Hong Hao: Markets in Crisis

2018-03-12 IMI

This article appeared in the author’s WeChat public account (ID: Honghaochinastrategy) on February 6, 2018. Hong Hao, Senior Research Fellow of IMI, Managing Director and Head of Research, BOCOM International Summary - It is the collapse of marginal capital efficiency versus interest rate, rather than rising interest rate alone that tends to trigger a market crisis. China’s marginal capital efficiency must improve further, before its incremental nominal GDP can sustain its pro-forma interest rate burden annually. The deleveraging campaign and tightening regulation have triggered a general increase in market interest rates and interest volatility. But the improvement in capital efficiency is falling behind, despite the successful supply-side reform. In the US, 10-year yield has surged above its long-term declining channel, to a level that portended market crises in the past. Prior to the global sell-off, the combination of low volatility, high valuation and tightening global central banks is the worst recipe for the market. Suppressed volatility, through either vol-shorting trades or through market stabilizing schemes, is like a botched face job – it looks good only on the outside. Despite the significant market sell-off, market sentiment stays elevated, suggesting selling pressure can be far from concluding. As price plunges, it can affect the current perception of strong economic fundamentals. Through reflexivity, price itself is the quintessential economic fundamental. As inflation pressure mounts in the near term, and interest rates are still at historical lows, central banks’ hands are tied, even if the sell-off spirals into crisis. For now, we would resist the temptation of catching a rebound through short-term technical weakness. And the market may have seen its high for the first half of 2018. Market sentiment remains elevated despite a significant sell-off. As we write, global markets continue their epic sell-off. Despite the plunge, market sentiment remains elevated. Of course, as the global markets roil, our market sentiment index will continue to shift towards a more neutral stance. But with market sentiment at its elevated level currently, the selling pressure does not appear to be concluding any time soon (Exhibit 1). As such, we would not attempt to catch falling knives, or be lured into technical rebounds that tend to follow any significant correction, before the dusts settle. In our most recent report titled “The Year of the Dog: Lessons from 2017”, just three trading days before this plunge, we warned of an impending correction. We suggest that we need to wait for the near-term market excess to dissipate, before re-establishing our market positions. Our sentiment indicator, albeit not infallible, has an excellent track record. For instance, it pinpointed the market peak in October 2007 when the Shanghai Composite was above 6000 points, and again in June 2015 when the Composite was above 5000 points - two of the biggest stock market bubbles in recent history. During market crisis, the correlation between markets quickly approaches one. As such, our sentiment indicator is a snapshot of global market conditions, especially at inflection points. Exhibit 1: Market sentiment has declined from extreme, but remains elevated.

Surging interest rates due to China’s deleverage campaign portends market risks.In our 2018 outlook report titled “View from the Peak” on 4 December 2017, we discussed how China’s deleveraging campaign had triggered a general rise in market interest rates in the domestic Chinese bond market. Indeed, the sell-off of bonds in November and December at times has been epic. And for the first time in history, the CDB one-year yield surged above the one-year benchmark lending rate. Such occurrences tended to herald market crises in the past, as we wrote in our 2018 outlook report (Exhibit 2). In the same 2018 outlook report “View from the Peak”, we foresaw an investment style change sometime during the first quarter, and posited that the market would look very different before and after the first quarter. Exhibit 2: Surging Chinese bond yields above benchmark lending rate portended market crisis in the past.

Surging long yield in the US also portends market risks. We believe that this latent development has been largely overlooked by pundits. Of course, the surging US ten-year yield is an easy candidate to blame. After all, it has pierced its long-term downward channel. And every time it happened, somewhere in the world there was a market crisis (Exhibit 3). And this time there is no exception. Surging interest rates in both the US and China seem to hint at a more systemic risk at play. Exhibit 3: Whenever US 10yr yield pierced its long-term downward channel historically, a market crisis broke out.

China’s pro-forma annual interest burden can potentially outweigh its incremental nominal GDP; capital efficiency could be declining. The average interest rate on China’s financing is estimated to be ~7%. At an M2 of RMB 168 trillion, China’s pro-forma interest burden should be around RMB 12 trillion. This is compared with RMB 8-9 trillion incremental nominal GDP added annually, calculated at 10% nominal growth on RMB 82 trillion GDP in 2017. That is, China’s annual pro-forma interest burden can be higher than its nominal GDP growth, due to the significant debt burden. Please note that these are very rough estimates. As such, China’s marginal capital efficiency, although may be improving due to the success of supply-side reform and SOE reform, must be rising slower than its interest rate burden. Meanwhile, credit per unit of GDP has surged, suggesting that capital efficiency could be outright declining. Our rough estimates have demonstrated the urgency of the deleveraging campaign. As Keynes posits in his magnum opus “General Theory”, it is because of marginal capital efficiency rising significantly slower than interest rate that will trigger a market crisis. This is either because marginal capital efficiency is collapsing, or interest rate is rising too fast, or both,. Not just because of rising interest rates. At the current juncture, with the global market correction unravelling, the Hang Seng’s return is still at a similar level that coincided with market peaks in the past. Keynes’s words some eighty years ago appear ever so prescient (Exhibit 4). Exhibit 4: Overseas retail sentiment remains elevated; HSI return is at similar levels prior to previous market corrections

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Hong Hao: Markets in Crisis

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