Volatility

Well it's been a bouncy couple of weeks but slowly a sense of calm seems to be returning to most markets. 2 months ago it was agreed the Chinese stock market was in a bubble, so quite why the bursting of that bubble came as such a shock I'm not sure. But the bigger question to my mind is quite why so many markets moved so far and so fast.  The FX liberalisation certainly didn't help - it was interpreted by many - probably incorrectly - as a devaluation and as such a sign that the Chinese economy is in dire straits. While I agree with the sentiment re the economy I don't think that they were aiming for a devaluation. Firstly there's the "face" involved in admitting your economy is so screwed you need to devalue, and secondly I just don't think they're that bright.

But back to the moves......  I believe there are 2 factors contributing to the violence of recent moves. Firstly - the typical illiquidity of August when half of the city's traders and fund managers are on the beach. And secondly I think the blame can be partly ascribed to the regulators and their wonderful new capital rules. 

Banks simply don't want to hold assets on their balance sheets. Inventories are kept to a minimum, and money is made on the buy/sell spread of put through rather than positioning. This is worse in the summer when the managers are away and the juniors are terrified of being left holding the baby in a falling or rising market. Thus when faced with a wave of buyers or sellers they will move prices far and fast in order to find keen buyers or sellers on the other side. To make matters worse, the new market makers are in many circumstances hedge funds. These guys are not worried about customer relations, or regulator oversight, so they can be as aggressive as they like in their pricing. Having prices gap higher or lower doesn't bother them, and they love volatility as it allows them to pick up very underpriced assets and sell very overpriced assets. They have little incentive to calm markets. Volatility is their friend.

I believe these factors apply in all markets, and the volatility in equities, bonds and commodities over the last few weeks can be largely attributed to that. Now that the banks few remaining big swingers are back at their desks, and hopefully have brought their trading balls with them, liquidity might start to return and the volatility of recent days will fade. If not regulators might need to rethink some of their new rules.

China - House of Cards?

As anyone who knows me will know, I've long been dubious on China. The numbers are too good, too consistent, too much "on target" and nowhere near volatile enough in a volatile word to be believable - too much like Bernie Madoff in fact.


So to me, the last few days news is not so much a shock as depressingly inevitable. The only real surprises are that the trigger was something as simple as currency liberation and that the moves were quite as violent as they have been, but with the benefit of hindsight the longer it took for the bubble to burst, the bigger the final bursting would be. The inherent contradictions of Communist party control of a supposedly free market capitalist system were bound to overwhelm the status quo at some point.

The more interesting question is what now? It would be hard to put the exchange rate liberalisation rabbit back in the hat - and would kill off any chance of the Yuan joining the IMF list of reserve currencies and forming part of the new SDR basket. And attempts to prop up the equity markets have failed despite the government reportedly spending $200billion in direct intervention and purchases, as well as effectively banning any short-selling, or in some cases even the closing of long positions.

It would seem that events have overtaken the party's attempts to control thjem, and they have now decided to sit back and let nature take its course.

Fortunately equity ownership in China is nowhere near as widespread as it is in the West, but I suspect that those that do own equities are much more highly leveraged, leading to a potential narrow but intense window of pain for a few. It shouldn't have a huge overspill into the broader Chinese economy though, and already the PBOC has taken steps to ease monetary policy by cutting rates 25bp and lowering the banks Reserve Requirement by 100bp to 18% which should mitigate further.

The government is also now attempting to slow the rate of capital flight from the country by cracking down on "shadow banking". The ostensible aim of this is because the shadow banks are illegally helping people take cash out of the country, and this is almost certainly part of the logic of the crackdown, but also reducing the role of shadow banks in the economy inevitably means that the partly government-owned and controlled official banks have a larger role, giving the communist party more control over the economy.

The wider question of course is what happens on the social front. People have grown used to the Chinese government effectively underwriting all their investments. Now a lot of those investments are going to be taking losses. Are the people going to take to the streets to protest? What will the government do if they do (apart presumably from block off Tiananmen Square)? Watch this space....

Malaysia. 2nd world country with 3rd world corruption

http://on.ft.com/1JHGZMs

It seems that finally the open secret that Malaysia is as corrupt as most of the rest of Asia is going to come into the spotlight. Malaysia is a political basket-case, with an entrenched pro-malay party which has been in charge since independence fighting off a rag tag combo of reasonably hard-core Islamists and disaffected Malays.

The Malay Chinese meanwhile continue to quietly run pretty much every business entity of note and are letting the Malays get on with whatever they do - corruption mainly.

If it does go pear-shaped for the PM then life there could get interesting

Switzerland

The strains are showing. Lots of stories here of companies reducing workforces, especially around the borders where people can simply hop into France, Germany etc to do their shopping and save 30-40%. Come this winter it'll be interesting to see how the big ski resorts fair given how much cheaper skiing in France, Italy or Austria is. Not only are Europeans likely to stay away but the Russians have seen prices double in Rouble terms so places like Verbier may well struggle.

I think Switzerland is about to experience it's first decent recession for a while. 

Devaluations

It's about time economists realised that things don't happen immediately. Companies sign supply contracts for periods of months or even years. So the recent devaluations of the € and the Yuan will take time to filter through to the respective economies. It takes 12-18 months typically for currency devaluations to work through into tangible benefits.

Europe is starting to get there but I wouldn't expect significant results till early 2016.

China is a different question. Their biggest concern has to be whether the creeping levels of defaults and economic slowdown leads to civil unrest as the population discovers that the communist party can't and doesn't underwrite everything. Yes, they have huge reserves, but there are 1.4 billion Chinese and terrible demographics - it's one of the most rapidly ageing populations - so they have plenty to spend money on already, and if they were to start aggressively selling down their reserves it could cause a rout in government bond markets reducing further the value of the bonds they hold. As the country's debt pile grows the options available to the government are reduced. I fear the time is fast approaching when they will find themselves between a rock and a hard place. 

Russia. I told you it was screwed

http://www.bloomberg.com/news/articles/2015-08-10/russian-economy-shrinks-4-6-as-oil-slump-risks-deeper-recession

And that's what they admit to. So imagine what the real contraction is.

I said it would take time for sanctions to work, but they increasingly are. The list of sanctioned individuals and companies is quietly growing, and increasingly Russia is being turned into an isolated economy. A lot of companies are going to grow increasingly reliant on government contracts and largesse. That would be fine if oil were over $100 a barrel and the coffers were full, but it isn't, and they're not.

It's going to be a long, slow, painful slide. Hopefully it won't lead to Putin lashing out, but he is a certifiable loon so who knows.

China. Is the house of cards starting to wobble?

Massive fall in lending, especially in the "shadow banking" sector.

Biggest currency devaluation since true financial market development began in 2000

Massive reduction in reserve requirements for local banks.

I fear the cracks are starting to show, but I suspect that they will succeed in papering over them again for a few more years. My concern is that the longer the inherent contradictions of a communist controlled capitalist economy are allowed to build up, the bigger the final crash will be.

And the outcome of that crash is unpredictable. Will the communists use force to hold on to power, potentially unleashing another civil war, or will they go the way of their USSR counterparts and leave behind a gaping hole which will be filled by rampant cronyism and corruption.

Either way, it'll be interesting to watch. I just hope it's contained within Chinese borders.

Saudi Arabia

Seems I was unnecessarily optimistic about the Saudi's prospects. Their cash burn is much faster than I had thought. They're screwed. Oil isn't going back to the levels they need until shale and the oil sands are exhausted.

http://www.telegraph.co.uk/finance/oilprices/11768136/Saudi-Arabia-may-go-broke-before-the-US-oil-industry-buckles.html

Arab Spring 2?

Saudi Arabia has announced it is going to start issuing bonds to shore up government finances. As is well known the dramatic drop in oil prices is largely due to Saudi Arabia's attempts to drive new producers such as U.S. Shale and Iran (their sworn enemy) out of the market. Unfortunately such is the largesse of the Saudi government's attempts to buy loyalty from a restive population that their budget only balances when oil is at $105 a barrel. It is currently around $50.

The problem is if they cut production and let prices rise, then that incentivises the higher cost producers such as shale back into the market. Estimates vary but it seems that shale is probably economic at around $60-70 a barrel, and in some cases lower. This means effectively the oil price is not going to go back to $105 in a hurry as higher prices will simply lead to increased production from non-OPEC suppliers. And that's not allowing for Russia which is desperate for revenues and will crank up supply at the drop of a hat.

To make things worse, solar is becoming more and more economically competitive and advancesat companies such as The Solar Cloth Company (www.thesolarclothcompany.com) mean that it is no longer necessary to have big, ugly, heavy glass panels on strengthened roofs, but effectively solar can be rolled out on almost any surface and simply stapled down. 

Meantime the Saudis have gone through $65bn in reserves in a year and have about $675bn left. Just over 10 years. After that they're totally screwed.

They simply have to reduce spending. Which of course may lead to domestic upheaval and another "Arab spring" style rebellion.

Watch this space. And avoid the bonds like the plague.

Malaysia. Approach with caution.

Superb. I would say only in Malaysia, but actually this could happen in most of Asia given the levels of corruption. Anyway it seems the Malaysian Anti-Corruption Commission has decided that the $650million found in Prime Minister Najib Razak's bank account was a donation, and in no way related to the $650million hole in the finances of government entity 1MDB.

So that's alright then.

Having spent several years living just across the causeway in Singapore, visiting Malaysia always felt like a visit to the second world. Nice smooth motorways with slum towns and villages on either side. Some ok, but not really maintained infrastructure surrounded by crap. It's stories like this that remind you that in fact in most ways it's really the third world with a few shiny towers and buildings thrown in. Anyone contemplating investing in anything Malaysian should assume it will go pear-shaped and treat any other outcome as a huge result. And don't forget to budget for the bribes. 

Russia - the cracks are starting to show

The Russian Central Bank has just cut rates to 11%. The rouble has spiked again and is back at over 60 to the $. Inflation is rising. The oil price is falling. The economy is crashing.

Again, I hate to say this, but I told you so 6 months ago....

This economics thing isn't so hard. Its mainly a combination of common sense and actually taking note of the blindingly obvious.

Greece - I told you so.

This falls under the title of better late than never. And gloating of course. But i did say they'd find a solution. And they did.

Surprise surprise.

There's nothing quite like the prospect of losing several hundred billion euros to focus minds on what needed to be done.

No doubt there's an under-the-table agreement that there will be debt relief and/or some sort of renegotiation (probably extending maturities and reducing interest rates) in the future.