“History is a nightmare from which I am trying wake.” – James Joyce, “Ulysses”

Summary: The destruction of margin trades and the path of a subsequent global volatility spill via a depreciating RMB distinguished the burst of the “Great China Bubble” in June 2015. One year after the crash, China’s stocks, bonds, property and currency are still expensive. The significant divergence between traditional risk indicators that suggests risk aversion and recent strong return of risk assets hint at a looming global volatility surge. Brexit, the Fed and the PBoC’s Circular 82 can be the potential triggers. Indeed, buried in the ruins of the crash is the fact that Shanghai tends to presage global volatility events by roughly one year.

Bond yields at record low and surging property prices in the face of a depreciating RMB are the weakest links. The property price cycle, as measured by the change in average national prices, will soon peak. Banks’ efforts to dodge various PBoC circulars directed at “shadowy banking” suggest actual leverage and financing costs are high. And falling investment returns due to frothy asset prices make this setup ever more unsustainable. 

Shanghai is still ~17% above the theoretical bottom support level of 2,500. But Hong Kong is trying to heal. That said, a surge in global volatility will inevitably affect China. The RMB, on the other hand, has reflected a lot of bad news, although it will remain volatile. The effects of supply-side reform will come in waves to relieve the oversold commodities. Gold will shine in this increasingly uncertain environment.

（这是今天盘前报告的英文版，中文版《伟大的中国泡沫：周年的领悟与展望》稍后发表)

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The origin and the burst of the “Great China Bubble”: One year after the burst of the “Great China bubble”, China’s stock market perches like an old ruin on the verge of the world. The sound of silence from those once-boisterous trading floors is echoed by the vast recesses of a harrowing year. Market turnover is now a fraction of its peak that used to dwarf all of the world’s greatest stock exchanges. Due to the restrictions on index futures trading, futures at the long end are trading at a consistent discount to spot since last summer, as hedging long positions becomes costly, unwieldy, and somehow politically incorrect. The crash has nearly halved Shanghai, and distorted market dynamics. Yet China’s stocks, bonds, property and currency remain expensive.

Just prior to the burst, extreme returns started to cluster nearing the peak of the bubble. Such occurrences are intuitive: traders are constantly assessing whether to stay in the market by comparing the return of holding stocks into the next period versus cashing in now. As the market rises, higher returns become less likely. Thus, the expected return that traders require to stay in the market must soar to compensate for the ever dwindling chance of winning it, as seen in the near-vertical climb of the market index. However, as these tail-end events continue to accumulate near the peak, the probability of further gains grows ever smaller – much like being dealt a straight flush every hand - till the probability becomes so small that a crash arrives inevitably.

When calculated on a free-float adjusted basis, Chinese market’s average holding period at the peak prior to the burst was about one week – a hallmark of intense speculative trades in the market. Everyone was busy looking for the greater fool. Note that at the height of the Taiwanese bubble in 1989, every available share on the exchange changed hands close to twenty times per annum. That is, the free-float shares on Taiwanese exchange changed hands every 15 days on average (please see “The Great China Bubble: Lessons from 800 Years of History” on June 16, 2015 for detailed discussions). The burst of the “Great China Bubble” was already written on the wall before June 15, 2015, with or without the vices of margin trading. Save the blame game.

Focus Chart 1: The origin and the burst of the “Great China Bubble”.

The burst of the “Great China Bubble” portends looming global volatility events: It is Bloomsday again. Memories of the dramatic CSRC rescue, the PBoC’s consecutive cuts of RRR and interest rate, the restrictions on index futures trading, the pursuit of algo-trading criminals, the ephemeral circuit breakers and the intervention by the “national team” are still fresh (Focus Chart 1). Pundits have not stopped ruing over the aftermath from the great crash. Yet to us, it is more important to discern the implications for market outlook from the crash a year ago.

What makes this crash different is that it had caused little disturbance in the American and the European markets at first. And Hong Kong indeed peaked about one and a half months ahead of Shanghai. Then as the RMB reform was initiated on August 1, 2015, volatility from Shanghai started to spread. On August 24 of 2015, the Dow experienced the largest single-day point loss ever of more than 1,000 points. And the Fed was forced to delay its long-contemplated rate hike till December. 

Then the second round of proactive RMB depreciation on January 8 of 2016 roiled the global markets again. The Shanghai Composite broke the circuit breaker four times in a week, and lost ~1,000 points in about two weeks. As global markets plunged towards their lowest in two years, the Fed frankly discussed how the China syndrome affected its interest rate decision. Apparently, China’s currency reform and the gradual opening of the country’s capital account have set the stage for global volatility spill. This is different from the other market crashes in the past.

Our research shows that the Shanghai Composite leads global volatility surge by about a year. Precisely how the path of this volatility spill works is still not yet clear (Focus Chart 2). Intuitively, the Shanghai Composite consistently leads China’s economic growth by about six months. As such, a weakening composite portends economic headwinds. Being an important global growth engine, an ailing Chinese economy spells trouble for the world, and the impact will eventually show up in global stock markets.

Focus Chart 2: The burst of the “Great China Bubble” presages looming global volatility events.

Leading indicators are falling, portending economic hard times: Global economic leading indicators appear to suggest an impending slowdown, despite years of QE. The slope of the yield curve, as measured by the difference between the yield of ten-year and two-year US treasury, has been falling. And so is the conference board leading economic indicator, albeit to a milder extent. As investors expect slower long-term growth, they are buying longer-end government bonds as hedge. Meanwhile, investors are swapping out of shorter-end bonds, as inflation could be a concern in the coming months due to a surge in commodity prices this year. A fast falling yield curve tends to predate recessions by at least one year in the last three out of five recessions (Focus Chart 3).

Focus Chart 3: Falling slope of yield curve portends slower growth. Further decline would suggest economic hard times.

Traditional risk indicators and stocks diverge – a significant expectation gap that must be bridged: The ratio of silver to gold measures silver’s return versus gold. Essentially, this indicator shows growth expectation implied by silver versus risk aversion hinted by gold. The lower the ratio of silver to gold, the more risk averse the market is, as it is now.Focus Chart 4 shows that the silver-to-gold ratio tends to move in tandem with the S&P500, verifying the ratio as an indicator for risk appetite.

Since 2014, however, this ratio has started to diverge from the S&P500. And recently, this divergence has reached an extreme that historically are concurrent with significant market volatility, such as the episodes in 2001 and 2008. Yet the S&P500 remains close to its all time high, and the NASDAQ seems to be double topping. Such a significant expectation gap must close.

Meanwhile, the ten-year yields in both the US and China have fallen very close to their historical lows. China’s long yield has not been this low since late 2008, and that of the US was around this level just before QE3 in late July 2012, and when “taper tantrum” started in May 2013 that in part contributed to China’s liquidity crisis. As with the falling silver-to-gold ratio, a plunge in long yields also suggests waning risk appetite, but stocks have been slow to adjust (Focus Chart 4).

Focus Chart 4: Traditional risk indicators suggest risk off. But S&P500 near all time high, NASDAQ double top.

Facing a looming volatility surge, stocks, bonds, currency, commodities and property - what gives? 

RMB will remain volatile, but room for further significant depreciation is limited: Across various asset classes, what will give at the advent of volatility surge? In recent weeks, the RMB has weakened against a strengthening Dollar. Yet the change in RMB 12-month NDF is falling towards its lows in late 2008. That is, the expectation of RMB depreciation had intensified to its historical worst. Late 2008 is an important reference point, as global financial crisis was engulfing the world, and China was not spared. If the expectation of RMB depreciation has reflected the malaises then, now at a similar level it must have done the same. Of course, no one can be certain 12 months later whether the world economy would deteriorate much worse than 2008. For now, the RMB will remain volatile when confronted by a strengthening Dollar before the Fed’s decision, but the RMB seems less prone to further significant weakening than it was during the last two sessions of proactive RMB depreciation (Focus Chart 5).

Focus Chart 5: Expectation for RMB depreciation near historical lows; slowing growth, RRR cuts and FX outflows.

Stocks will struggle, and is ~17% above its theoretical bottom support; volatile overseas markets a drag: The Shanghai Composite has halved since last summer. Since 1996, the composite has been growing at a compound rate of 7%, roughly the same as China’s long-term growth target set in many of the country’s Five-Year-Plans. At this growth rate, Shanghai has been doubling roughly every decade. The important market bottoms seen in 1996, 2005 and 2014 delineate an upward log-linear base line, with its slope equaling 7%. 

That is, China’s long-term growth target dictates the pace of Shanghai’s gain. The closer the Shanghai Composite gravitates towards this base line with a slope of 7%, the more significant is the support. And the lower the growth target, the lower the base-line support is. This phenomenon explains why stocks are sensitive to discussions regarding different shapes of China’s growth trajectories. 

As such, the theoretical bottom support for 2016 is computed to be ~2,500. At its current level, the Shanghai Composite is ~17% above this support level for 2016, and is still expensive. A potential liquidity event in the coming months, either induced by the Fed, or by the PBoC’s Circular 82, can be the trigger for a capitulation. Although Hong Kong is trying to heal, struggling global markets will be a drag. (Focus Chart 6. Please see “Market Bottom: When and Where” on June 4, 2016).

Focus Chart 6: The Shanghai Composite has been growing at 7%, doubling roughly every decade. 2016 support = ~2,500.

Bonds vulnerable near term: As long yields are close to historical lows, bonds are more vulnerable than the RMB and stocks. A surge in US bond yield historically coincides with episodes of global crisis. This phenomenon is evident in “Black Monday” of 1987, LatAM crisis in 1994, Asian Financial Crisis in 1997, LTCM in 1998, “9-11” in 2001 and the 2008 Global Financial Crisis. The US yield surge will inevitably affect Chinese bonds, as suggested by their close historical correlation (Focus Chart 4).

Recently, the PBoC has issued Circular 82 to tighten off b/s receivable investments. Ever since Circular 237 on interbank entrusted payment in August 2012, the central bank has issued a series of circulars to tighten the supervision over commercial banks’ lending behavior. For instance, Circular 8 on WMP in March 2013 was to curb the expansion of off-b/s credit-type WMP; Circular 127 on interbank assets was to tighten the control of on-b/s interbank assets. Essentially, commercial banks have been busy moving their assets/liabilities on and off balance sheets and in between various balance sheet items to evade regulatory supervision. The fact that banks have been trying so hard to circumvent the regulations hints at the magnitude and the multiplicity of the problem, which could one day pop like a pomegranate under the sun. 

Circular 82 is the latest regulatory attempt to plug the loopholes. Its requirements to bring some of these off-b/s assets back onto b/s will oblige banks to raise provision and capital. While still general in its scope, Circular 82 will expand with more details in the coming months. The effects this circular will have on liquidity conditions remain to be seen. The impact on smaller banks will be more significant than larger banks. After the liquidity crisis in June 2013 being partly induced by Circular 8 issued in March 2013, the PBoC should now be more prepared than ever.

The secular trend on property has turned; lower-tier cities will suffer: The RMB appreciation has been the fuel of China’s property bubble. But its secular rise has clearly stalled. In general, a country can use an undervalued currency for exports to build up forex reserve. Then it can start to revalue its currency upwards to allow for a massive asset revaluation. Once the currency revaluation approaches its equilibrium, asset revaluation will come to a halt. These steps of currency adjustments represent how wealth transfers first from foreign producers to domestic through a cheap currency regime, then to the upper class through asset revaluation and finally to the hoi polloi – the final relay of a bubble. 

And this process sounds familiar. In July 2005 when China started RMB revaluation, the country only had around USD 800 billion in forex reserve, but by 2015 this figure had grown four folds to close to four trillion. Meanwhile, Chinese property prices have risen dramatically to a frothy level. A depreciating RMB tends to be a strong headwind for asset price inflation, including properties and stocks, if history is any guide.

Focus Chart 7: Tier-1 cities property prices surge with M1; the ChiNext has crashed.

As property prices continue to surge in Tier-1 cities, together with China’s broad money supply, the ChiNext that historically correlated closely with these metrics has crashed (Focus Chart 7). While the secular trend on Chinese property has clearly turned, its doom is difficult to time. That said, the property bubble in many of the lower-tier cities has already burst. Property prices in these cities have not moved, or have outright fallen since 2014. They are now confronted with a significant supply glut that will take years to clear. 

Further, the property price cycle on a national level, as measured by the average rate of change in prices across different tiers of cities, has clearly plateaued. The coming twelve months will see a continuous unraveling of the property price bubble in many of the lower-tier cities, as economic reform compels local governments to cut back on their rash policy of destocking through household leverage.

Echoes from the “Great China Bubble”: One year after the burst of the “Great China Bubble”, China perches like an old ruin on the verge of the world. At first glance, her financial markets appear dead and distorted. Yet her capacity to intrigue and engage the world and to continue to roil global markets is the testament of the country’s systematic significance. Many market leading indicators have become inscrutable in the aftermath. Now deciphering them for clues about the future is much like negotiating through the Forbidden City - each gate leads to a deeper recess, distinguished only by the nuances of its facade, with an ultimate prophecy one could grasp only after long reflections.

In his classic “Devil take the hindmost”, Edward Chancellor wrote about how in 1987 after the October crash, “representatives of Japan’s largest brokerages were summoned to the Ministry of Finance. They were ordered to keep the Nikkei average above 21,000”. Indeed, similar rescue mission was attempted after the Great Crash in 1929, when bankers met at J.P. Morgan’s office to supply funds to stabilize the market. These failed endeavors evoke memories of the unprecedented coordination between different state departments during the burst of the “Great China Bubble”. How history rhymes.

On this anniversary of the burst of the “Great China Bubble”, let us conclude with one of Keynes’s quotes from Chapter 22 of his magnum opus “General Theory”. It is as relevant today as it was some 80 years ago, after the 1929 Great Crash: “It is of the nature of organized investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force”.

Hao Hong, CFA

2016-06-13