Intervention

From the July 16, 2015 HRA Journal: Issue 236

Right now it looks like Greece will be resolved though I think it’s destined for a fourth bailout which won’t be completed.  Hope I’m wrong about that but the debt mountain is getting to be un-scalable and the damage to its banking system worsens hourly.

Chinese markets look like they will get a reprieve either though volatility is so high in that market its dangerous to read much into one and two day moves.   Interventions like this don’t work most of the time.  Assuming this one won’t either is simply betting the odds.

As this was being completed news crossed the wires that China’s Q2 growth was a bit better than consensus.  Hopefully that means that stimulus applied earlier in the year is starting to kick in.   Another piece of recent news, a retail sales report for the US that was far weaker than expected, again points to ongoing failure to launch for the US.  I’ve made my position on the subject clear.  We can’t expect to see much acceleration in the US until we start seeing better wage gains.  After several years of deleveraging Americans don’t seem ready to outspend their incomes to the extent they did before the financial crisis.  Time for Wall St, and maybe the Fed too, to rework those models.

None of this has helped metals.  There is a sense that the end of the bear is near but many still expect, and want, that last leg down. I don’t see what would cause it but would love to be able to say it’s done.  Watching for those fabled black swans.  

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Both of the major crises of this summer have been deemed “resolved” by the markets. One (Shanghai) may be but the other (Greece) has become a fiscal high wire act that will forever be one slip away from disaster.  Not a situation that an objective observer would describe as a resolution. 

The two charts on the next page present the Shanghai composite index over the past three months and one year time frame.   The three month chart looks scary though the index has sustained a nice bounce off the 200 dma and rallied 16% in only three sessions.  The one year chart adds some much needed context.  The drop IS scary but it comes after a 150% twelve month run up that has to go down as one of the strongest, if not the strongest, major market rallies in history.

I’ve said for months this is a rally that would end badly.  In one respect it already has.  While the pullback is barely a month old it was enough to induce complete panic in the mandarins in Beijing.   It’s not overstatement to say the government freaked out.  From all the arm waving and cheerleading in state controlled media this year its clear the government was counting on a positive wealth effect from the surging stock market.  Based on the growth numbers China has posted this year it doesn't seem to have worked.  It’s a classic example of “be careful what you wish for”.

Instead of happy consumers/part time traders dipping into market winnings to spend out of newfound optimism Beijing helped to spawn China’s biggest casino yet.   Anyone who knows the Chinese isn’t too surprised by this so it’s a bit shocking the country's leadership is. 

The Chinese are some of the world’s great entrepreneurs and many of them love to gamble.  I think its no coincidence there has is a strong inverse correlation between the Shanghai market and gambling revenues in the famous casinos of Macau, which have really been hurting lately.  Why fly to Macau when you can take a flier on Shenzhen tech IPO?

The action on Shanghai and the even more volatile Shenzhen exchange became an irresistible draw for retail traders. Almost 100 million new accounts got opened in the past year or so.  These are not investors buying a piece of a business.  This is pure momentum trading, very similar to the late stages of the 1929 market and the internet bubble on NASDAQ.

Before I go further I want to make it clear you won’t be seeing some Great Depression comparison later in the article.  This is another case where slapping an old chart on top of a new one is a meaningless exercise.  There is very little real world similarity between China’s situation today and the US/Europe in 1929.  Almost none in fact.

The only point of similarity is the gambling nature of the market. That is true of all speculative blow offs though.  They all look the same in that respect.  The question is whether the end game is similar.  Beijing is trying hard to ensure it isn’t.

China’s government is scared and taking unprecedented steps to halt the market slide.  Half the companies on the exchange have been allowed to halt trading for at least a day.  There isn’t much pretext that the halts have any intent but to keep sellers from selling, regardless of the reasons.  Beijing has also outlawed selling (literally) by insiders and anyone who owns more than 5% of a stock, cancelled IPOs, forced brokerage firms and large equity funds to promise they would stick to the buy side and “encouraged” them to take all sorts on illiquid assets as margin collateral rather than forcing immediate margin calls.

The level of intervention is a clear sign of panic.  Its also a big mistake on many levels.  I don’t know how long companies can keep their stocks halted but it won’t matter if they don’t open at a good price. How many fresh margin calls get triggered when a bunch of stocks open 20 or 30 percent below their last trade level? 

All these measures had their intended effect, so far at least.  As you can see from the three month chart there was a massive rally on Shanghai.  Will it last?

I’m no conspiracy nut but there is no doubt in my mind that government agencies were direct buyers, especially at the start of the rally.  Someone was very active in the index futures and ETF markets that would have driven buying of index stocks in both Shanghai and Shenzhen. 

The situation is very reminiscent of Hong Kong turning its market around in 1998.   Back then, the return of the colony to China made both the Hang Seng index and the Hong Kong Dollar favorites for shorters.  Volumes were massive.  The government shocked the market by buying and buying hard in the forward currency market and in the index options and futures.  They managed to push hard enough to trigger a wave of stop losses set up by short sellers.  It was impressive.  And it worked. The Hong Kong market sustained a huge rally and the HK Dollar peg held.

Beijing is taking a page out Hong Kong’s book and its measures are more draconian.  They might work, but they are still a mistake.  China badly wants its currency to become one of two or three widely accepted reserve and trade currencies.  Its actions in the past week make that much harder. 

Do foreign investors want to enter a market where their stock could be locked up at any time?  Will traders feel drawn to bourses where price discovery is tenuous at best?   I doubt it.   I think these actions are going to come back to haunt Beijing, whatever the outcome.  Having a reserve currency means living with market swings.   You don’t get to step on the market every time you disagree with its direction.

So far its worked but government may have to keep up the brute force buying. Most of the late entrants into the Chinese stock market are retail traders chasing momentum stocks using margin.  They are too small to be subject to the sales restriction on big shareholders and few if any of them are short sellers. 

For the rally to continue, small investors have to trust the government will save them.  Maybe it will but as we all know these sorts of regulatory “puts” have a way of ending in tears.  Small traders won’t be protected from margin calls unless the stocks continue to rally strongly.  Beijing may be painting itself into a corner here.  We’ll see how far they are willing to take it and if traders continue to buy up everything in sight if Beijing backs off. In the end, this sort of intervention usually fails but few have tried it at the scale of Beijing.

In terms of knock on effects of the market plunge in Shanghai the copper chart above sums it up best.  It’s widely assumed at least some Shanghai copper warehouse inventories are being held as collateral against leveraged loans.  Loans that have been used for market speculation or hedge trades may be getting called. 

You can see that there is a strong positive correlation between the copper price and the Shanghai index recently.  This could be margin calls, traders fearing the effect of a market crash on the real economy or, most likely, both.  Trading volumes in the copper market have been massive lately, and the price dipped to levels seen during the February washout, before bouncing along with the Shanghai index. 

It’s too early to say how much wealth effect the drop on Shanghai may have.  If the government succeeds in getting buyers to run prices back up to recent highs it won’t have much impact.  The rally itself seemed to have consumers delaying big ticket items so they can leave their cash in brokerage accounts. 

If the market actually crashes it will have more impact but, still, the number of active traders is lower in relation to the overall population in China than in most developed economies.  I wouldn’t overestimate the impact unless and until we actually see it in consumer spending numbers.

It’s always been tricky to quantify the impact of stock market valuation on consumer behavior.   I don’t see why it should be easier in China.   Most economic readings have improved in the past month.  The market plunge could reverse that but it’s also likely to make the government’s efforts to support liquidity and growth even more aggressive.  Notwithstanding what has happened to industrial metals in the past couple of weeks I wouldn’t count China out just yet.

The other crisis, in Greece, is being treated as resolved and the markets are partying like its 2011.  If by “resolved” you mean “Greece has been squished like a bug under the boot of Germany and its northern neighbors” then I guess it is.

The EU, in a world class example of passive aggressiveness, has given Greece a choice.  Either capitulate completely to EU demands for more austerity, structural and legal changes to the economy and putting up €50 billion in ransom or watch the emergency support that has been keeping the Greek banking sector alive fade away. 

The difference between this warning and the last hundred or so from the EU is that this one has a very short timeline.  Its clear northern Europeans did this purposefully.  They are forcing the Greeks parliament to get to work immediately in order to have any hope of meeting the deadline. Even with a burst of frenetic activity it seems all but impossible for the Greeks to meet the deadlines.  They will have to pass a huge package of legislation in a couple of days.  If they do that, then the EU will start serious discussions about passing a new bailout package.  The message is clear “We’re done talking, negotiating and understanding”.

The concessions being asked for are much tougher than the ones Greeks voted against last week.  They lay bare the scale of Tsipras’s miscalculation.  As I have noted several times European markets clearly don’t view any potential endgame, including Grexit, as apocalyptic.  That has strengthened the hand and the resolve of northern Europeans.  Tsipras and his cohorts in the Syriza party assumed that when push came to shove the EU would not be willing to pull the plug on Greece.  While they misplayed that hand conditions worsened in Greece, especially in its banking sector, and the real cost of a rescue climbed rapidly.  In the end it was the other side doing all the pushing and shoving and Tsipras had no choice but to knuckle under or leave empty handed. 

It’s going to take at least €80 billion to keep Greece afloat and recapitalize its banks and the number grows daily.  I’m actually surprised the EU agreed to anything in the end.  As it stands, Greece becomes a client state and ward of the EU.  Even though the markets are trumpeting the deal I think there is still a real chance the Greeks decide its just too much to swallow.

While I’m certainly sympathetic to Greek hardships I’m unsurprised by how tough the deal is.  The Greeks have no credibility after vacillating and procrastinating on the last two bailouts.  Whether the bailouts make basic economic sense isn’t the point. I think they don’t but I can understand the skepticism on the part of the EU.

I think Greece is being made an example of and while the Greek state may deserve it the deal as it stands will probably fail again.  The EU agreed to no debt write down, which is the one thing that might have made the deal work longer term.  I think there is no chance that the EU gets all or even most of its money back. Even though Athens is apparently totally unprepared to deal with Grexit (another huge miscalculation) it should seriously consider pulling the plug itself.  Greece needs a huge reset to bring its internal costs (high) and productivity (poor) into line with costs in the surrounding region. That’s not possible as long as its pegged to the Eurozone. 

Greece would be better off going back to the Drachma, living through the inevitable and large devaluation that will follow and repudiating its debt.  It’s already a bond market pariah so there is nothing to be gained in leaving the Eurozone unless it’s going to write off the debt at the same time.

Greece is being treated as a done deal by the markets. Maybe it is but there are still many ways it could go wrong.  Gold bugs are frustrated the Greek saga didn’t drive gold prices higher.  I’ve said for months that Greece simply isn’t that important.  There would be a market shock if it exits but I think it would be brief and muted. 

With China and Greece suddenly bringing the “risk on” trade back of the large investment banks are pounding the table about Euro parity so we know which side of the trade they are on. A September rate increase is still high probability unless China falls further. I won’t be surprised if US metrics weaken a bit again through the summer.  That might give the Fed pause but if China and Greece seems resolved they don’t have much excuse to wait longer.

Traders still expect one more leg down in the gold price though its defended last year’s low of $1140 again. If we actually see Euro parity that market backdrop could certainly produce sub $1140 gold.  The ECB wants the cheaper Euro but, if Greece is “settled”, the Continent should continue to beat consensus with its economic metrics.  I don’t think the gap in real economic growth between the EU and the US will be large enough to justify a common currency that cheap.  We’ll see.

If China doesn’t continue to report improving growth numbers the pressure will continue in the industrial metal markets.  That is especially true if Beijing fails in its bid to keep talking the stock markets up.  The actual demand drop may be less than feared but we all know paper beats rock when it comes to commodity markets.  Traders will have their say in the short term. Don’t expect less volatility.

As this issue was being finished it was reported that a nuclear deal with Iran has been agreed to.  If that pans out it will add oil to the list of commodities under pressure.   Production hasn’t dropped off yet the way OPEC hoped.  If Iran brings another million plus barrels per day to the party it will be tough for oil to rally.

All of this adds up to a difficult backdrop for precious metals.  Traders need something to convince them a bottom is in.  A big dump would do that, though I don’t see catalyst if all these crises actually are resolved.

Bullish seasonals in the gold market should kick in right about now.  It remains to be seen if those will be enough to overcome negative outside markets. 

A risk on market environment returning means the focus is back on the Fed. Personally, I’m hoping the Fed pulls the trigger since it’s the most likely thing to mark a bottom in bullion.  Traders won’t stop being obsessed about a rate hike until it actually happens. I still think it could be a sell on news event for the US Dollar but the market won’t believe that until it happens.  The good news, if you can call it that, is that positioning in the futures market is already extremely bearish.  One sided markets have a way of flipping back. Bring on the rate rise.

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