So last week, I put you on “contagion alert” amid the chaos in commodities.
I’m not entirely sure why, but it doesn’t seem like people generally appreciate the extent to which collapsing metals, plunging crude, and China squeezing leverage out of the system is a really – really – bad combination of factors when it’s bumping up against an emerging markets complex that’s already been strikingly resilient in the face of an ostensibly challenging environment.
That is, everything with an EM prefix has managed to remain buoyant in the face of a looming Fed tightening cycle, which means the situation was already precarious.
And EM equities have so far managed to completely decouple from commodities:
To be sure, some of this has to do with the recent stability of the yuan:
But I’m not entirely sure how sustainable that is. This has always been a tightrope walk for China – devalue to support the economy, but don’t devalue too much because if you do, you’ll exacerbate capital flight, which will feed back into more RMB weakness, which will mean spending more FX reserves, and around the doom loop we go.
Well, recent data (PMIs and export/import) suggests the economy is rolling over. And that’s at the same time that Beijing is attempting to rein in leverage and speculation by draining liquidity and hiking OMO rates. If we’ve learned anything in the past couple of years, it’s that no matter how hard the Politburo tries, keeping growth at ~6.5%, keeping the RMB stable, and deleveraging are not goals that can all be pursued at once. They’re inherently incompatible. And last week, that inconsistency was readily apparent when the metals complex “snapped.” Here’s Citi from a couple of days ago:
Chinese macro uncertainties and onshore liquidity tightness concerns dominated recent metal market discussions, and the large-scale unwind of the “reflation trade” has sent prices of the industrial metal complex, including iron ore, steel, base metals, and to some extent coal, to their YTD lows.
One of the major drivers of the recent industrial metal sell-offs were increasing concerns over Chinese monetary conditions and macro slowdown. On April 26th, President Xi made a rare speech on financial stability during Politburo study meeting. Following the speech, the Chinese government is expected to implement specific measures on tightening financial regulation, preventing financial risks, and ensuring the absence of systematic risks. Citi believes these measures will likely lead to higher and more volatile money market rates than before. To contain such risks, the PBoC would likely need to resort to RRR cuts when its open market operations are no longer capable of smoothing onshore interest rate spikes in the near future.
When it comes to the commodities market, rising Chinese money market rates not only triggered large-scale unwind of the earlier reflation trades (mostly in the onshore futures market) which pushed iron ore lower, but also forced physical traders, especially the ones who stocked up with high leverage, to liquidate inventories, as well as accelerated the shift of downstream inventory cycle from restocking to destocking.
Note that first bolded passage. So that would seem to suggest Beijing is going to have to cut policy rates in order to offset OMO hikes. That just underscores how absurd this is and how convoluted this micro-managing effort has become. Here are some useful passages from Bloomberg:
What may be shaping up as China’s most concerted effort yet to bring its credit boom under control is spurring investors to gauge any contagion to broader financial markets, a-la 2015, when Chinese turmoil caused global ructions.
Policy makers’ moves to crack down on leverage have already wreaked about $500 billion of financial damage domestically, and — along with evidence economic growth may be peaking — are dragging on industrial metals and iron-ore prices globally. The key metrics to watch now: the yuan’s exchange rate and cross-border capital flows.
For now, what’s giving heart to foreign investors is China’s success in tamping down capital outflows, as seen in foreign-exchange reserves rising for three straight months. Also, moves to rein in shadow banking and tighten liquidity in money markets in recent months haven’t been accompanied by any unexpected tweaks to exchange-rate policy. Finally, there’s the ultimate sedative for investor anxiety: confidence that President Xi Jinping will avoid any major market crash before the Communist Party’s leadership gathering this fall.
Unlike developed nations in recent years where debt growth was concentrated at the national government and household levels, credit in China has boomed in corporate and local-authority spheres, much of it off official balance sheets — in a country where accounting standards are still in a process of development.Leverage has periodically inflated prices of everything from commodities to property and stocks.
So that last bolded passage is a reference to the country’s labyrinthine shadow banking complex that’s littered with all manner of toxic instruments including, but certainly not limited to, maturity-mismatched WMPs and entrusted bond deals, with the former a “known unknown” (so to speak) and the latter having proven its ability to destabilize markets in December. Back to Bloomberg:
The latest regulatory moves have brought some off-balance sheet items, including wealth-management products, under greater scrutiny, triggering a series of knock-on effects, including a near-shutdown in some areas of the onshore market for corporate bond issuance. Commodity prices have also been hit globally, with iron ore and copper tumbling, along with oil — though particular markets have been marked as well by global supply concerns.
What hasn’t happened is a broader hit to emerging markets, often seen as leveraged to China’s growth rate because of the second-largest economy’s influence on appetite for riskier assets more generally. South Korea’s stock market hit a record high Monday, and emerging-market bond premiums are still historically low, for example.
The subdued dollar is helping, with expectations for U.S. economic reflation easing and investors confident that the Federal Reserve isn’t about to embark on an accelerated tightening path that pulls down emerging-market currencies. That’s allowed the yuan to serve as an anchor for other exchange rates as well.
“Remember that what’s been achieved has happened while the dollar was stable,” Gene Ma, chief China economist at the Washington-based Institute of International Finance who previously worked at Tudor Investment, said at a Tokyo conference Tuesday, referring to the drop-off in Chinese capital outflows.
Again, this is so ridiculously precarious that it’s difficult to find the right words to describe it. Throw in the resurgent dollar and the outlook looks even more uncertain:
“Investors should reduce exposure to developing-nation currencies as supply-side pressures on commodities are still elevated,” Morgan Stanley’s Gordian Kemen warned on Tuesday, adding that traders should “watch inventory data for commodities to gauge risks for EM currencies [and be aware that the] pick-up in U.S. yields [is] not helping EM either.” Ultimately, Kemen says DXY should continue rebounding.
And while there are some counterarguments (see Goldman’s latest on commodities and note Richard Breslow’s point about not worrying so much about your carry trades and focusing a little more on the positive effects lower commodities have on DM economies), I would caution that from where I’m sitting, this looks like a disaster waiting to happen.
If anything goes wrong – that is, if any of the spinning plates highlighted above come crashing down – this could easily have spillover effects for global markets. Anyone who remembers August 2015 and/or January of last year knows how quickly this can spiral out of control.