While the Golden Week holiday was a time of recreation for many in China, it would be difficult to sugarcoat the risks brought on capital markets with the U.S. debt ceiling crisis. The fact that the U.S. has never voluntarily defaulted historically has made it all the more difficult to price-in the impact of continued fiscal deadlock. We are in unchartered territory.
That said, I believe the dominant strategy for both parties in the U.S. is to negotiate, as pursuing this strategy independently to maximize individual payoff will indeed ensure a satisfactory mutual outcome.
The debate is a modified version of Prisoner’s Dilemma. In this version, constant communication between the two parties will likely induce cooperation – as opposed to the classic version where the void of communication makes everyone a loser. Market intensity will rise with each passing day towards the deadline. But the intensity itself should precipitate a final resolution. And a relief rally will ensue.
For market participants, the uncertainty of the Fed tapering still looms. However, the debate indeed diminishes the probability of an immediate tapering. The government shutdown will affect growth – an important variable for the Fed’s tapering decision. We have already seen rising jobless claims and declining ISM employment sub-index. In the most unlikely scenario of a U.S. default, there will probably be no tapering – ever. As such, a last minute resolution and no immediate tapering appear to be the most likely outcome and should be our base scenario for investment strategy.
My colleagues and I were on the road in the past two weeks seeing clients. From these exchanges, three market concerns emerged: 1) the sustainability of the nascent economic recovery; 2) external uncertainties and what they mean for China; and 3) how much upside still to be had after a strong market surge since late June. Low inventory levels and rising purchasing intention by manufacturers suggest that the restocking activities have further room to run. As such, recovery should continue into the fourth quarter.
External uncertainties indeed have highlighted China as an island of safety, due to its still-closed capital account and markets. Debt ceiling debates have offered a 50/50 probability of positive returns since the 1990s. The chance is no better than a coin flip, and thus should not be a decision trigger. Recent government initiatives on financial reform and market deregulation are a definite plus. Further, note that many risk assets, including China, emerging markets and commodities are rebounding off their important long-term support levels, and have indeed outperformed the U.S. amid recent uncertainties. They all are growth assets and beneficiaries of the weak U.S. dollar, a victim of the ongoing debt ceiling debate and delayed Fed tapering.
Investors can use 15 percent of M2, or broad money, as a guidance to estimate China’s free-float market cap. The expansion of China’s forex fund position, an important component of China’s base money, has turned positive. Together with a seasonal release of fiscal deposit, as well as lending to support the government’s infrastructure programs, it will ensure China’s monetary supply expands on schedule. In turn, growing money supply with improving fundamentals will continue to heal the Chinese markets. Chinese markets will probably quickly reflect the external uncertainties occurred during the holiday, and then re-focus on the domestic positives.