Sunday / June 24.
HomeColumnsIs the next Chinese financial crash inevitable?

Is the next Chinese financial crash inevitable?

mateininvestA hundred years ago, an arms race between the dominant global superpower the (British Empire) and a rising power (Kaiser Wilhelm’s Germany) culminated in the mass slaughter of World War One. The deep mistrust between the United States and the People’s Republic of China has all the potential to spawn a traumatic chapter in international relations. Despite its “pivot” to Asia, the Obama White House was cautious and measured in its relations with an increasingly xenophobic, nationalist China. President Xi Jinping has concentrated more absolute power than any successor to Mao and Deng with the support of a cabal of fiercely anti-American Peoples Liberation Army generals.
In the US, President elect Donald Trump has enraged Beijing with his phone call to the President of Taiwan (the PRC’s “renegade province”), his public disdain for Washington’s post 1979 One China policy, his threats to impose a 45% tariff on Chinese goods and brand Beijing a currency manipulator. The admirals who command the US Pacific Fleet lobby for new naval construction, as do Trump’s hard right ex generals at the helm of the Pentagon and National Security Council to challenge Beijing’s territorial claims in the South China Sea. If Trump authorizes naval patrols in the Straits of Taiwan and Beijing’s ultra-nationalist generals persuade President Xi to attack American assets in the Pacific (the ghosts of General Tojo and the Japanese attack on Pearl Harbour), the world could face the ultimate black swan event of 2017.
A military confrontation between the United States and China. Unthinkable? World War One and the Pacific War were thought unthinkable yet they happened and changed the course of the human history. At the very least, Taiwan and the South China have replaced Ukraine and Syria/Iraq as the most dangerous flashpoints of international relations. Does the Volatility Index (VIX), Wall Street’s pendulum of greed and fear, remotely price this embryonic threat to world order? Absolutely not. This creates a money making opportunity with an asymmetric risk return payoff, the only kind that matters!
I am convinced that the iShare China Large Cap ETF, (symbol FXI) is a strategic short at $36 for a $30 one year target. The macro storm clouds have begun to darken in China. The Chinese yuan has fallen from 6.20 in early 2015 to 6.94 now, even though Beijing’s foreign exchange reserves have fallen $1 trillion to only $3.1 trillion. A hawkish Fed and a resurgent King Dollar means the People’s Bank of China could well lose control of its dirty float yuan currency regime. This means the Chinese yuan could well plummet to 7.80 sometime next year, a classis formula for a global stock market crash, as Wall Street learnt the hard way in August 2015 and January 2016.
China has spawned the greatest credit bubble in history, a monetary Frankenstein, with debt at 250% of GDP. China’s property bubble, financed by leveraged speculation and Ponzi daisy chains of hot money, has gone ballistic. China’s trillion dollar “shadow banking system” is a greater risk for international finance than Wall Street’s ill-fated fling with subprime mortgages and credit derivatives. This smart money in Planet Forex has grasped that a financial catastrophe in the People’s Republic is the inevitable endgame as the world transitions to a new era of tight money and higher US Treasury bond yields in the US. The Russian Tsar’s soldiers voted with their feet, Lenin boasted. Chinese millionaires and billionaires have voted with their offshore bank accounts and luxury mansions from Vancouver to Hampstead. The rich Chinese and the gnomes of Planet Forex know that China has no choice but to tacitly accept a major devaluation of the yuan in 2017 or risk a hemorrhage of its foreign exchange reserves and a politically explosive deflation shock.
The sharp rise in the Shanghai Interbank Offered Rate (SHIBOR) since Trump’s shock election win is no coincidence. This is a systemic risk to the Shanghai A shares market, the world’s most dangerous retail casino, with its 960 billion margin finance float and a sordid history of insider trading, stock manipulation schemes and regulatory mismanagement. Chinese securities regulators have also tightened regulations on mutual funds, insurance and phony “wealth management” banking products at precisely the same time as a liquidity squeeze afflicts the money markets. Chinese banks, hopelessly dependent on leverage from interbank borrowings, are ideal shorts. Unlike Las Vegas, what happens in China will not remain in China in 2017. So get real, get out lest Miss American Pie turns into shredded chop suey!
Currencies – Fed rate hikes and global currencies strategy ideas
The Federal Reserve has put the world financial markets on notice with another hike in the overnight borrowing rate and projections of three rate hikes in both 2017 and 2018. This has led to a surge in the US Dollar Index above 103, a 14 year high. The ten year US Treasury note has also risen to 2.57% amid a $2 trillion bloodbath in the global bond market since the election. While the rise in the US dollar has not led to financial catastrophe so far, I am alarmed by the rising risk of a Turkish banking crisis that could escalate into emerging market contagion – or a free fall in the Chinese yuan that could trigger a spasms of risk aversion in global markets, as happened in February 2016.
Janet Yellen acknowledged that Trump’s economic policies meant a “cloud of uncertainty” but his fiscal stimulus/protectionist rhetoric also boosts inflation expectations and increases the risk of far more aggressive Fed tightening in 2017. Investors unfortunate enough to own leveraged bonds or property in countries most at risk due to King Dollar face risk of ruin greater than in 2008-9. This time, sadly, the wolf is here.
US Treasury note spreads are now at a 20 year premium to German Bunds while political (French and German elections) and banking risks (Deutsche Bank, Italy) continue to rise. The risk to the Fed’s three dot plots in 2017 is to the upside, since the near double in oil prices will boost global inflation expectations and the US labour market is white hot, with the unemployment rates now only 4.6%. Short Euro to 1.02 and short Japanese yen to 122 remain my most favourite strategic currency ideas since the election. Despite the High Court’s challenge to the Tory government on Westminster approval for an Article 50 deal, I cannot see how cable can resist King Dollar and would short sterling on any uptick to 1.26. My bearish views on the Canadian dollar, despite Vienna, remains unchanged. No point being Canute to the tsunami that is the King Dollar uptrend!
Emerging markets currencies are most at risk from a hawkish Fed, a steeper US Treasury yield curve and Donald Trump in the White House. Nations with large external debt, stressed banking systems and high current account deficits are most vulnerable to an exodus of offshore capital as US interest rates begin to rise. This means the biggest downside risk remains in the Brazilian Real, the Turkish Lira, and the South African Rand. The Indonesian Rupiah and Malaysian Ringgit are vulnerable due to large foreign ownership of domestic debt markets and low reserve to short term debt ratios. A hawkish Fed means accelerated falls in the Chinese yuan, which also has the potential to destabilize emerging markets.
The Fed’s multiple projected rate hikes in 2017-18 mean 3 month EIBOR can well rise above 3% in the next twelve months. The era of easy money will end even though GCC economies face protracted bear markets in property as tourism/retail/FDI/homeowner values are hit by King Dollar and the risk in US Treasury bond yields. Expect steeper falls in property prices as mortgage costs rise, job losses accelerate and the cash squeeze in the banking system deepens.
Donald Trump’s election and the Federal Reserve’s rate hike projections have proved catastrophic for gold, which has now fallen from a $1338 high on election day to $1122 an ounce as I write five weeks later. Gold is now 18% below its July peak and now trades near lows last seen during last February’s China linked global markets mayhem. Even though the US Dollar Index has surged 5% since the election, it is far too dangerous to bottom fish in the yellow metal as the world’s cost of risk free capital surges to new highs. Gold is now an incredible $240 below its $1366 July peak. Higher US dollar borrowing rates is the kiss of death for gold, a zero yield asset. Gold’s sell off has been accelerated by long liquidation in exchange traded funds, who own more bullion than all but four global central banks. King Dollar and a hawkish Fed means selling pressure in gold continues. Stay short the gold miners index fund.
Macro Ideas – Indian equities and the passage to Dalal Street!
India’s rupee reform, while unquestionably beneficial for long term banking stability, public finance, sovereign credit and the growth of the taxpayer base, will hit domestic consumption and earnings momentum in the first six months of 2017. Ironically, the biggest risk to India is if the Chinese decide to sharply depreciate the yuan to retaliate against Trump’s protectionist tariffs or “One China” heresies. The cash crunch in the Indian economy will hit not just jewelers, farmers and homebuilders but also disrupt corporate supply chains in dozens of industries, thus cause nonperforming loans ratio to creep up in the banking system. Even the RBI acknowledges that current impaired loan ratio is 12% and Wall Street banking analysts believe this ratio is as high as 16-17%.
This means at least a $25 billion provisioning shortfall that will pressure the weak capital ratios of PSU banks, the Achilles heel of banks like Punjab National, Bank of Baroda and even the State Bank of India colossus. The last thing India’s public sector banks and their corporate borrowers, with stressed balance sheets, needed at this point was a cash crunch in Asia’s third largest economy at this precise point. With non-performing loans in the banking system at least 9% in 2017, more than double 2013 levels, I cannot see how RBI Governor Urijit Patel avoids at least one repo rate cut to 6%, especially since the Yellen Fed projects at least 3 rate hikes in 2017. This means the current strength of the Indian rupee at 67.5 against the US dollar is temporary and the rupee falls to the 70 level in the next six months to compensate for inflation differentials and a possible uptick in banking asset quality risk.
I expect another 8 – 10% downside risk in the Indian stock market as Dalal Street comes to grip with a grimmer earnings/growth scenario at a time of banking stress, King Dollar, $54 Brent crude and rising China risk. Trump, while happy to build a Trump Tower in Pune, will get tough with H1 visas (80% issued to Indians) and thus hit the IT services industries. This means the optimal level to buy Nifty could be somewhere near 7400, well above the 6800 low we witnessed during the global stock market turmoil in February 2016.
I have no problem with my friend CLSA strategist Christopher Wood’s rhapsodies on “Modi Magic” or even his recommended overweights on Maruti Suzuki, ICICI Bank, HDFC Bank and Power Grid, I disagree with CLSA on optimal buy levels and individual company targets. India is still the best demographic and domestic consumption themed story in the emerging markets. Dalal Street will not lose either its premium valuation metrics nor its consensus overweight status among global fund managers next year. The hawkish guidance from the Yellen Fed relative to consensus has only increased rupee risk, G-Sec risk and Nifty risk for me after the December FOMC. I am also alarmed at Standard & Poors comment that Modi’s currency demonetization has “cast a shadow” on the Reserve Bank of India’s independence and competence.
Indian e-commerce and digital payment systems constitute the world’s last online mass migration investment theme. Modi’s demonetization and war against “black money” only reinforces my conviction on this sector, with Paytm the unquestionable “unicorn” winner in this sector. Yet TVS Electronics, which produces point of sale (POS) debit/credit card sales, saw its shares double in the past month. RS Software, which builds and manages digital payment platforms and facilitates interbank money transfers using mobile technologies, has risen 40%. Bartronics India provides bar codes, biometric technologies, RFID and smart cards, the bricks and mortar of India’s new digital, data driven, cashless (?) future.
History may well remember the Modi’s banknote reform and Trump’s election win as the two shock black swan events of 2016, though Saudi Arabia’s decision to resume its swing producer role in OPEC is also hugely significant for the Indian economy as it led to a 25% rise in the global price for Brent crude oil. While Congress and politicians like AAP’s Arvind Kejriwal have predictably demonized Modi’s bank note reform, the proof of the political pudding will only be known with the BJP’s performance in the Punjab, UP and Gujarat elections. This means it makes strategic sense to go long capital Nifty volatility.