TSP Smart: The Greater Financial Crisis Emerges

Do you remember the US mortgage crisis which led to the Great Financial Crisis and deep recession? Now multiple that by 10 to understand what is unfolding in China. China has been the world’s growth engine, and real estate was China’s growth engine. Now it’s imploding. Expect a global recession and financial dislocations on the current course.

Excerpts:

Chinese aren’t necessarily known for their reverence for the sanctity of contracts. It’s started. Apartment buyers facing delays on their units refuse to honor their mortgages, and the word is spreading fast. And how might the typical owner respond when apartment values sink below the amount owed on their mortgage, especially for the estimated 60 to 100 million unoccupied units? For now, the mortgage boycott is a further major blow for a massive developer industry in collapse.

One can easily tally a Trillion dollars of liabilities from a handful of these gargantuan developers caught in a bond collapse vise. Ramifications are enormous – likely momentous.

Going “all out” with coerced lending at this stage of the cycle puts the entire banking system at only greater peril. Would Beijing continue to press the banks to lend aggressively if bank bonds were collapsing and depositors beginning to flee? This week’s CDS surge appeared to signal a new, more systemic Crisis Dynamics phase.

Contagion continues to gain momentum throughout the emerging markets.

De-risking/deleveraging has turned more systemic throughout the global “Periphery.”

It appears the relative stability fostered by talk of the ECB’s new “fragmentation” tool was as fleeting as Beijing’s list of stimulus measures. It’s unclear to me what can now reverse intensifying global de-risking/deleveraging dynamics.

The Periphery to Core Dynamic is today especially illuminating. Crisis Dynamics are now overwhelming the “Periphery.” Things are “breaking.” “Hot money” is exiting China and EM, spurring a self-reinforcing dollar melt-up speculative dynamic. Trouble at the euro-zone “Periphery” (notably Italy) is driving euro weakness, fear of an existential euro crisis, and resulting dollar strength. Crazy BOJ policies spur yen weakness/dollar strength.

At the “Core,” Treasury yields decline while sinking commodities prices spur optimism that inflation has peaked. A consensus is building that a Fed pivot will see rate cuts next year. Recession will be mild (a “shower” rather than a “hurricane”). In equities and corporate Credit, optimism builds that market lows are in.

I worry that U.S. markets, overly focused on domestic (“Core”) considerations, are not paying appropriate attention to powerful Global Crisis Dynamics. Considering the backdrop, there’s a stunning degree of complacency. Meanwhile, global “Periphery” contagion and illiquidity are bearing down on the “Core.” And it’s actually typical for U.S. markets to dismiss global Crisis Dynamics. I’m thinking particularly of the Mexican “tequila” crisis in late-94, Asian Tiger Bubble collapses in ’97, and Russia/LTCM in ‘98.

There are key differences: Global Crisis Dynamics are systemic these days, as opposed to the regional blowups from the nineties. The scope of the bursting China Bubble is without precedent. Moreover, post-Bubble U.S. markets are today acutely fragile. Indeed, I can see a scenario where Crisis Dynamics gain further momentum in China, Europe and EM. U.S. stocks, taking out recent lows, commence another tumultuous leg lower, with some panic sparking dislocations in equities and already liquidity-challenged corporate debt markets. And if this scenario is delayed, the Fed hammers global markets on the 27th with another 75 bps hike.

China has for years operated as banker to the EM “Periphery.” Now Beijing faces the predicament of throwing good “money” after bad or cutting bait and watching the dominoes begin to fall. And, by the way, how much of China’s $3.0 TN international reserve position is locked up in junk EM loans? We cannot today overstate the ramifications of Chinese financial instability.

Michael Bond comment: What also needs to be considered is that we are in an economic war with the axis of commodities (China, Russia, Saudi) and on a grand strategic level a global recession will bring down commodity prices hard, bring down their financial power (weapon) and give more life to the US dollars world reserve currency. There is a reason the US dollar is surging. But Doug is right, investors ignore the periphery in part because money first flows back to the US during global financial distress calming the markets. Until it hits.


Global Crisis Dynamics Update

by Doug Noland

CPI was up 9.1% y-o-y in June, the highest rate, as we all know by now, since 1981. Up 11.3% y-o-y, Producer Prices were also significantly above estimates. Retail Sales were stronger-than-expected, and there was even a decent pop in the Current Conditions component of the early-July confidence reading from the University of Michigan survey. Following last week’s strong payrolls report, data point to relatively resilient demand and pricing pressures. (Almost) Everything points to a second 75 bps hike at the FOMC’s July 27th meeting.

Yet 10-year Treasury yields dropped 16 bps this week to 2.92%, with yields now down about 56 bps from the June 14th peak. And with two-year yields up two bps this week (3.13%), the U.S. yield curve (2yr/10ry) ended the week inverted 20 bps. While conventional thinking points to imminent U.S. recession, it’s somewhat of a challenge to explain this week’s yield curve gyrations by domestic considerations. International developments make sense of it all.

Recall the Treasury curve inverted back at the end of March for the first time since the brief inversion in 2019 (and before that 2007). Not coincidently, the Chinese developer bond market was badly dislocating in March, as Country Garden, China’s largest developer, saw its yields surpass 30% (traded below 10% in February). Those Crisis Dynamics were quelled by a lengthy list of Beijing stimulus measures.

Crisis Dynamics have, however, returned more powerful than ever, leaving Beijing officials in quite a predicament. The old, the tried and true, isn’t working.

July 14 – Bloomberg (Shuli Ren): “It is spreading like wildfire. Homebuyers in China are refusing to pay the mortgage on properties they’ve bought but that their financially strapped developers can’t finish. Some say that they will only resume payments when construction restarts… The frustrated buyers accuse the developers of misusing sales proceeds and the banks of failing to safeguard their loans. China has never seen anything like this. As in the US — until the 2007 subprime crisis — the possibility of troubles in the mortgage market was vanishingly small.”

July 13 – Bloomberg: “A rapidly increasing number of disgruntled Chinese homebuyers are refusing to pay mortgages for unfinished construction projects, exacerbating the country’s real estate woes and stoking fears that the crisis will spread to the wider financial system. Homebuyers have stopped mortgage payments on at least 100 projects in more than 50 cities as of Wednesday, according to… China Real Estate Information Corp. That’s up from 58 projects on Tuesday and only 28 on Monday, according to Jefferies… analysts including Shujin Chen. ‘The names on the list doubled every day in the past three days,’ Chen wrote… ‘The incident would dampen buyer sentiment, especially for presold products offered by private developers given the higher risk on delivery, and weigh on the gradual sales recovery.’”

July 15 – Bloomberg: “China is censoring crowd-sourced documents tallying the number of mortgage boycotts spreading across the country, potentially hampering a key source of data for global investors and researchers tracking the property crisis. Shared files managed on platforms including China’s Quora-equivalent Zhihu Inc. and on sites like Kdocs and Wolai have been banned following reports that the number of homebuyers refusing to pay mortgages surged in a span of days… The file sharing has provided a key battleground for homeowners who are shunning mortgage payments for apartments that haven’t been built on time.”

China’s households, developers, banks, regulators and Beijing officials are breaking ground on their introductory housing/mortgage finance bust. It’s worth noting that Consumer (mostly mortgage) borrowings almost doubled over the past five years (up 400% in 10yrs) to $10.85 TN. Chinese Bank Assets (up a record $1.945 TN during Q1!) surged 50% over the past five years (200% in 10 years) to an incredible $53.0 TN. Reports have mortgage Credit at $6.8 TN.

It was a historic, reckless bubble, and, as we’re witnessing, the bursting will be no less spectacular.

July 15- Bloomberg (Richard Frost): “Former UBS Group AG economist Jonathan Anderson once called it ‘the most important sector in the universe.’ More than a decade on, Chinese property is again grabbing the attention of global investors — this time for all the wrong reasons. Mounting signs of stress this week in an industry that accounts for about a quarter of the world’s second-largest economy have roiled China’s credit markets, dragged down the nation’s bank stocks and pummeled commodities from iron ore to copper.”

Chinese aren’t necessarily known for their reverence for the sanctity of contracts. It’s started. Apartment buyers facing delays on their units refuse to honor their mortgages, and the word is spreading fast. And how might the typical owner respond when apartment values sink below the amount owed on their mortgage, especially for the estimated 60 to 100 million unoccupied units? For now, the mortgage boycott is a further major blow for a massive developer industry in collapse.

The Bloomberg China Real Estate Developers Index sank 10% this week. Number one developer Country Garden’s stock collapsed 27% (down 52% y-t-d). Vanke’s stock was down 18.9%, Longfor 20%, China Jinmao 13.7%, Agile Group 15.2%, China Overseas Land & Investment 10.8%, and China Resources 9.7%.

Yet stocks are a sideshow. Country Garden bond (3 1/8% 2025) yields surged 11.5 percentage points (11,543bps) this week to a record 41.02%, with a two-week gain of over 14 percentage points (14,085bps). Longfor bond yields this week surged 13 percentage points to 116%. This is a top-five Chinese developer whose bond yields began the year around 7%. Sunac, another top developer, saw its bond yields jump 600 bps this week to 112% (began the year at 22%). And let’s not forget #3: Evergrande yields rose another 358 bps this week to 141%. Basically, the market is saying they’re all either bust or heading in that direction.

One can easily tally a Trillion dollars of liabilities from a handful of these gargantuan developers caught in a bond collapse vise. Ramifications are enormous – likely momentous. It was ominous to see Chinese developers and banks at the top of the Asia CDS leaderboard this week. Lonfor CDS surged 225 bps. Vanke, China’s fourth-largest developer, saw its CDS trade above 500 bps this week for the first time (ended week at 502 bps). Vanke CDS traded at 250 bps in mid-June and was below 100 bps back in September.

July 14 – Bloomberg (Lorretta Chen): “Dollar-bond spreads for China’s bad-debt managers widened Thursday, as higher-than-expected June CPI in the US raised the potential of the biggest Fed interest-rate hike yet this year. Huarong’s 5.5% note due 2025 widened 35 bps to 585bps… Spread for Great Wall AMC’s 3.875% dollar bond due 2027 widened 6bps to 586bps, poised for a fourth-straight increase.”

July 13 – Bloomberg: “Chinese authorities held emergency meetings with banks after growing alarmed that an increasing number of homebuyers across the country are refusing to pay mortgages on stalled projects… The Ministry of Housing and Urban-Rural Development met with financial regulators and major Chinese banks this week to discuss the mortgage boycotts on concern that more buyers may follow suit… While there was no immediate solution, regulators asked local watchdogs and banks to report the impact, including property projects affected in their jurisdictions, as soon as possible, the people said. Some banks plan to tighten their mortgage lending requirements in high-risk cities, two of the people said.”

China’s CSI 300 Bank Index sank 7.7% this week (largest weekly loss since 2018) to near March 2020 lows. And the dam broke for Chinese bank CDS. China Construction Bank CDS jumped 17 Friday (25 on the week) to 123bps, surpassing the March 2020 pandemic crisis spike. With over $4 TN of assets, this is one of the largest banks in the world.

Of the other “big four,” Bank of China CDS surged 20 Friday (19 on the week) to 117 bps, the high back to 2014. China Development Bank CDS rose 11 this week to 107 bps (high since 2017). Industrial and Commercial Bank CDS rose four to 104 bps (high in data back to 2017).

China sovereign CDS jumped nine this week to 90 bps, just below the March 2020 spike (91.5bps).

July 9 – Bloomberg: “An official at China’s banking and insurance regulator said authorities will use policy tools ‘flexibly and precisely’ at proper times to stabilize the economy, while banks and insurers will ‘go all out’ to bolster funding. Authorities will support an ‘appropriate’ acceleration in infrastructure investments as demand remains weak, and will broaden long-term fund-raising channels including private capital, said Liu Fushou, chief risk officer of the China Banking & Insurance Regulatory Commission. Policy makers will also step up monitoring of debt default risks among large enterprises and seek to quicken the introduction of the nation’s financial stability law, he said…”

Going “all out” with coerced lending at this stage of the cycle puts the entire banking system at only greater peril. Would Beijing continue to press the banks to lend aggressively if bank bonds were collapsing and depositors beginning to flee? This week’s CDS surge appeared to signal a new, more systemic Crisis Dynamics phase.

Contagion continues to gain momentum throughout the emerging markets. An EM CDS index traded up to 395 bps intraday Thursday (up 50bps w-t-d!), the high back to April 3, 2020 – before ending the week up 30 to 375 bps. For perspective, EM CDS hasn’t had a weekly 50 bps jump since September 2020.

De-risking/deleveraging has turned more systemic throughout the global “Periphery.” Indonesia CDS jumped 20 this week to 165 bps, the high since May 2020. Vietnam rose 21 bps to 188 bps (July ’20), Philippines 18 to 148 bps (March ’20), Malaysia nine to 112 bps (May ’20), India seven to 175 bps (May ’20), Thailand six to 73 bps (April ’20), and South Korea six to 54 bps. Hungary CDS surged 48 (to 230bps) and Romania 39 (to 347bps). CDS surged 31 in South Africa to 369 bps (high since May 2020) and 13 in Turkey to an almost 20-year high 883 bps.

“Frontier” markets appear to suffer acute illiquidity. Mongolia CDS surged 161 to 604 bps (high August ’20), Egypt 344 (to 1,507 bps), Kenya 269 (1,417 bps), Iraq 131 (798 bps), Namibia 126 (728 bps), Argentina 274 (1,947 bps), and Nicaragua 91 (695 bps). Colombia CDS surged 45 (332 bps), Brazil 37 (331 bps), Costa Rica 31 (335 bps), Uruguay 30 (167 bps), Peru 29 (158 bps), Guatemala 25 (332 bps), Panama 25 (158 bps), Chile 25 (141 bps), and Mexico 18 (196 bps).

This overload of data underscores the degree and depth of unfolding market stress. Asia, Latin America, Africa and Europe. Italian CDS surged 23 this week to 162 bps, just shy of the June 14th spike to 166 bps.

The ECB is expected to raise rates next week for the first time in 11 years. A little baby step is anticipated. European banks were slammed 5.2% this week, with Italian banks hammered 8.4% (3-wk drop 12.8%). The spread between 10-year Italian (3.28%) and German (1.13%) yields surged 20 bps this week to a one-month high 215 bps. This spread traded at 100 bps back in October and spiked to 242 bps during June 14th Periphery (“fragmentation”) market disorder.

July 14 – Financial Times (Amy Kazmin): “Italy’s populist Five Star Movement has refused to support Prime Minister Mario Draghi’s national unity government in a critical parliamentary vote, plunging the country into a fresh round of political turmoil… Five Star — the second largest party in parliament — boycotted Thursday’s vote on a €26bn package aimed at shielding Italians from the impact of worsening inflation. Five Star’s leader Giuseppe Conte said he could no longer back Draghi’s cross-party government, which he accused of not doing enough to help families facing surging food and energy costs. ‘I have a strong fear that September will be a time when families will face the choice of paying their electricity bill or buying food,’ Conte said after a party meeting…”

July 14 – Bloomberg (Carolynn Look, Alessandra Migliaccio, and Libby Cherry): “A financial-market crisis focused on Italy might augur the worst turmoil in the history of the euro. Just as German policy makers feared and soothsaying economists prophesied at the birth of the currency more than two decades ago, the weakness and indebtedness of the euro area’s third-largest economy risks becoming everyone else’s problem. That prospect loomed even closer on Thursday as Mario Draghi’s government on the brink. The Italian premier is preparing to resign…, potentially triggering a new phase of market turbulence. That would increase the pressure on European Central Bank President Christine Lagarde to craft a short-term solution, and would also likely underscore the need for a new political settlement to fix the flaws in the euro area.”

It appears the relative stability fostered by talk of the ECB’s new “fragmentation” tool was as fleeting as Beijing’s list of stimulus measures. It’s unclear to me what can now reverse intensifying global de-risking/deleveraging dynamics.

The Periphery to Core Dynamic is today especially illuminating. Crisis Dynamics are now overwhelming the “Periphery.” Things are “breaking.” “Hot money” is exiting China and EM, spurring a self-reinforcing dollar melt-up speculative dynamic. Trouble at the euro-zone “Periphery” (notably Italy) is driving euro weakness, fear of an existential euro crisis, and resulting dollar strength. Crazy BOJ policies spur yen weakness/dollar strength.

At the “Core,” Treasury yields decline while sinking commodities prices spur optimism that inflation has peaked. A consensus is building that a Fed pivot will see rate cuts next year. Recession will be mild (a “shower” rather than a “hurricane”). In equities and corporate Credit, optimism builds that market lows are in.

I worry that U.S. markets, overly focused on domestic (“Core”) considerations, are not paying appropriate attention to powerful Global Crisis Dynamics. Considering the backdrop, there’s a stunning degree of complacency. Meanwhile, global “Periphery” contagion and illiquidity are bearing down on the “Core.” And it’s actually typical for U.S. markets to dismiss global Crisis Dynamics. I’m thinking particularly of the Mexican “tequila” crisis in late-94, Asian Tiger Bubble collapses in ’97, and Russia/LTCM in ‘98.

There are key differences: Global Crisis Dynamics are systemic these days, as opposed to the regional blowups from the nineties. The scope of the bursting China Bubble is without precedent. Moreover, post-Bubble U.S. markets are today acutely fragile. Indeed, I can see a scenario where Crisis Dynamics gain further momentum in China, Europe and EM. U.S. stocks, taking out recent lows, commence another tumultuous leg lower, with some panic sparking dislocations in equities and already liquidity-challenged corporate debt markets. And if this scenario is delayed, the Fed hammers global markets on the 27th with another 75 bps hike.

Some final China thoughts. The renminbi was down almost 1% this week. Accelerating Chinese currency weakness would not be surprising. Renminbi selling turning disorderly would likely spur heightened contagion and global market instability.

July 11 – Wall Street Journal (Rebecca Feng): “International investors are rapidly unwinding what was once a popular trade in Chinese bonds. For years, foreigners loaded up on debt from Chinese state-owned lenders known as policy banks, which fund domestic and overseas projects like dams, roads and airports. The easy-to-trade yuan-denominated bonds were viewed as almost as safe as China’s sovereign debt, and paid higher interest rates. Russia’s invasion of Ukraine has prompted a rethink… Two of the three Chinese policy banks, China Development Bank and the Export-Import Bank of China, have lent billions of dollars to Russian borrowers that needed funding for uses including energy projects. They have been mostly silent about their exposures to Russia since the war broke out.”

Chinese Credit growth bounced back strongly in June, a dynamic that if continued could prove problematic for Chinese currency stability.

July 11 – Bloomberg: “China’s credit jumped much more than expected last month to the highest on record for June due to a strong rebound in bank lending and record government bond sales. Aggregate financing, a broad measure of credit, reached 5.2 trillion yuan ($775bn), the People’s Bank of China said… That was the highest for any June in comparable data back to 2017 and beat the consensus estimate of 4.2 trillion yuan. Financial institutions made 2.8 trillion yuan of new loans in the month, also better than economists’ projection.”

China has for years operated as banker to the EM “Periphery.” Now Beijing faces the predicament of throwing good “money” after bad or cutting bait and watching the dominoes begin to fall. And, by the way, how much of China’s $3.0 TN international reserve position is locked up in junk EM loans? We cannot today overstate the ramifications of Chinese financial instability.

July 13 – Wall Street Journal (Alexander Saeedy and Philip Wen): “As Sri Lanka’s foreign-exchange reserves began to dwindle under a mountain of debt early in the Covid-19 pandemic, some officials argued it was time to ask for a bailout from the International Monetary Fund, a politically fraught move that traditionally comes with painful austerity measures. But China, Sri Lanka’s largest single creditor, offered a tempting alternative: Skip the IMF’s bitter medicine for now and just keep adding on new debt to pay off the old, according to current and former Sri Lankan officials. Sri Lanka agreed, and soon $3 billion in new credits poured in from Chinese banks in 2020 and 2021. Now that plan has blown up, plunging Sri Lanka into chaos.”

Original Post 16 July 2022


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