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Trading The China Crisis

|Includes: BHP, Caterpillar Inc. (CAT), FCX

Trading the China Crisis

Overview:

Seven years of zero interest rate policy and QE by the FED have driven great misallocations of capital. It is widely accepted that these cash flows have driven investors further out on the risk curve and created large investment growth in equities. I propose that this liquidity has also has flowed further out on the risk curve, into emerging markets through massive dollar carry trades. This liquidity combined with capital misallocations by Chinese Nationals have set up the emerging markets for a massive deflationary liquidation event as the dollar carry trade is unwound.

China Background:

The Chinese emperor has no clothes; and no growth. The US had no growth in 2006 as housewives and maids flipped 50% overvalued homes. China's "growth" is originating in much the same fashion. China is not the exporting superstar they market themselves as. They are a construction bubble. Net exports account for only 5% of Chinese GDP. Construction accounts for 70% of Chinese GDP, compared to only 7% in the US. In 2009 alone, China built 2.9 BILLION square METERS of commercial high rise real estate. That equates to a 5x5 cubicle for every man, woman, child, and infant in the entire country. Multiple cities have been built intended for 10s of millions of people that even the Chinese government numbers show having under 25% occupancy. The average price of apartments in these cities is over 100 thousand USD. This is in a country where the average citizen earns less than 5,000 USD per year. This real estate must be repriced at a much lower level. Many people will argue that this repricing will not cause systemic risk in the forms of contagion or a liquidity crunch because 30% of these investments are paid for with cash up front. However, this statistic fails to examine the sources of this "cash". Large portions of this cash actually originate from highly levered capital pools. Therefore, losses on these loans will have a much greater than anticipated effect on the overall Chinese financial system.

The Chinese financial system has seen massive growth over the recent years. The banking system has ballooned to over 30 Trillion USD in assets. The true health of these assets is one of Beijing's greatest secrets. They are currently marking nonperforming loans at roughly 1%. I believe this number is highly suspect. In China, a nonperforming loan is nothing but a legal term. Adjust the legal term; lower the percent of nonperforming loans. I believe this is what they have done. If you look back to 2005, when it appeared that the entire global economy was healthy, China reported nonperforming loans of over 8%. You must assume that the massive loans to the real estate industry are going to have large default rates. These defaults are going to have serious impacts on the health of the Chinese banking sector. As these banks begin to fail, it is reasonable to assume that the Chinese government will have to step in and save them. The biggest question I pose is, "Does Beijing have enough gunpowder to actually save the banks?" China currently has only 3.56 trillion USD in FX reserves. This means that if the banking sector's nonperforming loans are actually around 10% or 14%, you could see China's FX reserves completely wiped out.

Dollar Carry Trade:

The size of the dollar carry trade is over 9.5 Trillion dollars. This is the largest trade seen in the entire history of the world. The ZIRP of the FED has caused investors worldwide to borrow USD at extremely cheap rates and then lend in international currencies at higher rates with the expectation that the USD will be weaker when they unwind the trade. This trend has now changed. The USD continues to strengthen against currencies worldwide. This is causing huge losses on the carry trade as investors are essentially short the USD and long foreign currencies. I believe deflationary pressures in the US will drive the USD higher causing more investors to unwind carry trades and drive the dollar higher and a self-reinforcing cycle.

Trade Ideas

Long USD:

Buy the DXY. DXY is the US dollar index, with it weighted against 6 other currencies, Euro, Yen, Pound, CAD, Swedish Krona, and Swiss Franc. The dollar should continue a steady appreciation as the unwinding of the dollar carry becomes self-reinforcing. In the most recent dollar bull market, the dollar rose 47% before culminating in the '97 Asian currency crisis. The dollar bull market in the 80s saw a rise of nearly 100%. This implies that we still have a lot of potential room to the upside in this bull move.

Short Renminbi: OTM Puts

The renminbi is currently linked to the US dollar through a managed float, similar to a pegged currency but within a 2% band. As the US dollar gets stronger, the People's Bank of China must sell their USD FX reserves and buy Renminbi to maintain the exchange rate. As the PBOC fights this, they are essentially experiencing losses on a short USD position. The gains are experienced by the investors that maintain their USD carry positions. The total size of the USD carry trade into renminbi is estimated to be 2.5 trillion USD. If this carry trade unwinds the PBOC will have to burn through large amounts of their FX reserves to hold up the renminbi. At a certain point the PBOC will begin to question if they should be experiencing losses to enrich foreign gamblers holding the remaining carry trades. The recent devaluation this summer shows the mindset of the PBOC and indicates that they would continue the devaluing in a time of crisis. Furthermore, maintaining the peg hurts China on an overall level of economic competitiveness. As the country's neighbors maintain free floating rates, their currency naturally will weaken against the dollar. This will make all Chinese exports more expensive relative to the goods of countries with free floating currencies. This will likely cause large slowdowns in GDP growth that will further encourage the PBOC to devalue.

Just as the Thai government could not maintain the peg for the Bhat in '97, the Chinese will not be able to maintain the exchange rate for the renminbi. The renminbi will most likely devalue 20% to 40%. Currently this is not priced into the options market. There is no volatility skew in the option prices. Consequently, OTM puts are highly undervalued given the possible outcomes.

Short Commodities

Worldwide demand for all commodities is going to experience a major decline as global growth grinds to a halt. Additionally, all commodities are priced in USD. So as the USD continues to strengthen, we should expect commodities to continue to collapse. Copper and other industrial metals should experience exaggerated declines as the large amounts of investors using these assets as collateral for other positions liquidate their positions. Exposure to these asset classes should be totally avoided and when available, shorted. This can be done directly through futures or indirectly through companies such as FCX, BHP, and Glencore.

The Fiber Optics of Oil

In the late 90s many small companies spent exorbitant amounts of money and massively overbuilt the fiber optic lines and overall infrastructure for the internet boom. These companies eventually went bankrupt and were bought for pennies on the dollar. The companies that bought them no longer had to service the burden of the previous debt. Internet has since been very cheap and widely available for everyone.

In 2009, liquidity from the FED poured into risky assets as investors searched for higher returns. This liquidity pulled the entire fracking revolution forward. I am not saying that the revolution was not real. I am simply saying that liquidity made it happen faster and more inefficiently than it would have under a normal environment. Many "mom and pop" companies raised funding and greatly overpaid for real estate with marginal costs up to $85 per bbl. Infrastructure was widely overbuilt. As the dollar continues to strengthen and global demand slows, oil should fall into the low $30s or high $20s. At this point the small undercapitalized firms will go bankrupt and be bought up for a fraction of their original costs. Just as internet became cheaper and widely available for the masses, the same should happen in the oil markets. I think the long end of the crude futures curve is going to substantially fall off and flatten.

Short Caterpillar

CAT is a large equipment manufacturing company. Their main sources of revenue come from the construction, mining, and energy sectors. When the world realized the US housing market was overbuilt in 2007, CAT fell over 70%. The US housing collapse is just a drop in the ocean compared to China's construction bubble. And as the company's revenues from construction collapse, so will the revenues from mining and energy. No one will need backhoes to build empty skyscrapers. There will be no need to expand iron ore mines in Australia. CAT's revenues will continue to decline along with its stock price. I have been short this stock from $105 in November 2014. I believe it still has a long way to fall and should reach as low as the $30s.

Long TED Spread

Credit and liquidity risk are currently extremely underestimated. The TED spread is a rough indication of this risk as it represents this difference in the yield on 3 month treasuries compared to 3 month LIBOR. Many people are not familiar with this spread and its historical value. When asking most people when the previous financial crisis started, the most common answer is the collapse of Bear Sterns. I would argue that the crisis truly began in August 2007 when money markets began to break down and the TED spread jumped all the way up to 168 basis points. The TED spread eventually rose to over 450 basis point during the collapse of Lehman. This is a massive jump from the historical range between 19 to 25 basis points. The asymmetry of this move creates one of the greatest risk reward trades in the world right now. Realistically, you are risking 25 basis points to the downside to make 450 basis points to the upside. I have been long this spread since it broke out of its trading range and above 25 basis points this summer. I think the spread continues to run as you see liquidity dry up and credit risk to be more accurately valued.

Long 30 Year Treasuries

The 30 year treasury is still the tallest midget in the circus. The cleanest dirty shirt. It is the safe haven asset of the world. It is the worst places to put your money, until you realize how terrible every other place in the world is. I know this trade idea will face massive opposition as people fear being long bonds as the FED plans to raise short term rates and build ammo to fight the next recession. I however do not believe they will raise rates in December and probably not even in 2016. We have already tightened. Tapering was tightening. The strengthening of the dollar has been tightening. The economy cannot handle more tightening. I personally believe it is probable that we experience loosening of monetary policy before we ever see any more tightening. And even if the FED makes the mistake of raising rates, I believe it will cause enough turmoil that the yield curve will begin to invert and 30 year treasuries will show great returns. In deflationary markets, bonds and the dollar move together because a dollar tomorrow is worth more than a dollar today. So fixed coupon payments in the future will relatively be worth more. We are clearly in a deflationary market right now. Whether that is accelerated by the FED raising rates or deflation from China slowing global growth, 30 year treasuries should perform very well. The biggest risk in this trade is that the FED comes out and raises more than anyone expects or that they say they will raise at a much faster rate than anticipated. I personally do not believe these outcomes are that likely. I think they already have enough ammo to fight the next recession with the possibilities of QE 4 and negative rates.

Hedging Short Commodities Position: Long Uranium

This current portfolio would be heavily short commodities and have large exposure to the risk of commodity prices rising. Being long uranium is one of the best hedges against this exposure. No one has been watching this industry since its collapse in 2007. It a thinly traded market with retail traders as the main participants. This gives great opportunity for undervaluation. Many mines are currently at breakeven costs and with Japan restarting its nuclear facilities demand should see substantial increases.

Conclusion:

I know that disaster situations like this are naturally more exciting to talk about. It triggers the primal fight or flight instincts and captures your attention. It is possible that the real world will just be boring and grow slowly at 2% per year. However, "possible" is the most important word of that previous sentence. The world does not only have one outcome or only one future. All outcomes are possible. I have seriously considered the impacts of any distortions of my view and I still believe what I have described above to be the most probable outcome. I hope I am wrong, but I sadly don't think I will be.