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CREDITHOLICS: CHINA BINGE, HELP NEEDED

Takeaway: Heading into China's 3rd Plenary Session, we are looking for concrete solutions (if any) to China’s ongoing credit binge and financial risks

This note was originally published November 08, 2013 at 14:22 in Macro

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CREDITHOLICS: CHINA BINGE, HELP NEEDED - chinabubble

 

SUMMARY BULLETS:

  • This weekend top-ranking officials will convene in Beijing for the Third Plenary Session of the 18th Communist Party Central Committee (NOV 9-12).
  • Historically, the 3rd Plenary Session has been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.
  • While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.

“Hi I’m China, and I have a problem…”

 

SETTING THE STAGE

For much of the spring and summer months, we held an explicitly negative view on China’s structural economic growth potential. Specifically, we believed that a persistent rise in non-performing assets across the financial system would effectively tighten liquidity across the financial sector, at the margins, thus acting as a sustainable drag on incremental credit creation.

 

To review that thesis:

 

We first noticed pervasive risks in China’s financial sector upon completion of our proprietary EM Crisis Risk Model in mid-APR:

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - dale1

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 2

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 3

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 4

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 5

 

Digging deeper into the weeds confirmed much of what we already knew – Chinese credit growth has grown far too fast in recent years and a sizeable portion of that credit has done little more than support asset prices or existing liabilities in lieu of marginal economic activity:

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 6

 

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CREDITHOLICS: CHINA BINGE, HELP NEEDED - 8

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 9

 

The aforementioned dynamic has caused Chinese economic growth to slow, with the +7.7% YoY run-rate of headline GDP in the YTD threatening to claim the title of China’s slowest expansion since 1999. Moreover, forward-looking expectations for Chinese growth are even more lethargic:

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - 10

 

We backed away from the short side of China in early SEP (click HERE and HERE to review why) and followed that up with an incrementally more sanguine tone in the subsequent months, as the Shanghai FTZ looked to be a meaningful enough catalyst to offset the aforementioned financial sector headwinds, at the margins (click HERE and HERE to review why).

 

With only 157 firms holding a combined capital of $829M having registered for the Shanghai FTZ (mostly in the trade and services industries) as of OCT 23, it’s pretty clear the aforementioned catalyst has not yet addressed our initial concerns surrounding the structural lack of liquidity in the Chinese banking sector.

 

Specifically, we thought there would be significantly more activity regarding the importing of fresh capital into China’s financial system; thus far, results have been largely disappointing on that front.

 

PREVIEWING THIS WEEKEND’S PARTY

Now that we have reestablished the facts of China’s financial sector headwinds, we can now focus on what Chinese policymakers must do to overcome them – especially if China is to achieve what Premier Li has recently termed, “a golden mix” of structural reform and economic growth.

 

Simply put, if Chinese policymakers are going to avoid seeing GDP growth slow materially from here in the coming quarters and years, they absolutely have to outline [and eventually execute upon] specific and credible strategies that are expressly designed to relieve the banking sector of its structural liquidity constraints.

 

I’ll be the first analyst to tell you openly and honestly I have absolutely no idea what they plan to do with regards to this key issue, nor am I able to accurately gauge the momentum (or lack thereof) for meaningful changes on this front. All I know is that China must do something.

 

“Something” would include, but is not limited to:

 

  • Step 1: admit the country has a problem (i.e. it’s addicted to cheap credit);
  • Step 2: clearly delineate which institutions and corporations are to be saved and which would be allowed to ultimately fail or forced to sell/restructure;
  • Step 3: liberalize deposit rates so that weaker financial institutions are ultimately priced out of the market and forced to delever (CLICK HERE for more color on the threat deposit rate liberalization poses to China’s economy and general financial stability);
  • Step 4: recapitalize the remaining or systemically important banks and concomitantly force banks to write down non-performing loans that are currently being systematically rolled over (the aggregate loan-loss provision ratio of 279% of NPLs at the Big Four banks is well in excess of the 150% regulatory requirement and only begins to highlight the magnitude of China’s current problem with evergreening);
  • Step 5: introduce rigid targets for provincial-level GDP growth and subdued quotas for credit allocation to various industrial sectors so that banks don’t take steps 2-4 as a signal to inflate new bubbles; and
  • Step 6: allow for corporate defaults, the proliferation of financial insurance products and a dramatic expansion of the mutual fund industry so that Chinese financial markets can eventually learn to appropriately price, hedge and allocate risk across the system.

 

With the convoluted structure of bank and securities market regulation in China – the CBRC, CSRC, MoF and PBoC all operate largely independently of each other – we have little faith that such a wide-ranging reform process would be able to be implemented quickly.

 

That said, we’d settle for Chinese policymakers simply admitting to the fact that the country has a structural liquidity problem and subsequently outlining credible strategies to address it over the long-term TAIL. If they do not, we’d argue that Chinese tail risk – or a “hard landing” as it is more commonly referred to – should and would eventually heighten dramatically in the eyes of global investors and capital allocators.

 

PLAYING CHINA FROM HERE

Lastly, for those of you looking for answers with respect to our intermediate-term TREND duration, please review our OCT 24 note titled, “IF YOU HAVEN’T YET HEARD, CHINA IS TIGHTENING MONETARY POLICY”. Specifically, the PBoC’s recent tightening of monetary policy is in-line with our call for China to take a brief trip to Quad #3 (i.e. #GrowthSlowing as inflation accelerates) within our proprietary GIP framework here in 4Q13.

 

CREDITHOLICS: CHINA BINGE, HELP NEEDED - CHINA

 

It’s worth noting that Chinese property price pressures have continued to accelerate since then, with the latest data out from the China Real Estate Index System’s nationwide property price index (100 cities) showing prices up +10.7% YoY on average in OCT vs. +9.5% YoY in SEP. Moreover, OCT marked the 17th consecutive month of sequential appreciation (+1.2% Mo M vs. +1.1% MoM prior). Moreover, property price trends in China’s 10 major cities continue to outpace the national averages, with prices up +15.7% on a YoY basis and +2% on a sequential basis.

 

On that note, both Shanghai and Shenzhen have recently taken a page out of Beijing’s playbook by lowering peak LTV ratios on mortgages for 2nd homes to 30%, down from 40% prior. Perhaps that’s a signal that this weekend’s plenum may bring about broad-based tightening in the property market. The implementation of a nationwide property tax – while a huge positive for currently impaired local government finances over the long term (as would be expanding the muni bond market) – would obviously be serve as a meaningful blow to demand in this key segment of the Chinese economy.

 

All told, the 3rd Plenary Session has historically been one of great change with respect to economic and financial market reforms that have ultimately shaped the Chinese economy in the years and decades following. Bold promises for meaningful reforms out of President Xi would suggest 2013’s version is likely to not disappoint.

 

While a number of key socioeconomic strategies will be debated and outlined (such as rural land rights reform, nationwide social security, etc.) we are strongly of the view that some reforms are more impactful than others as it pertains to our long-term TAIL duration (i.e. 3Y or less). On that note, we are keenly focused on concrete solutions (if any) to China’s ongoing credit binge and financial risks.

 

Please feel free to email us with any follow-up questions; have a great weekend,

 

DD

 

Darius Dale

Associate: Macro Team


TOP READ NOTES: NOVEMBER 2013

Takeaway: Below we rank our top read notes from November. Click the note title for access.

TOP 10 MOST READ NOTES: NOVEMBER 2013

  1. 11/07/13 – The Casual Dining Bubble
  2. 11/19/13 – PBPB: Not Worthy Of The Multiple
  3. 11/25/13 – MCD: Testing The Espresso-Based Beverage Theory Early
  4. 11/27/13 – New Best Idea: Short Bloomin’ Brands
  5. 11/06/13 – Casual Dining Comps: Mgmt Commentary & Hedgeye’s Take
  6. 11/13/13 – YUM: October China Comps Beat Expectations
  7. 11/08/13 – MCD: #Growth Slowing
  8. 11/22/13 – Commodity Chartbook
  9. 11/04/13 – Top Read Notes: October 2013
  10. 11/12/13 – Dial-In & Materials: Can McDonald’s Get The Coffee Consumer In 2014?

Feel free to contact us if you have any questions, or would like to discuss any of our work in more detail.

 

 

 

Howard Penney

Managing Director

 


Raging Bull? SP500 Levels, Refreshed

Takeaway: Alongside this no-volume raging bull comes an increasing amount of mean reversion risk – so just know that.

If all you do into year-end is buy-the-damn-bubble #BTDB on dips, you’ll probably keep getting paid. But alongside this no-volume raging bull comes an increasing amount of mean reversion risk – so just know that.

 

What was best about today’s rip to new all-time highs was that it came on what’s really been driving the US stock market for the better part of the last 10-11 months. The ISM report’s growth components once again surprised on the upside (NOV's New Orders = 63.6 and Employment of 56.5 were the best monthly readings, respectively, of 2013).

 

Rates UP, Dollar UP today – and you know I like that. But the Fed doesn’t. Makes them look silly for not tapering (that’s what not being data dependent gets you into – a good ole politicized pickle!). So prepare for more @FederalReserve storytelling as they continue to pander to the Bond Bull Lobby @PIMCO.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE overbought = 1816
  2. Immediate-term TRADE support = 1782
  3. Intermediate-term TREND support = 1726

 

In other words, now you have 90 $SPY handles of mean reversion downside, or -5%, to my 1726 @Hedgeye TREND line. And every time it feels like we’re not going to correct, that’s about how much we’ve corrected (3 separate 5% corrections in 2013 YTD).

 

So keep your eyes on your fries and keep moving out there,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Raging Bull? SP500 Levels, Refreshed - SPX


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NOVEMBER ISM: TOPPING?

This morning’s headline ISM reading for November improved +0.9 MoM to 57.3, marking another YTD high and the highest reading since April of 2011. 

 

In fact, strength was pervasive across the sub-indices as the New Orders and Employment series hit their highest levels since April 2011 and April 2012, respectively.  Supplier Deliveries remained unremarkable at a middling 53 while inventory levels improved to 50.5 in November from 52.5 prior.   Reported respondent commentary was generally positive as well (Here)

 

Whether incremental strength in November could be partially attributed to deferred demand coming back online post the government shutdown resolution in October remains equivocal.  While October durable goods data showed a discrete deceleration, headline ISM advanced in October with Business Production, New Orders and Employment declining only modestly. 

 

Notably, in the ancillary index aggregates, backlogs continued to rise and the export index advanced for a third straight month (highest since Feb 2012) as demand from outside the U.S. continues to support domestic manufacturing activity. 

 

It’s not particularly surprising to see manufacturing gains outpace services gains domestically with household personal income and spending growth still constrained (largely stemming from sequestration and ongoing negative government employment growth) and European growth accelerating.  

 

While any reading >60 is solid, we’ll be interested to see if New Orders can make a higher high in December or if we get a repeat of August and another short cycle top as we head into the 2014 iteration of the budget/debt ceiling tragicomedy.   

 

In the more immediate term, with the dollar correlation to equities holding moderately negative, the market remains largely myopic in its focus on the implications of the macro data for prospective policy adjustments.  

 

With the dollar up, yields up and stocks up (so far) on strong macro today, perhaps we can get back to the ‘good being good’ dynamic that characterized much of pre-"No Taper" YTD.   

 

NOVEMBER ISM: TOPPING? - ISM Chart

 

NOVEMBER ISM: TOPPING? - ISM Table

 

NOVEMBER ISM: TOPPING? - Net Investment

 

 

Christian B. Drake

Associate



$AMZN Drone Delivery: One Big Liability?

Takeaway: This thing smells like one big liability.

Editor's note: Hedgeye Retail Sector Head Brian McGough says caution is in order on this Amazon headline.

 

Amazon Testing Drones for Same-Day Package Delivery, Bezos Says

 

$AMZN Drone Delivery: One Big Liability? - amzndrone

  • "Amazon.com Inc. is testing drones to deliver goods as the world’s largest e-commerce company works to improve efficiency and speed in getting products to consumers."
  • "Chief Executive Officer Jeff Bezos unveiled the plan on CBS’s '60 Minutes' news program in the U.S., showing interviewer Charlie Rose the flying machines that can serve as delivery vehicles. The CEO said the gadgets, called octocopters, can carry as much as five pounds within a 10-mile radius of an Amazon fulfillment center. Amazon may start using the drones, which can make a delivery within 30 minutes, within five years pending Federal Aviation Administration approval, Bezos said."

Takeaway: This is as big an idea as we've ever heard in retail. We'll assume that AMZN's logistics team fully vetted this one before they let Bezos get on TV and talk about it. But the risks inherent to the initiative -- thousands of unmanned propeller-driven machines whizzing around the country? We're sure the FAA is thrilled with this one --- and probably the Department of Defense as well. Something tells us that AMZN's capex budget is heading higher. This thing smells like one big liability. 

 

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