Talking Points:
- Volatility is extraordinarily low heading into the Summer which resembles similar conditions in Summer 2014 and 2015
- Complacency creates a systemic imbalance that can expose market participants to unexpected changes
- With a steady Shanghai Composite and USD/CNH, China seems a benign issue; but the same seemed true before a severe tumble
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Sudden market turns can be motived by surprise fundamental or speculative developments, but the breadth and intensity of those moves is rarely founded in the catalyst. The backdrop market conditions determine how far and aggressively market trends run. Looking at the lack of preparation, low return and tolerance for pushing expensive markets even higher; it is hard to dispute that the backdrop is not ripe for a possible crisis. However, when liquidity thins out and complacency hits extreme levels, sensitivity can increase to the serious fundamental sparks. There are plenty of explicit threats that observant traders have kept track of over the weeks and months, but the most problematic can be those that receive little appreciation even in these underprepared conditions.
Not too long ago, China's financial and economic health was a top concern for global traders. The world's second largest economy and one of the largest markets seemed to be operating just fine on paper. However, there was evidence that pressures were building and policy officials were struggling to contain it. Back in August 2015, after an extended period of extreme quiet from the markets, China's policy authority announced that it was changing the way it would calculate the official fix on its local currency (the Yuan). While they had said this was a move aimed at a more market-based pricing mechanism, global investors were concerned it was an overt move to bolster its trade advantage (devalue its currency) and in turn raise the prospect of a more intense trade war with the rest of the world. The reaction from the S&P 500, global equities, emerging market and other risk-based markets was intense. In subsequent volatility for the months following, the concern surrounding China was a frequent reference for risk reduction.
In recent months, we have seen the fear over China's detrimental influence to the world's financial health diminish significantly - though its fundamental backdrop actually improved little. This is likely owing to a greater number of distractions to pull attention in other directions. Yet, as volatility drops off and other concerns like elections start to retreat, this consistent threat is likely to come back into global investors' consciousness. As the market's attention returns, the evidence of trouble will start to grow more obvious. Considerations like the rising USD/HKD exchange rate which preceded previous USD/CNH and general China financial troubles is already raising serious flags. We discuss the risk that China continues to pose in this weekend Strategy Video.
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