It is no secret to readers of this column that I think China is in the beginning stages of a credit bubble unraveling, which is likely to have an outcome similar to the 1997-98 Asian Crisis. I am surprised that after the Chinese stock market crashed in 2015 we have not yet seen this hard landing.

It is true that China still has much stronger government control over its economy and the Chinese authorities are fighting this hard landing with all they’ve got. Many investors are looking at the stabilization of the Shanghai CompositeSHCOMP, +0.12%  and mainland economic data and thinking that China is out of the woods (see chart). Will China succeed in ultimately preventing a hard landing? I don’t think so.

First, the Shanghai Composite has not managed to recover what it lost in January 2016, which is what I have referred to as the Mother of All Dead Cat Bounces (MOADCB). This type of trading action has all the hallmarks of a bear market rally.

Second, commodity prices are refusing to rally in the seasonally strong part of the year, the current March-September period. China is the No. 1 consumer of most commodities. This type of price weakness across multiple commodities does not rhyme well with stronger-than-expected Chinese economic data (see chart). Could it be that the Chinese are cooking the books on some of their economic releases? Sure could.

Third, the action in the Chinese stock market shows a rather pronounced weakness under the surface. While the Shanghai Composite looks to be rebounding in MOADCB fashion, the mainland small-cap ChiNext Index 399006, -0.40% is going in the opposite direction. If the Shanghai Composite is experiencing a dead cat bounce, the ChiNext Index is the ultimate roadkill, as it has been flattened out after multiple trucks have run it over. ChiNext has long taken out that climactic January 2016 low when mainland Chinese stock exchanges re-crashed due to malfunctioning circuit breakers. It is now headed lower (see chart).

Some of this extreme dichotomy between mainland large-caps and small-caps can probably be explained by the decision of MSCI to add shares of 222 Chinese companies to its emerging markets benchmark next year for the first time. Accordingly, some index funds will begin to include Chinese stocks, with an initial flow of some $1.8 billion expected from passive funds. Ultimately that number is likely to be closer to $20 billion. The new weighting will include less than 1% of the MSCI indexes, which is not all that much in the grand scheme of things. This type of index decision is not large enough to explain a situation where the Shanghai Composite is going up and the ChiNext Index is going down.

Ultimately, the clock is running out on the Chinese economy, which is in the first stages of an unraveling credit bubble. As the Chinese economy has slowed dramatically, borrowing has picked up dramatically if you look at a broad credit measure like total social financing (see chart). It’s like living on credit cards to live beyond one’s means — only in this case the picture is incomplete as it does not include shadow-banking lending activities, which are as large as China’s GDP by some estimates. Include shadow banking, and China’s situation is similar to living large on credit cards, and when no credit lines are available, visiting the local loan shark and getting another high-rate loan.

Does North Korea travel ban signal invasion?

Last week the U.S. State Department announced it would ban Americans from traveling to North Korea, beginning in August, and called on all U.S. nationals in North Korea to depart immediately. This sure sounds like preparation for some action against North Korea and its leader Kim Jong Un, whose authoritarian government has stepped up its missile development to an unprecedented scale. Kim became a major point of discussion between President Donald Trump and Chinese President Xi Jinping in April. While Trump originally expressed hope that China would pressure North Korea about its nuclear program, he has since realized that China is unlikely to be of much help.

Chinese trade with North Korea is exploding. Furthermore, China takes in three-quarters of North Korean exports and supplies three-quarters of North Korean imports. It would not be an overstatement to say that without China, North Korea cannot function as a country. That exports and imports are so evenly balanced is due to the fact that this is the closest thing there is to a barter economy, where goods and services are paid for with coal and other natural resources. Still, the Chinese seem to be unwilling to use their massive leverage, as they don’t have too many allies throughout Asia. (Having a renegade ally is better than having none.)

If the U.S.-imposed travel ban is indeed the first step toward an attempt to depose Kim Jong Un, the U.S. Dollar Index DXY, +0.14%  is in a prime position to experience a significant rebound, as it is right at the bottom of a two-year trading range (see chart). Also, my theory that the Chinese may want to use the noise around the escalation of hostilities to devalue the yuan USDCNY, +0.0711%  to the tune of 20%-40% may get tested, as they have used yuan devaluations in the past to bypass an improperly functioning mainland financial system. I think there’s a high probability that China devalues the yuan again.

By Ivan Martchev
MarketWatch
Ivan Martchev is an investment specialist with institutional money manager 
 Navellier and Associates . The opinions expressed are his own.

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