posted: Jun. 24, 2013 @ 2:15p
Anybody looking at their portfolios today or pulling up the financial news has seen the impact of China's interbank markets on world asset prices over the last couple of business days.
Now there are times when problems show up, cause a small correction, and then seem to fade away. Then there are those rare risks that have the capacity of inflicting large amounts of damage over a period of time. The situation in China is in the latter category.
Now just about every post I've made about the markets has come with a list of designated risk factors. Those were PIIGS + F, Japan, and China(and their primary suppliers Brazil and Australia). I always had my guess that China represented the highest likelihood of getting out of control because of the sheer quantity of new credit required to keep them from a large real estate crash and financial crisis. The other reason was that the Chinese were the only ones that seemed to be trying to poke the bubble, but then spooking when they saw the sheer size of the problem once they started that(it's created this jigsaw policy making of trying to cool things down, then not liking the view, and then reflating only to try to cool things down again several months later). The other countries dealing with different issues were primarily focused on just kicking the can down the road.
Naive investors and commentators kept on talking about the Chinese ability to engineer a 'soft landing' where they seek to pop it and then support it's decline and then pop it again and support its decline. People that actually understood the scale of the problem knew that was impossible. Their society required massive new amounts of credit to just maintain status quo; most new debt goes to pay for old debt often times at exorbitant interest rates in the informal marketplace. Even if they just tried to stop the growth of credit(not letting new credit fall just halting its growth) many participants wouldn't be able to rollover their entire debt stock + expenses + interest for the year and they would be forced to default. So there is no slowly letting air out of this tire. It's either keep pumping it full of air or jam a hammer into it keep it from growing any larger.
So the key question that always remained was when would the Chinese stop playing this game and when would they realize that they just had to let it blow up and unwind.
The announcement by the PBoC today was a huge change in the situation. They expressly stated that they will not be coming to the rescue and told their banks that they're on their own. Those that have been paying attention will know that the overnight SHIBOR hit 25% for a short period of time last week. It is largely believed that the PBoC engineered that intentionally. SHIBOR rates of 10% represents largely a shut down of the interbank markets in China. The entire SHIBOR rate regime is floating close to that number as we speak.
This has coincided with major announcements of reform by the new leadership headed by Xi Jinping(I profiled the new leadership on here a couple of years ago). Xi appears to be targeting corruption, the state owned enterprises, and the excesses their massive credit expansion has created. Given these reforms and details being discussed it would make sense that he would behind a move to let blood out of the property and credit bubble of China. It also makes sense that he would do it so soon because he could blame it on his predecessor where as if he kept going for a while he would no longer enjoy that luxury.
Personally, I'm growing a bigger and bigger fan of Xi. He appears to have the balls to tackle very painful problems in China today even with severe short term consequences.
So you have all the necessary conditions for the bubble to be popped. You have massive excesses in property markets(ghost cities, prices ~40 times average income, massive over supply), huge credit growth(50% of the new global money supply over the last few years has been from China they've 'printed' far more than the US has), there is realistically not much more policymakers could delay the inevitable, and finally(and in today's "No Lehman's world" the most important) what appears to be the final capitulation moment where policymakers are now content to let it happen.
You get that mix and you have a recipe for serious market correction China. Now some believe that this is the PBoC just instigating a really harsh dosage of pain before injecting liquidity. Others believe they're in for the long haul. And even if they're are now in for the long haul they could spook again in the future. Non performing loans spike from 1% to 10% they could slam the market with more liquidity and lending to make the problem go away again(hell just in the last month several small banks have announced that their NPLs have spiked from 1% to 5% just in 1 months time).
Last couple of thoughts here:
A) If this plays out bad there is no way Bernanke is tapering this year. That fickle SOB spooks easier than just about any other central banker on Earth. So that is definitely a mitigating factor.
B) There is some debate how much impact this would have on US markets. Due to capital controls in China US institutional investors have always had a hard time getting capital into China to even have at risk. Chinese have always had a hard time getting capital out of China to be worried about that capital leaving the US in the future. So the banking crisis likely wont spread that much outside of China's borders nor should the property markets. But on the other end many domestically traded companies have significant sales in China and many domestically traded companies have manufacturing in China. So there is impact.
What I would do about this:
1) Too many factors to think about selling all equity holdings
2) But significant enough risk here to maybe review how much 'dry powder' you have. I think anybody 100% long equities here is pretty crazy, but I've been saying that for a little while now. Ultimately you just want to make sure that you a nice percentage(maybe 20-50% depending on your risk tolerance) dry that you would actually feel comfortable redeploying at cheaper stock prices down the road.
3) You can get dry powder via cash, near cash, or a systemic hedge(put option on maybe the S&P for a period of time).