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China Has A Problem

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:

  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 (NYSEARCA:JNK) relative to the aggregate bond market (NYSEARCA:AGG). The S&P 500 (NYSEARCA:SPY) 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.

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.

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 , financials (NYSEARCA:XLF), technology (NASDAQ:QQQ), small caps (NYSEARCA:IJR), Europe (NYSEARCA:FEZ), and global stocks (NYSEARCA:VT). The chart of the NASDAQ below continues to show a healthy and "leave it alone" trend.

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