Chinese banks have a lot on their mind…
As the world in general, and China in particular, reacts to the ever-changing narrative and concerns surrounding the COVID-19 coronavirus, Tom and I are equally busy tracking market risk and opportunity for our subscribers at Signals Matter.
For now, let’s take a deeper look at the data, market signals and broad allocation ideas we are tracking for our readers as conditions out of China and the Chinese banks continue to impact global markets, and hence your money.
Coronavirus Concerns Increase
As of this writing, the coronavirus has infected over 45,000 people and the current death toll linked to the worldwide virus has surpassed 1,350, with the vast majority of these deaths located in mainland China, from which the virus originated. Infections in Hubei alone have jumped to 15,000.
Such tragic numbers now exceed the human costs of the 2003 SARS virus and, as we recently reported, have raised the eyebrows of both the Federal Reserve and the U.S. markets as a legitimate tail risk event for global and U.S. markets.
Meanwhile, the Chinese authorities have made headlines to qualm fears and are suggesting the virus will be contained in the coming weeks, a message needed to contain not only a contagion fear in the health organizations of the world, but to contain an equally powerful fear of contagion in the security markets of the world.
Unfortunately, and not surprisingly, official data coming out of China, including containment promises, cannot be fully trusted, given that China, much like the USSR during the Chernobyl crisis, already has a long history of putting lipstick on genuine economic, political or social pigs when it comes to form over substance transparency.
In short, global investors have more than one reason to be concerned about the Coronavirus.
If the virus reaches pandemic levels, this would spell disaster for Chinese growth, and hence Chinese banks (below), which would in turn spread viral-like chaos into the already weak Potemkin Village that is the Chinese economy, not to mention the vastly growing number of Asian and other economies impacted.
Nevertheless, this same debt-driven Chinese economy has not only been the engine of global growth for over a decade, but also (and despite trade war tensions with the U.S.) a critical component of a highly interlinked global marketplace.
Hence, such an economic disaster in China would have massive ripple effects on international markets, money flows and security pricing. In short, get ready for massive money printing and fiscal stimulus if and when this virus fully hits our shores.
As we’ve said many times, when China sniffles, the rest of the world catches a cold. Sadly, this metaphor has become far more serious than we expected.
Below we examine why the coronavirus is becoming a far more serious economic concern than once thought, how it can play out, and most importantly, what investors can do about it.
A Fatal Virus for Chinese Banks
Love them or hate them, banks matter.
As we recently noted in a report on the health of European banks, many of which are edging mathematically closer to a genuine credit crisis, it is never a good thing for markets when banks fail, as the 2008 financial crisis in the U.S. is an obvious reminder.
Over the summer, for example, we expressed genuine and empirical concern over the balance sheets of Canadian banks and, of course, turned our attention as well to Germany and the dramatic fall of one of its more iconic names, Deutsche Bank.
As important as these reports and issues are and were regarding global banking risk, they pale in comparison to the risks now immediately facing the Chinese banks in the backdrop of the still deadly Coronavirus, as true a black swan as one could define.
Early in 2019, for example, the Chinese Central Bank gave a stress-test report on the health of 30 its largest and medium sized banks, confidently reporting that they would continue to shine in normally growing GDP ranges.
In a base-case scenario, for example, of only 5% GDP growth, a small number of those banks would see troublesome falls in capital ratios (i.e. ratios of available assets/cash to liabilities).
In the report’s worst-case scenario, namely of GDP falling to 4%, the Chinese report said more than half of their “tested” banks would fail their required capital ratio requirements and be a “cause for concern.”
Of course, in the first half of 2019, no one in the Chinese Central Bank nor its centralized government of yes-Sayers could ever imagine a “cause for concern” or such low GDP scenarios.
Nor could they publicly imagine (or at least admit to) any dangers embedded into a $41 trillion financial system in which $20 trillion of that banking system is comprised of “problematic” assets.
But Then Came the Coronavirus…
Needless to say, the Coronavirus has since changed the GDP outlooks for China in a major way, one that even the truth-challenged Chinese leadership can’t hide. If the virus takes hold in the US, expect a similar GDP plunge, filled by more QE, direct Fed ETF purchases and massive fiscal stimulus.
For now, most of the major U.S. bank analysts from JP Morgan to Goldman Sachs are forecasting dramatically lower GDP prints to come out of China, including growth numbers as low as 1% for Q1 2020 if the virus is contained, or negative GDP growth if it is not.
Over the last decade, total private and public debt in China has ballooned to surpass 300% of gross domestic product, casting a dark shadow over financial stability.
Folks, if such a scenario plays out and we see 2 consecutive negative quarterly GDP prints out of China, that would mean a recession in China, for which the ramifications to global markets would be sudden and extreme.
Again, a similar fate could easily await the US, sending the markets tanking, then revived by the Fed, and then tanking again once the Fed rally faces GDP and earnings reality…
If the Chinese economy slows further in the wake of pandemic health risks, the number of non-performing loans on the books of these “tested” Chinese banks would skyrocket, placing the banks in genuine risk of bank defaults and failure.
What’s even scarier about the Chinese banks is that even before the viral headlines, they were already experiencing record loan defaults, prompting a state bank seizure (i.e. nationalization) of a big-name bank (i.e. Baoshang Bank) as well as bailouts of other banks, such as Yingkou Coastal Bank and Heng Feng Bank.
Needless to say, the remaining Chinese banks are themselves deeply undercapitalized and suffering their own consequences of the trade war with the U.S.
The Chinese government and press, however, is making a valiant effort to stay optimistic despite the fact that Chinese companies, which owe debts to Chinese banks, are already pulling out of global commodity contracts by citing “act of God/Nature” (i.e. force majeure) provisions as their excuse.
If this trend continues, many banks in China will fail. And remember, a banking crisis is the worst kind of credit crisis.
Failing Banks? Been There, Done That…
Of course, here in the States, we know something about bailing out the banks that are deemed too big to fail.
Without getting too off track on the topic of whether that was ultimately a good or bad thing to do, let’s stick to one thing we can all agree upon: It’s expensive to bail out banks who have gone over their skis in debt.
China will be no exception.
According to Bloomberg analysts, a worst-case scenario under China’s own banking stress test would require a cash infusion of greater than $5.6 trillion yuan, adding to the $2.4 trillion yuan of existing non-performing loans on the books of Chinese banks, not to mention the books of China’s shadow Trust Company banking system that has been facing a record wall of financing repayments.
Where will this rescue money come from?
Well, some will come from other Chinese banks who will be forced to “assist” their peers in the way JP Morgan “assisted” Lehman Brothers-i.e. painfully…
But mostly, this assistance money will come from a familiar place-namely a money printer in China, quite similar in power and function to the one used by our own Federal Reserve.
Bottom Line: China is fragile. Handle with care, as Bloomberg Business Week suggested in its February 17, 2020 edition, where the Coronavirus, debt burdens, trade wars and local protests challenge the big gorilla in the room when it comes to trade.
What to Expect and What to Do?
If conditions worsen and the coronavirus is not quickly contained, the type of banking failures and monetary responses out of China would impact markets in numerous ways.
First, a slowdown in China would dramatically impact (i.e. reduce) commodity demand and hence pricing on non-precious metals like copper and aluminum.
Secondly, as more fiat yuan are “printed” to assist/bailout the already sick Chinese banks, the impact on precious metals like gold should be positive.
Thirdly, if viral contagion spreads without containment, fear too will spread in global markets, causing equity prices to fall generally by March, as investors understandably panic and look for safer places to park their funds– typically in government bonds, none of which beat reported or actual inflation.
As for our tracking tools and portfolio recommendations, they will hinge upon (and change with) the ever-changing signals from the markets, not speculations made here and now.
Toward that end, we will be tracking and determining if and when (and how much) more foreign money will leave the fear-torn zip codes of Asia and Europe for the “safe haven” of US markets, which may not be too safe in march if the virus spreads to the US.
We’ll track if such potential flows favor U.S. bonds and stocks equally, or tend more toward credits rather than equities. Again, much will also hinge on the impact of the virus in the US, which remains to be seen—but the outlook for March could be very bad indeed.
Again, we will have to wait for and track such flows, and then make allocations appropriate to the signals we receive.
Needless to say, if such viral fears, backed by further evidence of contagion rather than containment were to occur, our cash allocations would be immediately signaled to our subscribers to avoid a blood-letting in their portfolios.
As always, stay safe, which means, stay informed. And for all you hopeless romantics out there: Happy Valentine’s Day!
Matt & Tom