China Is Headed For Its First Domestic Bond Default – Is It Good or Bad For Investors? Remember GITIC?
For those who remember, 16 years ago in 1998 (2 years after I started my working life) GITIC, a provincial investment vehicle in China defaulted on its dollar bonds that had caused foreign banks and investors to panic. At that time, it was labelled as the first foreign bond default by a provisional government in China since Chinese Revolution in 1949. Why did the government allow GITIC to default and what was the consequences of it? The Chinese government allowed GITIC to default as a signalling to investors that they should be held accountable for their reckless lending. The consequences were future investors were being more selective in their lending and reassess the lending risk on Chinese companies.
Fast forward 16 years, the market potentially will see the first domestic bond default through Chaori Solar and potentially many more in weeks and months to come. This is much needed and timely to promote better lending and investment habits in China going forward. China is an economy with huge domestic net savings despite the strong credit growth in recent years. Hopefully through this lesson, efficient allocation of capital to those that need, deserve and more importantly value-add to the economy will help the government to maintain appropriate monetary condition to support the economic engine.
I have a strong feeling that domestic investors, both institutions and individuals will start to be more selective in their lending and investments. Inefficient and sub-par credit policies will see further improvement. Credit spreads of companies will start to reflect fundamentals of the borrowers rather than purely on implied ownership and importance to the economy. Should we worry about Chaori Solar default? I am not. I just hope there will be more to come and the Chinese government will allow more default to show to its citizens and corporations the meaning of risk versus reward. Only by allowing it will China risk premium finally narrow with western developed countries.
The Poll Result is out
Sitting on the plane in Haneda Airport in Tokyo can’t help to feel a sense of relief that two of my main macro predictions of 2013 were met this morning. 10years UST reached 3% yield while USD JPY crossed 105.
The former is the result of the potential FED QE pull back and bullish outlook on the US economy while the later is a catalyst for further bullishness in the Japanese economy in years to come.
Equity valuation in the US is at recent historical high caused by money moving out of bond into equity funds. However history has shown that the current pace of rising valuation is unsustainable. Bears on US govt bonds should beware if they are behind the curve as we could see an adjustments in equity markets in 2014 and the bond market will once again be the shelter if the 10years UST yields reaches 3.5%.
In the case of Japan, with a 30 percent fall in the currency, I am witnessing a very cheap Japan. Not from the perspective of the equity market but from the perspective of the real economy with real goods and services. My wife and I noticed that products ranging from cosmetics, basic consumer products, supermarket foods to higher end services like ski rentals to coaches are significantly cheaper that major cities in Asia. Hence unless there is a corresponding rise in inflation and bond yields the current yen at USD JPY rate of 105.00 would be a good level to square all yen shorts.
In my most recent post in early October, I suggested maintaining a long position in equities as an asset class. However, recent divergence of performance of momentum vs value stocks has given me signals that market momentum is stretched and will soon correct. I would suggest a move into cash or high quality fixed income instruments until early 2014 given in the past where such observations surfaces, volatility in the global market picks up and equities will have a biased to the downside.
For the past few months I have read many articles, reports and media coverage expecting a huge equity bear market to emerge? I am not convince once again despite the out performance this year. If you look at the reasons given by many experts out there predicting the end of the bond bull market many years ago; you will see the similar arguments now on equity markets. Small groups cited technical readings, some citing emerging market weakness lead by BRIC while a large group out there cited valuations. My philosophy to investing have been centered around relative value and opportunity cost of capital. Modern capital cares little on rising interest rate effect on equity valuation just as it ignore the valuation when interest was on decline for the past decades. This is because modern capital ignores valuation in the long term but instead concentrates on relative performance in the short term despite many participants continue to use medium/long term valuation to predict richness/cheapness of investments. Forward yields on Global Equities has been trading at the widest spread to government bonds for a long time and the time has come to narrow as capital now sees potential of relative out-performance. Even if my analysis is wrong, try using traditional financial methods of “Present Value” back the cash flow of equity yields versus bonds. Can you see how high the floor is? Hence, don’t jump, sit back and let the rising floor lift your returns.
An old video of my interview with Bloomberg TV discussing the development of RMB Bond Market