Keeping up with economic news is hard right now. Covid-19 is resurgent in America and has now claimed the lives of over a quarter of a million people and Thanksgiving, which could be the ultimate “super-spreader” event according to public health experts, is still to come. Obviously, that is taking a lot of our attention, as is the good news on the Covid front of the incredible success of the “Warp Speed” program and the race to get as many people as possible vaccinated as quickly as possible. And that’s not to mention the headline grabbing effect of a lame duck President who refuses to accept that he lost an election in which the other guy got six million more votes, and the increasingly weird story of his most high-profile lawyer and a once respected Mayor losing it before our eyes.
With all that going on it would be no surprise at all if something really important escaped the attention of investors, so here is the latest installment of my occasional series regarding important news you may have missed.
The first story is something that most people would be unaware of, even if there weren’t so many distractions. Let’s face it, who can honestly say that hey keep a close track on default rates for Chinese bonds? Given what has happened recently, however, maybe we should be doing just that.
There has been a series of defaults on bonds in China recently by State Owned Enterprises (SOEs), something that, prior to this year, was extremely rare. I am sure there are still some readers scratching their heads and saying “So? I don’t invest in Chinese bonds” but that is to miss the point. The Chinese domestic bond market is the world’s second largest, at $13 trillion, and that means a lot of exposure to that market, both direct and indirect, is inevitable for the world’s major banks.
If you doubt the effect that a series of defaults in some obscure instrument that gets out of hand can have on those banks, think back to 2007. The sub-prime mortgage market that collapsed and sparked that mess was one tenth of the size of the Chinese bond market, at $1.3 trillion and yet defaults there rapidly created a crisis of confidence that plunged the world into recession.
I am not predicting that the same thing will happen here. The situation is completely different for a number of reasons, but investors should be aware of what is going on and keep an eye on the situation.
The surprise here is that these are companies where the Chinese government owns a significant stake, if not the whole thing. In the past, investors have taken that to be an implicit guarantee of the bonds based on the assumption that the government would step in and meet any market obligations should the need arise. And that is what has usually happened. Over the last few months, though, they have refused to do that in several high-profile cases.
As always with Chinese economic policy, the reasons are opaque at best and the change has sparked a guessing game as to what it means. The most likely explanation looks to be that theses defaults are being used to send a message to Chinese corporations and to the bond market that leverage in the economy is higher than the government wants to see. A few high-profile defaults in “safe” bonds such as we have seen will make banks less inclined to lend generally and therefore discourage excessive borrowing.
That is fine as long as it stays in hand, but the danger is that should the defaults continue, it could create a crisis of trust in the banking system as a whole, both in China and elsewhere, as everyone tries to guess how badly everyone else has been hurt.
It is less likely that U.S. investors will have missed the second story as it is a domestic one, but it is still a bit obscure. Treasury Secretary Steve Mnuchin has announced that he intends to end some of the Fed-supported programs that were initiated in response to the coronavirus crisis.
As you might expect at the moment, that has been a controversial decision, but what has made this controversy a bit different is that the Fed itself has expressed opposition to the plan.
The Treasury’s argument is that the programs concerned were imperfect and anyway were in most cases rarely used. The Fed seems to be countering with imperfect is better than nothing, and that if they are not being used that much, why not keep them in place for when they might be needed?
From a practical perspective, both sides of the argument have merit here. If you look at unemployment, GDP and other economic data, the immediate crisis that prompted the loan and liquidity programs concerned has passed, and at some point, emergency, short-term help has to end, by definition. On the other hand, coronavirus cases and deaths are surging again, and shutdowns are being enacted all over the country. Is this the time to close these programs?
Unsurprisingly, this is all complicated by politics. There is a suspicion that this is all part of the defeated President’s scorched earth tactics, with an outgoing Treasury Secretary making moves that will hamper his successor. As Charles Schwab’s chief fixed income strategist, Kathy Jones, put it on Twitter “ So we’re in the midst of a surge in Covid-19 cases with deaths rising and a contested election result and now Mnuchin decides to quit and take his toys with him. Wow.”
Time and time again, however, history has shown that Wall Street tends to overreact when free government money or guarantees of risky loans or whatever other goodies they have become used to are taken away. Usually, the indignation fades with time, but just occasionally the hissy fit becomes a self-destructive crisis of trust in each other, and liquidity in the system starts to dry up.
As always with these less-publicized stories, the chance of a really bad outcome is minimal. However, when problems hit the market, it is usually because of something that comes as a surprise to most people. Bond defaults by Chinese SOEs and the ending of some little-used federal programs to backstop the system during the Covid-19 crisis are two stories that you may have missed in the deluge of news over the last few days, but either one could have lasting impact on markets, so both should be watched by investors.
