China reforms quietly begin to take effect
While we’ve all been waiting for China to devalue the yuan in order to expedite a long-overdue deleveraging process, the communist government may have been staging a bank bailout under our noses the entire time. UBS this week released analyses of 765 banks in China that shows a financial system cleanup well underway. The sector shed 1.8 trillion yuan ($271 billion) worth of bad loans between 2013 and 2015, raising nearly a third of that total in fresh capital over the same span. However, those measures are not enough to solve the problem entirely, with the Swiss bank estimating the need to shed an additional 4.5 trillion yuan of sour loans and infuse another 2 trillion worth of yuan in fresh capital to bridge shortfalls.
While efforts to shore up bank bailouts are underway, they widely from region to region.
“The write-offs undertaken by banks to date are certainly material but deeply inconsistent across the banking sector — and far from enough, in our view,” said UBS’s Jason Bedford said. “This is concerning and we believe that for every lender who has implemented an asset resolution plan, many others have not.”
China has for the past two years expressed intentions to begin the reform process in earnest, but been unwilling to pull the trigger for fear of stoking instability. UBS expressed concern about the continued expansion of credit, but we’re starting to see signs the government is taking the methadone treatment more seriously. Not only are Chinese companies continuing on aggressive M&A spreesto diversify out of the local currency, highlighted this week by a mooted $13 billion utility deal in Brazil, but bank lending has plummeted. The 493.6 billion yuan in new loans during July was the lowest figure in two years and well below estimates of 800 billion.
In addition, China’s economic activity slowed in July at its fastest pace since December 1999. Analysts had expected fixed-asset investment to rise 8.8% in the January-July period, but instead the figure increased only 8.1%. The shortfall was highlighted by a 22.9% decline in mining, evidence the government is fast-tracking the transition from industrial to consumption-driven economy. Today 530,000 former steel and coal workers now drive for ride-sharing service Didi Chuxing. China’s trade activity also declined while its surplus widened following 4.4% and 12.5% declines in export and import growth, respectively.
China is expected to continue with fiscal measures and structural reforms to stimulate growth rather than pursue more dovish monetary policy, which officials fear could put downward pressure on the yuan. Beijing is hoping the Keynesian multiplier can help the country’s economy grow out of its current problems as it did in the early 2000s. However, the conditions today are much different than a decade ago when global demand was more robust and China was well-positioned to benefit from entry into the World Trade Organization (WTO). With true federal and local debt likely near 50% of GDP, China’s credit expansion must stop –“either by choice or by force.” Beijing is now showing signs of wanting the deleveraging to take place on its own terms.
U.K. ECONOMY’S BREXIT HONEYMOON IS OFFICIALLY OVER
The British economy had one last hurrah in Q2 before the adverse effects of Brexit were expected to rear their ugly head. This week those fears became reality. Due largely to a steep drop in domestic consumer confidence, U.K. home salesdeclined the most since 2008. Data also showed home prices rising just 0.2% in July, down from a 5.5% annual growth rate. The Bank of England (BOE) has alsobegun to note a slowdown in job creation and investment from companies in the U.K. For top banking talent, the Brexit has caused London to lose some of its allure, with Goldman Sachs continuing to warn about a restructuring.
The greatest source of anxiety among multinational firms is uncertainty over Britain’s future standing with the single market, an E.U. construct allowing for free trading and movement of labor within the bloc. New U.K. Prime Minister Theresa May has expressed hope of leaving the E.U. while retaining access to the single market, but it appears E.U. officials are drawing a line in the sand. A Bloomberg survey of E.U. finance ministries found the overwhelming majority of E.U. countries, including Germany, believes the U.K. must allow free movement of labor if it wants to maintain single market access. Norway has been the most up front about potentially blocking the U.K. from rejoining the single market in any Brexit scenario.
The BOE has attempted to dampen the impact of Brexit with last week’s aggressive stimulus measures, which pushed the GBP/USD below 1.30 this week. However, even BOE Governor Mark Carney has acknowledged the limits of monetary policy, expressing an unwillingness to join with the European Central Bank (ECB) in moving rates into negative territory. With negative rates backfiring– causing more people and businesses to save rather than spend — who can blame him? Even the IMF has told the ECB to forget negative rates, which do more harm than good.
The biggest victim of the BOE’s new term-funding scheme has been Britain’s residential mortgage-backed securities (RMBS) market, which is likely to lower issuance that will further starve pension funds and asset managers of highly-rated paper.
PRODUCTIVITY DECLINE ALLOWS LABOR TO MAKE GAINS VERSUS CAPITAL
How can U.S. job creation be so rampant while headline GDP grows at such a lackluster pace? The answer is complicated, but the phenomenon owes most directly to a persistent slowdown in average worker productivity since the financial crisis.
Productivity during the business expansion starting in 2009 has been very low compared to historical norms, averaging barely 0.5%, or less than half its historical average in previous cycles. Last quarter non-farm productivity fell 0.5% following declines of 0.6% and 2.4% in the two previous quarters, pushing the year-on-year total into negative territory at -0.4%. It’s likely to stay there with the positive 2% print from Q3 2015 soon dropping out of series. This is only the second time since the start of the post-crisis expansion that annualized productivity growth has been negative.
As a byproduct of falling productivity, labor is starting to wrest back share of the economic pie from capital — reversing a 30-year trend. While unit labor costs have surprisingly not accelerated as sharply as expected (up only 2.1% from a year ago), a tighter labor market will continue to favor workers in wage negotiations. Private wages grew by 0.8% in July, a 10% annualized rate. While robust job gains are positive for future U.S. consumption, for the U.S. economy to grow more rapidly will require at least a slight normalization in historical productivity.
FINTECH CAN’T IGNORE ITS WALL STREET PARENTAGE
With global banks shedding jobs in the more tightly-regulated post-crisis world there has been greater attention paid to financial technology, or fintech. Electronic trading outfits like Virtu have increasingly taken control of market-making and liquidity provision, with Bloomberg running a feature on the company that never loses and its quest to re-make markets. But while Virtu has been a dominant player in speed-trading arms race, it isn’t alone in its ambition. Fintech startups have been shaving nanoseconds off trade execution, accelerating the push toward the speed of light. Even big banks like JP Morgan are enlisting the help of high-speed traders in order to understand short-term volatility in markets.
Meanwhile, the more fintech and cryptocurrencies grow, the more they come to resemble traditional finance. Bitcoin’s startling rise has been undermined by several high-profile hacks. The most recent setback came last week when Bitfinex, the largest U.S. bitcoin exchange, lost track of around $70 million worth of the digital currency. With its credibility compromised, analysts now wonder whether the exchange can survive. Facing potential insolvency, Bitfinex has socialized the losses among all of its account holders, replacing bitcoin tokens with new equity. In the real world that’s called a bankruptcy, and the process exists for a reason. So while banks have found success implementing blockchain-like distributed ledger technology in trade settlement processes, the more things change the more they’re likely to stay the same.
QUOTE OF THE WEEK
“Contrary to market perception, bank recapitalisation and bailouts have begun. Most interestingly, for the first time in a decade we note formal implementations of asset restructuring plans and recapitalisations and bailouts of individual — and large — institutions.”
- Jason Bedford, Director of Asian Financials Research at UBS Investment Bank, on China’s under-the-radar bank bailout
Amid the unwinding of the post-Brexit risk-off trade, banks are raising their guard against the possibility of a crash in Japanese government bonds. Among the nightmare scenarios for markets would be sharp a JGB correction that couldtrigger forced selling from risk-parity funds, which target bands of volatility within fixed income and have become popular among institutional investors.
Goldman procrastinated on unwinding its ownership in hedge funds and private equity firms and is no longer confident it can sell the stakes in time to meet regulatory requirements. Somebody could get a good deal. Wall Street banks want to avoid a similar situation with trading desks, asking the Fed for five more yearsto comply with Volcker rule.
The venture capital payoff structure rewards risky bets and big payoffs while accepting failures. “You need, in a sense, to ‘suspend disbelief’ — to put aside your normal human risk-aversion and skepticism, accept the probability that it could go to zero, and ask if this could ‘put a dent in the world’, and if so, how big.”
Post-crisis regulation has put the clamps on bank holding companies while creating opportunities for companies that didn’t take bailout money. Jeffries is one such player benefitting from its ability to make bolder moves than its peers.
While they should have been shoring up capital levels post-crisis, banks in European stress tests have paid out 20 billion euros worth of dividends since 2011– increasing the burden on bondholders and taxpayers should they fail.
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