Notwithstanding yesterday’s equity market rally (carried over into the Asian morning), the behavior of risk assets over the past month begs the question of whether a big financial actor is seriously “sick”. The constant plunge in commodities, the relentless rise in spreads and an inability of all major equity markets to hold on to a rally suggests that someone, somewhere, is just “puking” a massive portfolio (as AIG did in 2008).
The general impression offered by the financial media is that sovereign wealth funds, which in the past decade saw assets grow from US$3trn to US$7trn mostly on the back of rising oil wealth, are being liquidated to plug domestic budgetary holes (growing by the day in countries such as Saudi Arabia and Kazakhstan). And, to be sure, it is easy to imagine that given collapsing commodity prices, sovereign wealth funds have moved en masse from being the “marginal buyer” to the “marginal seller”. The same point can be made for the People’s Bank of China and the entities that manage China’s reserves: as the PBoC helps liquefy renminbi outflows, the likes of SAFE or CIC may well move to being marginal sellers.
Staying with China, it can also be argued that the stumbling and confusing communications offered by its financial authorities have set up the perfect trade for macro/momentum investors; namely a repeat of the 1998 trade in Hong Kong when investors conducted a “double play” by heavily shorting both the equity market and the currency to drive interbank rates sharply higher. At worst, a panic over both the exchange rate and interest rates triggers a sell-off on equities (so our macro investor can win on one side of the bet); at best, the currency breaks and the macro investor can win on both side of the bet. And since both the Chinese government and the PBoC have lost policy credibility since this summer’s botched intervention, the more they intervene, the more investors panic and sell.
If policymakers do nothing, momentum investors can keep pushing the pain threshold with impunity. This dynamic explains why the Hang Seng Index is trading below book value for the first time since 1998 and the P/E of the H-share index is 5.7x; either that, or China really is falling into a dark hole (in which case all other risk assets are not done falling!).
Having spent this week visiting US clients, the above topics (and especially whether China is “imploding”) were at the top of everyone’s discussion points. That is understandable, but we were minded to quote Jesus from the book of Matthew: “And why beholdest thou the mote that is in thy brother's eye, but considerest not the beam that is in thine own eye?”.
After all, the initial catalyst for the current sell-off seems to have been the collapse of the Third Avenue junk bond fund which shone a light on a troubled US high yield market. Let’s assume that the US high yield market represents about US$700bn of outstanding debt and that investors have had to handle about US$50bn of redemptions in the past six months. Unless this redemption cycle reverses (perhaps as yield starved investors are enticed by the higher yields?), the uncomfortable question is who will buy the “investment grade” debt of commodity producers and industrials that are likely to be downgraded to junk in the next 12 months? It is not an unrealistic assumption that such downgrades affect US$200bn of paper.
One possibility is that funds leave the equity market to capture the rising yields on debt. After all, as US investors age it makes sense for retiring baby boomers to gradually switch away from equities in favor of such debt instruments. By the same reasoning the next question is who becomes the next marginal buyer of equities? In recent years, it has been corporates , but given wider credit spreads, levered balance sheets and falling margins, this cannot be relied upon to continue. Since foreign investors seem unlikely to ride to the rescue given the strength of the US dollar, one is left with a troubling quandary as to the nature of the future marginal buyer.