Forget It Jake, It's China/Jeff Gundlach aka Macro Clown Jr.

Gundlach, a fellow Macro Clown?

Chuckling to myself at Gundlach throwing twitter shade at our very own Macro Man.

This is the same Gundlach who thought EM equities was going to fall 40% or more back in 2016. Oops. EEM has been up 40%+ since then. My Pnl is pretty glad I didn't listen to Gundlach on that one.

Now Gundlach has switched views, talking EM outperformance, citing valuation, growth differentials, and recent outperformance. Maybe he is secretly a fan of this blog - we'll know if he comes out soon endorsing a GBP long ;).

I'm not going to disagree with Gundlach here. But it's so key to anticipate while trading - the markets themselves are quick to discount, thus the best opportunities risk reward wise in markets are ones with high convexity/high gamma situations - those usually happen at the market turns. A lot of the easy money has been made in the EM trade.

Alright, alright. Let's get down to business.

Regardless of the blog topic, it seems like the comment section always reverts back to some talk about China. Thought I should take a look and see what the big deal is.

China has undoubtedly been the driver of global growth. The engine of said growth comes from China's once ever expanding (now recently, contracting) FX reserves. The FX reserves come from the country's trade surplus. The country uses the money to stockpile financial assets in the US and other countries, fueling economic growth.

When most people think China FX reserves - they immediately tie said thinking to US treasuries. However, I have on good word from an ex-SAFE Investment Company trader who was involved in the FX reserves liquidation, that they actually sold mostly emerging market assets during the move in 2014 to 2016.

I believe that was the main reason for emerging market decline we saw in 2015 (this was well telegraphed at the time). Back then, China was in a tightening cycle, in an attempt to defend against capital outflows and tried to reduce its spare capacity.

Looking at the world now, we are at a place where said decline in reserves seems to be bottoming. Whatever reserve contraction that has already taken place, should have been priced in.

Moving on to the different ways that the PBOC controls the Chinese economy. Such methods are numbered and in my opinion, byzantine.

The above are only some of the rates set by the PBOC - but from my understanding, the most important rate to watch out for is the 7-Day Repo Fixing. The majority of Chinese credit (from mortgages to hard money loans to credit cards) are tied to that 7-Day rate - we've currently seen a spike in said rate, hinting at a contraction of liquidity in China. The current spike is within historical precedence but should be monitored.

Looking at a few other indicators of liquidity, I do not see any canaries in this coal mine (....yet). M2 growth continues to decline as China seems like they want to lessen liquidity, but nothing out of the ordinary is evident versus the past couple of years. However, corporate lending rates are alarmingly elevated (over 8% for 1-day interbank corporate fixing) and look to be heading higher. This is by far the biggest concern I see.

Lastly, looking at inflation. Hot off the press after the latest print a day ago.

Don't see a big deal here yet. CPI is still very tame as food inflation has collapsed. PPI's spike in the past year has tapered off and came in below expectation. The recent PPI spike was due to China's policies to reduce spare capacity, and thus will be transitory. Overall, there doesn't seem to be a huge need for China to tighten in the near term from an inflation perspective.

With all things considered: long-term, China is looking to rein in misallocation of resources vis-à-vis bad debt and to stimulate more consumption as it tries to shift its behemoth economy from an export-driven one to an import-driven one. 

This means a couple of things: (Again keep in mind this is a very long-term phenomenon) a shrinking current account as trade surplus becomes a deficit. This, in turn, would increase the capital account, moving it from negative to positive - one way this occurs would be the liquidation of foreign reserves. 

Undoubtedly, our EM thesis will be put to the test if that occurs. As a shifting Chinese economy will have impacts globally - and we will see which is more negatively affected: the US or EM.

Hope this China post can spur some more lively discussion. Thanks guys,