January 11, 2016

China problems leading to US market weakness

Years of the Federal Reserve Zero's Interest Rate Policy and massive liquidity infusions have yielded a central-bank "put" on the markets, replacing natural price discovery with asset-price inflation.

But now, it looks like that movie is being run in reverse. That's because players are beginning to lose faith in the Fed and other central banks, or what I call the "Ah-Ha Moment."

We appear to now be at a place that I've been warning about for the past year. By inflating asset prices, central bankers have compressed risk like a coiled spring -- and money managers have all crowded into the same trade of being long on overvalued equities and other asset classes. But the past few days have shown what happens when many of these players want to exit the same trade at the same time.

Many of business TV's "talking heads" have been saying this week that investors should ignore China's woes, citing things like the fact that trade with the Asian nation represents just a small part of U.S. gross domestic product.

They're clueless!

I remain short on the iShares China Large-Cap ETF (FXI), and I issued another warning about China just two days ago in my column Don't Say We Didn't Warn You About China.

The Chinese markets are overleveraged, and after losing real estate/construction as an engine of growth, the government is devaluing China's currency in an attempt to resuscitate domestic economic growth.

Meanwhile, I've consistently argued that China's stock markets are much more broken than America's. Perhaps that's why the Chinese markets' circuit breakers -- which shut off trading early today for the second time this week -- are having the opposite effect of what the authorities intended.

Unfortunately, China's potential to "export" risk through capital flight and a devalued Chinese currency (one of the "surprises" I predicted for 2015) and could cause problems for Western markets as investors lose faith and unwind long positions.

In a world of tepid growth, the system's fragility and overvalued nature -- coupled with a loss of confidence in central bankers -- represents an outsized risk to our markets. So does the notion of America as an "oasis of prosperity" in a flat, interconnected and networked world.

Position: Short FXI