Tuesday, April 19, 2016

China’s Pension Gamble?

The Wall Street Journal reports on China’s Pension Gamble:
Beijing recently announced that it will allow state pension funds to invest in stocks, with the hope of lifting returns and aiding equity-market liquidity. This might even be a good idea, assuming China follows through on other market reforms.

State pensions have been restricted to bank deposits and government bonds, but China Daily reports that they will now be able to invest up to 30% of individual accounts in equities, funded by mandatory employee contributions. The move could channel some 600 billion yuan ($92.64 billion) into stocks.

State pensions lack adequate funding to support the country’s rapidly aging population, and investing in assets with higher returns could help make up the shortfall. A 2013 study by the Shanghai Institute of Finance and Law estimated that 8.2 trillion yuan must be pumped into pension funds merely to support civil-service retirees over the next 30 years. Meanwhile, their yields have dipped as low as 2%.

Institutional investors could also reduce volatility in China’s markets, which are still dominated by retail investors. Most small investors are inexperienced, with more then half having a high-school education or less.

The immediate impact on both pension funds and the stock market will be slight. Chinese stocks have been on a roller coaster, so regulators are expected to release funds gradually and restrict initial investments to blue chips. Provincial pension funds are also reluctant to shift money from banks, where investments give them leverage over lending decisions.

The policy’s impact will also be reduced if entrepreneurial companies can’t list on stock exchanges. The China Securities Regulatory Commission approves all initial public offerings and determines their pricing and timing. So it isn’t surprising that IPOs have been marked by corruption and rent-seeking. Three CSRC officials handling IPO approvals were arrested in 2015 for suspected graft.

A two-year reform plan toward a more transparent and fair registration-based system was expected to start earlier this year. But new CSRC chairman Liu Shiyu announced last month that the reforms will be done “in a gradual manner,” without providing a timeline. Funneling pension cash into stocks could be dangerous if reforms stall and pension funds become another tool for the government to manipulate stock prices.

Since markets tumbled in June, the government has been on a buying frenzy. Two entities owned by China’s securities regulator and sovereign-wealth fund spent 1.8 trillion yuan buying stocks between June and November, according to Goldman Sachs. Individual investors have come to believe that regulators will rescue the market when prices decline. This perception will grow when state pensions are involved.

Creating a mature stock market requires more than pumping in additional funds. China’s capital markets need wholesale reforms that minimize political interference more than they need pension money.
Last July, I covered China's pension fund to the rescue, stating the following:
My advice to China's policymakers, stop tampering with the markets, you're only going to turn a steep correction into a deep depression. Your pension funds can invest in Chinese equities but if they don't have the right governance and are told when to buy and sell equities, they're doomed to fail and they will lose a pile of dough which will create an even bigger problem down the road.

I'm far more worried about China now than anything else. If its stock market bubble bursts in a spectacular fashion, it will wreak havoc on China's real economy and reinforce global deflation pressures.

In fact, China's central bank has already admitted defeat in war on deflation. At a time of slowing economic growth and massive corporate debts, a deflationary spiral would be China’s worst nightmare. It  could potentially spell doom for developed economies as China's deflation will reinforce the Euro deflation crisis and potentially create global deflation that eventually hits the United States.

The global reflationists remain unfettered.  They say get ready for global reflation. I think they're way too optimistic and confusing short-term trends due to currency fluctuations, neglecting to understand that the long-term deflationary headwinds are picking up steam. There is a reason why 30-year U.S. bond yields are plunging and it's not just Greece. China and global deflation are much more worrisome.
Last week, I discussed whether the surging yen will trigger another crisis and then followed that up with a comment on whether we should worry about another Asian financial crisis.

A lot of people are getting excited about global growth given how oil prices rebounded after the collapse of Doha talks but I think they're completely missing the bigger macro risks out there.

What are those bigger macro risks? I've been warning you about them ever since I wrote my Outlook 2016, going over the risks of further deflation in emerging markets, especially in Asia, and how a full-blown currency war there will export deflation to the rest of the world.

At this writing, the NASDAQ just went red, biotechs are getting slammed, but the yen is weakening, which is generally good news for global risk assets. The stock market is extremely volatile. Meanwhile, the yield on the 10-year U.S. Treasury bond hasn't really budged, it's still hovering around 1.78% which tells you the bond market isn't getting too excited about oil's rebound following Doha.

In fact, while Jamie Dimon is warning that the Treasury rally will turn to a rout, Bill Gross is warning investors that China growing at 6% is one of many investor delusions which will be exposed.

And Jeffrey Gundlach, the widely followed investor who runs DoubleLine Capital, said on a webcast last week that the Federal Reserve's rate hike cycle "increasingly likely" looks like a one and done scenario this year:
Gundlach, who oversees $95 billion for Los Angeles-based DoubleLine, said the Fed should be cautious with raising rates because of the "gentle downward" trajectory in nominal gross domestic product.

The U.S. economy is growing at a pace below 1 percent in the first quarter, according to the Atlanta Federal Reserve's GDPNow forecast model.

Already, Federal Reserve chair Janet Yellen has been "talking conservatively" about interest rates because it is an election year in the United States, Gundlach said.

Gundlach said the Standard & Poor's 500 index will struggle and trade "sideways" because earnings continue to be persistently downgraded.

Last year, Gundlach correctly predicted that oil prices would plunge, junk bonds would live up to their name and China's slowing economy would pressure emerging markets. In 2014, Gundlach correctly forecast U.S. Treasury yields would fall, not rise as many others had expected.

Gundlach said he is still avoiding junk bonds. "The easy money has been made," Gundlach said. He said the high-yield downgrades resemble the cycle in 1998 and 2007-2008.

DoubleLine has been purchasing Puerto Rico municipal debt as well as commercial mortgage-backed securities.
I'm not even sure the Fed will proceed with a one and done rate hike this year. In fact, if deflationary pressures increase in China, Singapore, South Korea, Indonesia, Malaysia and Japan, you might see the Fed stand pat for the rest of the year, worried that any increase in rates could trigger a crisis in Asia.

And while Gundlach is avoiding junk bonds, I'm increasingly worried of the unprecedented boom in China’s $3 trillion corporate bond market which is starting to unravel:
Spooked by a fresh wave of defaults at state-owned enterprises, investors in China’s yuan-denominated company notes have driven up yields for nine of the past 10 days and triggered the biggest selloff in onshore junk debt since 2014. Local issuers have canceled 61.9 billion yuan ($9.6 billion) of bond sales in April alone, and Standard & Poor’s is cutting its assessment of Chinese firms at a pace unseen since 2003.

While bond yields in China are still well below historical averages, a sustained increase in borrowing costs could threaten an economy that’s more reliant on cheap credit than ever before. The numbers suggest more pain ahead: Listed firms’ ability to service their debt has dropped to the lowest since at least 1992, while analysts are cutting profit forecasts for Shanghai Composite Index companies by the most since the global financial crisis.

“The spreading of credit risks is only at its early stage in China,” said Qiu Xinhong, a Shenzhen-based money manager at First State Cinda Fund Management Co. “Many people have turned bearish.”
It's no wonder a top adviser to the Chinese government has warned that Beijing risks a currency blow-up akin to Britain's traumatic ordeal in 1992 and is openly calling for a 15% devaluation of the yuan.

Great, just what the world needs, another Big Bang out of China will will clobber global risk assets and send everyone scurrying back to the safety of good old U.S. bonds.

But investors remain undeterred, dipping back in emerging markets (EEM) even if some analysts are warning it's a head fake. Indeed, the rally in emerging markets (EEM), Chinese shares (FXI), energy (XLE), metals and mining (XME) and industrials (XLI) since the start of the year vindicate a lot of funds who bet big on a global recovery last year.

Just look at a sample of stocks leveraged to global growth and the move in Industrials (XLI) since the start of the year below and you'd be hard pressed to worry about any global economic shock (click on images):

My take? I think there are a lot of short sellers who got burnt in Q1 but if you think these rallies in sectors leveraged to global growth are going to continue in the second half of the year, you should be smoking up with the nuns growing medical marijuana, which is the image I embedded above.

On that note, I wish central bankers, Chinese interventionists, and global greenshoots the best of luck navigating this market as we head into the second half of the year. Keep your eyes peeled on the U.S. dollar, the yen and emerging market currencies. Something is going to break and it's not going to be pretty.

Below, Bloomberg's David Ingles discusses the stress in China's corporate debt market. So far, it's nothing alarming but that could change very quickly, especially if  another Asian financial crisis erupts in the region.

And while everyone is getting excited about a global recovery which is nothing more than a chimera, one analyst says forget stocks, this year the real money is in bonds. One more reason why hedge fund managers should sell their summer homes, return their hefty fees to investors they bamboozled and join those nuns smoking some hopium!

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