CHINESE ROULETTE

John Mauldin’s recent Thoughts from the Frontline featured a lengthy but excellent piece by Worth Wray: China’s Minsky Moment? is well worth reading in its entirety but here is the gist of it:

(…) With China’s new policy of allowing defaults (historically, China’s default rate has been 0%), there is a real risk that follow-on events could spin out of control, raising nonperforming loan ratios and sparking a panic as bank capital is significantly eroded.

In the meantime, the renminbi is trading down, most likely due to an intentional effort by the People’s Bank of China to aid in the slow unwinding of leveraged trade finance.

Now the signs of a Chinese slowdown (and thus a global one, as the world is geared to 8% Chinese growth) are clear, and people around the world are meeting uncertainty with emotion. With that in mind, let’s dig into the data that really matters and try to get to the heart of China’s dilemma.

(…) China’s total debt-to-GDP (including estimates for shadow banks) grew by roughly 20% per year, from just under 150% in 2008 to nearly than 210% at the end of 2012 … and continued rising in 2013. Even more ominous, corporate debt has soared from 92% in 2008 to 150% today against the expectation that China’s government would always backstop defaults. That makes Chinese corporates the most highly levered in the world and more than twice as levered as US corporates, just as  corporate defaults are happening for the very first time in more than 60 years.

(…) many analysts believe China’s official reported nonperforming loan ratio of 1% is more like 11% – or more than 20% of GDP.

(…) it seems the new government under President Xi Jinping is intent on popping the domestic debt bubble and allowing widespread defaults rather than continuing to leverage the system into an unmanageable crisis or a Japanese-style stagnation. The trouble is, their efforts may be too little too late to manage a gradual deleveraging from a massive debt bubble. They are about to perform a dive off the high board that has never been attempted, with the whole world watching. (…)

Trouble is, the People’s Bank of China has allowed some pretty wicked cash crunches over the past year. Some say it was an intentional move to discipline the shadow banking system. That scenario scares the hell out of me, because that kind of behavior suggests the Chinese are playing a dangerous game – and not just with their own economy. Interbank rates do not normally bounce from 2% to 12% in a healthy economy. (…)

Contrary to what many onlookers believe, the People’s Bank of China and China’s top leadership are probably not willing and possibly not able to defend the currency while also supporting growth in a deleveraging economy. They will have to make a choice, and frankly, they already have an incentive to let the renminbi fall as they attempt to put the right reforms in place to support long-term growth – or face a deflationary nightmare in the uncomfortably near future.

Not many people realize that China has lost a great deal of competitiveness as its real effective exchange rate has risen in recent years. (…)

To be clear, China doesn’t have to experience a deep recession in order to disrupt global growth. A slowdown to 2-3% real GDP growth and a corresponding decline in China’s import demand could fire demand shocks across emerging Asian economies like India and Indonesia, commodity producers like Australia and South Africa, and even deteriorating economies in the Eurozone like France and Italy.

The investor’s dilemma is that there is really no way to know what is happening in China today, much less what will happen tomorrow. The primary data is flawed at best, manipulated at worst, and there seem to be a lot of inconsistencies when we compare official data to more concrete measures of economic activity. (…)

manufacturing wagesHere’s one data that is not manipulated: China’s electricity consumption rose 4.5% YoY in January-February combined, down from +7.6% in December, down from +8.5% in November and down from +5.3% In January-February 2013 (ISI).

These risks are known unknowns with significant potential adverse consequences for China and every other country and markets. These risks were always present but, now, we are seeing clear signs that Chinese leaders are themselves getting worried to the point of no longer trying to hide the problems. They have acknowledged the faster slowing in GDP, they admit the debt problem, they allow defaults to happen in the open, they see the rising labour costs, that manufacturers are losing share and that profits are weakening in the face of elevated debt levels. They have recently hinted at stimulation. Significantly, they have decisively weakened their currency!, a pretty big deal, not only for China but for all Asian countries and the rest of the world for that matter. (Chart from Richard Bernstein Advisers via BI)

Ambrose Evans-Pritchard will scare you even more:

(…) The jitters come amid reports of fire-sales of Hong Kong property by Chinese investors desperate to raise cash, some slashing their prices by 20pc for a quick sale. A liquidity squeeze in mainland China has already led to the collapse of Zhejiang Xingrun real estate this week with $570m of debts, the biggest property failure so far.

The yuan weakened sharply on Thursday to 6.23 against the dollar and has now lost 3pc since January, a clear break with China’s long-standing policy of slow appreciation.

Geoffrey Kendrick, from Morgan Stanley, said the currency has broken through the 6.20 level where a cluster of structured products are triggered. These are known as losses on target redemption funds. The losses have already hit $3.5bn.

The latest move creates a potential “non-linear movement” that could push the yuan rapidly to the next level at 6.38, where estimated losses would reach $7.5bn, and from there jump to 6.50.

Mr Kendrick said banks in Singapore, Taiwan and South Korea are heavily exposed, but there could also be a serious fallout for Chinese airlines, shipping and property companies, as well as a nexus of finance built around use of copper and iron as collateral.

Chinese companies have borrowed $1.1 trillion on the Hong Kong markets, a quarter from UK-based banks. There is complex web “carry trade” of positions in which investors borrow in dollars to buy yuan assets, often with leverage. These trades are highly vulnerable to a dollar squeeze as the US Federal Reserve brings forward its plans for rate rises.

Morgan Stanley said the Chinese central bank may have to intervene to shore up the yuan by selling some of its US dollar bonds if the slide goes much further. The authorities spent $80bn in June/July 2012 to defend its currency band.

For now China seems to be weakening the yuan deliberately. Mark Williams and Qinwei Wang, from Capital Economics, said the data flow suggests that the central bank bought $25bn of foreign bonds last month in order to force down the currency. The motive is to teach speculators a lesson and curb hot money inflows.

However, suspicions are also are growing that China’s authorities have quietly switched to a devaluation policy to buffer the shock to the economy as they attempt to curb excess credit, even though this would risk a clash with Washington. “The more they undershoot their growth target, the more tempting it may look to have a weaker currency to help out,” said Kit Juckes, from Societe Generale.

Premier Li Keqiang said on Thursday that China would take steps quickly to “stabilise growth and boost domestic demand”, a sign Beijing is worried that tightening may have gone too far. Credit Agricole expects the central bank to slash the reserve requirement ratio for banks by 200 basis points this year.

Morgan Stanley said China is approaching a “Minsky Moment”, a turning point when credit bubbles implode under their weight. “There is evidence that this debt growth has become excessive and non-productive. It now takes four renminbi of debt to create one renminbi of GDP growth from a nearly 1:1 ratio in the early and mid-2000s.”

“It is clear to us that speculative and Ponzi finance dominate China’s economy at this stage. The question is when and how the system’s current instability resolves itself,” said the bank.

“A disorderly unwind could take Chinese growth down to 4pc in a shorter time frame with potentially disastrous consequences for levered Chinese assets (banks, property) and the entire commodity supply chain,” it said.

China’s growth falling from 8% to 4% would hurt the whole world economy if I may interject. Europe would be particularly vulnerable, especially Germany, the only reliable growth engine in the Eurozone.

Meanwhile, Russia is also hurting, creating more headwinds for Europe and China.

Fitch has revised down its growth forecast to less than 1% in 2014 and 2% in 2015. These projections still rely on a mild upturn in investment, which is now less likely. Indeed, recession is possible, given the impact of higher interest rates, a weaker rouble and geopolitical uncertainty. (Fitch)

imageChina and Russia are two of the emerging countries that were driving world growth for so many years with combined GDP growing at 8%+. Growth has recently dropped to 5% and threatens slowing even more. The slowdown began in 2011 and accelerated after the Fed first hinted at tapering about one year ago. Since then, equity markets have clearly differentiated between EM and non-EM sensitive companies, recognizing both the growth challenges and the embedded currency risks:

  • An index run by Stoxx, a data firm, of Western firms with high emerging-market exposures has lagged the broader S&P 500 index by about 40% over three years. (The Economist)
  • MSCI Emerging Market Index has underperformed the S&P 500 by 23% since April 2013 (RBC Capital Markets)

Meanwhile, the Fed is tapering and raising expectations for rate hikes in 2014, even while admitting it has low visibility for U.S. growth.  FYI, exports now account for 14% of U.S. GDP, up from less than 10% in 2004.

In reality, we are all watching central bankers and politicians attempting to steer their respective economies through uncharted waters using untested ways and means, each being increasingly, often admittedly, self-minded in their monetary policy experimentations and currency management, even though this remains a zero sum game. Currencies in Brazil, South Africa, India, Indonesia and Turkey have declined more than 15% since April 2013.

Between 2009 and 2012, equity markets recovered thanks primarily to strongly rising profits. During the past 12 months, equities have been mainly  pushed up by rising multiples which have now reached historically dangerous levels right when profit growth has slowed, liquidity is being tapered, interest rates are rising and policy risks are mounting carrying potentially disastrous outcomes. The problem is that rising earnings remain the only dependable and sustainable fuel for equities.

While investors are primarily focused on corporate results, in the near-term (3-12 months), valuations matter most. More specifically, our work indicates that 82% of returns can be attributed to P/Es over a 3-month horizon, versus 59% over 12 months and 16% over 10 years. (RBC Capital Markets)

image(Understanding The Rule Of 20 Equity Valuation Barometer)

Revenue growth for S&P 500 companies has averaged 2.2% during the last 4 quarters (+2.1% in Q4’13). Foreign sales account for 40% of S&P 500 companies revenues and these revenues have been declining by about 2% YoY since 2012. If China and other EM countries keep decelerating, the drag on total revenues will increase, even more so if currencies keep declining. This will make it tougher to generate stronger top line growth placing a lot of pressure on management to grow margins even more.

The continued advance in net margins is widely known and documented but few people really understand how margins have been able to rise as much. RBC Capital Markets has done the leg work. It reveals that EBIT margins have actually peaked in 2012 and that lower taxes and interest expense have allowed net margins to expand in recent years.

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Whether this continues or not is difficult to say but investors should be careful placing higher multiples on incremental profits generated by lower tax and interest rates, especially when countries are reviewing international taxation and as the Fed is tapering and openly talking long term interest rates up. Citigroup’s charts below are another illustration of how “non-operating” factors have benefitted after-tax margins. Using trailing 12-month data, Citi’s graph shows that EBIT margins are in fact below their 2007 peak. Importantly, it also reveals that excluding IT companies, margins are in fact pretty much in line with previous cycles. This strongly suggests that IT companies are the main factor in the recent boost in the S&P 500 Index earnings and that their very low tax rates are the main contributors to the current elevated margins.

Last year, I wrote about the impact that rising foreign earnings and lower tax rates were having on U.S. corporate profit margins, also pointing out that the rising weights of some low-taxed sectors in the S&P 500 Index were magnifying the effect.

Doomsayers on profit margins may finally prove right but for the wrong reasons. Margins could well decline towards some mean level in coming years but not because of a “natural tendency of mean-reverting”:

  • EBIT margins are behaving in a rather normal cyclical fashion and appear to have peaked.
  • Interest expenses have most likely bottomed and should be rising in coming years.
  • Tax rates have also reached a point where governments are reacting, not only in the U.S. but in most OECD countries. Industries with abnormally low tax rates are already targeted (e.g. Internet groups face global tax crackdown) and countries are actively cooperating to fight tax avoidance.

All this is occurring when revenue growth is weak. Using forward earnings is always dangerous but he could prove especially unwise in coming years.

Corporations are in effect finding it more difficult to surprise investors.

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In all, I don’t know about you but given the fast rising geopolitical, financial and monetary risks, I personally find it very difficult to make any solid forecasts for 2014. And those economic optimists among you should now consider themselves having been warned by Ms. Yellen and Mr. Market themselves: from now on, good economic news will mean higher interest rates and potentially lower equity prices.

Nevertheless, Barron’s tells us that the cheerleaders are cheerful to the max:

21 out of 21 strategists expect the Standard & Poor’s 500 to end this year above 1850.

Reminder: Bob Farrell’s rule no. 9:

When all the experts and forecasts agree — something else is going to happen.

Careful out there!

By the way, did you miss last week’s THE MID-TERM BUST-BOOM PATTERN?

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