Stock markets risk Wile E. Coyote fall despite Powell’s rush to support the S&P 500

How can companies and investors avoid losing money as the global economy goes into a China-led recession?  That’s the key question as we enter 2019.  We have reached a fork in the road:

The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:

“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

His words confirm he equates “the economy” with the stock market, as the chart shows:

  • The Fed no longer sees its core mandate on jobs and prices as defining its role
  • Instead it has become focused on making sure the S&P 500 moves steadily upwards
  • Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue

Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards.  But now it is very close to finding itself over the cliff edge.

CORPORATE DEBT IS THE KEY RISK FOR 2019

The Fed should have realised long ago that markets cannot keep climbing forever.  Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery.  As a result:

  • Investors now have no idea if are paying too much for their purchases
  • Companies don’t know if their new investments will actually make money

We are heading almost inevitably to another  ‘Minsky Moment’ as I described in September 2008,:

“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.

This time, however, the risk is in corporate debt, not US subprime lending.  As the charts above show:

  • The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before
  • Lending standards have collapsed with most investment debt in the lowest “Triple B” grade

Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.

And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China.  And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

  • Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
  • The Bank of International Settlements has already warned that Western central banks stimulus lending means that  >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK

As the chart shows, China’s corporate debt is now the highest in the world.  Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.

The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017,  China’s central bank governor warns of ‘Minsky Moment’ risk.  The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:

“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

Companies and investors need to take great care in 2019.  China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:

  • Companies with too much debt will go bankrupt, leading to the Minsky Moment
  • The domino effect of price wars and lower volumes will quickly hit other supply chains
  • Time spent today in understanding this risk will prove time very well spent later this year

Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down. 

“Everyone wants to be rich”: Divorces soar with land prices as China’s housing bubble enters its final stages

China housing Nov16One thing that “everyone knows” in China’s Tier 1 cities is that property prices can never go down.  As one resident told the South China Morning Post:

The only thing I know is that buying property will not turn out to be a loss.  From several thousand yuan a square metre to more than 100,000 yuan. Did it ever fall? Nope.

He and his wife got divorced in February, in order to buy a 4th apartment in Shanghai for 3.6m yuan (US$530k) on the basis that “ If we don’t buy this apartment, we’ll miss the chance to get rich.”  And as I noted back in September, his view of the market is technically correct:

“It is also easy to forget that housing was all state-owned until 1998, and still is in most rural areas.  Urban housing was built and allocated by the state – and there wasn’t even a word for “mortgage” in the Chinese language.  Not only have home-buyers never lived through a major house price collapse, they have also had few other places to invest their money”.

But whilst bubbles always last longer than anyone expects, in the end they have to burst.  Today, for example, unremarkable pieces of land in Shanghai are being sold at $2000/sq foot ($21500k/sq metre), nearly 3 times the average land price in Manhattan, New York.

China housing Nov16aAnd one sure sign that the bubble is ending, comes from the fact that “everyone” is now getting divorced in order to buy those 2 extra apartments – which will make them rich, as the Weibo picture shows.

Everyone has realised that a divorced couple can buy an extra 2 apartments with only a 30% deposit – and benefit from zero property tax.  As a result, prices have risen 30% so far this year in the Tier 1 cities.  Even more remarkably, prices for undeveloped land are higher than for existing apartments on neighbouring plots.

And mortgages, which only began to exist in the past 20 years, accounted for 71% of all new loans in July/August this year, compared to just 23% of new loans in 2014.

The bubble also highlights the growing split between President Xi and Premier Li over the future of stimulus policies.  As China Business Review notes:

While the State Council has always controlled economic policy, Xi has been gradually taking economic matters into his own hands since the State Council’s failures following the stock market crisis last summer. Li was noticeably absent from the Economic Situation Expert Seminar hosted by Xi in Beijing July 8, and was also sidelined at the Beidaihe Conference in August. Xi’s rejection of Li‘s stimulus approach further explains the torrent of measures issued in early October to limit housing purchases and curb overheating in the economy….

“Since August, it is increasingly common to see corruption cases featuring real estate conglomerates like Vanke and Dalian Wanda publicized…. it appears the anti-corruption campaign is being extended to deal with the housing bubble crisis.

China lending Nov16

China’s stimulus policies since 2008 mean that it now has $25tn of debt in an $11tn economy.  And as Deutsche Bank’s chart above shows:

  It now takes $450bn of debt to create 1% of GDP growth in China (even using the “official” overstated GDP figures)
  Back at the height of the US subprime bubble, it took $350bn of debt to generate 1% of GDP growth in 2007
  China’s wealthiest man, Wang Jianlin, said recently that China’s real estate market is “the biggest bubble in history
  He warned that prices are falling “in thousands of small cities”, even whilst they still rise in the large cities

Another worrying feature is that much of the financing for the bubble has been done in the shadow banking sector, via Wealth Management Products.  As US financial magazine Barron’s warned at the weekend:

“These WMPs are starkly reminiscent of the bad mortgage-backed paper in the U.S. that metastasized in 2008 into a full-blown global credit crisis.

So here’s the question.  Would you, if you were Chinese and married, get divorced today in order to buy new apartments?  Or would you have already got divorced, and be sitting back waiting for prices to rise ever higher?  Or would you be shaking your head in wonder, and fearing that “this will not end well?”