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The Economic World’s Pressure Points: China and Europe

The Economic World’s Pressure Points: China and Europe

James Stanley,

Talking Points:

- It was another wild night for Chinese equities, and regulators responded. Regulator actions in August and September stalled the meltdown for now (and created a bear-flag in the process), but for how long might this last?

- Regulator actions in China highlight yet another reason for investors to look to Japan to play a larger Asian-slowdown theme. Not only is Japan more ‘short-able,’ but their prospects of recovery are far less than that of China; and the BOJ might not have as much firepower.

- While Asia sees rampant volatility, a fragile European economy hangs in the balance. The ECB disappointed in December, but if history is any guide, they aren’t finished yet. Investors are already selling the EUR/USD as new lows are being printed.

It was another chaotic night for Chinese equities, albeit less severe than what was seen yesterday. The Shanghai Composite got punched by a -3% hit on the open to fall below the psychological 3200 level, only to then rally to a 1% gain. This didn’t last. The selling came back in after the mid-day break to set a lower-low with yet another break of 3200, and this time stocks promptly shot back up in a very familiar manner. This isn’t too different than what we saw in August and September when Chinese equities were in the process of melting down.

As stocks were putting in a near-historic move this summer, Chinese regulators jumped in with a flurry of actions. At first, their actions seemed to unnerve investors after China’s repeated pledges towards market-based reforms and this only exacerbated the meltdown that was being in stocks. A couple of the notable measures enacted were a short selling ban, a ban on new IPO’s, and a selling ban by anyone owning 5% or more of a Chinese company. This effectively froze a large portion of the equity market as institutional investors were hamstrung. Sure, this may have stopped the selling now, but what hedge funds are going to want to jump back into a market in which they were previously forbade from managing their positions (and in-turn, their businesses).

But as the selling slowed, prices rose. And as prices rose, more buyers came in to push prices even higher. Since those lows were put in towards latter August, Chinese stocks have been running higher ever since. To be sure, economic data was pretty much abysmal the entire time. Chinese growth finally fell below the vaulted 7% marker for the first time since the Financial Collapse, and markets seemed ‘ok’ with this as Chinese stocks continued to trudge higher. Imports fell a whopping -20% in November! That’s a contraction of 1/5th year-over-year, and markets didn’t seem to care as they just continued running higher. But this was par for the course: This is the stimulus-driven economic culture with which we live (or lived), and as more and more bad data poured out of the Chinese economy, stocks prices just continued running higher under the premise that Central Banks would continue shooting the stimulus cannon to put out any potential economic fires.

But all of this action never really changed the trend. It just slowed the selling temporarily, and that is what the world awoke to yesterday. As markets began to come back confidence was restored. So much so that we even got a rate hike from the Federal Reserve after they backed off of a hike in September for fears of pressure in the global economy. And as that confidence continued to build and as China looked to restore their image as market-reformers, those actions that stemmed the declines began to get repealed. First it was IPO’s, and then the removal of the selling ban for 5% shareholders, which was set to be removed at the end of this week. This is what freaked everybody out, because the selling that was contained by regulators in August and September was about to be unleashed on the world.

Yesterday was troubling. After that really bad PMI print, Chinese stocks throttled lower only to get curbed (circuit breakers). After re-opening from the curb, they got hit even harder and had to be halted into the close. Then they just stayed closed for the rest of the day. As you can imagine, there were probably a ton of sitting sell orders of investors who just wanted to get out of the stock market before institutions and executives were going to be allowed to sell out of their massive positions when the 5% ban was removed later in the week. On last night’s open, we saw the 3% gap lower, and the rebound is (from some media sources) being directly linked to state-sponsored buying from China.

This is yet another reason that we’ve been advocating to voice the Asian slowdown trade in Japan.

Chinese regulators are already working on a response. The 5% ban will remain beyond this week; its removal has been, well, ‘removed,’ for lack of a better word, and instead these shareholders will be massively restricted in how they can manage their positions. So these institutions that hold more than 5% in a Chinese company will be regulated in how they sell/manage these positions, and the short-selling ban will remain in effect. This will surely stem some of the downward pressure, but for how long?

In a statement overnight, a spokesman from the CSRC (China Securities Regulatory Commission) guaranteed that there would not be an extended sell-off in January. I’m not quite sure what to make of this. After spending my life in and around markets, I’ve learned to be weary anytime the ‘g’ word is thrown around, especially when coming from government officials. The one thing that is certain is what we talked about in Mid-December, when Chinese stocks were flying high again as the Fed looked down the barrel at a rate hike, and that is the fact that the longer-term setup on Chinese stocks was still very much bearish. We talked about this at length in the article, Is the World Ready for a Rate Hike From the Fed?

Since the lows were put in during the summer swoons, stock prices in China had been ratcheting higher, albeit in a much more mild manner than the euphoria that had driven prices up by more than 150% in less than a year. This led to one of the more phenomenal trend resumption price action formations that a trader might be able to find: A flag; specifically a bear flag in Chinese stocks. This is an upward sloping trend-channel after a gigantic move lower, and this will often pop up when a trend is taking a ‘break’ before continuing lower. Well that trend channel held until yesterday. And now the flag is broken. On the chart below we take a look at this flag, and please keep in mind that this chart does not include last night’s price action. This is current up until yesterday when Chinese stocks were halted. This is yet another reason to look to voice that Asian slowdown theme in Japan, Chinese market data isn’t easy to access, and Chinese equity markets cannot be shorted right now.

Chart created with Tradingview; prepared by James Stanley

With today’s wide range in daily traded prices but minimal difference from last night’s close, we have a long-legged Doji for today’s price action on the Shanghai Composite. This is not something you want to short in front of, a long-legged doji after a major move lower: This will often prelude a bump higher, at least in the near-term.

But the stage has been set: Investors have been reminded, yet again, that stock prices don’t always move up. And now with rates moving higher out of the United States, the next time stocks pop up, they likely won’t pop up as much (this is what creates lower-highs), and eventually they won’t pop up at all. The first part of that statement is what has been happening in the S&P as lower-highs have been coming in for the past 7 months.

Created with Marketscope/Trading Station II; prepared by James Stanley

Is the time to get short the Euro nearing (again)? The European Central Bank has a history of disappointment. But this is the reality of a supra-national economic governing body attempting to simultaneously manage 18 individual fiscal policies with one, unified monetary policy. In economic terms, this is like expecting one tail to direct 18 dogs, as monetary policy is supposed to be a short half-life, emergency, near-term type of mechanism. It’s fiscal policy that guides economies, and this is why Europe is a mess. Politicians want to get reelected, and the easiest way to do that is to not cause pain. The European Central Bank wants to steward in inflationary pressures and growth to the entire continent, and sometimes to do this pain is required. This is where the proverbial rubber meets the road, and this is why we’re still in this conundrum and this is also why the Greece story is far from over.

But the trade here is the fact that the ECB doesn’t have autonomy. They have to yield to and cater around political pressures, and this has been evident in their actions. We discussed this at length in the article, The ECB Fires a Warning Signal, but Will They Deliver in December?

As the European economy was being ripped to shambles in 2012, Mario Draghi stepped up to the plate and pledged that the European Central Bank would do ‘whatever it takes’ to keep the European-bloc together. This provided a much-needed dose of confidence to the Euro after a clear delineation had developed between Northern and Southern European states, and that was pretty much resultant of using a single currency. Before the Euro came about, whenever tough times were seen in Spain or Italy or Greece, these countries would simply weaken their currency. With their key trade locations, this made bringing in growth simple because now it was cost-advantageous to ship to or buy from these countries with their weaker currency.

But after the Euro’s inception, these economies were tied to the Northern States that held far different prospects. This kept the value of the Euro artificially high for these economically-strapped nations; and this hamstrung these economies from shaping monetary policy (the near-term one) to meet their needs. Instead they had to go to the European Central Bank to ask for help.

On those differing prospects: While those countries in Southern Europe were being obliterated (economically speaking) with unemployment rates over 25% with quarter-over-quarter contractions in their economy, the states in Northern Europe were crushing it. Pre-Euro, these countries would see safe-haven flows move from Greece, or Spain or Italy into the German Deutschmark or the French Franc. This would make these currencies more expensive, and that would slow down exporting activities.

But with the Euro, they now had an artificially weak currency that endangered their robust economies. This helped trade massively, as Germany could export like never before, using an artificially weak currency to drive exports around-the-world.

So when we were staring at the very real prospect of European disintegration in the summer of 2012, Mario Drahi’s promise to do ‘whatever it takes,’ provided a very-much needed dose of confidence to markets that the European continent would band together. This confidence inspired buying of the Euro, as those meltdown concerns receded, and this started a 2-year bull run that saw EUR/USD move from 1.2000 to 1.4000. And this is good and all, the confidence that is, but it made the prospect of recovery even more daunting, because now this more expensive Euro was putting pressure on those previously high-flying Northern European states. Now the entire continent is ensnared in a slowdown, and it isn’t just the Southern states.

Something had to be done. In May of last year, Mr. Draghi mentioned as much, and he said that the ECB would have an announcement in June. With baited breath, we awaited. And then June came, and nothing. No big QE announcements as many were inferring from Mr. Draghi’s May statement. The Euro rallied, and there were many questions as to the political discourse that was taking place around this decision. They finally delivered in July, and this started the ~3000 pip move that brought the Euro back towards parity against the US Dollar.

But this pattern is important. They didn’t move in May (when they wanted to), and they didn’t move in June (when they said they would). This likely wasn’t because they couldn’t or wouldn’t enact any new policies, but more likely (as was widely reported at the time) they were facing political resistance from countries that worried that a weaker Euro would bring on unsavory levels of inflation. This was a political move, and for matters of economics, that is vitally important to know/assimilate into one’s analysis.

After spending much of 2015 trending higher in a bear-flag formation, Mr. Draghi got active again in October as he pledged that the European Central Bank would ‘re-examine’ their QE outlay at their December meeting. This was largely inferred to be an increase in the QE program, and investors didn’t wait around to sell the Euro. The bear flag was broken and prices throttled lower all the way in to that ECB meeting. But then something very familiar happened: The ECB disappointed. There was no increase to the QE program, and the ECB merely made their deposit rate slightly more negative. The Euro promptly began to rally and ascended all the way to the 1.1000 level after approaching 1.0500 ahead of the December ECB meeting.

But this story is far from over. Europe is still facing downward pressure, and we likely haven’t seen the end (or last announcement) of European QE.

Perhaps further to that point – EUR/USD is heading lower and breaking below support, and we’ve just seen SSI flip to long on the pair, which may be signaling a short-side trend in the not-too-distant future.

Created with Marketscope/Trading Station II; prepared by James Stanley

In the near-term, be very careful of chasing. We’ve just broken below a key Fibonacci support level at 1.0756, and getting short right now runs a very high risk of selling a low. Instead, wait for this to swing higher, and look to get short on an extended top-side wick to illustrate a potential down-side turn.

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for

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