Monday, September 17, 2012

Watch for storm clouds on the horizon

The financial skies are clearing and the storm clouds are dissipating.

The market likes to use the infantry analogy of the soldier against tank, so I'll stay with it: We thought that maybe Mario Draghi and Ben Bernanke would unveil bazookas. Instead, they each produced a radio and spoke the code word "unlimited" into it, which was the signal to call down carpet bombing air attacks.

Wow! Talk about beating expectations.

What's more, there is evidence of unit labour cost convergence in the eurozone (see An inflection point for Europe?).Even the French appears to be tackling their labour issues (see Hollande's Nixon in China moment?). Should this restructuring trend continue, it should alleviate many of the concerns about the productivity gap between North and South. The time that the ECB bought with OMT will be indeed valuable and part of the long-term solution.

Two dark clouds on the horizon
Even though skies are clearing, there are two dark clouds ahead that appear ominous for the investor, namely the fiscal cliff and the risk of a crash landing in China.

I am not that worried about the fiscal cliff. Most strategists have focused on its possible negative effects so the downside is well known. This is a situation where the market may not be prepared for a positive surprise where lawmakers craft a deal to kick the can down the road yet one more time. I refer you to Josh Brown's comment about "wealthy white people". While he was referring to Europe at the time, the principle applies to the Administration and Congress as well [emphasis added]:
But here's the part where I help you. Because while I have no special expertise or experience in forecasting the vicissitudes of core European diplomacy and socioeconomic policy, I do know white people. And I know wealthy white people, in particular. And wealthy white people, American or otherwise, can always be counted on to compromise at the last moment so as to preserve the status quo. And that compromise will typically involve whichever option is the least painful, even if it means that more work must be done in the future (the proverbial can-kick). And we know that euro printing, even if it means a bit of inflation for the German middle class to wrassle with, is probably worth it if the task is preserving the hegemony of the creditors, rentiers, landed gentry and aristocracy.

And so eventually, no matter how scary the headlines become or how volatile markets become in the short-term, you can expect a compromise that the wealthy and powerful elites (read: the markets) can live with. You can set your Swiss watch by it. Keep this in the back of your mind when the bullshit artists come on TV or puke their newsletters into your inbox. They are very intellectually intelligent, but they are also misanthropic social outcasts who do not and have not ever understood the way people work.

China is the wildcard
I am more concerned about China. The Chinese have taken steps to stimulate with the same-old-same-old techniques of infrastructure spending, instead of re-balancing growth to the Chinese consumer (see Buy Canada, sell Australia and China, beyond the hard/soft landing debate). These steps are creating tremendous stress in their financial system. Bloomberg reported that cracks are appearing in the Chinese shadow banking system:
China’s slowest economic growth in three years and a slumping property market, where many so-called shadow-banking investments are parked, are squeezing millions of Chinese who have invested the money of friends and acquaintances chasing higher yields to honor those payments. The slowdown also is putting pressure on the government to rein in private lending to avoid a spate of defaults that could increase the number of victims and lead to social unrest.   The shadow bankers are now disappearing, committing suicide or reneging on agreements, leaving thousands of victims in their wake. In the first half of the year, more than 58,000 lawsuits involving disputes over 28.4 billion yuan in private lending were filed in Zhejiang province, where Wenzhou is located, up 27 percent from the same period in 2011 and the most in five years, according to the provincial supreme court. One-fifth of the cases were in Wenzhou, where authorities have set up a special court to handle the surge.
The stresses are showing up in the official banking system as well:
Banks also are feeling the pinch. The industry’s nonperforming loans increased for three consecutive quarters through June to 456.4 billion yuan, the longest streak of deterioration in eight years, according to the China Banking Regulatory Commission.   Loans overdue more than one day jumped 27 percent in the first half at the nation’s five largest lenders, including Industrial & Commercial Bank of China Ltd., the country’s biggest, and Bank of Communications Co., according to data compiled by Bloomberg based on semi-annual earnings statements.
The current policy of growth at any price is putting the squeeze on profit margins (see Crouching tiger, hidden profit). The margin squeeze is putting additional stress on the Chinese corporate balance sheets and exacerbating the problems in the financial system. This is creating a negative feedback loop, where financial pressures are adding to operating pressures, which lead to more stress...

The adverse effects of the negative feedback loop is starting to show up in the political sphere. According to Ambrose Evans-Pritchard, China may be at risk of Tiananmen Square style turmoil [emphasis added]:
We all know by now about the simmering leadership crisis in China. The Bo Xilai affair has lifted the lid on a hornet's nest. I had not realised quite how serious the situation has become until listening to China expert Cheng Li here at the Ambrosetti forum of the world policy elites on Lake Como. (My hardship assignment each year.) Nor had anybody else in the room at Villa d'Este. There were audible gasps. 
The rifts within the upper echelons of Chinese Communist Party are worse than they were during the build-up to Tiananmen Square, he said, and risks spiralling into "revolution". Dr Cheng — a Shanghai native — is research director of the Brookings Institution in Washington and a director of the National Committee on US-China Relations. He argues that China's economic hard-landing is intertwined with a leadership crisis as the ten-year power approaches this autumn. The two are feeding on each other. "You cannot forecast the Chinese economy unless you have a sophisticated view of the political landscape and the current succession crisis," he said.
Malcolm Moore of the Telegraph wrote that incoming leader Xi Jingping, who recently disappeared from public view for about two weeks, was harshly criticized by party elders in early August and questions were raised about his leadership. The Politburo is split and the risk of a political rift is becoming serious.
Xi Jinping, 59, came under attack from party elders, who described him as "unreliable" and questioned whether he should be elevated to the pinnacle of Chinese power.

The attacks came at the beginning of August at a short and bad-tempered meeting in Beidaihe, a Chinese seaside resort, when senior party members gathered to negotiate and plan their once-in-a-decade leadership change...
"They called him unreliable and even brought up the idea of significantly delaying the party congress," said the source. "The fight was so harsh that Jiang Zemin [the former president] had to mediate."
Evans-Prichard added that the political uncertainty has resulted in capital flight [emphasis added]:
The worry is that the transition could go badly awry as 70pc of top cadres and the military are replaced, the biggest changeover since the party came to power in the late 1940s. "That is what is causing capital flight. All the top officials are trying to get their money out of the country," he said.
The local money has been selling while the foreign money has been pouring into Chinese equities, according to Bloomberg. Ask yourself this: Who would you consider to be the "smart" money and the "dumb" money here?

International money managers are lining up to buy stocks in mainland China at a record pace, even as a third year of equity losses spurs local investors to empty trading accounts like never before.

While overseas firms were granted $6.9 billion of quotas to purchase mainland securities since December, more than in any full year since the government program began, the number of Chinese stock accounts containing funds dropped by 788,000 to 56.3 million in the year to Aug. 3, the most for a 12-month period. A record 110 million are empty or frozen, according to regulatory data compiled by Bloomberg.

The Chinese banks as the canaries in the coalmine
This isn't going to end well for China, but these kinds of things have way of not mattering to the market until they matter. I am closely watching the price behavior of the Chinese banks listed in HK for signs of that the stress is becoming too much:
None of the shares of Chinese banks are showing signs of panic. Take, for example, the price chart of China Merchants Bank. I am watching for signs of price weakness. In particular, signs of the violation of multi-year support. Should the stresses in the financial system become serious by falling to all-time lows, then it will be the market's signal that the systems is either on the verge of, or undergoing, a Lehman/Creditanstalt style implosion.

China Merchants Bank (3968.HK)

In the meantime, both the Fed and ECB are hosting a gigantic block party. There's lots of free food and drinks. I am sure that even the Chinese will be there. Go on and enjoy yourself. Just don't get so drunk that you get caught flat-footed when the cops raid the place.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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