China's Yuan Bears Predict More Trouble Ahead

Yuan Rally Unlikely to Last: Panmure Gordon
  • Walker of Asianomics predicts U.S. recession, Treasury rally
  • Raoul Pal sees `black swan' risk of European bank failures

Before China’s devaluation in August roiled global markets and spurred some of the hedge fund industry’s biggest names to bet against the yuan, a small cohort of researchers saw the whole thing coming.

Now, some of those same forecasters are warning that there’s more turmoil in store -- and it’s not just China they’re worried about.

Asianomics Group Ltd.’s Jim Walker, who predicted the yuan’s four-year advance would end a month before the currency peaked in January 2014, is forecasting a U.S. recession and says 10-year Treasury yields will plunge to all-time lows. Raoul Pal, publisher of the Global Macro Investor report and a yuan bear since 2012, says European bank shares will tumble by half. John Mauldin of Millennium Wave Advisors, who has argued since 2011 that the Chinese currency should weaken, sees the risk of heightened geopolitical instability in the Middle East as lower crude prices strain the budgets of oil-rich countries.

While all three forecasters see scope for further declines in the yuan, they’re also emphasizing risks outside the Chinese economy as the outlook for world growth dims and commodities trade near the lowest levels in more than 15 years. Their bearish stance has gained traction in global markets this year, with share prices from New York to Riyadh and Sydney sliding as investors shifted into gold and sovereign bonds.

QuickTake The People's Currency

“There’s a storm of troubles coming,” Pal, a former hedge-fund manager at GLG Partners whose clients now include pension plans and sovereign wealth funds, said in a phone interview from the Cayman Islands. “The risk of a very bad outcome in 2016 and 2017 remains the highest probability.”

Popular Trade

Investors who followed the advice of early yuan bears got a head start on what’s become one of the hedge fund industry’s most popular trades. After the August devaluation, managers including David Tepper of Appaloosa Management and Kyle Bass of Hayman Capital Management publicized their pessimistic views on the currency, while the cost of wagering on yuan declines in the options market -- as reflected in so-called risk reversals -- has more than doubled.

Walker, whose bearish call on the Chinese stock market in 2007 also proved prescient, says policy makers should allow a one-time devaluation of 10 percent because the yuan’s gradual decline in recent months has encouraged mainland investors to get in front of further weakness by shifting capital overseas.

U.S. Recession

When he looks beyond the Middle Kingdom, Walker says a contraction in the American economy will send 10-year Treasury yields to 0.5 percent by the second quarter of 2017, from 1.74 percent on Friday. He predicts gold will surge more than 60 percent to $2,000 an ounce this year as investors flock to haven assets.

“It’s not looking good for the U.S.,” he said in an interview in Hong Kong.

Walker’s predictions, like his yuan call in December 2013, are out of step with the consensus. The median forecasters tracked by Bloomberg see U.S. growth of more than 2 percent this year, while they project gold will end the year at $1,115 an ounce and yields on 10-year Treasuries will rise to 2.74 percent by the middle of next year.

Walker’s short recommendations also include the Hong Kong property sector and the Australian dollar, while he sees potential for resilience in Indian stocks and Southeast Asian banks. Emerging-market shares in Asia are poised to outperform counterparts in advanced markets, he says, because developing-country valuations already reflect waning prospects for the global economy.

For Pal, there’s more scope for turmoil in Europe’s banking system after disappointing earnings from Credit Suisse Group AG and Deutsche Bank AG helped send the region’s financial shares tumbling this year. He says stock prices in the industry may fall 50 percent over the next 18 months as banks’ derivative, currency and energy holdings sour. Pal has also advised clients to buy credit-default swaps on European lenders, calling bankruptcies or government bailouts a key “black swan” risk this year.

Oil Rout

Mauldin, who reiterated the case for a China devaluation in a June 2015 book on the nation’s economy, is now focused on the ramifications of oil’s collapse on the Middle East. The 45 percent plunge in Brent crude over the past 12 months has dragged down regional equity markets, prompted Saudi Arabia to cut spending and spurred bets that the country will abandon its currency peg to the U.S. dollar.

“I’m very concerned about the House of Saud losing its grip on power under financial stress and budget cuts, and sending the whole region into chaos,” Mauldin said in an e-mailed response to questions.

While yuan bears were vindicated after the currency weakened more than 7 percent from its two-decade high against the dollar in January 2014, Pal and Mauldin arguably flagged their concerns too early. Even Walker has issued recommendations that didn’t pan out; his advice to bet against Japanese stocks in November 2014 was followed by a rally in the benchmark Topix index to an eight-year high the following August.

What’s more, it’s unclear whether bearish yuan trades will turn into the big money-makers that many funds are now counting on. The yuan has rebounded 1.1 percent from this year’s closing low on Jan. 8, with policy makers saying there’s no basis for another sharp depreciation.

The Chinese currency was little changed at 6.5193 per dollar in onshore trading as of 4 p.m. Hong Kong time on Monday, while the MSCI All-Country World Index of global equities rose 0.3 percent.

Sinking Markets

Hedge funds hoping for a big devaluation “are not going to make money in the next 12 months on this trade,” said Paul Krake, the founder of research firm View from the Peak in Hong Kong who’s been bearish on Chinese stocks for three years. Authorities are committed to keeping the currency stable and can close the capital account if needed, said Krake, who previously worked at U.S. hedge funds Caxton Associates and Moore Capital Management.

Market moves this year have given more credence to the bearish predictions of Walker, Pal and Mauldin. The yield on 10-year Treasuries has declined 53 basis points so far in 2016 as the Standard & Poor’s 500 Index of U.S. shares retreated 6.2 percent. Benchmark stock indexes for European banks and Saudi Arabia have both dropped at least 14 percent, while Standard & Poor’s downgraded the kingdom’s credit rating on Wednesday.

Walker’s advice for clients in a Feb. 12 webcast? “Get your hard hats on for the state of the world economy.”

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