China crisis: ‘Don’t join the panic’

For the last fifteen years, SocGen’s investment strategist Albert Edwards has been warning about a dire scenario that he calls “The Ice Age”, involving widespread deflation, exacerbated by falling currencies in Emerging Markets which curb import prices in Developed Markets, and undermine economic growth.

Albert has used the China crisis as an opportunity to restate his view that: ‘Make no mistake, this is the start of something big, something ugly’.

Conclusions
We share some of Albert’s concerns about deflation, but not his conclusion that investors should be significantly underweight equities, and this is a view that he’s held through the fifteen years.

But there are issues and challenges that we do need to consider rather than just reject out of hand. Thus the 9% fall in the S&P500 from last Wednesday’s close through this Tuesday’s close will have hurt investors’ wealth, with the capitalisation of that index down by $1.6tn.

Whilst bear markets are caused by recessions, there is the fear that a market collapse can cause a recession, turning a bear market into another rrash, and recession into depression.

High frequency
Yet the fast move in prices does not look to be about price discovery and the connection of pricing and fundamentals, but far more about high frequency trading that distorts the market’s price-signalling mechanism. If the recent stock market sell-off has been exacerbated by high-frequency trading, then this will pass, just as previous ‘flash crashes’ have passed.

One interesting feature of the downturn is that volatility soared as liquidity dried up, particularly early in Monday’s trading day and the S&P 500 VIX jumped from 15.25 on Wednesday to 36.02 yesterday.

Yet had that shift been down to individual and institutional investors panicking out of stocks, then we should have seen a ‘flight to safety’. But whilst the yield spread between US High Yield and US Treasuries has been widening from last year’s low of 253bps on June 23^rd to 541bps yesterday, it is up only 28bps since Wednesday. It’s also hard to discern a flight to safety in the US 10-year Treasury yield, which rose to 2.07% on Tuesday.

It’s also hard to see much interest in precious metals. Gold, silver, platinum, and palladium are all trading below their falling 200-day moving averages.

Bears argue that commodities are the next debt-financed speculative bubble that will burst, but actually the 200-day moving average of the CRB raw industrials spot price index peaked during September 2011, and is down 21% since then to the lowest level since May 2010, and the index itself is the lowest since November 2009.

This index doesn’t include petroleum prices and the price of a barrel of Brent crude oil is down to $43.46 which is the lowest since March 2009 – so commodity prices may not have much further downside, if any, assuming that the world economy isn’t falling into a recession.

It’s hard to call a global recession with the latest US economic indicators looking at least okay – thus, the Consumer Confidence Index (CCI) rose sharply during August, led by its present situation component to the highest reading since November 2007, and the percentage of respondents to the CCI survey who agreed that jobs are hard to find, fell from 27.4% during July to 21.9% this month, the lowest percentage since January 2008.

This series is highly correlated with the unemployment rate, which was 5.3% during July, and the CCI series suggests that the jobless rate could soon fall below 5%.

The combination of the unemployment rate and the inflation rate, the so-called Misery Index, looks set to fall to new lows for this cycle – and in the past, bear markets have been associated with increases in the Misery Index, whilst cyclical lows in the Misery Index marked the tail ends of bull markets.

Good news
There’s also good news from the US ATA trucking index which rebounded in July, and is almost back to its record high during January of this year, whilst intermodel railcar loadings rose to a record high in mid-August.  As one wag has put it “Choo-choo” isn’t the sound of China sneezing.

There’s also good news from Euroland, with Germany’s Ifo business confidence index up in August, led by an increase in its present situation component to the highest since April 2014. Germany’s real GDP rose 1.8% (saar) during Q2. That’s relatively slow, but it should allow the Eurozone’s economy to continue muddling along.

These are not developments consistent with widespread persistent and worsening market malaise. We should not join the panic.