Top Economist: We're In 9th Inning And 'Game Is Almost Over'

This article was originally published on Moneyball Economics.

Three weeks ago Southbay Research discussed China’s collapsing exports and trade, as well as the fact that further bank loosening was coming.

More recently on Moneyball Economics, we released a comprehensive review of recent semiconductor company earnings calls. We repeated the forecast of imminent yuan devaluation because the semiconductor companies were uniformly calling out a drop in Chinese exports and overall factory demand.

Now here we are.

Preemptive Strike: Yuan Devaluation

The problem facing China – and the rest of the world – is shrinking trade. China’s consumer market is big, but not big enough to offset drooping exports. The reflex is to export its way back to health. Just as Saudi Arabia keeping up their oil production to preserve market share, China will lower the yuan to keep a big chunk of the trade pie.

At heart there are two problems that China is trying to address. The first is how to increase exports. Currency valuation has been a problem for China because the yuan is pegged to the dollar and the dollar has been inflating in value for over a year. For example, the exchange rate today is $1.14 to the Euro vs. $1.40 just a year ago. The Chinese government believes that exports are being hit because the yuan is overvalued.

The currency-is-to-blame meme is mostly nonsense. For example, China isn’t competing with other countries to build iPhones, but at some level there is a shift of manufacturing away from China because labor costs have shot up under a more expensive yuan. Vietnam, for example, has cheaper labor costs and some manufacturing has been shifting there accordingly (mostly low-end assembly work). However, it’s very, very slight.

Also, some of China’s key competitors are in the same boat because they too peg their currency to the dollar (like Taiwan).

The other problem China wants to address is a sluggish domestic economy. Towards that end, the borrowing rates were lowered this week. That will inject liquidity into the system which should expand business activity… or so it is hoped.

Initially China will target a cut in the range of 5 percent-10 percent. In terms of trade, the initial 2 percent devaluation won’t boost exports. Anything less than 5 percent devaluation won’t move the dial, but any higher than 10% and inflation will come knocking at the door. (Thanks to falling commodity prices, a little inflation can be easily absorbed, but only a little.)

To get there, expect a series of cuts. China will wait to see global reaction before doing more. So far, the reaction has been dismal. The unintended consequence of China’s cut has been a crash in the US stock market. More Chinese cuts that hit the dollar and hurt the stock market will very much put a chill in US consumer spending, effectively undermining everything China is pursuing.

Currency Wars Are On

China is not alone in looking to use currency devaluation. Korea also believes that its export woes are due to a less-competitive won. But this is not a price-sensitive situation. Like everywhere else, Korea is in denial that global economic growth is slowing and that demand for its products is falling, regardless of price.

The simple fact that Korean businesses are pushing for a rate cut speaks volumes. Right or wrong, pressure is building to devalue the currency.

A Rate Hike? Now? Seriously?

The US economy can absorb a rate hike (5.3 percent unemployment!), but it doesn’t need one – there is no overheating (GDP 2.3 percent, Payrolls a mild 215K, Inflation 1.8 percent).

In fact, the economy is cooling down fast. Jobless claims have started to inch back up. Inflation isn’t just pulling back; cheaper oil is driving further deflation and disinflation.

More critical is the collapse in manufacturing – the catalyst of China’s yuan cut. Manufacturing New Orders have been contracting faster every month this year.

In 1H we saw the US economy weather an oil sector meltdown.

In the 2H there’s a broader hit coming from the manufacturing sector. The combination of a global slowdown forcing cuts to CAPEX (capital expenditures) and a monstrous inventory overhang point to one thing: slower hiring followed by post-holiday layoffs.

The oil sector’s crash was contained, with limited geographic and economic impact. However a manufacturing pullback will have a broader effect and be much more visible. More states are involved in manufacturing.

That brings us to one bright spot: consumer spending.

At the moment consumer spending is strong (the latest figures showed 0.6 percent growth). Better still, retail doesn’t include travel and recreation which have been on fire. However we expect consumer sentiment to turn a bit more bearish.

The average household is back from vacation only to see a deep drop in their 401Ks. As they begin to ponder winter vacations and holiday shopping budgets, stock market performance will play a greater role in their spending calculations. That’s especially true if job security concerns enter the picture as companies start to freeze hiring (a discussion already underway in the executive hallways because slower hiring always follows slower sales).

Slowing business activity, anxious consumers… a rate hike would be a disaster and tip the economy into a recession.

There may be strategic reasons for the Federal Reserve to raise rates – plan for a non-ZIRP world, or just prove that it can – but tactically it is a foolish thing.

Back To China

The People’s Bank of China is not done. It has to stay vigilant. The PBoC is watching to see how other bankers respond, and then they will unleash again.

The timing is interesting. If you wanted to get the best bang for your buck, you would time a yuan cut in early spring, when the manufacturing cycle is under way. As it is, it’s almost September and factories are beginning to wind down and holiday goods must be on the shelves by October. A yuan cut today would have about as much impact as discounting ice cream in the winter.

Why now? A lot of ideas have been proposed. For example, the IMF was preparing a review of the yuan and, in response the PBoC, wanted to enable more transparency.

More likely it was triggered by the horrible export data released the day before the markets opened in China. It was remarkably bad: exports crashed -8 percent. It’s not something that materialized out of nowhere. Since the start of the year, we’ve been pointing out a steady contraction in Chinese exports, and surely the Chinese government was even more aware. But it has also been careful to manage information flow. So China mixed good news with bad news to avoid domestic panic, essentially saying, “Yes, exports have collapsed, but they will go up as we cut the yuan.”

And it worked, briefly. However the stock markets are reflecting poor faith in the Chinese government’s ability to navigate these waters. The Chinese stock markets are down 40 percent in just two months, and that’s after the government tried to mandate a jump in the market. First China threw $1T at the market, and more lately sought out falling knife catchers in the form of pension funds which have been ‘encouraged’ to buy into the stock market.

Meanwhile, through currency devaluation, China is trying to mandate a jump in exports. It doesn’t work that way when trade is slowing.

What Comes Next

Expect lots of volatility until the Fed’s meeting in September. The Fed has created a lot of uncertainty with respect to its next move. It is incredibly out of step with other central banks, which are cutting rates. The Federal Reserve is also incredibly out of step with the US economy. Throughout the past few weeks of China devaluation, it’s been completely mute.

Until clarity is restored, gold and other fear assets will jump. You should be selling gold as we get closer to the Fed’s decision. On the one hand, a rate hike raises the dollar and deflates the price of gold. On the other hand, the absence of a rate hike adds clarity, which in turn deflates the anxiety driving up gold and similar assets.

Right now the markets are still digesting the fallout of the yuan devaluation. Plus they are finally having to price in the potential impact of a rate hike. Both have led to a flight to safety. Money heading to the exits initiated a secondary wave of deleveraging (the institutional term for margin calls). We are now caught in a vicious cycle where fire sales are driving more fire sales.

Eventually the markets will settle. Better still, we could see a bit of a market jump as the Fed turns dovish and indicates no rate hike. In previous reports Southbay Research has advised moving into cash and selling into strength; waiting for jobless claims to hit 280K before exiting completely. Southbay also considered a further 4 percent rise in the market to end the year at 2200. That train may have already left the station. A market rebound is likely in September (on a no-hike move by the Fed) but the game is largely over.

The economy has turned. It’s the 9th inning and the game is almost over.