Back to Crisis: The Dollar, China and Emerging Markets


1. In medical science, the change of a disease which indicates its event; that change which indicates recovery or death. It is sometimes used to designate the excretion of something noxious from the body, or of the noxious fluids in a fever.

2. The decisive state of things, or the point of time when an affair is arrive to its highth, and must soon terminate or suffer a material change.
China has been experiencing 2 to 3 year credit/stimulus cycles since 2008. 2011, 2014 and 2018 are when these cycles topped out. The 2011 dip lasted about six months, with currency effects lingering for a year. The 2014 peak lasted more than a year if measured by global impact. The yuan depreciated in August 2015. Commodity prices and global equities bottomed out in February 2016. Currency and FX reserve impact lingered into late 2016. The current peak was in October 2017, when the National Congress signaled the deleveraging push was finally underway. See: 19th National Congress: Deleveraging Will Have No Negative Effect on GDP. My comment for that post was:
Set your watches! ...There hasn't been much of an effect because China isn't deleveraging...
Back in 2008, Chinese real estate and stock prices slumped. There was depreciation pressure on the yuan and it went back onto the dollar peg. In 2011, there was a decline in real estate prices and from late 2011 to spring 2012, depreciation pressure on the yuan.

The 2014-2016 period saw many credit guarantee firms go bankrupt, but the banks were protected. Banks are in trouble this time. Even if the government ends up "printing" its way out, a mini-crisis in the banking sector will have farther reaching impact than the prior cycle slowdown. The amount of paper needed is higher. Last time, USDCNY threatened the break 7.00 and China burned through $1 trillion in reserves. Following that model, currency effects could last well into 2020 even if the economic/credit nadir is in the next month or two. USDCNY is already near 7.00, strict capital controls are needed to preserve FX reserves and local governments are cracking down as signs of a housing bubble reappear. Even if China avoids a major credit event, it will not take much bad news to generate a wave of currency depreciation and financial market volatility.

Finally, this these are global cycles. In 2011, the European sovereign debt crisis was in full bloom and the U.S. was threatening to halt expanding the stock of U.S. treasuries (the debt limit debate). In June 2014, the U.S. dollar bottomed and began a major bull market. In January 2015, global stress forced the Swiss National Bank off their euro peg. Politics also became more volatile. The UK voted to leave the EU in June 2016 and the U.S. elected Donald Trump in November 2016. This tim, a "hard Brexit" appears likely in October and the British pound is already selling off in anticipation. A majority of House Democrats support impeaching Trump. The U.S. Dollar Index is on the cusp of breaking out of a two-decade basing pattern. By my reckoning, the U.S. dollar bull market should end in the next 12 months, but a breakout would shatter that assumption. I expected a spike in the dollar would be underway by now and the bull market would terminate within the roughly 6 year time frame of the prior 1990s bull market. Instead, a breakout now could unleash an incredible bull market similar to the early 1980s, complete with an emerging market (China) crisis on par with Latin American defaults in the early 1980s or the mid-1990s Asian Crisis. Although the dollar bulls are loud voices in the financial community, they don't have a deep following. It is a speculative position, not one that is held in corporate board rooms or central banks.

I thought we might get a global crisis in 2016 or 2017 though, and I was wrong. I could be wrong again. If so, the dollar bull market is on its last legs, commodities are cheap and inflation is about to become a much bigger worry than deflation.

For timing and positioning, I let the charts decide. Here's the U.S. Dollar Index. Peak in 1985, 17 years later in 2002, and 17 years later in 2019? I don't use this for timing, but the 50-month MA (the shape of the average, not the location of the index relative to it) shows why predicting a peak in the U.S. Dollar Index is the correct call. Although there's only two cycles, this is a major global economic cycle being expressed through the reserve currency. A downturn here is consistent with the past 40 years of economic history. A breakout in the dollar and an upturn in that 50-month MA is uncharted territory.
Next up is the emerging market ETF, EEM. It bounced at support on Friday. If it breaks that support line, a decline to the long-term support (former resistance) is likely. If my macro expectation is correct, it should eventually break the lower support line that stretches back to the 2007 peak. If that support holds, at worst there will be a brief, acute crisis. Downside risk in EEM is slightly more than 10 percent from Friday's close. The dollar will top in the process and begin its bear market cycle.
The China ETF, FXI, has broken below its long-term support/resistance line from the 2007 peak. It is weaker than EEM and weighing it down. It did not hold the 2016 support line as EEM did, but broke lower this week. Is China the leader or the follower? That's the difference between a bullish and bearish view on EMs for me. As for downside risk, FXI has about 12.5 percent risk if it heads for the 2008 support line. If it moves towards the 2004 line, that's about 30 percent risk from here, a 50 percent decline from the 2018 peak.
I prefer the ETFs in these cases because they include currency effects. China's Shanghai market is close to support though.
Finally, the Chinese currency looks similar to several EM currencies and the trade-weighted U.S. dollar from 2000 to 2019.

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