Cross-winds continue to gust in China, where rhetoric about deleveraging contradicts the acceleration of credit, and attacks on yuan-bearish hedge funds confound against a backdrop of historic cross-border M&A activity.
This week, well-respected China analyst Charlene Chu warned that unless economic growth and consumption magically accelerate well beyond current expectations for the next 5-10 years, the country will inevitably need a bailout in excess of one trillion dollars. While GDP growth slowed to an official reading of 6.9% last year, the off-balance sheet inventory of wealth-management products (WMPs) in China grew by an estimated 73%. WMPs cover a range of assets more diverse than mortgages, but are similar to credit derivatives like mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) sold in the U.S. prior to the 2008 financial crisis. The difference is "we have significantly less visibility on the [Chinese] assets than we did with subprime [mortgages]."
When China's renminbi was admitted last November into the World Bank's Special Drawing Rights currency basket, the government promised to let it float more freely. However, after seeing the effect of its large surprise devaluation last August, the Chinese government has chosen stability over reform.
To understand the motivations behind Chinese government policy decisions, look no further than their impact on State-Owned Enterprises (SOEs). While a large currency devaluation would allow the economy as a whole to better cope with its yuan-denominated debt overhang, it would make the massive dollar-denominated debt held by SOEs much harder to service. A 3% depreciation, for example, would add more than $25 billion in annual interest payments, according to BNP Paribas (via the Wall Street Journal). While SOEs make up less than a third of China's GDP, they account for around 80% of lending and financing, and since the end of 2007 there has been a significant deterioration in their return on assets (from 5% to 2%). A quarter of SOEs are currently operating at a loss, as opposed to 10% of private businesses.
The government has made half-hearted attempts to address the problem with layoffs in state-run natural resource industries, but those job cuts also raised alarms within the banking sector and triggered a freeze in new credit. This, naturally, has led to an uptick in defaults among Chinese SOEs, for which firms have offered up some strange excuses. No wonder China wants to set prices for the world's commodities.
The government could be defending its peg on the yuan long enough for corporations (especially those with opaque ties to senior government officials) to diversify out of the currency. As we mentioned last week, Chinese companies are buying almost any foreign insurance and real estate company they can get their hands on, with cross-border M&A already at a full-year record. The government can extend and pretend for a few more years, but eventually will be forced to bailout SOEs and the private sector.
Back in March, amid an explosion of credit in the first quarter, several prominent Chinese economists and bankers reportedly asked the People's Bank of China (PBoC) to let the currency depreciate. Enough is enough, they decided. This week, encouragingly, China's central bank set the renminbi fix at a five-year low. However, President Xi Jinping seems to think China is not yet ready for such liberalization, setting up a potential showdown at next year's National People's Congress (NPC), where the majority of seats on the all-powerful seven-member Politburo Standing Committee open up. President Xi, one of the most powerful Chinese leaders in decades who has also recently taken control of the nation's military, is expected to consolidate power by placing loyalists on the committee.
While the PBoC is being cautious with reforms, the People's Daily newspaper, considered the communist party mouthpiece, continues to run stories with quotes from an "authoritative figure" within the government about the need to reform policy and move away from debt-driven stimulus. Chinese leadership is adamant the currency will not need to undergo a major devaluation, while economic policy advisors appear increasingly eager to get it over with. The communist leadership will likely maintain their incredulity toward yuan bears until the day the other shoe drops.
Mixed fortunes of Chinese companies
Apple's (AAPL) dealings in China are a reminder (in case you needed one) that although the communist country has slowly opened itself up to more capitalistic forces, every piece of business still flows through the government. Apple saw iPhone sales contract for the first time ever in the most recent quarter, largely because of its inability to effectively penetrate the Chinese market. The company has run into numerous regulatory roadblocks from Beijing, cited by Carl Icahn as his primary reason for dumping a stock he once considered worth $240 per share.
Coincidentally, as we discussed last week, Apple made an expedient $1 billion investment into Chinese ride-hailing service Didi Chuxing. While the massive investment could pay off financially, many believe it was more heavily motivated by Apple's desire to ingratiate itself with Chinese officials.
And if you needed a reminder of why investors are cautious about investing in Chinese companies, e-commerce giant Alibaba (BABA) is being investigated by the Securities and Exchange Commission (SEC) over accounting practices.
Stocks surge into summer
Stocks rallied sharply last week in a low-volume pre-holiday tape, the Nasdaq leading the charge with a 3.4% gain but remaining the only major U.S. index in negative territory for the year. The S&P 500 leads so far in 2016, up 2.7%. While the impetus for several rallies since the financial crisis has been the expectation for additional monetary easing from the Federal Reserve, the market's current two-week win streak took place amid strong economic data that has increased expectations for a summer rate hike.
The trend of strong economic data continued this week. April new home sales grew at their fastest pace since 2008, coming in higher than expected (619,000 actual vs. 521,000 expected) while growth in pending home sales blew expectations out of the water (5.1% actual vs. 0.6% expected). The second estimate of Q1 Gross Domestic Product (GDP) growth increased from 0.5% to 0.8%, although it was slightly lower than expectations of 0.9%. However, given the strength of recent leading indicators, GDP growth is now expected to accelerate to a robust 2.5% in the second quarter. Oil also continued its rally, touching $50/barrel for the first time since October, up 85% from February lows.
In response to the data, expectations for a rate hike by the July meeting continued to grow. A chorus of Fed governors last week indicated the Federal Open Market Committee (FOMC) now saw it appropriate to raise rates at either its June or July meeting. The head honcho, Fed Chairwoman Janet Yellen, joined the fray this week, delaying departures to the Hamptons with a 1:15 PM ET Friday statement that said the Fed "could raise rates in the coming months." Expectations for a June hike held firm this week at 30%, evidence the market expects the FOMC to take caution with the "Brexit" vote coming a week after that meeting, but expectations for a hike by July grew from 55% to 62%. Last year the Fed primed the market for a September hike but waited until December to actually pull the trigger, by which time the rate increase barely sent a ripple across global bond markets. It appears the central bank could be doing something similar this summer - walking up real interest rates by focusing on the possibility of a June hike while intending to actually do the deed in July.
Although the dollar's four-week rally lost momentum this week (with only a 0.4% gain), the greenback is now up more than 4% from its lows of the year. Amid improving economic conditions, credit spreads have tightened with high-yield bonds surging. In a reflection of this week's low-volume, low-conviction rally, though, yield on the 10-year Treasury fell three basis points to 1.84%.
Wall Street entering age of artificial intelligence
The blockchain concept was pioneered within the context of crypto-currency Bitcoin, but engineers have imagined many other ways for distributed ledger technology to streamline the world. Stock exchanges and big banks, for example, are looking at blockchain-type systems as trading settlement platforms. Others have seen it as a system for enforcing laws.
Last week, a group called DAO (Decentralized Autonomous Organization), raised $100 million to find out whether it can create a corporation that runs effectively with no management or board of directions. In DAO, every detail of the company, from operations to accounting, runs itself according to a set of computer code. DAO is based on a new crypto-currency contract platform called Ethereum, which itself is now worth $1 billion and threatening Bitcoin's dominant position in the space.
A group of technologists is also getting closer to being able to mimic the monetary policy decisions of the Federal Reserve, imagining a future where a set of artificially intelligent machines, rather than humans, set monetary policy.
Government suffers setback in war on Wall Street
The U.S. Court of Appeals for the Second Circuit this week knocked down a prior ruling ordering Bank of America (BAC) to pay a $1.27 billion civil penalty in connection with the sale of mortgages by Countrywide (which Bank of America bought during the subprime crisis). The government failed to establish fraudulent intent of Countrywide regarding contracts guaranteeing the "investment quality" of mortgages it sold to Fannie Mae and Freddie Mac. While Countrywide promised to sell Fannie and Freddie only "investment quality mortgages" and later sold them mortgages it knew to be worthless, the fact the promise and action didn't occur at the same time apparently prevents the sales from being considered fraudulent.
The appeals court ruling is the latest setback for the government, which despite numerous settlements has had difficulty winning major cases. After seven years of litigation and 156 cases, the government has won few convictions against individual bank employees, much to the chagrin of Main Street.
Meanwhile, Citibank settled its Libor-rigging case for $425 million, and the battle continues over the future of Fannie Mae and Freddie after the government "bailout with no exit".
Hitching their wagon
If you are a traditional auto company and don't have a stake in or partnership with a ride-hailing service (and vice versa), you risk being left in the dust. General Motors (GM) has its stake in Lyft, which it hopes will put self-driving electric cars on the road within a year. Now Toyota, the world's biggest car company, has entered into a strategic partnership with Uber.
However, while the ride-sharing boom shows no signs of slowing down, venture capitalists are souring on "the Uber for [blank]" investment pitches.
The "Brexit" campaign is heating up weeks before the referendum. Finance ministers have thrown their weight firmly behind the "Remain" camp, with the U.K. Treasury this week saying a British exit from the European Union would cause at least a year-long recession and require two more years of austerity. Corporate debt investors believe a "Brexit" is increasingly unlikely.
Planting the seed
Bayer made its move for Monsanto with a $62 billion offer, which the agribusiness giant flirtatiously rebuffed. Bayer has limited room to raise its bid, but Monsanto Chairman and CEO Hugh Grant has $70 million reasons to get a deal done.