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 Friday 27 May 2016

PM Bulletin: Meanwhile in China

 

 
This week we saw US and European stock indices surge higher. Investors piled back into equities despite the increased likelihood the Federal Reserve will raise its headline Fed Funds rate this summer. The minutes of the FOMC’s April meeting were interpreted as being more hawkish than the original statement. Not only that but a succession of Federal Reserve members descended from their lofty perches to insist that the conditions for tightening monetary policy were close to being met. Like Dr Frankenstein, the Fed has harnessed enough energy to bring the rate hike monster back to life.
  

There was also an explicit charge that the markets had completely mispriced the odds on a hike in June, or, post the UK referendum, July. But small wonder. After all, this the same Fed that back in December, when it hiked rates for the first time since June 2006, predicted four further rate rises in 2016. Then three months later it slashed this to two. Now, with nearly half the year gone, some of its members are saying we should be prepared for three. 
  

So what are investors to make of all this? Well, to me the US stock market reaction suggests two possible explanations, and I’m sure there are many others. It could be that investors are prepared to believe the US central bank has suddenly gained extraordinary insight into the state of the global economy. Perhaps the Fed can see wonderful economic developments which remain hidden to most analysts. Or it could be that investors still don’t believe for one second that the Fed will hike this summer. 
  

The thing is that while the normalisation of interest rates is long overdue and probably a “good thing”, overall a hike isn’t good for equity markets. It may boost bank margins but it will also lift the dollar, particularly as the Fed is the only developed world central bank currently set on tightening monetary policy. A strong dollar causes problems in the current environment. It makes US exporters less competitive, although in fairness the US is less reliant on exports than most major economies. It also hurts US multinationals in terms of sales and translated earnings. But crucially it is a problem for China. The Chinese yuan is pegged to the US dollar. When the dollar goes up, so does the yuan. This makes China less competitive when compared to its neighbours. This is the last thing the country wants with growth rapidly slowing. China’s response to a strong dollar is to devalue the yuan. This happened twice in one week last August and again in January this year. In both cases equity markets tanked. 
     
 PM Bulletin 
  

   
The first chart is Spread Co’s “China Basket” ETF and the second is the US S&P500. One thing that is striking is the implied optimism of investors concerning US stocks when compared to Chinese ones. The S&P is back within a few percentage points of last year’s all-time high. The China Basket is 38% off its own 2015 high. For comparison the Shanghai Composite is off about 45%.
  
 
Of course, there are good reasons why investors are wary of Chinese equities, not least the draconian actions taken by the authorities to curb last summer’s rout. But as we can see, there’s been little investor appetite for Chinese stocks this week despite bullishness elsewhere
     
  PM Bulletin
  

   
I’m not saying that the two markets have to converge. But I do think there are “unknown unknowns” when it comes to China. This has never been too much of a problem in the past given China’s relative isolation from the rest of the world. But it really matters now. And it matters more than ever when US monetary policy is in such an unholy mess. 
  

David: Like Dr Frankenstein, the Fed has harnessed enough energy to bring the rate hike monster back to life.
  

Disclaimer:
  

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Tagged: Bulletin PM

Category: PM Bulletin


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