Entries from April 2018 ↓

China’s debt problem

RYAN  By Guest Blogger Ryan Lewenza

In recent blog posts Doug and I have the presented the bull case for China’s economy and more broadly emerging market (EM) equities. Last year we doubled up emerging market equity exposure in client accounts based on this bullish outlook, much to our clients benefit with EM equities up 30% last year. We continue to see good upside in EM equities but are closely monitoring one key risk to the Chinese economy – elevated corporate debt – which has the potential to provide a big negative shock to their economy and stock market in the coming years.

China’s transformation from a centrally planned, largely agrarian-based economy to the industrial powerhouse it is today has been nothing short of spectacular. Since 1980, 700 million Chinese have risen out of poverty, GDP per capita has increased from US$194 to US$8,833, and life expectancy has jumped from 70.5 years to 76.1. But much of this growth has been fueled by a dramatic rise in debt, which could make the country vulnerable down the road.

Just since 2004, Chinese corporate debt has surged from CN¥17 trillion (US$2.7 trillion) to CN¥132 trillion (US$20.7 trillion), representing the largest outstanding corporate debt in the world. As a percentage of GDP, debt has increased from 107% in 2004 to 160% today. To put this into perspective, US corporate debt currently stands at US$9 trillion or 46% of GDP.

What’s behind this historic build-up in debt?

China’s Corporate Debt Has Exploded in Recent Years

Source: Bloomberg, Turner Investments

In a word, infrastructure.

China has been spending heavily on infrastructure, with investment as a percentage of their economy rising from 35% in 1980 to 45% today. They’ve spent billions upon billions on much needed roads, buildings, airports, high speed trains etc., which has helped fuel their average 10% GDP growth over the last few decades.

Huge initiatives like the One Belt, One Road initiative proposed by President XI Jinping, called for infrastructure spending of US$5 trillion to help connect China with Eurasian countries, and is one example of these major investments that has contributed to the spending binge.

Much of this investment was sound and allowed the country to modernize and become the powerhouse it is today. However, some of these investments are likely to prove unproductive and problematic with some of these investments likely to go bad and the debt being written off.

A good example of these problematic investments is “China’s Ghost Cities”.

Over the last decade China has built dozens of these cities which house a 1+ million people and we’re built in anticipation of people moving from the rural countryside to large modern cities. Some of these cities sit largely vacant, hence the term “ghost city”.

There have been a number of great documentaries and specials on this. One of the best on the topic was a 60 Minutes special which can be viewed here https://www.youtube.com/watch?v=ei0FpwI1dqg.

Example of a Chinese Ghost City

Source: South China Morning Post

Debt, in and of itself is not the issue. It’s when it gets harder to meet the interest and principal payments that debt becomes an issue.

Often for these large build-ups in debt you need a “prick” or a catalyst for this nascent risk to set off and metastasize. I see two potential “pricks” that could bring this risk to the surface.

First, are higher interest rates. Currently, with interest rates in China and around the world at such low levels, the debt servicing costs remain relatively low despite record amounts of debt. But if interest rates start to spike then this will make servicing the debt that much harder and could be the catalyst that sets all this off.

China Interest Rates

Source: Bloomberg, Turner Investments

Second, is a material slowdown in China’s economy. Right now with China’s still high GDP growth they can meet the debt obligations. But was happens if their economy slows materially making it harder to pay off the debt. As the sage Warren Buffet once said, “you only find out who is swimming naked when the tide goes out.”

To be clear, I don’t see this as an imminent risk that is going to doom China and the global economy. I believe we’re still some years away from having to deal with this and why we continue to be constructive on China’s economy and EM stocks. Moreover, Chinese policymakers are going to do everything in their power to contain this growing risk. But I would not be surprised to see this issue on the front page of The Wall Street Journal over the next decade and it causing some stress to the global financial markets. The key then will be trying to getting ahead of it to ensure clients are minimally affected by this elephant (or more appropriate tiger) in the room.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.

Seriously

Shortly after I finished writing yesterday’s blog post about interest rates going up, they went up.

So two of the Big Five have increased the cost of mortgages and you can bet the other guys will follow. Toronto Dominion was most aggressive, adding almost a half point to its five-year home loan, pushing it out to 5.59%. RBC was gentler, adding 20 bips, for a posted rate of 5.34%. This suggests the Bank of Canada will soon up the benchmark rate it uses for the B20 stress test, currently sitting at 5.14%.

Why did this happen? Will it continue?

The Government of Canada five-year bond had a yield of just 1.6% six months ago, and this week it touched a seven-year high of about 2.2%. That’s an increase of almost 40% in a flash, and happened while the yield on 10-year US Treasuries (the Stormy Daniels of the debt world) touched 3% for the first time in years.

The cost of money, in short, is going up. No surprise there, since the world is inflating again. Global growth is on its way to 4% in 2018. The US economy’s doing pretty good. The Chinese trade war rhetoric is winding down. Kin Jung Un turns out to be a jolly little elf who just wants to be hugged. American corporate taxes have plunged and business profits are romping higher. Unemployment numbers are way down and the States is at technical full employment.

So, bonds are hot. The yield on risk-free government debt is now rivaling the dividends stocks pay, which is why a bucket of money is flowing from equities to fixed income. The election of the Trumpster is widely viewed as the moment in time when the switch was flipped from deflation to inflation, from contraction to growth, and from a low-yield, low-rate world to one in which the poor moisters are lost. Yes, kids, the Eighties are coming back. You’ll love it. Seriously. Lower house prices – but fatter rates.

Of course the posted bank mortgage rate is not the actual rate offered to customers. Five-year mortgages are still available for about 3.3% to renewers, but (a) that will soon change and (b) new borrowers have to prove they can pass the stress test.

So I’ll say it again. We are in the middle of a rate event, not at the end. The Fed has increased six times since the end of 2015 and five times in about the last year. The Bank of Canada has moved three times, and markets are betting the next comes in July.

The broad expectation now is for four Fed hikes this year, rather than the three anticipated a few weeks ago. The next one won’t occur on Wednesday, but like mid-summer, with another in the autumn. The Bank of Canada is expected to go twice by the end of the year, depending on the economic data – especially the pace of job creation.

Those who argue the cost of money will stay put because the central bank is afraid of the housing market are misguided. The bank cares about what you owe, not what you own. Household debt is out of control, with mortgage borrowing at unheard-of levels and HELOCs mushrooming monthly. Policymakers can’t afford to worry about average house prices in Vancouver or Toronto when keeping them aloft means family balance sheets continue to deteriorate. The greatest economic threat is excessive snorfling. Gradually and relentlessly higher rates are designed to throttle that. Besides, governments at all levels – from the feds (B20) to the provinces (anti-foreigner taxes) to the cities (empty houses levy) – have enacted laws to put the brakes on real estate. Forcing mortgage rates higher is entirely consistent.

Finally, remember that roughly half of all mortgages in Canada come up for renewal in 2018 – a quirky coincidence caused in part because so many people opted for cheaper two-and three-year loans when house prices started to explode in 2015. Thousands of families who borrowed at barely more than 2% will be renewing at a 50% increase – plus with B20 in effect most won’t dare switch lenders, seeking a better deal.

No, rates like these will not cause a recession or collapse the economy, as happened in the early 90s. There’ll be no tsunami of defaults. No jingle mail. No mattresses on the front lawn as bailiffs change the locks. No drama. Just the slow drip-drip loss of equity, as buyers are squeezed for financing and sellers get lonely.

By the way TD – while raising its fixed-rate mortgage rates – just dropped its variable by 15 bips. Be careful. This is the banker equivalent of a Victoria’s Secret push-up bra.

Can I still say that?