For China, This Time Is Different
Jonathan Rochford | Aug 03, 2017 13:34
Originally published by Narrow Road Capital
Risk assets posted gains in July across equities, credit and commodities. Equities in the US and China (both 1.9%) led the way with Europe (0.2%), Australia (flat) and Japan (-0.5%) more muted. Global credit posted strong gains in both high grade and high yield. Iron ore (13.5%), US oil (8.3%) and copper (6.7%) all soared as Gold (2.2%) posted good gains. US natural gas was the odd one out falling 6.9%.
Last month I wrote about how we are ten years on from the beginning of the credit crisis, but are seeing many of the same signs of hubris that were present then. There’s no reason to believe that this time is different, highly priced assets and easy credit are likely to correct in the medium term. However, one thing that is definitely different is the shadow that China now casts over the global economy. In 2008 China announced a massive stimulus package that helped its economy and the global economy weather the storm. But nearly ten years on, the situation is very different and China could shift from being a big contributor to global growth to an anchor slowing down the global economy.
The 2015 McKinsey report “debt and (not much) deleveraging” laid out how global debt levels have risen since the crisis. It highlighted three areas of particular concern; sovereign debt, consumer debt and China. However, as shown in the graphs below the growth in Chinese debt levels is drowning out progress made in other countries which have as a group reduced their debt levels. When China is excluded there has been meaningful deleveraging in global bank, corporate and consumer debt since 2009.
The next graph shows just fast China’s debt levels have grown in the last decade. In 2007, China had an above average level of debt for an emerging market. Roll forward to today and nobody talks about China’s debt levels in comparison to emerging markets anymore as it is so much bigger than its peers. Today people talk about China’s debt to GDP level as on par with developed economies, dismissing China’s substantially underdeveloped economic structures and financial markets. For an emerging market, China is carrying record levels of debt.
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Another factor that makes China’s debt growth extraordinary is the pace and length of the expansion. Arguably the best indicator of future debt issues for anyone (corporate, individual or government) is when the debt is growing much faster than the income used to make repayments. When talking about an economy as a whole, the IMF measures this using the credit to GDP gap. The chart below is particularly busy, but concentrate on the blue line. It shows that China’s debt has been growing way above sustainable levels since mid-2013. To maintain its high levels of GDP growth, China has had to use an enormous amount of debt stimulus.
Further demonstrating how record setting China’s credit growth has been is the following graph. This chart excludes government debt, focussing just on private sector debt. Note the near vertical rise in China’s debt levels that mirror the experience of Thailand and Spain in the lead up to their credit induced bubbles. Note also the comparison with Canada and Australia, which are both frequently cited as having excessive household debt and house prices.
This time is very much different for China. No other emerging market has reached such extraordinary levels of debt. Chinese institutions and investors are mostly amateurs with a track record of investing in unproductive assets. Default rates are kept artificially low as extend and pretend lending is commonplace. A generation of investors have seen nothing but good times and only fear missing out on more. The potential for losses is given little consideration other than the expectation that the government will bail out everyone if losses occur.
It is now a question of when, not if for China. China’s government believes it can reduce leverage whilst maintaining high levels of growth but there’s no precedent for this. China’s companies have dominated their domestic markets due to trade barriers but have struggled overseas. China now appears to be hitting a limit on growth from exports as other Asian nations undercut it on price and developed nations fight back against its hypocritical stance on “free trade”. If credit growth stops China’s growth will stop, with recession a foreseeable prospect. Given the size of China’s economy and its outsized contribution to global GDP growth a reversal in China could see it export a recession to other countries. This time is different for China, but in a very bad way.
h2 Low Returns Ahead for High Yield Debt?/h2A quick pulse check on global high yield debt shows that it is boom time once again. That’s great for borrowers wanting cheap debt with few conditions but bad for long term investors. Firstly, two graphs from Bloomberg on US high yield. The first shows that both investment grade and high yield debt carry more leverage than 10 years ago but that interest servicing costs are lower. In short, lower reserve rates have allowed corporates to borrow more without having to pay more in interest.
The second graph shows the breakdown of US high yield bonds into rating categories. Compared to a decade ago the higher quality BB’s make up a greater portion of the index, with B’s and CCC’s having shrunk a little. That’s a good thing, though it needs to be considered alongside two other factors that aren’t so positive.
The bad news for high yield investors is that covenant quality is worse than it has ever been. The graph below tracks the proportion of US and European sub-investment grade loans that have minimal or no covenant protection. Asia isn’t faring any better, covenant light bonds are at 61% of issuance in Singapore and 72% in Hong Kong. Fewer covenants mean that sick companies are allowed to operate unchecked for longer. A lack of covenants increases the proportion of debt that suffers monetary defaults and reduces the recovery rate.
The last key characteristic to note is that spreads over base rates are near the lowest in the last 10 years. US High Yield bond spreads are shown below, but the story for European debt and leveraged loans is the same. There’s been a wave of loans being repriced in the US and Europe this year; situations where borrowers reduce the spread they pay, usually without providing any offsetting risk reduction. Borrowers clearly have the whip hand over lenders.
Spreads are now at the level where the B and CCC rated segments are barely positive if historical average losses are subtracted. Not surprisingly, many are saying that now is the time to be a contrarian and sell high yield. Edward Altman sees high yield conditions as bad as 2007 and Howard Marks similarly warned about conditions in his latest memo. The initial yields on offer may look comparatively high, but that’s no guarantee of high returns in coming years.
h2 Austerity isn’t Dead, it will Come Back with a Vengeance/h2There’s been a steady stream of recent articles claiming that austerity is dead. This one from James McCormack at Fitch argues that populist politicians are responsible for killing off pragmatic economic policy. Whilst I don’t deny the medium term tide is against austerity, the very high levels of sovereign debt mean austerity will return. To understand why this must happen we need to deal with the three key fallacies that austerity opponents are propagating.
First, austerity is wrongly blamed for reducing economic growth. This is such a deceitful lie as it seems so logical and seems to be backed up by examples like Greece. However, the deception here is the false starting point used to measure the “reduction” in growth once austerity is implemented. Countries facing austerity have used debt financed government spending to inflate their GDP, in the same way Lance Armstrong used performing enhancing drugs to inflate his cycling abilities. No one questions that Armstrong was better as a result of using drugs. Yet it is hard for many to acknowledge that GDP is similarly inflated when governments spend excessively. Greece and many others cheated their way to inflated GDP levels and measuring against that is clearly spurious.
Second, there is the avoidance of the reality that increasing debt drags down future economic growth. Anyone that has personal debt understands that those repayments reduce their ability to spend until the debt is cleared. Yet when it comes to government debt, many cite “animal spirits” as the magic that will allow governments to grow into their debts. Even with low interest rates, which also ultimately undermine economic growth, the debt is still there and spending must eventually be reduced to cover the higher repayments. It is true that government investment in a small number of areas can promote long term growth but this isn’t where the vast majority of government spending is going.
Third, many are propagating the view that printing money isn’t the bogeyman it has been made out to be. Nothing bad has happened to Japan, Europe and the US so why worry? This argument conveniently ignores centuries of human history of money printing, including recent examples in Argentina, Venezuela and Zimbabwe. There’s no magic at play, it’s just a matter of time before investors flee dodgy currencies. They will flood to the safety of hard assets and to countries with responsible monetary and fiscal policies.
Austerity isn’t in favour and it could be a while yet before the consequences play out. The “magic” of false measurements, animal spirits and money printing are used to convince the gullible that there is an easy way out. Governments with loose fiscal and monetary policies can get away with it for a while, but in the long term they will exhaust their credibility with investors and lose control over their spending levels. At the exact time when standard economics would advocate governments running a deficit, these governments will be cut off from borrowing more. Austerity isn’t dead, it is just taking a break before it comes back with a vengeance.
h2 Media Worth Consuming/h2US Companies are running job fairs in prisons to recruit those nearing release to overcome labour shortages. Stopping refugees from working is dumb policy. Opioids are having a big impact on US labour force participation. Ohio councils are having to make tough budget decisions as heroin overdoses surge, costing their budget $4500 each. Universal basic income can be very regressive if it takes from targeted poverty alleviation to give to everyone. Los Angeles truck drivers are a modern equivalent of slave labour.
Brazilians are heckling their corrupt politicians at airports, restaurants and weddings. The US whistleblower investigations office fired an employee for trying to investigate legitimate claims against big companies. Two American whistleblowers will split $61 million in a JP Morgan mis-selling settlement. How technology has destroyed our attention spans. How power corrupts our brains. The three steps to creating a new habit.
New York City spends $2m to build four toilets. The simple economics of how renewables have made power more expensive and why 100% renewables is a long way off. “To conserve is conservative” – how Republicans are embracing lower pollution. Portugal decriminalised drugs and now has the lowest rate of drug deaths in Europe. A guilty Canadian imprisoned in Guantanamo Bay receives $10.5 million in compensation. A Canadian landlord ordered to pay $12,000 compensation to tenants for not taking his shoes off in the apartment he owns. Is it evil for Google (NASDAQ:GOOGL) to pay academics to produce research supporting its positions? Why don’t economists suffer when they screw up?
60% of global selfie deaths occur in India. A robot security guard commits suicide in a fountain. The CEO of a Swedish security firm was declared bankrupt after his identity was stolen. Thieves break in and steal computers from “elite” South African police unit. Americans don’t trust Trump, but trust the media and congress even less.
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