, it is of vital importance to realize that Trump does not write the bills. Trump does not pass the bills. The fractured and incompetent Congress does. A large portion of Democrats are still sore from “their” loss in November, and are opposing Trump on every issue imaginable. Meanwhile, the Republicans are split between a Border Adjusted Tax, repealing Obamacare, and a number of other issues. Republican Senator Rand Paul hasn’t even been allowed to see the current bill.

Trump’s stimulus is further out than the market and more importantly the Fed anticipates. It is more likely that the Fed is hiking into weakness than strength. Speaking further to probabilities, it is likely that the March rate hike will mark the peak in Fed’s hawkish stance for the year, and yet Hedge Funds are positioned for further US economic strength and inflation.

 

Somewhat paradoxically, funds are also incredibly long commodities.

The long dollar and long commodity trade is also known as the reflation trade. Rising global growth pushes up demand for commodities, which props up prices which in turn pushes up inflation thereby leading to a rise in bond yields. US bond yields rise higher than those in EU and Japan due the QE and NIRP policies further propelling the dollar higher.

But the reflation trade is not only old and well known but perhaps most importantly is likely turning. As I believe the origin of the reflation trade is found in China (not Trump), it should worry these reflation bulls that China’s economy is slowing not accelerating. It should be even more worrisome that the Fed is hiking not because of improving Chinese economic data but Trump’s rhetoric. From my post The Reflation Trade:

“But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. “

The base effects from reflation should peak this month (the data from February is released in March). The Fed with its well polished rearview mirror should fall hook line and sinker for the inflationary data just as it is peaking. Meanwhile growth from the EU (if the specter of Le Pen disappears) and Japan could surprise to the upside while the US lags. Going forward, we should expect Fed dovishness, not hawkishness and dollar weakness not strength.

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DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

 

Warning Signs Pile Up In The US

Warning Signs Pile Up In The US

In a follow up to my previous post, Trump’s First Stock Market Correction: Coming Soon, I am going to outline a growing list of warning signs that suggest the US equity markets are fast approaching a correction.


Damn do markets love inflation. They say hunger is the best sauce, but wow just wow, after 5 long years of deflation, PMIs around the globe have started to roar.

What is most incredible about this rally is how broad based it has become. Price action in Emerging Markets is incredibly bullish.

Brasil has clearly been eating its proverbial Wheaties as well. To think I wanted to short it last March…

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But in the land of the longest running bull market, despite what the Tweeter in Chief, Donald Trump, says the stock market does not reflect reality.

Exactly… we don’t even have a tax plan yet… or a functioning legislative branch for that matter. Jawad Mian of Stray Reflections adds:

“The political uncertainty so apparent in both the US and Europe has not really dented market optimism yet but the global equity rally is extremely stretched, with record levels of speculative long positioning in the Russell 2000 and the S&P 500 pricing-in a staggering 30% earnings growth for 2017.

Of course S&P 500 earnings have been falling for the past 8 months…

Cognitive dissonance indeed. Although you can’t entirely blame them given the elevated levels of economic surprises.

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It’s hard to imagine conditions will continue to surprise to the upside, in the US, especially, where most of the surprise has been in the form of soft data or sentiment.

Further compounding the peak in economic surprises, is the movement in US treasury bonds which typically has a negative impact on the economy.

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And yet the move higher in interest rates has not been enough to counteract the rise of inflation.

This has helped fuel the price of gold, as well as has Marine Le Pen’s rise in the polls.

As we approach the French elections which have the most binary outcome of any election, we should expect a pick up in volatility. At the same time, US equity markets have been historically calm.

To put this level of calm into perspective, the chart below shows the number of 1% down days out of the last 200. At just 5, we are at the all time lows last seen in the summer of 2007, when the dollar was about to fall off a cliff, while EM and commodities soared (we’ll get to this bit later).

The indicators only get worse from here… The VIX which has been sold short like never before is starting to mis-behave.

At the same time we are seeing further warning signals from inflation and bonds.

From a liquidity standpoint, the US is also at risk.

This can also be seen in the DXY forming a potential H&S pattern that would take us to the election night lows.

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And perhaps this is why EM is behaving so bullishly. If the dollar falls, EM could really rally further. This is further reflected in the momentum divergence in SPY/EEM. We’ve also broken the 4+ year trendline. This is something to watch going forward.

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I will caution this last statement with the fact that the reflation trade has thus far been a dollar positive story. As inflation rose, so too have interest rates in the US, which is the only large DM economy that is not undergoing some massive form of QE. This interest rate spread drove dollar strength against other DM countries as well as some EM countries (albeit initially).

We’ve seen currency strength out of places like Mexico, Turkey, South Africa, China, Chile, Brasil and quite a few others. Could the dollar strength be a DM only story going forward?  Gold mining companies have begun to prepare for such an event and have liquidated the majority of their RECORD short position.

 


DISCLAIMER: This blog is the diary of a twenty something millennial who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

 

Bitcoin: The Rising Tide Pressures The Biggest Leak

Bitcoin: The Rising Tide Pressures The Biggest Leak

China is the most interesting country both east and west of the Mississippi. Beijing is trying to have its cake and eat it too. It would like to pump as much credit as necessary to keep the economy running, while attempting to divert money to its sectors of choice. It can’t do this without a closed capital account, and although the account has been on the margin more closed off than previously, it is still by no means a steel trap.

The Chinese could learn an important lesson from the latest debacle in American infrastructure.

On the ground level it may seem like China has a closed capital account. The dam’s walls reach through the thick clouds of smog and must surely continue to infinity. Of course we know this is not to be true. The height of the walls, although unseen, is actually quite limited.

As China continues to pump credit into the system, the water level will continue to rise. In this case, the bubbles will grow bigger and bigger. Prices we find ridiculously high today, could get even more absurd. The rise in commodities, housing prices although under pressure for Chinese authorities could continue to rise as well.

The stock market which everyone believes left for dead, may rise from its shallow grave and roar like never before. Pension funds will begin allocating additional holdings to the stock market as soon as this week. This is pretty serious development. The last thing Beijing wants to do, is torpedo the pensions of millions of workers. On the back of this move, Chinese authorities have cut equity margin requirements from 40% to 20%.

Apart from another bubble in Chinese stocks, I think there’s an interesting plan here to push equity prices higher and then swap debt for the inflated equity prices. Whether or not this is the ultimate goal, it will be something to watch going forward.

And of course as these bubbles rise through the clouds and come out the other side they will be within reach of the wall’s towering heights. And once again, despite patching up most of the leaks in the dam, China will find itself in the midst of a capital outflow dilemma.

But before the water level reaches the wall’s towering heights, the pressure on the few remaining leaks in the walls will continue to build. The leak of my particular curiosity is bitcoin. Despite the Chinese Authorities trying the darndest to clamp down on bitcoin in China, the price has continued to rise.

In short, as the one of the few remaining pressure valves left to Chinese capital flight, this currency/commodity should continue to benefit immensely from the recent shift in Chinese policy to a more closed capital account and rising credit levels.


DISCLAIMER: This blog is the diary of a twenty something hedge fund manager who has never stepped foot inside a wall street bank. He has not taken an economic or business course since high school (for which he is immensely proud of) and has been long gold since 2012 (which he is not so proud of). In short his opinions and experiences make him uniquely unqualified to give advice. This blog post is NOT advice to buy or sell securities. He may have positions in the aforementioned trades/securities. He may change his opinion the instant the post is published. In short, what follows is pure fiction based loosely in the reality of the ever shifting narrative of the markets. These posts are meant for enjoyment and self reflection and nothing else. So ENJOY and REFLECT! 

 

Trump’s First Stock Market Correction: Coming Soon?

Trump’s First Stock Market Correction: Coming Soon?

“First they came for the Socialists, and I did not speak out—
Because I was not a Socialist.

Then they came for the Trade Unionists, and I did not speak out—
Because I was not a Trade Unionist.

Then they came for the Jews, and I did not speak out—
Because I was not a Jew.

Then they came for me—and there was no one left to speak for me.”

The US stock market, like the man in Pastor Martin Niemöller’s poem has ignored the continued absence of all the drivers which have pushed it higher. One by one the Trump rally dominos have continued to fall.

First the market turned for China.

Given my belief that Chinese economic activity is the largest driver of the global reflation trade, it is important to note that some of the indicators coming out of China turned long before Trump was elected. The PBOC began tightening in August of 2016. Shortly after, M1 Growth YoY turned down.

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The impact of this tightening bias from China’s central bank has continued to impact bond yields which have continue to hit multi-year highs.

Then the market turned for US treasuries.

“Accelerating” inflation and rising US growth was supposed to have marked the end of the bond bull market…

And yet the US 10 year peaked in mid-December.

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Meanwhile the 30 year never broke out of its range to begin with.

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Then the market turned for gold.

But who cares about the yellow metal? Investor fears are shifting from accelerating growth to stagflation, or are worried of the implications of rising populism around the world, particularly in the EU.

Soon the market will turn for stocks, and there will be no one left to hold them up…

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Russell 2000 (black),  US 10year (teal), Inverse of Gold (orange)

 

EXCEPT the euphoric levels of sentiment and positioning.

The only thing left holding up the US stock market at the moment is the narrative, which I think is in danger of a rather dramatic adjustment.

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Let me be clear, I am not calling for the end of the US equity bull market… yet. Simply that I believe the odds of a correction in the US stock market to be quite high over the next two to three months. I’m not loading up the boat this instant, but I am now keenly looking to add to a short position over the next month.


Disclosure: The Klendathu Capitalist is short IWM. This blog post is not advice to buy or sell securities. The author is simply informing you of his thought process in hopes that both the author and the reader will learn from his mistakes.

 

Euro vs Dollar: Ecks vs Sever

Euro vs Dollar: Ecks vs Sever

 

Ecks vs. Sever is an American-German film. It’s also one of the worst “films” of all time. I saw it when I was a boy and to be honest, I don’t remember the plot but the dueling spy film financed by Germans and Americans with the tagline “Your most dangerous enemies are the friends you’ve double-crossed” feels relevant to the tectonic shifts echoing back and forth across the Atlantic…


When I don’t know what to write about, I find myself looking at charts for inspiration. Given the one man nature of my operation, there’s always an interesting chart that I have overlooked, and this process of reviewing charts always leads to a revelation or two. The target of today’s conversation, is the Euro, but be warned, there’s a fair bit of geopolitical analysis in this piece.

We have a broken 20 year trend-line. We’ll get to that interesting momentum divergence later…

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A temporary bounce off at 12 year trend-line.

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As well as a strong line of support around 1.05 with positive divergence in RSI momentum.

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Add it all up and what do you get?

Back in December, I went tactically long on the Euro versus the Dollar. At the time my thought process was that sentiment was overly bearish (I could practically hear the screams for EUR/USD parity from my brother’s house in the mountains of Idaho). And despite years of record capital outflows, the Euro refused to break to parity.

Important to note that we’ve already begun to see a reversal in these capital flows. From the WSJ:

“Investors in the eurozone, for which data is more delayed, sold €15.99 billion ($17.2 billion) more in foreign bonds than they bought in the three months through November, becoming net sellers for the first time since 2012.”

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As shown earlier, the technical back drop was also compelling, at least from a short term perspective. RSI momentum had turned bullish, while the Euro refused to make a significant new low.

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Most importantly, inflation was finally on the rise and I thought that the monolithically slow ECB would be forced to taper faster than current market expectations. From Another Head Fake: Why The Euro Is Headed Higher:

“Imagine inflation hitting 1.5% over the next few months with an accelerating trajectory. In spite of the ECB’s QE, long term rates could begin to rise, and we would start to hear rumblings of a potentially accelerated taper out of the ECB further pushing rates European sovereign rates higher.”

Turns out, I was wrong. Inflation in Germany accelerated to 1.9% in January.

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German CPI (YoY)

Luckily I was generally right, rather than precisely wrong like Draghi was.

Meanwhile, as of writing this article, the 10 year German Bund is offering a paltry 41 basis points of yield. Inflation has gone too far, forcing a stern response from German Finance Minister Schauble. From the FT:

“The euro exchange rate is, strictly speaking, too low for the German economy’s competitive position,” he told Tagesspiegel. “When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany’s export surplus . . . I promised then not to publicly criticise this [policy] course. But then I don’t want to be criticised for the consequences of this policy.”

So to me, it seems the ECB has some ‘splaining to do. They have to sell NIRP to those “poor” German savers who are fighting 2% inflation. Clearly they aren’t selling it well. Support for Merkel’s Euro-centric party is waning.

Unfortunately, these are the sacrifices the northern creditor nations will have to make in order for the European project to succeed. The southern states simply owe too much debt. The only political remedy to said debt burden is devaluation through inflation and financial repression.

This puts the states of the EU at odds with one another and unfortunately this is the part where I get into some nasty geopolitical analysis, for the European Union is not an economic project but a political one. For those uninterested in my geopolitical analysis skip the following section denoted by the horizontal lines (apologies for the length):


“To combat the call of sin, ie., Resistance, the fundamentalist plunges either into action or into the study of sacred texts. He loses himself in these, much as the artist does in the process of creation. The difference is that while the one looks forward, hoping to create a better world, the other looks backward, seeking to return to a purer world from which he and all have fallen.” ~ Steven Pressfield

From the 1500’s to the dawn of the 20th century, the European nation state reigned supreme on the global stage. Through superior technology and capital pooling capabilities, these small countries were able to build empires on which the sun never set. But in the last 100 years, with the emergence of the supranational powers of the US, Russia, and most recently China, these countries have slowly faded into the background. In order to compete, the nations of Europe needed to band together, forming their own supranational organization, the European Union.

And yet, from the lens of global significance, the EU has been an unmitigated disaster. What started off as an interesting idea, quickly became a dying man’s last gasp for glory. With flattening population growth, a stagnant economy, and widening inequality, the European Union gives trashcan fires a bad name.

Already under tremendous pressure, the migrant crisis is not the final straw but the ten ton elephant that broke the camel’s back. At first these people lost their voice on the global stage. Then the bureaucrats from Brussels, took their voice in European affairs away. And now finally, they see the migrants as a threat to the last thing they have left, their national identity.

As Rahm Emanuel infamously said, “A crisis is a terrible thing to waste” and populist leaders have seized on this opportunity, promising their growing base a return to their nation’s imperialist glory (my emphasis in bold):

“The aim of this program is first of all to give France its freedom back and give the people a voice,” ~ Marine Le Penn

The people have lost their voice. They have lost their country. But now they have the opportunity to take it back. It doesn’t matter whether or not these people are good leaders they are saying all the right things to get elected. To turn the clocks back a bit and egotistically highlight a post I wrote back in November 2014 titled Desperation: Why We Will Continue To Elect Awful Leaders:

“The point is that it has become exceedingly obvious that politicians no longer have to be good at their job to get elected. They can skate by on big promises, grand statements, and “not doing stupid shit”. Of course these are terrible qualities to have in any human being let alone an elected official…”

This was the Trump playbook. Recall Trump’s main goal for the presidential debates was to not come off as an insane ego-maniac, while along the way promising everyone something: the resurgence of coal to West Virginia and Pennsylvania, the border taxes on foreign imports to the midwest, the repeal of Obamacare while maintaining coverage for all, etc… etc… And now like a New England Patriots coach, the populist candidates of Europe have stolen his playbook. The following is an excerpt from Reuters (my emphasis in bold) describing Le Pen’s “manifesto”:

“It says a generous policy of tax cuts and welfare increases would be made possible by fighting social security fraud, tax evasion and changing tack on the EU and migration, but without explaining how that would be done.

Tax cuts, increased welfare, no migrants, oh my! What a plan! How can anyone compete? Seriously? No explanation? Who cares! It all sounds so fantastic. Let’s have our cake and eat it too!

Status quo politicians cannot hope to promise as much as these rising right wing candidates can simply because the public has little to no trust in them. The status quo has failed to deliver on their campaign promises for decades as the middle class in developed economies has slowly been hollowed out. Most people in the US saw through Hillary’s phony promises in a heart beat, but Trump, they gave him the benefit of the doubt.

And in case you had any doubt, on the public’s level of trust in the status quo politicians versus these populists politicians, look no further than the French election. Francis Fillon who is arguably the best candidate (from an economics perspective) has been accused and will likely be indicted on charges of graft and misuse of state funds. From the NY Times:

“Mr. Fillon’s campaign was thrown into turmoil last week after Le Canard Enchaîné, a weekly newspaper that mixes satire and investigations, reported that his wife, Penelope Fillon, was paid with taxpayer money for a bogus job as a parliamentary assistant to her husband and his deputy in the National Assembly, the lower house of Parliament.”

Interestingly enough, Le Pen is under investigation for THE EXACT SAME BEHAVIOR and yet no one gives a shit. From the same NY Times article:

“Ms. Le Pen is facing her own allegations of financial misconduct at the European Parliament, where her party is accused of paying its staff members with European Union funds, which can only be used for parliamentary aides. Ms. Le Pen is refusing to repay the €300,000 that the European Parliament is seeking to recover.”

So once again, I must ask how are the status quo politicians supposed to compete with candidates who can promise the moon while simultaneously getting away with political suicide?

Given everything I’ve said, I believe the odds are quite high for a right wing nationalist to win a major election this year, whether it be the Dutch in March, the French in May, or the Italians in the summer.  If just one of these dominos falls it could set off a chain reaction leading to the break up of the EU.

 


BACK TO MACRO (sort of)!

I believe the geopolitical risk I have outlined has begun to be reflected in the breakage of the 20 year upward trend-line.

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So despite the positive momentum divergence, I do not expect this to be an important bottom that will give way to another sustainable push higher in the Euro. Like my previous post said, I believe this move to be a #HeadFake.

But given the inflationary pressures there’s still room for rates in the EU to push higher before their economies start to suffer from any tightening. Recall that interest rates were sub 1% out to 20 years in some EU states.

On top of being trapped in the same deflationary spiral the rest of the world finds itself in, the EU has been dealing with a series of rolling crises that has not allowed these economies to build any sort of momentum that would lead to significant investment. In short the European economies are starving for more investment. Higher rates will spur the banks to lend and that investment because of the prolonged drought will have outsized effects.

Unfortunately, the same cannot be said about the US, which has been growing somewhat consistently since the GFC. Perhaps more importantly, the US, despite what Trump says, does not suffer from a lack of capital investment.

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So far, the only thing higher US rates have achieved (other than rising bank stock prices and a stronger dollar) is a tightening of financial conditions for the US consumer who has been struggling under a massive debt burden.

It won’t be long till the other more connected sectors such as the auto or housing sectors feel their wrath. While Europe will benefit from rising rates, the US will not. And because rates pushed higher in the US first, the US has already begun to feel these negative effects. I expect this divergence to continue further compressing the spread between US and German interest rates, which is the major driver of the Euro versus the Dollar.

But despite my bullish short term disposition on the EUR/USD, there still remains quite a bit of overhead resistance. The thick bold line, is the 20 year trend-line. We could break above it temporarily, as nothing is set in stone, but in the end, given the geopolitics of the situation, it won’t be long till we see the Euro go much much lower.

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The Reflation Trade

The Reflation Trade

Dear Reader,

I wrote this post a few weeks ago, while on vacation but for a number of reasons I delayed posting it. If you’ve been keeping up with my posts, you’ll have already read a good portion of what follows. But what I think I’ve done here, is distilled the essence of what I believe is the reflation trade and (now that base effects are set to peak next month) its possible drivers going forward. Once again, at the very least, I hope you find this as stimulating to read as I did to write.

Cheers!


While my grandfather was working for the Institute for Defense Analysis during the 1970’s he developed an algorithm to break Russian codes.  It was quite successful and would go on to be applied to a number of important areas including the solar cycle. At the time, it was widely believed that there was an 11-year cycle that drove solar activity. But an article published in 2015 titled “Irregular heartbeat of the Sun driven by double dynamo” asserts that there is a second cycle or dynamo that drives solar activity. The authors go far as to predict these two dynamos would counteract each other in the 2030’s producing a cooling period that hasn’t been seen in over 400 years.

“The model draws on dynamo effects in two layers of the Sun, one close to the surface and one deep within its convection zone. Predictions from the model suggest that solar activity will fall by 60 percent during the 2030s to conditions last seen during the ‘mini ice age’ that began in 1645”

The analogies to the current climate of the global economy should not go overlooked. If the demographers and history are any guide, we are at the end of a debt super cycle, arguably the largest in history. When it ends, we too will enter a cooling period. With the emergence of China in the 21st century, the global economy finds itself driven by a pair of dynamos.

But investors have become so accustomed to the US driving the global credit cycle that they have missed the origin of the reflation trade. The dollar, commodities and inflation have all risen together for the first time in over a decade which has left investors scrambling for a narrative to explain this paradox. Fortunately, the recent US presidential election has provided just that. Despite the “coincidence” of commodities bottoming with China’s economy in February of last year, investors have latched on whole heartily to the “Trumpflation” narrative. Or to use another analogy, investors have entered the Jade City, but they have become distracted by the Giant Green Floating Head.

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Unbeknownst to investors, China is behind the curtain pulling the strings. And if we continue with the analogy, I guess my pulling back of the curtain makes me Toto.

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Although I’d hardly be the first to do so. CrossBorder capital and others have been trying to tell investors for months that this was the case. But unlike them, I am not a China bull. I am in the “China is a massive bubble” camp. The reflation trade, being yet another extension of said bubble, will eventually die out. Sooner rather than later I will argue. But before I do, let’s go back and look at the mood around the start of the reflation trade.

In the depths of the January 2016 sell off oil had plunged to $26, the trade weighted dollar hit a multi-decade high and most importantly, consensus believed China’s economy to be headed for a hard landing. Not to pick on Kyle Bass, but his February 2016 letter hit the proverbial nail on the head (my emphasis):

As it is obvious that China’s economy is slowing and loan losses are mounting, the primary question is what are China’s policy options to fix the current situation?”


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Yes, it was obvious. Looking up at the chart, industrial profits and sales had turned negative. Everyone knows you can’t service a growing debt burden on negative profits, just like everyone knows that China has an enormous debt bubble.

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But unlike the 2008 financial crisis when the central authorities, the Federal Reserve and US treasury, were completely oblivious to the actual problems, the Chinese authorities, and everyone else for that matter, knew exactly what the problems were. What Kyle Bass and others (myself included) missed was that the Chinese authorities were planning a Battle of the Bulge type counter attack in the form of a massive stimulus push.

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For those in need of a quick history lesson, in the winter of 1944, the Germans were trapped. Fighting a war on multiple fronts with dwindling resources it was obvious they would lose the war (sound familiar?). And because it was “so obvious” that Germany was going to lose, the Allies let down their guard and were caught flatfooted when Germany launched one of the largest counterattacks in human history. From Wikipedia:

“American forces bore the brunt of the attack and incurred their highest casualties of any operation during the war.”

History is not without a sense of irony, as western hedge funds and speculators have had their shorts knocked off them as this reflationary trade has gone further and farther than the bears could have possibly imagined. Throwing salt in the wound, the lynch pin of the Chinese economy, State Owned Enterprises (SOEs), have roared back to life with profit growth turning positive for the first time in over two years.

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But it would be foolish to think this stimulus is one, sustainable and two, without its costs. The Yuan took this reflationary policy on the chin. Despite spending $320B in reserves to defend the Yuan in 2016 it still fell 6.5% against the dollar. And even though China’s economy bottomed in Q1 2016, it still took months before the country stopped exporting deflation to the rest of the world.

More importantly, since China had been exporting deflation for so long, the market became convinced that deflation would continue in perpetuity. I think we all remember the panic last summer to reach for anything with a positive carry. What the market and more importantly Central Bankers were missing was the fact that deflation in China had in fact bottomed, and although still negative, was rising sharply.

                                               Chinese PPI
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This turn from deflation to inflation also fooled Chinese investors who piled into the record low bond yields. In fact, investors’ response to these rising inflationary pressures was so slow that yields in China did not bottom until PPI had already turned positive for the first time in over 4 years!

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And this is where things get very tricky for the Chinese authorities. They wanted this inflation. Just not this quickly. Locked in a deflationary debt spiral, a little inflation is a gift from the financial gods…

And we’ve actually seen the US, EU and Japanese economies all respond positively to these rising inflationary pressures. The combined strength of the three large economies all rising together may even be able to hold China’s slowing economy for a bit longer (we’ll get to that bit later).

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…BUT in China where the bond bubble is so intertwined and over levered that a mid-size brokerage firm can’t even default on some of its debt obligations without causing a major panic, rising rates are down right catastrophic. In the depths of China’s December bond panic, a “multi-billionaire defaulted” on just $13 million worth of bonds. I use quotes, because anyone can be a billionaire if they borrow a few billion dollars and ignore the liability side of their balance sheet.

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I doubt he’s the only one swimming naked. Wealth management products (WMPs) are incredibly susceptible to rising interest rates. These Ponzi-finance vehicles have increasingly invested in each other which has pushed counter party risk exponentially higher. From WSJ:

“Some 40% of the assets in wealth management products—the biggest portion—was invested in bonds as of the first half of this year, up from 29% in 2015, according to Moody’s Investors Service.”

This inter-connectivity of WMPs has further restrained the PBOC’s ability to tighten. In spite of rising inflation, if the PBOC wanted to keep the economy going they would have to inject more liquidity… and that is exactly what they did. From WSJ (my emphasis in bold):

“On Friday [December 16th], the PBOC tapped an emergency lending facility it created in 2014 to extend 394 billion yuan ($56.7 billion) in six-month and one-year loans to 19 banks. That pushes the net amount extended through the facility to 721.5 billion yuan so far in December, a monthly record, according to Beijing-based research firm NSBO.”

The Chinese government finds itself in a constant battle against short term destabilizing forces. Every time it tries to take its foot off the gas, the economy gets pulled into the deflationary whirlpool, Charybdis, prompting even more Cow Bell. I’m mixing metaphors but you get the point.

On the other hand, they can no longer stimulate as much as they want or else they’ll face, Scylla, the nine-headed inflation monster that will rip their debt to shreds. It is quite likely that China has now reached the point where stimulus’ effect on the economy over the medium term is net negative.

More specifically, artificial increases in credit pushes inflation higher which in turn pushes up interest rates which in turn tightens liquidity thereby defeating the purpose of stimulating in the first place. My guess is that the recent monthly record of stimulus injections will show up in the inflation data much sooner than the Chinese authorities would like.

And although we have not yet seen rip roaring inflation, China has gone from DEEP deflation to rising inflation within twelve short months. The Chinese Authorities are clearly aware of this shift, but it’s unlikely that they acted fast enough. The PBOC did not start tightening liquidity until a month before PPI turned positive.

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It needs to be said, that by comparison, the PBOC is light years ahead of their developed market counter parts. The BOJ in particular pinned bond yields to the floor the same month that Chinese PPI had turned positive for the first time in over four years! But we’ll get to this monumental mistake later (actually we won’t, sorry). For now, let’s place our focus back on China, the epicenter of the reflation trade. If Total Chinese Liquidity is an accurate indicator, Chinese PPI could continue higher for the next few months.

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With that said, increases in liquidity have lost effectiveness on the Chinese economy over time.

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For those that do not know, the Li Keqiang index is a combination of railway cargo volume, electricity consumption and loans disbursed by banks. Considering Chinese bank loans hit a new record in 2016, and enough electricity (produced via coal) was consumed to blanket North Eastern China in smog for the past few weeks, it is safe to say that this trick is unlikely to be played again. The Chinese Government’s pivot towards stability over all else further supports this thesis. From Bloomberg (emphasis is mine):

“The price was too high, the leaders agreed, according to a person familiar with the situation. The buildup of debt used to fuel smokestack industries from steel to cement had helped win the short-term battle for growth, but the triumph itself undermined the foundations of long-term expansion, the leaders decided, according to the person, who asked not to be named because the meeting was private.

What followed was an order to central and local government officials that if they are forced to choose this year, stability must be the priority while everything else, including the growth target and economic reform, is secondary, said another four people familiar with the situation.”

The prioritization of stability over growth is not exactly music to the ear of an investor who put money into China on the hopes of +7% GDP growth and a stable currency. Which begs the question, how do you maintain stability while at the same time growing your debt fueled economy without it tipping over? Given China’s shadow banking risks, rising inflation, and dwindling FX reserves the simple answer is you can’t. Like riding a bicycle, the closer your speed approaches zero the harder it is to balance.

In China’s case, they are riding a bicycle while spinning half a dozen plates of uranium while juggling a pair of Molotov cocktails. If they slow down too much, they will not only crash, they will explode. Given said conundrum, it will be interesting to see how the local governments interpret this seemingly contradictory directive of stability over growth. If the PBOC is any indicator, we are about to witness some very odd behavior coming out of the Chinese Authorities.

Taking the lunacy a step further, the PBOC cut the RRR for the 5 largest banks, and injected a even more liquidity just a week later…

Before ordering banks to curb new loans.

From Bloomberg:

“China’s central bank has ordered the nation’s lenders to strictly control new loans in the first quarter of the year, people familiar with the matter said, in another move to curb excess leverage in the financial system.”

Given the recent price action of iron ore, when it comes to China, we should always expect the unexpected.

Because clearly iron ore is in short supply in China…

Perhaps demand is set to sky rocket as China seeks to further build out OBOR projects as well as domestic projects…

Or perhaps, investors are panicking about what to do with their falling currency and are trying to hedge it. There’s a certain level of irony (pun intended… I’ll wait) that the largest source of instability in China comes from a “pegged” currency. It seems self-evident that China’s pivot towards stability would include a stable currency but given the rising inflation, slower growth pivot, dwindling reserves and lack of defensive options, one wonders just how long they can support the Yuan.

A falling Yuan is the worst thing that could happen for the Chinese Authorities. For one it undermines their credibility. Secondly, it forces the PBOC to intervene and drain liquidity from the market. And finally, it pushes inflation higher as the value of imported commodities and goods rises. With that said, recall that the Chinese bond market is a massive intertwined web of hidden risk, and in a falling liquidity and rising inflationary environment it will get butchered worse than the younglings in Star Wars Episode 3: Revenge of the Sith.

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Getting back to Kyle Bass’s letter, it’s important to note the key role both Wealth Management Products (WMPs) and Trust Beneficiary Rights (TBRs) play in the Chinese Banking System. As the sticky systemic glue that binds the over-levered Chinese banking system together, they will be the focal point of any meltdown. From Kyle Bass’s letter (my emphasis):

TBRs are one of the biggest ticking time bombs in the Chinese banking system because they have been used to hide loan losses. The table below illustrates how pervasive TBRs are throughout the Chinese banking system. One can make many assumptions regarding the collectability of such loans, but our takeaway is that the system is already full of massive losses. Pay particular attention to the column of the ratio of TBR’s to loans on each bank’s books.”

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We saw just how potent TBRs can be when Sealand Securities, a midsize brokerage firm, suggested it would default on loan contracts due to a “fake seal”… or as I used to say in elementary school, “my dog ate my homework”, although honest to God, one time it did, so maybe we should give Sealand Securities the benefit of the doubt.

Although, the Chinese bond market certainly didn’t. Bond values plunged and the PBOC was forced to inject $23.7B of liquidity in one day. By the end of the month, the PBOC injected a record $120B in liquidity. Recall, this all came against the backdrop of the highest SOE profit growth in over 3 years! It didn’t matter that the underlying fundamentals of the debt had improved (albeit temporarily), the bond market still cracked! This episode appears to have spooked investor appetite for corporate debt as well.

So, if the situation is this bad that not even a medium size company can default on its TBRs without sparking a major panic, then how are the authorities supposed to “maintain stability” without pumping more liquidity into the system? And how can they pump liquidity and credit into the system without pushing down the Yuan?  And how can they maintain stability if the currency is falling?

You see where I’m going with this. It’s not difficult. I don’t believe and I certainly don’t claim to have any unique insights. If there’s anything that I do possess whether right or wrong is a high conviction level which allows me to see through all the smoke screens put up by the Chinese Authorities. And yet one only needs look at investor positioning to see that they have fallen hook line and sinker for these very smoke screens! The shift is simply astounding.

In less than a year Copper positioning has gone from record short to record long.

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Net US 10-year bond positioning is at an all-time low.

And of course, oil positioning is back where it was in 2014, right before it fell over 70%.

NYSE short interest has also plummeted back to 2014 levels.

And for the cherry on top, the “world’s most bearish hedge fund” has begun to pare back its short book.

This is despite what the CIO, Russel Clark, believes is a dream set up for a potential China crisis (Zerohedge’s emphasis).

“I have been able to play into market trends that would also do well in a China crisis. But suddenly, with the election of Trump, the broader market trends are all the opposite of how you want to be positioned in a China crisis. Higher commodity prices, higher US yields, and cyclicals over staples. One answer would be to go to cash and wait it out. The problem with this is that, if you believe that a Chinese crisis is inevitable then what would be the signals to begin to put on a China crisis trade? The answer would be capital flight from China, rising Chinese yuan deposit rates in HK (as this is a commercial rate, not set by the PBOC), and increasing market talk of capital controls. Unfortunately, these are all happening today.”

Sentiment and positioning aside, I do believe there is a good chance for the reflation trade to continue a bit further. Recall that both China’s economy and the oil price bottomed in February of last year (Coincidence?). From base effects alone these two factors should provide an inflationary tailwind over the next month or so. Given renewed developed market economy strength as well as the market’s slow reaction function (see summer bond buying panic months after deflation had bottomed) the reflationary trade could continue for an additional few months after inflationary pressures from oil and China peak in Q1 of this year.

Adding to that, I do believe there is some room over the next month for China and the Yuan to surprise to the upside. The Chinese Authorities have done a relatively good job shifting the narrative these past few weeks. Although I’d say hiking HIBOR to 105% reeks of desperation, it’s not my opinion that drives markets (if only).

I also see incredible potential for the PBOC to defend the psychologically important $3T reserve level this month. Come the release in early February, the market may be shocked to discover that the $3T reserve level has held. The Yuan could strengthen and the narrative would temporarily shift to the masterful job done by the Chinese Authorities, and developed markets would rally on the back of higher inflation.

Remember, since China is the source of the rising inflation, a stronger currency only amplifies this effect. Higher inflation in the US would push interest rates higher, strengthening the dollar and further accelerating capital flight out of China. So, by defending the currency, China is actually reinforcing the pressures that forced its defense in the first place. And of course, all of this would ignore how the PBOC might manage to hold the line in the first place. From Bloomberg:

“Financial regulators have already encouraged some state-owned enterprises to sell foreign currency and may order them to temporarily convert some holdings into yuan under the current account if necessary, they added.”

The Chinese Authorities, lauded for their long-term planning, are actually some of the best short term fixers the world has ever seen. Their ability to pull any and every lever necessary to kick the can down the road is as impressive as it is myopic. Sadly, the game, now in quintuple overtime, is almost over. The players are about to drop dead from exhaustion and this is the part where I agree 100% with Kyle Bass:

“Once analysts, politicians, and investors alike realize the sheer size of the impending losses and how they compare to the current levels of reserves, all focus will swing to the banking system.

As it is obvious that China’s economy is slowing and loan losses are mounting, the primary question is what are China’s policy options to fix the current situation? We believe that a spike in unemployment, accelerated banking losses / a credit contraction, an old-fashioned bank run, or more likely the fear of one or all of these events, will force Chinese authorities to act decisively.”

Given investor sentiment and positioning it is quite clear that China has “control” of the narrative for now. But we’ve seen how quickly that narrative can turn, and once again to use the Battle of the Bulge analogy it is important to remember just how quickly Germany folded after the battle ended.  The following is an account from a German tank commander who fought in the battle:

The Führer has asked us to do our very best and not to let him down. We only need to keep the enemy at bay for about three more months “. Three more months, then we would see the new miracle weapons and these would force the enemy to negotiate. I believed that.”

Once again the parallels to modern China are eerily similar. With the pivot towards stability, the Chinese Authorities are desperately trying to make it to the government reshuffle. Just nine more months! Nine more months and the miracle weapons, I mean Xi Jinping will have all the power he needs to manage the economy! Of course, history tells us that the battle of the bulge lasted only 40 days, and despite the war lasting another four months, the German miracle weapons never materialized.

Maybe China makes it to the government shuffle (and they probably will), but I fail to see how higher debt levels, smaller FX reserves, and rising shadow bank risk will be any more manageable under a regime where Xi has “full” control. What separates China’s coming crisis from the US’s in 08, is that it will happen not because the authorities failed to notice the problems, but because they have exhausted all capabilities to prevent it. And perhaps most importantly what separates the next global crisis from the last, is that it will most likely not be driven by the US, but by China.


Disclaimer: This blog post is not advice to buy and or sell securities. I am merely informing you of my intentions/opinions. If you act on the words of a twenty something millennial over the internet you have only yourself to blame. 

Corrections: PBOC official reserves dropped $320B not $400B. The Yuan fell 6.5% against the dollar not 8% in 2016.

Keeping Up With The 2017 Predictions

Keeping Up With The 2017 Predictions

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I know what you are thinking, “Hey kid, it’s only been a week. Your predictions aren’t even cold yet!” Just humor me. I believe this thesis has continued to play out and there are important developments that I need to talk within the context I have previously provided. That context being that rising inflation due to both China’s temporary rebound and higher oil prices would lift Developed Market inflation much higher than current expectations.

I expected and continue to expect, that this pulse of inflation (DM central bankers better hope its just a pulse) would be highly disruptive, catching a lot of investors and central planners off guard. Although we are only a little over a week into the new year and 2 weeks removed from that post, I think some important data has come out that further supports this thesis.

For starters, crude oil is up +80% YoY. Although it’s not looking the best, technically speaking.

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But Saudi Arabia appears committed to this production cut…

As does Iraq…

Meanwhile Iran has dumped its excess oil onto the market and the price of oil is still above $50.

But most importantly, Russia has started to cut production.

The addition of Russia, to the production cuts is potentially a paradigm shift in the oil markets. OPEC+Russia is a new cartel the likes of which we haven’t seen in decades. Recall just over a month ago, when Qatar and Glencore bought a portion of Russian Oil Giant Rosneft.

At the time I said:

“With this bit of news, the OPEC production cut, in my estimation, has gone from an act of desperation to a smart gamble. OPEC+Russia now produces half the world’s oil, making it a much more formidable cartel. A cut of 10% of their production would amount to over 4 million bpd, the likes of which North American shale could simply not keep pace with.

But I’m not suggesting they do that all at once. This new cartel will likely take the Federal reserve’s approach of slow and steady moves. IF this first relatively small cut holds and by that I mean the price of oil stabilizes somewhere over $50, I could easily envision a scenario when as early as this spring we see significant chatter of a future cut that could come this summer. In essence, the cartel would force the market to price in additional production cuts before they even happen. OPEC+Russia future production quotas could become the new Fed dot plots.

So far so good. But where am I going with this? Well that inflationary pulse from oil base effects may have lasted only a few months, but now with this new cartel, the price of oil could continue to rise potentially above $60 further pumping inflation into the NIRP districts of Europe and Japan. And perhaps the most overlooked dynamic of OPEC’s production cut, are the guys they’ve ceded defeat to, US shale.

Their “enemy”, US producers, have hedged 50% more production than they did going into the summer of 2014. Getting rid of them during the next plunge would be even more difficult, and it was already bloody difficult when they were totally unprepared. Adding that the OPEC member countries still haven’t recovered from the prolonged low price of oil (you don’t create a massive revamp of your country and IPO your national treasure if things are going swell). It seems suicidal for them to let the price fall, and restart the all out pump war.

To look through the lens of game theory, it is now in each member’s self interest to ensure the success of the production cuts. That speaks to a low probability of failure, although it must be noted that if this new cartel does fail, the downside to the price of oil is tremendous. Assuming, $50 oil for the next few months, it will be interesting to see the BOJ and the ECB try to sell their negative interest rate policies to their citizens.

Although in Europe no one is panicking… yet.

As a matter of fact the EU economy has responded quite well to this inflationary pulse. Remember folks, a little inflation always feels good in the beginning. Especially after a long deflationary drought. They say hunger is the best sauce, and it seems the Eurozone is proving that to be true. From Economic Calendar:

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I’ve been calling for a bottom in the Euro since mid-December. The record spreads between US and German bond yields were particularly out of whack. Now that inflation is surging higher in Germany, I expect this spread to tighten.

Higher inflation, combined with rising rates and strengthening European economies, further supports the rebound in EU banks. These “failed and insolvent” institutions should continue to climb that wall of worry we all know so well.

From a technical perspective the charts on some of these banks are starting to look quite constructive as well. (DISCLAIMER: I OWN SHARES IN RBS)

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From my 2017 Predictions:

“Come spring of next year, trend followers will be tripping over themselves to get a slice of these no longer “dead beat” banks. With their banks no longer in free fall, and rising interest rates, capital should flow back into these economies. Given the huge flows into US as of late, I suspect the EUR/USD carry trade is about to unwind.”

The technical back drop for long EUR/USD also looks quite compelling.

The refusal to break to parity despite pleas from dollar bulls is another strong case for a turn around in the Euro. Readers of my blog will recognize this chart. Notice how the momentum has continued to diverge from price.

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But once again, it is important to remember that this is all a head fake… a very powerful head fake but a head fake all the same. Debts are too high to sustain any real move in interest rates. It is simply shocking how little talk rising LIBOR has received of late.

But of course, I’ve been ignoring the elephant in the room, China, and its increasingly large and increasingly fragile debt bubble.

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If you go back and read Kyle Bass’s letter from February 2016 (and I highly HIGHLY suggest that you do), you’ll notice part of his thesis was built around the fact that Chinese SOE profits had turned negative, and could no longer service their massive debts. Those debts are at the center of a massive speculative and interconnected bond bubble I might add (but we’ll get to that later). From Kyle Bass’s letter:

“As it is obvious that China’s economy is slowing and loan losses are mounting, the primary question is what are China’s policy options to fix the current situation?”

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Yes it was obvious. Look back at the chart, Industrial profits were negative. Everyone knows you can’t service a growing debt burden on negative profits. Unlike the 08 financial crisis, where the central authorities, Fed and US treasury, were completely oblivious to the actual problems, the Chinese authorities knew exactly what the problems were. So what Kyle Bass missed was that the Chinese authorities were planning a Battle of the Bulge type counter attack in the form of a massive stimulus push. And since then, Chinese SOEs have roared back to life with profits turning positive for the first time in 2 years.

It would be foolish to think this stimulus is one, without cost, and, two, is sustainable. The Yuan took this inflationary policy on the chin. Despite spending $400B in reserves to defend the Yuan, it still fell 8% against the dollar but arguably even more important, is inflation which has taken off. Producer prices surged the most in over FIVE YEARS!

 

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Chinese PPI

Higher inflation will push interest rates up and as victims of the US housing bubble will tell you, it’s hard to sustain a speculative debt bubble when interest rates are rising.

Although that won’t stop China from trying. After an arguably disastrous 2016, stability has now become paramount in the Middle Kingdom. From Bloomberg:

“The price was too high, the leaders agreed, according to a person familiar with the situation. The buildup of debt used to fuel smokestack industries from steel to cement had helped win the short-term battle for growth, but the triumph itself undermined the foundations of long-term expansion, the leaders decided, according to the person, who asked not to be named because the meeting was private.

What followed was an order to central and local government officials that if they are forced to choose this year, stability must be the priority while everything else, including the growth target and economic reform, is secondary, said another four people familiar with the situation.”

That sounds vaguely familiar. From We Need To Talk About China:

“Despite the 6.7% growth, 2016 has not been a good year for China. I’ll be the first to admit that I do not fully understand why Xi is waiting for the government reshuffle next fall. In spite of the smoothest GDP growth in economic history, I find it hard to believe that higher debt levels, smaller FX reserves, and rising shadow bank risk will be any more manageable under a regime where he has “full” control.”

It looks like the Chinese authorities agree with my assessment. Economic stability will now be prioritized over everything else including economic growth and reforms. Not exactly music to the ear of an investor who put money into China on the hopes of +7% GDP growth and a stable currency.

Which begs the question, how do you maintain stability while at the same time slowing your debt fueled economy without it tipping over? Given China’s shadow banking risks (which I’ll get to later), and the bond panic in December, the simple answer is you can’t. Like riding a bicycle, the closer your speed approaches zero the harder it is to balance.

And In China’s case they are riding a bicycle while spinning half a dozen plates of uranium at once while juggling a pair of Molotov cocktails. If they slow down too much, they will not only crash, they will explode. It will be interesting how local governments interpret this seemingly contradictory directive of stability over growth. If the PBOC is any indicator, we are about to witness some very odd behavior coming out of the Chinese Authorities.

Although given the recent price action of iron ore, when it comes to China we should always expect the unexpected.

Because clearly iron ore is in short supply in China… or not.

Perhaps demand is set to sky rocket as China seeks to further build out OBOR projects as well as domestic projects… or not.

Or perhaps, investors are panicking about what to do with their falling currency and are trying to hedge it. There’s a certain level of irony (pun intended… I’ll wait) that the largest source of instability in China comes from a “pegged” currency. It seems self evident that China’s pivot towards stability would include a stable currency but given the rising inflation, slower growth pivot, dwindling reserves and lack of defensive options, one wonders just how long they can support the Yuan.

A falling Yuan is perhaps the worst thing that could happen for the Chinese Authorities. For one it undermines their credibility. Secondly, it forces the PBoC to intervene and drain liquidity from the market. And finally, it pushes inflation higher as the value of imported commodities and goods rises. With that said, recall that the Chinese bond market is a massive intertwined web of hidden risk, and in a falling liquidity and rising inflationary environment it will get butchered worse than the younglings in Star Wars Episode 3: Revenge of the Sith.

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Once again getting back to Kyle Bass’s thesis, it’s important to note the key role both Wealth Management Products (WMPs) and Trust Beneficiary Rights (TBRs) play in the Chinese Banking System. As the sticky systemic glue that binds the over-levered Chinese banking system together, they will be the focal point of any meltdown. From Kyle Bass’s letter:

TBRs are one of the biggest ticking time bombs in the Chinese banking system because they have been used to hide loan losses.The table below illustrates how pervasive TBRs are throughout the Chinese banking system. One can make many assumptions regarding the collectability of such loans, but our takeaway is that the system is already full of massive losses. Pay particular attention to the column of the ratio of TBR’s to loans on each bank’s books.”

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We saw just how potent TBRs can be when Sealand Securities, a midsize brokerage firm, suggested it would default on loan contracts due to a “fake seal”.. or as I used to say in elementary school, “my dog ate my homework”, although honest to God, one time it did, so maybe we should give Sealand Securities the benefit of the doubt.

Although, the Chinese bond market certainly didn’t. Bond values plunged and the PBOC was forced to inject $23.7B of liquidity in one day. By the end of the month, the PBOC injected a record $120B in liquidity. Recall, this all came against the backdrop of the highest SOE profits in over 3 years! It didn’t matter that the underlying fundamentals of the debt had improved (albeit temporarily), the bond market still cracked!

So if the situation is this bad that not even a medium size company can default on its TBRs without sparking a major panic, then how are the authorities supposed to “maintain stability” without pumping more liquidity into the system? And how can they pump liquidity and credit into the system without pushing down the Yuan?  And how can they maintain stability if the currency is falling?

You see where I’m going with this. It’s not difficult. I don’t believe nor claim to have any unique insights. If there’s anything that I do possess whether right or wrong is a high conviction level which allows me to see through all the smoke screens put up by the Chinese Authorities.

With that said, I do believe there is some room over the short term (1-2 months), for China and the Yuan to surprise to the upside. They’ve done a relatively good job shifting the narrative these past few days. Although I’d say hiking HIBOR to 105% reeks of desperation, it’s not my opinion that drives markets (if only).

I also see incredible potential for the PBOC to defend the psychologically important $3T reserve level this month. Come the release in February, the market may be shocked to discover that the reserve level has held. The Yuan could strengthen, with bitcoin falling to the low 700s if not lower. The narrative would temporarily shift to the masterful job done by the Chinese Authorities, and developed markets would rally on the back of higher inflation. Of course all of this would ignore how the PBoC managed to hold the line. From Bloomberg:

“Financial regulators have already encouraged some state-owned enterprises to sell foreign currency and may order them to temporarily convert some holdings into yuan under the current account if necessary, they added.”

 

The Chinese Authorities, lauded for their long term planning, are actually some of the best short term fixers the world has ever seen. Their ability to pull any and every lever necessary to kick the can down the road is both impressive and incredibly myopic. And sadly, the game, now in quintuple overtime, is almost over. The players are about to drop dead from exhaustion and this is the part where I agree 100% with Kyle Bass:

“Once analysts, politicians, and investors alike realize the sheer size of the impending losses and how they compare to the current levels of reserves, all focus will swing to the banking system.

As it is obvious that China’s economy is slowing and loan losses are mounting, the primary question is what are China’s policy options to fix the current situation? We believe that a spike in unemployment, accelerated banking losses / a credit contraction, an old-fashioned bank run, or more likely the fear of one or all of these events, will force Chinese authorities to act decisively.”

Although we aren’t there at this point, we are very very close. What separates China’s coming crisis from the US’s in 08, it is that will happen not because the authorities failed to notice the problems, but because they have exhausted all short term stability mechanisms. My argument today is that they are already completely out of ammo, and the last shoe to drop is the narrative. Although they can manage the narrative for a few months, to think they can last the year is a bet I would not make.

The Klendathu Capitalist apologizes for his bearishness but sees few alternatives. Like the ’08 crisis, we should expect higher inflation before severe deflation. One only has to remember the Fed’s repeated rate cuts that pushed inflation and commodities to record highs in ’08 right up until the US economy imploded.

Once again we are on the trapped in the middle of a similar set of circumstances this time originating from China. It doesn’t matter what Trump does or doesn’t do, he is almost irrelevant when it comes to China’s short term debt cycle which was going to correct with or without him. But he certainly makes for an entertaining sideshow, distracting US investors and business.

 

Lastly, DB put out a list of 30 things for investors to worry about. Curiously, the Yuan-USD peg was missing. As Jay-Z once said, I got 30 simple issues and the Yuan-USD peg ain’t one.

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Disclaimer: This blog post is not advice to buy and or sell securities. I am merely informing you of my intentions. If you act on the words of a twenty something millennial over the internet you have only yourself to blame. 

 

One Belt One Road: Position Size and Time Horizons

One Belt One Road: Position Size and Time Horizons

I think of myself as a China bear, and yet a lot of my growth based investments revolve around China. It’s the elephant in the room that we are all forced to take into account with every investment decision we make. Whether it be its massive demand for resources or equally massive infrastructure build out, China has shaped the world in ways the US has not done for decades, but China is pivoting. The things that China needs to continue its ascendant path have changed and the world will be forced to adapt.

China’s battle versus its dirty growth model has reached a heightened level as of late. Although the government will continue to push debt and stimulus through the system to prevent a deleveraging, there is only so much smog the citizens can take. With bitcoin breaking above $1000, the year is off to an ominous start in China.

But China will and has been pivoting to a cleaner growth policy. Perhaps China’s first and most noticeable step forward is the build out of its electrified vehicle fleet.

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Electric vehicles require an array of unique materials from relatively small and esoteric markets. For example, the lithium market is incredibly tiny and run primarily by three companies. A large portion of the world’s cobalt comes from the Democratic Republic of the Congo, of which China has already secured a sizable portion of, leaving little for the Western companies such as Tesla to use for themselves. Then of course there is graphite, which makes up the anode of the lithium ion battery. The mining of graphite is an incredibly dirty process. China is already the world largest miner of graphite and it will be interesting to see how they strike a balance going forward.

Although supporters of electric vehicles at times suggest electricity from the grid is cleaner than a gas powered car, that isn’t always the case, especially in China where the bulk of grid power comes from old and inefficient coal fired power plants. So China cannot simply switch to electrical cars and buses and call it a day. Which is why it is building out a huge number of nuclear power plants. For those interested in the case for Uranium, I recommend “Uranium: The Falling Radioactive Knife.

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At the same time, China cannot easily abandon the “environmentally dirty” policies that have lifted hundreds of millions of people out of poverty. These industries still employ millions of people. And of course there are trillions of debt tied to these slowing sectors that cannot be simply erased with the sweep of a broom.

In large part this is where the One Belt One Road policy comes into play. China will continue its infrastructure growth model in other countries where the ROI is much much higher. The money to finance these projects will come from China. Chinese banks will lend cheap Yuan to State Owned Enterprises who will in turn export China’s infrastructure boom to the central and south Asia.

There is an obvious flaw in this strategy (Hint: commodities are priced in dollars not Yuan), but on the surface, China’s OBOR program is an ingenious move that widens China’s sphere of influence, and also eases China’s difficult economic transition. At an order of magnitude larger in size than the US’s post WWII Marshall program, it is an effort the likes of which the world has never seen and will shape the world for decades to come.

But is the OBOR’s enormous size, more a function of the massive imbalance in China than prudent investment policy? Under Hu Jintao, power was more distributed, which led to rise of powerful vested interests. These vested interests delayed the necessary pivot which in turn has led to an insurmountable build up of excess debt and risk within China. It now takes seven units of debt for every unit of GDP growth. China has put a lot of eggs in this OBOR basket, and needs it to not only pay dividends for the long term, but as things become more and more unstable in China, for the short term as well.

Which brings me to the issue of time horizons. As a small investor I have a hard enough job matching my time horizons with my position sizes, although part of that I will blame on China’s inability to do the same. For me, it is becoming abundantly clear, that the time horizon for China’s OBOR program does not match up with its shorter term debt cycle.

We’ve seen the liquidity crisis in the bond market force the PBOC unleash a record amount of liquidity last month. With inflation rippling through the economy, the PBOC’s days of easing the economy with record amounts of stimulus are coming to an end. Instead of easing liquidity, stimulus will push inflation and interest rates well above the safe levels. These recent instabilities have fueled further capital flight. And despite talking a tough game, with each passing month, and feeble attempt to stop further capital flight, the PBOC is showing the world just how weak its hand truly is.

 

From the FT:

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“Investment professionals, however, have queried how the ultimate use of the money could be verified. “If someone transfers money for overseas study or medical treatment, how is the bank supposed to check what they really spend the money on,” asked Kelly Jiang, a Beijing-based real-estate agent who helps Chinese investors buy properties in London. “

Like all governments, the CCP is only as strong as its citizens allow it to be. With the Yuan in a virtual free fall, the crowd of “speculators” picking off the PBOC is growing into an army. And of course, there is another short term cycle that is completely out of their control and in the hands of a seemingly hostile actor, Donald J. Trump.

 

In my 2017 Predictions, I largely ignored The Donald. This is a bit of a copout on my part, and yet, given my other assumptions (to be discussed later), and lack of knowledge on the subject of Donald Trump’s inner strategy, I find this to be the best position for me to take. My mother, chided me for such a foolish move. I’m sure the Chinese Authorities will not make the same mistake. On the surface, The Donald is a paradigm shift in US politics and not taking him into account is likely to bite some of my predictions in the butt.

At the same time, given my belief that the US consumer is quite weak, and the tightening Fed policy will exacerbate their overall health, I find it quite likely that Donald’s positive impact on the US economy will be minimal during his first year on the job. And let’s not forget the US election cycle’s correlation to US recessions. From Raoul Pal’s Global Macro Investor:

“I recently noted that since 1910, the US economy is either in recession or enters a recession within twelve months in every single instance at the end of a two-term presidency… effecting a 100% chance of recession for the new President.”

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Policy makers can steer the economy when it is moving with speed, but once it stalls, it doesn’t much matter what you do, turning the wheel doesn’t change the fact that you are stopped. Just recall the last two US recessions, when the Fed slashed interest rates to record lows (at the time) and still the US economy slowed, stocks fell, and bubbles still burst.

The evidence continues to point to similar circumstances. We are seeing the late cycle inflation that exacerbates the record high debt loads. We are seeing the US consumer roll over. And although the dollar may weaken in response to the slower US economy, the reprieve the Yuan will feel will be temporary. In the end, the rest of the world will follow the US down, and the larger forces driving the dollar higher will reappear. Most importantly, despite, the OBOR program, and China’s other efforts to diversify itself away from the dollar and the US sphere of influence, China will find itself pulled down with the mythic force of Charybdis.

Time horizons, position sizes, lithium batteries, nuclear power, and The Donald, I realize this article is all over the map. So here is my attempt to rein it in. China is a system, and like any other system, it has its limits. As it bumps into those limits, variables become constants, and the predictions become easier. The paths to China’s success are dwindling by the day. This post has been my attempt to illuminate the available paths, and their potential pitfalls. Relying on China to stay afloat forever, is a fools errand, but one that has worked out well for the past few decades. Although I believe the sands in China’s hourglass are almost out, I also believe that some of the pathways in front of us are too tempting to not explore. #StayHedged.


Disclaimer: This blog post is not advice to buy and or sell securities. I am merely informing you of my intentions. If you act on the words of a twenty something millennial over the internet you have only yourself to blame.