Doug Noland: Contagion

Another big miss for non-farm payrolls, with September’s 194,000 jobs gain less than half the 500,000 forecast. But with the Unemployment Rate down to 4.8% and Average Hourly Earnings up 4.6% y-o-y (not to mention almost 11 million job openings), there’s ample evidence that much of the labor market has turned exceptionally tight. The Senate passed debt ceiling legislation that should kick the can until early December. But let’s skip immediately to the week’s pressing developments.

It’s turning into a debacle. Evergrande bonds ended the week at 20 cents on the dollar, with yields surging to 72.5%. China’s real estate sector was hammered this week following the surprise default by mid-sized developer Fantasia Holdings.

October 6 – Bloomberg (Rebecca Choong Wilkins): “China’s property industry has suffered its first default on a dollar bond since China Evergrande Group sank deeper into crisis in recent weeks, fueling investor concerns over other highly leveraged borrowers and about global contagion. Fantasia Holdings Group Co., which develops high-end apartments and urban renewal projects, failed to repay a $205.7 million bond that came due Monday. That prompted a flurry of rating downgrades late Tuesday to levels signifying default. Creditors are now scanning debt repayment calendars as they try to suss out where the next flashpoints across the increasingly strained property industry may be — nearly a dozen firms have debt maturing through early 2022.”

October 7 – Wall Street Journal (Frances Yoon and Quentin Webb): “Fantasia’s nonpayment surprised investors because the… developer had recently said it had no liquidity issues, and indicated it had enough cash to repay the outstanding amount on a five-year dollar bond it issued in 2016. Fantasia, like Evergrande, was an active issuer of high-yield dollar bonds in the last few years. Some market participants surmised that Fantasia and its controlling shareholders had elected not to repay the company’s international debt, which raised doubts as to whether other Chinese developers might do the same to conserve cash or give priority to their onshore creditors. ‘Market confidence is shattered by the recent event, which has triggered a reassessment by investors of sponsors’ willingness to pay,’ said Jenny Zeng, co-head of Asia Pacific fixed income and a portfolio manager at AllianceBernstein in Hong Kong.”

October 8 – Bloomberg (Olivia Tam): “Yields on Chinese dollar junk-rated dollar bonds are poised for their worst week in 18 months as Fantasia’s surprise default accelerated worries about contagion risks from Evergrande’s debt crisis. Onshore notes were joining the declines Friday following the Golden Week holiday.”

Chinese developer bonds were routed. For example, Kaisa Group yields surged a full 15 percentage points this week to 35.5%, compared to only 13.5% to begin September. Easy Tactic yields were up 9.2 percentage points this week to 41.7%. Yango Justice International yields surged 27 percentage points to 50.9%, while Red Sun Properties yields jumped 5.2 percentage points to 20.5%. Times China Holdings yields spiked 18.5 percentage points to 26.7%, after yielding only 4.9% on September 15th. Sunac China Holdings yields rose 5.6 percentage points this week to 19.2%; China Aoyuan Group 4.6 percentage points to 16.4%; Yuzhou Group 6.7 percentage points to 23.3%; and Agile Group Holdings up 3.5 percentage points to 11.0%.

October 8 – Bloomberg: “Chinese property shares fell after a report that more than 90% of China’s top 100 property developers’ sales declined in September by an average of 36% from the same period last year… Sept. sales totaled 759.6b yuan, -36.2% from September 2020 and 17.7% lower from the same period in 2019: Shanghai Securities News, citing China Real Estate Information Corp. Research. Among companies, 60% of developers saw sales decrease by more than 30% y/y in Sept. (More than 90 developers saw a decline in their sales from a year ago). Beijing, Shenzhen and Guangzhou saw transaction volume of residential properties decline 30% y/y, while Shanghai fell 45%.”

Many major developers have lost access to new finance, while real estate transactions throughout China have slowed dramatically. Mounting evidence suggests China’s historic apartment Bubble has been pierced. Now it’s a matter of how rapidly prices deflate. And there appears no place to hide. Country Garden Holdings, China’s largest developer, saw yields (7.25%, 2026) surge 181 bps this week to 7.60%. Yields for this perceived pristine, investment-grade credit began September at 4.74%.

An index of Chinese high-yield dollar bonds was pummeled, with yields surging 310 bps this week to 17.5%. This index yielded 8.20% at the end of May, and 12.0% to conclude August. For further perspective, this yield briefly spiked to 14.0% during the March 2020 pandemic crisis (back down to 8% by August).

October 7 – Reuters (Marc Jones): “Investment bank JPMorgan has estimated that troubled Chinese property giant Evergrande and many of its major rivals have billions of dollars worth of off-balance sheet debt that, once added on, ramp up their leverage ratios. JPMorgan’s China and Hong Kong property analysts said the tactic is likely to have been used to help firms look like they were conforming with new borrowing cap rules introduced last year, but Evergrande’s case looks the most extreme. ‘Instead of true deleveraging, we think Evergrande has shifted some of the interest-bearing debt to off-balance sheet debt,’ JPMorgan’s analysts said. ‘Commercial papers, wealth management products and perpetual capital securities, etc, which are not officially counted as debt.’ They estimated Evergrande’s ‘net gearing,’ as debt as a ratio of a firm’s equity is known, was at least 177% at the end of the first half of the year, instead of the 100% its accounts reported.”

October 4 – Wall Street Journal (Yoko Kubota and Liyan Qi): “Rows of residential towers, some 26 stories high, stand unfinished in this provincial city about 350 miles west of Shanghai, their plastic tarps flapping in the wind. Elsewhere in Lu’an, golden Pegasus statues guard an uncompleted $9 billion theme park that was supposed to be bigger than Disneyland. A planned $4 billion electric-vehicle plant, central to local leaders’ economic dreams, remains a steel frame with overgrown vegetation spilling into the road. The structures are monuments to the once-grand ambitions of China Evergrande Group, now among the world’s most indebted property companies, and a case study in how China’s dependence on real estate as an economic engine helped feed those ambitions.”

October 7 – Reuters (Ryan Woo and Liangping Gao): “Sagging demand at China’s urban land auctions amid a crackdown on borrowing by private developers risks squeezing regional finances, pressuring local governments to scramble for other income sources to fund investments and support the economy. Land sales soared to a record 8.4 trillion yuan ($1.3 trillion) in 2020, the equivalent of Australia’s annual gross domestic product, bolstering fiscal budgets in a pandemic year. But tighter regulations on borrowing by private developers since the summer of last year are increasingly eroding demand for land. The value of nationwide land sales abruptly fell 17.5% on year in August…”

A few weeks back (“Evergrande Moment”), I posited that China had not reached a so-called “Lehman Moment.” The crisis at Evergrande was still unfolding at the “Periphery.” There was little at that point indicating a systemic crisis at the “Core.” This week showed notable gravitation in Crisis Dynamics toward China’s vulnerable “Core.”

The week was notable for contagion spreading to Chinese bank credit default swap (CDS) prices. China Construction Bank CDS jumped six to 73 bps, the high since June 2020, and up from 46 bps on September 17th. Industrial & Commercial Bank of China CDS gained five to 73 bps – the high since April 2020. China Development Bank CDS rose 5.5 to 66.5 bps – the high since April 2020, and up from 44 bps on September 16th. Bank of China CDS increased 3.5 to 70 bps – the high since May 2020, and up from 44 bps on September 17th.

China’s sovereign CDS rose a notable five this week to 52.5 bps – the highest level since June 2020. China CDS began September at 32.5 bps. This is one to watch. For comparison, South Korea CDS ended the week at 20 bps, with Thailand at 43 bps and Malaysia at 60 bps. For a system as egregiously levered as China, spiking market yields and CDS prices are analogous to a blitzkrieg of tiny pins attacking a bloated, timeworn and thin-skinned Bubble.

Contagion this week also spread to Asian sovereign CDS. Indonesia CDS jumped 10 to 88 bps, the high since March. Philippines CDS rose eight to 61 bps, the high back to July 2020, while Malaysia CDS rose seven to 60 bps (high since July ’20). Vietnam CDS gained six to 115 bps (high since July ’21).

It’s also worth noting the spike in CDS prices for some “frontier” markets. Sri Lanka CDS surged 104 this week to 1,688 bps; Mongolia 40 to 287 bps; Pakistan 33 bps to 475 bps; and Ghana 182 to 826 bps.

In general, the week provided corroboration of the EM de-risking/deleveraging thesis. Brazil’s real dropped another 2.6% to a six-month low, with the Chilean peso down 1.5%, the Turkish lira 1.2%, the Mexican peso 1.2%, the Hungarian forint 1.2%, and the Indian rupee 1.2%. In local currency bond markets, Turkish yields surged 49 bps to 18.14%; Malaysia rose 24 bps to 3.60% (high since July ’19); Poland 17 bps to 2.41% (high since June ’19); Romania 17 bps to 4.65% (high since April ’20); and South Africa 10 bps to 9.83% (high since May ’20). Philippine dollar bond yields surged 24 bps to 2.69%, the high since April 2020. Indonesian dollar bond yields rose 16 bps to 2.44% (high since March).

Contagion has even begun to wash up on our shores. U.S. Investment-grade CDS traded to 55 bps Wednesday, the high since March. High-yield CDS ended the week at 308 bps, also trading this week to six-month highs. Bank CDS prices rose for a third straight week. Goldman Sachs CDS traded to a six-month high 62 bps Wednesday, up from 51 bps on September 15th. Citigroup (56bps), Bank of America (50bps) and JPMorgan (49bps) CDS also traded Wednesday to six-month highs.

Those managing strategies that incorporate Treasuries as a risk market hedge must be nervous. Ten-year Treasury yields surged 15 bps this week to a four-month high 1.61%. Jumping 13 bps to 1.06%, five-year yields were back above 1% for the first time since February 2020. Benchmark MBS yields jumped 14 bps to an almost seven-month high 2.05%. Inflation Angst.

The five-year Treasury “breakeven” rate (market inflation gauge) jumped 12 bps this week to a five-month high 2.67%. WTI crude trade above $80 for the first time since October 2014, with a year-to-date gain of 64% (gasoline futures up 68% y-t-d). The Bloomberg Commodities Index jumped another 1.7% this week, increasing 2021 gains to 31.5%.

October 5 – Bloomberg (Saket Sundria and Elizabeth Low): “Asian buyers are paying top dollar for a variety of fuels that can be fed into steam boilers or power turbines as they seek alternatives to increasingly pricey natural gas. The electricity crisis is roiling energy markets from Europe to Asia, with fuels that can be used for heating or power generation such as propane, diesel and fuel oil in high demand. Goldman Sachs… predicts the crunch will drive greater consumption of crude later this year, while China has ordered state-owned firms to secure energy supplies for winter at all costs. In Asia, prices of propane — an oil product that’s typically used for cooking or making plastics — have surged to the highest since at least 2016, while fuel oil recently almost doubled from a year earlier.”

Panic buying and hoarding as the global energy crisis escalates. “China has ordered state-owned firms to secure energy supplies for winter at all costs,” as panic begins to envelop global energy markets. China, India and others are desperately short of coal. The UK and Europe are short of natural gas. With winter approaching, there is clear potential for the global inflation shock to intensify.

If global supply-chains weren’t already a huge mess…

October 7 – Bloomberg (Jeff Sutherland and Tom Hancock): “The hit from China’s energy crunch is starting to ripple throughout the globe, hurting everyone from Toyota Motor Corp. to Australian sheep farmers and makers of cardboard boxes. Not only is the extreme electricity shortage in the world’s largest exporter set to hurt its own growth, the knock-on impact to supply chains could crimp a global economy struggling to emerge from the pandemic. The timing couldn’t be worse, with the shipping industry already facing congested supply lines that are delaying deliveries of clothes and toys for the year-end holidays. It also comes just as China starts its harvest season, raising concerns over sharply higher grocery bills.”

The outlines of the unfolding crisis are beginning to come into clearer focus. Global de-risking/deleveraging is gaining momentum. China’s Bubble collapse appears poised to accelerate. With $3.2 TN of international reserves and the PBOC mandating price stability, China’s Renminbi has been a pillar of strength. But for how long? How much speculative leverage has accumulated in higher-yielding Chinese Credit instruments over this long cycle? How serious is the risk of a “hot money” exodus?

The PBOC added $123 billion of liquidity over ten sessions to calm the markets. What will be the scope of liquidity requirements when Crisis Dynamics engulf the “Core” – as confidence wanes in China’s banking system and financial structure more generally?

Beijing waited much too long to begin reining in its Bubble. Pandemic stimulus stoked already perilous excess. Now Chinese officials face a terrible predicament and onerous decisions. At this point, large liquidity injections could further stoke inflationary pressures, while risking a disorderly decline in the Renminbi.

The Fed waited much too long to begin reducing historic monetary stimulus. Pandemic stimulus stoked already perilous excess. Federal Reserve officials could soon face quite a predicament and difficult decisions.

Was the jobs report good enough for a November taper? That just doesn’t seem the crucial question today. What does the world look like a month from now? Has China’s unfolding crisis by then enveloped the “Core”? How powerful are de-risking/deleveraging dynamics in November, globally and in U.S. markets?

My thoughts harken back to the March 2020 dislocation in bond (and equities) ETFs. Since then, Fed pandemic measures have spurred additional gargantuan bond fund inflows (at historically low bond yields), while simultaneously unleashing powerful inflationary dynamics. Quite a combustible mix. Clearly, the Fed is not about to “slam on the brakes.” Might the bond market?

Original Post 9 October 2021

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