Q3 2021: “China and Contagion”
We’re living in a historic period, and it was yet another extraordinary quarter. In a recent Weekly Client Update, I wrote that “the stock market can be like a bull impaled by the matador’s sword. The mighty bull will succumb, but until that point one must be prepared for absolute bloody havoc.” The topping process tends to become a cutthroat fight between the bulls – armed with ample resources – against the lowly bears with deteriorating fundamentals on their side. And especially when the bears begin to make strides, the bulls will really come after them when given the opportunity. Rallies and short squeezes can be ferocious – and it often comes down to a game of chicken. As a manager of short exposure, I’ve got to ensure that if I lose a game of chicken that losses are manageable.
Key aspects of our macro thesis have begun to materialize. In particular, cracks have developed in China’s historic bubble. It’s also clear that inflation has become a major threat. Rather than transitory, inflation dynamics are appearing chronic. Global central bankers and bond markets have begun taking notice, posing great risk to an over-levered and destabilized world.
Let’s talk China. Recall that it took about 15 months in the U.S. from the initial 2007 subprime eruption to the late-2008 systemic crisis. Crisis dynamics typically unfold over time. It’s a process - ebbs and flows with respect to policy measures, market perceptions and confidence – with greed and fear. At this point, Chinese authorities are channeling Bernanke’s response to the subprime implosion, proclaiming that fallout from Evergrande is “controllable.”
The problem is Evergrande, with its $300bn of liabilities, is but the tip of the iceberg. Estimates have total Chinese developer debt in excess of a mindboggling $5 TN, and there are likely hundreds of billions of additional off-balance sheet obligations. Virtually all data associated with China’s real estate bubble are, as they say, “off the charts”.
According to estimates from Capital Economics, there are today up to 130 million unoccupied Chinese apartment units – 30 million unsold and 100 million purchased but not occupied. This is one of history’s spectacular speculative bubbles that Beijing’s repeated feeble tightening attempts completely failed to cool.
Estimates have China’s property sector representing almost 30% of Chinese GDP, while 41% of Chinese banking system assets are said to be associated with the property sector. Almost 80% of urban Chinese wealth is in apartments.
Well, existing apartment sales dropped sharply in September and were down 63% y-o-y during the first half of October. This suggests an abrupt and striking deterioration in market confidence.
I don’t think we can overstate the ramifications from the bursting of China’s apartment bubble. And from my few decades of analyzing bubbles, things tend to be much worse than even bearish analysts like myself appreciate.
I vividly remember the common refrain – “Washington will never allow a housing bust.” There remains today faith that Beijing has everything under control. Many believe recent developer woes are simply the result of policy tightening measures, and Beijing will now back off and things will stabilize. Let me suggest an alternative perspective: China’s vulnerable apartment bubble – pushed to only greater precarious extremes by pandemic stimulus measures - was poised to burst. Beijing’s tightening policies were simply the catalyst. And at this point, there’s no turning back.
With Evergrande teetering on default, the $5 TN developer sector in disarray, bond investors chastened, and confidence shaken, I doubt the bubble can be resuscitated – even if that were Beijing’s goal – which it is not. Beijing would prefer to gently deflate some bubble excess. That would be nice, but it’s just not the nature of prolonged, deeply systemic runaway bubbles. Control them early, or later containment efforts will lead to a lot of financial and economic pain. Let them run uncontrolled for years and you face catastrophe.
I am confident in the bursting bubble thesis, though there is today an unusual degree of uncertainty in the analysis. Beijing has enormous resources available to deploy – they hold massive international reserves and run big trade surpluses. For now, they maintain tight control over their currency. And the communist party will withhold information from its citizens. They can obfuscate and manipulate. They will initially ring-fence their banking system, while dictating targeted lending.
It is unclear how long it will take apartment prices to adjust to new realities. Local governments are already pressuring developers against major price cuts. But I am skeptical Beijing can sustain ridiculously overvalued apartments - often of suspect quality. And it will be impossible over time to suppress news of sinking prices. Word will travel quickly for subject matter of such keen national interest.
How owners of depreciating apartments react is a huge unknown. Will millions of units hit the market, with panicked sellers willing to accept steep discounts? Will owners of unoccupied apartments mail keys to their banks and stop making payments? Will the banking system just sit on tens of millions of units? For how long can Beijing quash the market adjustment process?
There is another critical aspect of the analysis that remains opaque. How much speculative leverage has accumulated in China’s wild west credit system? With Chinese credit having offered such enticing yields in a near-zero yield world – and with Beijing controlling a currency regime essentially pegged to the U.S. dollar – surely enormous levered “hot money” has been drawn to China. But when it comes to leveraged speculation, there’s no transparency. I am confident that the global hedge fund community has gravitated to Chinese fixed-income assets, while there’s been a proliferation of new hedge funds throughout China and Asia. China’s offshore bond market provided a convenient mechanism for levered speculation, and it’s no surprise this market has been the first to crumbled under incipient bubble stress.
In general, crisis dynamics first unfold at the “Periphery” and then begin gravitating toward the “Core.” It’s the weakest players at the fringe that get in trouble first – those with highly levered balance sheets, liquidity constraints and vulnerability to any tightening of financial conditions. Stated simply, if the weak lose access to new borrowings they’re toast. It’s worth adding that it’s the “periphery” that has been attracting massive yield-chasing speculative flows over the past 18 months, leaving it today acutely vulnerable to a shift to de-risking/deleveraging dynamics.
For purposes of analyzing China’s bubble, Evergrande and the highly levered developer community is at the “Periphery,” while China’s state-directed banking system would comprise the “Core.”
Acute stress has unfolded at China’s periphery, stoked by de-risking/deleveraging and a resulting dramatic tightening of credit availability and financial conditions more generally. And this development has quickly reverberated both within China and globally. Risk aversion now has market players watching for the next shoe to drop. And deteriorating risk vs. reward assessments and deleveraging beget illiquidity and broadening risk aversion.
We’ve seen contagion from China’s developer sector jump to Chinese high-yield borrowers more generally, as well as to Asian high-yield markets. Moreover, there are signs that contagion effects are creating a major change in the financial backdrop for the emerging markets. Indicators of individual country risk have jumped, in some case significantly. From my analytical perspective, crisis dynamics at China’s “periphery” have begun afflicting the global “periphery” – a major progression with huge market and economic ramifications.
For example, last week Brazilian stocks were down as much as 10%, with Brazil’s currency sinking another 3.3%. Local currency Brazilian yields surged almost 80 bps to a near five-year high 12.4%. The Turkish lira sank 3.6%, with local currency yields jumping 70 bps to a five-year high 19.4%.
Brazil and Turkey face major political, financial and economic challenges. These risks are not new, but suddenly markets are reacting with a much greater degree of concern and urgency. You have to ask, what changed? Well, Chinese contagion has ratcheted up general risk aversion. Global liquidity has begun to wane, and financial conditions have started tightening, which is now impacting the more vulnerable markets and economies. And de-leveraging within EM heavyweight Brazil and Turkey will further negatively impact liquidity for developing markets more generally.
Meanwhile, inflation has become a pressing issue around the globe, unsettling central bankers and bond markets alike. This comes with major policy and market ramifications. Chinese contagion has already manifested into weakening EM currency markets, compounding inflation risk in key EM economies. There is now heightened pressure on central banks – EM in particular – to raise rates - to bolster sinking currencies and counter mounting inflationary pressures.
The world is today confronting a unique confluence of synchronized fragile bubbles and surging inflation. And, importantly, the worsening inflationary backdrop is reducing central bank flexibility to use monetary stimulus in response to market instability. This is poised to become a key issue, with major ramifications for vulnerable market bubbles.
For some time now, markets have assumed that central bank liquidity would put a floor under market prices, while ensuring rapid market recovery in the event of a bout of instability. But central banks pushed things much too far. Especially after the pandemic response, unprecedented monetary stimulus further inflated historic bubbles while stoking the most powerful inflationary dynamics in decades. This creates a critical dilemma: When bubbles falter, central bankers will confront dislocated markets demanding Trillions of additional liquidity, in a backdrop of already powerful inflationary pressures. This will be a real nightmare for central bankers that supposedly have everything under control.
China producer prices are up almost 10% y-o-y. Chinese energy prices have spiked, with shortages causing plant shutdowns and inflationary bottlenecks. This creates quite a quandary for Beijing, and it will have the People’s Bank of China thinking twice before opening the monetary floodgates in response to their deflating apartment bubble. It also means China – faltering bubble and all - will be exporting higher inflation to the rest of the world.
Meanwhile, markets are underestimating the impact of China’s faltering bubble. Just a little data. Aggregate Financing, China’s main metric of system credit, ballooned to $43 TN from 2017’s $25 TN. Over the past 17 months, it surged an incredible $7.6 TN – in precarious “terminal phase” excess. Throughout this cycle, China evolved into the marginal source of global credit and, I believe, a key source of global liquidity more generally. Chinese money and credit growth has slowed over the past three months, and credit expansion will now be hampered by a sharp slowdown in real estate-related lending. And the harsh reality is that financial and economic systems distorted by such prolonged massive monetary inflation react poorly to waning credit growth. Beijing will dictate lending and investment to non-real estate sectors, but this doesn’t alter the reality that China faces a destabilizing change in the flow of finance throughout its asset markets and economy.
So, how does a faltering Chinese bubble impact U.S. markets? First, let me state that rising markets are self-reinforcing – they create their own liquidity, speculative buying, leverage and higher prices. I believe a “risk off” dynamic is gaining momentum globally, with de-leveraging and resulting fading liquidity. It’s a global bubble dynamic, with markets tightly interconnected by unparalleled “hot money” flows, leveraged speculation and derivatives trading. But so long as U.S. market prices are rising, risks can remain latent. It’s not until markets reverse lower and selling gains momentum that fragile underpinnings will be revealed.
But my indicators are pointing to a shifting backdrop. In both my Weekly Client Updates and Credit Bubble Bulletins, I routinely discuss credit default swap – or CDS prices. CDS prices are the cost of buying protection against a bond default. Think in terms of purchasing flood insurance. During a drought, writing flood insurance is essentially free money. And the longer the drought persists the more speculators will be attracted to the flood insurance marketplace bonanza. This speculative excess ensures insurance prices disconnect from risk – the risk of future flood losses. Yet, everything seems to work great – cheap insurance for the risk-takers building dream homes along the river and easy profits for the enterprising speculator community – that is until the torrential rains hit.
When “risk off” gains momentum globally, speculators will turn much more cautious writing market insurance. Many will move aggressively to offload risk. The cost of market insurance will rise and liquidity will wane. This has started to materialize over recent weeks, first in China, then the emerging markets, Europe and even somewhat here at home. Two weeks ago, U.S. investment-grade, high-yield and financial CDS jumped to eight-month highs, with some notable upside price gaps indicative of underlying liquidity issues.
I fully recognize that it’s easy today to dismiss the impact of China apartment builders on booming U.S. markets. The media is more focused on Tesla’s Trillion dollar market cap and record stock prices. It sometime ago became a full-fledged mania, and manic markets by their nature disregard risk.
Every cycle is different – each with its individual nuance. But there are recurring speculative dynamics, and today’s backdrop is reminiscent of the summer of 1998. At that year’s July 20th highs, the S&P500 enjoyed a y-t-d return of 23%. Financial stocks were even stronger, with the broker/dealer index up 31%. At the time, I was in disbelief: I was convinced Russia was on the cusp of financial crisis. How could markets disregard the risks associated with such a major development? The answer in the summer of ’98 was a rather simple mantra: “The West will never allow Russia to collapse.”
I knew the hedge funds had huge levered positions in Russia’s debt. I was also focused on a big increase in derivatives activity to hedge against declines in the ruble and Russian bonds. It was clear to me that Russia was in trouble, and if their markets faltered there was a high probability of illiquidity, dislocation and a financial collapse that would rock the leveraged speculating community and global markets.
In the six weeks between July 20th highs and September 1st lows, the S&P500 sank 21%. And between July highs and October lows, the broker/dealer index collapsed 56%. I was familiar with Long-term Capital Management going into the crisis, but I was as shocked as anyone to learn of their egregious leveraging and $1 TN notional value derivatives portfolio. It’s not an exaggeration to say the global financial system was pushed to the brink. The Fed orchestrated a bailout, there was the so-called “Committee to Save the World” – Greenspan, Rubin and Summers - and rate cuts – that reversed crisis dynamics and unleashed the 1999 mania.
Today’s risks so greatly dwarf 1998 that they’re hardly comparable. In key respects, China’s bubble is without precedent. It’s global financial and economic impact today rivals, if not exceeds, that of the U.S. The amount of global leveraged speculation today makes ‘98 excess seem trivial. And while I assume there are no global funds as recklessly positioned as LTCM was, there are reasons to fear that scores of funds have pushed the risk and leverage envelope. A seasoned hedge fund operator ran Archegos with more than 10 to 1 leverage in concentrated stock holdings. We also witnessed in March 2020 the chaos unleashed when de-risking/deleveraging gained momentum.
There’s another big difference between now and 1998: open-ended QE, and now unshakable confidence that central banks will do “whatever it takes” to sustain the boom. 1998’s “the West will never allow a Russia collapse” has evolved to today’s “Beijing and global central bankers have everything under control.” And such market perceptions are fundamental to the type of egregious speculative leverage and excess that ensure future crises. And, clearly, the world has never witnessed the scope of excess that has accumulated over the past decade – and especially over the last 19 months.
Zero rates and the perception of endless central bank liquidity have been fundamental to risk-taking and the accumulation of speculative leverage on an unprecedented global scale. But as I discussed earlier, surging inflation is in the process of limiting central bank flexibility, while creating acute risk of a global spike in bond yields with panicked de-risking and deleveraging.
Ten-year Treasuries are trading as we speak with a yield of 1.56%. CPI is up 5.4% y-o-y. The last time CPI was up this much 10-year yields were above 8%. Market expectations for inflation over the next five years – the five-year Treasury “breakeven rate” – yesterday was at 2.99% - the high in data back to 2001 when yields were above 5%. Treasury yields were above 4% the last time that University of Michigan one-year consumer inflation expectations matched today’s 4.8%.
Why have bond markets remained so placid in the face of rapidly escalating inflation risk? Because of vulnerable global bubbles and the near-certainty of additional massive QE bond purchases.
I’ll wrap up this section with a final thought. Markets are fundamentally broken. Regrettably, at this point there’s no fix – and the predicament is only worsened by additional monetary stimulus. Fixated on QE, bond markets disregard risk while yields fail to adjust – fueling manic excess throughout the securities, derivatives and asset markets. There are always costs associated with market dysfunction. These costs are today great and rising exponentially. In particular, the confluence of low yields and liquidity excess today accommodates what are powerful inflation dynamics, ensuring that inflationary pressures become only more problematic and deeply ingrained. Importantly, fragile global bubbles demand uninterrupted ultra-loose financial conditions, the perfect environment for stoking a secular upswing in inflation. This sets the stage for violent market reactions, as central bankers realize they must move with resolve to raise rates and tighten financial conditions.