The litmus test for the global economy

China’s property sector is at the epicentre of the crisis

A branch of Centaline Property Agency in Hong Kong © Bloomberg

Indebted Chinese property developers threaten a domino effect on western credit markets , as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

Second-order impacts are starting to appear as a result of China’s lockdowns. These are having a big impact on the critical property sector, which makes up as much as 25 per cent of gross domestic product.

Housing sales fell almost 40 per cent in February and seem likely to be down again in March, while developer Evergrande cut prices to try and maintain its cash flow. This creates growing risk in the offshore dollar market, where property developers have been significant borrowers, with Fitch already warning of possible defaults. It is unclear whether local authorities can provide much support, as their dependence on revenue from land sales means their own position is weakening.

Rightly, the world’s attention has focused on the impact on public health of the coronavirus pandemic and the best ways of mitigating it. But as Martin Wolf highlights in the Financial Times, the virus is an economic emergency too, with the ability to plunge the world into a depression. Talk of the reforms made to the world’s banking systems since 2008 misses the point. The risk is now centred on the vast build-up of corporate debt since the global financial crisis, under the easy money policies of the world’s central banks.


China’s property sector is unfortunately the epicentre of this debt. As we noted in the FT in August: “Its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.” Last month’s collapse of car sales back to 2005 levels of 244,000 confirms the damage that has been done.

Sales by China’s top 100 property developers plunged by 44 per cent in February, and Caixin reports that over 100 builders went bust in the January-February period, normally one of the busiest times for property sales. Equally worrying, as Caixin’s chart below illustrates, is that, although the largest developer, Evergrande, bucked the trend, this was only because it cut prices by 25 per cent in February and offered 22 per cent reductions this month.

There are few signs of a sustained upturn, with S&P reporting that housing starts were down 45 per cent across January-February. S&P adds that property sales could fall 20 per cent this year, if the effects of the lockdowns are still being felt in April, as seems likely.


The issue is that we are now starting to see second-order impacts of the lockdowns emerge, particularly in terms of consumer affordability and supply chain disruption:

  • The economic impact of the initial lockdowns was focused on two areas — companies and consumers. Companies were shut down, and consumers were quarantined
  • In turn, this led to a number of key impacts within and outside China
  • Within China, demand disappeared for a wide range of products as consumers were unable to leave their homes; supply also disappeared as companies shut down
  • And ‘out of sight’, critical logistic arrangements were being completely upended by quarantine measures, and the need to prioritise essential food/medical supplies

We can probably assume that truck drivers have now been released from emergency duties and from quarantine (if they travelled from infected areas across provincial borders). But we have no idea if their basic equipment — containers, specialist materials, etc — is in its normal place. We do know, however, from the shipping industry that its activity has been severely disrupted, with ships away from their usual moorings and many idled due to lack of work; containers and crew are equally disrupted.

It is safe to assume that most Chinese companies and consumers are short of cash and that consumers will cut back on all but essential spending, further depressing demand. This creates the risk of a vicious circle, whereby property sales remain depressed, reducing developer cash flow still further after most building activity came to a standstill during the lockdowns.

Fitch Ratings identified five Chinese corporations with a high risk of refinancing in a recent report, four of which are in the homebuilding sector, citing concerns about near-term capital market debt maturities and the unpredictability of the epidemic. A further sign of stress, as the Financial Times has reported, is that land sales are now running at less than a quarter of average levels.

Two key facts highlight our concerns:

  • Chinese developers ramped up their offshore dollar borrowing by 52 per cent to an all-time high of $75.2bn last year, according to Centaline Property Agency, as onshore funding became more difficult. And as S&P reported in November, before coronavirus hit: “For some developers, offshore yields to maturity have surged well beyond the mid-teens, reflecting low investor confidence.”
  • Chinese borrowers also tend to operate on a short-term basis, with an ICE BofA index of Chinese high-yield securities in dollars having 2.7 years to maturity, compared with 5.9 years for a similar US index.

We have warned here for some time that China’s property market has been ‘subprime on steroids’. Property sales have been buoyed by vast government stimulus programmes. And western investors have flocked to lend in the offshore dollar market, attracted by the high interest rates on offer compared to those in their domestic markets under central banks’ zero-interest rate policies.

The renminbi’s weakening beyond Rmb7 to the US dollar adds to the difficulties developers will face in servicing their dollar debts.

The potential for a domino impact on western credit markets from a coronavirus-related downturn in China’s property market should already be keeping regulators up at night.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.

“They may ring their bells now, before long they will be wringing their hands”

The wisdom of Sir Robert Walpole, the UK’s first premier, seems the only possible response to this weekend’s headline from the Wall Street Journal. How can a National Emergency ever be the basis for a major rise in stock markets?

Of course, we all know that stock markets have become addicted to stimulus. But the problem with stimulus is that the patient needs more and more of it, to keep markets moving higher:

But the headlines surrounding the National Emergency clearly did the job as far as the High-Frequency Traders were concerned. They still dominate equity and other major markets, and Friday afternoon was exactly the kind of bumper payday that they adore.

The only problem is that neither stock markets, nor even the Federal Reserve, can cure coronavirus. And if the pandemic continues as the experts expect:

  • Between 160 million and 214 million Americans will become infected
  • Between 2.4 million and 21 million people could require hospitalisation

Clearly, no hospital system in the world could cope with the higher end of this range, particularly if they all come at once. And although the US system is easily the most expensive in the world, its performance is relatively poor by comparison with other major Western nations.

One key issue, of course, is testing. Nobody can know the actual size of the problem until we know how many people are already affected. And yet, as the WSJ reports from the President’s speech on Friday:

“By early next week, Mr. Trump said, there would be a half-million additional tests available, with 5 million tests available within a month.”

By comparison, China already has the capacity to do 1.7 million tests a week, according to the World Health Organisation.

This, of course, is why the experts are talking about trying to ‘delay’ the pandemic, rather than ‘contain’ it, as the chart based on US Centers for Disease Control and Prevention analysis (interpreted by Vox) confirms.

The US lack of a proper social support system is also a major disadvantage. Around 34 million American workers have no access to paid sick leave, for example, and 27 million don’t have health insurance.  These people may well feel they have to keep working even if infected in order to pay the rent.

Hopefully, the new support package agreed on Friday night will help solve these problems. But who knows how long it will take to actually roll out the measures, and how many people will benefit?

The essence of populism, of course, is that it supplies simple answers to complex problems. And coronavirus is likely to prove a classic case of this weakness in action:

  • Experts suggest the virus will keep returning unless ‘herd immunity’ can be established
  • They estimate this means around 60% of the population therefore need to be infected

Data from China and Italy confirms that the main risk from coronavirus is to people over the age of 70, as the chart shows. The CDC also recommend that people with serious chronic medical conditions such as heart disease, diabetes and lung disease need to take special precautions.

But their voice is being drowned out. People are understandably frightened, and they need wise and well-informed leaders to give them clear messages. Leaders should be focused on aiming to manage the pandemic and on taking the obvious steps to protect those most vulnerable.  Unfortunately, the opposite is happening as former UK Finance Minister, Lord Darling  has noted:

“There is a striking lack of global cooperation in dealing with coronavirus”.

The issue is that effectively closing down large parts of the economy in response to coronavirus is a very high risk strategy:

  • Millions of businesses could well go bankrupt around the world, and tens of millions lose their jobs
  • And as watchdog the Institute of International Finance already warned on Thursday:

“Global growth is potentially approaching 1% this year (anything below 2.5% is essentially recession). The multitude of shocks in the system now risks a global “sudden stop”. Falling oil prices potentially accelerate mounting credit stress in the US. Vulnerable emerging markets are already seeing large outflows”.

Friday saw Wall Street celebrating its latest “fix” of easy money. But as Bloomberg also noted:

“For context, this was the S&P 500’s best day since Oct. 28, 2008. At the end of that day, the bottom was more than 4 months away, and there was a 29% fall before hitting the intraday low.”

We may well all come to regret, as we wring our hands in the summer, that the bells rang too soon.

 

 

Will stock markets see a Minsky Moment in 2020?

Few investors now remember the days when price discovery was thought to be the key role of stock markets. Instead, we know that prices are really now set by central banks, on the model of the Politburo in the old Soviet Union.

How else can one explain the above chart? It shows the US S&P 500 Index has risen 50% over the past 5 years, even though US corporate profits have fallen 5% (using US Bureau of Economic Analysis data).

As in the old USSR, central banks have also abolished “bad news”.

All news is now good news, as any ‘bad news’ means the Federal Reserve will rush to provide more price support. It has been so successful that the Index hasn’t even suffered a 20% correction over the past decade, as my Chart of the Decade confirmed.

But does this mean that stock markets will never fall again?  That is the real question as we enter 2020.

On the positive side, we know that companies have also provided major support via buybacks.  Apple alone did $240bn of buybacks between 2014 – 2018. Companies spent $800bn in total in 2018, but cash now seems to be tighter with 2019 purchases down around 15% to $700bn.

We also know that President Trump believes a strong stock market is key to his re-election this year. His Trade Adviser, Peter Navarro, has already suggested 2020 will be another record:

“It’s going to be the roaring 2020s. ”Dow 32,000 is a conservative estimate of where we’ll be at the end of the year.”

Certainly investors seem to be very positive, as the above charts confirm.  Share prices for the FANGAM stocks – Facebook, Apple, Netflix, Google and Amazon stocks have soared to new heights:

  • Apple for example, was up 32% in Q4 and nearly doubled in 2019
  • On its own, it provided 14% of the S&P’s gain in the quarter, and 8.5% of the annual gain

This wonderful performance took place even though Apple’s net income has fallen for the past 4 quarters. It is also hard to argue that Microsoft or the other FANGAM companies are suddenly about to see supercharged growth.

So is there a negative side?  Maybe old-fashioned investors were simply wrong to believe stock markets’ key role as price discovery and the efficient allocation of capital?

If one wants to worry, one has to instead look to the insights of Hyman Minsky, who warned that:

  • A long period of stability eventually leads to major instability
  • This is because investors forget that higher reward equals higher risk
  • Instead, they believe that a new paradigm has developed
  • They therefore take on high levels of debt to finance ever more speculative investments

His argument was that liquidity is not the same as solvency. Central banks can pump out trillions of dollars in stimulus, and make it ridiculously easy for companies to justify new investments. It is hard to argue with a CEO who claims:

“Why not borrow, as it’s not costing us anything with today’s interest rates“.

But what happens if the earnings from the new investments are too low to pay the interest due on the debt?

That is the risk we face today, given there is now a record $3tn of BBB grade debt – the lowest level of ‘investment grade’ debt. If some of these companies start to default, then confidence in the central banks’ ‘new paradigm’ will quickly disappear – and, with it, market liquidity

Investors will then find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid.  In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place.

China’s former central bank governor has already warned that it may be facing its own Minsky Moment. As investors finish celebrating their 2019 success, they might find it prudent to ponder whether the good times can really continue forever.

Chart of the Decade – the Fed’s support for the S&P 500 will end with a debt crisis

Each year, there has been only one possible candidate for Chart of the Year.  Last year it was the collapse of China’s shadow banking bubble; 2017 was Bitcoin’s stratospheric rise; 2016 the near-doubling in US 10-year interest rates; and 2015 the oil price fall.

This year, the ‘Chart of the Decade’ is in a league of its own. Produced by Goldman Sachs, it shows that the S&P 500 is in its longest-ever run without a 20% downturn.

The reason for this amazing performance is not hard to find.  It has been caused by the US Federal Reserve’s adoption of Ben Bernanke’s concept that:

“Higher stock prices will boost consumer wealth and help increase confidence“.

Set out in 2010, it replaced the previous policy set out by William McChesney Martin that their job was:

“To take away the punchbowl as the party gets going”.

“Don’t fight the Fed” is one of the best short-term investment principles, but the Fed’s success is quite extraordinary when one looks back over the past decade.  Each time the market has threatened to slide, they have rushed in with yet more support:

  • In QE1, the Fed pumped out $1.3tn of support for financial markets, in addition to reducing interest rates to near-zero
  • This free money mostly went straight into asset markets such as stocks, which weakened when the stimulus stopped
  • QE2 came to the rescue with another $600bn of support – but again, stocks then weakened
  • QE3 provided longer-term support, with $40bn/month then increasing to $85bn/month

President Trump’s tax cuts provided even further support when the Fed finally paused, as the Financial Times chart confirms, by encouraging a massive wave of share buybacks.

Remarkably, these buybacks came at a time when profits were actually falling as a percentage of GDP, as the third chart shows. Investors should really have been pulling out of shares, rather than buying more. But after so many years of Fed support, most asset managers had either forgotten how to read a Profit & Loss account and Balance Sheet – or had decided these were irrelevant to stock valuation.

Since September, we have been in a new Fed stimulus cycle. As I noted then, a $50bn hole had appeared in New York financial markets.  Regulators and consensus commentators combined to explain this was only due to temporary factors. But since then, the support has reached $376bn, and the Fed has announced it will happily supply another $500bn of support to cover possible year-end problems, probably taking the total close to $1tn since September.

Behind this panic is the IMF’s warning that the $8.1tn of Treasury bonds available as collateral for the repo market, are in fact “owned” by an average of 2.2 different banks at the same time. Understandably, bank CFOs are pulling back, and trying to establish if “their” Treasury bonds in fact belong to someone else.

Regulators should never have allowed this to happen.  They should also have focused long ago – as I suggested this time last year – on the implications of the decline in China’s shadow banking sector.  Just as I expected, China is now exporting deflation around the world, with its PPI falling since June.

China’s slowdown also means an end to the flow of Chinese cash that flooded into New York financial markets, which hedge funds have then leveraged into outsize profits in financial markets.

The Fed turned a blind eye to this, just as it allowed BBB corporate debt to expand at a record rate, as the chart from S&P confirms.   As we noted in June’s pH Report:

“US BBB grade debt, the lowest grade in which most funds are allowed to invest, is now more than $3tn, with 19% of this total ($579bn) in the very lowest BBB– grade. And this BBB– total jumps to $1tn if one includes financial sector debt. S&P also report that global BBB debt is now $7tn, with US companies accounting for 54% of the total.

“The problem is that BBB- debt becomes speculative debt if it is downgraded by just one notch to BB grade. And most investors are then forced by their mandate to sell their holding in a hurry, creating the potential for a vicious circle, as the most liquid bonds will inevitably be sold first. In turn, this creates the potential for a “waterfall effect” in the overall bond market – and to contagion in the stock market itself.”

The Fed’s focus on boosting the stock market is clearly going to end in a debt crisis.  But when warning of this, the consensus responds as in 2006-8, when I was warning of a global financial crash, “That’s impossible”.  And no doubt, once the debt crisis has occurred, it will again claim “nobody could have seen this coming”.

This is why the S&P 500 chart is my ‘chart of the decade’.

$50bn hole appears in New York financial markets – Fed is “looking into it”

Most people would quickly notice if $50 went missing from their purse or wallet. They would certainly notice if $50k suddenly disappeared from their bank account. But a fortnight ago, it took the New York Federal Reserve more than a day to notice that $50bn was missing from the money markets it was supposed to regulate.

Worse was to come. By the end of last week, the NY Fed was being forced to offer up to $100bn/day of overnight money.  And it was also clear that the authorities still have no idea of what is going wrong.

This is perhaps not surprising when one remembers, as I charted here between 2007-8, that the Fed failed to notice the subprime crisis until Lehman went bankrupt in September 2008.

For the past 2 weeks, extraordinary things have been happening in a critical part of the world’s financial markets. And unfortunately, the NY Fed didn’t notice until after it had begun, as the Financial Times later reported:

  • First, on Monday 16th, the repo market suddenly began to trade higher – reaching a high of 7%
  • Then as the market opened at 7am on Tuesday, “Rates rocketed upward again, to 6% within a few minutes and then to a high of 10%. That was four times the rate the repo market was trading the week before. Typically, repo prices move around by a few basis points each day — a few hundredths of a percentage point.

Finally, someone at the Fed woke up – or perhaps, somebody woke them up – and they announced $75bn of support to try and stop rates moving even higher. Even that had its problems, as “technical difficulties” meant the lending was delayed.

As Reuters then reported next day, this cash wasn’t enough. The shortage “forced the Fed to make an emergency injection of more than $125bn …. its first major market intervention since the financial crisis more than a decade ago.”

Of course, as with the early signs of the subprime crisis, the Fed then went into “don’t frighten the children mode“.  We were told it was all due to corporations needing cash to pay their quarterly tax bills, and banks needing to pay for the Treasury bonds they had bought recently.

Really! Don’t companies pay their tax bills every quarter? And don’t banks normally pay for their bonds?  Was this why some large banks found themselves forced to pay 10% for overnight money, when they would normally have paid around 2%?  And in any case, isn’t repo a $2.2tn market – and so should be easily able to cope with both events?

Equally, if it was just a one-off problem, why did the NY Fed President next have to announce daily support of “at least $75bn through 10 October” as well as other measures? And why did the Fed have to scale this up to $100bn/day last Wednesday, after banks needed $92bn of overnight money?

Was it that corporations were suddenly paying much more tax than expected, or banks buying up the entire Treasury market? The explanation is laughable, and shows the degree of panic in regulatory circles, that their explanation isn’t even remotely plausible.

We can expect many such stories to be put around over the next few days and weeks. As readers will remember, we were told in March 2008 that Bear Stearns’ collapse was only a minor issue. As I noted here at the time, S&P even told us that it meant “the end of the subprime write downs was now in sight“.

I didn’t believe these supposedly calming voices then, and I don’t believe them now. Common sense tells us that something is seriously wrong with the financial system, if large borrowers have to pay 10% for overnight money in a $2.2tn market.

And what is even more worrying is that, just as with subprime, the regulators clearly don’t have a clue about the nature of the problem(s).

My own view, as I warned in the Financial Times last month, is that “China’s (August 5) devaluation could prove to be the trigger for an international debt crisis”.  Current developments in the repo market may be a sign that this is more likely than many people realise.  I hope I am wrong.

 

China’s renminbi and the global ring of fire

China’s property bubble puts it at the epicentre of the ring of fire © Reuters 

China’s devaluation could be the trigger for an international debt crisis, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog

August has often seen the start of major debt crises. The Latin American crisis began on August 12, 1982. The Asian crisis began with Thailand’s IMF rescue on August 11, 1997. The Russian crisis began on August 17, 1998.

We fear that the renminbi’s fall below Rmb7 per dollar on August 5 will act as just such a catalyst — this time, for the onset of a global debt crisis that has long been in the category of an accident waiting to happen.

The risk is summarised in the chart below from the Institute of International Finance, showing the seemingly inexorable rise in global debt over the past 20 years

Central banks came to believe that business cycles could be abolished by the use of stimulus, first through subprime and then through quantitative easing. This would encourage the return of the legendary “animal spirits” and allow the debt created to be wiped out by a combination of growth and inflation.

© Institute of International Finance

Unfortunately, as we have argued here before, this belief took no account of demographics or the impact of today’s ageing populations in slowing demand growth.

The baby boomers, who created the growth supercycle when they moved into the wealth creator 25-54 generation, have now joined the cohort of perennials aged 55 and above. They already own most of what they need. The focus on stimulus means that policymakers have failed to develop the new social/economic policies needed to maintain soundly-based growth in a world of increasing life expectancy and falling fertility. Instead, stimulus policies have created overcapacity and today’s record levels of debt.

As William White, a former chief economist of the Bank for International Settlements, warned at Davos in 2016: “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.” Presciently, he suggested that the trigger for the crisis could be a Chinese devaluation.

Central banks have created a debt-fuelled ‘ring of fire’ with multiple fault-lines

The risk, outlined in our second chart, is that central banks have created a debt-fuelled global “ring of fire”. China has undertaken around half of all global stimulus since 2008, in effect creating subprime on steroids. As we noted here last year, its tier 1 cities boast some of the highest house-price-to-earnings ratios in the world, while profits from property speculation allowed car sales to rise fourfold from 500,000 a month in 2008 to 2m a month in 2017.

As the FT reported in April, investors have already been spooked by rising levels of dollar debt in China’s property sector. This debt is set to open the global ring of fire, as US president Donald Trump raises the stakes in his trade war. The president and his advisers seem to have chosen to ignore the very real risk of currency devaluation, as markets respond to the impact of tariffs on the economy:

  • China’s property bubble puts it at the epicentre of the ring of fire
  • This is now spreading out across Asia, impacting other Asian currencies and economies
  • The Bank of Japan is about to become the largest owner of Japanese stocks
  • The end of the property bubble is causing the end of the commodity bubble
  • In turn, this is impacting Australia, South Africa, Brazil, Russia and the Middle East
  • ECB stimulus means eurozone government bonds have negative interest rates
  • Banks cannot make a profit and savers have no income
  • President Trump’s China trade war risks connecting all the dots
  • The UK’s potential no-deal Brexit in October further threatens global supply chains

The issue is the risk of contagion from one market to another. Risks in individual silos can be bad enough, but if they spread across boundaries it quickly becomes hard to know who is holding the risk. As US Federal Reserve chairman Jay Powell warned in May while discussing potential problems in the market for collateralised loan obligations (CLO):

“Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs. We know that the US CLO market spans the globe . . . But right now, we mainly know where the CLOs are not — only $90bn of the $700bn in total CLOs are held by the largest US banks . . . In a downturn institutions anywhere could find themselves under pressure, especially those with inadequate loss-absorbing capacity or runnable short-term financing.”

The CLO market is just one part of the problem. As S&P Global reported recently, more than $3tn of US corporate debt is rated triple B, with $1tn rated triple B minus, the lowest level of investment grade. US companies account for 54 per cent of the world’s $7tn total triple B debt. The risk of contagion in any sell-off is clear, as many institutions would have to sell if recession forced rating agencies into downgrades, taking debt below investment grade.

In turn, this would add to the risks in US equity markets, which are already at extreme valuations. Pension funds would be most at risk as they have been major investors in corporate debt and in recent years have entered markets such as the Asian offshore US dollar market in their search for higher yields. A downturn in their returns would risk creating a vicious circle, forcing companies to increase their pension contributions just at the moment when their earnings are already under pressure as the trade war slows the global economy.

Mr Trump may come to regret his comment that “trade wars are good and easy to win”. We envisage a testing time ahead, particularly as only those over 60 have personal experience of even the “normal” business cycles seen before the boomer supercycle began.

Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.