THE REAL REASON BEHIND THIS SELLOFF / SEEKING ALPHA

 

The Real Reason Behind This Selloff

by: Martin Vlcek

 

 

Summary

 

- Currency and stock market regulations are making markets more volatile.

- Although these central bank and regulatory moves seemingly managed to suppress volatility, the risk will just rear its ugly head elsewhere, and with more vigor.

- China was probably the trigger for the current selloff, but the underlying reasons go much deeper.

- Tuesday's rebound driven by hopes for more China easing supports this assumption.

 

The U.S. (and global) markets have dealt investors an unpleasant welcome to 2016. In that light, please allow me a "shameless plug". Going into 2016, I expected very rough markets in 2016 compared to 2015. First, I heavily de-risked my premium subscription portfolio roughly a month ago on Dec. 23. Then I offered a very conservative guide to 2016 to all Seeking Alpha readers right before the market crash on Jan. 7 (written on Jan. 4th). I believe a lot of the rules in that article are still valid and will be extremely useful in 2016. So if I had to ask you to read just one article written by me recently, it would be this one.

 

The usual suspects

 

Back to the markets. The markets are selling off hard for a multitude of reasons. But let's not forget that markets don't really need any reason to sell off just as they have been rising throughout the last several years, often for no reason at all, or even against all good reason.

 

I believe the whole global economic system is interconnected and there is no one single reason that is the cause of the current selloff. The "usual suspects" include crashing oil prices, global weak growth, deflationary pressures, high corporate and public debt, high stock trading margin debt, high valuations of some stocks and other assets (QE, ZIRP effects), hedge fund redemptions induced by heavy 2015/early 2016 losses and I could go on and on.

 

What I believe is really behind the selloff

 

I believe some of the underlying causes of the selloff in equities include:

1. Too much central bank and government intervention in the currency, interest rate and stock markets (many central banks do this). Specifically, the currency pegs to the dollar, and the recent attempts by the Chinese regulators to ban short selling and prevent large investors from selling existing long positions.
2. QE and ZIRP policies of easy money that stimulate the creation of asset bubbles and excessive risk taking.
3. Lack of suitable hedges for the long stocks exposure (will be covered in the follow-up article).
4. The relative valuation of stocks relative to the "risk-free" Treasury yield and risk premium (will be covered in the follow-up article).

So let's have a closer look at the first two factors, starting with the Chinese currency and stock market interventions

 

China moving from a de-facto "fixed peg" to a de-facto "managed floating rate"

 

We could go on and on about how QEs and ZIRP cause bubbles in financial and real assets but the topic has been covered well. Let's focus specifically on the currencies. Many currencies are pegged to the dollar. When the U.S. dollar rises swiftly as it has in the past two years, this creates enormous pressures on the peg and negatively affects the local economies. Let's focus on the Chinese yuan because that is the currency that has been using a "managed floating exchange rate" but held the exchange rate more or less at a fixed level to the U.S. dollar, de-facto using a fixed peg for some time within the "managed float" regime.

 

Due to the dollar's rise, China recently decided to abandon the de-facto hard-wired peg to the U.S. dollar with a very narrow trading range and is now moving to the true "managed floating" currency regime, allowing the yuan to depreciate in a calm and managed way in order to get rid of some of the strength automatically acquired from the fixed peg to the dollar.

 

To cut things short, let's say that the "managed" moves are not always as smooth as desired and the markets of course try to front-run, out-guess the Chinese authorities on their next move, creating fluctuations. The moves are further exacerbated by the fact that markets fear that this may be just the beginning of a very large move in the USD/CNY currency, given how much the dollar has appreciated within the past two years.

 

How to hedge or front run this expected currency move?

 

But due to the "managed" nature of the currency float, market participants cannot really front-run this move or hedge enough against this move directly. Being short CNY/long USD is not enough for them and is hard due to other obstacles and currency flow regulations as well. So what do the markets do? How do they hedge or front run? They try to find correlated assets. One way for the U.S. denominated markets is to short the Chinese equities. In U.S. dollar terms, if the yuan depreciates by 10% and the local value of the stocks remains the same, the U.S.-denominated Chinese stocks will fall in value by 10%.

Some view many Chinese stocks as still being very overvalued, so being short Chinese stocks made sense even as a stand-alone trade without any considerations for the Chinese currency.

 

Many U.S. investors shorted the Chinese stocks as a hedge against a weakening global economy and falling commodity prices, and the trade has worked very well. But the bans on shorting and the ban on selling of large holdings makes this hedge less viable, so investors are searching elsewhere for a suitable hedge. They've found a refuge in shorting oil, natural gas and other commodities heavily dependent on China, and their futures being in heavy contango.

 

Excessive stock market regulation is making things worse

 

The recent actions of the Chinese authorities to try to stem the run on Chinese equities by effectively forbidding massive selling of existing large long positions of Chinese funds, brokers and other large market participants is having these two negative effects:

1. First, at the turn of the year, the Chinese markets tried to front-run the end of the previously imposed sell limitations, resuming the crash in Chinese stocks. So the regulations and the changes in regulations exacerbated the volatility and the fall.
2. Second, when the authorities effectively backtracked from their decision to remove the selling restrictions on Jan. 6 and extended the selling ban, the Chinese A-Shares (NYSEARCA:ASHR) were actually up for a day and flat the next day on the positive news that the ban would be extended (and central bank liquidity injection). But how did the U.S. markets react? The S&P was down the next trading day when this news could be reflected in U.S. markets, and the index more or less never looked back until now.

My view on the trigger of the selloff

 

We are getting to the crucial point of why I think the U.S. markets sold off. It is the renewed Chinese stock selling ban that was the direct cause in my opinion. What would you do if the U.S. markets were suddenly shut down, or you were not allowed to sell most of the stocks you held and at the same time you wanted to sell because you viewed the stocks as overvalued, the economy slowing, the currency expected to depreciate? Well, the only option you have left is to short some proxies for the Chinese market. Some of the most correlated assets to the Chinese stocks include U.S.-listed Chinese ADRs, other Asian and U.S. stocks directly exposed to China or to the global economy. And, of course, you would sell the commodities, of which China is a dominant importer, including oil.

Virtually all the assets mentioned above sold off hard. Not only that. This selloff in commodities reinforced in a circular fashion the expectations of troubles in the commodity and energy stocks (and their bonds) across the world. This commodity stocks risk-off mode and later panic selling dragged the global markets down.

 

I believe the immediate cause for the recent selloff in U.S. stocks lies in China

 

This does not mean one should solely "blame" China for the selloff. Everything is interconnected in the global financial markets; truth be told, the Chinese shares started another major down leg right around the Fed rate hike on Dec. 16-17. And the U.S. dollar strength can be partly attributed not only to the relative weakness of the other economies and currencies, but also the expectations of the divergent monetary policies (Fed rate hike expectations vs. more easing or stable easy conditions elsewhere).

 

So it's hard to blame Chinese markets directly for the recent U.S. selloff as the Chinese market bubble was partly caused by previous ultra-easy dollar interest rate monetary policy, and the subsequent selloff in Chinese stocks was caused by the strong dollar, the Fed rate hike expectations and the actual hike. So everything is interconnected and the original reasons run back years and years. We could argue forever what was the original cause in a "chicken or egg" fashion.

 

The conclusión

 

Global financial markets are very interconnected. I believe the immediate cause of the U.S. selloff was the Chinese extension of the selling ban on large equity holders. However, the real, original effects run deeper and are interconnected with the easy money policies around the globe, the low U.S. dollar interest rates, and the subsequent tightening, overcapacity caused by export-led growth policies in some countries, and many other factors.

 

In short, the feedback loop started with the sharp strengthening of the U.S. dollar over the past two years and gradually cascaded to other asset classes as the intermarket relations took effect, and as investors were looking to hedge their portfolio exposure or front-run the markets on the global effects of the strong dollar and easy monetary policies.

The central banks and other institutions' meddling with the financial markets are making the markets more unstable and prone to sharp moves and volatility bursts in unexpected places. The intervention only means the risk has to be hedged elsewhere and the volatility will simply have to resurface elsewhere, where it can, and with even higher power and speed. The Swiss Franc's 41% overnight move last year is such example and a warning sign of what happens when investors don't have enough reasonably priced "safe haven" assets for hedging and when central banks try to control and fix the price in the markets by force. I will cover the very important aspect of "safe haven" assets used for hedging in my follow-up article.