by Stephen S. Roach
Project Syndicate
October 24, 2016

NEW HAVEN – Is the Chinese economy about to implode? With its debt overhangs and property bubbles, its zombie state-owned enterprises and struggling banks, China is increasingly portrayed as the next disaster in a crisis-prone world.

I remain convinced that such fears are overblown, and that China has the strategy, wherewithal, and commitment to achieve a dramatic structural transformation into a services-based consumer society while successfully dodging daunting cyclical headwinds. But I certainly recognize that this is now a minority opinion.

For example, US Treasury Secretary Jacob J. Lew continues to express the rather puzzling view that the United States “can’t be the only engine in the world economy.” Actually, it’s not: the Chinese economy is on track to contribute well over four times as much to global growth as the US this year. But maybe Lew is already assuming the worst for China in his assessment of the world economy.

So what if the China doubters are right? What if China’s economy does indeed come crashing down, with its growth rate plunging into low single digits, or even negative territory, as would be the case in most crisis economies? China would suffer, of course, but so would an already-shaky global economy. With all the handwringing over the Chinese economy, it’s worth considering this thought experiment in detail.

For starters, without China, the world economy would already be in recession. China’s growth rate this year appears set to hit 6.7% – considerably higher than most forecasters have been expecting. According to the International Monetary Fund – the official arbiter of global economic metrics – the Chinese economy accounts for 17.3% of world GDP (measured on a purchasing-power-parity basis). A 6.7% increase in Chinese real GDP thus translates into about 1.2 percentage points of world growth. Absent China, that contribution would need to be subtracted from the IMF’s downwardly revised 3.1% estimate for world GDP growth in 2016, dragging it down to 1.9% – well below the 2.5% threshold commonly associated with global recessions.

Of course, that’s just the direct effect of a world without China. Then there are cross-border linkages with other major economies.

The so-called resource economies – namely, Australia, New Zealand, Canada, Russia, and Brazil – would be hit especially hard. As a resource-intensive growth juggernaut, China has transformed these economies, which collectively account for nearly 9% of world GDP. While all of them argue that they have diversified economic structures that are not overly dependent on Chinese commodity demand, currency markets say otherwise: whenever China’s growth expectations are revised – upward or downward – their exchange rates move in tandem. The IMF currently projects that these five economies will contract by a combined 0.7% in 2016, reflecting ongoing recessions in Russia and Brazil and modest growth in the other three. Needless to say, in a China implosion scenario, this baseline estimate would be revised downward significantly.

The same would be the case for China’s Asian trading partners – most of which remain export-dependent economies, with the Chinese market their largest source of external demand. That is true not only of smaller Asian developing economies such as Indonesia, the Philippines, and Thailand, but also of the larger and more developed economies in the region, such as Japan, Korea, and Taiwan. Collectively, these six China-dependent Asian economies make up another 11% of world GDP. A China implosion could easily knock at least one percentage point off their combined growth rate.

The United States is also a case in point. China is America’s third-largest and most rapidly growing export market. In a China-implosion scenario, that export demand would all but dry up – knocking approximately 0.2-0.3 percentage points off already subpar US economic growth of around 1.6% in 2016.

Finally, there is Europe to consider. Growth in Germany, long the engine of an otherwise sclerotic Continental economy, remains heavily dependent on exports. That is due increasingly to the importance of China – now Germany’s third-largest export market, after the European Union and the United States. In a China implosion scenario, German economic growth could also be significantly lower, dragging down the rest of a German-led Europe.

Interestingly, in its just-released October update of the World Economic Outlook, the IMF devotes an entire chapter to what it calls a China spillover analysis – a model-based assessment of the global impacts of a China slowdown. Consistent with the arguments above, the IMF focuses on linkages to commodity exporters, Asian exporters, and what they call “systemic advanced economies” (Germany, Japan, and the US) that would be most exposed to a Chinese downturn. By their reckoning, the impact on Asia would be the largest, followed closely by the resource economies; the sensitivity of the three developed economies is estimated to be about half that of China’s non-Japan Asian trading partners.

The IMF research suggests that China’s global spillovers would add about another 25% to the direct effects of China’s growth shortfall. That means that if Chinese economic growth vanished into thin air, in accordance with our thought experiment, the sum of the direct effects (1.2 percentage points of global growth) and indirect spillovers (roughly another 0.3 percentage points) would essentially halve the current baseline estimate of 2016 global growth, from 3.1% to 1.6%. While that would be far short of the record 0.1% global contraction in 2009, it wouldn’t be much different than two earlier deep world recessions, in 1975 (1% growth) and 1982 (0.7%).

I may be one of the only China optimists left. While I am hardly upbeat about prospects for the global economy, I think the world faces far bigger problems than a major meltdown in China. Yet I would be the first to concede that a post-crisis world economy without Chinese growth would be in grave difficulty. China bears need to be careful what they wish for.

October 19, 2016

More haunting even than the terrified screams of lambs being led was the silence that followed their slaughter.

Such was the searing pain of relentless recollection for FBI agent Clarice Starling, the tortured lead played to Oscar perfection by Jodie Foster. In an agonizingly whispered scene that has forever left its imprint on the minds of horrified audiences, we hear the bleating of Starling’s long-dead tormentors.

Clarice’s hushed revelations to Hannibal reveal a desperate act by her young orphaned self. Unable to bear the horror, she’s running away from the bloodbath of spring lambs being slaughtered and her cousin’s sheep ranch. Desperate to do something, anything, she struggles to drive them from their pens to freedom: “I tried to free them…I opened the gate of their pen – but they wouldn’t run. They just stood there confused. They wouldn’t run…”

A recent, reluctant re-viewing of the film, only the third in history to win the “Big Five” Oscars, Best Picture, Actor, Actress, Director and Screenplay, fed fresh food for thought. The image of captives rejecting their freedom brought to mind another flock of corralled and stunned lambs — bond market investors. They too have been given the opportunity to escape their fate. But so many choose instead to stay. Such is the reality of a world devoid of options, with time ticking ruthlessly by.

Against the cynical backdrop of bulls and bears manipulating data to plead their case, Salient Partners’ Ben Hunt’s insights stand out for their indisputability. In his latest missive he points to one chart that’s incapable of being “fudged,” to borrow his term – that of U.S. household net worth over time vis-à-vis U.S. nominal gross domestic product. Suffice it to say we’re farther off trend than we were even during the dotcom and housing manias.

Hunt asks in what should be rhetoric but is lost on so many: “Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can’t diverge by a lot and for a long time. We can’t be a lot richer than our economy can grow.”

And yet we are. The culprit, which too few identify as such, is runaway asset price inflation led by debt markets that have grown to be unfathomably immense in size and scope. At $100 trillion, the size of the global bond market eclipses that of the $64 trillion stock market. A bigger discussion for another day comes from McKinsey data that tell us the worldwide credit market is over $200 trillion in size.

Zero in on Corporate America and you really start to get a picture of pernicious growth. According to New Albion Partners’ Brian Reynolds, U.S. commercial paper and corporate bonds have swelled by $3.1 trillion, or 63 percent, since the 2008 financial crisis. “This compares to nominal GDP growth of only 27 percent, so we are leveraging the heck out of the economy.”

For a bit more historic context, consider that U.S firms are more levered today than they were at the precipice of the financial crisis. According to Moody’s data, the median debt/earnings before interest, taxes, depreciation and amortization (EBITDA) is five times today vs. 4.2-times in 2008 for high yield companies. For comparison purposes, investment grade companies’ median debt/EBITDA is 2.6-times today compared to 2.2-times in 2008.

Michael Lewitt, the leading authority on all things credit and creator of The Credit Strategist, worries that companies are sitting on this pile of debt with not much more to show for it than, well, being in hock up to their eyeballs. “Much of this debt was incurred for unproductive purposes – buybacks, dividends to private equity owners, etc. – rather than for things that grow these businesses. Many high yield companies are not generating much, if any, free cash flow and are dependent on the ability to roll over their debt.”

On that count, there’s trouble brewing. Moody’s publishes a Refunding Index which gauges the bond market’s ability to absorb high yield bonds maturing over the next 12 and 36-month periods at the current pace of issuance. In the quarter ending in September, the one-year index was down 50 percent over the prior year while that of the three-year index was off by 40 percent continuing a protracted two-year slide. In dollar figures, three-year high yield maturities are up 45 percent year-over-year; they now total $156 billion vs. $108 billion a year ago. The flip side of these coins is that issuance is down by $13 billion.

“Debt maturities continue to increase at a rapid rate and are expected to rise to historic peaks within the next couple of years,” said Moody’s Senior Analyst Tiina Siilaberg. “And defaults are getting up there. Along with weak refinancing conditions, default rates for US speculative-grade issuers have been above five percent since May and ended at 5.4 percent in September. This compares to just 1.9% in May 2015.” Siilaberg expects defaults to peak at six percent in the coming months.

We can only hope Siilaberg is not being overly optimistic. A separate data set released by Standard & Poor’s (S&P) tallies the “weakest links,” or companies that are 10-times more likely than the broad high yield universe to default. In September, this count hit a seven-year high. For the moment, with an eye on recovering oil prices, investors seem to be operating under the assumption that stress in the pipeline is dissipating. Fair enough. But only one-quarter of the weakest links are energy firms. Chances are defaults, already at the highest level since 2009, will continue to climb.

As for the much bigger investment grade (IG) market, it’s not an energy story but rather one entangling the financial sector that promises to capture headlines in the coming months. S&P Managing Director Dianne Vazza recently warned that financials dominate the fallen angel universe, as in IG firms likely to be downgraded to high yield. The culprits include their exposure to energy firms, the fallout from municipal mayhem in Puerto Rico and weakness in global growth.

The immediate fallout for these fallen firms is a spike in borrowing costs. But even for those that manage to remain in the celestial, expenses could be poised to rise.

“The market is not waiting for Janet Yellen to raise rates on corporate debt,” warned Lewitt. “The risk is not default, but lower earnings as these investment grade companies borrowed enormous amounts to fund buybacks and dividends and have enjoyed an interest rate holiday that will sooner or later come to an end.”

That’s saying something considering that even with interest rates near their lowest on record, the interest expense among companies in the benchmark S&P 500 Industrials has been on the rise since bottoming at four percent of nonfinancial earnings in the third quarter of 2010. According to data compiled by S&P’s Howard Silverblatt, interest expense first topped six percent in the quarter ended March of this year. It remains above that level, the highest since recordkeeping began in 1993. Since then, we know borrowing costs have started to tick back up. With record debt loads, it’s safe to say many companies can simply not afford interest rates to rise off the floor.

As tenuous as the situation appears, this credit cycle may have one last rally in its gas tank. “I don’t think this is the big one,” said George Goncalves, Nomura’s Head of U.S. Rates Strategy. “However, I do view any sort of unwind of the ‘portfolio rebalancing effect’ hurting both stocks and corporate and sovereign bonds initially.” Once that panic sets in, though, expect sovereigns to regain the flight-to-quality status and stage a rally.

Goncalves does foresee one potential fly in the ointment of the relatively happy ending: “Ironically, a second Fed rate hike could trigger more currency devaluations from overseas, notably China. If the secondary markets cannot handle the volumes, it could lead to broad-based selling.”

New Albion Partners’ Reynolds doesn’t figure even an exogenous event could put the brakes on the current credit cycle. Pensions and insurers simply have too much in the way of fresh funds to deploy to allow that to happen; they’ve absorbed half of the $3.1 trillion in new issuance. Given more funds are expected to flow into pension coffers in the coming years as Baby Boomers retire in droves, there should only be more to come. So we go from the mammoth to the monumental when it’s game over.

“The cherry on top of the sundae of this credit boom is the shift away from money market funds to cash funds that take ten times the risk to get ten times the yield,” cautioned Reynolds. If you’re still game for a bit more irony, “This shift has nothing to do with the fundamentals. It is occurring solely because of the money market rule changes.”

It would appear to be only a matter of timing, and in turn, magnitude. The outcome though is undeniable. With defaults on the rise, refinancing capability in increasing danger and more distress building in the pipeline, you would think we would be hearing investors screaming. But we don’t. Just the deafening sound of silence as most in the herd refuse to be early, even if waiting with the gate to the pen open offers them ultimate salvation.

by Luke Smolinski
Risk.net
30 September, 2016

Asset managers are disregarding the chances of a lasting shift in correlation between bond and equity prices, according to experts, with pension funds particularly unprepared.  Negative correlations have been the theoretical underpinning for investors diversifying their assets for 20 years. While some are optimistic about pension funds' resilience to correlations spiking, saying their liabilities drop more than the value of the stocks and bonds they own, others suggest pension funds are less prepared for falling bond prices than at any time in the past eight years.

Jack Goss, consultant for Imagine Software, a risk management technology firm in London, thinks many on the buy side are assuming a stable correlation in their value-at-risk models and will be ignoring stress tests that forecast big losses in the eventuality that correlations shift.  "We see people at the moment fearing that correlation will suddenly start to spike… If you get high inflation, low growth, both equities and bonds will fall together and that is an issue playing on people's minds," he says.  "The market in general is assuming correlation will not return to the levels of the 1970s and 80s."

Goss suggests that rather than plugging a different correlation number into VAR, risk managers should use some form of multivariate test, in which they can assume a range of probabilities of different correlations. Expected losses here would be determined mostly by the probability of a shift, he thinks.  For example, with a model assuming a one-in-five chance of correlation moving to +0.4, the risk manager's degree of conviction would have a greater effect than the precise change in correlation expected, he points out.

Concerns are heightened by the correlation turning positive in recent months. Three-month correlation between the S&P 500 and 10-year US Treasury bond prices switched from –0.66 immediately after the UK's EU referendum to +0.27 in the last month, according to analysts from Bank of America Merrill Lynch.  In early September, both bonds and equities sold off heavily, with the S&P 500 falling 2% on September 9 and US 10-year treasury yields hitting their highest levels since June.

Meanwhile, rolling yearly world equity-bond correlations have been negative with one exception since 1998, at an average of –0.35, before which they were mostly positive with an average of +0.24 since August 1962, according to quant fund Winton.  Goss also suggests risk managers are quietly disregarding stress tests they perform, as correlation spikes are thought to be unlikely. "[Stress testing] is being done at the moment," he says, "But a lot of people sort of say, ‘Well if it happens, we're in a fairly bad way', then they shrug their shoulders and move on. A lot of the time the result is so bad, what else can you do?"  Stress tests alone in this situation fail to impel asset managers to reallocate, whereas multivariate analysis would, he thinks.

A chief risk officer (CRO) at a fixed-income hedge fund says he tends to simply compare the losses in two correlation forecasts. "One can assign probabilities to different correlations, but it's very difficult to combine [them] together in a meaningful fashion that would be easy to explain to others," he says.  A lasting shift in correlation will affect pension funds most, suggests another hedge fund CRO.

Con Keating, head of research at BrightonRock Group, a London-based insurer for pension funds, says many pension funds might overlook the history of positive equity-bond correlations before 1998 as "the market's memory really does not extend beyond about seven years".  Asked how prepared pensions funds would be for a shift in correlation, Keating says: "Not at all. Quite the opposite: bond exposures have never been as high as they are now."  "All those who did liability-driven investment or moved their bond allocations up dramatically – which would be about 80% of them – are going to be hurt, because they're going to be sitting holding a lot of bonds that have performed badly. Their discount rates will go up, which will lower their liabilities, but the aggregate effect is not going to be good," he says.  He thinks pension funds cannot defy pain by diversifying into corporate bonds, commodities or hedge funds, and suggests they hedge bond exposures with options.

Hans den Boer, chief risk officer for the UK's Pension Protection Fund (PPF), which insures around 6,000 defined-benefit pension schemes, is more upbeat about pension funds' resilience.  "If interest rates go up and equity markets stay stable, that would mean asset values would go down, but the liability side would come down quicker, so their deficit situation would improve significantly," he says.  Many pension funds insured by the PPF have fewer than 100 members and would not have the scope to model correlation probabilities, he thinks.

The UK private pension deficit rose to £408 billion ($529 billion) in July, from £222 billion in January. Eighty-four percent of UK company pensions were in deficit and total assets stood at £1.4 trillion at the end of July.  Duncan Lamont, London-based head of research and analytics at Schroders, says high inflation led to positive equity-bond correlations before 2000.  Typically since 2000, interest rates rose as growth was revised up, so bond prices fell at the same time as investors valued company stocks higher. The prospect of central banks putting up rates after years of investors bulk-buying bonds is causing concerns about the correlation switching back to positive.  "Within pension funds, they are working hard to find asset classes which are not correlated," says Lamont, pointing to commodities and insurance-linked securities as non-correlated assets.

CNBC
by Jaff Cox
October 4, 2016

Central bankers have turned investing into a casino game with an unpleasant outcome likely, bond king Bill Gross said in his latest letter to investors.

The Janus Capital fund manager stepped up his criticism of institutions like the Federal Reserve, the European Central Bank and Bank of Japan, charging that the trillions in negative-yielding debt are presenting investors with unpleasant choices.

Recalling his days many years ago as a blackjack counter in Las Vegas, Gross reasons that "central bankers cannot continue to double down bets without risking a 'black' or perhaps 'grey' swan moment in global financial markets."

"At some point investors — leery and indeed weary of receiving negative or near zero returns on their money, may at the margin desert the standard financial complex, for higher returning or better yet, less risky alternatives," he added.

Among those potential choices: Gold, which has been a favorite option for Gross in recent months, and even digital currencies like bitcoin. He does not openly advocate that kind of choice but said it's the type of option investors might consider with central bankers suppressing financial conditions.

His comments come as global central bankers step up their actions to stimulate growth, particularly inflation. For instance, the BOJ recently announced an unconventional plan for "yield curve control," which aims to keep its benchmark 10-year note yield at zero.

Estimates put the total of negative-yielding debt upwards of $11 trillion, though Gross figures it's closer to $15 trillion, posing a looming specter to markets.

"Ultimately though, in broader, more subjective terms, it is capitalism itself that is threatened by the ongoing Martingale strategies of central banks," Gross said, referencing the bettor strategy of doubling down bets in blackjack with the idea that ultimately a winning hand will come along.

"As central bank purchases grow, and negative/zero interest rate policies persist, they will increasingly inhibit capitalism from carrying out its primary function — the effective allocation of resources based upon return relative to risk," he said.

Gross' $1.5 billion Janus Global Unconstrained Fund has gained just shy of 5 percent this year, putting it in the top third of its peers but slightly behind the 5.8 percent S&P 500 return, according to Morningstar.

His most recent comments are a carryover of recent admonitions for investors to ditch most stocks and bonds and instead focus on gold and real assets.

"Central bankers have fostered a casino like atmosphere where savers/investors are presented with a Hobson's Choice, or perhaps a more damaging Sophie's Choice of participating (or not) in markets previously beyond prior imagination," Gross wrote. "Investors/savers are now scrappin' like mongrel dogs for tidbits of return at the zero bound. This cannot end well."