Ad Hoc Commentary – China’s equity sell-off is driven by USDCNY outlook, not growth outlook; Yellen beware.

Probably one of the most misunderstood factor driving the equity markets is the impact of foreign exchange. In yours truly mind, the selloff in the Chinese markets has very little to do with the growth prospect of China, and is largely driven by the uncertainty in the USDCNY currency outlook. Slow growth is probably already priced in, as many realized that China will slowdown from 2016 to 2020. As we concluded in late Apr 2015:
“…In any case, China will very likely slowdown from 2016 to 2020. Yours truly believe that growing at 5% will be remarkable in itself for that 5-year period…”

Gavyn Davies blog on FT is spot on:
“…The risk of a large devaluation in the Chinese renminbi is once again spooking markets, which are firmly convinced that this as a very bad contingency for global risk assets in 2016…”
“…If the central bank passively permits the renminbi to continue its downward drift, the situation could rapidly get out of its control…”

However, be careful. The phrase “rapidly get out of its control” is unlikely to mean a Chinese hard-landing, but an eventual American hard-landing. To understand this we look back into 1985, when we had the Plaza Accord:
“…The Plaza Accord or Plaza Agreement was an agreement between the governments of France, West Germany, Japan, the United States, and the United Kingdom, to depreciate the U.S. dollar in relation to the Japanese yen and German Deutsche Mark by intervening in currency markets. The five governments signed the accord on September 22, 1985 at the Plaza Hotel in New York City…”

The final outcome of the Plaza Accord was Japanese capital fleeing America to return home to Japan. The Japanese capital flying out of USA into Japan created the Japanese heisei housing bubble which ended up in tears in 1989. Japan entered into her lost decades, and probably only recovered from it this year. History is likely to repeat itself, this time with capital flying from East to West, as opposed to West to East.

The comments by Trutheludes in response to Tom Mitchell’s article entitled ‘China meltdown a tale of policy mis-steps’ is particularly spot on:
“..Most of this capital [flighting out of China] is going into [the] US housing sector. [The] US economy is otherwise sluggish but its housing sector is performing very well. New home sales are higher by 9% and housing starts are up by 16%.

Sell-off in the Chinese stock market could also be a function of this flight of capital.

A sampling of the articles cited below tell the story of Chinese capital rushing into US real estate.

If the capital flying out of China finds a home in American real-estate, then expect USD strength to persist for another two years, and a buoyant real-estate market here in the USA. But this will likely end up in tears from 2017 onwards. Yellen has to beware the prospect of another American housing bubble driven by outside capital. However, in the short-term, her rate hikes in 2016 would likely fan the fire of the nascent housing bubble as it will lead to:

  1. Americans running into the housing sector to lock in low-rates,
  2. stronger USD as the USD carry trade unwinds,
  3. the above two leading to further gains for the Chinese investor who calculates profits in CNY.

The S&P500 will likely not follow the Chinese CSI300 into the dumps because of all the capital inflight coming from the Far East. In all likelihood, our S&P500 will trade sideways this year, or it might even surprise to the upside. This year is a very tough year to put out an outlook as Yellen started the rate hike cycle, and a lot depends on Yellen’s next steps, and how market participants respond to her likely further hikes.

Good luck in the markets.