the basic macro conditions: 2016-2017 · 2016. 2. 2. · solving the puzzle global macro is like...

The Basic Macro Conditions: 2016-2017REFLEXIVE PROPHECY/ WENCHANG QIAN

Solving the Puzzle

Global macro is like solving puzzles. One theme is one puzzle. You either piece everything together ahead of the future and collect your awards. Or the future itself will unravel everything for you and you collect news. The purpose of this presentation is trying to solve this puzzle ahead of us.

We believe that U.S. has entered a recessionary period that is led by China and EM markets.

In 2015, Federal Reserve’s rate hike decision was the dominant driver of the world financial markets

In 2016, China’s slowdown and continuous depreciation of RMB has become the dominant driver the world financial markets, which is likely to create different knock-on effects. The Fed’s decision to push dollar will become a sub-factor this year, as more than one hike is likely to be not possible. Instead, the dollar will majorly get pushed by China.

2/2/2016Reflexive Prophecy/ Wenchang Qian


Global Macro Forecasting Framework

Global Macro Forecasting Framework (Special Phase)

M: Current Market Conditions F: Fundamentals

M1: Expected Future Reflexive Conditions S: Participants' Sentiment

H: Future Economic Conditions based on Economic Theories

E: Confirming/Disconfirming Positive and Negative Events

T: Time Course of Developments

Source: The Alchemy of Finance, Reflexive Prophecy

M M1 (H)F

E

S

T

Global Macro Forecasting Framework (Regular Phase)

Feedback Blocked

M: Current Market Conditions F: Fundamentals

M1: Expected Future Market Conditions S: Participants' Sentiment

H: Future Economic Conditions based on Economic Theories

E: Confirming/Disconfirming Positive and Negative Events

T: Time Course of Developments

Source: The Alchemy of Finance, Reflexive Prophecy

M M1 HF

E

S

T

US is Here

Feedback Loop Unblocked

We have previously detailed our macro forecasting framework (reflexiveprophecy.com/framework) based on Theory of Reflexivity on our blog. Based on thelatest developments, we believe U.S. markets have entered the Special Phase of the framework, which means the feedback loop between F and M1 (M1and H become the same point during the Special Phase and cognitive function becomes embedded within M1(H)) is unblocked, and F and M1(H) start to bereflexive with each other. The key trigger of the special phase was the end of the QE and the Fed’s rate hike.


Multi-Sequence Reflexive Framework: 2016-2017

The flow chart on the left is the 2016-2017 macroforecasting framework that we have compiled –the whole puzzle, though we have to admit ourignorance of the future and all the things that havebeen rapidly developing. We could easily solve apart of the puzzle incorrectly.

There are two major self-reinforcing links that areworking in the framework. One is between China’sslowdown/RMB depreciation and a stronger trade-weighted dollar. The other is between a strongertrade-weighted dollar and dollar carrytrade/funding unwind.

And one should note the self-correcting factorsthat might or might not prevent the bigger picturefrom happening.

Keep in mind that if the Fed doesn’t ease with theECB, BOJ and PBOC, it may make the mattersworse (or at least not much better) as the dollarmay be driven even higher by policy divergence.

2016-2017 Macro Forecasting Framework

China Slowdown/ RMB Depreciation (Dominant Driver)

Stronger Trade Weighted Dollar (Accelerator)

Direct Effects Commodity Bust EM Equities/ Currencies Crash

Secondary Effects US HY Defaults/ Impacts on Shadow Banking Commodity Trading Firms Bankrupcy

(We Are Almost Here)

Dollary Carry Trade/Funding Unwind (Major Underlying Trend)

Potential EM Banking Crisis Potential EM Sovereign Debt Defaults

Tertiary Effects Worldwide Equity Crash World Economic Downturn

"Resolution" Significantly More Easing from the Fed, ECB, BOJ and PBOC (Self-Correcting)

Source: Reflexive Prophecy

Major Self-Reinforcing Links

Major Self-Reinforcing Links

Major Self-Correcting


Is China Slowing Down the Stimulus? No.

The answer is no, despite the fact that Li Keqiang, the prime minister of China has been claiming that China wouldn’t adopt super-size stimulus program as it did in 2008. China hasn’t stopped the stimulus at all and it has kept pumping the stimulus into theeconomy. So In fact the total debt to GDP went from 158% in 2007 to 282% as of 2Q14. In addition, nearly half of China’s debt isexposed to the real estate sector.


So why is China’s Economy Slower Now?

It has to do with China’s incremental capital-output ratio, which has increased form 3.5 to almost 6.0. In other words, China needs approximately 70%more investments to create the same stimulus effects as it did in 2008. Most countries’ incremental capital-output ratio is around 3.0.

In addition, China’s nominal effective exchange rate (NEER) has been appreciating by more than 20% over the last three years, which has largelydiminished China’s trade competitiveness over Japan and other Asian countries. Meanwhile, other EM countries have depreciated their currencysignificantly against the dollar.

Source: Goldman SachsSource: Morgan Stanley


Is China Going to Sharply Devaluate RMB?

We think the answer is yes, based on how fast the reserves have been depleting after trying to manage a 6% devaluation with continuous capital outflows. Inaddition, with a country of 1.4 billion people, as WSJ reported, if only 3% of the urban population buy $50,000 and sell RMB, that’s equivalent to one third of thereserves left. So the question really becomes when and how much they are going to devaluate and how many times they would end up having to devaluate. Basedon Chinese governments’ past experience dealing with the equity markets and their hostile attitude against short sellers of RMB, we think it’s safe to assume thatthe PBOC doesn’t know very well what the situation is and how the markets outside of China work; they might very likely under-devaluate its currency if it chose todo so. We tend to think that the PBOC is likely to devaluate RMB by 10%-20% first time and they will realize it might not be enough.

Devaluation Started


China’s Slowdown/RMB Depreciation: The Dominant Driver

Markets are not pricing in a major devaluation of Yuan and that is exactly why we think PBOC is going to trump the Fed and become the dominant driver.And if it happens, this is likely to create a major deflationary shock to the markets.

The trade weighted dollar is likely to spike much higher if a sharp yuan devaluation incurs. That is likely to create a major reinforcing trend with the dollarcarry trade unwind.

Taiwan and Korea are the most exposed countries if China significantly slows down or devalues its currency. And Taiwan is already in recession. China itself is likely to benefit from a sharp devaluation scenario temporarily, but the other trading partners will likely catch up with more competitive

devaluation. A currency war doesn’t benefit anyone in the end, but only debase the intrinsic value of paper currency and credibility of central banks in thelong term.

Source: Morgan Stanley


The Two-Tale Stories of Dollar: The Accelerator

Regarding dollar, trade-weighted dollar index (China included and China is a big trading partner with U.S. and China is depreciating its currency) has continued to go up,which is weighted against various currencies, including a lot of EM currencies. The DXY that Wall Street looks at hasn't gone up because it's sort of measuring how fastthe Fed is going to tighten relative to EU and Japan. Our answer is with zero or one hike this year. DXY might start going up some point in 2016, as EU and Japancontinue their courses of easing.

Source: FRED Source: Barchart


Was the Fed’s Hiking Decision Wrong? Yes, but…

A lot of investors have been calling the decision to hike the rate wrong. We agree with that, but it’s fair to point out that theFed can rarely get their decisions correct based on the nature of the entity, the operations that they conduct and theory ofreflexivity. In other words, they have always been fighting the game that is impossible for them to win but can only delay.

Let us explain a little on what we mean by that. We agree with Austrian economists (Austrian Business Cycle Theory) thatinterest rates should never be manipulated to drive demand or push market participants to chase risky assets that they wouldhave never been chasing. The Fed is constantly creating another bubble by fixing a crash, which was partially created by theFed at the beginning. The developments in U.S. shale oil sector over the past several years is a classic example.

In addition, based on Theory of Reflexivity (which is what our framework is based on), the very fact that the Fed has alwaysbeen trying to shape/influence the market participants’ expectations, makes the circular logic fallacy; what’s not in the Fed’smodel is that their decisions are also influenced by financial markets and they have to release their forward-lookingexpectations to the market participants. Here you have the Fed who is trying to influence the financial markets and decide thetiming of the rate hike based on latest economic conditions, which were partially influenced by the financial markets. This wasthe main playbook for 2015.

Direct Effects – Commodity Bust, EM Currency and Equity Crash

The direct effects are the ones we have already seen.

We have seen a major commodity bust. The trend has broken the resistance level in 2008 and gone all the way back to 2002 to 2003, exactly when China’s boom had started.

EM currency have also crashed and if the Chinese RMB goes down even more, which is likely to trigger another wave of sell-off.

EM equities currently are playing catch-ups with the commodity sector and the currency sector, and are likely to go down further.



While we have been experiencing quite a downturn in the commodities sector (non-oil), it's important to keep in mind as shown on the left in the table, the duration of the declines is below an average commodity bear market since 1790; An average bust lasts as long as six years and 2016 is the fifth year. In addition to that, the boom in the sector that ended in 2011 lasted 12 years since 1999 with an 88.75 increase in prices, which doubled the average commodity bull market in terms of both duration and magnitude.

In other words, based on historical contexts, the low in the commodity sector in general might not have been seen for another year or two.

Non-Oil Commodity Cycles: 1790-2015

Source: Carmen Reinhart, Vincent Reinhart, and Christoph Trebesch, 2016

Secondary Effects – Dollar Carry Trade/Funding Unwind


If the RMB continues to depreciate and the trade-weighted dollar continues to get stronger, this will likely trigger the secondary effects, which are associated with the dollar carry trade.

If the trend starts unwinding in a big way, we are likely to see more HY defaults and their impacts on the U.S. shadow banking industry, more bankruptcies from commodity trading firms and their impacts to the banks which are exposed to them, a potential EM banking crisis and a potential EM sovereign default cycle.

Note that if the Europe and Japan start expanding their QE programs without Fed’s reversal of its policy course, it will help the markets somewhat but will also drive the dollar higher, which creates negative impacts again.


Source: Matt King from Citi Research

Global Central Bank Purchases

Note that as soon as the Fed scales back its asset purchases (quantitative tightening), the net liquidity outflows in EM havedecreased as well. This partially explains the sell-off in the developed markets recently.


Dollar Credits and Its Uses

The dollar credits totaled approximately $9 trillion as of the end of 2013. Note that the majority of the dollar credits arebased offshore.



Note that the total EM dollar debt outstanding is $3.8 trillionas of 2Q15. China tops the list with $1.2 trillion dollar debtoutstanding. Russia has almost $300 billion dollar debtoutstanding and Brazil has $322 billion dollar debtoutstanding.

Note that non-financial corporate debt in China has swelled to$17 trillion; however only 5% of those debts are based indollars.

The maximum dollar share for Philippine’s external debt is80%; the maximum dollar share for Chile ‘s external debt is51%; the maximum dollar share for Mexico’s external debt is50%; the maximum dollar share for Turkey’s external debt is40%.



Out of the $4 trillion dollar credits, there are about $1.7 trillion dollar bonds.

EM governments and non-financial corporations are the biggest issuers of dollar bonds. Non-financial corporations account for 57% of the dollar bonds issued.


Sovereign Defaults Happen following Double Busts

Source: Carmen Reinhart, Vincent Reinhart, and Christoph Trebesch, 2016

As Carmen Reinhart has found empirically, From 1815 to 2015, sovereign defaults always follow a double bust (commodity bust and capital flow bust), which is currently happening right now. The last time it happened was 1983 and 1930s.


Sovereign Ratings Have Been Lowered

Source: Fitch

As a result of the aforementioned factors, we have seen more lower ratings of sovereign credits with a spike of broad USD index.

Tertiary Effects – World Economic Downturn/Equity Crash


So if the secondary effects happened as a result of the reflexive framework that we have pictured and forecasted, then the tertiary effects – worldwide equity crash will likely happen almost at the same time as markets are likely going into a panic mode.

Recently S&P is starting to account the direct effects and “predict” the secondary effects and tertiary effects. A lot of things started trading together with a strong correlation.

Events can shape markets and markets can precipitate events. However, one should note the self-correcting factors that might or might not prevent the bigger picture from happening.


How All These Impact the World Economy: Different from 1997-1998

Source: The Economist

The EM markets’ role to the world’s economy has significantly changed in the past two decades. EM share of world’s GDP has grown from roughly 35% to almost 50% in 2012.

Notice how the surge of the commodity prices have correlated with the world’s merchandise trade. And as previously discussed, the commodity markets have entered into a bear market since 2011, which will likely impact world merchandise trade; and that leads to a negative impact for world’s economy.


How All These Impact the World Economy: Different from 1997-1998

China now contributes to 13% of world’s GDP and approximately 40% of world’s GDP growth. In addition, China consumes enormousshare of commodities in the world. That is being unwound now and the recent commodity turmoil in 2015 indicated a hard landingdespite the official GDP figure and what the government wants you to believe.

Can Central Banks Save This Time?

We would like to take a bold guess and say yes, but under the following circumstances:

NIRP and QE 4 from the Federal Reserve

Perhaps an agreement like Plaza Accord to devaluate dollar against other major currencies

Some sort of major stimulus program from China

Dollar carry trade stops unwinding and being put back to the old path


How do We Know if We are Right? Confirming Signs

The confirming signs include a sharp depreciation or gradual depreciation of RMB with continuous drop of FX reserves.

We would need to see a continuous trend of stronger trade-weighted dollar.

We would need to see more stressful signs coming from commodity-linked countries and banks, including bankruptcies and defaults. Nigeria is seeking a $3.5 billion emergency loans; this is a sign towards that way.

We would need to see continuous capital outflows from EM and a continuous trend of dollar carry trade unwind.

We would need to see that the Fed continues its path of hiking rates and continues to think that the U.S. economy is doing okay; in other words we would like to see a continuation of policy divergence.

We would like to see another wave of heavy sell-off of junk bonds, regardless of industries .

We would like to see S&P continue to account those factors and have high correlation with other risk assets.

We would like to see the economic indicators coming in weaker than the consensus, as a fact that markets are merely precipitating the downturn in the fundamental economic conditions.

Should those trends stated above discontinue, then there might be a shift of the paradigm and we could be wrong in our judgements of the basic conditions in this presentation.


How Can We be Wrong? Disconfirming Signs

We can be wrong that if the Fed reverses its tightening cycle much faster than we thought

We can be wrong that if the PBOC starts its own QE much sooner than we thought

We can also be wrong if the Chinese government starts massive stimulus plans much sooner than we thought

We can be wrong if the impacts of dollar carry trade unwind on the EM sovereign debts and banking system turned out to be smaller than we thought

We can be wrong if EM sovereign defaults and bank failures didn't trigger contagion and cause worldwide economic downturn


the basic macro conditions: 2016-2017 · 2016. 2. 2. · solving the puzzle global macro is like...

Documents