China, Lehman Squared?
<p>Following up on the recent pick-up in volatility and risk-off around a potential default of China´s large and highly leveraged real estate developer Evergrande, in line with our objective of proactive communication and transparency, please find enclosed a summary of our views and portfolio positioning with particular focus on China insurance. </p><ol><li><strong> BIG PICTURE</strong></li></ol><p><strong>Monetary and fiscal policies without limits <u>do not solve</u> problems</strong>, but rather: </p><p>1) <strong>Delay Problems </strong>(kick the can down the road via debt), </p><p>2) <strong>Transfer Problems </strong>(via currency and trade wars), </p><p>3) <strong>Transform Problems </strong>(via inflation and inequality) and </p><p>4) <strong>Enlarge Problems </strong>(via systemic bubbles too big to fail). </p><ol start="2"><li><strong> CHINA AND MACRO VIEWS</strong></li></ol><p><strong>China credit and real estate bubbles are a huge problem for China, and for the rest of the world.</strong> China´s imbalances are not new and have been accumulating for the past two decades due to a combination of well-known factors, such as global monetary and fiscal policies without limits discussed above, plus idiosyncratic problems such as central planning, currency controls, shadow banking, inflation, demographics, speculation, etc, which have created bubbles too big to fail. The damage, I am afraid, is already done. </p><p>Evergrande is not an isolated problem, but rather the tip of a giant iceberg of debt, leverage, and complex onshore/offshore private and state-owned entities and implied guarantees.<strong> </strong>The catalyst for Evegrande´s potential default is a simple combination of aggressive expansion plans, high debt, high leverage, high real estate prices, low disposable income. The key next step coupon payments that Evergrande is due 23rd Sep ($840mn offshore and RMB232m onshore) due to banks. In anticipation of a potential default, as discussed in my monthly call last month, Evergrande´s debt has collapsed creating a potential hole of $300b that will need to be restructured with an expected hair-cut of 70% that is a direct hit to banks, asset managers and private individuals. To put Evergrande in perspective, as pointed out by Daniel Lacalle, "the total assets of Evergrande that are on the brink of bankruptcy outnumber the entire subprime bubble in the United States".</p><p><strong>Contagion risk: Bear Stearns vs Lehman</strong>. Beyond the large direct financial damage to Evergrande´s investors and debtors, there is a clear risk of contagion to other players in the real estate sector (the largest contributor to China´s economy), and other related sectors such as financials or commodities, both within and outside of China. Some market participants are comparing a potential Evergrande default to Lehman due to the large size, but we believe Evergrande is more likely to be like Bear Stearns: a dot we will connect back in time as hard evidence of the global synchronous bubbles we have created.</p><p>The key is whether the potential default will be managed orderly or disorderly. The most likely scenario in our view is an orderly default (restructuring, hair-cuts, real estate buyers protection, etc) but there is a non-negligible possibility that a debt crisis could spin out of control (a-la-Lehman) via the vicious cycle of volatility, risk reduction, liquidity, correlation, that we have discussed in previous newsletters (more on this below). </p><p><strong>China needs to do more monetary and fiscal. </strong>PBOC (the Central Banks of China) has been injecting liquidity and may need to cut interest rates to address the rising tensions across real estate and credit markets. In addition to aggressive monetary easing, we expect the government to step up fiscal measures too to address its growth target of 6%. In the absence of aggressive monetary and fiscal, Chinese growth, and therefore global growth will suffer and may expose the complacent expectations priced in across risk assets.</p><p><strong>Xi´s Modern Socialism Model is a game-changer. </strong>In addition to Evergrande´s self-inflicted pain described above, there is another important catalyst, more strategic in nature, that has been at play all year whereby the Chinese Government has decided to move away from the Private Western Capitalist Model that has created large private corporations and billionaires (such as Jack Ma and Alibaba) to a new model of Chinese Modern Socialism Model that seeks to regain control via technology and distribute wealth. This strategic change has already created massive losses across the Chinese equities and technology sector in particular.</p><p>Deleveraging will impact growth. Even if the potential default is orderly, we expect further deleveraging across private corporations<strong> </strong>that, as discussed above, will increase the pressure on the Central Government to achieve its 6% target growth plan. </p><p><strong>Don´t forget geopolitics</strong>. In addition to the internal problems China is facing, there is a long-term strategic cold war seeking to control technology and global trade. The relationship between China and the US was very tense with Trump but has not dramatically improved with Biden. Watch out for Hong Kong, Taiwan, South China Sea, delisting of Chinese equities, trade wars, amongst other headwinds that may negatively impact China... </p><p><strong>The End Game is Stagflation</strong>. Overall, as a result of the risk of the fragility of the system and house of cards created by bubbles and wealth effects, we believe the Chinese and Global Central Banks and Governments (the creators of the bubbles) will be forced to respond to the inevitable risk-off and volatility events such as Evergrande´s default with “more of the same” (print, spend, borrow, bail-out, and tax the rich without limits) towards an<strong> </strong>“end game” of inequality and stagflation<strong> </strong>(high inflation, low growth) that is negative for paper currencies such as the Chinese Yuan and supportive for real assets and gold. </p><p><strong>Watch out for Volatility and Risk-Off events</strong>. Whilst Stagflation is the end game in our view, the path will be bumpy. Either the Central Banks and Governments continue the status quo of monetary policies without limits designed to support risk assets at the expense of inflation, bubbles and inequality, or they try to remove accommodation and normalize their monetary and fiscal policies, which in our view will likely result in a collapse in risk assets that will bring us to step one of more monetary and fiscal. Yes, sorry, the damage is already done. </p><p><strong>Structurally bearish the Chinese Yuan. </strong>Worth noting that our view stands in stark contrast to the current consensus and investor flows, which have accumulated large amounts of Chinese Government Bonds at attractive yields (10-year around 3% yield) which is being viewed and positioned as a "US Treasury Replacement". This relatively new development was not there in the 2015 and 2019 currency crises and could add momentum to a potential forced liquidation in the event of a large increase in volatility and/or risk-off event. As discussed above, we believe inflation and currency devaluation are unavoidable due to monetary and fiscal policies without limits.</p><p><strong>Fed Taper is likely to be at a glacially slow pace. </strong>The market expects a reduction to be appropriate "this year" as long as the economy remains on track, but Powell once again maintained optionality about the exact timing. Unless the economy and labour market materially surprise to the downside, the expectation is an announcement by November. In any event, we expect the Taper to be "glacial", kicking the can further down the road, to protect risk markets. </p><p><strong>First USD Interest Rate Hike expected towards the end of 2023, with several hikes expected for 2024</strong>. Powell is likely to separate tapering from rate hike decisions, emphasizing that there is no mechanical link between them. The updated "dot plot" will give more information to the views of the Board. </p><ol start="3"><li><strong> CHINA POSITIONING AND TRADE EXAMPLES</strong></li></ol><p>We already own and continue to selective accumulate insurance against a potential devaluation of the Chinese Yuan, our favoured implementation for Bearish China plays. Whilst implied volatility is low and attractive, the high interest-rate differential between the CNH vs the USD creates a negative carry of approx 3% p.a., a consideration for bearish trades as potential gains during a currency via weaker spot and higher implied and realized volatility would likely be partially offset by lower CNH interest rates. </p><p>We also remain structurally bullish on Gold and continue to take advantage of correlation benefits (the market expects Gold and CNH to move in tandem vs USD) to cheapen the cost of insurance against a synchronous appreciation of Gold and depreciation of the Yuan. This week we added 1-year worst-off insurance risking 1% of our capital with 100% upside to the gold appreciation above spot or the Yuan depreciation vs spot, whichever is lower. In addition to achieving a 70% discount to the vanilla, the structure benefits from neutral/positive carry and positions investors to benefit from uncapped directional and volatility moves. Happy to provide more details as needed. </p><p>In addition, we also own positive carry insurance against a potential devaluation of the Taiwan Dollar, a currency with a very high realized term correlation to the Chinese Yuan that offers both protection against China slowdown and potential geopolitical conflicts, that provides a rare case of tail risk with positive carry. We have accumulated large insurance linked to gold that currently offers 50 to 1 risk reward and could result in large gains for the portfolio. </p><p> </p><p> </p>