Complex Made Simple

Will the June rally in global equities end in tears at Osaka G-20?

The macroeconomic logic of a weaker Chinese yuan is irrefutable and the repercussions will be felt far and wide

There is another macro risk ignored by the financial markets. The US-China trade war is about to escalate into a currency war The Korean won, the Taiwanese dollar, the Malaysian ringgit and the Indonesia rupiah would come under speculative attack Expect the Federal Open market Committee (FOMC) conclave on Wednesday to not cut the Fed Funds rate

By Matein Khalid: Chief Investment Officer and Partner at Asas Capital   

Leon Trotsky once said, “revolution is unthinkable until it becomes inevitable”. Are we witnessing a revolution enacted in the streets of Hong Kong and what will be its end game for the Chinese Communist Party?

The sight of 2 million Hong Kong citizens protesting the extradition law evokes an eerie feeling of déjà vu in me thirty years after the Tiananmen Square massacre on June 1989, when idealistic young students in the heart of Beijing challenged the autocratic power of the same totalitarian Marxist-Leninist dictatorship that has ruled China since October 1949. Yet the peaceful student revolt ended in a horrific massacre once Paramount Leader Deng Xiaoping ordered the tanks of the People’s Liberation Army into Tiananmen Square.

Hong Kong Chief Executive Carrie Lam has actually capitulated to the demands of the protestors to scrap the extradition law and preserve the illusion that “one country, two systems” still governs the geopolitical umbilical cord that ties the former British Crown Colony to Mainland China. This capitulation in Hong Kong is a monumental loss of face for President Xi Jinping, the single most powerful “Red Emperor” to rule China since the death of Chairman Mao Tse-tung in 1976. President Xi Jinping’s legitimacy, his Confucian mandate of heaven and chokehold over the Communist Party, the military and the Politburo has been compromised by the black swan “Hong Kong spring” of 2019.

More by Matein: Saudi Arabia and the calculus of petro power

This makes it even more unlikely that Xi, in turn, will offer concessions to Donald Trump at the G-20 summit in Osaka, Japan. A deal is all the more unlikely since 2019 happens to be the seventieth anniversary of the creation of the People’s Republic of China by Chairman Mao. A mood of visceral nationalism has swept across China, as reflected in the orchestrated campaign to fire my erudite friend UBS Wealth chief economist Paul Donovan over a non-issue deliberately twisted by his critics as a racist slur against Chinese people. Paul is not a racist, au contraire, he is a gentleman to the core and shame on UBS for forcing an innocent man to take a leave of absence for a crime he did not commit.

There are profound market implications for the political tai fan (“big wind”, the root of the English word typhoon!) in Hong Kong and Beijing. The financial markets have priced in a swift resolution of the US-China trade dispute, akin to Trump’s U-turn on Mexican tariffs. This is simply not credible. President Xi Jinping will opt for economic nationalism, sovereign prickliness and political intransigence at Osaka, evoke Sun Tzu and Mao, not the Art of the Deal.

There is another macro risk ignored by the financial markets. The US-China trade war is about to escalate into a currency war, a global game of monetary chicken between Beijing and Washington. China’s Politburo will instruct the People’s Bank of China (PBOC) to slash the reserve requirement ratio for its largest banks by 100 basis points. This will trigger a plunge in the Chinese yuan, already at its weakest level against the US dollar since 2008, to well below the psychologically significant exchange rate of 7. As the Chinese yuan falls 7.3 or even 7.4, the Trump White House and Congress will seethe with rage, try to declare China a “currency manipulator” and impose punitive foreign exchange tariffs.

More by Matein:World financial markets are at an inflection point in mid-June 2019

The Korean won, the Taiwanese dollar, the Malaysian ringgit and the Indonesia rupiah, Asian economies most dependent on exports to China, would come under speculative attack. The world will see a swift, brutal spasm of intercontinental contagion across the emerging markets, as we witnessed in August 2015, January 2016 and the final quarter of 2018. The macroeconomic logic of a weaker Chinese yuan is irrefutable. Chinese GDP growth has slowed to 6.2%, the lowest since 1990, the lowest in a generation. Trump’s tariff threats will have a devastating impact on Chinese exports to the US. China’s President will weaponize the renminbi as an instrument of economic/foreign policy, just as President Trump has weaponized the US dollar, the US banking system and US trade/investment policy as instruments of a new Cold War.

The MSCI emerging market index has derated in its valuation metrics from 13 in late 2017 to 10.4 times forward earnings in June 2019. Yet if Osaka does not lead to a Trump-Xi handshake, a 20% fall in emerging markets will not be a macro strategist’s idle midsummer nights dream. That much, at least, is certain.

Fiscal stimulus and monetary tightness are the historic twin pillars of a currency bull market, such as the Reagan-Volcker dollar of 1981-85 or the Deutschmark after the fall of the Berlin Wall and Chancellor Kohl’s decision to bail out East Germany (DDR) with an Ostmark parity exchange rate. Yet fiscal headwinds and monetary easing lead to a potential depreciation in a currency, as is the case with the US dollar in June 2019. Yet while King Dollar is up 30% since the summer of 2014, it can well decline 10% on its trade-weighted index in the second half of 2019.

Despite the dismal 75,000 May non-farm payrolls and mediocre wage growth, retail sales resilience helped arrest the US dollar index’s fall below 97. As I recommended last week, the Mexican peso was the star in emerging markets, up 2.5% against the gringo greenback on Trump tariffs U-turn euphoria.

More by Matein: Making money in the US Treasury bond yield curve panic

I expect the Federal Open market Committee (FOMC) conclave on Wednesday will not cut the Fed Funds rate but Chairman Powell will jawbone easy money sweet whispers to the capital markets. The Fed could even signal a July FOMC rate cut, as priced in by the Chicago Fed Fund /Eurodollar futures markets. Wall Street smart money is confused. Pimco expects three rate cuts in 2019, Goldman expects none. There could also be bombshells from the ECB annual forum in Sintra or the Bank of Japan’s MPC huddle conclave in Tokyo. Yet the real event risk for late June is Trump and Xi failing to reach an accord at the G-20 in Osaka. If this happens, all bets are off and it will be time to fasten seatbelts and brace for the mother of all risk aversion spasms!