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Takeaway: In today's Macro Playbook, we detail our bullish-to-bearish fundamental reversal on Chinese equities. This is both new and worth your time.

THEMATIC INVESTMENT CONCLUSIONS

Long Ideas/Overweight Recommendations

  1. Utilities Select Sector SPDR Fund (XLU)
  2. iShares 20+ Year Treasury Bond ETF (TLT)
  3. SPDR Gold Shares (GLD)
  4. Consumer Staples Select Sector SPDR Fund (XLP)
  5. iShares U.S. Home Construction ETF (ITB)
  1. LONG BENCH: PowerShares DB U.S. Dollar Index Bullish Fund (UUP), Vanguard REIT ETF (VNQ), Vanguard Extended Duration Treasury ETF (EDV), Healthcare Select Sector SPDR Fund (XLV)

Short Ideas/Underweight Recommendations

  1. SPDR Barclays High Yield Bond ETF (JNK)
  2. SPDR S&P Regional Banking ETF (KRE)
  3. Industrial Select Sector SPDR Fund (XLI)
  4. iShares MSCI Emerging Markets ETF (EEM)
  1. iPath S&P GSCI Crude Oil Total Return ETN (OIL)
  1. SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)

***Please note we are dropping the DXY from our top-5 long ideas for the time being. Refer to our scenario analysis for the next 4-6 weeks in yesterday’s Macro Playbook for more details. In lieu of the dollar, we are “upgrading” our bullish bias on Utes in light of our bearish outlook for Treasury bond yields from here.***

QUANT SIGNALS & RESEARCH CONTEXT

“We Will Sell China”: Today we are removing our bullish bias on Chinese equities and view this asset class as one to “short on strength” rather than a “buy on weakness”. Since we outlined our bullish bias in our 1/13 edition of the Macro Playbook, the Morgan Stanley China-A Share Fund (CAF) has declined -245bps.

Our decision to not let a small loss turn into a larger one is threefold:

  1. Momentum is breaking down as the market responds poorly to a lack of sufficient liquidity provision by policymakers.
  2. The PBoC is not inclined to deliver a sufficient amount of liquidity provision while the State Council is inclined to stand pat on sovereign fiscal policy – effectively forcing cash-strapped local governments to bear the brunt of any fiscal stimulus.
  3. This is because a large provision of liquidity is likely to put incremental pressure on the Chinese yuan against the backdrop of a preference for exchange rate stability in Beijing.

Regarding point #1:

  • Today the Shanghai Composite Index confirmed a breakdown through what had been intermediate-term TREND support of 3,202.
  • The market is down -3.1% over the past two days – following Wednesday’s post-close announcement of a system-wide -50bps RRR cut out of the PBoC – the first system-wide cut since May of 2012.
  • According to our calculations, that frees up about ~570B CNY into the financial system, which pales in comparison to the estimated 2.05T CNY lockup ahead of 24 IPOs next week or the cumulative 1.98T CNY of capital that has left the country since the steady trend of outflows began in June.
  • Such capital outflows have perpetuated a +155bps back-up in China’s benchmark 7-day repo rate since the start of the fourth quarter.

THE HEDGEYE MACRO PLAYBOOK - SHCOMP

THE HEDGEYE MACRO PLAYBOOK - China Benchmark Interest Rates

THE HEDGEYE MACRO PLAYBOOK - cf

Source: Bloomberg L.P.

THE HEDGEYE MACRO PLAYBOOK - 7d

Source: Bloomberg L.P.

Regarding point #2:

  • While the PBoC has added a 195 CNY into the banking system via reverse repos over the past three weeks, it has neither lowered rates on those repos nor signaled that such injections are designed for anything more than liquidity provision ahead of the always-tight Lunar New Year holiday.
  • In fact, Lu Lei, head of the PBoC’s research bureau confirmed that to be case – as well as stating firmly that the aforementioned RRR cut shouldn’t be taken as a sign of the start of a broader, stronger monetary easing cycle.
  • On the fiscal policy side of the ledger, growth in central government expenditures continues to slow on both a sequential and trending basis – effectively leaving the “heavy lifting” to the provincial governments.
  • That sounds fine in the context of China’s fragmented political economy – as well as the announced 15T CNY in planned infrastructure investment across 14 provinces  in recent weeks/months – but not in the context of land sales declining -14% YoY and broad credit growth slowing on both a sequential and trending basis, begging the question: how will such projects be financed?
  • Central government fiscal revenue slowed to +8.6% YoY in 2014 – the slowest pace since 1991 – which implies China has limited options besides levering up the sovereign balance sheet to finance such lofty development targets.

THE HEDGEYE MACRO PLAYBOOK - CHINA High Frequency GIP Data Monitor

THE HEDGEYE MACRO PLAYBOOK - CHINA Property Market Monitor

Regarding point #3:

  • In an attempt to deter incremental capital outflows, today the PBoC raised the yuan's reference rate to a level that forced appreciation back into the currency’s +/- 2% trading band.
  • Specifically, the CNY reference rate was hiked by +0.17% to 6.1261 per USD, which was +2.06% stronger than Thursday’s close. This move that perpetuated a +0.12% “short-squeeze” in the USD/CNY cross to 6.2447 (a -1.9% discount to the reference rate).
  • Recall that such capital outflows perpetuated a -2.4% decline in the CNY vis-à-vis the USD last year – the first annual decline since 2009. The non-deliverable forwards market is pricing in roughly the same degree of downside over the NTM.
  • That such speculation is occurring in an environment of rising real interest rates speaks volumes to following key economic risks that continue to weigh on Chinese GDP growth estimates:
    • A continued unwind of the fixed assets investment bubble as both demand and prices contract in the property market. Specifically, property prices in first, second and third tier cites are down -3.1% YoY, -4.3% YoY and -4.5% YoY, respectively – and growth is getting incrementally negative by the month.
    • A continued slowdown in the pace of credit intermediation as growth in China’s banking sector liabilities slows amid structural current account rebalancing.
    • A continued slowdown in the pace of credit intermediation as debt rollovers in an environment of negative industrial profit growth (down -8% YoY in DEC) broadly restrain the marginal supply of credit. China’s low-NPL ratio is arguably the root cause of its economic slowdown.

THE HEDGEYE MACRO PLAYBOOK - CNY Forward Spread

THE HEDGEYE MACRO PLAYBOOK - China Real Interest Rate

THE HEDGEYE MACRO PLAYBOOK - China REER

THE HEDGEYE MACRO PLAYBOOK - China FX Reserves CAGR vs. Nominal GDP CAGR

THE HEDGEYE MACRO PLAYBOOK - China Deposits vs. M2

THE HEDGEYE MACRO PLAYBOOK - China 5 30 Rule  1

THE HEDGEYE MACRO PLAYBOOK - China 5 30 Rule  2

THE HEDGEYE MACRO PLAYBOOK - China 5 30 Rule  3

All told, we now anticipate that Chinese shares have considerable downside risk over the intermediate term – so long as the aforementioned policy stance remains in place. And until that changes, our bias on Chinese equity ETFs – namely the CAF and FXI – will remain bearish.

Chinese stocks are now overvalued vis-à-vis other international equity markets and have been overbid with massive margin leverage (a record 778B CNY on the Shanghai Stock Exchange) relative to what now looks like a rapidly declining probability of meaningful enough monetary stimulus to combat the obvious downside to Chinese growth over the intermediate-to-long term.

THE HEDGEYE MACRO PLAYBOOK - ev

THE HEDGEYE MACRO PLAYBOOK - China Iron Ore  Rebar and Coal YoY vs. GDP

***CLICK HERE to download the full TACRM presentation.***

TRACKING OUR ACTIVE MACRO THEMES

Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.

The Hedgeye Macro Playbook (2/5)

#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.

EARLY LOOK: Anchorman (2/5)

Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014.  2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.

HOUSING: Purchase Apps | Easings & Accelerations (2/4)

Best of luck out there,

DD

Darius Dale

Associate: Macro Team

About the Hedgeye Macro Playbook

The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.