Is China's anti-corruption campaign responsible for global commodities sell-off?

Commodities came under severe pressure yesterday, in part driven by some negative news out of China, the world's largest single consumer of natural resources.

CRB Commodity Index (Bloomberg)

The nation's GDP growth rate came in below expectations.

Source: Econoday

Anecdotal evidence suggests that some large hedge funds were forced to unwind commodity holdings across the board. This latest move has been extraordinarily painful for investors, who are left scratching their heads in trying to understand the fundamentals. Many point to China's lackluster industrial production as the cause for this weaker than expected growth. But there is a new theory emerging to explain China's negative surprise. Some analysts believe that the latest anti-corruption campaign is having a chilling effect on the nation's economy.

Worried about being accused of spending excesses, local officials have cut down on extravagant parties and gifts used to entice (and essentially bribe) central government bureaucrats. Restaurants and luxury goods have been hit especially hard.

Global Post: - Since the end of last year, Xi has spearheaded a drive to curb officials' notoriously lavish dinners and high-end gift-giving. At a Party meeting in December, he called for new regulations that require cadres to cut back on liquor, flowers and extravagant banquets. Some provinces even banned the use of red carpets to greet visiting officials.
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"Abalone, baby birds, sharks, big prawns, sea cucumbers and geoduck clams are just some of the creatures who can breathe easier, for a bit at least," says Bill Bishop, a commentator in Beijing and author of the influential Sinocism newsletter. "But [food and beverage] businesses should expect more pain."

Can a slowdown in these sectors really have a significant effect on China's overall growth? Some economists are convinced that the impact is quite real and is indeed responsible for slower growth.

Bloomberg: - “The anti-corruption action by Xi is creating unprecedented phenomena, including an absolute fall in high-end restaurant sales,” said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, who previously worked for the European Central Bank. “It’s certainly a big factor dragging down short-term growth.”

And that in turn could be a big part of the story behind the latest sell-off in commodities.

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Canadian households may face more deleveraging

Some recent data out of Canada points to a slowdown in growth of consumer indebtedness. According to RBC, the non-mortgage consumer debt has grown at the slowest rate in 20 years.

Global News: - Non-mortgage debt including credit cards, personal loans, lines of credit and other loans stood at $512 billion — up 2.5 per cent, the smallest 12-month increase since July 1993.

This is clearly a positive development, but when taking mortgage debt into account, Canadians still represent some of the most indebted households in the developed world (outside of the Netherlands who is undergoing a housing crisis, as well as a few others).

Source: JPMorgan

Residential construction remains strong in Canada as low rates encourage more borrowing. In spite of a recent slowdown (starts in Q1 are 12.5% below Q4), housing starts are rising once again.

Bloomberg: - Canadian housing starts unexpectedly increased for a second month in March and building permits rose in February, evidence that low borrowing costs are supporting construction.

Starts were 184,028 at a seasonally adjusted annual pace during the month, up from a revised 183,207 in February, the Ottawa-based Canada Mortgage & Housing Corp. said on its website today. In a separate report, Statistics Canada said building permits rose for a second month in February on a rebound in non- residential projects.

Construction has been supported by some of the lowest mortgage rates in decades, along with historically cheap borrowing for businesses, even as the government tries to tighten the mortgage market amid concern prices in some cities have become inflated.

This is particularly troubling given the nation's substantial dependence on natural resources and persistent weakness in the energy markets.

May WTI Crude Oil Futures Contract

Canadian oil prices are significantly lower than the Cushing prices (above) and many of the nation's energy firms operate on tighter margins these days. Alberta's existing oil sands projects for example are still profitable, but with rising labor and equipment costs, margins are being pressured. At the same time, new projects don't make sense at current price levels, making further improvements in Alberta's labor markets unlikely.

The overall economy now clearly faces some headwinds as well (see post), ultimately putting pressure on households. The equity markets are already pricing in some of these risks (chart below), but the deleveraging of Canadian households is yet to come.

S&P/TSX (blue) vs. S&P500 (red)

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Declining dry powder of LBO funds

The private equity industry's capacity for leveraged buyouts continues to decline. Here are some reasons for this trend:

Monetizations of portfolio companies have been talking longer in recent years. That traps investors' capital, reducing capacity for redeployment in new funds or in some cases for recycling in existing funds.

Newly launched buyout funds - even from established managers - are having an increasingly difficult time raising the same amounts of capital they did in earlier funds. Large institutional investors have been cautious on private equity due to liquidity constraints they encountered in 2008 as well as poor return expectations for the whole sector.

Many pensions and endowments are staying away from some of the mega-funds with the belief they are too bulky to achieve superior returns. And in cases where major investors do come into large LBO funds, they often demand to directly co-invest with these funds on buyout deals. These co-investments, on which pensions do not pay fees, become a significant portion of investors' private equity allocations. Pensions holding company shares directly on their books limits the amount of capital available for LBO funds. Some years back when deals were too large for a single fund, LBO firms would call each other to club on transactions. Now they call their investors to present co-investment opportunities.

Source: Preqin

Another trend causing a slowdown in institutional demand for LBO equity funds - the largest among private equity products - has to do with the ongoing rebalancing in retirement funding. Increasingly employers are shifting from defined benefits to defined contribution pensions. Defined contribution accounts are managed by individuals rather than pension funds and do not have access to alternative investments such as private equity. The slower growth in defined benefits accounts (as well as the ageing population of employees with these benefits) limits the overall demand for private equity, making fundraising for LBO shops enormously challenging in an already competitive environment.

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Corporate CDS tightens to multi-year lows; bonds lag

US corporate CDS are tightening to new lows, as the Fed continues to pump liquidity into the market. The JPMorgan CDX indices which measure spreads for the "on-the-run" CDX (and include rolling into the most current series) are showing the tightest spreads in years. In fact the HY CDX spread is now at levels not seen since 2007.

Source: JPMorgan

Bond spreads have been tighter as well, but have not kept up with the action in the credit default swap market. The chart below shows how HY bond spreads performed over the same period (compared with the chart above).

Part of the reason for cash bonds' underperformance vs. their synthetic cousins is the unease with fixed rate products such as corporate bonds. Selling CDS is a way to increase corporate credit exposure without taking on rate risk (as opposed to buying corporate bonds).

The same trend is taking place in the investment grade universe. The JULI spread is JPMorgan's investment grade bond index spread, which is regressed against the 5-year IG CDX below. CDX spreads have tightened considerably more than bond spreads.

Source: JPMorgan

In the past, market participants would close this gap by buying corporate bonds, buying cheaper CDS protection and entering into a rate swap.  But with rate swaps expected to move onto the clearinghouse, there is risk of having to post margin on both the bonds (at the prime broker) and the swaps (at the clearinghouse) - making it less appealing to for traders to execute this arb. Regulation is creating a bit of a market distortion.

The upshot of the latest market moves is that credit risk appetite continues to increase, approaching the pre-crisis frothy levels. At the same time investors remain cautious on interest rates.

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The recent bet on US retail could be premature

Among the bets that may end up backfiring later this year is the recent bet by investors on US retail shares. Just this year the S&P Retail Index has outperformed the S&P500 by nearly 6%.

Source: Ycharts (click to enlarge)

With the current improvements in the labor and housing markets, investors have piled into retail-focused companies. However, today's retail sales surprise to the downside (see chart on Twitter) points to potential weakness in the retail sector. This was followed by another consumer-related surprise - the UMichigan Consumer Sentiment, which came in materially below expectations.

Source: Econoday

MarketWatch: - The University of Michigan-Thomson Reuters consumer-sentiment gauge dropped to a preliminary April reading of 72.3 -- the lowest result since July -- from a final March reading of 78.6, reports said Friday. Economists polled by MarketWatch had expected a preliminary April reading of 79.3. However, consumers have faced negative news on jobs and federal spending.

With the consumer being such a large part of the economy, these results point to potentially sluggish growth in the US. It is possible that the seasonal pattern (discussed here) of US economic activity could be repeating itself.

Reuters: - The data supports the view that the U.S. economy continues to struggle and hasn't performed as well as analysts believed just a few weeks ago. Many analysts cut their growth forecasts for the first quarter.

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US government's bearish crude oil forecast

In spite of the Fed's ongoing monetary expansion, the US Department of Energy is projecting a moderate decline in crude prices over the next couple of years. Here is the key component of their rationale:

EIA: - Non-OPEC supply growth, particularly in North America, is expected to keep pace with world liquid fuels consumption growth and contribute to modest declines in world crude oil prices.

Source: EIA

Based on the latest data from EIA, US oil inventories remain elevated while imports continue to decline.

EIA: - U.S. crude oil imports averaged over 7.7 million barrels per day last week, down by 211 thousand barrels per day from the previous week. Over the last four weeks, crude oil imports have averaged 7.8 million barrels per day, about 1.2 million barrels per day below the same four-week period last year.

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U.S. commercial crude oil inventories (excluding those in the Strategic Petroleum Reserve) increased by 0.3 million barrels from the previous week. At 388.9 million barrels, U.S. crude oil inventories are well above the upper limit of the average range for this time of year.

Part of the government's assumption in forecasting declining oil prices is the stability of the US dollar.  And that assumption has been holding up well so far, as other major central banks also maintain highly accommodative policies (see post). Aside from geopolitical risks however, dollar strength remains a key factor that could derail the government's bearish forecast on crude prices.

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ABS meets EBay - the disintermediation of consumer finance

Can unsecured consumer lending be disintermediated? At least one fairly successful company thinks it can - as long as you get large groups of people willing to borrow and investors willing to lend. The company is called Lending Club. The firm allows for pooling of personal loans, with borrowers rated from from A to G based on the credit profile. In this low rate environment returns generated by this lending look attractive and are available to investors who don't own a credit card provider.

Source: Lending Club

Lending Club charges both the investors and the borrowers some fees - with the riskier borrowers paying higher charges. Investors can come into this program through their IRA account to get tax free interest income.

Sounds risky? It all depends on how diversified the portfolio is. About $20k buys some 800 "notes". An investor can build a portfolio by selecting pieces of loans from rated borrowers as they come online. The system also tells investors a very indicative "use of proceeds" as well as what portion of each desired loan has been raised so far. Each investor effectively becomes "the bank", electing how much to lend to whom (although for regulatory purposes it seems that loans are funneled through "WebBank, a Utah-chartered Industrial Bank").

Source: Lending Club

What's good about this program is that unlike credit cards who generally charge a high rate to all borrowers, the credit scoring provides cheaper capital to the strongest borrowers. These are credit markets at work - applied at the retail level.

According to the company almost $1.5bn has been funded this way. It's a drop in the bucket compared to trillions in consumer finance, but is certainly a good proof of concept.

Is this a sign of where consumer lending is headed? Should the credit card industry be concerned that technology-based free market will one day disintermediate them?

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Taking QE to a whole new level

The Bank of Japan is taking the concept of quantitative easing to a whole new level. Unlike the Fed who is only focused on treasuries and agency MBS securities, the BOJ is authorized to purchase ETFs and REITs in addition to JGBs.

Reuters: - "The BOJ can buy whatever amount of ETFs and REITs it can. It can even buy government bonds more forcefully, as if it were to buy the entire amount in markets," Hamada said in an interview with Reuters.

"There are also other various measures, although the BOJ must also be mindful of the drawbacks."

According to Credit Suisse, the BOJ's balance sheet as a proportion of the nation's GDP will far outstrip that of the other major central banks (excluding the SNB) within the next two years. This is uncharted territory - nothing of this magnitude has been tried before in a developed economy.  As a result, dollar/yen is at 99 (the yen is down some 25% over the past 6 months) and Japan's stock market just hit a 5-year high.

Source: Credit Suisse

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