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Takeaway: The Shanghai Composite Index closed above its 2,123 TREND line today on really meaningful – and potentially very positive – news.

SUMMARY BULLETS:

  • The Shanghai Composite Index closed above its 2,123 TREND line today. While this move needs to confirm itself on a closing price basis over the next few days and weeks, we’d be remiss not call out this groundbreaking quantitative signal as anything other than that.
  • Perhaps the most important part about China closing above its TREND line today was that it happened amid some really meaningful news:
    • The Politburo plans to speed up the development of the Shanghai free-trade zone (to be launched later this month), with the intention that it will take the lead in financial reform – eventually rivaling Hong Kong as China’s main international financial center with intentions for it to become a global financial center by 2020.
    • In the free-trade zone, 19 commercial sectors are to be liberalized with the banking sector being the most important of the 19, considering the plans for the Shanghai free-trade zone to be at the forefront of interest rate liberalization in China.
    • Additionally, regulators will authorize full capital account conversion on a trial basis, though it remains to be seen how much the exchange rate will be allowed to fluctuate because of it.
  • All in all, this could wind up being extremely positive as it relates to offsetting China’s structural liquidity headwinds with new sources of capital, but we simply need more data to confirm that hypothesis.
  • The one thing we can tell you is that if the market thinks the Shanghai free-trade zone will be meaningful enough to help offset the structural liquidity constraints we see weighing on Chinese economic growth over the long term, then we do as well. Unlike the consensus US equity bears in 2013, we’re not and never will be smarter than the market…
  • We’ll be on the sidelines awaiting more details as it relates to these developments and we suggest you do the same; at the bare minimum, investors should no longer be shorting China here. A small loss on the short side is always better than getting royally squeezed for an even bigger one (NOTE: the MSCI China Financials Index is up +1.3% since we turned bearish on Chinese financials and property developers back on JUN 7).

Roughly three weeks ago on AUG 15, we published a note titled, “ANTI-DATA MINING IN CHINA: IS IT TIME TO RELOAD ON THE SHORT SIDE?” where we thoroughly dissected the confirming and disconfirming evidence underpinning the current rally in the Chinese equity market – particularly with respect to its sustainability on our intermediate-term TREND duration. We greatly expanded upon that analysis on slides 58-72 in our AUG 30 presentation titled, “PADDLING UPSTREAM?: NAVIGATING #EMERGINGOUTFLOWS” and in our SEP 3 note titled, “HUNTING FOR ASIAN EQUITY ALPHA: LONG SOUTH KOREA VS. SHORT CHINA?”.

In each piece, we ultimately concluded that the recent recovery in Chinese economic growth was not sustainable; thus, we concluded that the Chinese equity market’s dead-cat bounce off its late-JUN lows was likely beginning to fade. In the interest of brevity, we’ll refer you to the aforementioned slides and research notes for the analysis supporting this economic and financial market call.

Needless to say, that was the wrong call to make. Since AUG 15, the Shanghai Composite Index has advanced +2.8%, which is good for the 2nd best gain throughout all of Asia and well ahead of the regional median equity market delta of -0.2% over that time frame. More importantly, the Shanghai Composite Index closed above its 2,123 TREND line today. While this move needs to confirm itself on a closing price basis over the next few days and weeks, we’d be remiss not call out this groundbreaking quantitative signal as anything other than that.

CHINA GOES BULLISH TREND ON THE ONLY POSITIVE DATA POINT THAT ACTUALLY MATTERS - China SHCOMP

The worst thing we can do as one of your trusted resources in Global Macro Risk Management is pound the table on the short side in light of the aforementioned delta. That would be disingenuous and inconsistent with our proven, repetitive investment idea generation process:

CHINA GOES BULLISH TREND ON THE ONLY POSITIVE DATA POINT THAT ACTUALLY MATTERS - 2

Perhaps the most important part about China closing above its TREND line today was that it happened amid some really meaningful news:

  • The Politburo plans to speed up the development of the Shanghai free-trade zone (to be launched later this month), with the intention that it will take the lead in financial reform – eventually rivaling Hong Kong as China’s main international financial center with intentions for it to become a global financial center by 2020.
  • In the free-trade zone, 19 commercial sectors are to be liberalized with the banking sector being the most important of the 19, considering the plans for the Shanghai free-trade zone to be at the forefront of interest rate liberalization in China.
  • Additionally, regulators will authorize full capital account conversion on a trial basis, though it remains to be seen how much the exchange rate will be allowed to fluctuate because of it.

All in all, this could wind up being extremely positive as it relates to offsetting China’s structural liquidity headwinds with new sources of capital, but we simply need more data to confirm that hypothesis.

The one thing we can tell you is that if the market thinks the Shanghai free-trade zone will be meaningful enough to help offset the structural liquidity constraints we see weighing on Chinese economic growth over the long term, then we do as well. Unlike the consensus US equity bears in 2013, we’re not and never will be smarter than the market…

We’ll be on the sidelines awaiting more details as it relates to these developments and we suggest you do the same; at the bare minimum, investors should no longer be shorting China here. A small loss on the short side is always better than getting royally squeezed for an even bigger one (NOTE: the MSCI China Financials Index is up +1.3% since we turned bearish on Chinese financials and property developers back on JUN 7).

Moreover, to the extent our fears (i.e. the market’s cheers) are confirmed, a positive inflection in China’s structural economic outlook would obviously have meaningful implications for the supply/demand/price dynamics across key commodity markets, broader EM economic growth and investor sentiment surrounding EM capital and currency markets (NOTE: the latest BofA flows data shows a rolling-3M outflow from EM stock and bond funds of $60B, which is the largest rolling 3M outflow since 2008).

Sit tight and stay tuned for more clarity is the best advice we can give you at the current juncture. Anything more than that would also be disingenuous, as knowing when and what you don’t know is often times as important as knowing when you’re flat-out wrong.

Have a great weekend,

Darius Dale

Senior Analyst