Russia / China – The Great Wall of Worry

Radioactive_ashes_-_Google_SearchBy David Nelson, CFA

Markets in the U.S. will likely face their biggest test this year over the next couple of months. There are two dynamics investors will be forced to confront as we head into spring.

First of course is the ongoing crisis in the Ukraine with governments and investors trying to decipher Putin’s next move. On Sunday, Crimea with a largely ethnic Russian population, voted to join Russia. Next steps are unclear. Already President Obama and other world leaders have said they won’t recognize the referendum.

China is the Bigger Nightmare

Despite what looks like a return to a Cold War Politics, I feel the financial issues in China are of more concern. Markets of course react violently to geopolitical turmoil and the ongoing crisis in the Ukraine certainly qualifies. However, in the end market and stock prices will be determined by earnings and investment flows. Unless it turns into a shooting war, I doubt the annexation of Crimea will dent the earnings at Home Depot (HD) or Google (GOOG).

Investors are always concerned about something, hence the phrase Wall of Worry. Well, I’m no different from you and have my own demons that keep me up at night. For me, China is the bigger nightmare.

Earlier this month I was interviewed on Canada’s Business News Network BNN and asked my thoughts on the coming bond default in China by Shanghai Solar Company Chaori. During my comments I said; “ultimately this is good thing as China’s bond markets are finally showing some signs of maturity.” I went on to say that, “While there may be a knee jerk reaction I don’t think this will be a Bear Stearns moment.” 

I haven’t wavered on my first statement but my confidence level on the second is rapidly waning. It seems the acid test is likely to come between the months of April & July this year. A high level of Chinese corporate debt and collective trusts are about to come due. The trusts are of even more concern since low quality borrowers tend to use these vehicles. Falling coal prices put the coal mine trusts particularly at risk.

David Cui of Merrill Lynch has done some excellent work in this area and the chart below shows increasing levels of debt and trust maturity dates during the April to July time frame.


How Big is the Problem?

China is an opaque society and very difficult for investors to analyze. They let us see what they want us to see. Many believe including yours truly that government data coming from China including past releases shouldn’t be relied upon.

Outwardly, it appears that President Xi is attempting to normalize the financial system and even embracing some free market reforms. The widening of the Yuan trading band while still a small gesture, is a step in that direction.

We’ve all seen the pictures of brand new buildings in China completely empty, looking eerily like an end of world holocaust. It is clear that for some time China has been operating under a framework designed to show growth at any cost. The questions investors have to wrestle with today are the following;

  • Is President Xi permitting us to witness data in real time accurately or, is he trying to deflate the bubble slowly giving us massaged numbers hoping at some point to get the bad news out?
  • Were the growth numbers we saw in previous years a complete fraud?

Last week economists were taken back after a wave of releases just prior to Chinese Premier Li Keqiang once a year news conference. During the conference he made it clear to expect a ratcheting down of growth expectations. Most economists have cut their GDP expectations from about 8% to just above 7%. February’s export numbers were down over 18%.

In a vacuum 7% GDP seems like a great number but again coming up with real estimates seems more of an art than a science. Frankly, given my lack of confidence in their reported data, I wouldn’t be surprised to see a minus sign in front.

China is unwinding a growth mirage that was never sustainable based on an implied government guarantee and shadow banking system. To make the necessary reforms the new administration is faced with the task of juggling growth alongside investor demands for market reform.

Admittedly getting through the news coming from the Ukraine this week is going to be job 1. Watching a Russian news anchor in front of a mushroom cloud saying Russia “is able to turn the USA into radioactive ashes,” doesn’t give investors a warm and fuzzy feeling. Despite these concerns I believe the larger issue is China’s ability to navigate a minefield of defaults in the weeks and months ahead.

Funds managed by David Nelson are long shares of GOOG