MorningWord 5/9/16: Some Costanzas are starting to blink – $FXI

by Dan May 9, 2016 10:09 am • Commentary

You know the old saying, Credit leads Equities. And in China, the country’s fairly well documented credit bubble is leading their stock market down a long road to ruin. The Shanghai Composite closed down 2.8% overnight, marking a 20% decline for 2016, and a 45% drop from its 52 week highs made in June 2015. I know, the Chinese stock market is not the Chinese economy. But the data overnight about April exports and imports are not exactly indicative of a soft landing as the country tries to transition from an industrial economy to a consumer economy.

Obviously, one months of data does not spell the end of a transformation (that will take years if not decades). But I think it is safe to say that over the last 10 years the largest risk asset volatility shocks have been from fears of systemic risk from credit bubbles (see the U.S. subprime crisis and Euro Sovereign Debt crisis). The denial by many market pundits of a credit bubble in China, or the notion that the largest centrally planned economy the world has ever seen will be unable to manage a soft landing may soon be debunked.  And so it begins:

The natives are getting restless.  In a government where denial of facts is the foundation for establishing a new truth, and it’s not a lie if you believe it, maybe just maybe, some Costanzas are starting to blink.

It’s a pretty amazing read. A couple highlights here:

High leverage is the “original sin” that leads to risks in the foreign-exchange market, stocks, bonds, real estate and bank credit, the People’s Daily said in a full-page interview with an unnamed “authoritative person” starting on page one and filling the second page on Monday.

China should put deleveraging ahead of short-term growth and drop the “fantasy” of stimulating the economy through monetary easing, the person was cited as saying. The nation needs to be proactive in dealing with rising bad loans, rather than delaying or hiding them, the report said.

If we have learned anything from the rolling credit crisis that began in the U.S. in 2007, is that without a de-leveraging reset, there can’t really be a healthy backdrop for a return to organic growth.  Yet back in March Chinese Premier Li Keqiang said:

“Development is of primary importance to China and is the key to solving every problem we face,”

“Pursuing development is like sailing against the current: you either forge ahead or you drift downstream.”

So far that strategy has merely kept the ship afloat. As Barron’s noted last month (Big Trouble in China’s Little Zombie Cities), the “problem is HOW China is fueling this growth” at time when GDP has been cut in half from its 2010 highs:

Most worrisome is how little bang China may get for all the fresh debt and shadow-lending excess it’s amassing. The thing with overcapacity-plagued economies is that they need ever larger stimulus jolts to get the desired GDP effect. Unless Beijing can generate true demand via higher wages and accelerate the shift to a services-based economy, it’s just planting the seeds for another debt crisis.

You’ve already seen this chart, China’s Mounting Debt Burden. It’s at a record high at more than 240% of GDP. Some see it rising to 300% by 2020.


You’d think that all this debt would be fueling the sort of growth that would benefit equities. Well it did, and not just in China. In many ways it was the reason, coupled with the weak dollar for the commodity super-cycle that inflated and burst since 2009. And it wasn’t until mid 2014 that Chinese stock’s took notice and awoke from their dirt nap with a more than 150% rally. But it was born into a grave. I suspect a re-tracement back to 2000 is in the cards for the Shanghai Composite:

From Bloomberg
From Bloomberg

The S&P 500 (SPX) has been disconnected from the volatility in Chinese stocks for the most part. But a precipitous drop in the Shanghai Comp from here would indicate that investors are getting worried about the unintended consequences of China’s growth plan and most specifically a systemic debt crisis. The weakness in the U.S. dollar and the subsequent rise in industrial commodities this year might have put off the inevitable, but if recent history is any guide, a debt crisis is coming. It’s merely a matter of when and how bad. Pundits and strategists will claim that Chinese stocks are cheap. But think about how much cheaper stocks will be when leverage ratios of corporate and sovereign debt is forced to come down.

It’s difficult to play a sort of doom and gloom scenario in China because you can get turned around by surprise government moves. But selling into rallies in Chinese stocks is still an attractive trade and that remains until they overshoot on the downside, the way they did on the upside last June.

Disclosure: bearishly positioned in FXI (here, here)