S&P 500 retraces while Shanghai shudders

The S&P 500 retreated from resistance at 2800. Retracement is modest and I expect support above the rising trendline (2700). Volatility (Twiggs 21-Day) is below 1.0%, indicating that market risk has returned to normal levels.

S&P 500 and Twiggs Volatility

The tech-heavy Nasdaq 100 is in a stronger position, making a new high at 7300, but is now likely to retrace to test the new support level at 7000. I am wary of Twiggs Money Flow as a lower peak would signal bearish divergence. A lot will depend on how buyers react at the new support level.

Nasdaq 100

China’s Shanghai Composite Index, on the other hand, broke support at 3000, signaling a primary decline. Initial target is the February 2016 low at 2700.

Shanghai Composite Index

Hong Kong’s Hang Seng Index weakened in sympathy. Breach of support at 29000 would signal a primary down-trend.

Hang Seng Index

Zombie banks or zombie economies?

The last three decades was the era of zombie banks, with financial crises threatening the very survival of our financial system. Major banks close to the edge of the precipice, first in Japan but followed by the USA and Europe, were only rescued by drastic action by central banks. The flood of easy money kept the zombie banks afloat but every action has unintended consequences, especially when you are the Fed, BOJ or ECB.

Fed Balance Sheet and Funds Rate Target

Now that the Fed is attempting to unwind its swollen $4.4 trillion balance sheet — see The Big Shrink Commences — and normalize interest rates, Stephen Bartholomeusz at The Age highlights some of the unforeseen consequences:

US rate hikes are already sending threatening ripples through other economies as capital flows towards the US and the US dollar strengthens.

Argentina has sought assistance from the International Monetary Fund. Turkey, Indonesia, the Philippines, Brazil, India and Pakistan have all been forced to raise their rates to defend their currencies.

US monetary policy and its rate structure is setting it apart from most of the rest of the developed world in a fashion that will impose pressure on economies that may be more fragile than they might previously have been regarded in an ultra-low global rates environment.

…..A consequence of the policies pursued by the Fed, the ECB and the Bank of Japan since 2008 has been a significant increase in global debt – at government, corporate and household levels – as ultra-low rates and torrents of liquidity ignited a global borrowing binge.

There was a particular appetite in developing economies for US dollar-denominated debt, which became abundant and cheap as US investors were incentivised and enabled by the Fed to take on more risk in return for higher returns.

The US rate rises, combined with a stronger US dollar, are now putting a squeeze on emerging market economies.

If the ECB were to also start unwinding its stimulus, economies and banking systems within the weaker southern regions of the eurozone would come under intense pressure, along with more debt-laden companies.

It shouldn’t come as a surprise to anyone that after a decade of unprecedented policy interventions in economies and markets there could be unintended consequences that emerge as those policies are wound back.

The ECB indicated overnight that it will halt bond purchases at the end of 2018 and plans to keep interest rates accommodative “through the summer of 2019 and in any case for as long as necessary…”

ECB unwinding still appears some way off but tighter monetary conditions emanating from the Fed may be sufficient. Developing economies that gorged on low-rate US dollar-denominated debt during the liquidity surge are finding themselves in difficulties as the tide goes out.

Meanwhile in Australia

From Karen Maley at the AFR:

Australian banks are being squeezed by higher borrowing costs as the US Federal Reserve accelerates its interest rate hikes and drains liquidity from global financial markets…..

The woes of the local banks have been exacerbated by an unexpected and savage spike in a key Australian short-term interest rate benchmark – the three-month bank bill swap rate, or BBSW, in the past few weeks.

Analysts estimated that the spreads paid by Australian banks have climbed by close to 40 basis points since the beginning of the year, which has swollen the wholesale borrowing costs of the country’s banks by some $4.4 billion a year.

The ASX 300 Banks Index is headed for a test of primary support at 7000/7200. Breach of 7000 would warn of another decline, with a long-term target of the September 2011 low at 5000.

ASX 300 Banks Index

Aussie banks are being squeezed by higher interest rates on their international borrowing but are unable to pass this on to borrowers for fear of upsetting the local housing market. House prices are already under the pump, especially in the top end of the market.

Zombie banks would be too harsh but Aussie banks are in for a rough time over the next year or two.

China sees red

From Darren Gray & Kirsty Needham at The Age:

Relations with China have taken another backward step after one of Australia’s biggest exporters, Treasury Wine Estates, was among several companies whose products were being stalled because of new customs rules targeting Australian companies and industries….

2018/2019 Budget Net Debt and Fiscal Deficit/Surplus

“Chinese officials have introduced new and different verification and certification processes and we’ve been working with the Chinese authorities and the officials, as well as with Australian authorities and officials, to ensure that we can meet these new and additional processes, which are not just applied to Treasury Wine Estates, it’s being applied to a number of other companies, across a number of different industries from Australia,” Treasury boss Michael Clarke said.

Australian Trade Minister Steven Ciobo said in Shanghai he had been informed of the situation by Treasury, the largest importer of foreign wine into China, in the past 24-36 hours.

“The questions being asked relate to certificates of origin. We will look at precisely what the situation is and if we can get to the bottom of it,” Mr Ciobo said.

….Amid a looming trade war between the US and China, and threatened punitive tariff packages worth hundreds of billions of dollars, American exporters have also reportedly encountered pre-emptive slow downs and extra scrutiny from Chinese customs in recent weeks.

China is attempting to use trade relationships to coerce trading partners into complying with their political demands, applying Lenin’s dictum “Probe with a bayonet. If you meet steel, stop. If you meet mush, then push.”

Australia faces a clear choice. Acquiesce and the trade issues will likely disappear…for a short time until China wants something else. Effectively we will become China’s southernmost province, responding to the will of the Central Committee in Beijing.

The alternative is a lot tougher: politely but firmly resist any pressure from Beijing and demand to be treated as an equal partner in international relations. The price is high but the rewards are far greater. Our freedom and independence.

Does China have the ‘financial arsenic’ to ruin the US?

The media has been highly critical of Donald Trump’s threatened tariff war with China, suggesting that China has the stronger hand.

Twitter: US-China trade deficit

I disagree on two points:

  1. Trump is right to confront China. Even Paul Krugman, not a noted Trump supporter, called for this in 2010.
  2. China’s position may not be as strong as many assume. Ambrose Evans-Pritchard sums this up neatly in The Age:

The Bank for International Settlements says offshore dollar debt has ballooned to $US25 trillion in direct loans and equivalent derivatives. At least $US1.7 trillion is debt owed by Chinese companies, often circumventing credit curbs at home. Any serious stress in the world financial system quickly turns into a vast dollar “margin call”. Woe betide any debtor who had to roll over three-month funding.

The Communist Party leadership will not kowtow to Donald Trump.

Photo: Bloomberg

The financial “carry trade” would seize up across Asia, now the epicentre of global financial risk. Nomura said the region is a flashing map of red alerts under the bank’s predictive model of future financial blow-ups. East Asia is vulnerable to any external upset. The world biggest “credit gap” is in Hong Kong where the overshoot above trend is 45 per cent of GDP. It is an accident waiting to happen.

China is of course a command economy with a state-controlled banking system. It can bathe the economy with stimulus and order lenders to refinance bad debts. It has adequate foreign reserve cover to bail out its foreign currency debtors. But it is also dangerously stretched, with an “augmented fiscal deficit” above 12 per cent of GDP.

It is grappling with the aftermath of an immense credit bubble that has pushed its debt-to-GDP ratio from 130 per cent to 270 per cent in 11 years, and it has reached credit saturation. Each yuan of new debt creates barely 0.3 yuan of extra GDP. The model is exhausted.

China has little to gain and much to lose from irate and impulsive gestures. Its deep interests are better served by seeking out the high ground – hoping the world will quietly forgive two decades of technology piracy – and biding its time as Mr Trump destroys American credibility in Asia.

East to West: Headed for war?

Followers of international relations can take their pick of wars at present. There is a trade war brewing between Donald Trump and Xi Jinping, which could descend into a currency war with competing devaluations. We have a Russia waging a cyber war on the West, a Cold War in Eastern Europe and the Baltics, a proxy war in Yemen between Saudia Arabia and Iran, a frozen war in Georgia and Ukraine, and a hot war in Syria that threatens to escalate into a major confrontation between Russia and the West. On top of that we have Kim Jong-un trying to break into the big leagues by test-firing ICBMs over Japan. It’s a tough neighborhood.

The “peace dividend” that was supposed to follow the collapse of Communism is well and truly over. The next major ideological conflict is upon us. Democracy versus the Dictators. For the West to prevail it will have to engage in a coordinated muscular diplomacy over the next few decades. A good start would be Margaret Thatcher’s Statecraft: Strategies for a Changing World (2002):

Margaret Thatcher and Ronald Reagan in the oval office, 1988

Margaret Thatcher and Ronald Reagan in the oval office, 1988

“For my part, I favour an approach to statecraft that embraces principles, as long as it is not stifled by them; and I prefer such principles to be accompanied by steel along with good intentions.

…The habit of ubiquitous interventionism, combining pinprick strikes by precision weapons with pious invocations of high principle, would lead us into endless difficulties. Interventions must be limited in number and overwhelming in their impact.

….I should therefore prefer to restrict my guidelines to the following:

Don’t believe that military interventions, no matter how morally justified, can succeed without clear military goals.

Don’t fall into the trap of imagining that the West can remake societies.

Don’t take public opinion for granted — but don’t either underrate the degree to which good people will endure sacrifices for a worthwhile cause.

Don’t allow tyrants and aggressors to get away with it

And when you fight — fight to win.’

But the West also needs to clean up its own house and correct many of the abuses to which Capitalism has been subjected over the last few decades. Martin Wolf sums up the challenges in US-China rivalry will shape the 21st century:

‘The threat is the decadence of the west, very much including the US — the prevalence of rent extraction as a way of economic life, the indifference to the fate of much of its citizenry, the corrupting role of money in politics, the indifference to the truth, and the sacrifice of long-term investment to private and public consumption….’

Bold leadership is required. To fight the wars we have to but, more importantly, to resolve conflicts by other means wherever possible. That doesn’t mean avoiding conflict by retreating from red lines. It means establishing and vigorously enforcing new rules that benefit everyone. No one wins in a war. Whether it is a trade war, a cold war or a hot war. Everyone pays a price.

‘It must be thoroughly understood that war is a necessity, and that the more readily we accept it, the less will be the ardor of our opponents….’

~ Thucydides (circa 400 BC)

Trade Wars: Playing hardball with China

Remember North Korea and the imminent nuclear war? With leaders trading insults on Twitter and bragging: “My nuclear button is bigger than yours.” It may resemble a WWF arena more than international diplomacy but that is how Donald Trump conducts foreign affairs.

The current Twitter war over trade tarrifs is no different. Threat and counter-threat of wider and deeper trade tariffs are likely to bounce back-and-forth over the next few weeks. Xi Jinping thinks he has the upper hand because he doesn’t face criticism from a hostile media at home. Nor does he need to front up to a hostile domestic opposition. They’re all safely tucked away in jail. His stock market has already crashed, so there is not too much to worry about on that front either.

Shanghai Composite Index

Xi will do his best to undermine Trump’s shaky support. Targeting Trump’s electoral base with tariffs on soy bean imports (farming states) and steel tubing (Texas) in order to undermine his support. Targeting technology companies like Boeing and Apple, where China is a large slice of their global market, is also likely to elicit strenuous lobbying in Washington. As are well-timed tweets aimed at undermining stock support levels, threatening a major stock market rout.

Dow Jones Industrial Average

Trump probably recognizes that China can withstand more pain, but figures that he has the capacity to inflict more pain. The US has a large trade deficit with China.

Twitter: US-China trade deficit

And exports comprise a larger percentage of China’s GDP.

In 2010, Paul Krugman wrote:

Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”

But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.

I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.

Krugman (no surprise) now seems more opposed to trade tariffs but observes:

….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.

I believe that Krugman’s original 2010 argument is still valid and that Trump is right in confronting China. The gap between imports and exports of goods is widening, especially since 2014, not shrinking.

Exports and Imports: Value of Goods for China

But let’s hope that Trump has done his homework. At this stage this is just a Twitter war rather than a trade war, intended to soften up your opponent rather than inflict real damage. But for Trump to succeed he must demonstrate that the US is prepared to endure the pain of a lengthy trade war if needed.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)

China holds its head above water

A quick snapshot from the latest RBA chart pack.

Manufacturing is holding its head above water (50 on the PMI chart) and industrial production shows a small upturn but investment growth is falling, as in many global economies including the US and Australia. Retail sales growth has declined but remains healthy at 10% a year.

China

Electricity generation continues to climb but steel, cement and plate glass production all warn that real estate and infrastructure development are slowing.

China

Interest rates remain accommodative.

China

Real estate price growth is slowing but remains an unhealthy 10% a year. Real estate development investment rallied in response to lower interest rates but is clearly in a long-term decline.

China

There are no signs of an economy in immediate trouble but there are indications that the real estate and infrastructure boom may be ending. Through a combination of fiscal stimulus and accommodative monetary policy the Chinese have managed to stave off a capitalism-style correction. But failure to clear some of the excesses of the past decade will mean that the inevitable correction, when it does come, is likely to display familiar Asian severity (Japan 1992, Asian Crisis 1997).

Around the markets: Hong Kong & India bullish

Canada’s TSX 60 continues to test resistance at the former primary support level of 900. Bearish divergence on Twiggs Money Flow warns of strong selling pressure. Decline below 880 would confirm a primary down-trend, with an initial target of 865*.

TSX 60 Index

* Target calculation: 900 – ( 935 – 900 ) = 865

The Footsie recovered above 7400 but bearish divergence on Twiggs Money Flow warns of long-term selling pressure. Another test of primary support at 7100 remains likely.

FTSE 100 Index

European stocks are taking a beating, with the Dow Jones Euro Stoxx 50 Index testing support at 3400. Sharp decline on Twiggs Money Flow warns of selling pressure. Breach of 3400 would warn of a test of 3200.

DJ Euro Stoxx 50 Index

* Target calculation: 3650 – ( 3650 – 3450 ) = 3850

India’s Sensex remains in a bull market.

BSE Sensex

* Target calculation: 29000 + ( 29000 – 26000 ) = 32000

As does Hong Kong’s Hang Seng Index.

Hang Seng Index

* Target calculation: 24000 – ( 24000 – 21500 ) = 26500

While China’s Shanghai Composite index ranges between 3000 and 3300. Government interference remains a concern.

Shanghai Composite Index

Round the world: India & Hong Kong advance, Canada falters

Canada’s TSX 60 retraced to test resistance at the former primary support level of 900. Respect is likely and would signal a bear market. Decline of Twiggs Money Flow/Trend Index below zero would strengthen the bear signal. Medium-term target for the decline is 865*.

TSX 60 Index

* Target calculation: 900 – ( 935 – 900 ) = 865

The Footsie is losing momentum, with penetration of successive trendlines and declining Twiggs Trend Index. A test of primary support at 7100 is likely.

FTSE 100 Index

Dow Jones Euro Stoxx 50 Index, representing the 50 largest stocks in the Euro Zone, found support above 3400. Penetration of the declining trendline would indicate the correction is over and suggest the start of another advance — confirmed if the index breaks its recent (May 2017) high.

DJ Euro Stoxx 50 Index

* Target calculation: 3650 – ( 3650 – 3450 ) = 3850

It’s full steam ahead for India’s Sensex. Trend Index troughs above zero indicate strong buying pressure. Expect some profit-taking at the target of 32000* but any correction is likely to be shallow as the bull market gathers momentum.

BSE Sensex

* Target calculation: 29000 + ( 29000 – 26000 ) = 32000

Hong Kong’s Hang Seng Index has also reached its target of 26500. Again Trend Index troughs above zero indicate solid buying pressure.

Hang Seng Index

* Target calculation: 24000 – ( 24000 – 21500 ) = 26500

China’s Shanghai Composite index is also rallying but I remain wary of government intervention.

Shanghai Composite Index