Here’s what’s killing China’s economic growth

By Satyajit Das

Opinion: Reform state-owned enterprises and investment will follow SYDNEY (MarketWatch) — Central to China’s economic growth is a shift from debt-driven investment to consumption. China’s development has been driven by investment, which represents around 50% of Gross Domestic Product. About half of this investment is in property. Infrastructure investment is also high, far greater annually than the U.S. and Europe, but also than other emerging markets — double that of India and around four times that of Latin America. China’s total investment levels are also 10%-15% of GDP higher than comparable countries, such as Japan and South Korea, at the equivalent stage of development. China’s central government wants to enhance domestic demand and consumption, but the task is made even more difficult by the influence that state-owned enterprises command over the national economy. China has about 150,000 SOEs, which control around 50% of industrial assets and employ around 20% of the nation’s workforce. These SOEs receive plenty of government support — except they aren’t as profitable as their private sector peers. SOEs have become a drag on China’s economic potential and are need reform. How, and how much, that will happen is questionable. That said, China’s consumption has not been static, growing strongly at around 8% annually over the past decade. However, the growth in consumer spending has been slower than that of the overall economy and the increase in gross fixed investment, at an average annual growth of over 13% annually, has dropped private consumption to about 35% of GDP. If China’s economy grows at 8% annually , consumption needs to grow by around 11% just to increase the share of consumption one percentage point, 36% of GDP, in a year. Assuming a growth rate of 8% and consumption increases of 11%, it would take around five years to increase consumption to 40% of GDP. If growth slows, then the difficulty increases. Second, legacy issues of rapid expansion and excessive investment will need to be managed. Many projects have dubious economics. The charges that would have to be levied to recover the capital cost and operating expenses of high-speed trains and toll roads, for example, are beyond the means of their users. Many investments will not generate sufficient revenues to repay the borrowings used to finance them, resulting in potential losses to lenders. Third, boosting consumption will reduce savings, affecting the deposit base and cost of funding of Chinese banks, which will reduce their flexibility in managing rising losses from bad loans. It will also require a significant boost in household income, which will affect the profitability of Chinese companies that already operate on thin margins and are struggling to remain cost-competitive globally. It will necessitate investment in social welfare infrastructure, which will make claims on public finances. Fourth, the rebalance will result in slower growth, at least during the period of transition, reflecting the reduction in the growth rate of or decline in investment levels. The resulting economic slowdown will further compound the challenges. These difficulties mean that the temptation for China’s leaders is to continue a strategy of debt-fueled investment — at least until it is absolutely impossible. State-owned surprises China’s SOEs contribute around one-third of total economic value added. Yet probably only around 50 of the 1,500 listed companies on the two Chinese stock exchanges are genuinely private businesses. The SOEs enjoy several advantages. First, key sectors of the economy, such as construction, infrastructure, finance and banking, insurance, resources, media and telecommunications, are reserved for SOEs. A system of licenses and permits controlled by various levels of governments and the Chinese Communist Party guarantees government-controlled firms a major role in economic activity. Second, SOEs enjoy preferential access to finance from state controlled financial institutions, receiving around 60% of all bank loans and more than 75% of the country’s capital. The SOEs benefit from low cost of this capital, reflecting their often monopolistic or protected market positions. Third, SOEs benefit from a range of subsidies, ranging from tax benefits, subsidized input costs and preferred procurement position for government contracts. Fourth, the SOEs pay low dividends, preferring to reinvest earnings, sometime in diverse, unrelated businesses. Despite these significant competitive advantages, the profitability of SOEs lags well behind that of China’s four million to five million private sector firms, which are far more important in terms of employment, tax receipts and output. These private sector firms are responsible for about 80% of China’s urban employment and 90% of net new job creation as well as two-thirds of total fixed-asset investment. SOEs sap the economy The major role played by frequently large, unproductive and unaccountable SOEs distorts capital allocation and economic and financial inefficiencies. Protected SOEs frequently do not pursue profits or greater efficiency, choosing instead (with tacit government support) to increase size, diversify, make foreign acquisitions and acquire new technology. This has contributed to overcapacity in many industries. One notable case was over investment in solar energy, pursuant to a government diktat to increase exposure to renewable clean energy. It resulted in a global glut of solar panels and the bankruptcy of Chinese manufacturers such as Suntech. Local private sector and foreign businesses find it difficult to compete with large dominant SOEs, resulting in higher prices and limited product choice, which must borne by Chinese citizens. The dominant role of SOEs, which favor heavy industry, may impede the development of China’s service sector. The Chinese government, in a moment of uncharacteristic candor, admitted to failing to meet targets in relation to service industries, which account for 40%-45% of its GDP and 35% of its employment, well-below the 60% or more in countries at a comparable stage of development. Successive governments have recognized the need to reform SOEs. Following the 1993 plenum, then premier Zhu Rongji led a program whereby the number of SOEs was reduced by around half, with thousands of loss making concerns being restructured, sold or privatized with around 40 million workers losing their jobs. Subsequently, reform of the SOEs slowed. This reflected concern about the loss of jobs and the fact that the remaining businesses were not loss-making, reducing the immediate need for restructuring. Over time, the state has reasserted its control over the economy with SOEs dominating critical sectors, including banking, finance, transport, energy, natural resources and heavy industry. Large scale privatizations are unlikely. New reform initiatives focus increasing dividend payouts to boost government revenues and on the State acting as a patient, long-term investor maximizing the value of its holdings. Not surprisingly, the SOEs oppose change. The economic and political power of large SOEs and their leaders, many of whom hold ministerial rank, may thwart reform. For example, removal of subsidies by the central government frequently results in provincial governments increasing these to maintain the business. For example, bankrupt Suntech was bailed out by Wuxi’s city government. Confucius is reported as having stated: “Only the wisest and stupidest of men never change”. For the moment, Chinese believe it is wise to maintain the present strategy. History will judge their wisdom.

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What India elections mean for the market

By Michael Kitchen

LOS ANGELES (MarketWatch) — India’s general election — a massive exercise, with more than 800 million voters, that will run until May 12 — began on Monday, and the outcome has mixed implications for investors in the country. There is a lengthy menu of parties and candidates but really just two main contenders for the prime ministership. In one corner is Rahul Gandhi. While no relation to India’s founder Mahatma Gandhi, his father was prime minister, his grandmother was prime minister (both were assassinated), and he is the flag bearer for the Indian National Congress party, which leads the current ruling coalition. In the other corner is Narendra Modi, leader of Bharatiya Janata Party (BJP). The son of a tea merchant, Modi is a vegetarian and writer of poetry, and his critics describe him as a Hindu nationalist culpable for the deaths of hundred if not thousands of Muslims in communal violence when he was Gujarat chief minister. But whatever the controversy, Modi is the clear front-runner. While Indian election polls aren’t always so accurate, Modi’s BJP is seen winning 259 seats in the Lok Sabha (the dominant house of parliament) against 123 for Congress, according to a recent survey from network NDTV cited by Agence France-Presse. With 272 seats needed to control the legislature, the BJP and its alliance look very likely to form India’s next government. Some supporters of Modi say the markets have already priced in a BJP victory, dubbing recent gains for Indian stocks and the rupee /quotes/zigman/4868630/realtime/sampled USDINR +0.18%   as “Modi Magic.” The benchmark Sensex /quotes/zigman/1652085/realtime IN:1 -0.60%  and CNX Nifty are up 5.6% and 6.2%, respectively, for the year to date. Such chatter has grown loud enough that current Finance Minister Palaniappan Chidambaram felt compelled to trash the theory in recent speeches. “I am amused to read in some sections of the media that it’s the hope of a stable government that is bringing in investments and driving up the capital market and the value of the rupee,” The Wall Street Journal quoted him as saying in a speech late last month, adding that those gains are really a function of the current government. “It’s obvious that Big Business — and I am using the word Big with a capital B — is supporting BJP, but that’s because Modi is known to favor crony capitalism,” Chidambaram said at a subsequent press briefing. In fact, the details of Modi’s economic policy (inevitably dubbed “Modinomics” by the local news media) are still vague, with the BJP expected to release a list of proposals this week. Reuters offers some clues as to the thrust of Modinomics, quoting some of his advisors and other supporters as comparing Modi to conservative British Prime Minister Margaret Thatcher. “If you define Thatcherism as less government, free enterprise, then there is no difference between Modinomics and Thatcherism,” the Reuters report quotes Deepak Kanth, a London-based banker and Modi supporter, as saying. Specifically, Kanth sees Modi as smashing through India’s red tape to revive long-stalled infrastructure projects. Indian economist Arvind Subramanian agrees that Modi’s intentions involve a Thatcher-like “Big Bang” of policy moves, but he’s not sure the BJP leader (assuming he becomes prime minister) can pull it off. “On arrival in office, he is expected to identify the 25-50 most important stalled infrastructure projects, locate the bottlenecks and authorize their removal. Hyperactivity on resuscitating big projects will be the most visible sign of the new regime,” Subramanian wrote in a commentary published recently in several newspapers. “But this hyperactivity will face two challenges. Economic decentralization being well advanced, the levers of economic power affecting infrastructure projects ... reside with the states. A majority, including the large states, will be controlled by opposition parties. Similarly, getting the large private-sector infrastructure companies to invest might require taking some of the debts off their books, which will raise concerns about cronyism, create moral hazard and weaken further bank balance sheets,” he writes. Meanwhile, HSBC is tipping a pullback for the rupee, at least once the election dust settles. “We have found the currency tends to benefit into an election but struggles to maintain such positive momentum after the event,” HSBC economists wrote in a recent note. HSBC also warns investors to expect far more government spending than what was outlined in the interim budget earlier this year, which they saw as containing “overly optimistic assumptions on increases in tax revenues and reduction in subsidy expenditure.” “An analysis of past elections reveals that borrowing estimates presented in the interim budget tend to be revised higher during the final budget. The largest revision in borrowing numbers occurred in the 2004-05 fiscal year, when the BJP-led National Democratic Alliance was replaced by the [Congress-led] United Progressive Alliance,” they write.

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Framework for Understanding Market Tops and Bottoms

by Mike "Mish" Shedlock

Last week I received an excellent article from Variant Perception on "Market Tops", and have permission to excerpt some of it. Here is a link to the summary page of Understanding Market Tops. What follows are a few snips from the full report. Framework for Understanding Tops In the following table, we summarize the signs of market bottoms and tops. The signs can be divided into the following categories: corporate, valuation, economic, market and sentiment. Clearly many signs of a top are in place, but there are many characteristics that are currently missing. In the coming pages we will look at each category separately. click on any chart for sharper image Today the market shows many of the elements that are present near market tops. In particular, sentiment is extremely bullish, investors are long and leveraged, and valuations are extended on a wide variety of measures. However, leading economic indicators are still not negative, and so far breadth and technicals have not deteriorated. The medium-term stock market returns are likely to be negative due to excessive valuation, but there is no imminent sign of a medium-term market top. Tops are a process, not a single event. They tend to last a long period of time, and markets whipsaw traders and disappoint bears and short sellers. For example, many signs of a market top were clearly visible in late 1998, but it was not until the end of 2000 that most major market indices started to collapse. Likewise, many elements of a market top were evident in late 2006, but markets didn’t begin to collapse until very early 2008. CORPORATE ACTIVITY: WE’RE SEEING TYPICAL SIGNS OF MARKET TOPS CEOs are bad capital allocators of corporate cash and provide contrarian clues, but insiders are much better at providing insight with what they do with their own cash. A CEO should issue shares when they are overvalued and buy them back when they are undervalued. Likewise, a CEO should buy competitors when they are cheap and avoid overbidding when prices rise. Unfortunately, most share buybacks and most mergers and acquisitions happen at very high prices near market tops, and companies divest units and issue shares near market bottoms. Insiders, however, are smart. IPOs surge near market tops as insiders sell out. Also, near market bottoms insiders buy their own stocks. The fewest buybacks in each cycle happened when stocks were cheapest. It is impossible to make this up. CEOs are just like “dumb money” retail investors, buying high and selling low. If you look exclusively at the US, you can see that M&A levels are very frothy and are near where they were in 2007. Greed is alive and well in the US. They are significantly below levels seen in 2000, but that was the biggest M&A wave ever and marked the peak of telecom, media and internet bubble. It included the likes of AOL’s purchase of Time Warner and other mammoth deals. One area that currently is frothy is the biotechnology sector. The number of biotech deals is the highest it has reached since 2000, and the dollar value is the second highest in history. During the final phases of bull markets, not only does the number of IPOs rise, but the quality of IPOs deteriorates. The following chart shows that only during the final phases of the internet bubble did we see such a high percentage of money-losing IPOs. Investors are chasing unproven business models. In the past decade, private equity players have become more important “insiders”, and the number of IPOs from private equity backed groups has now reached all-time highs. Furthermore, the follow-on deals from private equity sponsored groups are also at all-time highs. Smart firms were buying companies in the bad times and are now floating them and getting out while they can. CEOs and managers tend to overpay for share buybacks and for M&A activity with shareholder money. They don’t mind sticking it to investors. However, when it comes to their own personal money, they are much shrewder. Insiders consistently sell their own stock when markets are high and buy large quantities of their own stock when markets fall sharply and become cheap. CREDIT SIGNS OF A TOP: TODAY LOTS OF JUNK DEBT AND VERY LOW QUALITY In May 2013 Variant Perception wrote a report titled Credit Bubble, Toil and Trouble. We argued that ultra-low interest rates were already leading to a bubble in corporate debt. Investors were issuing large quantities of corporate debt at low spreads. The situation has only got worse since we wrote in our report. As the following chart shows, in 2013 we saw the highest issuance of junk bonds ever. This was true in absolute numbers and as a percentage of all corporate debt. Not only is the issuance of junk at record highs, but we have seen the highest LBO transaction volume since 2007. In fact, the market peak in 2007 is the only year where we saw more leveraged buyouts.

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Disinflationary pressures beyond the euro area

by SoberLook.com

According to the Conference Board, disinflationary pressures are not limited to the Eurozone and can be seen across a large number of the "developed economies". The so-called "Harmonized Indexes of Consumer Prices" or HICP (a measure of inflation that has been standardized based on the EU definition) seems to show consumer prices weakening broadly, with only a couple of exceptions. The Conference Board: - “While the Euro Area has been nearing the deflationary boundary over the past several months, countries outside the monetary union are not spared that same concern,” said Elizabeth Crofoot, Senior Economist with the International Labor Comparisons program at The Conference Board. “Price growth is nearly zero in Denmark and Sweden, and has once again reached deflationary territory in Switzerland, last seen in May 2013. In contrast, after years of having the lowest inflation rate, Japan—together with Norway—is experiencing the highest inflation among the countries compared.” In the US the TIPS market seems to agree with this assessment as the breakeven rates remain subdued (see chart). The HICP trend in the next two months will be critical. It will drive the monetary policy trajectory across key economies, particularly in the Eurozone which is now coming to terms with the possibility of QE (see story).

Putting the jobs number in context

By Jeff Greenblatt

The jobs number was very interesting. At 192,000, it wasn’t a bad number. But the Nasdaq got crushed. Then, for the first time, the bears came out of hibernation on the Dow as well. So what is going on? Recently, I told you that Clinton was credited with 22 million jobs in eight years. That’s 2.75 million a year, which converts to 229,000 a month. Obviously, some months will be better, some not so much. But remember, he was in office at the right place and the right time. He was the beneficiary of a historic Internet breakthrough. He was the beneficiary of the back end of all the good work created by Ronald Reagan. So they are only 40,000 jobs off that pace. What’s a measly 40,000 among friends? Apparently, somebody thinks we should do better. We continue to see the complacency and arrogance as represented by the VIX. This is an economy only five years removed from the worst economic crisis since the Great Depression. They expect this economy to measure up to that one? Who’s kidding whom? I see this very low VIX starting to manifest itself in many kinds of weird ways. But now this market is making new highs again, and when markets make new highs it means it’s priced to perfection. I remember back in the summer of 2000 when stocks were priced to perfection and in fact some of the earnings reports were good. It didn’t matter.

Those were the heady days of the “whisper number,” and if it didn’t hit that number they took the stock out to the woodshed. Stock meets expectation? Not good enough, the whisper number was higher. In this case some of the experts felt the number should have been north of 200,000. Why? They had no idea why? These people are just pulling numbers out of the sky. Here we were coming off the coldest winter in years, and just 30 days ago they were praying the numbers were skewed by the weather. So in essence, 192,000 should have been more than good enough. If you saw some the reactions by Democrats, they weren’t happy at all. You’d think they already lost the election. Now it’s too late. Maybe some of them shouldn’t have been so full of ideology and more pragmatic about the economy. Part of the problem is the sticker shock many are experiencing as they look for houses this season. According to a CNBC article, home prices are up 12.2 percent from this time a year ago and the source is CoreLogic, while wages are only up 2.1 percent. That could be why the stock market got crushed last session. Now lenders actually require buyers to come up with a healthy down payment, something that didn’t happen during the housing boom last decade. The only people who have it are the hedge funds and other investors, which are suddenly backing off. To give you an idea, 65% of mortgage originations were at a fixed rate, while we are above 95% right now. Additionally, buyers could get in with 1% teaser variable rates. Rising rates, higher down payments and a less-accommodating economy add up to shrinking affordability. According to Zillow, by historical standards there is a 62.4% unaffordability rating for Miami. Los Angeles is 57.2%. San Diego is 55.3%. Denver, San Francisco and San Jose are all above 50%. This is a strange set of circumstances. Why? The dollar was up last week out of its triangle and if we follow the usual inverse relationship equities should’ve been down. They were, but it was incredibly uneven as certain areas like biotech and housing got hit especially hard, not to mention some of the newer technology like the Mark Zuckerberg stock. Until Friday afternoon, the SPX and Dow were just fine. Adding to the confusion is the technical situation of what was already hit. Look at this NDX chart. From the last rally leg in February, which I happen to believe was the less-sophisticated chasing performance, they initially retraced it to 61%. Going back the other way on this bounce, they also retraced it back 61%. Forget Friday for a minute. When a pattern retraces 61% one way and then does the exact same thing going back the other way, it confuses traders. What does 61% mean in the first place? The 61% retracement means the underlying strength of the trend is weakening. That means the bull going up was losing strength or else it wouldn’t have had such a steep retracement. Many 61% retracements barely make new extreme pivots (in this case a high). Okay now you have the snap back which was also 61%. What that means is the snapback wasn’t all that strong. So you don’t have too much strength going either way. Now let’s bring in Friday. Right now the bull has zero margin for error at 61/61. But let’s just say it shouldn’t have come back to the low so quickly. Right now we are back where we started from when they bounced it originally. It took about eight 360-minute candles to get to a high, and it was erased mostly in one stretch. Any more selling below this level and one just about could eliminate the trading range scenario. Concerning the bears you know I’ve had a lot to say about them since November 2011. Since the time window in March which this chart is validating I’ve told you the bears are coming with more courage if not a new brand of boldness. Putin had a lot to do with it. But if you had one strong reason to believe in the correction (geopolitical) now with the jobs number and housing affordability issues this thing is suddenly about to let the cat out of the bag. Your takeaway technically coming into the new week is a market that suddenly has zero margin for error and we are starting to hit the seasonal point in the year where markets tend to correct. That would be the May to October phase. Last week I told you this was going to be a market frustrating to both bulls and bears. You see the NDX pattern, it’s a roller coaster. But how about those people trading the patterns similar to the Dow and SPX? Do you think they enjoyed the failure to break out on the new high? If anything changes this week it could be less frustrating to bears. But I still suspect we end up with a winding and grinding type of correction reminiscent of the old patterns from the 70’s. Just a quick update on the meeting I told you I attended last week with the well-known spiritual leader. In my last post I passed along his view the Middle East was hanging by a thread. Part of the problem is peace proposals floated between the Palestinians and Israelis are not acceptable to either party. On Friday, John Kerry stated the United States is reconsidering its role in the peace process altogether. It was just this morning that Ben Stein went on CBS Sunday Morning and said it was time for John Kerry to “wake up.” In a nutshell, the Palestinians are looking for a deal where they would recognize the state of Israel as a state but not a Jewish state. That would mean refugees from across the Middle East who left after Israel became a state in 1948 could return to Israel. Obviously, a lot of those people are no longer alive but their offspring are numerous. What that would do is make the Jewish people a minority in their own country. In a post-holocaust world, that is never going to happen. The John Kerry imposed deadline for talks between the parties is April 29. These days a lot of Americans do not care for Israel as past generations did. But I am here to tell you whether you like Israel or not, it is the absolute key to world geopolitics. If Israel were to hit any nation in the Middle East, especially Iran, a major war would break out and it certainly would impact financial markets. I’ve shown you what happens to charts when war breaks out. Despite the latest excuses to take the market down on Friday, I still believe 2014 has the greatest potential to be the most important geopolitical year of the young century since September 11.

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Changes to the Investment Climate

by Marc Chandler

There are four changes to the broad investment climate. 1. The ECB has stepped up its threat of unconventional action and may have purchased a two month grace period. 2. Confidence in the US economic rebound from sub-par growth in Q1 is strengthening. 3. After a strong start, the major developed countries' equity markets appear poised to correct lower into the start of the US earnings season. 4.  While geopolitical risks with Russia have stabilized albeit at elevated levels, the risks in Asia are rising. How is this for coincidence? The German newspaper, Frankfurter Allgemeine Zeitung (FAZ), broke two stories before the weekend. In one story, the paper quoted BBK President Weidmann and EU Economics Commissioner Rehn arguing against the push from France for greater leeway on its fiscal targets. In another article, reported, without citing a source, that the ECB has modeled a one trillion euro QE program that would boost inflation between 0.2% and 0.8%. When queried by other journalists at a different forum, ECB Vice President Constancio denied knowing about the report, though seemingly, by implication, not the research. One cannot help but suspect it is purposeful leak that is meant to reinforce the Draghi's effort to step up his attempt to hold the market at bay. At last week's press conference, following the ECB meeting, Draghi escalated his verbal jousting increased calls for action, including by the head of the IMF. To appreciate what is going on, consider the contrast: in recent years, the Federal Reserve has been dominated by a single individual--Volcker, Greenspan, Bernanke--. The ECB is much more of a collective. We suspect that Draghi is slowly shepherding the national central bank presidents onto the QE path. Because of the Easter quirk, there is reason to suspect that April will see an uptick in CPI (the flash reading is due on April 30)) from the flash 0.5% March pace. Judging from economic surveys, many economists expect Q1 to be the low point in the inflation, i.e., the greatest risks of deflation. The creditors in the euro area, especially Germany, are wary of pursuing unconventionally inflationary policies just as inflation begins to rise on its own accord. This analysis points to a new realistic window for ECB action seems not in May, which would be many observers tendency (just push out the expectation another month), but in June. This seems to be also along the line former ECB board member Bini-Smaghi suggested in a newswire interview, as well. The possibility of QE will help support peripheral bond markets. Although some US credit spreads are back to levels seen since before the crisis, Spanish and Italian premiums over German remain substantially above pre-crisis levels. The premiums now are around 150 bp. For many years, into 2008, Spain and Italy a smaller premium than France pays now. Indeed, according to Bloomberg generic bond data, between 2003 and 2006, there were brief periods when the Spain would trade through Germany (lower interest rate). We note that there were some technical changes in the ECB's collateral rules that went into effect last week. These changes will increase the haircut on Spanish and Italian T-bills used for collateral. It appears to be instrument specific and will not impact residual maturity of bonds. Reports suggest that this may not have much impact as Spanish and Italian banks use bills for managing liquidity more than collateral. On the hand, changes may also make more assets eligible for use in ECB operations. We took the middle ground between those who suggested that the weakness of the US economy was only weather-induced and those who said the weakness showed that the economy was addicted to QE. We recognized that other influences, such as the build of inventories in H2 13 and the tax break on corporate investment brought forward some projects, also slowed the economy. We also recognized that some housing data had peaked in H2 13 and were already softening before the turn of the year. However, weather also contributed to the sub-par performance and last week's news, both the surge in auto sales and the constructive employment report, point to an economy regaining traction. In particular, we note that the participation rate rose to 63.2%, a six month high, without an uptick in the unemployment rate. We appeared to have been too cynical in our anticipation that the loss of emergency jobless benefits would generate further declines in the participation and unemployment rates. The workweek increased to 34.5 hours, the best since last November. If the US economy expanded around 1.75% in Q1, then it appears that growth can return toward 3.0% here in Q2. This keeps the Federal Reserve's path clear. Tapering continues apace. Indicative interest rates for the end of 2015 (look at both the Eurodollar and Fed funds futures strip) finished last week at their lowest levels since the FOMC meeting on March 19 and Yellen's press conference. A rate hike in H2 2015 still seems like the most likely time frame, assuming no significant shocks, which would include renewed decline in core inflation. The decline US interest rates before the weekend was more a function of the drop in equity market than the US economic news. The NASDAQ fell 2.5%, which is its third steepest drop since the start of 2012. It peaked a month ago.  It finished last week below its 100-day moving average fore the first time since the end of 2012.  The S&P 500 posted its record high before the weekend, but proceeded to sell-off and finished below last Thursday's low. Technicians refer to this price action as a key reversal. There are also bearish divergences in some technical indicators like RSI and MACDs. Given the magnitude of the sell-off in US equities and the appreciation of the yen, the Nikkei and other regional markets are at risk of steep losses at the start of the week. More interesting will be the European bourses reaction. On one hand, the risk of QE and lower interest rates would seem to encourage equity market flows. On the other hand, consider the performances just since mid-March: the Italian and Spanish markets are up about 10.5%. The German DAX is up 9% and the French CAC up 7.5%. Spain and Italy's markets are above the top of their Bollinger Bands, (two standard deviations above the 20-day moving average). France and Germany are flirting the top of their bands. Given that the UK's FTSE has not fully participated in the latest leg up, gaining less than half of the CAC's rise, it may hold up better, if a correction sets in. And it looks to us as if the risks of such a correction have increased. It is not uncommon, it seems, to see reversals at the start of new quarters or as the US earnings season begins. The dispute over islands in the South China Sea appeared to pose the greatest geopolitical risks before Russia's take-over of Crimea. While the tensions with Russia remain at high levels, they have stabilized. There is risk that the breakaway province of Moldova, on the east border of Ukraine, Transnistria, becomes a new flash point. If Q1 was about Europe, Q2 might be about to Asia. Later this month, President Obama will visit South Korea, Malaysia, Japan and the Philippines. The Japan-China dispute had appeared the most pressing. Unbeknownst to many, the dispute with between China and the Philippines has escalated and is, arguably, surpassing the dispute with Japan. There have been two developments that have escaped the notice of many observers. First, China tried in vain to stop the Philippines from re-provisioning a garrison it created on the disputed Second Thomas Shoal in 1999. That China failed does not necessarily mean that it will give up, expressing it displeasure at the Philippines insistence of using force to resolve the dispute. It does not like fait accompli. Second, the Philippines also pressed its legal case, filing a 4000-page opening argument with the International Permanent Court Arbitration at The Hague. China is not happy about this either. The sovereignty of the disputed islands is outside of the court's jurisdiction, but it can decide whether it is really land or not, as they are often submerged. If it is not land, then the Philippines' claim is stronger. But not just the Philippines' but Vietnam, Malaysia, Brunei, Indonesia, and Taiwan's claims may be stronger, as well. At the end of last week, the US State Department's point man on Asia, Assistant Secretary of State for East Asia, Daniel Russel warned China not to take inspiration from Russia's annexation of Crimea (we anticipated this here). China took exception with the official remarks, Make no mistake about: although Russia's threat in Europe is real and will not go away as long as Putin rules, the geopolitical problems in Asia are even more vexing. Yet, what Kissinger once purported to have asked about Europe (who do you call?) is more applicable to Asia now. It is not just the US adversaries that ought to act in a restrained fashion, but so too should US allies. The nationalization of disputed islands by Japan prodded China with a stick. The Philippines are flaunting their security pact with the US to embarrass China. The US and China would have preferred to let sleeping dogs lie. But now that they have been awoken, they may come back to bite in the period ahead.

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