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January Review: Optimism Swings to Realism

Jonathan Rochford

Narrow Road Capital

The raw return numbers for January could have been much worse as the heavy sell-off at the beginning of the month was partially reversed in the last week. Equity indices in the US (-5.1%), Australia (-5.5%), Europe (-6.8%) and Japan (-8.0%) all recorded sizeable losses but it was the -21.0% return for Chinese equities that particularly stands out. In commodities US oil (-9.2%) had a horrible month dragging down the Bloomberg Commodity Index (-1.7%). Copper (-3.2%), iron ore (-2.4%) and US natural gas (-1.7%) also fell, but gold (5.4%) bucked the trend. Credit spread indices for all ratings and jurisdictions moved wider with US high yield bonds nearly a full percent wider over the month.

The impact of the falling oil price was seen for both countries and companies that depend on it. The currencies of Brazil and Russia hit new lows. The peg fixing the Saudi Arabian Riyal to the US dollar is under further pressure, with the government responding by introducing capital controls as outflows accelerate. Angola became the latest of a string of small nations to markedly devalue its currency.

For oil companies, credit spreads are blowing wider making refinancing difficult or impossible, credit limits are being cut and recovery rates are awful for those that can’t remain solvent. One iceberg lurking in the US high yield debt markets is the US$325 billion of debt owed by cashflow negative oil producers. With US oil inventories at their highest since 1930 and crack spreads plummeting defaults are set to be much worse in 2016.

On other energy commodities, Singapore natural gas prices are down over 50% in the last 15 months and half of all US coal producers are in bankruptcy. The Baltic Dry index continues to hit record lows as US and global transport volumes continue to fall. It’s now cheaper to rent a ship for a day than a Ferrari and a wave of defaults is likely for shipowners as LVR triggers are hit and cashflows are negative.

The fallacy of omnipotent Chinese authorities was exposed again in January. Trading limits put into place to stop panic selling of shares lead to further falls. After two 7% limit down days the new system was scrapped. The President’s prediction that the Shanghai index is heading towards 10,000 now looks particularly foolish. With a median PE metric of 57 times Chinese equities are the still the most overvalued in the world.

Authorities have switched their attention to the Yuan and are adopting desperate measures to stop it falling further. Overnight interest rates in Hong Kong hit 66.8% as the authorities pulled liquidity out of that market to flush out short sellers. On the mainland, huge amounts of liquidity are being injected to prop up the currency and lending activities. Anecdotes abound that Chinese banks are running out of physical US currency or blocking people from exchanging Yuan to US dollars. The latest trick for getting money out of China is buying and selling internet domain names.   

Once again the authorities appear to be trying to stop a speeding bus by standing in front it. Chinese asset managers are openly advising their clients to get their money out of China. The major newspaper of the Communist party said that George Soros and others hadn’t done their homework when they suggested shorting the Yuan. Goldman Sachs estimated that January outflows were US$185 billion with a few days to go before month end. The US$3.3 trillion of reserves is often cited as great wall protecting the Yuan, but these reserves are mostly illiquid or earmarked and the remainder could be exhausted within a year.

Italian banks continue to struggle with non-performing loans and the share prices of its banks continue to fall. A deal has been struck with the European Commission that will see Italian banks issue securitisations of non-performing loans (NPLs) to clean up their balance sheets. The Italian Government will guarantee senior tranches of the securitisations and will receive a premium for doing this. The Italian Government says it will only insure the “safest” non-performing loans. (There’s a contender for oxymoron of the year!)

I can’t find any detail of the deal on the European Commission website, but on the surface there are three key problems. If the loans to be insured are safe, as the Italian Government insists, why are they non-performing? Removing safe loans from a bank’s balance sheet won’t solve an NPL problem. Secondly, who will buy the uninsured tranches of these deals? If the riskiest tranches remain with banks then the risk won’t have been reduced much, if at all. Thirdly, the quality of the guarantee from the Italian Government is of dubious quality. The government has more than enough debt already and may not be in a position to cover losses if they arise in future years. This “solution” appears to do little to recapitalise banks or transfer risks away from them. Without the banks or the government contributing new capital it is simply kicking the ball up the hill – the problem will come right back to you. 

1 topic

Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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