Chinese stocks enter bear market

Markets can only be described as fickle as they gyrate back and forth depending on the latest news or earnings report and as a result direction is changing not just daily but also intra-day.  Investors in most asset classes will continue to focus on stocks especially the recently underperforming Chinese equity market (Shanghai A share index) which officially moved into bearish territory after falling by over 20% from its early August high. 

Various reasons for the drop can be cited including regulator’s curbs on the stock market, high valuations, absence of new fund launches, limits on institutional buying,  high level of new accounts adding to volatility, tighter regulations on real estate, etc, but whatever the reason the direction has been clearly downwards and the impact is being felt across markets.

The turnaround in equity markets during Wednesday’s sessions was dramatic and was led by the turnaround in Chinese stocks which dragged other Asian bourses down with it.   This outweighed any positive sentiment from Market positives so far this week including a strong reading for the German August ZEW survey which surpassed forecasts by a large margin.  This followed the extension of the TALF by the Fed, and a jump in the US Empire manufacturing survey at the beginning of the week.  

Aside from weaker equities the usual FX beneficiaries including the dollar and yen strengthened on the back of the Chinese stock rout.   S&P’s affirmation of China’s credit ratings and positive comments from China’s stats office about the economic outlook in the months ahead  failed to support sentiment.  This would have been expected to provide a positive backdrop for Asian markets but Chinese stock market jitters provided a strong headwind to local markets. 

Overall most measures of risk have seen a substantial improvement over the past few months but there is no doubt that nerves are creeping back into the market.   This time the nervousness is coming from China and worryingly it is swamping the effect of any good news on the global economy and earnings.   This may prove to be a blip on the long road to recovery in risk appetite but it is difficult to ignore such a sharp fall in Chinese stocks without looking at the potential contagion to other equity markets.  

On the FX front those currencies that are most correlated with risk aversion such as the Australian dollar, New Zealand dollar, South African rand, Indonesian rupiah, Brazilian real and Mexican peso will gyrate in relation to the moves in risk appetite.   These currencies have had the highest correlations with risk aversion over the past month and in the current environment will come under some pressure at least until risk sentiment changes again, which in this market could happen at any moment and without warning.


All eyes on Chinese stocks

Equity markets extended their declines overnight as European and US stocks were smacked across the board.  One of the biggest pull backs has occurred in the Chinese stock market where stocks are down by around 17% since early (3rd) August although stocks are still up close to 73% on the year.  Some of this could be on fears of monetary tightening in China as well as missed profit estimates. 

Risk trades were sold and the dollar and yen strengthened whilst bond markets continued to rally.  News that contributed to the move could have included a sharp 35.7% YoY decline in FDI flows to China in July as well as a broad tightening of lending standards in Q2 according to the latest Senior Loan Officer survey by the Fed.  In contrast there was some positive news on the manufacturing front as the US Empire manufacturing survey jumped 13 points to its highest reading since November 2007. 

The Fed announced that the TALF with a capacity of as much as $1 trillion will expire on June 30 rather than December 31 but for other asset backed securities and CMBS sold before January the plan was extended by three months.   This extension failed to prevent a drop in financial shares overnight with the S&P financials index down 4.2%. 

Commodity prices also extended their drop, with the CRB index now down by around 5.6% since 5 August.   This will continue to play negatively for commodity currencies including the Australian, NZ and Canadian dollars, with the currencies looking vulnerable to more downside today.   Expectations of rising oil inventories and a firmer dollar tone are also playing negatively for commodities. 

Some relief may come today from firmer economic data expected in the US and Eurozone.   US housing starts and building permits are set to reveal further signs of stabilisation in the US housing market whilst the German ZEW survey will rise in August on the back of better economic data and past stronger equity market performance.  It is debatable how much economic data can help counter the worsening in equity sentiment but it may at least provide a semblance of relief.  

The dollar index is trading around the top of its recent range and sentiment for the currency has clearly become less negative as reflected in the latest CFTC Commitments of Traders Report which showed a sharp pull back in net aggregate dollar short positions in the latest week.  

Nonetheless, the dollar is likely to show little inclination to break out of its recent ranges against most currencies.  Overall FX market attention will focus on the Shanghai composite to lead the way in terms of risk appetite and overall direction. Thin holiday trading will leave the markets prone to exaggerated moves over the near term.

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