It was a rough week for global markets. Across the markets, there was clear evidence of big investors reducing exposure. The theme was persistently risk-off (which means some money moving out of stocks and into bonds, out of broader commodities and into gold).
Unusually, it had nothing to do with economic data or central banks.
It had everything to with politics.
With the perception that the gap has closed on the presidential race this week, the uncertainty surrounding the outcome has elevated. And that’s being reflected in some skittishness across markets. And all we hear from Wall Streeters is that they don’t like uncertainty, and can’t calibrate properly on the potential outcomes on the presidential race might bring — as if they’ve been operating with such certainty and precision for the past eight years.
The reality: As we’ve seen over and over, throughout the crisis period, the global political environment has been anything but predictable. The economic environment has been anything but predictable.
If we think about all of the events along the way, over the past eight years: we’ve had the near global economic apocalypse, there was Cypress, Greece, the near defaults of Italy and Spain, the debt ceiling sagas, government shutdowns, Russia/Ukraine, threats from North Korea, the Ebola scare, an oil price crash, Brexit, and more.
Each has brought a potential shock to a global environment that was already on very shaky and uncertain footing, within which some semblance of stability and recovery was only present because it was being manufactured and managed carefully by the world’s biggest central banks.
With that, little, if any, credit can be given to the current President for the economic recovery. And it’s unlikely that the next Presidency will move the needle much either, unless it can come with a supportive Congress, to approve big and bold fiscal stimulus.
The debate last night was entertaining. It’s sad to see how the media manipulates facts and cherry picks quotes to fit their narrative.
But that’s what they do and it ultimately shapes views for voters, unfortunately.
Today, I want to focus on China and Trump’s comments on China’s currency manipulation. Everyone knows the U.S. has lost jobs to China. Everyone knows China has become the world’s manufacturer. But not everyone knows how they did it.
Is it just because the labor is so cheap? Or is there more to it?
There’s more to it. A lot more.
China’s biggest and most effective tool is and always has been its currency. China ascended to the second largest economy in the world over the past two decades by massively devaluing its currency, and then pegging it at ultra–cheap levels.
Take a look at this chart …
In this chart, the rising line represents a weaker Chinese yuan and a stronger U.S. dollar. You can see from the early 80s to the mid 90s, the value of the yuan declined dramatically, an 82% decline against the dollar. They trashed their currency for economic advantage – and it worked, big time. And it worked because the rest of the world stood by and let it happen.
For the next decade, the Chinese pegged their currency against the dollar at 8.29 yuan per dollar (a dollar buys 8.29 yuan).
With the massive devaluation of the 80s into the early 90s, and then the peg through 2005, the Chinese economy exploded in size. It enabled China to corner the world’s export market, and suck jobs and foreign currency out of the developed world. This is precisely what Donald Trump is alluding to when he says “China is stealing from us.”
Their economy went from $350 billion to $3.5 trillion through 2005, making it the third largest economy in the world.
This next chart is U.S. GDP during the same period. You can see the incredible ground gained by the Chinese on the U.S. through this period of mass currency manipulation.
And because they’ve undercut the world on price, they’ve become the world’s Wal-Mart (sellers to everyone) and have accumulated a mountain for foreign currency as a result. China is the holder of the largest foreign currency reserves in the world, at over $3 trillion dollars (mostly U.S. dollars). What do they do with those dollars? They buy U.S. Treasuries, keeping rates low, so that U.S. consumers can borrow cheap and buy more of their goods – adding to their mountain of currency reserves, adding to their wealth and depleting the U.S. of wealth (and the cycle continues).
The U.S. woke up in 2005, and started threatening tariffs against Chinese goods unless they abandoned their cheap currency policies. China finally conceded (sort of). They agreed to abandon the peg to the dollar, and to start appreciating their currency.
They allowed the currency to strengthen by about 4.5% a year from 2005 through 2013. That might sound good, but that was a drop in the bucket compared to the double digit pace the Chinese economy was growing at through most of that period. Still, the U.S. passively threatened along the way, but allowed it to continue.
With that, the Chinese economy has ascended to the second largest economy in the world now – on pace to the biggest soon (though it still has just an eight of the per capita GDP as the U.S.). But China’s currency is a bigger threat, at this stage, than just the emergence of China as an economic power. The G-20 (the group of the world’s top 20 economies) has had China’s weak currency policy at the top of its list of concerns for a reason.
The current global imbalances are the underlying cause of the global financial crisis, and China’s currency is at the heart of it.
And without a more fairly valued yuan, repairing those imbalances — those lopsided economies too dependent upon either exports or imports — isn’t going to happen. It’s a recipe for more cycles of booms and busts … and with greater frequency.
Are big tariffs the answer? Historically that’s a recipe for disaster, economically and geopolitically.
What’s the solution? I’ve thought that the Bank of Japan will ultimately crush the value of the yen, as the answer to Japan’s multi-decade economic malaise and as an answer to the stagnant global economic recovery. It’s an answer for everyone, except China. A much weaker yen could crush the China threat, by displacing China as the world’s exporter.
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All eyes are on the Presidential debate/face-off tonight. Heading into the event, stocks are lower, yields are lower and the dollar is lower — all a “risk-off” tone.
And the VIX (implied S&P 500 vol/an indicator of uncertainty) has popped higher from the very low levels it had returned to as of Friday. Speculators are out today making bets on a political firework show tonight, and thus betting on more uncertainty in the outcome and in post-election policy making.
If we step back a bit though, given the difficulties in getting through the legislative process, the biggest potential market influence from the election may be more about the prospects of getting a fiscal stimulus package done, rather than the many promises that are made on an campaign trail. Both candidates have been out promising a spending package to boost the economy. And on the heals of a package from Japan, and the unknown risks from Brexit, the idea is becoming more politically palatable.
As we discussed on Friday, the Fed has taken a strategically more pessimistic public view on the economy, in effort to underpin the current economic drivers in place (stability, low rates and incentives to reach for risk).
Following the Fed and BOJ events last week, the 10-year yield is back in the 1.50s and sitting in a big technical level. This will be an important chart to keep an eye on tomorrow.
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The word China is often thrown around to explain why markets are in turmoil. China doing well was a threat to western civilization. China doing poorly is now a threat to Western civilization.
Which one is true?
First, a bit of background. Over the past twenty years, China’s economy has grown more than fourteen-fold! … to $10 trillion. It’s now the second largest economy in the world.
During the same period, the U.S. economy has grown 2.5x in size.
So how did China achieve such an ascent and position in the global economy? One word: Currency.
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For a decade, China maintained a fixed exchange rate policy — the yuan was pegged against the dollar. One U.S. dollar bought 8.27 yuan. This allowed China to undercut the rest of the world, churning out cheap commoditized goods, competing on one thing: Price.
But in 2005, China changed its currency policy. It abandoned the peg.
After political tensions rose between China and its key trading partners, namely the U.S., China adopted a “managed float.” Under this policy China agreed to let the yuan trade in a defined daily trading band, while gradually allowing it to appreciate. This was China’s way of pacifying its trading partners while maintaining complete control over its currency.
Over the next three years the Chinese yuan climbed 17 percent against the dollar, enough to ease a politically sensitive issue, but far less than the relative economic growth would warrant. In fact, China’s economy grew by 43 percent while the U.S. economy grew only 10 percent.
That timeline leads us up to the bursting of the global credit bubble. What caused it? The housing bubble can be credited to a key decision made by the government sponsored credit agencies (Fitch, Standard and Poors, Moody’s), all of which stamped AAA ratings on the mortgage bond securities that Wall Street was churning out.
With a AAA rating, massive pension funds couldn’t resist (if they wanted to keep their jobs) loading up on the superior yields these AAA securities were offering. That’s where the money came from. That’s the money that was ultimately creating the demand to give anyone with a pulse a mortgage. That mortgage was then thrown into a mix of other mortgages and the ratings agencies stamped them AAA. They rinsed and they repeated.
But where did all of the credit come from in the first place, to fuel the U.S. (and global) consumption, the stock market, jobs, investment, government spending … a lot of the drivers of the capital that contributed to the pin the pricked the global credit bubble (i.e. the U.S. housing bust)? It came from China.
China sells us goods. We give them dollars. They take our dollars and buy U.S. Treasuries, which suppresses U.S. interest rates, incentives borrowing, which fuels consumption. And the cycle continues. Here’s how it looked (and still looks):
The result: China collects and stockpiles dollars and perpetuates a cycle of booms and busts for the world.
That’s the structural imbalance in the world that led to the crisis, and that problem has yet to be solved. And the outlook, longer term, for a solution looks grim because it requires China to move to develop a more robust, and consumer led economy. That structural shift could take decades. And going from double digit growth to low single digit growth in the process is a recipe for social uprising of its billion plus people.
In the near term, the likelihood that China will fight economic weakness with a weaker currency is high. We’ve seen glimpses of it since August. And the hedge fund community is ramping up bets that it’s just starting, not ending.
Above is a look at the dollar vs the yuan chart (the line going lower represents yuan appreciation, dollar depreciation). Longer term, China’s weak currency policy is a threat to economic stability and geopolitical stability. But short term, it could be a shot in the arm for their economy and for the global economy.
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As we headed into this past weekend, we talked about the threat that the oil bust poses to the global financial system (not too dissimilar from the housing bust), and we talked about the prospect of central bank intervention over the thinly traded U.S. holiday (Monday).
Both the Bank of Japan and the European Central Bank did indeed go on the offensive, verbally, promising more action to combat the shaky global financial market environment.
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The result was a 9.5% rally in the Japanese stock market from Friday’s close. And all global markets followed suit. Within the white box in the chart below, you can see the central bank induced jump in the Nikkei (in orange) and the S&P 500 futures (in purple).
Source: Billionaire’s Portfolio
This is purely the influence on confidence by the two central banks that are now driving the global economic recovery (the BOJ and the ECB). However, the potency of the verbal threats and promises has been waning. Big words have marked bottoms along the way over the past several years for stocks, and the overall ebb and flow of global risk appetite. But it’s becoming more evident that real, bold action is required. And given that it’s cheap oil that represents the big risk to financial stability at the moment, we’ve argued that central banks should outright buy commodities (particularly oil). And we think they will.
Source: Billionaire’s Portfolio
In 2009, despite the evaporation of global demand, oil prices spiked from $32 to $73 in four months after China tapped its $3 trillion currency reserves to snap up cheap commodities. Within two years, oil was back above $100.
China’s role in the commodity market was a huge contributor to the recovery in emerging markets from the depths of the global financial and economic crisis. Brazil went from recession to growing at close to 8%. Many were saying emerging markets had survived the recession better than advanced markets, and that they were driving the global economic recovery. And Wall Street was claiming a torch passing from the developed world to the emerging world as the future of growth and leadership.
How are emerging markets doing now? Terrible. Not surprisingly, it turns out the emerging market economies need a healthy developed world to survive. And now with the additional hit of the plunge in commodity prices, Venezuela (heavily reliant on oil exports) is very near default. Brazil and Russia are both in recession. The longer oil prices stay down here, Venezuela will be the first domino to go, and others will follow. With that, we expect intervention to come. And as you can see in the response to the Nikkei overnight, it will pack a punch – and if it’s bold, a lasting one. Remember, as we said last week, historical turning points for markets often come from some form of intervention (public or private policy).
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