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A Singular Viewpoint

A Singular Viewpoint

John Hsu
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Global Overview January 11, 2016

US

“China Drags Down Markets.” This was the lead headline in the Wall Street Journal last Friday, January 8th that said it all. Global markets from the get-go this year were pounded by mostly panic selling. It was compounded by technical issues in the marketplace although fundamentals were largely stable. Given what had happened late last summer in China, everyone was tracking intensely what was going on in the Shanghai market. Those fears quickly broadened to a focus on the yuan, the Chinese currency, and a concern about Beijing’s diminishing foreign currency reserves. However, as we pointed out earlier, these reserves still stand at $3.3 trillion at the end of last year. I think in large part due to the current focus on outflows and the possible pressure of further devaluation of the yuan, the PBOC through our old friend Ma Jun who is currently the chief economist of its Research Bureau, stated that China should fix the yuan to a basket of currencies rather than a single one which is the dollar. Beijing’s quick response suggests that the Chinese are now much more attuned to market sentiment and is reacting correspondingly.

Last year, the US stock market reacted negatively every time there was a hint of the normalization of interest rates by the Fed. From that perspective, the bad news is out of the way since Chair Yellen’s announcement. However, the Fed has openly professed for us to expect four rate hikes this year. In a way this has put the sword of Damocles back over our heads and resurrects the great debate as to whether good news is good news or whether it is not. Under this scenario, good news may likely accelerate the prospect of rate hikes whereas bad news may likely delay hikes which will be viewed constructively!

Any inflationary pressure that may accelerate the process will likely come from the labor front. Minimum wage increases have already been blessed by politicians since it is an election year. This is balanced by material costs which continue to be under pressure on a global basis. Nevertheless, we were always reminded by our mentor Alan Greenspan that inflation is a pendulum that swings from extreme to extreme. So therefore it is illusionary on the part of the current Fed and its Chair to believe that a 2% inflation target without overshoot is attainable.

On another point, it is perfectly fine to view the initial 25 basis point hike in interest rates as miniscule and insignificant. However, we maintain that it was a major and significant reversal of interest rate policy in 10 years. As such, we are likely to experience a continuum of rate hikes in order for the Fed to normalize its interest rate policy.

Away from the outlook on interest rates, uncertainties abound during this major election year. Of course at the top is the occupant of the White House, but there is also the possibility that the democrats may regain a Senate majority come November.

Overseas, whether Eastern Europe, North Korea or the Middle East, many of the same issues continue to dog us. However, in the case of the Middle East, the issues are not only exacerbated by the presence of Russia but now we have to contend with heightened tensions between Shiites and Sunni’s, in particular between Iranians and Saudis. The situation has been further complicated by recent events that have led to the break of diplomatic relations between the Sunni kingdoms and Iran. Furthermore, if Iran is allowed to follow through with last year’s agreement on nuclear proliferation, there is no question that the Sunni nations led by Saudi Arabia will go nuclear. These are a few of the issues that will confront the US and financial markets.

Nevertheless, the continued pressure on energy prices on a global basis is likely to persist due to excess supply. As such, US households will be a major beneficiary of low fuel prices. Under Abenomics, the yen will continue to be under pressure. Now there is the possibility that the yuan may devalue another 5%. Under this scenario, we believe that the US consumer will provide momentum and will help sustain a 2 to 2½ % growth rate this year for the US economy.  

 

China                                                                                                                          January 7, 2016

 

The 2016 global stock market meltdown is easily attributable to China. After all, China not only led the way timewise but also in terms of magnitude. Ostensibly, the China debacle was triggered by the widening spread between the onshore and offshore yuan and the ultimate move by the PBOC in changing the fixing of the yuan to the dollar. In many respects, the further devaluation of the yuan has been anticipated since last August. Stock market sentiment has been further pressured by the anticipated lifting of the ban on trading by large shareholders. It was scheduled to expire towards the end of this week. Sentiment was not helped by newly formulated circuit breakers.

We knew from our experiences in US markets that as much as circuit breakers are meant to calm the markets, more often than not they tend to exacerbate the problem at least on the short term. In the China market where 80% of investors are retail and where we euphemistically call it the “Wild Wild East”, the reaction was anything if not extreme. It is natural to assume that especially given the circumstances, the initiation of the use of the circuit breaker would bring on additional selling pressure and that it did this morning when the Shanghai market declined 7% in the first 29 minutes of trading.

This of course creates an opportunity for everyone, those who know about China and its financial markets and many who know very little, to sound off. This includes those who have superficially studied it but have never been to China, and everyone who is a self-styled master of the universe.

As we enter a new year, the annual ritual of, “Will there be a hard landing in China this year?” again rears its ugly head. We are amused by a self-styled expert appearing on TV the other day reciting the time tested statement that every government statistic by China is fraudulent and that the real economy in China is growing at about 1%. Unlike North Korea, China is not a state that is ruled by fear so it makes one wonder how a one-party regime can stay in power. After all of the bad news about China that has been globally telegraphed, the latest piece of the doomsday jigsaw puzzle is the issue of declining foreign reserves. Foreign currency reserves dropped to $3.3 trillion by the end of 2015. The naysayers have seized upon this as another sign of the beginning of the end of China’s growth story. I think we all understand that foreign currency reserves is not a never ending expanding number for China. Much of the last trillion literally were added in the last 5 years. After the July/August 2015 market debacle, it would be natural to assume a decline in the reserves, but at year end it still stands at $3.3 trillion.

When it comes to China, there is no question that there are key fundamental issues at hand. In addition, the Chinese authorities have made serious misjudgments about the fundamental nature of financial markets. However, the speedy abandonment of the recently instituted circuit breakers makes us hopeful that they are quick learners. We have maintained that instead of worrying about the short term behavior of the marketplace, the Chinese government should focus on the principal issue at hand, which is the direction and health of the Chinese economy and not be distracted by side shows such as the behavior of stocks at least over the short term. Not only are they distractions but in their focus on market behavior it makes some of us believe that they are taking their eyes off the ball. In fixing the health and well-being of the Chinese economy, all of these other issues become very secondary.

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