PAUL KRAKE: The Shanghai Discord


The Shanghai Discord

This post is an excerpt from the flagship report from June 25.

Is there a scenario where both the USD and RMB can weaken simultaneously? We have seen this before, and it came in the guise of the Shanghai Accord. Back in Q1 2016, the G20 Finance Ministers went to Shanghai for a scheduled meeting. Off to the side, the economic heads of the US, EU, China and Japan got together and established what is known as the Shanghai Accord, a badly kept secret designed to allow both the US and the Chinese to weaken their currencies as an attempt stimulate both their own domestic demand but to give the global economy a well needed shot in the arm. The connection between the accord and the synchronized global uptick that began in the summer of 2016 is a bit dubious. However, there is little doubt that it stabilized sentiment towards China that had been reeling from the 2015 bursting of its equity bubble and currency volatility regarding its move away from a direct link to the USD and to a focus on managing the currency on a more trade weighted basis. The Fed eased back on tightening policy, the USD began to slide, and Chinese equities rebounded after what had been a horrendous 12 months.

Remember those days when a courteous discourse could result in a coordinated policy response?

To state the obvious, such measures appear very unlikely in the era of Trump. Accords have been replaced by twitter threats, discourse with tariffs, cooperation with every man for himself. However, can we have the effects of the Shanghai Accord without the accord itself? Is it possible for the market to weaken the USD and RMB at the same time without global, targeted policy action? I believe this to be the case, and in fact, this outcome is probable and could well lead to a structural bottom in Chinese equities.

The RMB is an overblown, overhyped currency. The tail doesn’t wag the dog.

I have long held the view that the RMB is the most over-talked about asset on the planet. Preparing for this report, I went back and re-read some articles about the Shanghai Accord and the transition from the RMB being roughly pegged to the USD to the CFETS basket, a link to the currencies of many of China’s major trading partners. At the time, the market was very focused on the shock to global risk assets generated from two “devaluation” periods: August 2015, a 3% decline when the CFETS basket was announced, effectively an appeasement to the IMF for entry into their Special Drawings Rights Basket or SDR. The 3% decline in the RMB versus the USD saw global equity markets crater as fears of a disorderly depreciation in the RMB became the prevailing narrative at the end of summer 2015.

The second period was January 2016, when the CNH dropped 2% at the start of the year, leading to a 10% decline in the SPX in the first four weeks of the year, and a near 20% decline in the Shanghai composite, establishing one of the weakest Januarys on record. Everything stabilized in February 2016, post the Shanghai Accord.

The point I would like to make here is twofold: Firstly, that financial assets have a history of overreacting to small changes in the RMB. While I appreciate the notion of paradigm shifts away from the norm, i.e. a 3% move in the RMB in August 2015 sparking fears of potentially something greater, the reality is the RMB is an incredibly low volatility currency compared to other major currencies such as the Euro and Yen. The value of the Euro routinely moves 1%-2% in a day, yet the market response is a yawn. While one can extrapolate policy changes from outsized moves in the RMB, the reality is that the economic impacts of a 100bps move in the RMB are probably no more significant than the equivalent move in the currency of another major trading economy. Moves in the RMB are overhyped, overanalyzed and disproportionately influential on global asset prices.

Secondly, and an extension of this, maybe the RMB isn’t the all-powerful currency pair that many investors think it is. Does the RMB drive the value of the USD or does it merely respond to broader USD moves? While there are many that believe that the USDCNY exchange rate is the most important on earth, I feel that it responds to major changes in the US policy outlook just as the Euro and Yen do, and it takes extraordinary amounts of manipulation to prevent the inherent volatility that those other major currency pairs experience. While domestic policy is also important, Chinese authorities cannot determine the broader direction versus the USD, they can only slow the trajectory. Figure 2 sums this up perfectly.

Clearly, Chinese authorities attempt to manipulate the value of their currency both in terms of the rate versus the dollar, and also against major trading partners in the form of the CFETS basket. However, I challenge the notion that it is weakness in the RMB that was the root cause of the USD bounce in the past several months. While a slightly weaker currency versus the USD is in China’s interest given the softening of growth we have witnessed, and the potential for further slowing based on the escalation of trade rhetoric, is Chinese policy a driver of the USD’s strength in recent months or merely an accidental beneficiary? While one shouldn’t discount the importance of the USDCNH exchange rate given USD funding by many Chinese banks and corporates, the trade weighted value of the RMB is much more important, economically.

The arguments that it is the RMB that is a primary determinant of the value of the USD are completely overblown.

The CFETS Basket as a policy tool

With the CFETS basket back to its strongest levels since the Shanghai Accord was penned, is the trade weighted RMB about to move lower again? Or to put it another way, are the Chinese about to implement policies to weaken the RMB on a trade weighted basis? China is facing some economic headwinds, and while I believe that softening of credit growth and activity in general are completely overblown, I look at the current environment regarding US trade rhetoric and ask the following:

Do any of you truly believe that the Chinese will not attempt to stimulate their economy if there are negative impacts on growth generated by US / China trade?

It is naïve to believe that the Chinese will not respond with a stimulus to support the hundreds of thousands of small companies that could be affected by US tariffs if President Trump fulfils his promises. The logical place to do this is via the currency and while deliberately weakening the RMB against the USD is next to impossible, weakening the RMB on a trade weighted basis is much easier, especially if the USD itself is moving lower.

Why the USD will weaken throughout the summer months and beyond

I have been making the point for the past several weeks that the preconditions for the USD to maintain a range are beginning to playout. The USD will weaken because the path for US interest rates looks well and truly established, i.e. the market and the Fed are in alignment for the next 9-12 months. If Fed expectations are fully priced over the medium term, then it is difficult for me to see how the USD moves higher.

Weakness in emerging market currencies appears overblown and specific to many individual markets that should not lead to contagion. As I write, the Turkish Lira is rallying after the expected election result that returned President Erdogan to power. Is Turkey out of the woods? Absolutely not. Mr. Erdogan could do something silly and remove the independence of the Central Bank, but the chances of a crisis in the next three to six months are reduced. The election results in Mexico will be broadly as expected and hence a further sharp depreciation of the Peso is very unlikely. Brazil has issues, as does South Africa, but nothing is imminent and therefore being short EM currencies aka long the USD over the summer months could be painful from a short carry perspective.

Italy is a problem for Europe, but probably not until Q4. Brexit is a mess, but this is well known. With US interest rates looking capped, I just do not see what is new on the horizon for the USD to move out of what has been a clearly defined range since February when global asset volatility began to normalize.

So, if the USD is capped at 95 in the DXY, then weakness in the RMB versus the USD must also be coming to an end. As with the Shanghai Accord in February 2016, the world’s economic stewards put in place a scenario where both the USD and RMB weakened on a trade weighted basis in order to stimulate demand. This time around, there is no accord, but we have situations where both these currencies could weaken independently.

The RMB will weaken versus the CFETS basket in a similar way as it did post Q1 2016, i.e. it weakened against its trading partners but didn’t depreciate significantly versus the USD. However, this time around, there will be no coordination. In fact, with trade rhetoric likely to continue to deteriorate between now and the US mid-term election in November, China and the US will be positioning themselves for the optimal economic advantage. Both currencies will weaken over the course of the next several months, just for very different reasons.

Fiscal, monetary and currency stimulus will stabilize Chinese stocks

The conventional wisdom, based on two extreme periods of RMB volatility is that the dramatic underperformance of Chinese equities, especially versus US stocks, does appear, in no small part, to be based on weakness in the RMB versus the USD. While western investors have a limited knowledge on what drives the mindset of the average Chinese retail investors, over the longer haul, this does not really appear to be the case.

Chinese stocks weakened prior to the Shanghai Accord predominantly out of fear that disorderly policy changes regarding the currency would result in capital flight. Remember, the market was dealing with the remanence of the bursting of the 2015 property bubble and sentiment was worsened by the shoddy handling of both this and the move toward managing the currency versus a basket rather than the USD.

This all changed when the Shanghai accord led to a coordinated weakening of the currency on a trade weighted basis. Equities rebounded solidly, property markets performed well, and growth stabilized in line with the strength of global growth. While not all of this should be assigned to a 5% depreciation of the CFETS basket, it definitely helped sentiment and the turning point was the Accord.

There will be no such grandiose moment this time around, but I feel that a three-pronged Chinese stimulus is coming and when this becomes clear, it will be enough for Chinese stocks to rebound from what I would described as quite depressed levels.

Again, I go back to the point I have made on numerous occasions in recent weeks:

Do any of you truly believe that the Chinese will not attempt to stimulate their economy if there are negative impacts on growth generated by US / China trade?

We have already seen a cut in reserve requirements. We have heard hints that a fiscal spending program is coming and official support for a struggling equity market was witness both in terms of physical buying and jaw-boning. Do you really want to be short or under exposed to Chinese assets if a large scale monetary and fiscal stimulus is coming? Throw in a weakening of the CFETS basket and the agenda of the Chinese authorities looks clear.

Chinese assets historically respond well to stimulus and this will be no exception. The thematic model portfolio remains aggressively over weight Chinese equities and I believe that this remains the number one alpha opportunity for 2018

China wins from a weaker USD. US small caps don’t.

It is undeniable that the USD is a major driver of the relative performance of US small caps versus the SPX. The performance of the Russel over the past four months has been driven in no small part to the rebound in the dollar. I am not going to argue the merits of this; it just is what it is.

So, putting it simply and looking at the 23% outperformance of the Russell versus the Shanghai composite so far in 2018, logic tells me that being long China and Short Russell in an environment of a weaker USD is as high a conviction strategy as I can think of.

On Monday the thematic model portfolio covered our hedge in the HSCEI and tonight we will replace this with a 15% short in the Russell. This shows the extremes of the underperformance of Chinese related equities with HSCEI down 4% on the year while the Russell is up close to 10%.


The View