A Correction Fireside Chat with the "10th Man"

By Jared Dillian 

I don’t really enjoy these things like I used to. Keep in mind, I’ve traded through a lot of blowups, going back to 1997...1998...2001...2002-2003...2007-2009...2011...Today. They all kind of feel the same after a while.

Nobody wins from corrections except for the traders, which today mostly means computers. I forget who said this: “In bear markets, bulls lose money and bears lose money. Everyone loses money. The purpose of a bear market is to destroy capital.”....And that’s what is going on today.

For starters, long-term investors inevitably get sucked into the media MARKET TURMOIL spin cycle and puke their well-researched, treasured positions at the worst possible time. But I’m not trying to minimize the significance of a correction, because some corrections turn into bona fide bear markets. And if you are in a bear market, you should get out. If it is only a correction, you probably want to add to your holdings.

How can you tell the difference?

My Opinion: This Is a Correction

So what were the two big bear markets in the last 20 years? The dot com bust, and the global financial crisis. Two generational bear markets in a 10 year span. Hopefully something we’ll never see again. In one case, we had the biggest stock market bubble ever and in the other, the biggest housing/debt crisis ever.

Both good reasons for a bear market.

What are we selling off for again? Something wrong with China?

Again, not to minimize what is going on in China, because it is now the world’s second-largest economy. Forget the GDP statistics. After a decade of ridiculous overinvestment, it is possible that they’re on the cusp of a very serious recession, whether they admit it or not. But the good news is that the yuan is strong and can weaken a lot, and interest rates are high and can come down a lot. China has a lot of policy tools it can use (unlike the United States).

Let’s think about these “minor” corrections over the last 20 years.....
1997: Asian Financial Crisis
1998: Russia/Long-Term Capital Management (LTCM)
2001: 9/11
2011: Greece

All of these were VIX 40+ events.

In retrospect, these “crises” look kind of silly, even junior varsity. The Thai baht broke—big deal.

Russia’s debt default was only a problem because it was a surprise. And the amount of money LTCM was down—about $7 billion—is peanuts by today’s standards. After 9/11, stocks were down 20% in a week. The ultimate buying opportunity.

And in hindsight, we can see that the market greatly underestimated the ECB’s commitment to the euro.
So what are we going to say when we look back at this correction in 10-20 years? What will we name it? Will we call it the China crisis? I mean, if it’s a VIX 40 event, it needs a name.

I try to have what I call forward hindsight. Like, I pretend it’s the future and I’m looking back at the present as if it were the past. My guess is that we will think this was pretty stupid.

What to Buy

I saw a sell-side research note yesterday suggesting that this crisis is marking the capitulation bottom in emerging markets. I haven’t fully evaluated that statement, but I have a hunch that it is correct. China is cheap, by the way. But if China is too scary, they are just giving away India. I literally cannot buy enough. And I have a hunch that Brazil’s president, Dilma Rousseff, is going to be impeached and the situation in Brazil is going to improve relatively soon.

Think about it. The most contrarian trade on the board. Long the big, old, bloated, corrupt, ugly, bear market BRICs. Also the scariest trade. But the scary trades are often the good trades. There’s more. If you think we’re in the midst of a generational health care/biotech bull market, prices are a lot more attractive today than they were a few weeks ago. I also like gold here because central banks are no longer omnipotent.

That reminds me—there was something I wanted to say on China. The reason everyone hates China isn’t because of the economic situation. It’s because they made complete fools of themselves trying to prop up the stock market. So virtually overnight, we went from “China can do anything” to “China is full of incompetent idiots.” Zero confidence in the authorities.

You want to know when this crisis is going to end? When China manages to restore confidence. When they have that “whatever it takes” moment, like Draghi. If they keep easing monetary policy, sooner or later there will be an effect.

I Am Bored

I used to get all revved up about this stuff. That’s when I made my living timing tops and bottoms. I don’t do that anymore. I do fundamental work, and I go to the gym and play racquetball. The mark-to-market is a nuisance. Also, if you can’t get excited about a VIX 50 event, you have probably been trading for too long.
There is a silver lining. The disaster scenario, where the credit markets collapse due to lack of liquidity, isn’t happening. Everyone is hiding and too scared to trade.

Honestly, high-grade credit isn’t acting all that bad. And it shouldn’t. I don’t see any big changes in the default rate. Anyway, if you want to go be a hero and bid with both hands, be my guest. It’s best to be careful and average into stuff. These prices will look pretty good a couple of months from now, I think.


Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: A Correction Fireside Chat was originally published at mauldineconomics.com.

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Playing the Chinese Trump Card

By John Mauldin

“I know the Chinese. I’ve made a lot of money with the Chinese. I understand the Chinese mind.” – Donald Trump, 2011

Back in the olden days (pre-2000 or so), information junkies like me relied on printed newspapers, paper magazines, TV newscasts, and snail mail newsletters. All these channels still exist, but they can’t begin to compete with the constant stream of data rushing into our tablets and smartphones. And on some days the stream rushes faster.

Last week, for instance, it seemed I couldn’t go five minutes without another story on either (a) China or (b) Donald Trump. For a day or so, I really wondered if someone had planted malware in my browser to make me think all other topics were inconsequential. It was all Trump and China, all day and all night. China has pushed the Fed into second place (for a few days at least) – perhaps we should be grateful that at least something has. Of course, there is the little problem that a bear market might be in the offing. Commodity prices seem to be in the toilet. Global currency markets are throwing up. Isn’t the world supposed to be on vacation in August?

Let’s see if we can find a connecting thought or three among all these topics. Plus, I want to show you how the current market meltdown is being brought to you courtesy of your friendly US Federal Reserve Bank. As our starting point, though, let’s cast an eye at The Donald and Chinese currency manipulation.

“Nobody Does Anything”

As we all know by now, on Aug. 11 the People’s Bank of China changed the way it manages the renminbi daily trading band against the US dollar. The result was a two day drop for the RMB and a lot of consternation on trading floors around the world.

Taking questions at an event in Michigan that day, Donald Trump had this to say:

I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.

Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.

                       

They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly – great question – it’s a disgrace.” Before you dismiss this as nonsense, remember that it comes from a Wharton School graduate.

Still not impressed? You’re right; it is indeed nonsense. Trump and all those who prattle on about Chinese currency manipulation have the economic comprehension of a parakeet. Is Trump really so clueless?

In one sense, it doesn’t matter. Trump isn’t talking to most of us. He draws an audience of frustrated, mostly middle-class Americans who are still hurting from the Great Recession. They want to blame someone. China is an easy target. So are illegal immigrants and Mexico and other faceless culprits. Furthermore, his audience has legitimate concerns. They are fully aware that both political parties ignore them.

A recent Gallup poll shows that 75% of our country believes there is significant corruption in government. They’re tired of it. They want to try something different. It is telling that a recent Michigan poll of Republican party activists found that 55% would go with either untested non politicians or Ted Cruz, who is about as much of an outsider as you can find inside the Washington DC Beltway.

I find almost nothing attractive about Donald Trump, but significant numbers in both parties have clearly demonstrated that they are looking for real change. Shades of Greece and Syriza’s coming to power, or France and the startling surge by Marine Le Pen’s Front National. The US is beginning to experience what our European friends have been living through the past few years.

Back to Trump and currency manipulation. I could do a sentence-by-sentence analysis of his populist harangue on China, but let’s take the really egregious statement: How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.

No, they haven’t. This whole myth that China has purposely kept their currency undervalued needs to be completely excised from the economic discussion. First off, the two largest currency manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands down leading manipulator would have been the Federal Reserve of the United States. The leaders/aggressors in the currency wars come and go.

Today, the euro is off over 30% from its highs, as is the Japanese yen. Numerous other currencies are likewise well into double digit slides. China has moved maybe 3 to 4%. Oh, wow.

Secondly, Donald (and to be fair I should address this to Senators Schumer and Graham, et al., too) the Chinese have not been continuously cutting their currency for years. In fact, if they have manipulated their currency, it was first to make it even stronger when the dollar was falling and then to hold those gains in the face of the steadily rising dollar. Meanwhile the rest of the world (Japan, Europe, Great Britain, Brazil, India, among others) was letting their currencies drift down.

The simple fact is that the Chinese currency rose by 20% over the last five years up until a week ago, for reasons we will examine a little later. It is utterly wrong headed to call a 20% rise over almost 10 years “continuous devaluation.” Yes, prior to that time they did allow their currency to devalue rather precipitously, but if you look back and think about it, they were faced with something of a crisis at the time. Most currencies do fall during periods of economic stress.

Don’t get me wrong. The United States and China have a several page list of issues that need to be worked out between them. If you read my recent book on China, you learned about more than a few of those problems. But given that the Federal Reserve has been the most egregious currency manipulator in the world over the last five years, hearing the pot calling the kettle black probably sticks in the craw of most non US citizens. I understand it makes for a great populist harangue. It’s always easiest to blame our problems on someone else. But it doesn’t get us anywhere we want to go.

Back to the main story. Let’s look at this fascinating chart from my friend Chris Whalen over at the Kroll Bond Rating Agency:

Chris writes:

With the end of QE in sight in 2014, the dollar began to climb against most major currencies with the exception of the yuan, which remained effectively pegged against the dollar because of intervention by the PBOC. The yuan has, in fact, appreciated steadily against the dollar since 2006 and continued to move higher within the managed foreign exchange regime maintained by the Chinese government. 

Until last week, the PBOC had been using its foreign exchange reserves to cope with the increased demand for dollars from domestic investors. The decision to end the defense of the currency has economic as well as financial ramifications. For example, investors are starting to wonder just how much foreign currency debt China has accumulated to fund infrastructure investment as well as foreign ventures, and whether this total is reflected in official debt statistics.

Oil and copper are priced in dollars. From the point of view of China, and much of the rest of the world, oil is up several times in the last 15 years, and copper is up 2 to 3 times, even after the recent selloffs. From an inflation-adjusted standpoint, the rest of the world just sees things as getting back to normal. A strong dollar can do that.

Chinese Déjà Vu

Trump’s China complaints are nothing new. I wrote an entire issue on this topic five years ago (and Jonathan Tepper and I dealt with it at length in both Endgame and Code Red.) At that time, economist Paul Krugman and a group of senators led by New York Democrat Chuck Schumer wanted to impose a 25% tariff on Chinese imports. This is from my March 20, 2010, issue: I probably shouldn't take on a Nobel Laureate who got his prize for his work on trade, but this truly scares me. People pay attention to this nonsense, including the five senators, led by Schumer of New York, who want to start the process of targeting China.

First, the Chinese have got to be wondering what they have to do to make these guys happy. In 2005 they were demanding a 30% revaluation of the Chinese yuan. And over the next three years the yuan actually rose by 22% at a gradual and sustained pace. Then the credit crisis hit, and China again pegged their currency [even as the dollar got weaker!]. From their standpoint, what else were they to do? Force their country into a recession to appease our politicians?

They responded by a massive forcing of loans to their businesses and governments and huge infrastructure projects. Kind of like our stimulus, except they got a lot more infrastructure to show for their money. It remains to be seen how wise that policy was, and how large the bad (non performing) loans will be that came from that push – just as there are those (your humble analyst included) who do not think the way we went about the stimulus plan in the US was the wisest allocation of capital.

But the reality is that the Chinese will do what is in their best interest. I wrote in 2005 that the yuan would rise slowly over time. The political posturing of Schumer, et al., was counterproductive then, and it still is now.

My prediction? The Chinese will begin to allow the yuan to rise again sometime this year, just as they did three years ago, because it will be to their advantage. A stronger yuan will act as a buffer to inflation, which they may face due to the massive stimulus they created. They are going to need some help in that area. But it will be 5–7% a year, so as not to create a shock to their export economy. Not 25% at one time. And at some point they will allow the yuan to float against the dollar. They know they will have to in order to get the currency status they want.

Back then, it was Schumer and Krugman who wanted to “rein in” China. Now we have Trump saying more or less the same things. Look at what happened in the intervening five years, in this chart from Krugman’s home-base New York Times.

And sure enough, right on schedule and as I predicted in 2010, the RMB began to slowly rise and rose through early 2014. This was about the same time that “China stopped acting Chinese,” as I wrote earlier this month. At about that time, China Beige Book detected a noticeable shift in Chinese business behavior, when companies stopped using the government’s stimulus to add new capacity.

Our hypothesis, you may recall, is that the Chinese monetary stimulus began going into stocks instead of capital improvement projects. That inflow led to the stock bubble that has popped over the last few weeks. Which resulted in an apparent panic in the halls of Chinese government.

Code Red at the PBOC

Sorting through the approximately 47,000 China reports people sent me in the last 10 days, I see two broad categories of analysis. To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: Playing the Chinese Trump Card was originally published at mauldineconomics.com.

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Why Russia Will Halt the Ruble’s Slide and Keep Pumping Crude Oil

By Marin Katusa, Chief Energy Investment Strategist

The harsh reality is that U.S. shale fields have much more to fear from plummeting oil prices than the Russians, since their costs of production are much higher, says Marin Katusa, author of The Colder War: How the Global Energy Trade Slipped from America’s Grasp.

Russia’s ruble may have strengthened sharply Wednesday, but it’s plunge in recent days has encouraged plenty of talk about the country’s catastrophe, with some even proclaiming that the new Russia is about to go the way of the old USSR.

Don’t believe it. Russia is not the United States, and the effects of a rapidly declining currency over there are much less dramatic than they would be in the U.S.

One important thing to remember is that the fall of the ruble has accompanied a precipitous decline in the per barrel price of oil. But the two are not as intimately connected as might be supposed. Yes, Russia has a resource based economy that is hurt by oil weakness. However, oil is traded nearly everywhere in U.S. dollars, which are presently enjoying considerable strength.

This means that Russian oil producers can sell their product in these strong dollars but pay their expenses in devalued rubles. Thus, they can make capital improvements, invest in new capacity, or do further explorations for less than it would have cost before the ruble’s value was halved against the dollar. The sector remains healthy, and able to continue contributing the lion’s share of governmental tax revenues.

Nor is ruble volatility going to affect the ability of most Russian companies to service their debt. Most of the dollar-denominated corporate debt that has to be rolled over in the coming months was borrowed by state companies, which have a steady stream of foreign currency revenues from oil and gas exports.

Russian consumers will be hurt, of course, due to the higher costs of imported goods, as well as the squeeze inflation puts on their incomes. But, by the same token, exports become much more attractive to foreign buyers. A cheaper ruble boosts the profit outlook for all Russian companies involved in international trade. Additionally, when the present currency weakness is added to the ban on food imports from the European Union, the two could eventually lead to an import substitution boom in Russia.

In any event, don’t expect any deprivations to inspire riots in the streets of Moscow. Russian President Vladimir Putin’s popularity has soared since the beginning of the Ukraine crisis. The people trust him. They’ll tighten their belts and there will be no widespread revolt against his policies.

Further, the high price of oil during the commodity super cycle, coupled with a high real exchange rate, led to a serious decline in the Russia’s manufacturing and agricultural sectors over the past 15 years. This correlation — termed by economists “Dutch disease”— lowered the Russian manufacturing sector’s share of its economy to 8% from 21% in 2000.

The longer the ruble remains weak, however, the less Dutch disease will rule the day. A lower currency means investment in Russian manufacturing and agriculture will make good economic sense again. Both should be given a real fillip.

Low oil prices are also good for Russia’s big customers, especially China, with which Putin has been forging ever stronger ties. If, as expected, Russia and China agree to transactions in rubles and/or yuan, that will push them even closer together and further undermine the dollar’s worldwide hegemony. Putin always thinks decades ahead, and any short term loss of energy revenues will be far offset by the long term gains of his economic alliances.

In the most recent development, the Russian central bank has reacted by raising interest rates to 17%. On the one hand, this is meant to curb inflation. On the other, it’s an direct response to the short selling speculators who’ve been attacking the ruble. They now have to pay additional premiums, so the risk/reward ratio has gone up. Speculators are going to be much warier going forward.

The rise in interest rates mirrors how former U.S. Fed Chair Paul Volcker fought inflation in the U.S. in the early ‘80s. It worked for Volcker, as the U.S. stock market embarked on a historic bull run. The Russians — whose market has been beaten down during the oil/currency crisis — are expecting a similar result.

Not that the Russian market is anywhere near as important to that country’s economy as the US’s is to its. Russians don’t play the market like Americans do. There is no Jim Kramerovsky’s Mad Money in Russia.

Russia is not some Zimbabwe-to-be. It’s sitting on a surplus of foreign assets and very healthy foreign exchange reserves of around $375 billion. Moreover, it has a strong debt-to-GDP ratio of just 13% and a large (and steadily growing) stockpile of gold. Why Russia will arrest the ruble’s slide and keep pumping oil
And there is Russia’s energy relationship with the EU, particularly Germany. Putin showed his clout when he axed the South Stream pipeline and announced that he would run a pipeline through Turkey instead.

The cancellation barely lasted long enough to speak it before the EU caved and offered Putin what he needed to get South Stream back on line. Germany is never going to let Turkey be a gatekeeper of European energy security. With winter arriving, the EU’s dependence on Russian oil and gas will take center stage, and the union will become a stabilizing influence on Russia once again.

In short, while the current situation is not working in Russia’s favor, the country is far from down for the count. It will arrest the ruble’s slide and keep pumping oil. Its economy will contract but not crumble. The harsh reality is that American shale fields have much more to fear from plummeting oil prices than the Russians (or the Saudis), since their costs of production are much higher. Many US shale wells will become uneconomic if oil falls much further. And it they start shutting down, it’ll be disastrous for the American economy, since the growth of the shale industry has underpinned 100% of US economic growth for the past several years.

Those waving their arms about the ruble might do better to look at countries facing real currency crises, like oil dependent Venezuela and Nigeria, as well as Ukraine. That’s where the serious trouble is going to come.
The collapse in oil prices is just the opening salvo in a decades long conflict to control the world’s energy trade. To find out what the future holds, specifically how Vladimir Putin has positioned Russia to come roaring back by leveraging its immense natural resource wealth, click here to get your copy of Marin Katusa’s smash hit New York Times bestseller, The Colder War. Inside, you’ll discover how underestimating Putin will have dire consequences.

And you’ll also discover how dangerous the deepening alliance between China, Russia and the emerging markets is to the future of American prosperity. Click here to get your copy.

The article Why Russia Will Halt the Ruble’s Slide and Keep Pumping Oil was originally published at casey research

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