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The Growing Trend of Chinese Corporate Defaults

01 March 2019

Precious metals eased lower this week with gold retreating to USD$1,313 on the back of a stronger US GDP print, and silver dropped to USD$15.60 per ounce. Palladium looks like it may have potentially found a top at USD$1,564 and platinum rallied sharply to USD$867 per ounce.
 
We talked recently of the dislocation between the platinum to palladium ratio as palladium continued to look very bubbly. It is finally looking like the ‘sell palladium to buy platinum’ trade may be in play soon as the premium between the two metals of around USD$700 is not expected to last forever. Gold, palladium and platinum charts in USD are shown below respectively.
 
CFDs on Gold
CFDs on Palladium
CDFs on Platinum 
 
In local currency terms, the AUD/USD hovers just under 71.00 US cents, with gold trading at AUD$1,853 and silver at AUD$22.15 per ounce. We warned of the likelihood of gold in USD terms pulling back a bit in last week’s update, stating that ‘gold is looking short-term overbought on the weekly chart, and at risk of coming into some resistance on the back of profit taking around this level.’
 
So we have had a small dip in price after a substantial rally since late last year, with the news of geopolitical escalation on the Indian-Pakistani border not enough to get the yellow metal moving higher.
 
Reports of an Indian fighter jet being shot down in Pakistan this week sparked further escalation of the crisis between the two nuclear powers. Pakistan claimed to have captured an Indian pilot and there are rumours of tanks amassing on the border of both sides. More can be found on this here.

 

U.S. Mint Silver Coin Demand Exhausts Supply

 
With silver prices lagging gold of late and the ratio at extremes, it makes sense that we continue to see very strong demand for silver at these low levels. Likewise, the U.S. Mint has seen silver bullion coin sales double in February compared to the same month last year, leading to demand exhausting supply and waiting periods for new orders.
 
The U.S. Mint has sold over six million American Eagles year-to-date, which is remarkable given it took until the end of April to reach that number last year.
 
The U.S. Mint numbers usually give a good indication of where physical investment demand sits, as we continue to see silver sales picking up domestically of late too, as the ratio of 83+ makes silver seem the better value currently.
 
U.S Mint Silver Eagle Sales
Source: GoldCore
 
 

The Growing Trend of Chinese Corporate Defaults

 
There are two concerning trends developing in China of late – one being that the highly dubious GDP growth numbers are starting to tick lower, and the second is that large corporations are continuing to miss bond payments.
 
Labelled China’s “JPMorgan Wannabe” by Bloomberg, China Minsheng Investment Group (CMIG) has reportedly missed another bond payment this week leaving bondholders on the hook. They are the second of two large Chinese borrowers who have missed payment deadlines just this month, highlighting the issues with corporate debt in China.
 
CMIG is certainly an interesting one, with over USD$34 billion in debt after splurging on USD$46.3 billion in assets from Bermuda to London.  When you have a government guarantee to come up with funds for your bond payments, it surely has to influence the level of risk you’re willing to take on new investments.
 
CMIG is but one example of a growing behemoth state-backed enterprise in China that has enjoyed the advantages of easy credit and central government backing. But after a splurge in investments, it doesn’t even have the earnings or cash flow to come up with enough money for bond payments. When it comes to China, only one can guess the number of similar inefficient firms that are being propped up by government funds, and this strategy to run an economy never ends well.
 
Investment and acquisitions 
 
In true “Big Short” fashion, despite the slither of net profit the company reports in comparison to it’s liabilities, the company has a AAA credit rating by ‘Shanghai Brilliance Credit Rating & Investors’ Service’ – ring any bells?
 
CMIG's profit and loss
 
As China reins in the shadow-banking system that supported its private sector with cheap credit in recent years, companies that were meant to be pillars of the nation’s growth are proving to be surprisingly fragile.
 
China has been struggling to limit surging corporate debt as the issue has recently taken a back seat to the propping up of short-term growth. We talked of the Chinese official GDP QOQ numbers looking way too consistent to not spur scepticism, and if growth is slowing, the level of bad debts may start rising to the surface. Last year saw a new record for bond defaults in China and 2019 is off to a cracking start:
 
Record Defaults 
 
The concern is that the issues with China Minsheng Investment’s (CMIG) are not isolated and are in fact wide spread.
 
Just last week in fact saw the first government-owned enterprise debt default in 20 years, as Qinghai Provincial Investment Group failed to pay an USD$11 million interest payment on an offshore USD$300 million bond on Friday.
 
Why this is so significant is that it must be a sign of the increasing strain on corporations spilling over to debt loaded provincial governments. As for how wide spread the problem could be, China now has more distressed corporate debt than all other EMs combined. Furthermore, many debts are held offshore in US dollars, so any weakening of the Chinese Yuan would see the cost of borrowing rising further, and more firms failing to meet upcoming payments. According to the Bank of International Settlements (BIS) China’s overall debt to GDP ratio sits at 255% of GDP, with its corporate debt alone standing at 160% of GDP, well above Japan or the US.
 
China's distressed bonds fuels
 
The short term strategy of government to prop up cash strapped corporations will surely lead to long term implications for the broader economy.
 
For more reading into the Chinese credit expansion, one can research hedge fund manager ‘Kyle Bass’, famous for betting against subprime mortgages during the 2008 financial crisis, or you can read further on a recent detailed ABC News article here.
 
 

1% by Melbourne Cup Day

 
Westpac has come out with a call for the Melbourne Cup and it’s not a pick for a horse, but rather a call that the RBA will cut rates twice before Melbourne Cup day this year.
 
Anticipating lower than forecasted GDP growth this year, the bank expects a cut in both August and November, which would put the cash rate at a low 1%.
 
For a short video on why, you can see Bill Evans on ‘the case for RBA rate cuts’ here.
 
Westpac released its February Housing Pulse Report and there are some interesting charts, as it is starting to become obvious that further material weakening in housing markets is set to continue into 2019-2020.
 
Firstly, consumer sentiment towards property price expectations can be seen below and price expectations have plummeted to the worst level since 2009.
 
Consumer Sentiment Housing 
 
With lower expectations for prices, it is obvious that the sentiment in the market has undertaken a massive shift, leading to clearance rates falling and new listings spiking, as owners start to get concerned about prices rolling over and may have started panicking.
 
Auction clearance rates/ residential property listings
 
GDP growth is expected to slow moving forward and if we indeed see a 1% cash rate this year, one could expect two things:
 
1. Cash deposits in banks will have even lower returns in the near future
2. The AUD/USD will come under a huge amount of selling pressure and likely fail to hold above 0.70c this year.
 
One could argue that a lower cash rate should encourage money to move out of bank deposits, off the sidelines, and further into risk assets as investors seek higher yields. But we think this won’t be enough to spur a further bubble in property. Although one might see those higher dividend yielding stocks looking more attractive, the trouble is that the ASX performance will be somewhat reliant on positive US equity market performance, which is hard to see materialising given the extremely high valuations of the market in general, and the fact that the Fed is moving in an opposite tightening direction. 
 
As gold is a defensive asset class that is often seen as an alternative to holding cash, the case for allocating a higher percentage of your cash position into PMs only rises if rates move lower. The absolute real returns of a savings account will be negative after inflation, and any interest earned is taxable in full.
 
The case for gold should only be stronger if the RBA does follow the path that Westpac expects. What’s even more concerning is that the RBA sees Quantitative Easing as a success and a tool that could be deployed if rate cuts aren’t enough to keep the economy from falling into a recession. So don’t be surprised in a few years if we see some form of QE here in Australia as we follow the US housing bubble narrative tick for tick, only 10 years later.
 

Until next time,
 
John Feeney

Disclaimer
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