#$cny

Here’s the deal: I am a trader, not an economist. I have no qualifications that would allow me to dig up any data that others don’t have or create innovative econometric models. What I am good at (I think) is coming up with trading strategies given an economic paradigm.

The USA has been my bread-and-butter for many years. Some find it challenging to operate in such transparent and well-researched market; they bemoan the lack of informational advantage. I am very happy with the lack of informational disadvantage. When it comes any broad domestic market, I can rely on widely available research to formulate my strategies. In fact, I don’t even have to read in-depth any particular research - a mere osmosis gives me sufficient idea of what is going in the United States. Following any given researcher closely accords more of this person’s opinions and little in a way of informational advantage.

This way of thinking has been leaving me in the dust when it came to China. The future of this country is one of the largest (if not THE largest) variables which will affect the course of global economy. And I have been at a loss of how to formulate a China strategy for over a decade. Any trade I could conceive of left me at a huge informational disadvantage.

The problem is dual. Any official statistic coming out of China is unreliable. But even if I had the correct numbers, I wouldn't know how to interpret them: Chinese party-controlled society needn't obey the same causality laws as a true free market economy.

The hodge-podge of conflicting opinions on social media was very confusing and I have been having hard time distinguishing between biases (including my own) and hard facts.

It was like playing poker without knowing the hand rankings.

This is why, I have so much looked forward to a comprehensive modern book on Chinese economics. Yes, modern. I didn't need a review of the Ming Dynasty politics, but a systematic professional presentation on what is going on now.

John Mauldin and Worth Wray, the creators of the anthology A Great Leap Forward? didn't disappoint. The editors, as well as their contributors, are not afraid to state their opinions, but what distinguishes this book is the intellectual discipline of separating those opinions from facts.

The anthology engages China sceptics and optimists to deliver every point of view to a reader.

China bears tend to focus on ballooning credit growth problem, mounting inefficiencies, and pressures on the RMB carry trade. Meanwhile, the bulls talk about the unique positioning of China, its potential to technologically leapfrog the West, and the government being on the right track to conducting the necessary reforms.

Yet the book’s discourse on China cannot be characterized as simply a battle between two opposing camps. The interaction of economic and geopolitical scenarios creates a non-linear set of outcomes. The contributors all realize the underlying uncertainty, but they assign different probabilities to various possible paths for China.

The styles of chapters are as diverse as opinions: some are very technical and some read like excerpts from a geopolitical thriller. Fortunately for a non-professional reader, the editors present a summary for every chapter, which allows one to decide where to focus their attention.

There was a bit of tough love for me. l did not finish this book with a clear plan or strategy imposed, rather I was given the facts and arguments and will have to come up with my own decisions. It is more daunting, but in the end, this is the way I prefer it.

Those who follow me may have noticed that my tendency is to side with China sceptics. I do have three inherent biases:

I am sceptic of any government being able to retain control, as they manage economic transitions.

I have very low respect for Communist ideology and the ability of Party to control corruption.

I have observed Chinese historical tendency to self-destruct each time they have risen to dominance.

A Great Leap Forward helped me to see past those biases and remember that

On one hand, the current positioning of China is truly unique and unprecedented.

On the other hand, there are examples of authoritarians rulers successfully implementing economic reforms (Pinochet’s Chile and Peter the Great’s Russia come to mind).

The next step is to parse what I've read, discover undeniable common threads, and to find asymmetric macro bets.

For example, the opinions on the imminent RMB devaluation range from near certainty to very low likelihood. But this is where I can get useful takeaways.

Assume I believe the estimate of a China optimist and relative RMB bull that chances for this year are:

75% no deval

15% small deval

10% large deval

An economist in my place would say “my forecast is no deval”. But as a trader I say “there might be limited downside, positive expectation bets on deval”.

Or, when a contributors thinks that in the event of continued dollar appreciation RMB will deval slightly against the dollar, but perform well against other currencies, I say “Aha, I can have a low risk bet on strong dollar via shorting RMB”.

So, I am still leaning toward the sceptics, not because I am certain they are right, but because they offer positive expectation bets that can have an additional benefit of protecting portfolios in the event of China-induced global slowdown.

A Great Leap Forward is a must read for anyone whose financial fortunes are in any way linked to China (which is by now almost anyone).

This morning’s Thundering Word note at Merrill Lynch contains an interesting passage about the litany of “pain trades” that have blown up as the end of the “max liquidity” regime has wreaked havoc in some of the most crowded areas of the market…

A “Cesspool of Rotation” 2015 asset returns have been none too shabby: stocks 7%, commodities 6%, bonds -1%, dollar 4%. But this should not be mistaken for Wall Street terra firma. Since Fed tapering was announced (Feb’14) investors have been scarred by a series of vicious “pain trades” (Table 1), crowded trades suffering harmful reversals.

For example, many were positioned this Jan for US macro liftoff. Once weaker- than-expected Q1 data caused the Fed to “blink” in March, an immediate painful US$ peak, biotech selloff and trough in oil prices ensued. In the same vein, bond investors were “all-in” on ECB QE at the end of Q1. German bunds and other European bond markets were priced-to-perfection. Few acknowledged the surprise turn higher in EU inflation expectations as even Spain outperformed US growth in Q1. A sudden “buyers strike” for $6tn of negatively-yielding global government bonds (it’s now $4.5tn) caused a 16% crash in German bund futures in 13 trading days.

Josh here – this cuts to the heart of the idea that nobody knows nothin’ and that the blowup will always occur just when enough people have caught on to a theme and there’s no one left on the other side of the seesaw.

Jeff Gundlach likes to say “When you hear people in the investment business say the word ‘Never’, that’s when it’s about to happen.” In the case of many of these pain trades, the term “never” was often assigned to the other side of them – ie: Utilities will never outperform in an improving economy. Oh well.

Source:

Each year brings new mutterings that China is interested in methodically dismantling currency controls that keep the yuan pegged to the dollar, with the eventual goal of making the yuan a (more) freely convertible currency.

It’s a wonderful thought but, to be fair, we’re probably still a long way off from that happening. China initiated a currency peg to the U.S. dollar back in 1994 in an effort to secure their spot as the world’s leading exporter. With a weak yuan, China’s exports have remained competitive on a global level and, developed countries like the U.S., have exported hundreds of thousands (perhaps millions) of low-skilled manufacturing jobs there as a result.

What’s lost in domestic manufacturing for developed countries, like the U.S., is gained in cheaper imports of goods and the cheaper manufacture of higher-end goods (since some parts are sourced and built in Chinese plants then brought back to the U.S. for final assembly).

It’s not a perfect model and, politically, it’s a sticky issue (since jobs are lost). But, all things considered, there’s a net economic benefit—the U.S. (and global) consumer gets lower prices and the Chinese economy has seen blistering growth over the last 30 years. Taken together, this has provided an overall boost to the global economy and lifted a lot of other ships with it, like Emerging Markets economies and stock prices.

Some of you might be thinking, sure, but isn’t this still just plain and simple unfair trade? China manipulated its currency to keep its goods hyper-cheap, relative to the world, and essentially created a monopoly on manufacturing in the process. A lot of people here are out of work as a result.

This is true, and it’s why the U.S. has put political pressure on China over the last decade to allow its currency to appreciate – something I believe China should absolutely do. But at this stage, we have to also be very careful about “biting the hand that feeds us,” so to speak. A rapid appreciation of the yuan could mean goods made in China become more expensive, a cost that will likely get passed to consumers (you). Additionally, a stronger yuan would mean a slowdown of Chinese manufacturing, which makes up over 25% of its economy. If China weakens substantially, the global economy will feel it, and it could hurt global growth and stock prices.

If it sounds like a Catch-22, it’s because it is. But it’s only a Catch-22 if the yuan rapidly and sharply appreciates against the dollar. What I would rather see is a gradual move toward greater flexibility, much like China started back in 2010. By some estimates, the yuan could be undervalued by 25%, so moving the trading band by a few percentages each year could be a smart solution to leveling the playing field, and to making removal of the peg easier when that day finally comes. Currency hardliners would like to think that the solution is as simple as, "let the currency float and the free market will handle the rest.” But it’s not that simple — considering these pros and cons below will underscore why:

Pros to Letting the Yuan Float:

Helps U.S. Exports – and European exports, for that matter. If the playing field is leveled suddenly, China may not be the best solution for cheap goods and production (and the attractiveness of U.S. and European goods inherently rises). That could even lead to some manufacturing jobs returning to the U.S.

Promotes New Types of Investment in China – if China and multinationals lose their “subsidy” for expanding the manufacturing sector, it could free up capital for investment in other areas (like expanding the service economy and promoting domestic consumption).

Empowers the Chinese Consumer – speaking of domestic consumption, the middle class in China is one of the fastest growing demographics in the world. If their currency goes a longer way towards purchasing goods in the global economy, everybody wins.

Creates New Wealth for Emerging Industrial Countries – if the cost of manufacturing in China rises with a rising yuan, it could open new doors for other industrial nations with cheap labor, like Mexico and Vietnam. If there’s one thing you can be fairly certain of, it’s that multinationals will find a place with cheaper cost of production and move there. Doing so could help an emerging economy really gain steam, and create new wealth.

Cons to a Rapidly Appreciating Yuan:

Chinese Exports Hurt – If the manufacturing boom slows, or even contracts, it could affect China’s overall growth rate. As the second largest economy in the world, China is a hugely meaningful component to global GDP. Softening global GDP could threaten stock prices.

Softens China’s Demand for U.S. Treasuries - China sells yuan and buys dollars to control the currency, but they recycle those dollars to buy U.S. Treasuries. Doing so helps the U.S. finance our budget deficits. If the yuan floats, Chinese demand could sap.

Higher Production Costs for Some U.S. Multinationals – as production costs rise, those could get passed along to the consumer. Over time, those multinationals will likely seek cheaper production and move operations (a positive), but in the short term it could affect prices.

The Bottom Line for Investors

Having the yuan float is a tricky issue – both economically and politically – and I’m not sure there’s a perfect solution. Regardless, the bottom line is that any change will happen only gradually, which should give the market plenty of time to digest the economic effect one way or the other. If the announcement comes that China is ready to move the trading band for the currency again, or even ready to let it float, I think there will be some clear winners and losers to emerge and investment implications would likely apply. Until then, it’s a wait-and-see.

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By Garikai Chengu

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Originally posted on 3/21/14: stks.co/c0M4s.