The Overnight Report: Chinese Burn

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By Greg Peel

The Dow closed down 261 points or 1.5% while the S&P lost 1.7% to 2046 and the Nasdaq dropped 1.8%.

Reality

I suggested yesterday morning that I wouldn’t be at all surprised to see the ASX200 down a hundred points for Wednesday, having rallied a hundred on Tuesday in a rather inexplicable fashion, although I was never prepared to put the house on it.

I should have.

The only remarkable thing about yesterday’s plunge on Bridge Street was that it is so easy to explain only one day after a rally that clearly had little macro incentive, even though it appeared to be an index-wide order or orders with a little help from short-covering that sent the market surging.

The bottom line is that despite everything the Chinese government has thrown at its plunging stock market, nothing has come close to holding back the tide. What a greenhorn administration in Beijing is learning, when it comes to the realities of capitalism, is that if you encourage margin lending on the one hand you have to be prepared for the impact of margin calls on the other.

Leverage is the reason the Chinese stock market cannot find a floor. If you are margin-called on your stock market borrowing and you don’t have a pot of gold to draw upon, you must sell your stocks to cover your loan. If you are forced to sell at a lower price you risk still being underwater and getting margin called again. You must simply sell at whatever price you can get before you are completely wiped out, as presumably, many a Chinese retail investor is now, having bought on the government’s encouragement when the Shanghai index had already doubled in a heartbeat.

If you don’t want to try to sell into a vacuum on the stock market but still have to cover your margins, or if you have sold but not received enough at the price to repay your loan, then you must sell something else. The Chinese stock market is not the only market for which finance can be attained. Hence as we have watched prices fall in iron ore and copper this week for example, it is not just a matter of a read-through to a weaker Chinese economy. Big Chinese stock market investors will be selling whatever assets they have, including commodities, to cover their losses and loans.

It is probably also why we see gold having fallen around 50 bucks from its earlier rusted on price of 1200 despite the potential sovereign risk Greece throws up. What’s next? Houses in Sydney?

Snowball

I’ll leave that last thought hanging in the air as I note the iron ore price fell 11.3% last night.

The rise and fall of Chinese iron ore prices over time is typically driven by the ebb and flow of seasonal restocking and destocking of Chinese steelmaker inventories, with an underlying trend determined by the demand for steel. Steel demand has certainly weakened but now we have this flow-through effect on commodity prices from the Chinese stock market crash.

When the Shanghai Exchange opened at 11.30am Sydney time yesterday it immediately fell 8%, which was enough to accelerate the general selling on the Australian stock market. But the iron ore price was also down 4% overnight, prompting screams of OMG, for God sake get me out of my Fortescue. The losses are snowballing in Shanghai and snowballing in Sydney (if we ignore Tuesday).

Materials (-3%) and energy (-2.5%) led the ASX200 sectors lower yesterday when all other sectors lost 1-2%.

The good news, if there is any, is that Shanghai closed down 6%, not 8%, after Bridge Street had closed. But not before capitalist China reverted to what it knows best – communism – and simply halted trade in a lot of stocks.

Greece

We must not forget that the Greek drama is continuing in the background. If anyone remains in doubt whether Greece or China is the biggest issue facing global markets at present, consider that the 32% fall in the Chinese stock markets to date is equivalent, in dollar terms, to fifteen Greek economies.

Last night the news was that Tsipras has prepared a new three-year bailout proposal to take to the creditors which supposedly includes a more realistic reform agenda. This was taken on European markets to mean a sign of deal being possible, so European stock markets staged a bit of a rally and the euro found support. A short-covering rally was also triggered on the London Metals Exchange.

But presumably Tsipras’ proposal includes little of the way of concessions to the creditors’ demands, given that on the weekend his people told him to hold his ground. So, again, it can only come down to some sort of concession from the creditors if Greece is to stay in the eurozone.

Despite Tsipras' Disneyland promises made before last weekend’s referendum, Greek banks will now be closed beyond this Sunday, being the deadline for a new proposal.

Wall Street Gremlins

Usually European traders carry their closing tone into the opening of US stock markets before they all head home for the night. Not so last night, where China was the main cause of concern and US stocks dropped sharply from the open.

At least until late morning, when a software glitch, supposed triggered by an upgrade implementation gone wrong (cyber-attack has been ruled out), closed the NYSE trading floor. Electronic NYSE trading continued on the Nasdaq exchange and on the other ten or so exchanges in the US so the US stock markets were not shut down, but it was about four hours before floor trading resumed on the NYSE and minimal volume suggested brokers were very wary of returning on the day.

There may have been some element of shutdown fear that helped the Dow, for example, fall further on alternate exchanges but the US indices had already tumbled in early trade on the China story.

That story, and Greece, was not lost on the Fed’s FOMC when it met in June to discuss interest rate policy, and the implication from the minutes released last night is that the Fed may hold off on “lift off”, as it is now being popularly referred to, even if the state of the US economy suggests otherwise, given global market issues. This is exactly what Yellen’s bestie Christine Lagarde has been pleading all along. So whereas September may have been firming as the lift-off month, December is now the preferred prediction, if at all in 2015.

Last night the US ten-year yield fell 3 basis points to 2.21%.

Commodity Mix

As noted, the iron ore price fell 11.3% last night or $5.60 to US$44.10/t.

The story was nevertheless different in other commodities that have also been hammered this week. While China is often at the forefront of LME influence, London is also the hub of European base metal trading and thus developments in Europe are also influential. Base metal prices had been slammed all week so the supposed glimmer of hope for Greece and the fact many saw metals as oversold meant a price turnaround last night.

That turnaround sparked short-covering and by the close, nickel and zinc had rallied over 1%, copper close to 2% and lead and tin close to 3%. Only aluminium sat it out.

The European disconnect was also evident in oil prices last night. Weekly US inventory numbers came out showing an unexpected gain in crude and gasoline stocks, hence West Texas fell US$1.13 to US$51.83/bbl. Yet Brent was virtually unchanged at US$57.25/bbl. Having tightened into below three dollars recently, the Brent-WTI spread has eased back out to over five dollars.

Gold managed a US$3.50 rally to US$1158.00/oz, with a little help from a 0.6% fall in the US dollar index on euro strength.

The Aussie is this morning trading down 0.3% on a 24 hour basis at US$0.7426 but it did get down to around 73.70 yesterday as Bridge Street tumbled.

Today

The SPI Overnight closed down 34 points or 0.6%.

Alcoa reported June quarter earnings last night after the bell on Wall Street to kick off reporting season. Without looking into the details I note Alcoa shares are trading just a little higher in the aftermarket having fallen 5% in the day-session.

This report means JV partner Alumina Ltd ((ALU)) will kick off the local resource sector quarterly production report season today on Bridge Street.

The ABS will roll its local jobs numbers dice today.

Beijing will release China’s June CPI result.

All eyes will be on the Chinese stock market.

Rudi will make his weekly appearance on Sky Business' Lunch Money, noon-12.45pm.

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