FYI | Mar 01 2007
By Greg Peel
The stories were a bit vague coming out of China on Tuesday but it now seems the reason for the sell-off was a comment from the government suggesting it would clamp down on illegal share trading activity. Well, there must be a lot of crooks out there.
The 9% fall in the Chinese markets was significant in that it was the biggest day’s fall since the government let on a decade ago that Deng Xiaoping had actually died. However, in the scheme of intensely volatile Chinese share markets, it was hardly anything to cause panic. To put things into perspective, the ASX200 has been the best performing index in the developed world over the past twelve months, rising 23% up to yesterday. The Chinese A share market had risen over 130%.
A 9% fall? Big deal!
Not only is the A share market small by comparison to global markets, only locals are permitted to own A shares. This should have been a fairly localised blip that shook out the shonkies. The foreigner-accessible Hong Kong market, which contains cross-listings, only fell 1.8% at the same time.
And besides, isn’t it a positive that the Chinese government should try to root out illegal activity in its share market? Wouldn’t any investor be pleased to know that the market is all above board? Shouldn’t the rest of the world feel a bit happier after Tuesday?
Yet that night in the US, the wheels fell off. For most of the day the Dow Jones was only down around a 100 points, which is nothing too scary on 12,000 plus. But suddenly it collapsed. Overnight reports suggested the catalyst – apart from China – was comments from Alan Greenspan that the US may yet face a recession. But (a) comments from the incumbent Fed chief Bernanke have been positive of late and (b) Greenspan actually said that on Monday.
So why did the US – and indeed the world – collapse?
In a rather timely bit of analysis, investment consultant GaveKal had shared its thoughts with subscribers only this last Monday (Is Risk Losing Its Appeal?; FYI; 27/02/07). Here’s an excerpt:
“Given that the liquidity surge of the past few years has come from the private sector multiplying what is actually shrinking primary liquidity, the sort of returns we’ve been enjoying would not be sustainable should the secondary liquidity dry up. Credit spreads remain tight at present, real rates are low and volatility is low. If this stays the case, markets will be okay. ‘However, we fear that in the coming weeks, one of these variables could change.'”
Well they only had to wait a day before low volatility gave way.
GaveKal had noted that the Indian share market (the little brother to the Chinese stock market in economic development terms) fell 2.8% on Friday – not an insignificant move. The analysts also noted there had been a spate of failures of sub-prime mortgage lenders in the US. These little observations led GaveKal to ponder whether the global appetite for risk wasn’t reaching a turning point. They suggested their very bullish stance on global equities may have to be “reined in” somewhat.
I am reminded of the small, seemingly minor events that lead up to a movie earthquake. A ditch caves in all of a sudden. Upright timber planks fall over for no apparent reason. Animals disappear. There is a shudder…
The earthquake that hit global equity markets had its source as much in the seriously overbought position of the market as much as China’s influence or anything else. GaveKal notes that the MSCI World Index had been trading at a 30-day relative strength index of over 60 for about the last three months. For those who appreciate such things, this is a long period of overbought-ness.
In a report this morning, the Australian equity strategists at Merrill Lynch noted:
“Our technical indicators for the ASX200 showed the market in heavily overbought territory. In our Investment Companion Weekly dated on 26 February, we stated that the market was technically overbought but we could not see a near-term catalyst to restore fair value.”
They didn’t have to wait long.
GaveKal also makes note of that age-old consideration that we were approaching the end of the calendar month, when fund mangers rule off their books before reporting to unitholders. After a good month, why take the risk? Lock in profits quickly before they’re all gone. Perhaps everybody had the same idea.
Respected market analyst Dennis Gartman noted in his newsletter yesterday that “sometimes it is not a matter of what you wish to sell, but what you can sell”. Many of the China A shares went “limit down” on Tuesday, meaning a halt to trading. Unable to liquidate, Chinese investors would have been forced to look elsewhere to cover positions – such as US securities or even gold. Gartman acknowledges the wisdom of Lord Keynes who said:
“The market can remain illogical far longer than you or I can remain solvent.”
Which may go some way to explaining the US$20/oz sell-off in gold on Tuesday night. Gartman notes that that trading session was one of the most volatile in memory. First, gold rallied some US$14/oz. That is the sort of response one might expect when the global markets suddenly get the jitters. However, late in the session it turned tail and dropped about US$30/oz. This, suggests Gartman, was due to panic liquidation of anything.
Gartman is adamant that the ultimate response from gold was actually one in the wrong direction, if not explainable.
The real impact of the global trigger was felt in emerging markets. Stocks in Brazil, Mexico, South Africa and elsewhere took a big hit, as did the relevant currencies when sellers needed to repatriate the proceeds. Such a response is one that screams risk reduction. And this is perhaps the real tsunami that has been brewing in 2007.
For a long, long time now there have been warnings about the yen carry trade. (See “It’s The End Of The World As We Know It, If The Yen Carry Trade Is Unwound”; Sell&Buyology; 15/06/06).
The yen carry trade has long been established as a means whereby investors play a virtual arbitrage by borrowing in yen for next to nothing and investing in higher interest paying currencies as far a-field as the US, Australia and Iceland. It has also become a sort of global investment model generally, where investors awash with liquidity eschew low-return scenarios and push the boundaries higher – into the likes of emerging markets and commodities as well as mature market securities. High liquidity ignites an appetite for risk.
Central banks in many parts of the world, including Europe, and more importantly Japan, have indicated recently that they will be tough on inflationary pressures and are more likely to raise rates than cut them. In the case of Japan, after a false dawn last year it appears the Japanese economy is reaching the point where a tightening phase may actually be in order. At the same time, central banks in the likes of the US and Australia have halted tightening, and may even be soon looking at easing, irrespective of ongoing rhetoric.
Notes Merrill Lynch:
“In essence the risk profile of the Japanese investors can result in large swings as
to where funds are allocated … during periods of risk aversion, they allocate to lower risk assets (bonds) and during periods of elevated risk appetite they allocate to risk or the so-called carry trades.”
Just as surely as a wave rushes onto the shore, it rushes out again.
While I have suggested the yen carry trade is a “virtual arbitrage” it is by no means a true arbitrage. For it to be successful, the relevant currencies must remain within a comfortable trading band. It is still a risk game. Thus when the wobbles set in it is likely that hedge funds et al would look to reduce exposures quickly.
The world has now begun a clear process of diversifying out of US assets. This is largely due to the perceived future discrepancy between the US economy and the global economy. The US economy, despite recent indications to the contrary, is expected to weaken while the rest of the world’s economy will not necessarily weaken at the same pace. Central banks are now diversifying into euro and yen, and in some cases gold. While this may be a healthy redistribution of global investment, it does tighten up carry trade opportunities, and make riskier trades look vulnerable.
Long hanging over the global economy’s head has been the size of the US current account deficit, which it holds mostly against Europe, Japan, and Asia. As the world diversifies out of the US, the US trade deficit is improving. This may sound promising, but that ain’t necessarily so. Notes GaveKal:
“Illustrating this point is the fact that every significant improvement in the US trade balance has led to an international financial crisis. And this makes perfect sense: a smaller US trade deficit means that getting a hold of US$ is difficult; and when that happens, a marginal user of US$ somewhere around the world gets cut off…and goes belly up. If growth around the world today does decouple from a slowing US, and if as a consequence the US does start to export less US$ (a scenario which not only “feels right” but which is increasingly backed up by data), then investors should be careful to avoid all borrowers of US$ and negative cash flow assets”.
So is this the beginning of Armageddon? No.
Looking at the realities, GaveKal notes that: equity and risk assets around the world were very overbought and have now corrected a little; real interest rates are much lower today than they were six weeks ago; and volatility has just increased markedly.
What the analysts believe is that: economic growth is slowing but it will not fall off a cliff, and we will not enter into a “deflationary bust”; and the liquidity environment could be changing.
Instead of having central banks withdrawing liquidity from the system and the private sector multiplying it rapidly, notes GaveKal, we could be moving towards a situation where the private sector’s ability to multiply money becomes constrained.
How to respond?
GaveKal suggests such an environment is one in which high quality growth companies do quite well while cyclicals struggle. This is actually the opposite of what has been happening so far in 2007. The analysts believe the bond market is indicating that “inflationary boom” trades will not pan out.
“We do not believe, however, that the overall upside trend in global equity markets is currently at risk. As we write the markets are trying to figure out whether the US, and the rest of the World, will enter into a deflationary bust. We won’t. And once the markets figure that out, the uptrend will restart. Finding this answer may, however, take a few weeks”.
GaveKal’s views are shared elsewhere.
In Australia, Merrill Lynch is advising to position toward large cap, blue chip stocks.
For now, the analysts recommend investors continue to hold domestic banks, property, large cap miners (BHP, RIO) and blue chips, and reduce small caps and small miners. They do recommend, however, keeping an eye out for a drop in the Aussie-yen that would signal a rush out of the yen carry trade. They are also a bit concerned about the oil price heading north again.
Citigroup analysts see the fundamentals unchanged, and yesterday as just an overdue correction. The Australian market will remain volatile as an abundance of liquidity and ongoing leverage hold markets at the top of their valuation ranges. Citi points to an expected cash inflow into the Australian market of $30 billion this year, compared to $6 billion in 2004. Overweight banks and accumulate resources, says Citi.
But watch out for, says Citi, a faster than expected unwinding of the yen carry trade, a mortgage credit crunch in the US, and the scale of private equity deals.
Everybody is watching the scale of private equity deals. The biggest one ever just occurred in the US – at about 80% debt. Hmmm.
The general feeling around the traps is that worn out concept of a correction we had to have. Just like May last year. And like last year, there might yet be more downside, and certainly more volatility. But then we resume. Hopefully.
We might want to hope the US doesn’t attack Iran.