The China-Driven Panic Continues

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Includes: CHN, CN, CNY, CXSE, CYB, EPI, FCA, FXCH, FXI, FXP, GCH, GXC, IIF, INDA, INDL, INDY, INP, INXX, JFC, MCHI, PGJ, PIN, TDF, XPP, YANG, YAO, YINN, YXI
by: Ivan Martchev

china It is difficult to believe that the selling that has marked the first two weeks of January will continue at the same pace. At the January selling rate, the Chinese stock market will disappear by June while the U.S. stock market will disappear by year end, neither of which is likely to happen. The U.S. market is entering earnings season, which is unlikely to be all that bad, and is likely to create a rebound for the S&P 500.

For the Shanghai Composite the situation remains dire. My base-case scenario is that the China is facing a generational economic unravelling which is hitting the Chinese yuan with record capital flight, declining economic numbers (as much as one can believe mainland statistics), and a falling Chinese stock market.

I have serious doubts that China can create a recession in the U.S. For the time being I am treating the bad news hitting the U.S. stock market as an external shock, similar to the one we saw in the Asian Crisis in 1997-98. As I have explained previously, the U.S. stock market can get hit by external shocks but it also has a much easier time rebounding from those than if the problem was generated by the U.S. economy.

The Shanghai Composite last week closed at 2900, which puts it 900 points away from the upper end of my target range of 1000-2000 in 12-24 months. There are no earnings to support most mainland Chinese equities and as I have previously shown, they are more than three times more expensive (65 P/E) than the median valuation for U.S. stocks (19 P/E) at a time when the economy is rapidly deteriorating, as reflected by commodity prices, where China has been the #1 or #2 consumer of most major commodities.

Shanghai Composite - Daily Nearest OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Chinese stocks have created a rather peculiar technical pattern called a head-and-shoulders top (marked by my blue lines, above), which puts a rough target for the Shanghai Composite below 1000. This is possible in the sense that a nasty recession could dramatically suppress earnings for Chinese stocks on top of them being quite overvalued based on their current median P/E multiples.

Commodities Research Bureau Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

We have not only taken out the major support in the CRB commodity index in the 180-200 range, but we have now penetrated 160, closing at 159.93, a level not seen since early 1973. It is true that the CRB commodity index has been reformulated more than once since the 1970s, but it is also true that it still serves as a valid gauge of commodity demand, which is collapsing at the moment. Many of the components of the S&P 500 Index have also changed over the past 20 years but it too serves as a good gauge of the health of corporate America. Reformulated or not, the CRB Index signals no bottom in sight.

Crude Oil WTI - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Based on February 2016 WTI crude oil futures, we have now cracked the $30 barrier and closed at $29.42/bbl. last week. Soon the March 2016 WTI futures will become the front-month and they still hold that important psychological level. I don't think $30 will hold and $20 may not hold, given that Iran's sanctions have now been lifted, which will unleash plenty of crude oil to push crude oil prices lower.

One unintended consequence of this China-driven panic has been the rally in Treasury prices and the marginal breach of the 2% barrier by the 10-year Treasury note yield, closing the week at 2.03%.

I raised a lot of eyebrows in my conversations with investors at the end of 2015 when some were telling me that Treasury yields were headed higher due to the coming Fed funds rate hikes. My point of view is different, in that I am looking for Treasury yields to make all-time lows in 2016.

Ten Year Treasury Yield Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Pictured above is the weekly chart of the 10-year Treasury Yield Index, which is basically the 10-year note yield times 10. The all-time low in the 10-year note yield is 1.39%, set in 2012. That is about 60 basis points away from here. Those 60 basis points would be quite the move in the bond market, provided that the Fed has not yet officially given up on its future rate hike plans. I would expect the 10-year note yield to make all-time lows in the second half of 2016 as the Fed gives up on its rate-hike strategy.

I don't think that the Fed should be hiking interest rates in this environment, but those giant egos that sit on the FOMC are likely to have trouble admitting that the December rate hike was a policy mistake. They will have to "discuss" and "debate" their mistake before admitting it and perhaps make another mistake before backtracking. This monetary flip-flopping should be quite entertaining to watch as it develops.

India: The Last Emerging Market Standing

While the MSCI Emerging Markets Index is now under serious pressure as most countries in the index have China leverage via commodity prices or close trade relationships in Asia, one index member stands out, India. On a relative basis, the Indian Sensex flagship benchmark looks like a rocket ship about to enter outer space when plotted against the MSCI EM Index (see below).

India Bombay Stock Exchange Sensex Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In reality, the Sensex has sold off marginally, even though the MSCI EM Index has sold off quite a bit more. Since the MSCI EM Index is the benchmark for investors interested in emerging markets, or the equivalent of the S&P 500 in this country, it is rather peculiar to see India in this situation.

The issue is that the BRIC quartet - Brazil, Russia, India, and China - has more or less disintegrated. Brazil and Russia have been pushed lower by China's unravelling because of the collapse in commodity prices, but in a strange way whatever is pressuring most emerging markets now is actually helping India. The global deflationary backdrop is lowering the persistently higher Indian inflation rate, which has allowed for four interest rate cuts in a little over a year. Low inflation and lower interest rates are supporting this relatively closed economy.

Emerging Markets Free Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This may be a tradeable market trend. I don't think that China is done suppressing commodity prices. There are numerous Indian ETFs and more than one that follow the MSCI EM Index. Being long India and short the MSCI EM Index may have more time to work out. The MSCI EM Index is likely to take out the 2008 low simply because the economic unravelling in China is a bigger deal to many emerging markets, be they dependent on commodity prices or on China trade with manufactured goods, than the 2008 Great Financial Crisis. In this environment I fully expect India to remain the best-performing emerging market.

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