Tags: China | Federal Reserve | Investors | Stock Markets

China, Fed May Spark 'Perfect Storm' in Many Places and Markets

Monday, 27 July 2015 12:12 PM Current | Bio | Archive

Chinese stock markets indexes tumbled substantially.

The Shanghai Composite Index was down 8.48 percent while the Shenzhen CSI 300 Index was down 8.55 percent for the day, which represented their largest one-day drop in 8 years.

This sudden drop of the two most important Chinese stock market indexes certainly doesn’t reflect the real situation of the state of the economy, but coincidence or not, last week, the MNI China Business Sentiment Indicator fell to 48.8 in July from 53.5 in June, which was its lowest level since January 2009.

Anyway, whatever the reason for today’s plunge, it’s a fact the Chinese GDP is on a downward path and long-term investors could do well keeping in mind and according to JP Morgan every drop of 1 percent in China’s GDP from current levels has the potential for causing:
  • a drop of about 12 percent in base & precious metals;
  • a drop of about 17 percent in oil;
  • a drop of about 25 percent in iron ore;
  • a drop of about 6 percent in commodity currencies.
When we add to the Chinese slowing-growth situation the probability the Federal Reserve will start hiking its Fed funds rate rather sooner than later, albeit by only 0.25 percent, it cannot be excluded we could be on the cusp during the coming months of a setup for a perfect storm in many places and markets.

The IMF “2015 Spillover Report” warns that sustained U.S. dollar appreciation, which can be expected when Fed rates start to rise, associated with expected divergence in monetary policies among systemic advanced economies (U.S. and the United Kingdom) poses significant risks for other countries.

Many emerging markets and low-income countries that have large gross positions and their currency compositions of their foreign exchange debt positions could pose vulnerabilities for these countries.

Also corporate debt in emerging markets could also become a source of risk because many highly leveraged corporate sectors have high foreign exchange exposures. Past episodes of sustained dollar appreciation have mostly been associated with crises in emerging markets as has been the case in 1980, 1995 and 2008-2009.

I’d like to add here the story of the stronger isn’t over yet when we take the dollar real effective exchange rate, or REER, as a reference and that is at present (93.897) still about 16 percent lower than where it was in March 2002 (112.242).

The IMF also states that lower oil prices, more monetary stimulus in the eurozone and Japan and as already mentioned here before expectations for interest rate rises in the U.S. and the U.K. should create a “spillover-rich” environment.

Unfortunately, that’s not all the latest news to worry about.

In its staff report on Japan the IMF signals serious doubts about long-term fiscal sustainability of Japan (sounds familiar?) that could lead to a jump in the sovereign risk premium, forcing abrupt further fiscal adjustment with adverse feedback to the financial system and the real economy.

This could compound low profitability of the banking system and trigger excessive volatility in the Japanese Government Bonds (JGB) and currency markets.

If the latter were to happen, it would be “fasten seatbelts.”

Putting all that together, as a long-term investor I’d prefer sitting on the fence for some time to come and have dollar cash (equivalents) available in case markets enter panic mode.

Finally about gold we’ve learned when practically everybody is pessimistic about a specific investment, the moment is coming nearer for buying opportunities.

Now, last week we’ve seen hedge funds going “net short” in gold futures, as measured by the Commodity Futures Trading Commission (CFTC) for the very first time in the CFTC history while Market Vane’s Bullish Consensus of commodity trading advisers and financial newsletters had fallen to only 28 percent of gold bulls, which was its lowest percentage since April 26, 2001 and which was then near the last long term bottom in gold.

In today’s situation and in case a counter rally in gold should develop we could see it go up to around the $1,300 per ounce. Before that would happen, gold should not fall through the $1,020 level.

Please keep in mind, all this doesn’t change the longer term bearish trend in gold. Stepping in now under the conditions as mentioned here before should better be seen as a play for those who are willing to take on some risk, but, of course, that’s everybody’s personal choice.

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When we add to the Chinese slowing-growth situation the probability the Federal Reserve will start hiking its Fed funds rate rather sooner than later, we could be on the cusp of a perfect storm in many places and markets.
China, Federal Reserve, Investors, Stock Markets
Monday, 27 July 2015 12:12 PM
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