What’s happening?

Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever - Nassim Nicholas Taleb

The last few weeks have seen significant volatility in the international markets with only one market China which has been an exception. Last year’s decline in energy and the commodity complex led to a singular decline in global bond yields (of course Uber, SpaceX and Airbnb also have a deflationary impact). And, as the bund yield declined so did the EUR/USD touching a low of 1.05 and then recovering now with yield correction back to 1.14. While the S&P 500 has continued to nudge higher over the last year delivering 13% YoY return, STOXX 600 has appreciated 15.7% YoY and within that the German markets have gone up 18.9% benefiting disproportionately from EUR decline.

10 Yr Yield	Current	1 Month Ago	1 Year Ago	1M Change	1Yr Change
US	2.15%	1.89%	2.49%	0.26%	(0.34)%
Germany	0.62%	0.11%	1.31%	0.51%	(0.69)%
Japan	0.39%	0.32%	0.58%	0.07%	(0.19)%
China	3.37%	3.62%	4.17%	(0.25%)	(0.80)%
India	7.95%	7.78%	8.79%	0.17%	(0.84)%

The US bond yields are reacting to 2 factors principally – oil and an anticipation of Fed rate increase later in the year backed better GDP data (Q2 GDP 3x stronger than Q1 in the last 15 years). The recent reversal in German yields has been driven by a combination of factors:

• Sharp pick-up in German PMIs and global oil prices (brent has recovered from under 50 to 67 levels);
• Large supply of government paper despite the ECB purchases;
• A proposal from European governments that infrastructure funding would be beyond Maastricht budget criteria;
• The potential of Greece default in July.

German inflation expectations have been at 1.87%, so most of the recovery in yields has been real yield from (1.76)% to (1.25)%. Further, in most quantitative easing situations yields typically fell in anticipation of the outcome but once the purchases started yields have in a few months tended to stabilize or rise back to levels 3-6 months prior to the QE.

The ongoing financial repression of savers globally in US, Japan and Euro has been implemented to stabilize government debt to GDP while aiding asset markets to support consumption. The asset markets are supported by reduced cost of capital, lower cost of leverage and these in turn support cash financed M&A activity and repurchases. This move by central bank have tended to enhance beta in stock prices by making risk-free near zero cost of equity being pretty much comprised of equity risk premia and therefore the volatility.

Japan is the highest beta market and global tech has the best operational leverage (with low financial leverage) to benefit as global economy improves and bonds yields rise. Yield plays (utilities, REITs, high dividend stocks) and staples will underperform as US rates rise. USD rise should resume shortly as bunds stabilize.

Chinese Exception

While the globe is witnessing a asset price correction, China is on its own path given its unique economic backdrop of GDP, credit and investment growth. (some recent media articles)

• China’s exports fell 6.4% from a year earlier in dollar terms, after a drop of 15% in March, data from the General Administration of Customs showed Friday. The result was well below the median forecast of a 2.5% increase by 13 economists in a survey by The Wall Street Journal.
• The People's Bank of China (PBOC) reduced both the benchmark lending and deposit rate by 25 basis points to 5.1 percent (third cut in 6 months) and 2.25 percent, respectively, in response to weaker-than-expected economic activity data, which has raised concerns that the government's annual gross domestic growth (GDP) target of "around 7 percent" could be at risk.
• In meetings this week, officials with the People’s Bank of China have called on commercial banks to hold maximum deposit rates at levels set in February and not raise them to a new, higher ceiling the central bank set on Sunday, said two bankers with direct knowledge with the matter. (Given the high levels of corporate and municipal leverage PBOC is worried what higher cost of capital would do) 
• Stock values took off a year ago this month after new rules made it easier for Chinese nationals to buy shares. That encouragement came at the same time wealthy Chinese buyers were increasingly looking for places to invest, analysts say, primarily because Chinese officials were tightening the rules on investing in the property market, the traditional magnet for Chinese money. (Shanghai A share market is up 113% in a year)
• So what if almost two-thirds of new domestic equity investors in China left school before 15? Or that six per cent are illiterate. Wall Street analysts are just as dazzled by market rallies. Okay, three million new account openings a fortnight seems frothy. As does a third of stocks in the Shenzhen A index more than doubling in the past year, with an average price-to-earnings ratio of 180 times. (Sadly forward multiples are harder to calculate as a third of these companies will not be making profits this year.) Bubble watchers point out median earnings multiples for Chinese technology stocks are twice US peer valuations at their dotcom peak. More worrying perhaps is a health-goods-from-deer-antlers producer on 70 times, the seamless underwear manufacturer on 90 times or those school uniform and ketchup makers on 330 times!
• "Almost everyone is doing margin trading, so I am following the trend,” said Zhang, who borrowed as much as 1 million yuan from her brokerage. “If I buy good stocks, the returns can completely cover the costs.” Zhang said she doesn’t pay attention to corporate debt levels, which reached 125 percent of gross domestic product in 2014, according to the McKinsey Global Institute. The aggregate margin lending balance at China's stock exchanges has almost doubled since end-2014 to CNY1.9trn (USD302bn), equating to 3.1% of domestic market capitalisation as of 8 May.
• Chinese businesses raised more than 252 billion yuan ($41 billion) from share sales in 2015 through Thursday, on pace for the busiest year on record, according to data compiled by Bloomberg. At least 30 of those companies, including HeiLongJiang ZBD Pharmaceutical Co. and Silvery Dragon Prestressed Materials Co., are using a portion of the proceeds to pay down liabilities. The Shanghai Composite has surged 120 percent from last year’s low in January and it’s gone 479 days without a 10 percent drop from a recent peak, the longest stretch in its more than two-decade history.

In summary, as internal and external growth momentum falters, PBOC is reducing rates to support the high levels of corporate and local government leverage. China equity market has seen a massive increase as real estate returns decline and regulations make it a more difficult investment option. Margin lending is on the rise and corporates are raising more and more equity capital to repay leverage, potentially transferring risk to households.

The impact of the Chinese slowdown is widespread – Copper has been on a decline since 2011 was down another 7% for the year, USD/AUD and USD/BRL up 18% and 35% respectively. If China has a hard landing, with a lending crises or growth rates falters under 5% or exchange rates start depreciating, we would again see a revival in global bond bulls.

For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases--the equity bubble in 2000 and the credit bubble in 2007--central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy. - Stephen Roach, Morgan Stanley

The Chinese are making the same mistakes as the west did in keeping asset markets high and now compounding the risks created by historical high leverage based expansion.