FXI: Slower China Growth, Rising Inflation Equals Crash in Equities

03/14/2018 1:40 pm EST


Landon Whaley

Editor, Gravitational Edge

FXI has been playing with house money for over a year, and it looks like the winning streak has run its course. China’s Fundamental Gravity remains bearish for Chinese equities, says Landon Whaley of Whaley Global Research writing in his Gravitational Edge Wednesday.

If you were hoping for a complete breakdown of the market impact of Gary Cohn’s resignation, I’m sorry to disappoint. I won’t be talking Cohn, tariffs, or anything else Washington-related this week.

Remember the first six months of 2017 when markets jerked every time a new soundbite hit the airwaves out of Washington about Trump’s tax plan? None of those soundbites or the subsequent market reactions mattered once the final plan was approved. I argue that the tax plan itself doesn’t matter until its existence is felt in the U.S. Fundamental Gravity later this year, at the earliest. But I digress.

In contrast to most investors, I like to focus on better understanding what’s happening right now. More importantly, I prefer to place my laser-like focus on critical developments in critical markets. Right now, I’m focused on the recent alignment between Chinese equities and China’s Fundamental Gravity after almost a year of the two diverging from each other.

Fundamental Gravity says what?
There are two critical parts to any economic equation: growth and inflation. On the growth side of that equation, growth in China has been slowing since April 2017.

If I was stuck on a desert island and could only see three pieces of Chinese growth-related data each month, I would choose what I call the Big 3: industrial production, fixed asset investment and retail sales.

While three sets of data can’t possibly tell you everything about the underlying economy, the Big 3 come damn close.

--Industrial production peaked at +7.6% annual growth in March 2017 and finished the year at +6.2%.

--Fixed asset investment growth also peaked last March at 9.2%, finishing the year at +7.2%.

--And finishing out the trifecta, retail sales growth peaked at 11% in June (just above March’s 10.9% growth rate) and finished the year at +9.4%.

I’m not cherry-picking here; there are other critical indicators confirming this downtrend in growth. But growth is just one side of the economic equation. Inflation is just as critical.

While growth has been slowing, Chinese inflation has been accelerating. The Chinese CPI bottomed in February 2017 at +0.8%, accelerated for most of 2017, and finished the year at a +1.5% annual rate. The February CPI was reported last Thursday night and came in red hot, accelerating from +1.5% to +2.9%.

Folks, if that rate of acceleration was a pepper, it would be a Carolina Reaper! China’s core inflation has also been on a tear, accelerating from +1.8% last March to 2.5% in February, according to Thursday’s data report.

I regale you with this data deluge not to put you to sleep, but because this “growth down, inflation up” Fundamental Gravity has a profound impact on Chinese equities.

Since 2010, China has been through three regimes lasting at least five months when growth slowed while inflation accelerated: December 2010-September 2011, December 2012–November 2013, and May 2015–April 2016.

During those three regimes, the iShares China Large Cap ETF (FXI) returned −27.3%, +1.8%, and −3.4%, respectively. While the returns are scattered, they are clearly anything but bullishly inclined. On the risk side of the ledger, FXI’s maximum drawdowns registered at −32.4%, −23.8%, and −28%, respectively.

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The bottom line is that when the Chinese economic equation is growth slowing plus inflation running, it equals a crash in Chinese equities. Ouch!

Despite the impact this particular type of Fundamental Gravity has had on Chinese equities in the recent past, 2017 saw a dramatic divergence from this precedent.

During 2017, FXI gained a whopping 34.5%, while experiencing a maximum peak-to-trough drawdown of just −7.3%. Divergence, anyone?

Not only that, but FXI started 2018 by being shot out of a canon. In just the first four weeks of the year, FXI popped +13%, experiencing a nothing burger of a max drawdown of −1.3%.

However, since the “market meltdown” in early February, this divergence has reversed quick, fast, and in a hurry, and FXI has now realigned with its bearish Fundamental Gravity.

Quantitative Gravity says what?
Since peaking on January 26, FXI has lost 12% and experienced a max drawdown of −14.7%. Whammy! I’d hate to be one of those investors who chased FXI’s canon-shot performance early in the year. Remember folks, we don’t tug on Superman’s cape, we don’t spit into the wind, we don’t pull the mask off that ol’ Lone Ranger, and we don’t chase markets.

As a quick reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is both ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.

We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.

Social is our measure of a market’s current energy, or trend. After starting 2018 in full party mode, FXI’s energy has shifted and is quickly approaching the morning after a bachelor’s party, or hangover mode.

Momo is our measure of the amount of force behind the market’s current state. FXI’s Momo peaked on January 23 (three days before the price peaked), and has been careening south ever since. The decisive drop in this indicator is a key contributor to my belief that FXI will move into hangover mode in the coming days.

Barometric is our measure of the rate of force behind the current Momo. FXI’s buying pressure also peaked on January 23 (three days before the price peaked) and has been driving to Key West ever since. This measure gives us immensely more information about investors’ degree of conviction than a simple measure of volume alone, and it’s telling me that selling pressure is building.

Finally, Topo is our measure of a market’s irregularity. I’ll keep this one simple: when a market or company is rallying, then a declining Topo confirms the upswing. On the flipside, if a market is falling, a rising Topo is the confirmation signal that the downtrend is more than just a pullback. To that end, FXI’s Topo reading hasn’t been this high since November 2008. Not only is the current reading the highest in a decade, but it’s also the highest reading since the crux of the 2008 financial crisis! How’s that for a bear market confirmation signal?

FXI has bounced +9.0% off its February 9 low, but despite that, all four quantitative dimensions are confirming that the most likely direction for FXI from here is lower.

Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price.

If you’re new to our Quantitative Gravity framework, it’s important to note that the four quantitative dimensions of a market that we monitor typically move ahead of price. Said another way, price is the last aspect of a financial market to move, quantitatively speaking.

The price confirmation of that will be an FXI close below $46.10 and $44.79. I’ll be pumped if FXI closes below $46.15, but if it closes below $44.79, I’ll put the women and children to bed and go huntin’ for wabbit.

Behavioral Gravity says what?
Our Behavioral Gravity lets us evaluate investors’ perception of this market and how that perception is changing as we move through time.

Retail investors added $1.8B to the five largest Chinese equity ETFs so far in 2018, and nearly $4B in the last twelve months alone. These folks are blissfully unaware of what’s going on from a Fundamental Gravity perspective, and are simply chasing price charts.

I consider this level of bullishness to be a bearish Behavioral Gravity for FXI. Anytime people are throwing money at a market when the Fundamental Gravity is decidedly bearish, it’s usually a great shorting opportunity.

The bottom line
A market’s Quantitative Gravity can diverge from its Fundamental Gravity for long periods of time. But eventually, all markets move in the direction dictated by the Fundamental Gravity of the economy where they trade.

FXI has been playing with house money for over a year, and it looks like the winning streak has run its course. China’s Fundamental Gravity remains bearish for Chinese equities, the Quantitative Gravity is now bearish for the first time since November 2016, and the Behavioral Gravity is bearish because investors don’t realize the club lights have come on and it’s closing time.

Let other investors get distracted by the latest financial market flavor of the day. Remain data dependent, process driven and risk conscious to consistently gain insights into the risks and opportunities that most investors miss.

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