China bears trump taper bulls

IFR 2020 15 February to 21 February 2014
5 min read
Asia
Jonathan Rogers

AN INTERESTING PHENOMENON reared its head in Asia’s offshore credit markets last week: as Treasury yields rose, spreads widened. That isn’t supposed to happen, and it makes the job of hedging credit rather problematic. Short-term credit plays versus short Treasury cash or futures positions tend to be a solid bet when Treasury yields succumb to upward pressure.

What explains this unusual spread widening phenomenon? It might well be the first sign of a gradual erosion of the emerging market premium as the secular switch away from EM assets commences, and the markets follow the nightmare version of the Fed tapering script. But it might be something else. EM assets sold off this month on the back of weak China PMI data, and the tail risk of a hard landing in China is once again becoming standard market chatter.

Societe Generale recently published a report entitled “What if China lands hard?”, and the contents are both fascinating and somewhat alarming. Whatever you make of the French analysts’ conclusions, the hard landing scenario in China should be factored into any money manager’s risk model.

SG’s survey asked clients to project worst-case outcomes for China’s GDP growth. Interestingly, twice as many respondents saw the possibility of a 2% expansion than did last year (8% of answers versus 4% in the same questionnaire sent out at the same time last year).

Those individuals might perhaps belong in the “crank” category, but as the bank’s chief China economist Wei Yao observed in her contribution to the report: “The landing could be almost as hard as one dares to imagine, since the history of economic crises is packed with nasty surprises.”

Perhaps the big story of 2014 will not be Fed tapering after all, but China’s deleveraging

WISE WORDS INDEED, and nobody can afford to take their eyes off the rear-view mirror when an economic meltdown may be closer than it appears.

How close such a collapse of China’s growth may be is difficult to say, but there’s no doubt that vast change is under way in the country under premier Xi Jinping. It is not just about the headline-grabbing purges of corrupt party officials. It involves a massive deleveraging and the attempt to rebalance China’s economy away from a reliance on capital investment and towards consumption-led spending.

There can be no doubt about the desire to reduce leverage. Last summer’s spike in interbank rates was not just a warning shot across the bows of China’s banks, but a message that the easy money the country has enjoyed since the stimulus put in place after the 2008 crisis is going to be withdrawn.

Just what that process brings along with it is a tough call, but defaults there will be, at the local government and shadow banking level, and it seems likely that some of the smaller deposit-takers will go to the wall.

Meanwhile here’s a knuckle-whitener for you: SG’s analysts believe that if there is a hard landing in China, spreads on Asian investment-grade credit could return to the 800bp-odd over US Treasuries level last seen in 2008. In fact, they suggest that spreads could overshoot to 1,000bp over, given that much of the issuance seen over the past few years has come from cyclical sectors.

The thinking behind this call is that the knock-on economic effects of a big China slowdown will hit corporate cashflows, leaving companies falling like boats on a receding tide.

SO PERHAPS THE big story of 2014 will not be Fed tapering after all, but China’s deleveraging and the effects of slower Chinese economic growth on the rest of Asia and further afield. The SG survey shows that just 18% of US investors believe China would unveil another stimulus should economic growth drop precipitously, as it did after Lehman’s collapse in 2008, but would instead let market forces deal with the fallout.

Asian and European investors surveyed were more optimistic that a stimulus would emerge, but I reckon there has been a sea change in the country and that the market is indeed being nurtured to supremacy in China. No more bailouts.

In the long run the Chinese economy will emerge stronger if the nettle is grasped, but there will be no escaping the pain. In those circumstances, as SG’s analysts observed, the winners are likely to be US Treasury bonds and the US dollar as a vast flight to quality emerges in the face of collapsing Chinese growth.

But credit will be another story. You’d best run the hedge backwards and short liquid Asian credits where repo financing is available against a long Treasury position. Perhaps that’s what last week’s unusual spread action is telling us. Ignore the China hard landing scenario at your peril.