March Review: The Bulls are Back in Town

Jonathan Rochford

Narrow Road Capital

March saw strong gains across risk assets, with dovish central bankers providing investors reassurance that they will do “whatever it takes” to support the tepid global economy. Equities rallied most strongly in emerging markets notably Brazil (17.0%) and China (11.9%), but the US (6.6%), Japan (4.6%), Australia (4.1%) and Europe (2.0%) all posted healthy gains as well. Almost all major currencies made gains against the US dollar except for the Yen which was unchanged. The Bloomberg Commodity Index was up (3.8%), with US natural gas (14.6%) and oil (12.4%) posting the largest gains. Iron ore (8.8%) and copper (2.5%) were also up, with gold (-0.5%) holding onto recent gains in spite of the risk-on mentality. Credit spreads narrowed across the board, from investment grade through to CCC and below.

In US economic news the good outcomes on headline employment levels are balanced by the worsening outcomes for tax receipts. The seeming contradiction is explained by the reduction in high paying jobs in the energy sector but growth in low paying jobs in retail and restaurants. World trade volumes were down 0.4% month on month but up 1.1% year on year and point to 2016 being one of worst years for global GDP growth this century. Prior to the financial crisis volume growth of 4-10% year on year was normal. The Baltic Dry Index (commodity shipping) has bounced off record low rates but container freight indices are still setting record lows.

The recent bounce-back in US equities is all about P/E expansion with no change in earnings expectations over the past month. The earnings quality issue is looking a lot like 2001 and 2009 and that’s never a good comparison. Share buy backs are being referred to as the buyer of last resort as the amount companies are spending on buybacks is very high relative to net income and cashflow. Asian and Australian banks caught up a little with their overseas counterparts in share price falls as prospective bad debts in the resources sector hit Standard Chartered and ANZ shares in particular.

The recovery in US high yield as a result of strong retail inflows masks several underlying problems. Investment banks and brokers are laying off staff and pulling back on underwriting new high yield debt after taking substantial losses on previous deals. Credit Suisse raised provisions to cover losses on high yield and distressed debt, with the CEO claiming he had been blindsided by the risk these business units were taking. Standard and Poor’s has year to date defaults as the second highest in the last 12 years, only surpassed by 2009. The distress ratio for high yield bonds has fallen from 33% to 25%, but the same ratio for leveraged loans is still increasing. This looks more like a temporary reprieve than a sustainable improvement in market conditions.

In bankruptcy watch, Atlantic City has said it will stop paying non-essential workers and the State of New Jersey has threatened to take over management of the city. Renewable energy company SunEdison is on brink of an $11.7 billion bankruptcy due to a debt funded acquisition binge. The Catalonia region of Spain missed interest payments on bank loans and was downgraded to B+ as part of a dispute with the nation’s government. The Puerto Rican Governor likes the debt restructuring proposal offered by US politicians but doesn’t like the controls that come with it. That’s the reality of going bankrupt, someone else gets to tell you how you can spend your money.

The bounce back in oil prices has been one of the most divisive issues of the month. Most of the opinions I’ve read are suggesting either prices will go over $50 in the next year or that prices will go back below $30 a barrel. It’s unusual to see so few saying that current prices are about right. The oil exporters meeting due for April 17th is being seen as a critical test of whether supply can be lowered. There’s much debate over who will attend and who won’t with some of the non-attenders the countries that are most likely to be increasing their oil exports this year. The calls for a production freeze have helped to lift prices higher, but unless there are production cuts then the over-supply of oil won’t be cleared anytime soon.

Economic news for China was dour with both service sector and manufacturing PMIs at post crisis lows. The quarterly beige book survey was again unpleasant reading, with a weak outlook for capital expenditure and jobs growth. Chinese nominal economic growth for 2015 was 4.25%, well below the official 6.5-7.0% target for the coming five years. Slow growth will make debt servicing on China’s rapidly growing mountain of debt even more difficult.

Following in the footsteps of Italy, China has come up with a plan to reduce non-performing loans via securitisation and debt for equity swaps. The naivety of offering these as solutions is stunning. Unless the Chinese banks can find “muppets” to buy bad loans at full price, they’ll need to mark the loans down to sell them or on conversion to equity. Either event means the bank’s capital position is reduced and the government or investors will need to recapitalise the banks. Even the banks themselves recognise the problems with these plans, one bank manager said he didn’t support a plan that would see “bad debt swapped for bad equity”. The regulator may have recognised the broader issues with Chinese banks as it is asking them to increase their capital levels by retaining profits. 

Chinese corporate defaults were previously unheard of but there’s now a handful of large collapses each month. One recent default involved a state backed metals company that had total debt exposures in excess of $2 billion, proving that even strong connections are not enough to save some. Chinese firms are struggling to collect their debts with average receivables now up to 83 days. Global distressed debt buyers are opening offices in China expecting more defaults. Another reason not to lend to Chinese companies, a Chinese developer wants relief from debt covenants but is still planning to pay record shareholder dividends.

As more companies are resorting to not paying their workers and millions are expected to become unemployed as a result of industry rationalisation, labour unrest is increasing. This has the Chinese government particularly worried, warning local officials their jobs are on the line if there is unrest in their jurisdictions. Public trials and jail sentences for protestors are being used to attempt to kill-off any thoughts of uprisings. China has recently jailed 20 people in an attempt to find the “loyal communists” who wrote a widely disseminated letter that called for President Xi to resign.

Home prices in Vancouver have been skyrocketing, with a fairly standard home recently selling for $4 million, $1.6 million above valuation. Home prices in Shenzhen have also been soaring. What’s the link you ask? Well, one-third of buyers in Vancouver in 2015 were Chinese. There’s more reports that online lenders are helping Chinese buyers skirt minimum deposit requirements as high interest unsecured loans are used to replace equity in the deal. China is easing lending requirements for car buyers in order to boost demand.

Another potential bubble is wealth management products, which rose by 56% in 2015 with mid-tier Chinese banks particularly exposed. Some have suggested that these products have been used for speculating on iron ore causing the surge in iron ore prices, but there does seem to have been a temporary surge in demand for steel. China is looking to pump up the stock market again with margin lending restrictions being eased. The country’s pension fund will be allowed to invest in shares. China has decided to invest in technology development and venture capital and it won’t be doing it in half measures. One experienced investment banker warned that Chinese venture capital is “lawless”.

The IMF is finally catching on to China’s shenanigans with currency derivatives and has asked China for detail on what exposures it has. The IMF should be interested as it has included the Yuan in its basket of currencies for Special Drawing Rights. It appears that Chinese banks have been undertaking substantial forward currency swaps on behalf of the government in order to stabilise the currency. If reports are accurate, China has hidden US$150-300 billion of currency outflows this way. The latest scheme for getting around the currency controls is buying insurance policies in Hong Kong. The $5,000 credit card transaction limit is a pain though, as it can take 15-20 credit card purchases to move as much as is desired. China is considering the introduction of a tax on foreign exchange transactions as another way to stem the outflows, but this could backfire badly if implemented.

Corporates are using debt fuelled international M&A as a way to play the currency devaluation story, borrowing heavily in Yuan to buy assets overseas. There are some concerns that corporate China is overpaying for assets in its $113 billion buying spree this year, as was the case with Japan in the 1980’s.  There’s soaring demand from Chinese companies to lock-in the exchange rate for their US$ debts, fearing that another devaluation could occur.

In emerging markets, the Egyptian currency was devalued by 13% and a dollar shortage was reported for the United Arab Emirates. In Mexico the major oil producer, Pemex, has $100 billion in debt, $90 billion in pension liabilities and recorded a $30 billion loss for 2015. Brazil’s Petrobras lost $10 billion in the 4th quarter but says it has enough liquidity to get to the end of 2017 whilst covering interest and maturities on its $200 billion of debt. Others are saying it needs $25 billion of capital soon, with the pre-sale of $10 billion of oil to China perhaps an indication of the weakness.

The US treasury market showed some very unhealthy signs in March. Firstly, the amount of repurchase agreement failures surged for 10-year treasuries. Secondly, dealers have been stuck with growing piles of off-the-run treasuries. The contrast is stark as there’s huge demand for very liquid bonds but little demand for less liquid bonds. Riding the potentially volatile margin between these two groups was one of the things that brought LTCM unstuck.

Zero and negative interest rates are having unintended consequences on banks. Firstly, banks can’t make a profit on deposits so they may turn them away or charge for accepting them, killing off one of the key functions of banking. Secondly, banks may seek to recover their costs by raising lending rates – producing the opposite outcome of what was intended. Higher lending rates for Swiss home loans wasn’t on anyone’s desired outcome list but it has happened. Lastly, banks are lending longer and riskier in order to make a profit, undermining stability and solvency.

It’s often said that insanity is doing the same thing repeatedly and hoping for a different outcome. I’ll put forward that financial insanity is buying 10-year Japanese government bonds at a negative yield and hoping that you’ll make a profit. Lending to a country that is likely to default on its debts at some point during that period is bad enough, paying them for holding your money as well is downright stupid. 

The huge quantitative easing program in Japan has seen government bonds become very difficult to buy and when they are available they are mostly trading at negative yields. Japan has seen a surge in the cost of swaps covering yen for dollars as Japanese investors are desperate to get their money out of the country into somewhere that can give them a decent yield. Those that aren’t sending money abroad are increasing cash levels with physical cash levels increasing and a surge in safe purchases to hold the cash. HSBC put forward six ways other countries can avoid ending up like Japan, but all of them are ugly. Some academics are arguing that unlimited government spending is ok.

The drums are beating ever louder for helicopter money as the next step for central bankers running out of options. Japan has started down this pathway with a plan to give low income young people vouchers to spend. I have some sympathy for younger Japanese people as they are on a hiding to nothing with all of the government debt and pension obligations the older generations are seeking to leave them with. The soaring rate of imprisonment of elderly Japanese people for mostly small scale theft is just one symptom of the many problems an aging Japan faces. I won’t be surprised if Australia and other western nations see a lot more migration of young Japanese professionals as they seek to leave these problems behind.


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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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