Up and Down Wall Street
China’s Stocks Swoon, but the Yuan Is the Real Weak Spot
Capital flight makes further depreciation certain. Efforts to prop up the currency only worsen economic woes.
By Randall W. Forsyth
You might have spilled coffee all over your shirt just before a big meeting; or hit that insidious “Reply to All” tab when you were just e-mailing back your buddy; or entered “Buy” when you meant to “Sell” in your brokerage account; or, worst of all, shot back that all-too-clever, but none-too-nice retort to your significant other, even though you suspected your quick wit might not be appreciated.
Just hit that circuit breaker and everything stops; maybe you can repair the damage or at least prevent it from getting worse. And if that doesn’t work and another disaster befalls you, simply call it a day, even if it’s only midmorning.
Dubious about this notion? You’re right to be, based on last week’s experience in China’s stock market. Circuit breakers shut down trading there twice last week, in fact, in a matter of just 29 minutes on Thursday morning on the Shanghai Stock Exchange.
Far from making things better, it seemed that the circuit breakers only encouraged investors to dump their holdings before the market could shut down. And in a panic, the rational thing to do is sell sooner, rather than later, to get your money out. In recognition of that unfortunate fact of life, Chinese regulators scrapped the circuit breakers after realizing that the mechanism created unstable surges, instead of preventing them.
The reasons investors might want to resume their run for the exits that they began last summer were deftly detailed in this space last week (“The Trouble With China,” Jan. 4) by my learned colleague Jon Laing, so I will defer to him on the deteriorating fundamentals. They’ve been evident to anyone willing to listen since Jon began sounding the warnings back in December 2014.
The surge of selling that tripped the circuit breakers gave dramatic evidence of those weakening fundamentals, which upset the confidence of investors around the globe, who then had to examine what China’s slowing growth meant for the rest of the world. As last week’s column concluded, a Chinese economy based more on consumer spending and services, instead of capital investments and exports, probably means less of a lift for the rest of the world.
So, while the Shanghai Composite fell 10% last week, the Stoxx Europe 600 plunged a nasty 6.7%, as major capital goods exporters probably face shrinking orders from a China that’s overbuilt and beset by excess capacity.
Yet, China’s stock market might be only the most visible symptom of the nation’s woes, one that can play on television and front pages, where its paroxysms got unaccustomed prominent play. The real nexus is in the currency market.
Financial sophisticates have been connecting the dots from the decline in the previously tightly controlled yuan exchange rate since its tether first was loosened last summer (“You Say Yuan a Revolution?” Aug. 17). But, as with so much in China, what really happens is sub rosa and can only be inferred from abstruse data, and then with considerable time lag.
But the numbers starkly make clear one ineluctable fact: Money is fleeing China on a scale not generally realized. And, notwithstanding the insistence of U.S. politicians, Chinese authorities have been desperately trying to prop up their currency, not drive it down, in the face of massive capital flight. Forgive me for stating the obvious: That rush for the exits isn’t exactly a vote of confidence.
The most dramatic evidence of Chinese monetary authorities’ extreme exertions to push up the yuan was news of a sharp decline in the nation’s foreign-exchange reserves in December, a plunge of $108 billion, the biggest monthly drop since 2003. That’s evidently what it took to keep the currency’s value from falling further last month.
The authorities apparently decided to stop throwing good money after bad and permitted the yuan to drop 1.5% last week, which spooked the market. Conventional wisdom had been that Beijing would maintain stability, especially after the yuan’s inclusion in the basket that makes up the International Monetary Fund’s special drawing rights, or SDRs. That was a particular point of pride for Beijing, and it was thought that the yuan would be stabilized to demonstrate it deserved that status.
That task’s enormousness is made clear in the Chinese balance-of-payments numbers. JPMorgan economist Nikolaos Panigirtzoglou has found that a stunning $930 billion of capital fled China from second-quarter 2014 through third-quarter 2015, the most recent period for which data are available, which takes in last summer’s initial currency upheavals.
There’s good news and bad news in the latest numbers, he finds. Chinese tourists are using travel as a means of getting money out of the country. Chinese businesses are using “trade credits” to obtain dollars and reduce yuan holdings. Meanwhile, fixed direct investment has fallen sharply.
Part of the capital outflows also has resulted from reducing foreign-currency indebtedness (which requires borrowers to obtain dollars or other currencies to repay the loans). That’s good, in that Chinese businesses and banks are less exposed to increased burdens on their foreign-denominated debt from a fall in the yuan and a rise in the greenback.
But, Panigirtzoglou adds, the lower foreign-currency exposure of Chinese banks and corporations “removes one hurdle in terms of Chinese authorities allowing a larger and faster depreciation from here.” Inclusion of the yuan in the SDRs also opens the way for further devaluation after last week’s decline.
While global markets were encouraged by the yuan’s being fixed a hair higher on Friday, that is a form of denial. Given the capital flight, Chinese monetary authorities can push up the price of the yuan only by restricting the supply. That’s deflationary. The slowing economy calls for a further loosening of monetary policy, not a tightening to peg the exchange rate.
There’s no getting around it: The weakening economy and capital flight from China mean further declines in the yuan, which probably puts further downward pressure on emerging markets and commodity prices. And, in turn, global capital markets are likely to continue to be roiled.
ALL OF WHICH MADE FOR the worst first week of a year ever for U.S. stock markets, with the Standard & Poor’s 500 index shedding 6%. That put it and other major averages solidly in correction territory, which somebody decided was a 10% drop. The Russell 2000 small-stock index ended the week down 19.3% from its peak of last June, just shy of the 20% drop that signals a bear market.
These declines, not surprisingly, have had a depressing effect on traders’ psyches. Woody Dorsey’s Market Semiotics advisory in Castleton, Vt., registered a 1% bullish reading in its sentiment data on Friday. With the swoon in the final hour of trading for the week, that should make for some downbeat conversations among investors over the weekend. Another drop may be in the offing on Monday, with a pop on Tuesday and afterward, but nothing more, he thinks.
Looking farther out, as go the first five trading days of the year, so goes the year, according to data collected by Jeffrey and Yale Hirsch in their annual compendium, The Stock Trader’s Almanac. When the first five sessions were higher, as they have been in 41 years since 1950, the S&P 500 ended the year in the plus column 35 times, making the prediction 85% accurate. The average gain: 14%.
The record when the first five days of the year are downers is less certain. In the 24 times that has happened since midcentury, the S&P actually ended the year higher in just over half of the instances: 13 times. But the average gain in years that got off badly was paltry, a mere 0.7%.
Perusing the Hirsch numbers, there were a number of years in which the S&P’s gains would best be described as “meh,” when the first five sessions were negative: 2007, 3.5%; 2005, 3%; 1978, 1.1%.
Other positive years that started off negatively occurred in the Happy Days of the 1950s: 1955, when the S&P was up 26.4%, and 1956, when it rose just 2.6%. During the secular bull market of that decade, buy and hold paid off well, if not every single year.
In the other instances when the stock market stumbled at the outset but ended strong, the Federal Reserve was clearly in easing mode. In 1985, 1991, and 1998, the Federal Reserve cut interest rates, and the S&P 500 posted 20%-plus gains.
The current Fed, in contrast, began raising its key policy rate with a quarter-point hike last month, to a range of 0.25% to 0.5%. Fed Vice Chairman Stanley Fischer indicated in an interview last week with CNBC that market expectations of four rate increases this year are “in the ballpark.”
Last week’s stock declines eclipsed even the 5.3% plunge in the first five trading sessions of 2008, as that year’s historic bear market began; it ended with the S&P 500 38.5% lower. But after the 4.6% drop at the outset of 1991, the S&P wound up 26.3% higher, with the Fed aggressively slashing the federal-funds rate from more than 7% all the way to a then-unthinkably low 3% by late 1992.
That’s not the way the breezes are blowing now. Indeed, the S&P 500 has made no headway since the central bank ended quantitative easing in late 2014, fluctuating about 70 points above and below the 2000 mark.
The Fed doesn’t explain all, however. Politics also may matter. As the Hirsches point out, the first-five-days indicator worked in 14 of the past 16 presidential-election years. In case you haven’t noticed, there’s a campaign for the White House going on, and I haven’t heard anything from it that makes me feel bullish.
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