To understand the Chinese economy it is necessary to understand the collective Chinese psyche. it is one of great insecurity, feeling hard done by from all quarters, still harbouring an inferiority complex, and thinking that the world sees it as weak, backward and belligerent. As a result, it comes across precisely as insecure and belligerent. Even as China engages more openly in the international arena, China’s neuroses require it to behave more aggressively than it has to, for a local domestic audience, to address and belie perceived weaknesses. Most of China’s external behavior becomes more explainable in this context.

At home, China’s people have grown comfortable and confident in their economic success. Economic policy, however, is no surer, no more confident, certainly no more confident than the US Fed for example. China’s reform efforts to instill rule of law, market discipline and strength of institutions, have introduced more uncertainty into policy. It is this uncertainty that complicates much of China’s policymaking in recent times. In a centrally planned economy, policy was decree and there was a clear separation between target and measure, between state variable and control variable. As markets become more open and price driven, the effects Goodhart’s Law assert themselves. Policy cannot be made without considering the reaction of the economic agents and without risk of triggering unintended consequences. Legacy cultural tendencies to report success and suppress failure lead to noisy macroeconomic data exacerbating the problem of effective policymaking.

 

China’s ministry of finance, central bank and market and banking regulators are intelligent but are also inexperienced in operating under such conditions where policy is no longer simple or linear. Policy under open markets with all the feedback loops introduced by expectations mean a lot more than policy but include skillful communications and management of expectations. Recent policy missteps by the regulators have not so much been a failure of policy than a failure to manage expectations and communication.

 

In China, the state has interfered extensively and directly in allocating resources through administrative and price controls, guarantees, credit guidelines, pervasive ownership of financial institutions and regulatory policies, and it has done this with the SOE as principal accomplice. Recognizing the inefficiency of SOEs, China is in the midst of reforming the sector. Foreign investment will be introduced into state-owned firms via restructurings and joint ventures, as well as overseas mergers and acquisitions, the State Council said in new guidelines on SOE reforms. While welcome, the statement was deemed insufficient and vague. Notwithstanding the size and influence of SOEs, some believe that the driver of growth in China has been private businesses. According to the Economist: “Average growth in output for industrial private firms since 2008 has been 18%, twice as much as for industrial SOEs.” Private enterprise is heavily disadvantaged in particular in terms of access to credit. SOE’s still consume more credit and at lower cost than private enterprise and therefore represent unfair competition to the private sector.

 

China has a history of enterprise and innovation. The current centrally planned economy is in many ways the last ripples from the anomaly that was Communism which gripped China in 1949. China’s rehabilitation began with Deng XiaoPing who a reformer and rolled back some of the less sensible Maoist policies and principles. After him, Jiang ZeMin was the pragmatist, slowing reform where it threatened to rupture the economy or society but maintaining the general principle of Socialism with Chinese characteristics, Jiang’s own slogan was “socialist market economy”. Jiang’s leadership saw the demise of many SOEs as market reform exposed their un-competitiveness. It also coincided with a increase in corruption and cronyism and in the emergence of an oligarchy with penetrating interests in government and business. The next 10 years under Hu JinTao saw a maturing of the Chinese economy with all the associated social frictions that come from a growing middle class. In many ways, the Hu leadership set the stage for the current leadership under Xi as it sought to address some of the inequality and excesses of wealth and influence in China. Notably Hu’s government began to address corruption and lack of transparency in government and sought to narrow the gap between rich and poor as well as development between coastal areas and the interior. It was also a period where China began to more actively integrate itself into the global community beyond a purely commercial context and to assume more of the social and political norms of developed nations. Navigating this evolving political landscape was a vibrant private sector full of innovation and enterprise, saddled with the burden or task of working around market distorting policy, but profiting from the surge in investment in infrastructure both physical and institutional.

 

The image of China as a backward, reverse-engineering, IP stealing, technological laggard is persistent but mistaken. In 2014, the top and third most prolific patent filers were Huawei and ZTE, both Chinese companies. China’s annual R&D spend as a percentage of GDP, at 2%, has now exceeded Europe’s and is catching up with the US’s 2.8%. The numbers belie another trend, which is that private sector innovation is driving growth. Total factor productivity is growing 3X faster at private firms than at SOEs, according to the World Bank. A report by the McKinsey Global Institute finds that Chinese firms are particularly adept at innovation in a number of industries, in consumer facing indu
stries such as e-commerce, in efficiency driven ones, such as manufacturing but lag in science and technology. Over regulation in developed countries may also provide China’s pragmatic model with an advantage. The same heavy hand of the state that meddles may also turn a blind eye to less ecologically or ethically ambiguous pursuits where more conservative western regulators would have acted.

 

China under Xi JinPing is facing the continuing issues of a growing middle class and a slowing economy, slowing naturally under the weight of its own size, the consequence of prior growth. Slowing growth is to be expected; economist sometimes forget that constant growth is exponential growth and unsustainable. The burden of central planning sitting alongside private enterprise is that price signals are attenuated leading to misallocation of capital and in China’s case, over investment and over capacity. Other areas such as consumer credit and mortgage credit are undersupplied. Recognizing these imbalances, the Chinese government has engaged macro prudential policies to redirect the flow of credit and lower the cost of credit for particular segments. Specifically, they intend to prevent excess credit in speculative markets, local government white elephants and SOEs while improving the access to credit for SMEs, private enterprise, consumer loans and mortgages.

 

At a more fundamental level, the Communist Party is trying to reform itself. This may appear mainly cosmetic but there are good reasons why the reform may be in earnest. A growing middle class, a better educated people, the proliferation of social media, have created an environment of de facto transparency which the government cannot reverse. To stave off an existential threat, the Communist Party has to embrace greater transparency, the rule of law, reliance on institutions, and other international norms as its new pillars. If you cannot hide, you should not try, is the principle. Transparency also places a greater responsibility back upon the people to play their part and to respond appropriately to policy. The new ideal is, however, in its own way, difficult to manage, especially for a government unused to intransigence and criticism. The rapid development of China, the size of her economy and the massive forces at play can be intimidating to the government and can and has led to policy miscalculations and hesitations. The handling of the sharp downturn in the domestic A share markets are an example.

 

From 2010, the PBOC the central bank has kept monetary conditions fairly tight with interest rates rising from 5.31% to 6.56% and the RRR rising from 15.50% to 21.50% as inflation accelerated from 2009 through 2011. Despite cheap valuations and decent earnings growth Chinese equities performed dismally, locked in a bear trend from late 2009 to mid-2014. It was only when the PBOC embarked on expansionary policy as US QE was tapered off and inflation receded that Chinese equity markets were ignited. From mid 2014 to mid 2015, the Shanghai Composite Index rose 148% in a liquidity accelerated ascent that defied reasonable valuations. Latecomers to the equity rally used leverage and margin accounts to boost returns and drove valuations further out of line with fundamentals.

 

Note that the motivation for the PBOC’s expansion was falling inflation and slowing growth, both incompatible with accelerating earnings growth. The market was driven by liquidity and sentiment alone. This is not to say that the astute investor recognizing the dynamics of the market could not participate profitably but it did mean that at the end the exit cost would be high. Ultimately the rally was ended by the confluence of an accelerated IPO pipeline, weakening company fundamentals, and the regulators themselves removing the punchbowl by regulating the growth of margin trading accounts.

 

Having burst the equity bubble the PBOC, alarmed by the pace and extent of the correction acted to slow the descent and limit the downside with a series of clumsy regulations including short sale bans, selling bans, market support funds and moral suasion. For all of September, the Shanghai Composite Index traded in a narrow band between 3000 and 3300. A 148% bull market had ended in a -44% bear market and although the market remains some 50% higher than when the stock frenzy began, sentiment has been damaged and the China market has become both the centre of attention for global investors and the alleged culprit for every market disappointment from the US to emerging markets.

 

In June 2015 the Shanghai Composite traded at a PE of 21X, still shy of the 27X seen in 2008; it currently trades at 13X, closer to levels seen in 2011. While growth is slowing, earnings growth rates remain high at over 20%. H shares in HK currently trade at a PE of 7 albeit with lower earnings growth potential, well below the recent peak of 11X in June 2015. These are aggregates of course and hide a rich detail. But even so, Chinese stocks which were acutely over-valued in the summer are now cheap.

 

 

Beware markets exhibiting low volatility and complacency. As markets rise steadily, investors with profits can protect their profits by buying put options. They tend to do this at key technical levels on broad market indices. Option counterparties do two things. They either act as middlemen, selling puts to investors seeking protection and buying puts from investors who seek to earn a premium and gain some positive delta exposure to the market. The net delta or exposure that they cannot match up, they need to hedge by trading in the underlying instruments that the options refer to.

Consider when the investor community is net long protection, or net long puts on the market. A long put position is one of positive gamma, or convexity. Option counterparties are therefore net short gamma or convexity. Their hedging strategy involves selling the underlying market when it falls and buying the underlying market when it rises. To further illustrate this, note that if the market is net long puts, the option hedgers must be net short puts. A short put is a long stock and a short call. A short call is hedged by buying at higher levels and selling at lower levels. The expected trading loss is the option premium.

 

Thus, if a market has been rising steadily and investors have been sufficiently careful to lock in some of their profits with put protection, it creates net gamma at important levels in the market. The gamma at these levels simply implies that the market cannot settle at these levels, they either rise above it or they fall below it but they cannot linger for long at those levels. It looks like 2050 was such a level on the S&P, as was 2000. And there are other important levels. As the market rose, investors would have bought protection at 1850. As we get to those levels, the gamma will cause the market to either rebound sharply, or fall sharply, but is unlikely to loiter at that level.

What will the Fed do?

 

The Fed might raise rates in September because:

• It wants to reset a policy tool.

• It honestly thinks that inflation is a future risk and that the labour market is sufficiently healthy.

• It has signaled to the market that it wants to raise rates and if it doesn’t the current market volatility will get worse.

• If it postpones a rate hike to December things might look worse and if it doesn’t raise rates this year, the market reaction might be even more severe.

 

The Fed might postpone a rate hike because:

• There is no sign of inflation anywhere.

• Even the labour market strength is hardly excessive.

• USD strength may be exacerbated and this is already hurting profits.

• Markets have already tightened credit and liquidity conditions on behalf of the Fed.

• Recent equity market weakness around the globe may cause a negative wealth effect.

 

If the Fed stays in September, it might have to move in December because:

• If it doesn’t it will be a signal of a weak economy which would spook markets further and could end up tightening liquidity conditions.

• It would have a pretty hard time managing expectations. If it didn’t hike this year it would have to prepare the markets well before December and guide the market toward an early 2016 move.

 

Conclusions:

• If the Fed moves in September it will be raising rates into a slowing global economy, if not a slowing US economy. The US economy is likely still stable but is not overheating and an early rate hike will slow it down. The impact on the short end of the treasury curve will be quite direct, as one would expect, but the impact on the long end might be to suppress it. The curve is more likely to flatten. The impact on the USD would be negative. A rate decision in September would take away the expectations supporting the USD since the next rate hike would probably skip a couple of meetings and be no more than 25 basis points. USD weakness would put pressure on European and Japanese equities via the EUR and JPY as funding currencies.

• If the Fed doesn’t move in September it will be under pressure to move in December. Delaying into 2016 may be taken as a sign of weakness which could increase volatility and likely depress equity and credit markets. The impact of a delay to December will be positive for USD as it keeps the prospect of a rate hike on the table. The impact on European and Japanese equity markets is likely to be positive through the EUR and JPY as funding currencies.

• Looking at general conditions the Fed may have to delay liftoff indefinitely and only raise rates when data suggests it is suitable to do so. This will likely introduce short term volatility into treasuries and credit markets and weaken the dollar in the short term but keep it on a firm footing over the long term. The dollar will probably only weaken after a rate hike and not before.

 

If you sold in May and went away you’d have been back in July, re-established positions and got your throat slit in August. The S&P and broad equity market benchmarks have lost some 10% in a week, most of it in a couple of days, Europe has done slight worse, down some 12%, and China, apparent epicenter of the troubles is down a fifth, yes, 20% in the last week. Emerging markets have lost some 28% since April in a steady decline. In this time, US, European and Japanese equity markets ground steadily higher, until last week. And then they played catch up. Is this then an emerging market phenomenon unfolding before us? The Lat Am equity markets have been falling steadily since last August (2014). They have lost 50% since then, and 30% since April 2015. Emerging markets as a group are not the catalyst. Was it just China? China equities peaked in mid-June then fell precipitously while western markets chugged along unfazed. It could have been China’s signal that it would no longer support its equity markets but would allow western style market forces for price discovery that broke the camel’s back.

What about credit markets which investors have been fretting over for the past year or two, worrying about market liquidity and the risk of higher interest rates? The US high yield market is down 5.4% since its April high, its European counterparts are down 2.3%. The leveraged loan market is down 1.3% from its April high. Emerging market bonds are generally off their April highs by some 4.3%. Treasuries have rallied, even the US variety where a potential interest rate hike looms.

On August 11, the PBOC introduced market forces into the determination of its CNY reference rate, which resulted in a 2% devaluation. Emerging market currencies which were already weak from weak commodity markets fell further while the relative strength of the USD to EM currencies reduced the probability of a September rate hike thus bolstering JPY and EUR. But the lags in currency movements to the PBOC’s announcement was measured in days, not minutes or seconds as is usual for FX markets.

Commodity prices have been weak since early 2011 with an acceleration to the downside in oil beginning in mid-2014. Commodity prices seem to have correlated well with emerging market equities and currencies.

No smoking gun. Sometimes markets move because of a confluence of events and technical price patterns. Could economic fundamentals be driving markets? The US economy is stable and growing at a very steady if slightly tepid rate. Europe is in a cyclical recovery even if it is a structurally flawed region; Europe is simply not an optimal currency region. Greece is out of the limelight, despite having found no lasting solution; it may once again serve as a focus sometime down the road. China’s economic weakness is a known fact, perhaps the degree of the slowdown has been underestimated. The PBOC’s relaxing of the currency reference rate mechanism could be seen as a competitive devaluation strategy signaling greater problems in China. But China has the economic and financial resources to manage any kind of liquidity crisis. In any case, given the semi closed structure of China’s markets, there should not be and has not been contagion at the financial market level. There will likely be economic consequences of slowing Chinese growth. The Chinese stock market phenomenon is remarkable in the lack of contagion to its credit markets, both USD and RMB. The Chinese high yield market has seen a 3% retracement in the last couple of weeks which is well within the volatility tolerances of this market. At the fundamental level, corporate China has been borrowing against equity to invest in equity markets, a clearly unhealthy practice.

So we cannot explain what happened apart from blaming technicals and jumpy investors. So far so normal. It will not deter us from making predictions about the how the various economies and markets will evolve.

Let us look for excuses to sell the markets.

Central bank policy has created a number of problems. The US Fed is apparently at the point of raising interest rates, and some time down the line, reducing the size of its balance sheet. The Bank of England is similarly advanced in the cycle. The ECB is only in month 6 of an 18 month QE program. The Bank of Japan is in the middle of an interminable QQE program. The PBOC has been in expansionary mode since mid-2014 although it hasn’t yet started to directly buy assets, it is a pretty sizeable repo counterparty.

The Fed is in a difficult position having very early on telegraphed its intentions to raise interest rates. It counted on a long runway to manage expectations and soften the blow of raising interest rates from 0.25%. A long runway has its advantages but is also vulnerable to changing conditions. The US economy is stable but there is no sign of above target inflation and one could argue quite easily is far from being in need of higher interest rates. If the Fed raised interest rates now it would certainly slow an economy only showing tepid growth. In the meantime, expectations of higher interest rates and a resurgent manufacturing sector have boosted the USD and tightened financial conditions. The recent equity market volatility is also tightening financial conditions for the Fed, making a rate hike less justifiable. Having so early on signaled its intentions to raise rates, however, the Fed now risks investors interpreting prevarication as a sign of a weakness, which could lead to wider credit spreads, weaker equity markets and thus tighter financial conditions. Over and above the question of interest rates there is the Fed’s expanded balance sheet which needs to be shrunk at some point, hopefully in an orderly manner. The question of how to shrink a balance sheet gently is a question which will be asked of all the world’s central banks at some stage or other.

The rally since 2011 has been driven re-rating, not so much by earnings growth. Re-rating has been driven by falling interest rates, falling cost of debt to fund buybacks. US equities are unlikely to face falling earnings but they may face a gradual de-rating. Even if earnings grow at 2X GDP growth, the range is 5-7%. A de-rating from 16.5 to 14.5 would still lead to a lower market level. European equities are cheaper than US equities but they show the same trading pattern, that is, much of the returns have come from a re-rating. That said, earnings growth in Europe is expected to be quite robust at c.18%. Also, the ECB is not quite as late in the cycle as the US Fed. The risk of de-rating is not as great.

So much is dependent on central bank policy. The widespread use of QE has led to a disconnect between fundamentals and asset prices to the extent that it is difficult to estimate asset prices in the absence of QE. The recent volatility in the US equity market is an interesting case in point. While other economies have their problems, the US economy is sufficiently robust, at least according to the Fed in the past months, for lift higher interest rates. And yet, the stock market was in free fall for three whole days, losing some 10% of value. As discussed, there are no credible single catalysts for this volatility. Perhaps it is the difficulty in valuing US assets under QE and the fact that interest rates may be raised at a time when the Fed is no longer expanding its balance sheet, and may in fact shrink its balance sheet a year from the first rate hike, that is responsible for this volatility.

The fact that the Fed Funds effective rate is 15 bps and not 25 bps is reason enough not to raise rates. Central banks should refrain from moving rates about as they see fit. For one, their understanding of the economy is no better than anyone else’s. How can one make interest rate policy amid this much ignorance? For another, they tinker with the most important price of all, the price of money, which anchors all other relative prices.

Market interest rates, are telling us something already. Let them be our guide. The market is being distorted by Fed OMO and rate prognostications. The market doesn’t need to watch a Fed that is watching the economy. If the market focuses on the economy, the Fed can be absolved from that responsibility and go where all central banks should go absent crisis. The scrapheap.

On a more topical and practical note, the Fed has backed itself into a corner. If it raises rates, it does so into a US economy that isn’t exactly firing on all 8 cylinders. You don’t raise rates when inflation is this conspicuously absent, when you clutch at straws to find strength in labour markets. It is clear that the Fed wants to raise rates, is looking for an excuse to raise rates, because it telegraphed its intentions too soon, based on data that is now stale. If the Fed doesn’t raise rates, given current sentiment, the market will take it as a sign of weakness and asset values will tumble further. Since the Fed has been revealed to be supporting asset markets, it won’t do that. If it does raise rates, it will allay the market’s fears but it will slow the real economy. It will have to go very slowly indeed into the next rate hike. And it will have to provide more liquidity support to the market. It couldn’t possibly do a QE4, so a backdoor QE like the ECB’s LTRO may be one idea. But if it did do that, then the effective rate would not rise substantially to the target rate and the Fed risks losing the little credibility it has left.

So we have this situation where the Fed is damned if it does and damned if it doesn’t. In other words, the Fed is simply damned.