In early November, we discussed how commentators were disturbed by the sell-off in Chinese government bonds after the Party Congress, which saw yields rise to 4.0%. The anomaly was that yields in less-liquid, unsecured Chinese corporate bonds had barely moved. Some sleuthing on the part of the Wall Street Journal discovered that the most likely explanation was that redemptions in China’s shadow banking sector, especially in the infamous $4 trillion Wealth Management Products (WMP), meant that cash needed to be raised…quickly. Highly liquid government bonds were the easiest option. Furthermore, retaining the higher-yielding corporate bonds was handy in meeting the guaranteed returns in the WMP Ponzi schemes.
The relative stability in corporate bond yields was short-lived, with the Chinese bond sell-off spreading to the corporate sector as November progressed. Besides the post-Congress focus on deleveraging, the mainstream explanation was that investors were differentiating between good and bad credits ahead of more than $1 trillion of local bonds maturing in 2018-19. The spin was positive as it would lead to capital being channeled more productively.
Needless to say, this was not how we viewed it. From our perspective, it looked like the emergence of cascading sell-offs within Chinese financial markets which have been abused by excessive leverage and Ponzi characteristics. Recent plunges in Chinese equities have strengthened our conviction. Indeed, as the new trading week opened, equities were hit again, as we pointed out last night and as Bloomberg observes this morning:
After taking a breather in the wake of a battering Thursday, Chinese shares resumed their decline Monday, with some previously high-flying consumer and technology companies among the hardest hit. The CSI 300 Index of large-cap stocks was down 1.3 percent as of the mid-day trading break, with ZTE Corp. and BOE Technology Group Co. both falling more than 6 percent…“Institutional investors are choosing to cash in toward year-end as valuations are near historic highs and market sentiment deteriorated after official media targeted Moutai,” said Shen Zhengyang, Shanghai-based analyst at Northeast Securities Co. He said the market “lacks steam” for further gains.
The CSI 300 finished the session down 1.3%, deepening a 6.8% decline posted in the final three sessions of last week, and reflecting disappointment that on Monday the PBOC provided no net liquidity to the system.
“The slides continue as blue chips have gained significantly this year,” said Shao Rui, analyst at Shanghai Securities Co. “The tighter liquidity conditions prompt institutional investors to lock in their profits.” After injecting a net 150 billion yuan last week, the central bank’s additions via open-market operations matched maturities Monday, suggesting cash supply will remain tight. China’s 12-month interest-rate swaps climbed for the first time in three sessions.
The consumer discretionary index fared even worse, falling 2.1 percent as BYD weighed. The Shanghai Composite Index lost 0.9 percent and the Shenzhen benchmark dropped 1.6 percent, with losses accelerating through the afternoon. What was notable is that for the second time in one week, the Chinese national team was not there to rescue investors with buying in the last hour of trading.
While the sell-off in Chinese equities is unnerving, our primary focus remains on conditions in credit markers in China and Hong Kong. After the Chinese open, we highlighted the tightness of credit in the Hong Kong interbank market, where 1-month HKD HIBOR spiked to its highest level since December 2008.
In this increasingly fragile environment, the portfolio manager who runs China’s best-performing bond fund sees a “high probability” that the rout in corporate bond markets will get worse in 2018. According to Bloomberg.
It’s been the worst month for China’s local corporate notes in two years. And it might just be the start, as the nation’s top bond fund manager says yield premiums could rise further in 2018. President Xi Jinping is stepping up efforts to trim the world’s largest corporate debt burden, after emerging even more powerful from the Communist Party’s twice-a-decade congress in October. Financial institutions are hoarding cash amid expectations the government will announce more measures to curb leverage, and that is pushing up borrowing costs in the money market.
“There is a high probability that credit spreads will widen next year given that there hasn’t been any improvement in the tight liquidity,” said Zhang Qinghua, general manager of fixed-income fund investment at E Fund Management Co. His E Fund Stable Value Bond-A fund has returned 15 percent, the best among fixed-income funds in China with more than 3 billion yuan ($454 million) of assets that are tracked by Bloomberg data.
Policy makers must walk a fine line. Bond market pain has already spilled over into equities, as rising borrowing costs tarnish corporate balance sheets. Economic growth could also be jeopardized if deleveraging sparked a rash of defaults. For now things appear under control. While two more firms missed bond deadlines recently, there have been only about 21 note defaults this year compared with 29 for all of 2016.
The 31 basis-point rise in the AAA corporate bond spread this month is the biggest increase since March 2015. Zhang sees further deleveraging measures by the Chinese authorities triggering a rise in the number of defaults.
Despite those market moves, the government is rolling out more deleveraging measures. Financial regulators this month proposed sweeping rules to curb risks in the country’s $15 trillion of asset-management products. The government is still focused on preventing financial risks and curbing leverage, as economic slowdown looks limited, according to Zhang. Closure of zombie companies may accelerate next year and some individual companies’ credit events are unavoidable. However, overall credit risks are declining because of improving profits and declining leverage ratios, he said.
While we agree with Zhang’s outlook for corporate bonds, we are less confident about his upbeat stance on Chinese equities.
Convertible bonds will outperform government and corporate securities next year because listed companies’ profit growth may remain high, boosting attractiveness of equity assets, according to Zhang. “Liquidity may also flow from the cooling property market to the equity market next year, supporting better performance of the equity market,” said Zhang.
Our sense is that the cascading, "snap sell-offs", such as the one seen overnight in China, are going to get worse before they get better, and equities will increasingly be drawn into the mix.