June 1, 2016

Ring of Fire

Yesterday China’s stock-futures market Flash-Crashed 10% and recovered in the same single minute.

For those new to market structure, the term “Flash Crash” references a hyperbolic rout and recovery in US equities May 6, 2010 in which the Dow 30 erased a thousand points and gained most of that back, all in 20 minutes. It’s vital to understand the cause, whether you’re the investor-relations officer for a public company or an investor.

China blamed a futures trade for prompting Tuesday’s fleeting plunge. A year ago, China’s stock-futures market had exploded into the planet’s busiest. Then as its equity market was imploding last summer, the government cracked down on futures trading. China also moved to devalue its currency in August last year, ahead of a dizzying Aug 24 plunge in US equities that saw trading in hundreds of Exchange Traded Funds (ETFs) halted as share-prices and fund asset-values veered sharply apart.

Trading in 2016 Chinese stock futures is a shadow of its 2015 glory but yet again sharp volatility in derivatives followed a currency move. Monday as the USA marked Memorial Day the People’s Bank of China pegged the yuan, China’s currency, at the lowest relative level versus the dollar since the Euro crisis of 2011, which also brought rocking volatility to US stocks.  A similar move Aug 12 preceded last summer’s global stock-market stammer.

Every time there’s an earthquake in Japan or Indonesia, it seems like another follows in Chile or New Zealand.  What geologists call the “Ring of Fire” runs from Chile and Peru up along the west coast of the United States and out through the Aleutian Islands of Alaska and down past Japan and Southeast Asia to the South Pacific and New Zealand.

The more things interconnect, the greater the risk. Tectonic connections are a fact of life on this planet, and we adapt.  But we’ve turned global securities markets into a sort of ring of fire as well. In geology, we link tectonic events and observable consequences. In global securities markets, we don’t yet give the magma of money its due.

Globalization helped to intertwine the planet, sure. But it’s not the fault line. All the money denominating everything from your house to Chinese futures is linked via the dollar, the globe’s “reserve currency,” meaning it’s the House Money, the one every country’s central bank must have. If for instance a country’s currency is falling, it can sell dollars and other currencies and buy its own to improve the ratio and thus the value.

Two consequences arise that feed directly back to US public companies and investors.  Suppose the world’s markets were all tied together with a single string and each market had a little coil to play out. That’s currency. Money.  If one market is doing well, the others may be tempted to tug on the string in order to be pulled along, or to let out some string to change the balance of investment flows.

The process becomes an end unto itself.  The connecting currency string is tugged and played in an effort to promote global equilibrium in prices of assets and performance of economies. So arbitrage develops, which is investing in the expectations of outcomes rather than the outcomes themselves. Focus shifts from long-term returns to how things may change based on this economic data point or that central-bank policy shift.

The fissures that develop can be minute monetary arbitrage imbalances like China’s futures flash crash yesterday.  Or much larger and harder to see, like trillions of dollars in ETFs focused on a stock market trading 15% over long-term valuations that rest on economic growth half that of historical averages.

Before the May 2010 Flash Crash, the Euro was falling sharply as Greece neared collapse.  Before 2011 market turmoil globally, the Euro was again shuddering and some thought it was in danger of failing as a currency (that risk remains).  In Japan, the stock market is up 80% since the government there embarked in 2012 on a massive currency expansion. Now this year, the government having paused that expansion, it’s down 10%.  Has the market corrected or is it inflated?  Is the problem the economy or the money?

On the globe’s geological Ring of Fire, unless we achieve some monumental technological advance, living on it comes with risk and no amount of adjustment in human behavior will have an iota of impact. It’s tectonic.

In the stock market, fundamentals matter. But beneath lies a larger consideration. Markets are linked by currencies and central banks toying with strings.  The lesson for public companies and investors alike is that a grand unifying theme exists, like the physical fact of a Ring of Fire: Watch the string.

And there was a tremor in China again.

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