Chinese Financial Conditions Loosening As Economy Slows

It does appear that the Chinese government is now loosening monetary conditions in the country in a bid to combat a slowing economy and heightened trade tensions with the United States. This comes as a deviation from Beijing's financial de-leveraging / de-risking campaign, which has been ongoing since late 2016.

The Chinese economy has been showing signs of fatigue as the first half of 2018 has come to a close.

Source: China National Bureau of Statistics

Investment in real-estate in China weakened for a third consecutive month to 9.7% growth in the year of 2018 through June. While this was above the 2017-through-June value of 8.5%, it marked a drop of 0.5 percentage points month-on-month, and the metric is now 0.7 percentage points lower from a peak of 10.4% growth in the first three months of the year, in annualized terms.

Source: China National Bureau of Statistics

In another concerning sign, the new orders portion of the China non-manufacturing purchasing managers' index (PMI) recorded its second consecutive fall in June to a value of 50.6. The 50.0 mark separates expanding activity (above 50) from contracting activity (below 50). In this instance, new orders are still expanding, but just barely as the metric floats above the threshold.

The drop-off in June appears to have been rather pronounced, with the new orders index falling 0.4 points to 50.6. It could be argued that Chinese companies and individuals became concerned with the escalating trade rhetoric from the United States in May and June, and therefore fewer new orders were submitted. The PMI data for July will be watched keenly for signs of continued falls in this new orders index, as early July marked the first implementation of U.S. tariffs on $34 billion of Chinese goods, with immediate Chinese retaliation of the same magnitude.

The Chinese economy has been heavily reliant on credit to maintain high growth rates since the global financial crisis, and this has left it with a substantial debt load.

Data from BIS

From the first quarter of 2015 to the first quarter of 2017, total private non-financial sector credit (all sectors) as a percentage of GDP jumped from roughly 190% of GDP to over 210% of GDP- quite an acceleration for the world's second-largest economy.

In late 2016, the Chinese government announced its intention to pursue a campaign of financial deleveraging and de-risking, an effort that authorities hoped would lower debt levels and close out opaque areas of financing, namely the shadow banking sector. As this campaign has plowed on, debt as a percent of GDP has fallen from a peak of 211.1% in the first quarter of 2017 to 189.8% in the first quarter of 2018.

That improvement, while still leaving the debt nearly double the annual output of the Chinese economy, is nothing to shake a stick at. This deleveraging campaign has put a dent in the credit-hungry habits of Chinese corporations and local governments (households maintain a debt-to-GDP ratio of less than 50%, per the BIS). This progress has come at the cost of economic growth, as the above data show. The side effect of a slowing economy was expected, as credit dried up and firms that truly relied on cheap credit to function began to struggle, but the slowing economy is now testing the resolve of the authorities. Beijing can either choose to continue tightening financial conditions and continue ahead with the deleveraging campaign, or the government may opt to pause the campaign and loosen monetary conditions to keep economic growth elevated, hoping that the stimulus does not destabilize the economy through asset price bubbles or other factors.

It now appears that Beijing has chosen to go with the latter option, as onshore financial conditions have undoubtedly eased during the first half of 2018. For evidence of this, we begin with interbank lending rates in China, benchmarked by the Shanghai Interbank Offered Rates or SHIBOR.

Source: Shibor.org

Traditionally, across global interbank lending markets, higher rates are a potential sign of stress, as banks may become less willing to lend to each other, thereby increasing the interest rates. Similarly, a flood of cheap credit may make banks rather lax about lending money, knowing their financial system is awash in liquidity (at least on the surface), and thus they reduce the interest rates at which they're willing to lend money.

The most-watched slice of the interbank rates is the overnight tenor, abbreviated above as O/N. This is the interest rate Chinese banks are charging each other to lend money simply for the overnight period. In the U.S., such overnight lending is primarily used for banks to maintain certain capital thresholds at the end of the day, for regulatory purposes. While I would assume the same can be said in China, I cannot say this for certain.

In any case, across tenors, interest rates have been falling. This trend has been most pronounced in the longer-term tenors, where rates are more stable. In particular, the interbank lending rates for periods exceeding 1 week (abbreviated as 1W above) really plunged around late-May or early-June, just eyeballing the graphs. I expect that these lower interbank interest rates surfacing around the time of escalating trade tensions with the United States is not a coincidence in the slightest, and instead is an effort by the Chinese government to cushion enterprises against any outsize effects from the U.S. tariffs.

Lending rates across all tenors, including overnight, have recently been falling yet again, with interest rates at the two-week period and beyond reaching >five month lows. This is another symptom of further monetary easing engineered by the Chinese government, which is now seeking to toe the line between supporting economic growth and deterring a resurgence of risk appetite as credit is re-introduced to the system. With trade tensions remaining elevated and the U.S. threatening tariffs on practically all of its imports from China, Beijing will likely continue keeping the deleveraging campaign in a holding pattern, instead preferring to support the economy via stimulus measures (both monetary and fiscal).

Source: AsianBondsOnline

Chinese local-currency sovereign bond yields have also recorded significant drops across the entire yield curve year-to-date, again a symptom of financial conditions easing instead of tightening. In an environment of tightening financial conditions, yields on bonds increase as credit in the financial system dries up, making money less readily available and thus placing a premium on attaining such money. This had been a feature of the Chinese financial system from late 2016 to early 2018, when the 10-year sovereign bond yield peaked at just over 4.00%, but since then yields on these bonds have fallen.

The yield curve can be used to determine the cause of these falling interest rates. Recall that interest rates in the longer-term end of the yield curve are primarily influenced by expectations for future economic growth, inflation and similar large-scale economic factors. In contrast, interest rates at the short-term end of the yield curve are more influenced by shorter-term economic and financial events; it is for this reason that the Italian 2-year sovereign bond yield exploded higher by a greater number of basis points than the 10-year yield did when political instability (a short-term factor, not a long-term factor like the business cycle) hit in May.

Year-to-date, the one-year Chinese local-currency sovereign bond yield has seen the steepest drop in basis points across the yield curve, falling 84 bps to stand at 2.98% as of the above image. In contrast, far tamer falls have been observed in the multi-year tenors, where the YTD basis points move has been confined to roughly 40.

Using the 'separation' of the yield curve explained in the second paragraph above, it is safe to determine that the significant fall in short-term yields relative to long-term yields stems from Chinese expectations and/or consequences of the government loosening financial conditions yet again to support the economy. It's the same situation as when short-term U.S. Treasury note yields rise in response to a Federal Reserve interest rate increase, but the 10-year and 30-year yields may barely budge; monetary policy primarily plays out in short-term interest rates.

Source: MarketWatch

Elsewhere in financial markets, the Chinese yuan (renminbi/Rmb) has rapidly depreciated against the U.S. dollar since mid-June, with the exchange rate jumping from Rmb 6.40 per US$ to Rmb 6.80. Much talk of the yuan has stemmed from U.S. President Donald Trump's accusation of currency manipulation by Beijing; whether or not that is the case is not to be decided in this post. Rather, the weakening of the yuan since April is another sign of easing financial conditions in China.

The gradual strengthening of the yuan throughout (at least) the second half of 2017 in the above image is not a fluke, but can be attributed to the tightening financial conditions observed in China throughout 2017 (for evidence, see the reduction of credit in the second half of 2017 from earlier in this post). In economic theory, the reduction of easily-available money in the Chinese financial system makes the remaining currency more valuable to hold, consequentially making that currency (the yuan) appreciate. This played out according to that script in 2017 as cheap credit dried up.

Now, as Beijing appears to relax financial conditions, the yuan has depreciated once again. It is necessary to consider that the depreciation in the yuan here may also be due to a variety of factors, such as trade tensions with the United States, a resurgent U.S. dollar amid U.S. economic outperformance relative to the world (especially the E.U.), overarching concerns about the slowing domestic economy, and even policy interest rate differentials with the U.S. No matter the amalgamation of factors that have contributed to the yuan's weakness in the second quarter of 2018, the easing of Chinese financial conditions has likely played a part.

Source: MarketWatch

Lastly, the renewed easing of Chinese financial conditions recently (as per the new leg down in most SHIBOR interest rates) has likely played a non-trivial role in the rebound of Chinese equities. The Shanghai Composite closed out June by entering a technical bear market, defined as a 20% drop from a recent peak. The above chart shows this sudden drop in mid-June, before the bleeding finally stopped in early July.

Since that nadir, the Shanghai Composite has drifted upwards, gaining as much as 200 index points as of this typing. Again, a number of factors may have contributed to this rebound, but this time it's a little less opaque than analysis of the yuan's moves. On one hand, Chinese stocks rebounded despite no material improvements in U.S. / China trade tensions. It is plausible to consider that the higher stock prices reflect optimism from investors that domestic companies will be able to take advantage of the depreciated yuan and see a boost in exports, but this assumption is destabilized when considering the still-murky final impacts of the still-unfolding U.S. / China trade tensions.

The rebound in the Shanghai Composite came despite the release of rather pessimistic Chinese economic data in mid-July; a brief dip was seen, but the index has more than erased those losses. For these reasons, I'm led to believe that Chinese stocks have benefitted in a non-trivial way from the government easing financial conditions within the last several weeks.

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As the Chinese government continues its balancing act of supporting the economy but discouraging irrational investment activities, further gradual easing of domestic financial conditions are expected. The U.S. Federal Reserve is expected to continue increasing interest rates this year and next - in addition to continuing its balance sheet normalization program -, while the European Central Bank will end its asset purchase program at the end of this year. Both actions will see global liquidity continue to dry up, tightening global financial conditions in general.

With Beijing showing its desire to support economic growth at the expense of delaying further progress in the financial deleveraging / de-risking campaign, further easing of domestic financial conditions looks probable. Chinese stocks and bonds look set to benefit further, absent an unexpected deviation from the path.

Andrew

Vulnerability in the High Yield and Leveraged Loan Markets

This is a research report I wrote up earlier today on a specific vulnerability that worries me in the riskier areas of fixed income. 

Summary

Over eight years after the end of the Great Recession, the economic recovery that has slowly but surely powered the United States into a 4.1% unemployment rate and sent stock market indexes to dozens of record highs this year has now spread around the globe. With heavy-handed support from leading central banks, financial markets are thriving, with suppressed volatility and generally-positive economic data supporting both advanced and emerging economies. Unconventional monetary policies employed by G20 central banks, particularly the European Central Bank (ECB) and Bank of Japan (BOJ), have led to an asymmetric recovery in certain sectors of global financial markets, however, whether directly or indirectly. In this report, unconventional monetary policies will be connected to the increasing deterioration of covenants in riskier sections of the fixed income market, and concerns over systemic risk posed by such sectors of the fixed income market will be outlined.

            Introduction

In response to the 2007-2008 financial crisis and succeeding deep recession, central banks in advanced economies found that their conventional monetary policy tools were not as effective as desired. Faced with the zero lower bound dilemma, leading central banks asserted themselves into uncharted territory with the use of new monetary policy measures. The most visible and widely-discussed tool at hand was that of quantitative easing (QE), the process by which a central bank purchased their nation’s sovereign debt (for the ECB, up to 33% of each EU member’s sovereign debt), in a bid to stimulate the economy and lower borrowing costs for consumers. Through such QE operations, the G4 central banks (the Federal Reserve, the ECB, the BOJ and the Bank of England) purchased securities that sent their balance sheets to a combined 37.4% of their cumulative GDP.

Figure 1. Source: Bloomberg

            The composition of the balance sheets for each central bank vary, however. For example, the Federal Reserve invested its $4.5 trillion balance sheet primarily in Treasury securities, as well as agency debt and mortgage-backed securities (MBS):

Figure 2. Source: Bloomberg

            In contrast, the European Central Bank has accumulated nearly 33% of each European Union member’s sovereign debt, the threshold of which was set by the Bank and is unlikely to be increased due to German opposition to the continuation of QE. The ECB also undertook significant purchases of corporate bonds, a program which also is still ongoing. The Bank of Japan has employed the most unconventional monetary policy of the G4 banks, and perhaps of the world. Indeed, the BOJ now employs ‘Quantitative and Qualitative Easing’ (QQE) and ‘Yield Curve Control’ (YCC), as well as maintaining a benchmark interest rate of -0.4%. The YCC portion involves the Bank of Japan maintaining the 10-year Japanese government bond yield at a rate of around 0.00%. The Bank had stepped in with offers to buy an unlimited amount of bonds at a rate of 0.11% earlier this year, when the 10-year yield began climbing, in a motion similar to that of a central bank offering to defend its currency peg if necessary. As part of its QQE program, the Bank of Japan now holds significant stakes in the Japanese sovereign debt market, Japanese corporate debt, Japanese stocks and exchange-traded funds (ETFs), all in bids to suppress volatility and encourage consumer spending.

            The successes and failures of these varied monetary easing programs are not for discussion in this report. Rather, we aim to focus in on the Federal Reserve’s quantitative easing operations, and its consequences as reflected on riskier portions of the fixed income market- namely, leveraged loans and the high-yield corporate debt sectors.

            The Federal Reserve’s QE program was designed to decrease borrowing costs for consumers, and the suppressed nature of the 10-year Treasury note yield shows that this has happened.

Figure 3. Source: Bloomberg

            With Treasury yields continuing to plumb record low levels over the last several years due to the Federal Reserve’s QE, investors have been driven to riskier assets in their search for yield. A primary beneficiary of this tactic (a deliberate one, at that) has been the stock market, with the Dow Jones Industrial Average (DJIA), S&P 500 and Nasdaq Composite setting over 100 record closes combined this year. While this is due in large part to investor enthusiasm over the expected agenda of President Donald Trump, stock markets were strong and looking stronger in the months leading up to the 2016 presidential election.

            In a sign of investors’ search for yield, even riskier assets have seen stronger returns than stocks. A prime example of this is the return offered on Bank of America Merrill Lynch’s High Yield corporate bond index.

Figure 4. Source: Federal Reserve Bank of St. Louis – FRED.

            On an indexed basis, where the beginning of the 2007-2009 recession was set to 100, the S&P 500 has seen its value increase by a multiple of 1.8, through the end of October 2017. BAML’s High Yield Total Return Index, however, has seen its value more than double over the same period, appreciating by a multiple of nearly 2.2 through October 2017. It is no secret that investors who favored junk bonds over the last eight years have been handsomely rewarded- even today, the effective yield of BAML’s High Yield corporate bond index still tracks above the 10-year U.S. Treasury note, but that’s where the concern starts.

Figure 5. Source: Federal Reserve Bank of St. Louis – FRED

            The effective yield has hit record lows on multiple occasions since the end of the previous recession, with the most recent nadir in 2014, though even today junk bonds hold a slim premium over Treasuries.

            Let’s recall the purpose of a premium. We first recognize that U.S. Treasuries are the risk-free rate, as the U.S. government will not default on its debt (this has been called into question over the last decade, but for all intents and purposes, we will leave this assumption undisturbed). To hold an asset that is riskier than Treasuries, therefore, leaves investors demanding compensation for retaining that risk. Such compensation comes in the form of a premium, the higher yield compared to Treasuries. Relative to Treasuries, highly-rated investment grade corporate bonds (i.e. AAA-rated or AA-rated) will trade with a small premium to Treasuries, as they are quite unlikely to default. Riskier corporate bonds, such as A-rated bonds, will contain a larger premium with their correspondingly-higher risk, and so on. Junk bonds, sitting at the bottom of the ladder, are those with the highest risk, and thus the highest premium… until this economic expansion.

Figure 6. Source: Federal Reserve Bank of St. Louis – FRED

            Above is a graph depicting the spread between Moody’s Seasoned Baa-rated corporate bond yield and the 10-year Treasury note yield, in percentage points. While we remain above the record lows reached prior to the 2007-2009 recession, we continue trudging further down the scale. This depression of the spread indicates investors are willing to receive less of a premium to hold these risky bonds over U.S. Treasuries, as investors continue to hunt for yield.

            At first blush this chart is not all that impressive, but let’s view it in tandem with Figure 5. The Baa-10 year Treasury spread in Figure 6 is low, but the effective yield of BAML’s High Yield corporate bond index is at or near record lows. So, while the premium for Baa corporate bonds isn’t as low as it was in 2006, the actual yield of those Baa corporate bonds is lower, leaving investors with less income overall. That drive for income we discussed earlier only pushes investors deeper into riskier segments of the financial markets, and makes them more willing to take on risk to receive income. This is an intended consequence of the Federal Reserve’s QE program, but it’s a consequence that is beginning to lead to deteriorating credit conditions.

Credit Boom

            The Federal Reserve’s intent to make investors become more willing to take on risks has combined with the Federal Reserve’s lowering of borrowing costs to increase lending to make a dangerous entity in high yield bonds and leveraged loans. Let us first review the volume of total U.S. corporate bonds, U.S. leveraged loans, and U.S. high yield bonds in a historical sense, respectively.

Figure 1. Source: Bloomberg.

Figure 2. Source: Bloomberg.

Figure 3. Source: Bloomberg.

            It is not difficult to ascertain the trend in the broad corporate bond market. As shown in Figure 1, we are already well past the previous year-to-date record of U.S. corporate bond issuance, with just over $1.7 trillion in corporate debt issued through mid-November. The same is found in the leveraged loan market, with volume once again surging past the previous year-to-date record to clock in now at $1.2 trillion. We are not yet at a new year-to-date record in the U.S. high yield sector, currently in at $300 billion through mid-November. It remains to be seen if a new year-to-date record will be achieved in 2018 or later, but is unlikely to happen this year.

            The volume of these riskier loans is a testament to investors’ increasingly-frenzied hunt for yield. Unfortunately for investors, this has placed the bargaining power in the hands of the lender & debt issuer, given if one investor doesn’t like the terms, another investor that is more driven for income will take those same terms. This has led to a startling deterioration in the quality of investor protections on high yield and leveraged loan securities, as evidenced in the following quote from a Bloomberg article:

“Protections have gotten so lax in the $1 trillion market for U.S. leveraged loans that if an offering comes with decent covenants, lenders take it as a sign that something’s wrong with the deal.

“You do have to think twice when you see a loan with a covenant these days,” says Thomas Majewski, managing partner and founder of Eagle Point Credit Management.

It’s not a crazy assumption in a market where 75 percent of new loans are now defined as “covenant-lite,” meaning a company could, for example, rack up as much debt as it wants regardless of its performance. In such a lenient atmosphere, the reasoning goes, a loan must be a stinker if a borrower has to resort to promising even standard protections.”

            Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants

Speaking from a common sense viewpoint, one could (and perhaps should) find it alarming that investors continue to eat up leveraged loans which come with increasingly fewer protections for investors. The phenomenon is not limited to the United States, either – in Europe, “cov-lite” loans have emerged as a popular security for those searching for income – despite a different name, the concept of less protection for investors is the same.

Moody’s, which publishes its Covenant Quality Index, has also noted the decline in protections for investors.

Figure 4. Source: https://www.bloomberg.com/news/articles/2017-09-21/safety-becomes-stigma-in-loan-market-that-s-ditching-covenants

            Another quote from the aforementioned article, this time from a Moody’s executive, once again strikes a risk-averse investor as quite alarming.

“ “It’s basically the worst it’s ever been in terms of loan covenant protections,” says Derek Gluckman, senior covenant officer at credit-rating firm Moody’s Investors Service. And that includes the heady pre-crisis year of 2007. ”

Conclusion

It is a sense of dread that many may have felt when looking back on the subprime mortgage industry after it succumbed during the financial crisis. Back then, investors were also hunting for extra income, and the issuance of such securities seemed to benefit all parties involved: the issuer, underwriter and trader for the associated fees and profits, and the homeowner for getting a home. But, of course, it all came crashing down when those investors began to realize just how deteriorated the subprime loans have become.

            It is important to distinguish between the subprime crisis, which was severely exacerbated by a lack of regulation and truly abhorrent lending practices, and this concern over riskier sections of the fixed income market. It remains to be seen how these deteriorating leveraged loans and high yield corporate bonds will fare when (not if) financial conditions begin to tighten. The Federal Reserve is expected to once again increase interest rates next month, and gradual tightening of monetary policy is also expected through the Federal Reserve’s balance sheet tapering. While it remains plausible companies are able to rein in the weakest links of such deteriorating credit instruments, history tells us it’s far more appetizing for both the corporation and the investor to put profits first and handle the consequences later.

Venezuela Projected To Begin 2018 With Under $5.3 Billion in Forex Reserves

Using a linear forecast of Venezuela foreign exchange reserves, and accounting for roughly $3.8 billion in debt payments through the government and state-owned PDVSA through December 2017, I am projecting the level of foreign exchange reserves to end up at just under the $5.3 billion mark on 1/1/2018.

Data source: Central Bank of Venezuela
Chart source: Author's creation

As of July 22, 2017, Venezuela's foreign exchange reserves stood at $9.971 billion, the lowest level of reserves seen during the current crisis. As the chart above shows, the country's foreign exchange reserves have been broadly falling since the start of 2017, from a few ticks under $11 billion at the beginning of the year to the $9.971 billion level we are at now.

I took these two data points and, to satisfy my own curiosity, used the data points to create a linear projection of foreign exchange reserves for each day through the end of 2017. Using these data points, the linear equation was calculated to be:

Y = -7.75x + 10,995

where Y is the level of foreign exchange reserves in millions of USD, and X is the date in basic number format. For example, July 21, 2017 was assigned the number 134, as it was the 134th data point in the foreign exchange reserves data set as provided by the Central Bank of Venezuela. I have filtered out all weekend dates, so the linear projection does not create an artificially-low ending forex reserve level by incorrectly lowering reserves on weekends. It should be noted that this model does not account for holidays or other days off during the workweek.

January 1st, 2018 was the 250th data point in this data set, so the projection was calculated to be Y = (-7.75*250) + 10,995. This resulted in $9.055 billion of foreign exchange reserves to start 2018. When we account for sovereign and PDVSA debt that will be paid from August 2017 through December, however, we subtract $3.8 billion to receive an estimated foreign exchange reserves level of $5.26 billion on January 1st.

There are many caveats to this forecasting methodology, of course, a primary flaw being that the world of finance (and the world as a whole) generally does not move linearly. If it did, we wouldn't need posts like this trying to make predictions, because everything would be so linear we could forecast decades and decades into the future. An additional threat to the integrity of this model is that Venezuela could strike further bond deals, as it did controversially with Goldman Sachs earlier this year.

However, using duct tape to fix a crumbling building can only do so much, per se. Venezuela will continue to struggle amidst this economic, political, social and broadly-humanitarian crisis. With the Venezuelan bolivar recording a 750%+ depreciation over the last year as of this typing, a currency crisis appears to be blooming. This is quite ominous, as currency crises historically have been seen to precede sovereign debt crises. Investors appear to be baking such a potential credit event into their investments, with the Venezuela five-year credit default swap spread reaching levels not seen since 2016 this past Thursday (Figure 1 below).

Figure 1: Venezuela's 5-year CDS spread.
Chart from http://www.boursorama.com/bourse/cours/graphiques/historique.phtml?symbole=3xVENZ

The vultures continue to circle around Venezuela, and while a credit event may not occur for some time, it's quite apparent that the economic & financial situation, much less the social and political situation, is unsustainable.

Andrew