The recent experience of relentless selling in our stock market is still unexplainable. As voiced in my recent video to clients, there are many single reasons in the world to scare investors, but “who knows” why the market was down? For us at Cadinha & Co., our internal disciplines forced us to a defensive position, but we want to know who did the selling and more importantly, why? Only by knowing the answers to these questions can we assess the risk in the market going forward.
I have spent the last few days in deep thought, talking to respected money professionals, and reading all that I possibly can, in order to answer the who and why questions surrounding our market volatility. I now have an answer that is indeed plausible, but new, different, and somewhat out of our control. In order to explain it in an understandable way, we will need to go through a series of explanations, so please bear with me.
Stocks vs. Bond Behavior
Bonds have long been a natural hedge for stock market risk. When stocks turn bad, investors typically move to the safety of bonds, pushing bond prices up while moving interest rates down. In the midst of a thousand-point stock decline last week, Treasury bond prices were down, rather than being up. This bond movement was completely out of character and started our probing as to why.
China Currency “Peg”
As we all know, China has enjoyed a couple of decades of high economic growth and a resulting inflow of foreign capital hoping to share in the profits emanating from this growth. Much of this initial growth centered on China’s booming exports to foreign countries. In order to keep her goods competitive, the Chinese Central Bank adopted a strategy of keeping their currency “steady,” to keep export prices from rising. They decided to “peg” the yuan to the U.S. dollar to assure this outcome. This peg worked for years and actually was responsible for creating excess cash in the Chinese system. This cash was spent on creating cities, high speed rails, and much of their modernized infrastructure now in place in China.
In practice, a peg mandated printing new yuan in amounts equivalent to all foreign capital coming into China. Only by doing this, could they insure that the yuan would not appreciate. In effect, China had their own massive “QE” that resulted in speculative bubbles in real estate and the stock market.
The Bubble Bursts
The real estate bubble burst first and in an effort to avoid a serious economic contraction, the Chinese government began encouraging stock market loans and investments. After a sizeable advance in the Chinese stock market, this bubble burst several months ago and now has been accompanied by a capital flight from China.
The government response to the stock market decline was dramatic and very interventionist, with government actually investing in stocks in order to “shore up” pricing. In the end, China found herself faced with a mountain of debt (approximately 300% of GDP), an economic slowdown, and a worsening capital flight away from China.
Devaluation In desperation, the Chinese government decided to officially devalue the yuan by 2%-3% in two stages. When foreign capital flees, investments must be sold, with the sellers receiving renminbi as a payment. (The renminbi is the internal currency of China, while the yuan is the external currency.) The Chinese currency is taken to the Bank of China and exchanged for foreign currency. (As an example, we’ll use the U.S. dollar.) These dollars come from the Chinese government and in order to maintain the exchange rate “peg,” the Chinese currency is not put back in circulation. In a very convoluted result, the Bank of China now finds itself tightening in order to maintain a steady currency. This practice leaves the economy with less cash in circulation, and forcibly creates a further slowdown.
This vicious cycle that is triggered by the outflow of capital actually stimulates even greater levels of capital flight.
Meeting the Demands
In order to meet the demands of capital flight, China has decided to spend its reserves rather than devalue its currency to a much lower level.
Due to its “pegging” process, China set up reserves against much of the incoming capital as well as the free proceeds from the selling of goods to foreign consumers. As a result, China is estimated to have reserves in excess of 3 trillion dollars. Much of the dollar reserves are in U. S. Treasury bonds (Approximately $1.5 trillion). The path that China chose to meet capital calls was to liquidate some of the $1.5 trillion in U.S. Treasury bonds.
A few years ago, China chose to establish a country owned investment fund for the purpose of making direct investments in projects, stocks, and other securities.
Some of these securities are outside of China and are invested in a typical, professional manner. To the best of our knowledge, China’s investment in U.S. common stocks amounts to approximately $160-180 billion, with some of that possibly coming from the country’s reserve account.
Important Background China’s long time ambition is to have the yuan replace the U.S. dollar as the reserve currency for the world. She has initiated a large development bank for Asia, and not included the U.S. Additionally, in the summer of 2014, China was instrumental in the establishment of an international Central Bank to compete with the International Monetary Fund (IMF). Her partners in the venture are: Russia, India, Brazil, and South Africa. As an interesting aside, the U.S. dollar started its upward march the day after this Central Bank was formed!
A key stepping stone to the yuan’s legitimacy was to finally be included as a reserve currency in the IMF’s basket of currencies. Currently, that basket is comprised of the U.S. dollar, yen, euro, and pound. In the IMF’s scheduled October meeting this year, China’s inclusion was scheduled as a main, agenda item, so China was on its best behavior, quietly dealing with her own internal economic issues.
It is important to know that the IMF is controlled by the U.S. and any inclusion of China would take U.S. concurrence. In a surprise announcement, the staff of the IMF, after a lengthy study, announced that China was not ready for inclusion, citing the non-establishment of liquid markets for the yuan as a reason. To our way of thinking, this reason is legitimate as only a week prior had London approved the trading of yuan Paper.
Nevertheless, China’s failure to qualify until next year, was clearly a disappointment and China announced her devaluation the very next day!
Now, the tying up of all these facts into our conclusion can’t be proved, but we believe that China’s timing of its devaluation was not the best, and perhaps, exhibits a “sour grape” attitude in Beijing.
Back to China’s problem of meeting currency demands.
It is our belief that China decided to meet currency demands by selling reserves and converting them to the yuan in an effort to stabilize her currency. The specific reserve component chosen was the U.S. Treasury bonds that are in her reserve accounts.
The selling of a massive amount of Treasuries carries a problem with it, centering on the liquidity for such a sale. How to effect a sale of $300 billion of bonds without suffering severe price declines needed an answer. If, however, China could precipitate a stock market decline, wouldn’t money flee to the bond market as it always had? Wouldn’t China then be able to sell its bonds to those buyers rushing into the bond market?
Our assumption is that China used $10-20 billion of its stock holding in the sovereign fund’s portfolio to trigger a stock market decline in the U.S. in order to sell some of her Treasuries. If one could sell a billion dollars of each well selected security, wouldn’t that be enough to trigger sell orders from the many automatic algorithms that make up much of our market structure today? We believe so and further believe that this is what we recently experienced.
Such a maneuver would explain why the bond market declined when the stock market dropped a thousand points. Such a maneuver explains why there were no sellers apparent in the violent snapback rally that recently occurred. A typical sell-off of this magnitude has always been tied to some fundamental issue, and invariably invites more sellers to step forward into any rally attempt. That is why bear markets usually take months to complete. But a few days? No, there is something else in play, and China’s selling is our best conclusion.
Would China really effect such a manipulative course of action? Why not? She has exhibited no appreciation for free markets and manipulates the Chinese stock market all the time.
A look back over the last few days reveals that China has actually sold bonds and expects to sell more. Much of these transactions came through Belgium, so it’s hard to determine exactly how much was sold, but we would guess an amount upwards of $250 billion was liquidated.
Where from Here?
We have no way to knowing how bad the vicious cycle is for China. We do know, however, that China will likely sell more reserves before it is done. We don’t know whether stock sales will be forthcoming, and there is no analysis that can tell us when and how much. We, nevertheless, can conclude that China will be a big seller of Treasuries, in addition to our own Treasury’s annual sales to finance our deficits. We can also conclude that interest rates in the U.S. will have an upward bias, so our strategy will factor in these conclusions. What Janet Yellen does is yet another story.
Our plan of action will be to select companies with no exposure to China, and with little, if any, foreign exposure. These global conditions increase the risk of conflict, so our decision will be to stay home. Additionally, our actions will be deliberate, hoping to grab bargains during market downdrafts. I welcome any questions you may have.