China Strategy Overview

I’ve been somewhat prematurely congratulated on the success of my China strategy. Indeed, I have been vocally sceptic this year about Chinese stock market and currency. And given that I ALWAYS put my money where mouth is, it is natural for my followers to assume that I making “fortunes untold” on those trades.

The reality is that the trades I have been involved in this year have been, while profitable thus far, were by no means “slam-dunks” and may yet end being in the red.

The readers of my book “The Next Perfect Trade” have pointed out that the long USDCNH trade, for example, may not meet some of my criteria for a superior trade.

My book had been mostly completed before China came into focus. In this post, by popular demand, I will outline my approach to trading RMB and $FXI in the light of my broader strategies.

As far back as 2006, I have started to suspect that Chinese economy was a giant Ponzi Scheme destined for a collapse far more devastating than what happened to Japan in the 80’s.

To be clear: I don’t produce my own economic research, all I can do is listen to people and side with those who make more sense.

However, for years I have stayed out of betting against China, because I couldn’t formulate any bearish strategy that would fit my criteria. I’ve written before how difficult, in general, it is to be short a stock market and as for the currency – the appreciation trend had been overwhelming.

I have mentioned in my book that if you can’t a find a good trade to express a view, you may want to question the view. So despite, having a wrong view for almost a decade, I have escaped much damage by failing to find a trade fitting into my strategy.

By 2013-2014 the China troubles appeared more imminent to some experts, but my eyes were turned elsewhere. I saw tremendous value in being long dollar vs. yen and, later, vs’ euro. But my strongest conviction was in the long end of the US Treasuries curve, where I had a disproportionate risk concentration by the beginning of 2014.

According to my strategic language (which I explain in detail in my book) being long USDCNY  (betting on RMB devaluation) was, while attractive on its own, a strictly inferior trade with respect to other positions in my portfolio.

For the currency devaluation to occur, at least one, if not both of the following conditions had to be concurrently satisfied:

  • Broad dollar strength
  • Dramatic weakening of Chinese economy

My portfolio was already directly aligned with the first condition; and a massive Chinese slowdown was likely to affect the global risk appetite and cause a flight to the US bonds. Thus, in 2014, the currency bet was redundant to my portfolio and I stayed out.

In 2015, the game had changed: the dollar had already rallied and so had the bonds, making those bets no longer as superior. I was increasingly convinced by the arguments for the necessity of the Chinese credit cycle unwind. (I will omit the discussion of idiosyncratic pros and cons  – I have written on the subject enough and for further information read “A Great Leap Forward?” by John Mauldin and Worth Wray.)

Yet I was waiting for another shoe to drop: the stock market. I thought Chinese stocks screaming up would give the government a good excuse not to devalue. Yet without devaluation the equity bonanza was likely to end in tears.

So I got involved in two very uncharacteristic trades: long USDCNH (offshore bet against RMB; at this point it appears I might have done better with USDCNY) and short FXI (Hong Kong listed Chinese large cap). I chose to bet against the dollar expressed ETF, because I was hoping for an additional benefit in the event of currency devaluation.

But Chinese stocks were rallying and I had no intention to be wiped out by shorting into the bubble (I’ve written about this too). So my only “option” was to buy puts, illiquid and expensive as they were. And as the market continued to rally another 25% since I started, I kept adding more puts, but I was beginning experience pain.

Why would I get involved in buying options and in betting against a currency with positive carry? I have cautioned against both of those things in my book. There are times though when the risk-reward appears so skewed, that it is beginning to have the flavor of a “free lunch”. I decided that the opportunity was too great, and in the absence of the ability to structure a “no-lose” trade, I had to risk some fixed amount of capital.

Initiate the positions and run them to the bitter end. No hedging, no whining.

Not only my long dollar/long bonds came under pressure in Q2 of 2015, but the capital committed to bets against China was grinding away. Fortunately, I had been positioned with enough caution to keep all the trades.

Needless to say in Q3 things got much better.

But I want to emphasize that my entry points were not perfect and the trades are far from complete with my portfolio still leaking carry and decay. In fact, the extreme scenarios, I have been hoping for, HAVE NOT yet materialized.

The equity trade I think will be over soon one way or another. But I still see no way out of further currency devaluation, and I will continue to pay carry to stay in the trade. With the full understanding that the whole strategy may yet end up being a loser.

Chart Source: Yahoo! Finance

Image: Terracotta Army by Tom Wachtel

Currency regime changes: not the “How”, but the “What”.

Like the old Soviet Regime, certain market regimes seem to be entrenched so thoroughly, that it is impossible to visualize any mechanism, by which they can be dislodged. But the Soviet Union fell and did so in a fashion few could have foreseen.

Until only a few years ago, Japan appeared to be caught in the never-ending purgatory of deflation, sagging growth and capital markets, and meaningless reform promises. In 2012, the current account surplus was not scheduled to elapse for a few more years, and the market flows, according to strategists, continued to support the yen. And then the sudden collapse of DPJ and Abenomics. You know the story.

And you also know the story of the Swiss Franc. First it was immovably pegged at a too weak 1.20 exchange rate to the euro. Then the immovable and indestructible peg suddenly evanesced. The franc briefly rallied above parity, which was way too strong. It appeared that the SNB had no means to control the currency appreciation. Until they did. And guess what? EURCHF drifted to somewhere in between 1.00 and 1.20. Probably where it should have been to begin with.

You probably can see where I am going with that. If general economic principles and historical patterns dictate that something has to happen, it probably will. Even if you see no possible mechanism to drive the transition.

Which, of course, brings us to China. In my post 

from June 13, 2015, 

I reviewed a book by John Mauldin and Worth Wray A Great Leap Forward?

 I conceded that both China bulls and bears were making strong points. And with regards to currency I was giving heed to both those who said that a massive devaluation was inevitable and those who pointed out the imminent deval was neither necessary nor in the interest of the government.

There were few precedents to establish how price and credit overextensions unwind in tightly controlled communist/capitalist markets.

Personally though, I leaned to the bearish case for both equities and currency, based on the historical pattern for countries with credit growth excesses. Until proven wrong, I had to assume that the “what” of the equities correction and currency deval, even if I didn’t know the “how”.

And given that I ALWAYS put my money where my mouth is, my strategy did not permit me not to trade accordingly. 

It was not cheap and my timing was not perfect. And today it is too early to celebrate victory: all my gains are reversible.

Now what? Do I stick to my guns and expect more of the same?

If you were wondering why I haven’t posted any anything extensive on the RMB devaluation thus far (I suspect you have better things to do than to wonder why I don’t post): I had relatively little to contribute to the discussion. I don’t have a clear idea why they did what they did and what their long-term plan is.

So in the absence of such insights, I have to stick the fundamental principle which drove the China trade, as well as other examples above:

Unsustainable will not be sustained.

If you see a major dislocation what have to bet on it eventually being rectified, even if you fail to understand the mechanism of the shift.

One of the reasons I prefer simple directional trades is because the “what” of the market is often easier to discern than the “how”.

And with the respect to China, if (and that’s a big if) you believe that the major dislocations are still there, it is reasonable to assume that they won’t be fixed by a 5% currency move. And so, regardless of what the authorities may have in mind, the odds are skewed towards further devaluation.

Chart source: Yahoo! Finance

Image: The Unstoppable Wave by Theophilos Papadopoulos

Greece and China: Crisis doesn’t happen on schedule.

It has been a fun weekend. Between the escalation of Greek crisis and the surprise liquidity measures in China, it was as if the market never closed.

When considering market significance of a geopolitical event, it is important to distinguish between

  • The actual economic effect
  • The immediate impact on market players

In the case of the on-going Greek debt crisis and the potential so-called “Grexit”, remember that Greek economy commands only about 2% of the Eurozone GDP. Whether Greece muddles through or exits, the long-term economic impact should be moderate.

Two points that have been made by multiple people:

  • Greece exit might create a blueprint for an exit by other countries on the periphery, such as Portugal or even Spain.
  • Eurozone might be actually economically better off and the euro incrementally stronger without Greece.

What concerns me now though, is whether whatever happens in Greece may trigger a market panic or even a new crisis. There I encounter the “positioning” conundrum.

Paradoxically, it is easier to describe what would happen to the  markets in the aftermath of a completely unanticipated and destructive event such as 9/11. We would expect a sharp equities sell-off, a flight to U.S. Treasuries and to defensive currencies such as dollar, swiss franc, and yen. The reason is that if market players are not positioned for this particular event, it is easy to guess what they would do.

But when an event was in the making for five years, the prediction is much harder. The “buy the rumor, sell the fact” paradigm comes into play. If we assume that most of speculative money was already positioned defensively with respect to Greece, any resolution may come as a relief.

But let’s go to the next level. If the speculators anticipate the post-resolution relief rally in Greek bonds and stocks, they may actually not be positoned defensively.

You know that I know that you know…

A parallel begs to be drawn with the Russian crisis of 1998. Russia didn’t default exactly overnight. But market players were anticipating either default or devaluation of ruble, not both. Caught by surprise, over-leveraged hedge funds folded like dominos, liquidating all positions, good or bad. Everything, from swap spreads to implied equity vol to municipal bonds went into a crisis mode.

So the question we have to ask ourselves is not just what exactly going to happen to Greece, but how is the “fast money” positioned.

Greek banks are not opening on Monday.

Stock market is likely not opening.

Virtually nothing should surprise us on Monday morning. Not a huge market commotion, not a relief rally,  and not even business as usual.

Generally I am a fan of the concept that “crisis doesn’t happen on schedule”. We have learned it after the Y2K. And we knew in advance, about all the deadline for Greece and the dates for Brussels summit. 

As I write this on sunday afternoon in California, the euro is down moderately (1.5-2%) and US Bonds are rallying quite a bit. My usual intuition would be not to get overexcited and stay with my core positions without adding anything. Which happen to short euro and long bonds as all my readers know.

If anything my bias would have been to expect for things to calm down and pull back to normal on Monday.

However, for me China is the enormous extra variable in this equation. I have tweeted earlier that extraordinary measures taken by the PBOC over this weekend indicate to me that might more problems there than it looks from the outside. Indeed, the correction in the stock indices like SHCOMP which are still tremendously up on the year is hardly a disaster by itself. But the aggressive central bank’s response may instill further doubt rather than inspire confidence.

But beware of contagion! Risk aversion in Europe may spill into Asia and converse. And when it comes to positioning in China  – I have a feeling – the majority market players expect the government to be able to back-stop any crisis.

This type of confidence has been a path to disaster over and over again in the course of history.

My readers know me as a general global growth and economy bull. I don’t cry “crisis” often. But the confluence of events over last few days is making me view risks as highly elevated.

China: You have to know the rules to play the game.

Here’s the deal: I am a trader, not an economist. I have no qualifications that would allow me to dig up any data that others don’t have or create innovative econometric models. What I am good at (I think) is coming up with trading strategies given an economic paradigm.

The USA has been my bread-and-butter for many years. Some find it challenging to operate in such transparent and well-researched market; they bemoan the lack of informational advantage. I am very happy with the lack of informational disadvantage. When it comes any broad domestic market, I can rely on widely available research to formulate my strategies. In fact, I don’t even have to read in-depth any particular research – a mere osmosis gives me sufficient idea of what is going in the United States. Following any given researcher closely accords more of this person’s opinions and little in a way of informational advantage.

This way of thinking has been leaving me in the dust when it came to China. The future of this country is one of the largest (if not THE largest) variables which will affect the course of global economy. And I have been at a loss of how to formulate a China strategy for over a decade. Any trade I could conceive of left me at a huge informational disadvantage.

The problem is dual. Any official statistic coming out of China is unreliable. But even if I had the correct numbers, I wouldn’t know how to interpret them: Chinese party-controlled society needn’t obey the same causality laws as a true free market economy.

The hodge-podge of conflicting opinions on social media was very confusing and I have been having hard time distinguishing between biases (including my own) and hard facts.

It was like playing poker without knowing the hand rankings.

This is why, I have so much looked forward to a comprehensive modern book on Chinese economics. Yes, modern. I didn’t need a review of the Ming Dynasty politics, but a systematic professional presentation on what is going on now.

John Mauldin and Worth Wray, the creators of the anthology A Great Leap Forward? didn’t disappoint. The editors, as well as their contributors, are not afraid to state their opinions, but what distinguishes this book is the intellectual discipline of separating those opinions from facts.

The anthology engages China sceptics and optimists to deliver every point of view to a reader.

China bears tend to focus on ballooning credit growth problem, mounting inefficiencies, and pressures on the RMB carry trade. Meanwhile, the bulls talk about the unique positioning of China, its potential to technologically leapfrog the West, and the government being on the right track to conducting the necessary reforms.

Yet the book’s discourse on China cannot be characterized as simply a battle between two opposing camps. The interaction of economic and geopolitical scenarios creates a non-linear set of outcomes. The contributors all realize the underlying uncertainty, but they assign different probabilities to various possible paths for China.

The styles of chapters are as diverse as opinions: some are very technical and some read like excerpts from a geopolitical thriller. Fortunately for a non-professional reader, the editors present a summary for every chapter, which allows one to decide where to focus their attention.

There was a bit of tough love for me. l did not finish this book with a clear plan or strategy imposed, rather I was given the facts and arguments and will have to come up with my own decisions. It is more daunting, but in the end, this is the way I prefer it.

Those who follow me may have noticed that my tendency is to side with China sceptics. I do have three inherent biases:

  • I am sceptic of any government being able to retain control, as they manage economic transitions.
  • I have very low respect for Communist ideology and the ability of Party to control corruption.
  • I have observed Chinese historical tendency to self-destruct each time they have risen to dominance.
  • A Great Leap Forward helped me to see past those biases and remember that

    • On one hand, the current positioning of China is truly unique and unprecedented.
    • On the other hand, there are examples of authoritarians rulers successfully implementing economic reforms (Pinochet’s Chile and Peter the Great’s Russia come to mind).

    The next step is to parse what I’ve read, discover undeniable common threads, and to find asymmetric macro bets.

    For example, the opinions on the imminent RMB devaluation range from near certainty to very low likelihood. But this is where I can get useful takeaways.

    Assume I believe the estimate of a China optimist and relative RMB bull that chances for this year are:

  • 75% no deval
  • 15% small deval
  • 10% large deval
  • An economist in my place would say “my forecast is no deval”. But as a trader I say “there might be limited downside, positive expectation bets on deval”.

    Or, when a contributors thinks that in the event of continued dollar appreciation RMB will deval slightly against the dollar, but perform well against other currencies, I say “Aha, I can have a low risk bet on strong dollar via shorting RMB”.

    So, I am still leaning toward the sceptics, not because I am certain they are right, but because they offer positive expectation bets that can have an additional benefit of protecting portfolios in the event of China-induced global slowdown.

    A Great Leap Forward is a must read for anyone whose financial fortunes are in any way linked to China (which is by now almost anyone).