wknd notes: China's Shrinking Box

“So I have a hot economy going. Every time we do something, he raises rates,” said Trump. “Now, what does that do? That means we pay more on debt and we slow down the economy, both bad things,” continued the President. On Monday he proposed a 10% middle-class tax cut. By Friday the S&P 500 fell -3.9%, down -9.8% from the highs. “Now, when there’s inflation, which there’s not of any consequence, I’m all for hiking interest rates. I’d even do it more. I’d rather do it slower and heavier, at a later date, if we need it,” he explained, sounding like he wouldn’t mind handling the job himself. “A very great guy last week was saying, ‘If you take what Trump has done and you leave interest rates where they were when I took over, we’d have the greatest - well, we already do; we already have - but we’d have the greatest economy in history,” said Trump. Q3 GDP printed +3.5%, down from Q2’s +4.2%, but still nearly double America’s 2% potential GDP. Stocks are lower on the year, despite the $1.5trln tax cut, the expanded budget, hurricane rebuild, deregulation, and Nafta resolution. The S&P 500 trades 15.7x one-year forward earnings, down from 17x in the runup to the 2016 election. What’s good for the economy and what’s good for financial asset prices are not always one and the same. “In theory Powell’s supposed to be independent. But I’m not happy with what he’s doing at all.” A WSJ reporter then asked what level of action Powell would have to take before Trump stepped up? “Well, there’ll be a point when I would have to find out. Look, there are a lot of people that agree with me, just so we understand, you know. I read them all. I read everybody. There are a lot of people that agree with me,” answered the President.

Week-in-Review (expressed in YoY terms): Mon: Chinese stocks +4% on pledges of government support (biggest jump in 2yrs), Russia warns US exit from nuclear treaty is dangerous, Italy defies Brussels and sticks to budget deficit plans, EU urges US to remain in nuclear treaty, Brazilian polls show Bolsonaro easily winning Sunday’s election, S&P -0.4%; Tue: Saudis pledge to meet any oil shortage, US company earnings cite input cost inflation, S&P -0.6%; Wed: Japan manu PMI +0.6 to 53.1, South Africa cuts 2018 GDP forecast -0.8 to +0.7% (raises budget deficit forecast +0.4 to +4.0%), Saudi’s MBS decries “heinous Khashoggi murder,” Corbyn calls for higher public spending in autumn budget, EU manu PMI -1.1 to 52.1 (Germany -1.4 to 52.3, France -1.3 to 51.1), Sweden’s Riksbank “to hike in Dec or Feb,” Canada hikes 25bps to +1.75% (3rd in 2018), US new home sales -13.2% (5mths of declines), mean home prices -0.6% (median home prices -3.5%), Tim Cook calls for US privacy protections similar to Europe, Ford cites “unexpected deterioration in Europe and China business and very strong results in North America,” Nasdaq worst day in 7yrs (-4.4%), terrorist mails bombs to Obama/Clinton/Soros/CNN, S&P -3.1%; Thur: Top Chinese military official lashes out at US, South Korea Q3 GDP +2.0% (exp +2.2%), Saudis admit Khashoggi murder was premeditated, Turkey central bank holds rates at +24% (CPI +25%), ECB reiterates plan to end bond-buying in Dec, Draghi “economic risks broadly balanced despite weaker momentum,” Draghi “confident of Italy/EU budget agreement,” US 10yr break-even inflation falls to 2.05% (January lows), Amazon earnings miss and soft guidance for holiday season (stock -9% after hours), Google advertising business slows (-5% after hours), Intel beats revenue estimates and raises guidance, S&P +1.9%; Fri: China’s renminbi hits 10yr low (volume spikes), Russia leaves rates unch at +7.5% (CPI +3.4%), US Q3 GDP -0.7 to +3.5% (exp +3.3%), Q3 personal consumption +0.2 to +4.0% (non-residential fixed investment -7.9 to +0.8%, inventories jump), core PCE -0.5 to +1.6% (exp +1.8%), S&P -1.7%; Sat/Sun: Brazilian presidential election.

Weekly Close: S&P 500 -3.9% and VIX +4.27 at +24.16. Nikkei -6.0%, Shanghai +1.9%, Euro Stoxx -2.5%, Bovespa +1.8%, MSCI World -2.7%, and MSCI Emerging -2.3%. USD rose +1.9% vs Sterling, +1.6% vs Sweden, +1.3% vs South Africa, +1.0% vs Chile, +1.0% vs Euro, +0.4% vs Australia, +0.4% vs Mexico, +0.2% vs Russia, +0.2% vs China, +0.2% vs Indonesia, +0.2% vs India, and flat vs Canada. USD fell -1.9% vs Brazil, -0.8% vs Turkey, -0.6% vs Yen, -0.3% vs Ethereum, and -0.3% vs Bitcoin. Gold +0.4%, Silver +0.4%, Oil -2.8%, Copper -1.2%, Iron Ore +5.7%, Corn +0.6%. 5y5y inflation swaps (EU -1bp at 1.66%, US -5bps at 2.35%, JP flat at 0.27%, and UK +1bp at 3.56%). 2yr Notes -10bps at 2.81% and 10yr Notes -12bps at 3.08%.

2018 YTD Equity Indexes: UAE +11% priced in US dollars (+11% in UAE dirham), Saudi Arabia +8.4% in dollars (+8.4% in riyals), Norway +6% in dollars (+8% in euros), NASDAQ +3.8%, Colombia +1.8% (+8.5%), Brazil +1% (+12.2%), S&P 500 -0.6%, Israel -2.5% (+3.9%), Russell -3.4%, Russia -4.9% (+8.7%), Mexico -6.1% (-7.2%), New Zealand -6.2% (+2%), Japan -6.4% (-6.9%), Portugal -7.1% (-2%), Finland -8.3% (-3.3%), Thailand -8.5% (-7.1%), Malaysia -8.9% (-6.3%), Switzerland -9.9% (-7.6%), Czech Republic -10.3% (-4.3%), France -11.4% (-6.5%), Netherlands -11.7% (-6.8%), Canada -12.1% (-8.1%), UK -14.4% (-9.7%), Taiwan -14.6% (-10.8%), Austria -15.1% (-10.2%), Euro Stoxx 50 -15.2% (-10.5%), Australia -15.2% (-6.6%), Singapore -15.4% (-12.7%), Sweden -15.5% (-5.8%), India -16.9% (-4.8%), Hungary -17% (-8.7%), Chile -17.6% (-7.9%), Spain -17.6% (-13.1%), HK -17.7% (-17.4%), Germany -17.8% (-13.3%), Indonesia -18.6% (-9%), Italy -19% (-14.5%), Denmark -19.3% (-14.7%), Ireland -19.5% (-15.1%), Belgium -19.6% (-15.2%), Poland -22.1% (-15.2%), Korea -22.9% (-17.8%), Philippines -22.9% (-17.5%), Greece -25.2% (-21.1%), China -26.4% (-21.4%), South Africa -27.9% (-15%), Turkey -46.8% (-21.5%), and Argentina -50.7% (-2.3%).

V-Day: “America built the global trading system, but we don’t really need it,” said the strategist. “We defend it, but we don’t require it.” For all the free-trade talk, the US is the most closed of all major economies. “When you include Canada and Mexico – basically vassal states – you could cut off trade with every other country and America would run just fine.” Plus we haven’t even started fracking south of the border. “We built the trading system to support our allies during the Cold War. We subsidized them for so long we forgot why we were doing it. But the war is over.”

V-Day II: “The US pays for the security that underpins world trade,” continued the strategist. “And we provide the excess demand that allows the world’s mercantilists to function.” No large nation/block is willing to run a current account deficit like we do. “The Bushes and Clintons kept it going. Obama too. They kept the Cold War alive. And it was great for Wall Street, multi-nationals, their executives.” But it wasn’t great for most workers. “The rearrangement we see today was inevitable. It just needed a leader strong-willed enough to defy the establishment.”

V-Day III: “Neither Democrats nor Republican leaders wanted this change,” explained the strategist. “But almost overnight, voters have woken to the notion that China is not our friend. It’s a strategic rival.” This genie will not return to the bottle. “Neoliberalists assured us that welcoming China in the WTO would yield a win-win.” It certainly helped them get rich. “A strong China is not really a win for the US. It’s not a win for Vietnam either.” Or anyone within 1,000 miles of Beijing. “This change is generational. And the impact on China will be terminal.”

Dead Presidents: “Read McKinley’s speeches, they were very interesting,” said our President. So I did. “He talked about how we won’t allow the outsider to come in and take our wealth from us without having to pay,” continued Trump. The 38%-50% McKinley Tariff passed in 1890, before William became President in 1897. McKinley introduced the term “reciprocal trade” and as President, threatened additional tariffs to lower foreign barriers. The economy flourished in his 1st term. He won a 2nd, warmed up to more open trade, then got shot. Teddy came next. 

Bond Math: “We own Chinese bonds,” said the investor. “But by the time we hedge out the currency risk and pay various ancillary costs, we end up with close to a zero yield,” he said. “We own the bonds because Chinese rates have a long, long way to fall.” If that happens, they’ll make money on the rally in bond prices, even though they earn no yield. “But China needs to attract capital from real money players - the kind of investors who are willing to take the risk of holding renminbi. Guys like us who hedge the FX risk don’t really help China solve its problems.”

Bond Math II: “In order to attract real inflows, China needs to offer a bond yield that’s competitive with US treasuries,” explained the same investor. “There are two ways.” They can hike interest rates or devalue the renminbi sufficiently far that investors feel they no longer need to hedge the currency. “Hiking rates is out of the question.” Higher rates would destroy their over-leveraged economy. “So, they’ll need to devalue their currency to a point that investors can buy bonds, unhedged, and believe they may make money on a rebound in the renminbi.”

Anecdote: “There are two types of macro traders,” said the macro trader. “The first makes money when what’s supposed to happen actually happens,” he continued. “They tend to own emerging markets, the S&P 500. They buy high yield and anything that rolls down a curve.” These strategies are implicitly short volatility; usually a winning proposition. “The second type of macro trader looks for situations where policy makers have found themselves trapped in a box. And to escape, they need to pay you.” These opportunities are less frequent. “The more acute the policy dilemma and the more advanced the corresponding stress or euphoria, the better. As the box gets smaller and the exits narrow it becomes easier to game out how they’ll ultimately act.” The most famous example was Soros’s bet against the Bank of England in 1992; the BOE’s only viable escape was a sterling devaluation. “I made a lot of money in 2014 as the European economy struggled and the Euro soared. The ECB was boxed. They either needed to ease and devalue the currency, or their banking system was going to implode.” Draghi made the ‘whatever it takes’ speech in 2012 but had not yet adopted QE. “There was no other way out of the box. So you could short European stocks against the S&P 500 and short the Euro versus the dollar.” In every plausible outcome, you were going to win. “Today, the Chinese are trapped. They need to keep policy easy to prevent implosion of their crazy-levered economy, but easing pressures their currency, which induces capital flight. So far, they’ve sidestepped this dilemma through capital controls and portfolio inflows (the latter a result of coopting global asset managers and bureaucrats by getting included into global benchmarks and the SDR basket). But these are just delaying tactics.” As the box keeps shrinking.

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

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