Bear Traps
November 27, 2015
Bear Traps @ The Bear Traps Report
Independent investment letter focusing on global political and systemic risk

China - Global Epicenter of Risk

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Ideas from The Bear Traps team:

The global epicenter of risk lies in China. If you’re long U.S. equities, navigating systemic risk coming at American markets from Asia will be the key to delivering alpha, above average returns. It's very clear the 12% drop in U.S. equities over the summer had its genesis 6600 hundred miles away from Wall Street, close to the Forbidden City. We must manage these threats in the coming months.

This isn't the 80's or 90’s where US GDP was 50% of global output. Today, the US’s 18 trillion of GDP is just a fraction of the globes 78 trillion. Equity performance will be driven by the Fed and developments far outside the United States.

iTraxx CDX Index is a basket of credit default swaps used to hedge credit risk and a solid leading indicator for U.S. equities. When credit under-performs, global stocks tend to follow and sell off. Currently, the iTraxx is starting to widen again, this will most likely be followed by U.S. equities rolling over. The Investment Grade CDX is family of CDS' covering North America and emerging markets. Similar to the iTraxx CDX, a very good risk indicator.

The Fed has been trying to talk the dollar lower with little success, this will prevent them from raising rates in December, and push out to 2016, most likely June. Asian credit has been a very predictive leading risk indicator for U.S. and European stocks.

China continues to throw $50 billion dollar punches at a $5 billion dollar problem and as we've sated in multiple Bear Traps reports, we expect them to devalue their currency going forward. It's our estimation the remembi is 15% overvalued. Unless you have a good grasp on Chinese banking policy, we suggest to stay clear as wild currency swings will surely intensify overseas.

Banking System & the Trillions of Dollars of Debt

It’s our belief as money leaves China the beast will near its ugly head bringing other global markets with it.

Furthermore, we don't see any catalysts for this to change and as bad loans begin to be written off, fund flows should continue to be drawn out of emerging markets.

Its worth noting that Goldman Sachs is citing major out-flows which are cause for concern and the figures released by the PBoC are spotty at best. FX renminbi purchases declined $120B in September, which added to the $115B decline in August. At this rate, a full blown QE program by China would need to be launched in 2016.

The real concern isn’t that China and all emerging markets are slowing, but the hidden bank balance sheets and the leverage the consumer has taken on.

Interest rates at zero for 6 years and $4.5 Trillion of QE was an experimental drug. It pumped up asset prices and helped the Chinese borrow dollars. Chinese debt increased from $11 trillion pre-QE to $33 trillion today.

Outstanding Loans in Asia are up 400% in the past 15 years, U.S. based economists continue to ignore this when evaluating Fed policy.

All this debt led to an infrastructure boom in China and an expansion of "ghost cities". In 2015, local governments advertised over 3.5 trillion yuan worth of projects, we feel this pace is highly unsustainable, especially for a country that is heading towards a recession, taking the globe with it.

Chinese leadership made their position clear over the last decade; they wanted to buy resources in vast quantities as Wall Street told us "farmers were moving to cities, changing their diets". This buying helped resource nations such as Canada, Australia, and Brazil weather the global recession in 2008 better than most, however a lot of the companies funded growth via leverage and the taps are slowly being turned off.

Developed Markets Global Debt Load

2015: $97T

2000: $32T

1990: $11T

As China devalues their currency, the spread between FX renminbi deposits and the dollar grow and there will be more to come.

Developed Markets GDP Growth:

2015: 3.1%

2000: 7.8%

1990: 8.2%

Commodities & China's Hard Landing:

It's our assessment that the return of the commodities complex is near, although we believe China is just starting to slow down. Gold miners as an example are down almost 80% from their highs and a lot of negative news has been priced in. However, most of these assets are priced in dollars, and sensitive to Fed policy. As currency wars escalate, we'll see a more market accommodative FOMC, trying to stop the dollar's surge.

China's export growth is declining:

2015: -8%

2014: +14%

2013: +10%

2012: +16%

2011: +33%

2010: +45%


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