July 2015 – Monthly Commentary

July 2015

The capital markets continued to demonstrate heightened volatility as investor appetite for risk vacillated between insatiable and intolerant.

Given the surprisingly hawkish tone of the July Federal Open Market Committee statement, we were surprised that the news took a back seat to the plunge in Chinese stocks. The Chinese stock market had been on a tear since late last year, with the broad indices rising more than 50% through June. The Chinese media has reported that there had been an explosion in the growth of retail trading accounts as the Chinese population rushed to get in on what seemed to be easy money. Reminiscent of the dot-com trading boom in the U.S., participants ranged from uneducated workers mortgaging their homes for trading capital to dirt poor farmers abandoning the fields to trade stocks. The buying frenzy peaked in June and almost immediately fell into freefall. By July 6th, the major indices had given nearly all of the gains back. Fearful of the effect of further losses on broad economy, Chinese government officials suspended the trading of most issues and banned selling of those stocks still trading. Several institutional asset managers were told they were no longer permitted to trade Chinese shares. Coinciding with the selloff in Chinese shares, commodity prices have fallen sharply. The assumption is that the commodity swoon was related to the Chinese market with two differing explanations. The first was that macro hedge funds were betting that the Chinese stock market crash would further slow growth in that economy which, in turn, would ultimately crush demand for commodities. The second theory also pointed to hedge funds with the assumption that the funds held leveraged derivative positions in Chinese stocks and were forced to sell their commodities to meet margin calls. We suspect there is a bit of truth to both. What’s certain is that the Chinese government has fully assumed control of their capital markets. In addition to mandating that equity prices don’t go down, they are again maintaining absolute control of the Yuan versus the U.S. dollar.

The dislocation comes at an inconvenient time for the Chinese, as they have applied to the International Money Fund (IMF) to be included in the IMF Special Drawing Rights (SDR) basket. Inclusion in the SDR would afford China the prestige of being considered a reserve currency. Given that they have become a leading exporter and hold significant amounts of foreign reserves would argue that they meet the requirements of being a reserve currency. IMF Managing Director, Christine Lagarde has said that she is in favor of the inclusion of the Yuan in the basket. The trouble is that explicitly rigging their equity and currency markets is not emblematic of a reserve currency. The IMF had until the end of this year to decide on inclusion. Deciding that it would be unlikely to include the Yuan in the SDR with the Chinese markets in such disarray, the IMF announced that they are considering extending the review until September 2016. Such an extension would give the Chinese central planners time to step back from market and currency manipulation. The problem, as we see it, is that there likely remains pent up selling that would cause further losses should the government allow the markets to trade freely and, hence, the government will be very slow to end the tactic. Their actions lead us to conclude that they don’t understand the role confidence plays in the determination of asset prices. In banning selling, they have removed that element of confidence, and with it people’s desire to invest. That loss of confidence may cost them inclusion in the SDR for the time being.