Market Thinking

making sense of the narrative

Mid-Autumn Winds

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With China closed for the Mid Autumn Festival holiday, the noise traders are all over Evergrande Contagion as their new narrative, when in fact the bigger short term risk is the gamma positions among market makers in the US post last week’s option expiry. There is a risk that they could flip from dampening markets to exaggerating their moves as Vix spikes up again. In that sense this is really all about short term technicals and noise trading. Meanwhile as Europeans complain that Russia is manipulating gas markets amid political panic about energy price spikes derailing the Zero Carbon political bandwagon, we see the reality that the West is composed of Middle Men looking to command a spread between buying and selling in controlled markets, while China, the Middle Kingdom, is not only building things that people want to buy, but is managing their economy along classical economic lines and puncturing bubbles rather than bailing out speculators. A different kind of sustainable investment opportunity.

Short Term Uncertainties

The Monday Morning Quarterbacks are all in today with a new narrative about Chinese Property, with the continued bad news about Evergrande over the weekend. Combined with a ‘crucial’ Fed meeting this week, the short term noise traders are all on the bear tack. Hong Kong this morning has seen the expected “short me a basket of developers” trade from short-term traders, but the hype about another Lehman or another LTCM (the latest one) looks wildly over-hyped.

In fact, what is really upsetting markets this week are the market mechanics of the options market – the usual boring technicalities that aren’t as easy a ‘story’ to sell as one about China real estate or inflation. And, as ever, it is best summed up in the Vix chart.

Chart 2. Friday’s spike in implied Volatility is the real story

Source Bloomberg, Market Thinking

As previously discussed, (after the March options expiry) when we get the triple and quadruple witching each quarter, there is always the danger of a flip in the gamma position of market makers – without getting too technical it means they can flip from stabilising market moves – selling rallies and buying dips – to exacerbating them – selling dips and buying rallies. Nomura’s Charlie McElligot, often found quoted on ZeroHedge lives and breathes this stuff for those interested. If you think of the Vix as the price of put options, then asset allocators worrying about a correction (which became a consensus on returning from holiday) will go out and buy puts for downside protection. All else being equal this pushes up the price (as reflected in the Vix). The market makers who sell them those puts will then hedge their books by selling the underlying stocks or index, which appears to be self fulfilling in the very short term. Usually however it tends to self-stabilise, as the market makers then buy back lower down. However, on occasion it can de-stabilise instead. There is another factor to bear in mind as well, which is the existence of the quants (as also discussed here previously) who are running low volatility risk parity strategies. If volatility rises, then they ‘automatically’ sell the underlying asset.

Medium Term Risks

Meanwhile, if you are of the “China is a speculative bubble dependent on US consumers” school of thinking (as many people appear to be), then this Evergrande event looks like your moment of vindication and they are rushing to appear on CNBC to say ” I told you so”. However, while there is no doubt that an awful lot of people really, really want this narrative of a massive hit to the Chinese economy to be true, that doesn’t mean that it is. If wishes were fishes as they say. In the real world, this view of China is approximately 20 years out of date, China has moved on, even if the bears have not. The Chinese economy certainly does have leverage, but it is not in the consumer sector and is also much, much less in the shadow banking system. This whole exercise is about a deliberate de-leveraging, not an accidental bubble bursting.

Also, as we noted last week, Evergrande’s problems can hardly count as ‘news’ and the only unusual thing about it is in fact the most positive thing about it; the Chinese authorities are not going to bail the company out, demonstrating instead an adherence to the Schumpeterian school of creative destruction that has been missing from ‘capitalist countries’ for many years now, if not decades. Equally the stories that Hong Kong developers are going to have to provide more affordable housing with the prospect of forced release of hoarded landbanks is entirely consistent with the CCP focusing on the needs of the 99% rather than the 1% and is a far better explanation of their price weakness than any ‘contagion’ story.

One of the main ways the China bears have tried to monetise their thesis has been through the currency markets. One of the biggest bears on China has been Kyle Bass, who comes from the school of having made money at the GFC and therefore is ‘right about everything’. Until they are not (see John Paulson et al). Kyle has been ‘calling’ the China collapse since at least 2016, but launched a fund last summer specifically to put a leveraged bet on HK dollar peg breaking by Christmas 2021 and apparently was using an eye watering 200x leverage according to this article. As far as we can tell, he has raised around $200m for this bet, so on 200x leverage that is $40bn to try and break the peg (for context that is twice the size of the offshore Evergrande Bonds). Realistically, the chance of this happening by year end and his ‘investors’ not losing all their money is even more remote than that of Hong Kong abandoning its zero Covid policy over the same period.

Others were shorting the the offshore Yuan (ticker CNY). The chart is somewhat confusing, for a ‘short position’ in this instance means that the rate rises since it means you get more Yuan for every dollar. The US hedge funds were basically betting that the rate would go from 7 to 7.9. Also highly leveraged. Eek.

Chart 1: Is short CNY the new Widow-maker trade?

Well the good news is that after this ‘crisis’ they are now only down 10% rather than 11.25% – assuming he has lasted this long, but clearly the FX market isn’t really buying into the collapse story. The reality is that China has $3trn in $ reserves and there is zero chance that they are going to let US hedge funds trash their currency. Perhaps these guys should have checked with George Soros about what happened last time he tried. They used to call going short the Japanese Bond Market the Widowmaker Trade. It’s looking like the CNY might be taking on that mantle. Meanwhile, the sell off in China stocks, not just the tech ADRs, but especially in mining and commodities stocks on the basis of a ‘collapse’, makes them look extremely attractive to those with a longer time horizon.

Longer Term Trends – The Middle Man versus the Middle Kingdom

The winds of change are blowing this Autumn, even if the actual winds in Europe are not, and beyond the excuses of Brexit and Covid, a lot of System failures are now being exposed. Perhaps most urgent for Europe is the energy situation, in particular the (over) promotion of renewables and the decommissioning of reliable generation from coal and nuclear and to some extent even gas. European governments have failed to fill up gas storage facilities, partly down to the obsession with green energy that has so captured the imagination of the political class – who are choosing to believe that the quoted capacity of renewables is actually there on anything but exceptional days – and partly down to poor speculation on pricing. In this, the politicians and civil servants have once again failed to learn the lesson of markets. We have talked before about ‘the china price’, the notion that China is so large that it can distort prices; when China wants to buy more of something the price rises, when it turns up selling something, the price falls. When it comes to energy, Europe has just discovered the Europe price, which is that they have no energy and thus no pricing power. Russia is now in the position of Australia selling iron ore to China; you want it? Well this is the new price. The idea that Russia should cut prices to allow Europe to fill up its storage facilities cheaply shows how far away from understanding markets ‘the west’ now finds itself. This is why we discussed the risk of being over-exposed to the failing industry (renewables) at the expense of the practical alternatives like gas and especially Nuclear.

Part of the problem is that the west has too many agents and not enough principals. It has become controlled by middle men looking to take a turn, or a spread or a fee based on some monopoly or quasi monopoly position. Lobbyists are everywhere. By contrast, the Middle Kingdom is based on more classical economic lines of production and exchange. And trade. The old concept of economic growth being down to returns on factors of production – land, labour or capital – provides a sensible framework to understand sustainability of returns. When more than 70% of the Assets of the S&P500 companies are so called ‘intangibles’ it is worth considering how much of the future return on those assets is a function of monopoly or quasi monopoly positions dependent on government regulation. If the US is no longer able to ‘set the rules’ for the world, then it is also no longer able to protect those monopolies globally, or increasingly even locally. In particular, the ability to sustain ‘middle man’ profits is under a lot of pressure. Investors could do worse than think about what happens when Crony Capitalism meets global competition.

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