A Proactive Approach to Chinese Developments

Andy Waldock |

Obviously, China has dominated the news this week. There has been rampant speculation regarding the, “first roach” philosophy which suggests there’s much more to come in the way of Chinese Yuan/Renmimbi devaluation. I’m not very good at projecting political developments along an investment front. However, I do know enough to hunt down the information no one is talking about amid the hyperbole. What follows are a few actionable ideas based on the historical context of recent US economic developments and the transference of these principles to the Chinese economy’s cyclicality.

First of all, let’s begin with the general health of the Chinese economy. Information out of Beijing is notoriously spotty but, we’ll use what we can get. Our first chart shows Chinese GDP back to 1989. It is widely expected that Chinese Gross Domestic Product (GDP) may fall as low as 6% for 2015, down from early projections of 6.5%. While this may seem drastic, the Chinese economy is still one of the strongest in the world by growth. This means even more considering China is the second largest economy in the world. As this year has progressed and their market tanked, China’s first move, back in April, was to cut their lending reserve rate. This is the amount of capital that banks must keep on hand relative to their outstanding loan exposure. Traders may think of it as a margin to equity ratio. The lower this ratio gets, the more currency it allows to float on the open market and is therefore a growth stimulant. The recent currency devaluation makes owning Chinese currency, and therefore equities priced in Yuan or Renmimbi that much cheaper on the global market.

Chinese versus US gross domestic product.
 

Chinese versus US gross domestic product.

The US equity markets have been fueled by cheap dollars and cheaper interest rates. The combination of the stock market crash from 2008 -2009 along with a declining US Dollar as destroyed by the Federal Reserve Board (FRB) helped US equities become a bargain on the global market. This allowed foreign buyers to come in and purchase US equities at both a nominal value based on the market’s decline as well as a relative value based on their home currency. Foreign investors have capitalized on both the rise in the US equity markets as well as the strengthening US Dollar as shown on the chart below.

Once the US stock market became cheap enough on a nominal basis, foreign traders began to buy US equities in Dollars and benefited from the rally in both the equity rally and Dollar appreciation.

Once the US stock market became cheap enough on a nominal basis, foreign traders began to buy US equities in Dollars. They benefited from the rally in both the equity rally and Dollar appreciation.

I believe that we’re seeing the early stages of the same thing in the Chinese market through the Dow Jones Shanghai Composite.

The tandem effect of a falling Chinese stock market and a Yuan/Renmimbi devaluation will make Chinese equities more attractive on the global market.

The tandem effect of a falling Chinese stock market and a Yuan/Renmimbi devaluation will make Chinese equities more attractive on the global market.

Despite the dramatic Chinese equity sell off since June, their stock markets are still solidly in the black for the year, up more than 20% as I write this. Could it be that the Chinese officials are simply more proactive than the reactive nature of the FRB in our times of trouble? If so, this could be the beginning of the opportunity of the decade in Chinese equities.

The second trading point that I’ve yet to hear discussed is the seeming disconnect between the popular sentiment among the talking heads on the news regarding how these events will affect the September meeting of the Federal Reserve Board of Governors meeting. The general consensus that I’ve been reading is that this could very well push any move in interest rates out to 2016. The rhetoric has been decidedly dovish on this aspect. However, the Fed Fund futures are saying the exact opposite. The difference between rhetoric and the Fed Fund futures is that one is based on hyperbole while the other is a quantitative financial instrument. Let’s look at how they’ve reacted this week.

Fed Fund futures anticipate the possibility of a rate hike at the September 17th FRB meeting.

Fed Fund futures anticipate the possibility of a rate hike at the September 17th FRB meeting.

This panel shows Monday’s possibility of a .25% rate hike at the September Fed meeting was 46.43%. By Tuesday, this had jumped to 55%.

Contrary to popular opinion, based on all of the recent action, the market is more certain of a rate hike at the September meeting.

Contrary to popular opinion, based on all of the recent action, the market is more certain of a rate hike at the September meeting.

Should the market’s prognostication be correct, two things could happen. First of all, many retail traders will be on the wrong side of the trade which will lead to increased volatility as the market sorts itself out. Secondly, it will make Dollars more attractive on the open market as one of the few industrial economies with attractive yields. This would cause the Yuan/Renmimbi to decline further and perhaps create a washout bottom which would allow us to buy Chinese equities at even more attractive prices based on our purchases being made in Dollars through Shanghai.

Lastly, I want to focus on the gold market here in the US and obviously, priced in Dollars. A strengthening US economy in a globally devaluing world market should lead to price increases in the gold market. As more countries devalue, the outlook becomes increasingly negative to members of the devaluing countries which leads them to search for tangible assets to hold. I believe much of this money will find its way into the gold market as it’s understandable to investors. Whether it’s a true inflation hedge or, not isn’t the point of this piece. We’ve noted a couple of times recently that commercial traders had been swooping in to buy gold’s decline. Our most recent piece in Futures Magazine noted that commercial traders had become the most bullish on gold since 2001 and that a close above $1,100 per ounce could breathe some life into this market.

There are far more angles to deal with here than I have the space, time or, brainpower to elucidate. I try to keep things simple and look for trades. I leave the macro economic forecasting those better equipped. As it is, I definitely feel there are trades worth exploring using this heightened volatility to maximize the rallies to be sold like the US Dollar as well as declines to buy like gold.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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