Well, that was one hell of a January!
Thank goodness it’s over.
Unfortunately the issues that caused the volatility are far from over.
The world financial markets are worried about two big macro issues here, in my opinion. The first being the artificial peg the renembi (RMB) – China’s currency – has with the US dollar. And the second being actions or should I say future actions of the US Federal Reserve. As we all know the Fed has increased interest rates in December along with preparing the market with rhetoric about further increases in 2016: What in heavens name do they do now with the world economy and the US economy clearly slowing down from the albeit low growth levels of 2015?
Until we have answers to these questions… that will reveal themselves over time, obviously… the US equity markets and global markets will be under stress, in my opinion.
Let’s deal with these two issues.
Renembi (RMB) Currency Peg
As I have said in my January market comments (here), China’s economy has clearly and currently slowing down. And at the same time the government wants to transform its economy from a high investment spending/growth economy to one where the consumer leads future economic growth. Again as I said previously, China is doing this transition with large amounts of foreign reserves and the best economic brainpower on the planet. That being said China’s central bank, the PBOC, is literally spending billions on a monthly basis to maintain their RMB currency peg to the US dollar. For example, in December authorities estimate that the PBOC spent $120-$150 billion US dollars buying/purchasing RMB to help maintain the value of RMB against the US dollar. The result? The RMB still depreciated by over 2% against the US dollar in the month of December!
We are waiting for the PBOC numbers but leading experts estimate that the Chinese central bank was more aggressive buying RMB in January than in December. [News Flash – Goldman just estimated that the PBOC spent $197 billion US dollars for the month of January.]
As we all know money is not infinite and experts (and markets) are wondering whether how long the PBOC can keep this up.
The other observation I will make is on this topic is the S&P 500 was down heavily in the first two thirds of the month of January and reversed course and rallied hard for the final third of the month.
Why did the S&P 500, and other global markets rally so hard, at the same time you maybe asking?
I believe little noticed in the business press was a rare interview with Premier Li in Davos, Switzerland – I saw his quote on Twitter and not in the leading business papers. (Premier Li, for those who don’t know is the number two guy in the Politburo and is responsible for China’s economy.)
Mr. Li simply stated that China will not devalue the RMB and the equity rally was on!
But the S&P 500 Index was still down over 5 percent for the month of January.
The world’s leading hedge fund managers are lining up and shorting the RMB believing China will inevitably devalue the RMB against the US dollar. This push/pull will last certainly for 2016 and beyond.
For what’s it worth, I believe China will not devalue its currency. If China wants to become the global superpower of the next 50 years, displacing the United States, the RMB needs to be viewed as safe for international transactions and a store of value for global savings. In lieu of devaluation, China must work hard at internal reforms so transformational that economic change can occur in their domestic economy spurring economic growth and ultimately supporting the value of the RMB.
US Federal Reserve
What will they do?
Will the December interest rate increase, be the only rate increase this business cycle? What happens if the US economy slows markedly in the coming months? Would they reverse course and lower interest rates they just increased? Would they reinitiate Quantitative Easing [QE4]? And what would be the impact of the Fed’s credibility if future policy decisions were to reverse course and additional non-traditional monetary experiments were put in action.
What if we just hit an unexplained soft patch in the US economy in the fourth quarter and the US economy re-accelerates economic growth for the balance of 2016? And the Fed stays the course and continues with hiking interest rates and draining excess bank reserves. Certainly this policy response would result in the US dollar gaining strength in the foreign exchange markets, further increasing the pressure on the PBOC trying to maintain the currency peg I was describing previously.
Model Price Chart
Let’s have a look at our current Model Price chart for the month of January, leading into the month of February 2016 of the S&P 500 Index.
S&P 500 Index Model Price Chart with EBV Levels and Weekly Price Bars
As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.
As you can observe the US equity market, as defined by the S&P 500 closed February 1st at 1939.38. If the market rallied to EBV+4 (2199) this would represent a gain of some 13%. If the market corrected back to EBV+3 (1766) investors would be suffering Index losses of almost 9%.
For people new to Model Price Theory [MPT] the index value or equity price can move within an EBV zone with no real consequence. However when a transit occurs – index value or equity price crosses one of our parallel lines – our EBV line, either positive or negative this gives Model Price users a signal that fundamentals are improving or deteriorating, respectively.
I believe the most amazing thing about the US equity market is we are not at EBV+3, yes some 9% lower! The market is throwing some big macro issues at all financial markets and the S&P 500 index seems to be the most resilient of any global equity market. Yes, stocks in the S&P 500 index have been getting crushed and are in their own BEAR market. However others, admittedly few, are reaching new all-time highs keeping the index value above our calculated EBV level.
Obviously this could change at anytime. And, if or when, the S&P 500 were to fall to EBV+3 the market could crawl along this EBV level for quite sometime.
But, in my opinion, global macro issues are in control here and we need some clarity certainly on the two issues raised above before equity valuations go substantially higher.
As always we’ll see what happens.