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Friday, 15 December 2017

Tectonic shift for global economy as China adjusts

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  • Divyang Shah

Concerns ripple through asset markets, vols shift higher.

The ripples being felt by EM FX and energy/commodity prices highlight the degree to which markets worry about the outlook for China.

We should expect another large RRR cut (100bp) and rate cut (25bp) from the PBoC as it looks to counter the liquidity effects of capital outflows and FX intervention through RRR cuts and stimulate the economy through lower borrowing costs.

Actions to boost the economy via smart fiscal stimulus and the local government bond market will be much more important than liquidity-based tools. This is China’s version of QE and likely more effective than conventional monetary policy tools.

China’s reluctance to adopt a 2009-style quick fix suggests that the market is not going to be out of the woods when it comes to volatility. This is a partial reversal of the positive externalities that commodity and Asian exporters had seen pre- and post-crisis and from what demand growth in the future was vastly overestimated.

This is a tectonic shift for the global economy, but China is not going to go cold turkey as it wants to control the fallout from this shift to its labour market for fear that it could lead to social instability. While lower global growth is an understandable by-product of this shift, so too is the likelihood that global disinflation will persist beyond just lower oil prices.

Falling EUR inflation swaps and USD inflation break-evens go beyond just oil. In such an environment, the Fed or BoE will struggle to find a consensus to hike interest rates aggressively even if both are itchy about inflation risks tied to ongoing labour market strength.

The risks are that the Fed will delay lift-off into 2016, while the BoE will delay a rate hike into H2 2016. If itchy fingers prevail, the tightening cycle is going to be very shallow. Staying long FI remains attractive as investors fleeing EMs search for a new, safer more liquid home.

For FX markets, USD weakness against commodity and EM currencies is still in vogue. Stick with the more liquid plays and play the illiquid FX pairs (USD/TRY) via options.

Uncertainty shifts vols higher

Fear, not greed, is dominating the price action as markets worry about the global outlook, made worse by growing doubts about both the PBoC and Fed’s reaction functions. A flight- to-quality and liquidity bid has been favoured, especially when the cost of hedging is soaring: our Z-score measure of asset market volatility (see http://link.reuters.com/sah44w) shows that equity and FX implied vols are sharply higher, particularly equity market vols.

The disconnect between commodity and equity prices is being resolved by equity prices realigning themselves with weaker commodities. Higher equity and FX implied vols make it difficult for those with existing positions to hedge exposure (though some of the sharp swings being seen in S&P futures are due to short gamma conditions created by previous hedging). This means that position unwinds will be favoured, especially given the risk that others will be leaning the same way and illiquidity will make exits tricky.

Despite higher vols, we would still favour very OTM options to protect the portfolio from tail risk beyond any shift to cash. Attention now turns to the extent to which policymakers will act to calm markets.

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