In December 2014 we noted that the gold/crude oil ratio had never broken above 20 without the development of a “nameable” crisis. Both assets are synonymous with inflation. Gold is more of a monetary barometer, while oil typically reflects the level of economic activity. In that regard, the spike in gold/oil makes sense, because central banks are pumping stimulus into the system but it’s not resulting in stronger growth. It’s far too early, but if a crisis does unfold, what would it be called? Undoubtedly the name would include “China,” but the Chinese don’t deserve all the blame for this.
Remember, it was the Chinese who rescued the global economy from a depression in 2009. The violent swings in Chinese stocks get all the attention these days, but that’s not why the S&P 500 is slumping. On Tuesday, the IMF downgraded its projection for growth (again) over the next two years. They now estimate the world economy will grow 3.4% this year and 3.6% in 2017, down -0.2% from their estimates last fall. China’s +6.9% Y/Y GDP reading for 4Q15 might be bogus, but the country’s growth is still much higher than anywhere in the West. The problem is that policymakers globally became way too dependent on China for growth, and now their economy is shifting gears.
China accounts for 34% of global growth, and the nation’s multiplier effect on emerging markets takes that number to over 50%. Take oil for example. Coal still accounts for 70% of total Chinese energy consumption, but the country plays a huge role in the oil market. In the decade ending in 2014, growth in Chinese consumption accounted for 48% of the total growth in global oil demand. This was never going to be sustainable. Now, oil supply is outpacing demand and prices are falling. This gives a huge boost to USD, which tightens liquidity in China because of the currency peg. Now, the PBoC is letting CNY decline a little bit as a release valve and everyone is panicked.
However, it’s a mistake to think the recent CNY depreciation against USD is part of the “currency war.” In a sluggish global economy, it would take a considerably larger depreciation to boost exports enough to offset downward pressures elsewhere in China. And a big devaluation would contradict Beijing’s core strategy of moving from exports toward domestic consumption. CNY is down -6% vs. USD since July, but it’s still up +25% since 2005. Other central banks, like the ECB or BoJ, might respond to a weaker CNY by pushing down their own currencies, but China’s just protecting their interests by offsetting the Fed, not racing to the bottom.
This Chinese slowdown is nothing new, only the narrative has shifted. Last year, it looked like China would just pass the baton to the US as the ballast for global growth. Now, weak 4Q data indicates the US is just as vulnerable as everybody else. To make things worse, the Fed, seemingly oblivious to what’s happening in the market, formally raised interest rates in December after watching monetary conditions tighten relentlessly since August 2014. That’s why markets look so shaky, not Chinese stocks. Unless the Fed reverses course, it looks like the global economy is off its moorings and headed into uncharted waters.
With that I give you this week's letter:
The Cup & Handle Fund is up around +1.5% YTD, and +6.0% Y/Y. Not the start we were looking for, but outperforming all of the benchmark indices. I think everyone came into 2016 with little exposure, then started selling heavily when everything turned down. At some point I think those positions will get cleaned out and we’ll see a decent rally before another downdraft. We’re positioned to do well in either scenario, it’s just a matter of being patient. If you’d like to start receiving these letters click here.
As always, if you have any questions or comments or just want to vent, please send me an email at firstname.lastname@example.org.
Until next time, tread lightly out there,
Managing Editor – Cup & Handle Macro