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China: Just a Steep Correction, or a Lehman Moment?

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China: Just a Steep Correction, or a Lehman Moment?
Much of the US market’s recent jitters have been caused by concerns that the Chinese economic miracle is suddenly collapsing. US markets remain volatile, there was big selling pressure to close last week, and now a huge reversal higher to start Tuesday’s post-holiday action.

China similarly led the way, with their markets taking another huge dive Friday, as measured by the A-Shares index ETF (ASHR). However, Tuesday, ASHR has powered the reversal in sentiment, posting a rather stunning 10.5% gain so far in morning action.

On the one side, bears say that China has grown too much, too fast, and with too loose a check on new investments. They claim that such hyper-growth, regularly in excess of 8% a year simply is not possible without a truckload of malinvestment. Videos of 100-story skyscrapers built overnight in the middle of Outer Mongolia would tend to support this belief.

This line of reasoning is compelling, and seems rooted in basic economic truths. Economies don’t normally grow anywhere near as quickly as China has done over the past two decades. While certain factors have aided China’s growth, their upward trajectory has still been unnaturally high.

Bears argue that, like in the US and Western Europe in 2007, the long bull market driven by excessive loans, too much real estate construction, and too many high interest loans to low-quality businesses will eventually cause a spectacular flame-out.

This is in fact precisely what happened in the US. So is this an accurate case of history repeating, or are the pessimists using the wrong playbook?

In the case of China, I’d say that while the same cycle is definitely at work, there’s clear overspending and excessive construction in uneconomic sectors of the economy, the result will not be a stunning 2008-style collapse, at least not anytime soon. No, I don’t think we are on the verge of a Lehman moment.

Some fundamental differences to keep in mind between the US/Western economies and China.

First, China is a very new, very inexperienced developing capitalist society. It, in many ways, lacks the pool of skilled and specialized businessmen, regulators, and investors that long-running capitalist societies maintain.

As such, when something novel hits the system, say a blistering 50% meltdown in the country’s stock market over the span of a couple months, people are left dazed and confused. Like drivers in Texas trying to deal with a freak snowstorm, the Chinese are not yet acclimatized to the sorts of sudden financial panics that are a mainstay of a normal capitalist market.

Thus, when markets started to tank, investors started wantonly dumping shares, often without any regard to valuation. The market is viewed much more as a casino than as a responsible way for growing long-term capital. It’s not surprising that a market heavily populated by new and unseasoned investors who view it as more of a casino would be prone to wild gyrations.

And the government’s regulation of the situation hasn’t helped matters. Reflexive actions such as banning short selling, halting hundreds of issues for many days at a time, and forcing pension funds to buy the market just reek of poor heavy-handed regulation.

However, that government heavy-handedness does come with an upside. China can, does, and is using its truly gargantuan balance sheet and concentrated state power to manage the market’s decline.

With a fortress balance sheet holding trillions of sound US dollar denominated assets, low inflation, and vast power concentrated in the central government, the Chinese state is ideally equipped for the role of stabilizing a falling economy, regardless of whether or not that is the right action in an economic, moral, or ideological sense.

If GDP were to start to decline, the Chinese can, and likely will spend hundreds of billions of dollars on new infrastructure, jobs programs, and other such things to keep the economy humming. Their government, unlike in a multi-party democracy, is much more vulnerable to economic populism fomenting against them if the financial tides stay low too long.

And China, it must be remembered, has a massive savings rate, they have among the highest rates of domestic capital in the world. While there can and probably will be gigantic losses from misplaced bets on real estate and Chinese equities, among other things, it’s unclear how badly these losses will actually hit the economy.

Given the high rate that domestic savings were used to fund the boom, it’s quite possible losses will merely be shifted around inside of China, rather than causing much pain outside the country to foreign holders and creditors.

So in sum, yes China is experiencing a major economic slowdown. The stock market remains volatile there and will likely continue to be as new and confused investors react emotionally to stomach-turning gyrations.

But unlike the US, the Chinese government is taking strong concrete measures in the way a one-party government can do to head off the impending bust. Will it work completely? Probably not. Will it be enough to avoid a Lehman moment and massive recession? Yes, it probably will.

Countering China’s Assassin’s Mace with a Laser Shield

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When President Barack Obama paid a visit to Alaska, he spent most of his time viewing a glacier and tramping in the wilderness with reality TV star Bear Grylls. One of the sights he could have seen had he wished to was a flotilla of five Chinese naval vessels which sailed into the Bering Sea, at one point passing through American territorial waters. This oversight irked Alaska’s most famous politician, Sarah Palin, who pointed out that this show the flag cruise represents a more aggressive posture on the part of China, eyeing the Arctic region’s rich natural resources.

Countering China’s Assassin’s Mace with a Laser Shield

Somewhat more concerning than a group of Chinese ships visiting the waters off Alaska at the same time President Obama paid a visit there is China’s development of a group of weapons systems under the rubric of “assassin’s mace.” The term is used by the Chinese to describe a game-changing weapon that is designed to attack an enemy’s weak point. In this case, the enemy is the United States. The weapons under development include anti-satellite, cyberwar technology, and a ballistic missile called Dongfeng 21D.

A recent article in the Daily Caller describes the Dongfeng 21D as an aircraft carrier killer. It has a range of 1,000 miles. It would launch into space and then reenter the atmosphere at hypersonic speeds, hitting its intended target 15 minutes after liftoff. Intercepting the Dongfeng 21D would be next to impossible using conventional anti-missile weapons.

Fortunately, the United States Navy is developing its own weapon system that should all but neutralize the Chinese carrier killer. The Navy is currently testing a ship-based laser system that is designed to kill missiles, drones, aircraft, and speed boats used by terrorists to attack Navy ships. Initial tests of the system, mounted on the USS Ponce, have proven to be quite promising,

Using lasers to kill missiles has been a concept for decades, made most famous during the Reagan-era Strategic Defense Initiative. The technology has advanced enough so that the United States military can contemplate building a missile defense system around it. The Chinese can rain Dongfengs down on an aircraft carrier task force. But as long as the laser cannon have energy available, they can shoot them down at about a dollar a shot.

Considering that the Chinese contemplate attacking American space assets in the event of a conflict, the United States might want to consider putting these new laser systems into space. A Japanese experiment on the International Space Station is already planned to use a laser to clear space junk. The United States could defend reconnaissance and navigation satellites using similar technology.

The bottom line is that China or any other enemy can attempt to develop technology that will strike at the United States military with a goal of supplanting America as the sole superpower. But, as long as the United States has the will, it can easily outpace any such development and have a countermeasure available. Technology is America’s great inherent advantage and, as long as it has the will, is going to be crucial for maintaining its superiority over potential enemies such as China.

Robo-advisors: the next big thing?

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Recently, a new phenomenon takes retail investing by storm: Robo-advisors. This type of financial advisor, may be the largest threat to financial advisors since the introduction of ETFs. According to a recent study by Citigroup, total assets under management (AUM) increased from virtually zero to USD 19 billion end of 2014 (figures of Corporate Insight) and potentially explode to USD 5 trillion in the next 10 years. Consulting firm A.T. Kearney projected an increase to USD 2.2 trillion in the next 5 years. These projections lead to the question if Robo-advisors are indeed the next big thing in asset management.

Robots taking over

Let’s first take a look at what a Robo-advisor is. As the name simply puts it, it is an automatic advisor who replaces the traditional financial advisor who helps us making the right decisions, suited to our personal situation. Where the traditional human advisor relied on his own expertise and insights, the Robo-Advisor uses algorithms searching for the best investment options adapted to the personal situation of the client. The advantage is that smaller client portfolios can also be serviced with quality asset management. For the asset management firms, Robo-advisors offer long term cost reductions and increasing potential client base. Robo-advisors are a potential answer to today’s challenges within the sector. Currently, most Robo-advisors are limited to portfolio management services, but the concept could also address issues such as retirement planning and more sophisticated financial services.

Changing environment advisory services

During the recent years, advisory services faced heavy pressure on fees and margins. In addition, new generations are less interested in direct contact with an advisor and more keen to online banking services. Robo-advisors fill this gap. A number of large asset and wealth managers join the party. Last month, the world largest asset manager BlackRock Inc. acquired FutureAdvisor for reportedly USD 152 million. Charles Schwab launched earlier this year its own Robo-advisor, Schwab Intelligent Portfolio and reportedly seized USD 1.5 billion in AUM in six weeks. These developments make clear that Robo-advisors are not a gimmick but being endorsed by the industry leaders. That means that private investors will likely face sooner or later (if not already) at their financial advisor a similar product offer.

Strengths / weaknesses

The huge advantage for clients Is that Robo-advisors save time and energy. A client just fills an online question form regarding his or her situation, goals and risk tolerance. There’s no need for coming over to an investment office (with lousy coffee), but the software choose the right composition of the clients portfolio. The client is not dependent on the expertise of an individual advisor which may vary widely, but enjoys the ‘best’ the asset manager of choice offers. Also tax-issues are instantly checked. Main reason is off course the lower costs. But transparency could also increase dramatically, since it’s an automatic process which provides data which potentially can reproduced online meeting the clients specific wishes.

Nevertheless, a human financial advisor may still offer huge benefits. Since most Robo-advisors are limited to portfolio management services, a cross check with other relevant components in a person’s financial planning may be required. Also a financial advisor can adapt to changes in a personal situation. Sometimes a person benefits greatly from human services and simply isn’t a suited candidate for an automatic service.

Impact on Financial system

The recent history has taught us that a more automatic, passive approach leads to fundamental changes in the system. Take for instance the gradual move from active mutual funds who are stock picking to passive ETFs who follow an index or market. Certain feedback loops can be created. When certain Robo-advisors become large in size, glitches in the software can have a significant impact. Humans are known for errors, but software for glitches so there’s only a change in type of risk. In addition, the used algorithms should be smarter than humans, but we can’t be sure since the future is not included in the algorithm. Robo-advisors are early in the game, time will tell if they are able to beat the human factor. But they’re poised to shake up the industry.

China’s Yuan SDR-inclusion step closer after G20 meeting

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China’s policy makers see an important role for their currency Yuan, or Renminbi, in today’s and tomorrow’s world. Acceptance of the Yuan into the IMF’s currency basket for Special Drawing Rights (SDR) would mark an important step. After China’s decision to devalue its currency and following statements of international policymakers at the sidelines of the recent G20 meeting in Ankara, it will be probably only a matter of time before inclusion becomes a fact.

Global policymakers acknowledge role Yuan

SDR’s are seen as a global monetary reserve currency, created by the International Monetary Fund (IMF). SDR’s are a global alternative to prevent dependency on one country’s currency, for example the US Dollar. The value is derived from a basket of the most important currencies used in global transactions, namely US Dollar, Euro, Pound Sterling and Yen.

The reflection of global trade in the SDR’s is exactly why the Yuan makes a realistic chance to be included soon. As German Central Bank President Weidmann puts it: “The currency basket by definition should mirror global economic forces. It is beyond doubt that China is an economic heavyweight (…)”. But also other emerging economies seek China’s inclusion. India’s Chief Economic Advisor Subramanian stated end of August that his country should encourage entry of the Yuan into IMF’s SDR. On the other end are the United States who are still skeptical due to China’s currency policy in the past. Nevertheless, the IMF welcomes a potential inclusion. Managing Director Christine Lagarde thinks it’s not a question if, but when the Yuan will be included in the currency basket. It may probably not happen in November’s board vote, but some economists expect that China’s bid has a realistic chance in Spring 2016. The vote needs a 70% majority.

Recent policy steps game changer

A major criteria for inclusion into the SDR basket is that a currency is “freely usable”. That means that the currency should be widely used in international transactions and is widely traded in the principal exchange markets. The IMF underlines that this doesn’t necessary means that the currency should be freely floating or fully convertible. Technically, the Yuan would meet both criteria. However, a currency with a hard peg is regarded as less ideal for the SDR basket by many economists. The recent devaluation of Yuan and a more flexible peg is seen as an important step, since it would indicate that the Yuan is in the process of getting more market related. Also indications that China’s policy makers may want to close the gap between “onshore” Yuan trading (with symbol CNY) and “offshore” Yuan trading (CNH) support this view. Due to capital controls, there’s still a difference, where CNH is seen as the market price. Potential measures to close the gap imply a more floating regime, with more focus on the market price instead of merely allowing more fluctuations around the flexible peg.

Shift in currency markets

The big question for investors is what the impact could be of an inclusion of the Chinese Yuan into the SDR basket. First, this would indicate that the Yuan is a world currency for global markets. Money managers and currency funds would seek (additional) exposure. Second, Central Banks across the globe would add the Yuan in their currency reserves when it is included in the SDR Basket. Demand for the currency could rise dramatically. This could also lead to more instruments denominated in Yuan. In the recent years, some major companies did already place Yuan debt issues, so called dim sum bonds. The size of this market is with USD 33.4 billion in 2014 and USD 16 million in 2015 up to end of August relatively modest. With larger use of the Yuan as a result of SDR-inclusion, this market could also be more attractive and grow significantly. It will be easier to hedge the currency risk for issuers and lenders. But more importantly, a SDR composition including Yuan would give China a far bigger role in the IMF and world economics.

ECB likely to expand and extend QE, concerns about China

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Mario Draghi World Economic Forum 2013 During today’s press conference after keeping interest rates unchanged, European Central Bank (ECB) President Mario Draghi made clear that the ECB may use further stimulus. Mr. Draghi, who celebrates his 68th birthday today, told reporters that there is “willingness and capacity” for the ECB to act with additional measures. He also stated that the current expanded Asset Purchase Programme (APP) offers enough “flexibility” to be adjusted. On questions of reporters Mr. Draghi sounded concerned about the recent developments in emerging markets, in particular China. But also growth in the Eurozone was somewhat weaker than the ECB previously expected.

Inflation target not in reach

Mr. Draghi comments followed the accompanying ECB Staff Macroeconomic projections which indicated that the increase in annual inflation rates is currently somewhat weaker than previously expected. The ECB sees inflation stay very low in 2015 and reaching 1.7% in 2017. It downgraded its June forecast of 1.5% to 1.4% for 2015 of Eurozone’s economic growth, cutting the 2016 and 2017 projections with 0.2% to 1.7% and 1.8%.

ECB likely to expand and extend QE, concerns about China

President Draghi attributed the slower growth and a more gradual pickup in inflation to weaker exports to China and other emerging markets. He said that downside risks in inflation increased lately. Nevertheless, the APP introduced earlier this year is working smoothly, albeit slowly, according to the ECB-president, and noted that it’s premature to take further action.

ECB speak indicates more action soon

Contrary to Fed-speak, Mr. Draghi’s words, or ECB-speak if you like, are quite clear. It is hard to misread the signs “In particular the Governing Council recalls that the asset purchase program provides sufficient flexibility in terms of adjusting the size, composition and duration of the program”. This is a strong indication the ECB will act soon if the situation does not improve in the coming weeks. We might see already in the next meeting an expansion of the ECB’s QE. In addition, the ECB made an adjustment in the APP: it is now able to buy up to a 33 percent stake instead of 25 percent of any sovereign bond issue, provided the stake does not give the ECB a blocking minority. This seems a precautionary measure to warrant a smooth functioning of a potential increase in sizing of APP.

Draghi warns for more volatility

On a question of one of the reporters if the recent volatility is according a previous statement by Draghi, the ECB-president was very cautious. His earlier remarks that market participants should get used to more market movements was aimed at short term volatility, but according to Mr. Draghi recent developments may indicate a structural change which could warrant longer periods of uncertainty. He expects more clarity from China regarding its plan to tack declining economic activity and conditions on Friday’s G20-meeting. He referred to a visible tightening across the board and a clear increase in risk premiums in several assets. This is a warning for investors to brace for a prolonged period of time in which volatility is elevated, certainly compared to recent years were volatility was virtually absent.

Diverging paths

The willingness to act and pursue a more expansive monetary policy is in contrast with recent developments in the US. Fed-officials indicated to lean towards a lift off in interest rates, although data, especially inflation figures, is not yet warranting a potential rate hike. Only employment figures could warrant a certain move. Nevertheless, it is clear that both institutions are on diverging paths. This could push the EUR/USD exchange rate further down. Tomorrows Non Farming Payrolls are important, if better than expected the declining trend in EUR/USD may continue. Also a rotation from US stocks in Eurozone stocks could get stronger, providing Chinese developments do not worsen investment climate and add to volatility on the markets. Today’s ECB press conference made clear we have interesting times before us.