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“And what would you do, … if you could rule the world for a day? I suppose I would have no choice but to abolish reality.”
― Robert Musil, The Man Without Qualities Vol. 1

Commentary & Analysis
Vulnerable Aussie – Chinese stocks and the Reserve Bank of Australia

The Australian dollar has fallen a long way from its high against the US dollar. And from a technical perspective may have done enough; at least it may be poised to “correct” higher in the near- to medium-term. But an examination of the fundamental factors suggests there could be more room to fall—maybe a lot more room.

Two considerations come to mind:

  1. The Chinese connection. Over the last few years, when speaking at conferences and peening these missives to Currency Currents readers, I have suggested Australia has become a satellite country of China. A bit of hyperbole? Yes indeed. But used in an effort to make the point Australia’s economy is closely linked with China’s; especially in regards to China’s demand for raw materials.

    China’s economy is slowing, most of us know that. But most of us likely don’t give much thought to just how far and how fast economic growth in China has fallen.

    From the Financial Times 6/23/15:

    • “A lot of the arguments over whether China’s official growth rate of 7 per cent is real or not actually miss the point that the nominal GDP growth rate has fallen from more than 20 per cent to less than 6 per cent in the first quarter, which is a much more dramatic slowdown that many people realise,” said Chen Long, China economist at Gavekal Dragonomics in Beijing.
    • Revenue growth for companies listed in mainland China, which excludes volatile energy and financial stocks, closely matches the trend in nominal growth rates over the last decade.

    • Average revenue growth for listed companies slumped from nearly 30 per cent expansion in the first quarter of 2011 to just 0.7 per cent in the first quarter.

  2. The chart below (next page) displays an interesting juxtaposition, i.e. a huge divergence, or complete change in correlation, between commodities (Thomson Reuters Commodities Index) and Chinese stocks (Shanghai SE Composite Index); think of it as a divergence between the real economy and the financial economy.

    Massive money flow to China, as during those halcyon days of the consumer credit boom, when was China shipping all the stuff they could to US consumers tapping their home-based ATMs as fast could to buy the stuff China was shipping. I think it was Jim Grant who said something like, they shit ups stuff and we ship back dollars in the otherwise empty shipping containers.

    I referred to this environment as the symbiotic relationship (it has been called the single currency zone period). The credit crunch triggered the breakdown in the symbiotic relationship. Or was it the over saturation of US capital markets driven by the symbiotic relationship which triggered the credit crunch. I think the latter. But either way, it marked a sea change in the global economy and the end of easy demand for all those things China was making; it represented the beginning of what we are now experience—the painful process of global rebalancing of current account deficit nations with current account surplus nations. [Of course governments and central banks have been fighting the rebalancing with earnest, and thus prolonging the pain.]

    This is a secular event. The symbiotic relationship between the US and China will not be revived soon, if ever again. Interestingly, one of the side effects of this breakdown—a bubble in the Chinese stock market—was one of our expectations as far back as 2010.

    Key points:

    1. China government stimulus has been substituted for the lost US consumer demand
      stimulus; it has pushed debt levels in China sharply higher.
    2. China has maintained, for the most part, its global manufacturer status, but its trading partners in Asia have borne a lot of that burden; foreign direct investment into emerging markets continues fall. [Expected to intensify as the Fed starts raising interest rates. It will not help local demand for Chinese goods. Yet another reason why I expect China will start letting their currency depreciate against the US dollar as others have.]
    3. Under the dictum “money must go somewhere,” we anticipated bubbles in both real estate and the stock market, i.e. the roach motel effect of China’s closed economy— money can get in but it’s hard to get out. So those with money inside play the games they can, i.e. commodities, real estate, and stock market speculation. Maybe the stock market is the last domino to fall?

    I realize there are seemingly solid rationales for the Chinese stock market to continue to rally selffeeding reflexive relationships have a way of lasting longer than we think. But self-feeding relationships cut both ways; here is a reminder from Mr. George Soros’s book Alchemy of Finance:

    “We have here a reflexive relationship in which stock prices are determined by two factors—underlying trend and prevailing bias—both of which are, in turn, influenced by stock prices.

    “The underlying trend becomes increasingly influenced by stock prices and the rise in stock prices becomes increasingly dependent on the prevailing bias, so that both the underlying trend and the prevailing bias become increasingly vulnerable.

    “If the underlying trend has become overly dependent on stock prices, the correction may turn into a total reversal.”

    If one is to assume global growth is about to turn upward, it represents a solid rationale (really and expectation based on a solid rationale) to support Chinese stock prices. But I think most observers are skeptical about future growth prospects in a world still characterized by powerful deflationary forces, too much debt, tepid demand, and central banks running low on ammunition.

    If you accept the secular slow-growth premise, then it increases the probability the run up in Chinese stocks is overly dependent on stock prices; thus widening the gap between the financial and real economy. [An interesting tidbit from the story I referenced above in the Financial Times suggests Chinese investors aren’t real concerned with underlying value but are more likely trend following: “Chinese investors hold shares for an average of only four weeks, according to Gavekal Dragonomics research.”]

    Granted, this relative financial-to-real economy valuation conundrum isn’t only playing out in China, but something to consider when evaluating every major stock market on the planet. But as it relates to China, the problem of divergent values i.e. real versus financial, seems larger than elsewhere given the dramatic slowdown in GDP and still massive industrial overcapacity evidenced by the country’s decline in demand growth for all things commodities.

    And though central banks have created QE heaven on earth, and may have changed the dynamic forever, gray hairs (like me) still believe in the old religion. We cling to the view there is a valuation tether between stocks and real economy and sooner or later there will be hell to pay.

    If you accept the idea:

    Stock markets represent the largest repository of collateral value for the real economy

    …then you should be very concerned about what we’ve witnessed in QE heaven.

    It seems the massive run-up in stock prices has done relatively little to spur real economic value and growth. Thus it begs the question: If stock markets stage a significant self-feeding correction to the downside—something serious—won’t it crush the underlying “fragile” real economy?

    A big correction in stocks would represent a powerful deflationary event. It would be another nail in the coffin for already nascent global demand. In short, currencies most leveraged to growth— the commodity currencies such as the Australian dollar—would likely be hit very hard. And keep in mind the world reserve currency—the US dollar—will by virtue of money moving back to the center, especially if hot money runs out of China, likely be “bid” higher against the pack. That is why we want to pair a commodity currency against the US dollar if such comes to pass.

  3. The Reserve Bank of Australia might surprise the market.
  4. Australian economic growth is highly suspect, because the economy is still exposed to falling demand and prices for raw materials mined in the country. For example:

    According to Lombard Street Research, there is “Capex [capital expenditures] cliff” that will hammer Australia’s growth in 2016.

    Net trade has buoyed Australia’s GDP in recent quarters, but disappointing business capex is darkening the outlook for growth. Construction is a bright spot, yet overall non-mining investment has so far failed to pick up the slack from the resource sector’s slump. Mining expenditure has fallen in each of the last six quarters, and is set to fall further. The Australian Bureau of Statistics’ latest estimate is for a 25% drop in total planned investment in FY2016, pointing to a towering capex ‘cliff’.

    The capex cliff coupled with already declining wage growth and rising household debt levels, suggests rebalancing the Australian economy away from the mining sector is only in its infancy, according to Lombard Street. Given that dynamic, it is seems more likely the Reserve Bank of Australia will surprise to the downside on rates. It has 200 basis points left till it gets to zero—a lot more room than most central banks.

    Below is the rate forecast from Capital Economics compared to market expectations. If Capital Economics is right, and I think their guess makes sense given what we know now, then the Australian dollar could have a lot further to fall as it loses its relative yield support against the US dollar.

    And just today, Bloomberg reported the IMF is suggesting the Reserve Bank of Australia be prepared to cut interest rates given the country’s growth outlook.

    So, where does the currency go from here? Aussie is now trading at around 0.7700 against the US dollar. The post credit crunch low is 0.5988. There is a lot of air between the two.

    The chart below shows AUD/USD [gold] vs. 2-yr Benchmark Yield Spread Australia-United States [purple] vs. Chinese stocks [red]:

    As the Aussie’s relative yield spread falls, so goes the Aussie against the dollar, based on the current correlation as you can see in the chart above [AUD/USD rate in gold; 2-yr yield spread in purple]. If the Reserve Bank of Australia continues to cut rates while the Federal Reserve starts raising rates, the relative yield favoring the Aussie will fall much further. And if the correlation between the Aussie and its spread remains intact, then down goes Aussie.