Urban Dictionary defines “A bull in a china shop” as “a simile used to describe an extremely rough or dangerous person in a place where gentleness is a must. It brings to mind the image of a huge rodeo bull exploding into a tiny curio store and throwing his weight around in a berserk rage, annihilating every last teacup.”
When I ask our accounts lately which major threat to the bull market in stocks they most fear, the number-one reply is a meltdown in China. That’s the bear that could trip up the bull market in the US and around the world. Of course, there are other concerns, such as a rebound in inflation, a stalling of US economic growth, and the failure of Washington to implement President Trump’s tax reform agenda. However, China is the number-one concern, especially since the second half of April, when Chinese officials started a new round of credit tightening.
The Shanghai Stock Price A-Share Index peaked last month on April 11, and fell 5.7% through Friday (Fig. 1). That’s a minor decline so far, especially compared to the 48.6% plunge from its record high on June 12, 2015 through January 28, 2016. Meanwhile, both the Hong Kong Hang Seng China Enterprises Index and the China MSCI stock price index are above their April highs, and up 11.3% and 14.8% ytd, respectively (Fig. 2).
So why the long face (as the bartender asked the horse, who stepped up to the bar for a drink)?
Here is the recent litany of worrisome developments in China:
(1) War on debt. A 5/5 WSJ article titled “China’s War on Debt Causes Stocks to Drop, Bond Yields to Shoot Up and Defaults to Rise” summarized the recent woes nicely: “A wave of regulations aimed at cutting risk in China’s financial system is rippling through the country’s markets and sending banks and companies scrambling for funds. During the past month, Chinese shares have fallen nearly 5%, draining almost half a trillion dollars out of the country’s markets. Bond yields have shot up to their highest levels in two years, and bond defaults hover at record levels. The uncertainty has also weighed on metals and commodity prices, already hurt by doubts around China’s growth momentum. The price of iron ore plunged 8% on Thursday, the daily trading limit.”
(2) Xi’s ultimatum. Chinese President Xi Jinping recently called for greater stability, warning finance regulators not to miss “a single risk” or “hidden danger.” The message was heard loud and clear. For example, the chairman of the China Banking Regulatory Commission (CBRC) said, “Strong medicine must be prescribed. If the banking industry gets into a mess, I will resign.” More likely, he will be fired.
(3) Lurking in the shadow. The problem in China is a huge shadow banking system that sells so-called “wealth management products” (WMPs) to the public and then lends the money to risky companies without setting aside any capital for possible losses. WMPs are debt or debt-like instruments that pay out higher interest rates to investors. Banks have kept them off their balance sheets. However, the People's Bank of China just put them on its macroprudential assessment of banks' risks.
The WSJ article cited above reported, “Such grey-area investments reached nearly 20 trillion yuan ($2.8 trillion) at the end of last year, says Fitch Ratings, or about 26% of China’s gross domestic product in 2016, up from less than 10% three years earlier. They now represent an average of 19% of small and midsize banks’ total assets, compared with about 1% for big state banks, according to Fitch.” Fitch says total debt reached 258% of China’s GDP last year, a ratio it expects will grow this year and next.
(4) Not so trusted. The CBRC is also cracking down on the practice of banks’ lending to external managers money for “entrusted investments.” Banks have been lending to brokerage firms with high interest. The brokerages then lend to customers, often allowing leverage to be extended to customers if they have a problem. The brokerages make their money from trade execution and sharing in returns. So, they get paid first.
(5) Deadbeats. During the first four months of this year, 12 companies, including steelmakers and construction firms, defaulted on their corporate bonds because they couldn’t refinance their debts. That matches the record hit during the same period last year, when China was under great stress from accelerating capital outflows.
(6) Dimon sounds alarmed. On May 1, Jamie Dimon, the CEO of JPMorgan, told a crowd at the Milken Institute's Global Conference that China has him worried. What scares Dimon is that China’s latest campaign to rein in credit excesses, if done too quickly, may drain too much liquidity from the system, killing smaller players and grinding things to a halt.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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