August 7, 2018

During the front end of August – when U.S. earnings season is winding down, foreign markets are trading under pressure, and fewer market participants are trading – investors need to put in overtime in their stock selection. Apple’s move to new highs can’t do all the heavy lifting for the whole market, even if it’s the largest weighting in most indexes and most ETFs. In addition, the news flow on the looming “trade war” looks to only intensify leading up to the next round of tariffs, set to go into effect in early September.

While the trade war rhetoric heats up even further, as President Trump has threatened to raise the tariffs on $200 billion of Chinese imports to 25% (from the previous 10%), the market is doing a good job of digesting the dialogue. In fact, the U.S. stock market trades with an undertone of confidence that a full-blown trade war will not break out as threatened. Conversely, China’s Shanghai Composite Index continues to tank, taking that key market average back down to test its 52-week low of 2,691.

Clearly, investor sentiment in China is considerably more worried than its U.S. counterpart about the implications of tariffs on their economy at a time when leaders in Beijing are challenged to keep GDP on its current 6.5% growth rate. From the way their market is trading, it would not surprise most analysts if China were cuffing their GDP data to where the actual number is well below Beijing’s official GDP data.

China’s total debt now exceeds 250% of its GDP vs. U.S. debt at about 100% of GDP. After years of loose banking regulations, China’s leverage is high and its government has taken ambitious steps to deleverage the shadow banking industry, where credible data is hard to get. Many global economists fear that any downturn in growth could precipitate a debt crisis, so there is every incentive to inflate economic data.

One interesting data point is that, according to U.S. Census estimates, China’s population is set to begin shrinking as soon as 2026, which will invariably pull economic growth rates down. Perhaps the 21st Century won’t be dubbed the “China Century” after all. In any event, “fake news” is nothing new to the Chinese government and it will be telling to global equity markets to see how long China will keep its “poker face” over trade policies at the expense of “saving face” publicly and tanking their economy.

The Shanghai index officially entered bear market territory even as many U.S. indexes are at or near record highs. China may be the first to blink in the trade war, because, as CNBC’s John Rutledge put it, “China’s markets are heavily influenced by foreign capital flows, and capital has been flowing out of China.”

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

Is the Weak Yuan a Result of Manipulation or Something Structural?

There is much talk of China’s “currency manipulation,” but could something more important and ominous (to China’s economy) be happening?  Since Chinese foreign exchange reserves equal only about 10% of money supply, a large-scale capital exodus could quickly deplete its liquid currency reserves. There are many indications that China could suffer deeply from a capital flight similar to that of 2015-16. Interest rates in Western economies are up, and Chinese savers don’t have access to favorable interest rates at home. Fears of tax increases or currency devaluation are other factors that might drive wealthy Chinese to try to move their capital abroad and circumvent the government’s strict capital controls.

The dollar/yuan exchange rate has ballooned to 6.83 yuan per U.S. dollar as of last Friday, a level not seen since late 2016. Last week the Peoples Bank of China (PBOC) raised the margin requirement by 20% for those trying to short the yuan. This is the first big move that China has made to defend its currency, which is a real shift in policy. In doing so, the PBOC is saying that the magnitude of the latest move is too great.

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

Take this central bank policy move in conjunction with the recent deleveraging campaign, rising domestic defaults, and declining growth rates and party officials have real concerns about where the economy is headed right now. China issued a lot of U.S. dollar-denominated debt in the past five years and allowing the yuan to depreciate too much is going to be that much more of a debt load to have to pay off.

Despite this boa constrictor-like squeeze, China still holds the world’s largest foreign currency reserves, $3.16 trillion. A sizeable war chest of foreign currency reserves is very handy during a currency crisis since it can be used to defend against specific attacks on the national currency. By comparison, the U.S. had foreign currency reserves of $42.8 billion as of March. The PBOC has a lot of firepower to defend the yuan for an extended period and will use its reserve to reassure investors it is committed to a stable yuan.

Boiling down these huge crosscurrents of tariffs, currency moves, regulations, and political will, it’s my view that the U.S.-China standoff can brew for a prolonged period, but both the U.S. and China have enough firepower to wage a long-term trade war and the market may be pricing in this reality.

President Trump is going to push hard to get China to strike a deal well before the mid-term elections. How that plays out is anyone’s guess at this point, but what is crystal clear is that the latest read on the ISM Manufacturing Index (at a 4-month low) and the ISM Services Index (at an 11-month low), on the heels of softer housing and wage data, is seen by the bond market as a sign that the economy will expand, but not at the same torrid clip that has been recently reported. It should also send a strong message to income investors that dividend-growth stocks (in lieu of pure growth stocks) will likely shine in the second half of 2018 as third- and fourth- quarter earnings (versus Q3 and Q4 2017) won’t be as impressive.

Rotation of capital is a beautiful thing, as long as you know where it’s going. Though the Fed may have plans for two more rate hikes this year and three more for 2019, if the economic calendar doesn’t register more robust data over the next quarter, there just might be one (in September) and “done” for the cycle.

About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. *All content of “Income Mail” represents the opinion of Bryan Perry*


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