Are Default Fears Spreading From China To The U.S.?

By: Chris Ciovacco | Wed, Jan 22, 2014
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China Has A Problem

China Credit Expansion - Problems starting

When the U.S. markets are healthy, overseas concerns often get overlooked. You have seen headlines about China recently, but may not have taken the time to click-through. From CNNMoney:

It starts with an epic credit binge. When the global financial crisis hit in 2008, the Chinese government ordered the credit lines open. Banks and other lenders responded, funding massive building and infrastructure projects. The strategy worked, and China emerged relatively unscathed from the global financial crisis. But credit growth never really slowed down. Analysts now worry that new credit is no longer generating strong economic returns. And, worse, the ballooning borrowing could sap growth if the central government is forced to stand behind defaulting local governments or agencies, through which much of the lending flowed.


Default Fears Are Increasing In China

Charlene Chu covered China for Fitch Ratings over the past eight years. In a recent interview, she answered the "why should we care?" question. From The Wall Street Journal:

WSJ: What do you make of the concern over the possibility that a 3 billion-yuan set of trust products sold by ICBC might default at the end of the month?

Ms. Chu: The reason why this matters is we've never been in an environment in China where defaults are allowed to happen, whether in the bond market or trust sector or other parts of the financial sector. It could be interpreted as a new willingness by authorities to start to allow things to default. The question after that is how far they are willing to go, because there are many questionable exposures out there. Over the last couple of years there were lots of stories about corporates about to default on domestic bonds, but it never happens in the end.


Stock Investors In The U.S. Could Be Impacted

If you work on Wall Street, you may be familiar with the theory that "bond guys catch things before stock guys do", which means credit markets often wave yellow flags before problems reach the stock market. The credit market (a.k.a. bond market) focuses on two major issues:

Cartoon: Yield vs Safety
  1. How much does this bond pay?
  2. What are the odds of default?

When the market determines bond default probabilities, it includes an assessment of the economy. If the odds of a recession are low, then the odds of widespread bond defaults are also low. Conversely, if the odds of a recession are high, the odds of bond defaults also begin to increase. If you believe the odds of widespread bond defaults are low, then you would prefer to own a bond that pays a higher yield. If you believe the odds of bond defaults are rising, then you would prefer to own a higher rated and more conservative bond.


Credit Foreshadowed 2011 Stock Plunge

The meat of the chart below shows the performance of higher-yielding (riskier) junk bonds (JNK) relative to the aggregate bond market (AGG). The S&P 500 is shown for reference purposes. When the JNK/AGG ratio is rising, it tells us the market would rather chase yield, since it is not too concerned about bond defaults. When the JNK/AGG ratio falls, it tells us demand for riskier junk bonds is decreasing due to increasing concerns about getting paid back. The JNK/AGG ratio was in an established downtrend (lower high, lower low) before the S&P 500 dropped 18% between points A and B, meaning it was helpful in terms of reducing exposure to stocks.

JNK:AGG SPDR Barclay HY Bond/iShares Barclays Bon NYSE/NYSE


What Is Credit Telling Us Now?

The JNK/AGG ratio looks much less concerning in 2014 than it did in 2011. The current rising trend tells us in 2014, so far, the market would rather chase yield, since it is not too concerned about bond defaults. If the ratio morphs into a look similar to point C, our concerns about the U.S. stock market would increase.

JNK:AGG SPDR Barclay HY Bond/iShares Barclays Bon NYSE/NYSE


Investment Implications - Leave It Alone For Now

When markets lack conviction they tend to consolidate, which is a Wall Street term for "go nowhere". In a low-conviction environment, it is best to remain patient until the market tips its hand in a bullish or bearish manner. As we outlined in this week's video, the market's big picture tolerance for risk is still favorable. If the recent stall morphs into a more concerning look, our market model will reduce risk incrementally at a rate in line with the observable deterioration. For now, the evidence continues to favor stocks over bonds. Consequently, we continue to maintain positions in U.S. stocks (VTI), financials (XLF), technology (QQQ), small caps (IJR), Europe (FEZ), and global stocks (VT). The chart of the NASDAQ below continues to show a healthy and "leave it alone" trend.

$COMPQ Nasdaq Composite INDX

 


 

Chris Ciovacco

Author: Chris Ciovacco

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors and tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS ARTICLE.

Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. CCM helps individual investors and businesses, large & small; achieve improved investment results via research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions.

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