Thursday, September 29, 2011

China Squeeze

Europe and all things European have been holding the world's attention to an extent that it’s all too easy to forget that life goes on elsewhere. One of the corollaries of the European shock has been a general global deleveraging rolling right through to the emerging markets.

TMM had some pretty dark things to say at the start of the year about emerging markets and particularly China. As trades go, this has worked – The Hang Seng and Hang Seng China Enterprises index has dropped gradually throughout the year and has really been hammered since August in particular. As noted by the esteemed commodities analysts at the US ex-investment bank, copper is very closely correlated to China fixed asset investment, which appears to have become public enemy number 1 of the People’s Bank of China’s latest tightening campaign. It dropped off heavily and has taken copper with it. See below the bonds of Evergrande, a property developer, and copper and China fixed asset investment. All jokes aside, the China real estate bond market really is copper with a coupon.

Much of what seems to have kicked off this panic is not anything particularly new to TMM: China has an unbalanced economy, is too dependent upon fixed asset investment and its banks end up short puts on a lot of bad investments. So far so good – China property, banks and basic materials have been a great short.

But here is where TMM find themselves out of line with the market thinking. First, you haven’t thought anything through until you consider the government and likely policy responses, given the command economy context. In TMM’s opinion watching the banking sector explode into a flaming wreck is not something the government will sit by and watch idly and the last time we heard of Wenzhou SME’s blowing up, credit loosening was not far behind. Similarly, some will point to high levels of inflation, but breaking China inflation down into food, non food and housing (see chart below; white line - food, orange line - non food, yellow line - rents), a big part of non-food makes it pretty clear that food is beginning to turn for its own reasons, while house prices and rents really are falling out of bed. Given what global financial conditions have been doing (and reading some chemical company transcripts), we are inclined to think that the global situation has gotten bad enough for the PBOC hawks to stay hooded when the local banks scream for looser credit.

In summary: the worst may be yet to come, but probably not in the next 6 months.

On valuation, China’s banks are about as beat up as they ever have been historically as you can see below:

On a back-to-basics corporate finance level they are looking cheap, assuming that most of the book value isn’t a complete write off. Now, bears may scream “BUT IT IS, INNIT?”, to which TMM would agree, - but then again we would also note that the government has demonstrated prior ability to take on pools of toxic loans, throw them in an AMC and forget about it for quite some time (lessons for the Europeans?). Being super short on the assumption that the banks will have to issue equity that will allow you to cover may not work. Given these numbers, if we see a combination of loans bought by Huarong and Cinda and a stimulus, we could see a squeeze that could rip this stuff 30-40% higher.

Which gets us to positioning data and, suffice it to say, the market has got itself very net short in copper per the COT data and the short sale turnover / total turnover picture in HK below is looking pretty extreme too.

And on that point, TMM are covering and running. When shorting Chalco and Anhui Conch looks more like a T8 Typhoon day in Hong Kong (see below), we’ll be back.

In the meantime, we’d rather sit out the next move down and not risk the squeeze and instead start thinking about what the next white elephant nation building/wealth expropriating capex binge China will come up with next. Rail? Soooo 2008! TMM are looking at stuff like this instead.


Skippy said...

Good note Pol, no real argument from me. I would also add that a few of the sycophant sell-side brokers have capitulated this week on Chinese banks.

What has puzzled me for some time is why some of the China adjuncts -e.g. the commodity currencies - have not corrected by more in sympathy with copper and Chinese developers.

Secret--Sauce said...

Come on guys - think bigger - that's better!

I'm waiting for the Pechora-Kama canal solution to be refloated and put on short copper/long uranium.

Polemic said...

Thanks Skippy, but this is actually nemo's baby.. will let him handle the questions.

Anonymous said...

C says'
China has it's won mess to clean up,but it does have the advantage in this arena of being able to do so without Europolitical dissent getting in the way.,or indeed the bond market jumping all over them directly.Indeed if it was perceibed they shovelling big brown stuff under some mountain in the outermost reaches of China what would happen? Oh yes ,their currency would be pressured and they wouldn't want that would they?

We've been in the let's all tighten boys' Bric madw world,stand by for the cycle of loosen up guys there's no such thing as inflation only the opportunities of great growth ;)

Meanwhile back in Euroland on the austerity feelgood diet it is rumoured that Berlusconi will now only be having 3 orgies a week ,but at his age he anticipates he might live longer.

Anonymous said...

won ..own
freudian slip

Nemo Incognito said...

Skippy - no idea. I think there's still a big bid out for those currencies so long as we don't get a full scale EM FX unwind - ie $ diversification running backwards. Long run these should revert with terms of trade but... well, that's a long wait generally speaking.

Anonymous said...

@Skippy re Commdolls -

CAD = 1.06 U$D July 26th

CAD =.9690 today.

And Cdn oil majors like SU and coal names like Teck smashed!

Anonymous said...


Re Pechoa-Kama canal - you'll see a war over water between India-China sometimes this century!

Most water in Indian north/western states(major agri. states) comes from Tibetan lakes fed by Himalayan glaciers. I think Doug Kass(in his yearly 10 things to watch) is too early.

Skippy said...

Anon @ 2.59, clearly there has been a correction in commodity currencies and miners over the past two months, but it is still fairly modest relative to Chinese developers other risk assets (equities and some EM currencies) in general.


Leftback said...

Feels like a good day to have very few positions on. That morning rally was certainly sold in a hurry.

The big macro question of the week is surely: is the recent dollar rally complete, or just taking a breather? If not, then it's hard to see how most markets can climb from here, as a dollar rally to DXY 80 or thereabouts would take down the miners, industrials and banks. Most of the regulars here seem to think EURUSD and the metals, and commodity FX like AUDUSD etc. will have another leg down.

There will be a monster China squeeze, but isn't it going to be ignited by global QE?

Skippy said...

My working assumption is that this consolidation range in the S&P is likely to be a continuation pattern and break to the downside.

As LB noted yesterday, the failure to punch above 1200 is potentially bearish.

I suspect that 1000 is more likely than 1300 over the next few weeks. That may crush any residual optimism in the teflon coated EM and commodity currencies.

Nemo Incognito said...

FWIW Skippy I like shorting Silver (yes, I'm young and don't have heart disease yet) simply because there's a lot of it being produced from by-product credits and absolutely no uptake from central banks. Sure its high vol but it seems a lot more yogi bear as a short than copper tbh.

willem said...

USDCAD off 10%, AUDUSD 13%, USDZAR 25%, etc.
Not sure I would call that holding up.

Leftback said...

LB is short silver, there are so many people who own it but now not quite sure exactly why they bought it.

Inflation hedge? Industrial metal? DGDF? Sky falling? Mad Max scenario bartering instrument?

Lemmiwinks said...

0.5% losses on assets is a joke.
No one really knows the real figure.

Anonymous said...

DOJ probing Chinese ADRs - Reuters

Dee Dee Humberside said...

For those of you who are in the US: yes, even after the massive correction, silver is still more overpriced than Carl Crawford.

(Also as has been pointed out here before, the late session dumping of the favourites - US tech, staples etc - while the turds - basically, banks - outperform is not a good omen for October)