Wednesday, April 2, 2014

The biggest risk to today’s markets – an end to perpetual bailouts

By: John Stepek

China has been creeping up everyone’s worry list again recently.

While Ukraine has been grabbing the headlines, in the background, China’s growth has been slowing. The currency has slumped (within its tightly controlled boundaries, at least). A few companies have gone bust – a rarity anywhere these days, let alone China.

Its government is now even talking about ‘stimulating’ the economy again.

Should we be worried? You should certainly be keeping your eyes peeled for trouble – but perhaps not quite in the way you might expect.

Janet Yellen © Getty Images

China needs to reverse financial repression

The FT this morning looks at China’s banking system, and the threat from falling property prices in particular.

For anyone new to the China story, here’s a quick summary of the state of play. When the global financial crisis hit in 2008, global trade dried up. That could have scuppered China’s economy, which relied on selling cheap stuff to the rest of the world.

With demand drying up, banks were ordered to lend money hand over fist. Infrastructure deals and property projects were funded left, right and centre, with no real care for whether they could pay for themselves or not.

The country is now dealing with the fallout from that. China wants to become an economy that’s driven more by consumption than manufacturing. For that to happen, savers need to get a better deal.

At the moment, returns to savers are ‘repressed’ in favour of keeping money cheap for big borrowers. China needs to change that if it wants its economy to change. But that’ll involve some short-term pain, as interest rates rise and unproductive investments are wiped out.

China’s problem is our problem too

The point of the FT piece is that most people in Hong Kong and China apparently believe the government can handle all this. One way or another, it’ll make everything OK.

However, the most insightful line in the piece comes from a ‘prominent Hong Kong credit investor’. He highlights one key fact: yes, the government might have the capacity to bail everyone out. But will it necessarily want to?

“We have become too accustomed to bailouts. Everyone focuses on the government’s ability, not its willingness, for bailouts. We are all too complacent.”

What I like about this line is that he’s summed up not just China’s problem, but the whole world’s problem.

Over here in the West, we laugh and point at China for funding ‘ghost towns’ that will never pay off. But investors in this neck of the woods are being pretty indiscriminate about what they choose to fund as well.

As the FT also reports this morning, terms for ‘leveraged loans’ have never been more lax. Broadly speaking, leveraged loans are loans to companies that already have debt, so they’re on the risky side of the lending spectrum.

There have already been lots of worried mutterings about ‘cov-lite’ loans (loans with few covenants or protections for investors). Now a big buyer of these loans – US fund manager Eaton Vance – is complaining that things are getting even worse.

Under what it calls ‘cov-lite 2.0’, borrowers are getting even better terms. As one leveraged loan manager put it: “there is a tremendous amount of flexibility that the borrowers are getting that they haven’t typically got in the past… So you’re really not quite sure what you’re lending to from day one”.

What this boils down to is that – thanks primarily to the ongoing actions of the Federal Reserve across the career of most of today’s active investors – investors believe that default risk has been abolished. If things go pear-shaped, an ever-forgiving central bank will step in to bail everyone out.

So in the desperate hunt for returns, they’ll lend money to just about anyone on any terms, as long as they can eke a half-decent yield out of it.

This is an understandable path to take. It might not be sensible to buy expensive equities or to lend money on very forgiving terms. But the Fed has conditioned everyone to over-ride their better instincts, or face losing out.

However, what if there comes a time when the Fed can no longer come to the rescue without inflicting serious damage elsewhere in the economy?

Inflation could leave the Fed between a rock and a hard place

How could this come about? The Fed is already trying to ‘exit’ quantitative easing (QE). The assumption is that any hint of a renewed slump would see QE start up again. Fed boss Janet Yellen hinted as much in a speech yesterday, which soothed market jitters over her earlier suggestion that interest rates might rise sooner than expected.

But there is one thing that could stop central banks from simply hitting the ‘print’ button in the future – a return of inflation.

It might seem a long way off just now, but Esther George, head of the Kansas City Fed warned the other day that she sees some signs of pressure to drive wages higher. The US apparently faces a shortage of skilled welders at the moment (Google ‘welder shortage’ if you fancy retraining) due partly to the phenomenon of ‘reshoring’, where manufacturing jobs are returning to the US.

If inflation did rear its head again, central banks would suddenly be under real pressure to tighten monetary policy. That would do two things: it would destroy the belief in perpetual bailouts, and it would leave lots of investments made at low yields looking very poor value indeed.

My colleague Merryn Somerset Webb has been talking to Dr Pippa Malmgren about how inflation could make a comeback. The full interview is in this week’s issue of MoneyWeek magazine – you won’t want to miss it, as this could be one of the biggest themes shaping all of our investment choices in the coming years. If you’re not already a subscriber, make sure you catch it by signing up to get your first three issues free now.

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