Why Is Everyone So Bearish? The Bull Case – Stray Reflections by Jawad S. Mian, Stray Reflections – Readers can find a full report below – reposted with permission

Why So Bearish?

Judging by our conversations with market participants, global investors are short conviction and long fear. For every bullish interpretation of market developments, there exists an equal and opposite bearish one.

Confidence remains fragile and investors are extremely wary of embracing risk assets. Citi strategists claim the world economy is trapped in a “death spiral.” RBS has recommended that investors “sell everything” in what will prove to be a “cataclysmic year.”

In this special issue, we attempt to separate the signal, or the underlying economic and market trend, from the noise.

Betting On Apocalypse Now

Three fears seem to be influencing market psychology: 1) the prospect of a sizeable devaluation in China’s currency, 2) contagion from the oil price collapse, and 3) the threat of a US or global recession. Taken together, these risks have the potential to cause a cascading decline across various risk assets.

[drizzle]

As it is, markets are trading as if something bad is about to happen.

Why Is Everyone So Bearish
Why Is Everyone So Bearish

To appreciate the complex investment landscape, we must begin with the single most important macro variable: the US dollar.

The duration and magnitude of the dollar advance has not been seen for several decades. This is sending a signal of tightening dollar liquidity, which is generally bearish for asset prices.

Emerging markets (EM) are more vulnerable to tighter global funding conditions than developed markets and are suffering as a result, especially given the rise in debt levels and falling returns on capital. EM stocks have fallen 43% in US dollar terms since 2011.

Why Is Everyone So Bearish

To appreciate the complex investment landscape, we must begin with the single most important macro variable: the US dollar.

The duration and magnitude of the dollar advance has not been seen for several decades. This is sending a signal of tightening dollar liquidity, which is generally bearish for asset prices.

Emerging markets (EM) are more vulnerable to tighter global funding conditions than developed markets and are suffering as a result, especially given the rise in debt levels and falling returns on capital. EM stocks have fallen 43% in US dollar terms since 2011.

The $800 billion decline in China’s FX reserves is seen as proof that authorities no longer have control of the economic situation. The prevailing wisdom is that China must now devalue its currency to boost growth. Hedge funds have declared “war on the renminbi” and are betting on a 30-50% decline.

In 2015, the renminbi fell 5.8% against the dollar, although it rose 0.9% against the RMB index, a trade-weighted basket of 13 currencies.

A year ago, we had concerns about how the dollar bull market may end. In our February 2015 issue, we wrote:

In our current experience, the dollar bull-market has followed a rotational pattern. The first up-leg was primarily driven by a falling Japanese yen in 2012, followed by a decline in EM FX in 2013 after the taper announcement, a crash in commodity FX in 2014 with the oil market rout, and recently the fallout in the euro in 2015. Could the Chinese renminbi be the final shoe to drop?

If China devalues, all hell will break loose. The global economy will fall of a cliff, stock prices will slice in half, and oil will trade in the teens.

It is no coincidence that oil prices peaked in June 2014, just as the dollar began its incredible bull run. Over the past eighteen-months, the dollar and oil have been joined at the hip.

If oil falls any lower from here, the contagion can prove destabilizing, as it will threaten credit markets and dramatically deteriorate the outlook for commodity-based economies, which represent 21% of global GDP. There are already concerns about loan defaults and bankruptcies in the US shale oil patch. The widening of credit spreads is a warning shot for the credit cycle.

The strong dollar and commodity fallout is hurting global manufacturing activity. Investment, orders, shipments, and output are all in recession territory, seeing as energy and mining account for 40% of global capex.

The impact of the dollar bull market is also apparent at the corporate level with US profits struggling in the past year. We have already had three consecutive quarters of year over year earnings decline. According to Hedgeye CEO Keith McCullough, stocks have always crashed when US corporate profits go negative for two consecutive quarters.

Why Is Everyone So Bearish

Lastly, to make matters worse, who the hell hikes interest rates with the dollar at a 13-year high and in the midst of a manufacturing and profits recession?

The Fed usually begins to normalize monetary policy when the unemployment rate is higher and there is ample room for a recovery in earnings. In contrast, the Fed has begun the tightening process much later compared to past cycles, and while global risks are clearly on the rise.

Consequently, markets seem intent on humiliating the Fed. The S&P 500 fell 15% from the record high in May.

Mix it all together, and these macro forces, set in motion by the unrelenting rise in the US dollar, are pushing the world closer to a tipping point.

Sell everything?

Why Is Everyone So Bearish

China: WTF?

For as long as we can recall, there has been a parade of endless calls for a China hard landing. While it is possible that 2016 is the year it happens, our analysis suggests otherwise. We find evidence of stabilization in the Chinese economy, which is being overwhelmed by negative investor sentiment. Most economic data looked worse last summer, than it does now.

The weakest parts of the economy are concentrated in the “rust belt,” where heavy industries related to construction and resource extraction are based. In those five northeastern provinces, GDP growth is less than 4%, and unemployment is likely higher than the national average.

Why Is Everyone So Bearish

But the fast development and strength of the services sector has to a large extent offset the impact of the downturn in manufacturing. Last year, services and consumption accounted for more than half of China’s GDP. A bet on a hard landing is a bet that all of the trends listed below will turn negative.

China faces a structural slowdown due to a peak in the investment rate, changes in demographics, and the base effect. That’s important. But economic rebalancing, driven by healthy consumer fundamentals, will ensure the deceleration is gradual. Income growth is more than 6% in real terms and consumption equals roughly two-thirds of GDP growth.

We believe China’s trend growth rate will be about 5% through 2020. Old China (manufacturing and construction) will grow at 2-3%, as state-owned enterprises retrench and slowly shutter overcapacity, while New China (services and consumption) will grow at 6-7%.

Private firms will increasingly drive growth as they become the backbone of China’s economy. Already, Matthews Asia estimates more than 80% of employment and all new job creation comes from private firms.

This brings us to why a renminbi devaluation does not make economic sense for China:

1) A cheaper currency is of no benefit as the Chinese economy is no longer reliant on exports. Exports haven’t contributed to GDP growth for the past seven years. Exports as a share of GDP peaked in 2006 at 35% and stand at 22% today.

2) China is not uncompetitive. Given productivity gains, there is no evidence of currency overvaluation. Even as the renminbi appreciated 58% in the last decade, China’s market share of global exports kept rising.

3) A big drop in the value of the renminbi would act as a tax on consumption, and reverse much of the progress policymakers have made in rebalancing thus far.

4) The purchasing price index for industrial inputs, or PPI, has been stuck in deflation for almost four years. But this reflects lower commodity prices rather than domestic issues. The core consumer price index (CPI) was up 1.6% last year, on par with the historical average. A large-scale devaluation would extend the commodity bear market and worsen goods price deflation.

5) A one-off devaluation would not suddenly cure China’s main problem of excess capacity (and associated debt) in a number of sunset industries.

We are dumbfounded by the notion that China must devalue to escape a hard landing. From our vantage point, the only way China experiences a hard landing is if they surprise with a large-scale devaluation.

There is, of course, a third argument. Even if China does not want to devalue, they will be forced to regardless because of massive capital outflows.

Let’s first consider this in the shadow of the last major EM crisis.

By 1997, Asian countries had built up large foreign debts. Currency devaluation was sparked by “hot money” outflows driven by foreigners. In contrast, China maintains a very low relative level of external debt (estimated at $1 trillion), and foreign investment flows into China are still positive (new FDI grew 5.5% in 2015). Basically, China 2016 is different than Asia 1997/98.

It is surprising how little attention is being paid to understanding the nature of capital outflows. Based on our review, no single factor comes close to explaining how money is “vanishing” out of China.

We make some observations about the outflows and try to dissect the $800 billion fall in China’s FX reserves to dispel some of the myths:

1) Looking at the consumer spending data (on page 6), we do not get the impression that the people of China feel pessimistic about the trajectory of their economy. We doubt Chinese money decided to vote with its feet.

2) Capital controls limit Chinese citizens to taking out $50,000 a year out of China. Considering average household wealth is $60,000, and that out of the 50 million active brokerage accounts, 73% hold less than $15,000, while fewer than 1% have more than $1 million, we find it hard to imagine this as the source of capital outflows.

3) Mis-invoicing is surely partly to blame. Firms can spirit funds out of the country by understating their exports and over reporting their imports. But with China’s trade surplus at a record high, up 55% to $595 billion in 2015, this leaves us scratching our heads.

4) At least $150 billion reflects a net repayment of foreign debt by China’s corporate sector. This is actually prudent debt management.

5) Valuation adjustments due to exchange rate changes account for $200 billion. China’s FX reserves peaked in June 2014 at $4 trillion, just as the dollar began to rally against other major currencies.

6) Using the current account surplus ($270 billion) versus the merchandise trade balance ($600 billion) to compute outflows is more rigorous as China runs a service deficit. Most analysts don’t do this, and thereby overstate capital outflows.

The remaining drop in FX is likely due to Beijing’s intervention in the offshore renminbi market, and an adjustment of the mismatch that builds up in the foreign exchange market due to “termaillage” (leads and lags in trade settlements which created a “float” that artificially boosted China’s FX reserves). Contrary to what the headlines insist, this is not all bad news, and certainly does not suggest a loss of confidence in policymakers.

China is not on the verge of a major financial reckoning. We believe the market is exaggerating the extent of capital flight out of the country. An assessment of the factors driving the decline in China’s FX reserves implies that the depletion will gradually wane. The corollary is worries about China’s economy and its currency are set to dissipate.

Why Is Everyone So Bearish

See full PDF below.

[/drizzle]