China's central bank governor Zhou Xiaochuan speaks during a session on the second day of the 19th National Congress of the Communist Party of China in Beijing. Photo: Reuters/Thomas Peter
China's central bank governor Zhou Xiaochuan speaks during a session on the second day of the 19th National Congress of the Communist Party of China in Beijing. Photo: Reuters/Thomas Peter

1. Deleveraging discomfort

China’s market participants are having a hard time deciding if the government’s intent to redouble efforts to deleverage the economy are good for stock prices. The stock market has been volatile since the 19th Communist Party congress in mid-October, particularly after China’s central bank governor Zhou Xiaochuan said authorities will do their best to fend off risks from excessive optimism that could lead to a “Minsky Moment,” while other policymakers pledged to strengthen financial regulation.

Government bond yields have risen on expectation lending markets will remain tight. But the worst fears about the deleveraging exercise seem to be abating. This week, the blue-chip index has hit two-year highs, while stock funds are selling faster and margin lending in the stock markets is at levels last seen in early 2016. The newly formed Financial Stability and Development Committee has pledged to prevent instability, and the securities regulator is sending signals it is going to be tough and rigorous in approving new share offerings.

The CSI’s banking sub-index is still hurting but the healthcare index, a barometer of economic and financial optimism, is at record highs. In contrast, start-up board ChiNext once the darling of local investors and a hotbed for speculation, is on the decline.


2. Raw power

US stocks are striking record highs on a weekly, if not daily, basis of late as a nearly nine-year bull market grinds ever onward even as Congress and the Trump administration struggle to deliver their long-promised tax reform. It prompts analysts, economists, investors and other market observers to repeatedly ask: When is the correction coming?

One popular indicator, devised by Ed Yardeni at Yardeni Research, does not suggest a turn around in equities is at all imminent. Yardeni’s “Boom-Bust Barometer” divides the CRB industrial raw materials spot index by the four-week moving average of US first-time claims for unemployment benefits.

Its premise is that if industrial raw materials prices are rising – which on balance they have been – and the US job market is stable or strengthening – which it is – then the outlook for growth and equities is constructive. When the S&P 500 is overlaid, it appears that Yardeni’s “BBB” is a reliable coincidental indicator for US equities.

The brief dive in the BBB in September and October was largely do to the short-lived jump in jobless benefits claims caused by hurricanes Harvey and Irma. Claims have since dropped back to recent trend and the BBB has recovered.


3. Junk in the yard

Nervous traders fretting about how long the bull market can carry on and what might spark the long-awaited correction would do worse than keep their other eye on high yield, or “junk,” bonds. The rally they’ve been on this year puts the stock market charge in the shade, and by some measures they are the most expensive assets in the world right now.

A selloff here could ripple quickly and deeply across all markets. The first signs of these tremors were felt this week. Global high yield bonds had their biggest fall since March on Thursday, and European junk bonds their biggest fall in a year. Outflows from high yield bond funds stand at $1.8 billion in just two weeks, according to Lipper, and are the highest in two months, according to EPFR. No surprise that Wall Street and other major stock markets wobbled. There’s precedence too – the 20% market correction in 2015-16 was in large part sparked by the collapse of the junk bond market. Will history repeat itself?


4. Shifting sands

Markets will be watching the fast-moving developments in the Middle East where Saudi Arabia’s Crown Prince in midst of a major consolidation of his power and Lebanon has been thrown into turmoil again by the surprise resignation of its Prime Minister Saad al-Hariri.

Local stock markets have the dollar-bonds of many Gulf and Middle Eastern states have been left at either record or multi-year lows and traders will now be on alert for any sign that these countries currency pegs are a risk of being abandoned.

Lebanese officials have said they believe Hariri is being held in Saudi Arabia, while Riyadh and other Gulf countries have warned their citizens against travel to Lebanon, sparking speculation Saudi Arabia’s Crown Prince may be sizing up a strike at Hezbollah.

Meanwhile Saudi intercepting a ballistic missile that it said was fired toward Riyadh by the Iran-allied Houthi militia controlling large parts of neighboring Yemen has added to the tension.


5. Curve control

Along with stubbornly low volatility and productivity, one of the conundrums dominating economic and market debate recently is the flatness of bond yield curves. The US curve, in particular, is subject of much debate. It’s the flattest in over a decade and dragging other yield curves around the world down with it.

Is this the traditional signal that slowing growth is just around the corner, or are other forces keeping longer-dated yields down? What is clear is, for whatever reason, demand for long-dated bonds is pretty strong. The euro zone bond market faces its first major test since the ECB announced it will gradually begin pulling back its extraordinary stimulus, with 25-30 billion euros of bond supply next week.

Demand at these auctions will give us an indication of whether the bond market can ride the storm of lower policy support. Spain’s auction of 50-year bonds on Thursday will be closely scrutinized.