Deep Discomfort - Taking on Asian High Yield

Updated: Nov 16, 2021

One of my mentors used to say that the best trades are often when you feel deeply uncomfortable about the position. Asian High Yield falls into that category. Nevertheless, the credit risk compensation in Asian High Yield is a 4+ standard deviation event, beyond where it traded during the March 2020 low and considerably wider than junk bond credit in the United States (chart 1). It is also episodic in the sense that it is tied to the “growth scare” in China, the regulatory crackdown, demographic time-bomb and price itself has started to fall in a non-linear way which signals a panic or capitulation in beliefs (“get me out at any price” for investors with levered exposure in some private banks).

While the contagion has been limited so far, the weakness in Chinese markets has had a non-trivial impact on regional assets (Asian equities have also materially underperformed developed markets this year). There has also been a spill over into directly affected markets like iron ore and steel which is obviously important for property and construction in China. To be fair, spot iron ore was coming from an elevated level in June 2021 (chart 2).

The other critical point to note is that the weakness in China and Asia High Yield is not an emotional over reaction. It has been a warranted reaction to tightening in credit and liquidity to an over-levered sector (see “the credit market leads” attached below) and obviously in response to genuine economic loss (defaults) in the sector in China.

From a macro perspective, property has also provided a very important contribution to aggregate activity in China both directly and indirectly via local government land revenue, real estate services and raw materials. The approximate impact of the sector is ~1.5 percentage points to growth per annum over the past decade or so. Looking forward, that could flip to -1 percentage point per annum in 2022 unless the authorities pivot and decide to accelerate debt creation again to pump up construction to maintain targeted GDP growth rates. It is a dilemma, because that would clearly exacerbate underlying imbalances. However, the alternative is accepting lower trend growth and the potential fall out (weaker employment and potential social instability and loss of face for the leadership). As we noted in October, radical transformation of the growth model will take some time and will require acceptance of lower trend growth overall.

In spite of the elevated credit risk compensation on offer we have been standing aside from Asian High Yield in 2021 primarily because the weakness was driven by a legitimate problem in China real estate (~40% of the Asian High Yield index) that would lead to genuine defaults and contagion. That has broadly been validated by the price action.

However, outright yields and spreads are now over 1250 basis points. The market is already in distress with key issues already priced for default and trading at cents in the dollar. Our sense (like Goldman Sachs) is that the authorities will probably be uncomfortable with the disorderly price action, contagion and second order self-reinforcing impact on growth. We would also note that the credit impulse is also -8% and near trough levels seen in previous mini-cycle episodes over the last decade. In conclusion, we are starting to accumulate a long position in Asian High Yield today.

The Credit Market Leads…, 20th of October

While those who have predicted the imminent political, financial and social collapse in China have been wrong – mainly because they failed to understand the structure of the Chinese financial system – there has been a legitimate unsustainable process building over the past decade or more. Related to a self-reinforcing cycle of credit expansion and investment.

As Michael Pettis has noted, the longer China takes to adjust, the more difficult the adjustment will be. The big picture point is that whenever China faced a problem that threatened economic growth, Beijing always responded by accelerating debt creation and pumping up property and infrastructure investment by enough to maintain targeted GDP growth rates. Stated differently, China didn’t adjust, but rather goosed growth by exacerbating underlying imbalances. This is the key reason why the authorities have always been “successful” in avoiding a crisis. To be fair, the same could be said of the Western policy response to the recent crisis.

However, the challenge today is that the key problem threatening future growth is the unsustainable level of debt. As we noted recently, China’s private sector credit is now over 220% of GDP and greater than the larger than Japan at the peak of their real estate bubble (chart 1). Also note in the time series below that China has never experienced a major de-leveraging phase over the past 20 years.