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Greetings,

It’s possible that China is not ready for free markets. The first sign was in the first half of 2015 when regulators let Chinese stocks soar, fueled by hugely speculative investments and a surge in margin trading. Then, after the bubble popped, policymakers cobbled together a haphazard rescue package that ultimately failed to support the market. The currency “devaluation” was an attempt to appease the IMF and also jumpstart the country’s stagnant manufacturing industry. But allowing CNY to drop a mere 3% before resuming intervention will not spark economic activity.

Most alarming was the PBoC’s inability to lower money market rates last week while the local stock market dropped 10% in one session. Last Tuesday, the PBoC injected 150bn CNY into the banking system through reverse repos. On the same day, 120bn CNY worth of repos matured – making the net injection 30bn CNY. It’s often overlooked, but the PBoC doesn’t actually intervene in FX markets. Instead, it instructs state-backed banks to intervene on its behalf. The same day, Chinese banks sold ~$15bn USD/CNY to protect the exchange rate. However, that soaked up another 96bn CNY ($15bn*6.4) of capital from the system. At the end of the day, the PBoC actually tightened liquidity by 66bn CNY.

The tightening of liquidity served to push up repo-rates, which is exactly what the market didn’t need. By Wednesday, the PBoC had figured this out and dropped the hammer with a 25bps interest rate cut combined with a RRR reduction. This was effective in dropping repo rates, but their inability to manipulate a state-controlled market in a time of panic feeds the narrative that China is not ready for the major leagues.

Cup & Handle subscribers have known for a while that, more than anything, China needs lower real interest rates. Even now, after five policy rate cuts, real rates are only back to 2012 levels when GDP was running above +8% Y/Y. They’ll need to drop a lot further for the domestic economy to generate any momentum, but, at the same time, policymakers don’t want to add to an enormous debt burden. It will be a very tricky balancing act, and the release valve could be a much weaker CNY.

The market has its eyes squarely fixed on China now, and developments in the Middle Kingdom will be the key factor in the future direction of asset prices. The first snapshot of economic data for August was ugly. The preliminary Caixin manufacturing PMI was 47.1, well below expectations. Investors will now turn their attention to US non-farm payrolls on Friday before we see China’s exports, CPI and lending data next week. More than anything Chinese policymakers need to show the market that they have a handle on things. The explosion in Tianjin and subsequent lack of response did nothing to soothe concerns. Premier Li Keqiang is already thought to be on the hot seat, and if things don’t settle down President Xi will name other scapegoats.

The Cup & Handle Fund is up around 7.0% YTD, and +27% Y/Y. The portfolio was up huge last Monday, but gave back some gains during the subsequent rally. I’ve adjusted the portfolio slightly, but the fundamental thesis hasn’t changed much. Expect big gains later this year. Without being redundant, the last two monthly letters have been home runs. If you’d like to start receiving these letters click here.

Today’s letter will cover several topics, including:

• China
• US
• Europe
• Chart of the Week

With that I give you this week's letter:

August 30, 2015

As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro