Juggling Dynamite

On Friday China had what some are calling its “Bear Stearns moment”. For the first time ever in the history of the People’s Republic, a domestic company announced it could not make an interest payment due on one of its loans, and Beijing did not intervene or lean on creditors to suppress their claims. In allowing the first ever bond default to proceed, the concept of risk has been introduced to the Chinese $1.4 trillion corporate bond market, that had heretofore been blindly chasing the highest coupon payments with no concern for the creditworthiness of the borrower. The revelation that capital loss is now part of the investment landscape naturally causes participants to re-evaluate risk and look for significantly higher yields in compensation.

Up until this point, Chinese officials were able to pretend and extend in order to keep the Ponzi of Chinese debt ever growing. But reckless spending over the past 5 years amid still slowing global growth and plunging exports have introduced a cash crunch. As in the rest of the world, artificially low yields since 2007 courtesy of belief in government and central bank bailouts, have not eased credit strains, but rather only aggravated them, as households, corporations and governments were enticed to borrow their brains out. See more here: Whistling Past The Graveyard After China’s 1st ever bond default.

Meanwhile copper and iron prices are being suitably whacked lower as metals–hoarded the past few years as collateral for binge-borrowing and off-balance sheet financing–are now coming out of the woodsheds. Broader than China, global investment banks that were churning and burning through most asset markets the past few years are now being squeezed out by tighter regulation and investigations into widespread market manipulation. This is leading them to dump holdings and exit the space.

Copper is now down 28% since April 2011, 5% in just the past 2 days, and iron ore even more. The Shanghai Composite Stock Exchange retraced below 2000 last night, 67% below its bubble peak in October 2007 and now just 13% above its all time low seen in the market collapse of 2008.

As much as precious metal lovers talk about the safe haven currency of gold and silver, to date they too have failed to decouple from global de-levering trends dominating other commodity markets. One might do well to realize that although its true most financial assets and markets have been highly manipulated, hoarded and traded the past 5 years, a cessation of such practices usually leads to lower, not higher prices. So far precious metals have failed to buck that trend.

I vividly recall the mania of previous bull peaks; most recently 2007/08. As risk markets roared away from any reasonable connection with earnings trends, consumer demand or economic growth, participants became increasingly intoxicated and enamored with the fire. The structure was burning as the majority held capital in the flames on the promise of warmth. It is painful to watch this demented cycle prey once more on the weak and ill-informed.

Today as global debt pushes through a mind-boggling 100 trillion (up more than 30 trillion since the credit crisis first exploded in 2007) and margin debt surges to the highest levels ever recorded (chart below), financial conditions are even more treacherous on nearly every risk measurement than 2007 and even 2000. And still the risk-sellers are confidently herding followers toward the warmth of the blaze.

Last week famed Hedge Fund Manager Seth Klarman offered this warning in his client note:

“When the markets reverse, everything investors thought they knew will be turned upside down and inside out. ‘Buy the dips’ will be replaced with ‘what was I thinking?’ . . .  Anyone who is poorly positioned and ill-prepared will find there’s a long way to fall. Few, if any, will escape unscathed.”

See also this excellent overview: 7 signs we’re near a market top

“The market is wearing no clothes

Just like the emperor, the market is wearing no clothes. Right now, many people see only what they want to believe. It’s been a long time since investors felt full-throated fear, and many have forgotten what it feels like. The panic to buy will be replaced by the urgency to get out at any price. No one can know what will cause perceptions to change, but they will.

At the moment, emerging markets are in deep trouble, and what is happening in Ukraine didn’t help. Nevertheless, the CEOs of several major brokerage firms have urged investors to “go long” emerging markets because they are so “cheap.” Once again, these well-educated salesmen are wrong. Emerging markets will recover one day, but not soon. Urging investors to buy on the dip is disgraceful.”

“BBC’s Robert Peston travels to China to investigate how this mighty economic giant could actually be in serious trouble. China is now the second largest economy in the world and for the last 30 years China’s economy has been growing at an astonishing rate. While Britain has been in the grip of the worst recession in a generation, China’s economic miracle has wowed the world.

Now, for BBC Two’s award-winning strand This World, Peston reveals what has actually happened inside China since the economic collapse in the west in 2008. It is a story of spending and investment on a scale never seen before in human history – 30 new airports, 26,000 miles of motorways and a new skyscraper every five days have been built in China in the last five years. But, in a situation eerily reminiscent of what has happened in the west, the vast majority of it has been built on credit. This has now left the Chinese economy with huge debts and questions over whether much of the money can ever be paid back.

Interviewing key players including the former American treasury secretary Henry Paulson, Lord Adair Turner, former chairman of the FSA, and Charlene Chu, a leading Chinese banking analyst, Robert Peston reveals how China’s extraordinary spending has left the country with levels of debt that many believe can only end in an economic crash with untold consequences for us all.”

Here is a direct video link to the full report (not presently available for some reason, check back later).
Here is a segment clip from the full report.

Here is a second segment clip.