October 16, 2018

Unlike President Trump, I do not believe that the Fed has gone “crazy,” and neither do I believe that the trade war has anything to do with last week’s decline, which felt eerily similar to what we experienced in February; but both the Fed and recent trade frictions PLUS the proliferation of high-frequency trading let the algos trade with other algos and left human traders scratching their heads for any rhyme or reason in the super-fast moves in the major indexes last week. That’s what happens when you let computer programs chase fractions of a cent at the speed of light. (For more see my February 14, 2018 Marketwatch article, “This is what happens when Skynet from ‘Terminator’ takes over the stock market.”)

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Unlike President Trump, I do not believe that the Fed has gone “crazy,” and neither do I believe that the trade war has anything to do with last week’s decline, which felt eerily similar to what we experienced in February; but both the Fed and recent trade frictions PLUS the proliferation of high-frequency trading let the algos trade with other algos and left human traders scratching their heads for any rhyme or reason in the super-fast moves in the major indexes last week. That’s what happens when you let computer programs chase fractions of a cent at the speed of light. (For more see my February 14, 2018 Marketwatch article, “This is what happens when Skynet from ‘Terminator’ takes over the stock market.”)

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

While the Turkish lira and the Argentine peso have stabilized somewhat, capital outflows from emerging markets in general are still here and they may continue with the rampant Federal Reserve quantitative tightening and the unfortunate consequences that most emerging markets – Turkey and Argentina included – have accumulated massive dollar-denominated debts in the past 10 years.

As I have explained previously here, dollar borrowing is equal to dollar shorting, as emerging-market borrowers take loans in dollars and then sell them for their own currencies. When they repay those loans, they have to buy those dollars back. Rising U.S. interest rates accelerate loan repayments and create a synthetic short squeeze in the exchange rate of the dollar, particularly against emerging market currencies. This is why the JP Morgan Emerging Markets Currency Index made an all-time low in September and why it looks a lot weaker than the U.S. Dollar Index, which includes no emerging markets currencies.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Broad Trade-Weighted U.S. Dollar Index, which includes major emerging markets currencies like the Chinese yuan, is likely to hit an all-time high in this cycle, particularly if President Trump’s unorthodox attempts to rebalance the U.S. trade deficit bear fruit. But even if there is a trade deal with China, the Chinese may choose to devalue the yuan anyway, given the precarious situation in the Chinese economy.

The Mother of All Dead-Cat Bounces is Over

I have previously referred to the rally in the Shanghai Composite off the climactic low in January of 2016 as the “mother of all dead-cat bounces,” or MOADCB. This “bounce” is now over, in my view. It began with a January 2016 low at 2650, but that level was taken out last week as the Shanghai Composite could not recover from what it lost in the single month of January 2016, when malfunctioning circuit breakers on mainland exchanges caused the index to re-crash after it initially crashed in the summer of 2015.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is entirely likely that even if there is a trade deal and a trade war is averted, there will be a recession in China. A trade deal only postpones the inevitable, as the Chinese have tried to eliminate the economic cycle, which cannot be done, as shown by hundreds of years of economic history.

Via the policy of forced lending quotas at major banks, which the Chinese government controls, the Chinese economy grew over 10-fold in the past 20 years while total credit in the economy grew over 40-fold. This caused the total debt-to-GDP ratio in the Chinese economy to be over 400%, if one includes the infamous shadow banking system. Despite efforts by Chinese authorities to deleverage the system, it may very well be too late to intervene as forced deleveraging itself may cause China to go into a recession.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Extending the economic cycle for 25 years produced an “economic miracle” in China at a very high cost, as the coming recession is likely to be much worse than a normal recession, if it had not been postponed via the policy of forced lending quotas. The last time there was a recession was 1993 – a recession which the authorities did not officially admit, but which showed up in secondary (un-doctored) loan loss numbers – when the Chinese felt compelled to devalue the yuan by 34%.

The odds are high they do the same this time, only this time the stakes are higher as the Chinese economy is much bigger and the effects of such a devaluation will be highly deflationary for the global economy.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*

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