Disappearing trick

China’s vanished current-account surplus will change the world economy

The yuan will become more volatile, but also start to rival the dollar

NOT long ago China was a leading culprit in global economic imbalances. Whether blame was ascribed to its undervalued yuan or its frugal people, the problem seemed clear. China was selling a lot abroad and buying too little back. One data-point summed this up: its current account surplus reached 10% of GDP in 2007, well above the level that is generally seen as reasonable. Far less attention has been paid to its steady decline since then. In the first quarter of 2018 China ran a current-account deficit, its first since joining the World Trade Organisation in 2001. Just as its massive surpluses of yore had big consequences for the global economy, so does this swing in the opposite direction.

China still exports many more goods than it imports, to the tune of nearly $500bn annually. But its share of global exports appears to have peaked. At the same time its trade deficit in services is getting bigger, largely thanks to all its tourists venturing abroad (see chart).

At bottom, a current-account balance is the difference between a country’s investment and savings. When China had a big surplus, its savings, at 50% of GDP, far outstripped even its colossal investment. Data on savings are patchy in China. But it is known that investment has declined as a share of GDP. The implication is that the rate of savings has almost certainly declined more sharply, reflecting a big increase in consumption. Its economy is, in other words, better balanced than just a short while ago.

China’s current-account deficit in the first quarter was exaggerated, since exports tend to be subdued at the start of the year. It is likely to return to a surplus in the coming months. But Ding Shuang of Standard Chartered, an emerging-markets bank, forecasts that the surplus will be just 1% of GDP this year and 0.5% next year. The trade ruckus with America could reinforce the downward trend. To placate President Donald Trump, China will try to import more from America and pay more for foreign intellectual property (IP), Mr Ding says.

One probable outcome is that the exchange rate will become more volatile. In recent years capital outflows have pressed down on the yuan, but the current-account surplus has countered that effect. In the future China will have a thinner cushion. Depending on quarterly trade swings, the yuan will be as likely to fall as to rise.

If China’s current-account deficits become more frequent, it will have to run down its foreign assets or borrow more from abroad to pay for its consumption. Should its external liabilities—that is, money it owes the rest of the world—increase rapidly, that might signal greater financial vulnerability. But as long as the increase is moderate, it could actually help China by boosting the yuan’s global profile.

To fund its deficit, China might choose to sell more bonds to foreign investors. And in paying more for goods and services than it earns, it could supply its currency abroad. By itself this would not be enough to make the yuan go global. Investors would need more faith in China’s institutions. But technically, the conditions would be ripe for the yuan’s emergence as a more credible rival to the dollar. America might find itself pining for the days when the Chinese currency was undervalued.

Iran, Russia: What’s at Stake in the Syrian Civil War

By Xander Snyder

The era of foreign intervention in Syria is coming to an end – at least that’s what Russian President Vladimir Putin said when Bashar Assad, Syria’s president, visited Sochi last week. Granted, Putin’s statement was ambiguous – “in connection with the significant victories … of the Syrian army … foreign armed forces will be withdrawn from the territory of the Syrian Arab Republic” – but Russia’s Syria envoy clarified the next day that Putin was, in fact, calling on all militaries to vacate the country.

Needless to say, this didn’t sit well with Iran, which has been cooperating with Russia in support of the Assad government. Iran rejected Russia’s announcement, insisting that it deployed its military at the behest of the Syrian government. Iran has its own reasons for being in Syria, of course, regardless of what the government in Damascus wants. It means to establish greater command of the Middle East and acquire land access to Lebanon and sea access to the Mediterranean. Even if this territory isn’t under its direct authority, Iran wants to keep Israel and Turkey from encroaching on its borders. In the process, Iran, the de facto leader of Shiite Muslims, hopes to quell Sunni resistance, which, as the Islamic State showed, can be a potent threat.
Russia shares none of these goals with Iran. The two may tactically work toward the same goal – keeping Assad in power – but cooperation between Russia and Iran has always been a marriage of convenience, not a true alliance. Russia needs to prevent any one power from controlling too much of the Middle East. A state that eliminates competition in the Middle East would be able to look north, to the South Caucasus, a critical buffer region for Russia. Any power that can gain a foothold in the South Caucasus threatens the North Caucasus, which, in turn, threatens the Russian heartland. Russia must keep Middle Eastern powers competing against one another if it is to prevent any single actor from cementing a position of strength in the South Caucasus.
Russia and Iran’s interests also diverge on oil. The government in Moscow relies heavily on oil and natural gas revenue, so any increase in the price of oil benefits Russia. Iran has a relatively low fiscal breakeven point for producing oil – it can turn a profit when oil is roughly $55-65 per barrel – so it could afford to produce more to keep prices low. Now that the Iran nuclear deal is all but dead, uncertainty around Iranian production has driven up oil prices, giving Russia a little more breathing room. In other words, sanctions on one U.S. enemy, Iran, benefit another, Russia.
Then there’s Israel, with which Russia has friendly relations. Iran’s expansion has begun to invite attacks from Israel, which objects to having an Iranian presence so close to its northeastern border. While Russia is content to bomb rebels in Syria who have no real way to defend against air attacks, it is far more apprehensive about getting caught up in a war against a country with a powerful military and strong motivations to intervene. Israel’s fight isn’t with Russia, and Russia’s isn’t with Israel. But Russia and Iran’s joint support of Assad nevertheless risks pitting Russia against a country it has no interest in fighting.

This explains why Russian declined to retaliate after Israel attacked Russian anti-aircraft installations controlled by the Syrian military. In fact, Moscow didn’t even mention the incident. Sure, the installations in question were outdated, but the fact that Russia decided against selling Syria a more modern air-defense system, the S-300, a day after Prime Minister Benjamin Netanyahu’s visit to Moscow illustrates Russia’s desire to avoid providing Syria with the capability to damage Israel’s air force.
But for all the geostrategic reasons behind Russia’s intervention in Syria, Moscow also had a far simpler reason for propping up Assad: It needed to show the Russian people that, despite ongoing hardships, Russia had re-emerged as a global power. After 25 years of losing ground to NATO and the West, it needed to prove that it could counter the United States. It needed to test the preparedness of its military, which has undergone a number of reforms since its 2008 war with Georgia. (For Russia, the war was a success, but it exposed some weaknesses in its air force and in its missile capabilities.)
In Syria, a successful show of Russian force requires a victory and an exit strategy. Claiming that the Syrian military is strong enough to fend for itself, thanks largely to Russian assistance, fits with this narrative. It enables Russia to save face despite the fact it has been in Syria months after it declared its mission accomplished.
It’s unclear when, exactly, Moscow intends to withdraw its forces. When it does, Iran will be left with only a few options. It can continue to support Assad by spending more on the Syrian war, and begin to commit its air force, which, compared with Russia’s, is dated and dilapidated. Spending more is a difficult proposition for a country in the throes of protests over economic issues.
Otherwise, Iran could maintain its current level of support of Assad, but if Russia were to withdraw, Iran would be faced with Israel in its south and Turkey, which also has a modern air force, to its north. Without Russia’s backing, rebels, especially those who benefit from Turkish air support, would stand a better chance of retaking territory that they had lost to Assad.
Last, Iran could reduce its presence in Syria and instead focus on gaining greater control of Iraq, which is much closer to home anyway. That, however, presents its own set of challenges, and in any case risks opening up Syrian territory currently serving as buffer space to be taken by Turkey.
Though Russia hasn’t yet left Syria, its departure will put even more pressure on Iran and open the Middle East up to Turkey. Russia just needs a public relations victory. Iran’s battle is existential, and there are no clear paths to exit in sight. Nevertheless, fissures in the Iran-Russia relationship, even if just rhetorical, reflect the weakness of Russia’s position in the Middle East.

North Korea Is a Dangerous Distraction

The real struggle in Asia is with China — and Trump is throwing away U.S. advantages.

By Michael Fullilove, Hervé Lemahieu

People watch a television news screen showing pictures of US President Donald Trump (center) and North Korean leader Kim Jong-Un (right) at a railway station in Seoul on Nov. 29, 2017. (Jung Yeon-Je/AFP/Getty Images)
People watch a television news screen showing pictures of US President Donald Trump (center) and North Korean leader Kim Jong-Un (right) at a railway station in Seoul on Nov. 29, 2017. (Jung Yeon-Je/AFP/Getty Images)

President Donald Trump continues to express enthusiasm for a summit meeting with North Korean leader Kim Jong Un despite growing signs in the past few days that the summit will be delayed or may not happen at all due to Pyongyang’s latest recalcitrance.

The U.S. president has not abandoned hope that he will be able to pull off the deal of the century even if it now leaves him open to being stood up. If the summit meeting proceeds at all, the United States will go in from a position of strength. The inaugural Lowy Institute Asia Power Index, released this month, finds that the United States remains the preeminent power in Asia — in large part because it retains the most powerful military force and a network of allies in the región.

The index ranks 25 countries and territories in terms of their capacity to influence regional events. In the largest comparative assessment of its kind, we evaluate states’ military capabilities and defense networks, economic resources and relationships, diplomatic and cultural influence, resilience, and future trends.

Yet the U.S. position in Asia also faces significant challenges. Pyongyang’s brash nuclear-fueled confidence has distracted Trump from the real Asian story. After all, North Korea is a misfit middle power, ranked only 17th in the Asia Power Index. Its power is concentrated in one instrument — a nuclear arsenal that it cannot use without provoking retaliation that would end the regime.

Trump has shrunk the White House’s Asia policy to the dimensions of North Korea. His singular focus stands in stark contrast to his administration’s national security and defense strategy papers, which emphasize China as the true peer competitor of the United States. The president’s approach to his Chinese counterpart, Xi Jinping, as with several other authoritarian strongmen, has oscillated between the transactional and the acquiescent. Ultimately, Trump’s unorthodox worldview undercuts Washington’s ability to compete effectively against Beijing in the Asian power game.

China is closing in fast on the United States. By 2030, China’s GDP in purchasing power parity terms is forecast to be almost twice as big as that of the United States.

While U.S. military commitments are spread across the globe, China can concentrate its resources on its near abroad. As Adm. Philip Davidson, tapped to lead U.S. Pacific Command, acknowledged in his recent confirmation hearings, the People’s Liberation Army Navy is now capable of controlling the South China Sea in all scenarios short of a war with the United States. For now, China is unlikely to choose a fight with the most powerful military force in Asia. Instead, it is playing a long game, hoping the United States will eventually become weary of its Asian commitments.

The Asia Power Index demonstrates that Beijing has been successful at competing with Washington below the threshold of conflict. The Belt and Road Initiative and other projects play to Beijing’s strengths as the primary trade partner — and main source of foreign assistance and lending — in the region.

Yet the United States still remains preeminent in Asia, thanks in large part to its regional alliances. Defense networks are a cost-effective force multiplier. China has only one mutual defense treaty in the region — North Korea — and it is hardly reliable. Beijing eschews traditional alliances but has so far had limited success with its defense diplomacy despite its alleged interest in gaining enhanced access for its navy to bases and ports in the region. In addition, China has ongoing boundary disputes with many of its neighbors, several of which, such as India and Vietnam, are deeply distrustful of its intentions.

China’s soft power has hardened in recent years. But promises of the Chinese dream are still no match for America’s appeal in the region, as evidenced by the half-million Asian students choosing to attend U.S. universities each year compared with the tens of thousands enrolled in China. Independent U.S. newspapers and broadcasters — lambasted by Trump as “fake news” — constitute the most popular foreign media in all the countries covered by the Asia Power Index. China has spent billions of dollars on its state-owned media offensive abroad but has achieved only a fraction of this success.

For decades, Trump has shown himself to be allergic to free trade agreements and hostile to alliances. Yet these are the pillars of U.S. power in Asia. His policies in these two fields now threaten America’s standing in the región. 
Washington’s withdrawal from the Trans-Pacific Partnership was self-destructive. The threatened use of tariffs as a means of furthering U.S. economic foreign policy will only exacerbate what is already a weakness of U.S. power in Asia — its economic relationships. By virtue of its lower trade-to-GDP ratio, China is more insulated from escalating trade tensions than most other Asian economies. The biggest victims of U.S. economic nationalism and escalating trade tensions will be other Asian economies that are more reliant on global trade and the World Trade Organization’s rules-based system that Washington has long championed. With global production chains spanning across Asia, then, a trade war with China would amount to a trade war with Asia.

Finally, Trump’s long-held alliance skepticism is raising fears that he could yet undermine the credibility of U.S. security commitments in Asia, particularly extended nuclear deterrence. North Korea’s recent moves make it even clearer that the prospect of full denuclearization is off the table. One concern is that any deal with North Korea might therefore focus on Pyongyang giving up its intercontinental ballistic missile capability, which threatens the U.S. homeland, but would fail to resolve the security concerns of regional allies.

The long-term presence of U.S. troops on the Korean Peninsula has also been brought into question. Last month, Defense Secretary James Mattis caused international alarm when he said changes to U.S. force posture in South Korea would be discussed with Kim. The administration has denied reports that Trump had requested that the Defense Department prepare options for drawing down troop numbers. However, the president’s personal instincts clearly favor retrenchment. “At some point into the future, I would like to save the money,” he said recently.

A relocation of U.S. forces could conceivably be used to rebalance and consolidate U.S. defense commitments in the region in a way that offers greater security for U.S. allies and friends. But given Trump’s inclinations, it seems far more likely that it would only enable broader U.S. disengagement from the region by trading away security interests in return for a narrow peace dividend.

For seven decades, a formidable U.S. military presence in Asia has underpinned regional stability. The United States has kept a lid on interstate friction, encouraged economic liberalism, and maintained an open regional order that has allowed the rise of successive Asian countries. Now, just when a challenger is rising fast up the index of Asian power, America’s president seems unconvinced of the value of leading in Asia at all.

The Sea of Leverage in Chinese Markets

Large chunks of China’s stock markets have been pledged as collateral for loans

By Jacky Wong

Leveraged positions in China A share markets, as a percentage of market capitalization

Source: Bank of America Merrill Lynch

Passive investors are about to get more involved in Chinese stocks thanks to MSCI’s decision to include several of them in its key indexes. They will find themselves exposed to a market swimming in leverage.

About $1 trillion worth of stocks listed in Shanghai or Shenzhen—China’s two main markets—are being pledged as collateral for loans, according to data from the China Securities Depository and Clearing Corp., or ChinaClear. That’s equivalent to about 12% of the market.

Plenty of Chinese stocks are also used as collateral in margin financing, whereby investors borrow to plow more money into stocks. In all, some 23% of all market positions were leveraged in some way by the end of last year in China, according to Bank of America Merrill Lynch. 
    An investor monitors stock prices at a brokerage house in Beijing in 2016. Photo: Mark Schiefelbein/Associated Press 

The pledging of shares as loan collateral is particularly prevalent among smaller private companies. Unlike in the U.S., where institutional shareholders are a big market presence, private Chinese firms are often controlled by a major shareholders, who often own more than half of company. These big stakes are the most convenient tool for such big shareholders to raise their own funds. 
It isn’t always clear where the money they raise ends up. Former technology star Jia Yueting pledged his majority shareholding in Shenzhen-listed Leshi Internet Information & Technology to get funds to fuel his ambitions for the company from electric cars to film studios. The company still suffered a cash crunch last year, after which it was suspended from trading for nine months.

The risk for other investors when big shareholders take out such share-backed loans is that stocks can plunge sharply when the borrowers run into trouble. Hong Kong-listed China Huishan Dairy fell 85% in one day in March 2017: It is unclear what triggered the selloff in the first place, but the fact that Huishan’s chairman had pledged almost all of his majority shareholding in the company to creditors likely made the crash worse.

MSCI has limited its coming index inclusion of domestic Chinese shares to only big cap stocks, but that doesn’t mean it is free of problems. Some new entrants such as Kangmei Pharmaceutical , China Grand Automotive Services or Giant Network Group have about half or even more of their shares pledged as collateral for loans, based on data from ChinaClear.

Investors thinking of following MSCI’s lead and plunging into Chinese stocks should be aware of such hidden risks.

High Yield Train Wreck

By John Mauldin

My still-unfolding Train Wreck series is getting a lot of attention. It’s not exactly good news, but people at least appreciate the warnings. Thanks to all who sent thought-provoking comments. I always consider them carefully.

A few readers characterized the crisis I foresee as being a repeat of the 2008 fiasco. That’s partly right, in the sense we will have a painful economic and market downturn, but the causes will be quite different.
Last time around, the root problem was excessive residential real estate debt. Reckless lenders made unwise loans so unqualified borrowers could buy overpriced homes. These loans morphed into securities and derivatives and all blew up. I don’t think it will happen that way again. The next crisis will spring from corporate debt, equally imprudent but structurally different.
This train wreck will be similar in one respect, though. The first defaults will occur at the lowest end of the problematic market: high yield or “junk” bonds. They will play a role comparable to subprime mortgages in the last crisis. We’ll see mortgage problems as well, but I think overleveraged companies will be the core problem.
Before we go into that, you might want to review prior installments in this series or read them first if you’re just now joining us.
Today, we’ll look at a not-so-prime example of the reckless investments people are making in high-yield bonds, then consider how big the problem can get.
But we’ll start with a little history.

What Are They Selling?
Older readers will remember a Houston-based company called Enron that blew itself, its employees, and investors to smithereens during the 2001–2002 recession. Investigations followed. Some management (properly) went to prison.
In the late 1990s, Enron engaged former Reagan speechwriter and Wall Street Journal columnist Peggy Noonan to help explain itself to the world. Noonan, possibly the greatest business writer of her generation, couldn’t do it. She described the experience in a 2002 column.
Let me tell you what I saw when I was there. I saw cavernous rooms with big monitors on the walls and on desks too. The monitors and computers were blinking out numbers. I remember the numbers and words on the screens as bright green. Young future Masters of the Universe were standing with phones, monitoring the numbers, saying things, buying and selling. I met with a woman famous in the company for being in charge of putting big natural gas pipelines into Central or South America and India. She seemed intense and intelligent and, like the men, very Armani but kind of Texas Armani—everyone well-tailored but with more gold, more colors than Wall Street people, who are sort of more gray-hued…
And I thought, they spend a lot of money. That was one thing that hit me hard in Houston: They were “hemorrhaging money!” as Tom Wolfe’s Sherman McCoy said. They were building this and tearing down that, they were, they told me, talking to legislators in various state houses, lobbying to get deregulation bills passed. All of it seemed expensive, labor-intensive, time-intensive.
And it all seemed so tentative, so provisional. The Enron building was huge; the Enron sign outside, the big tilted E, was huge; the gold earrings on the women executives were huge; the watches on the men were huge; the paychecks were huge; the company’s ambitions were huge. But all of it seemed to depend on things that were provisional. If they are able to build the big pipeline in India, it will be great and profitable—provided it happens. If they are able to get states to deregulate electricity, and Enron is able to provide it, and it all goes well, it will be great and profitable—if it happens. If the Central or South American pipeline goes through and works and runs a profit it will be great—if it happens. An empire built on ifs. It all seemed so provisional…
I went away for a few weeks and worked hard and tried to put together a speech and make a contribution to the annual report, but none of it really worked… the key part was that I couldn’t help them explain their mission because I didn’t fully understand what their mission was. I understand what the Kenneth Cole shoe company does. It makes shoes and sells them in stores. Firestone makes tires. I couldn’t figure out how Enron was making its money, what exactly it was selling, and every time I asked, I got a kind of gobbledygook answer or a cryptic one, like “The future!”

Sound familiar? That’s probably how you or I would feel if we toured some Silicon Valley unicorns today. They’re very confident and have big dreams. Whether the dreams can ever make money is a different question.
Enron wasn’t entirely vaporware. Those people Peggy Noonan saw really did trade electricity. Before the collapse, it spun off a subsidiary called Enron Oil & Gas which survives today as EOG Resources, a major shale player. But most of the dreams went nowhere, disguised by accounting fictions that eventually fell apart.
This is all obvious now. Back then, it wasn’t. Intelligent, seasoned investors believed Enron really was “the future!” and gave it their hard-earned money not only for equity but for debt. Lots of debt. Enron's bankruptcy filings showed $13.1 billion in debt for the parent company and an additional $18.1 billion for affiliates. But that doesn't include at least $20 billion more estimated to exist off the balance sheet.
Now other investors are buying into today’s dreams. Maybe some will end more happily than Enron did. But you might not want to bet your own financial future on it.

Office Space
I’ve talked about potential problems in the high-yield bond market. That’s the polite name for “junk” bonds, issued by companies that can’t earn an investment-grade rating even from our famously lenient bond rating agencies.
This is a two-layer threat. First, many of these companies are so marginal that even a mild economic downturn could render them unable to make bond payments. The second layer is that bondholders will want to sell those bonds, but the liquidity they presume probably won’t be there.
I could point to many examples, but we’ll take one that was in the news recently: WeWork. The still-private company issued bonds last month, giving the public a peek into the books. The offering raised $702 million at 7.875%—a nice yield if it lasts the full seven-year term. That is if you get your capital back at the end of those years. I’m not convinced investors Will.
WeWork, at least, has a clear business model, one proven by other companies, and they are executing with panache and flair. It signs long-term leases for office space, then subleases to the hordes of freelancers and independent contractors who need an inexpensive workspace. Much of it is just tabletop space in open suites. This is apparently attractive to the younger set who like being close to peers, and the price is certainly right. WeWork provides all sorts of amenities which create an enjoyable workplace. Founder Adam Neumann is a charismatic executive who’s obviously adept at raising capital. So, it could last for some time.
The risk is that WeWork’s renters could disappear quickly if their own income dries up, as will happen for many when the economy breaks. Investors seem to believe this risk isn’t just manageable, but negligible.
Grant Williams featured a lengthy WeWork analysis in this month’s Things That Make You Go Hmmm... (You can read it here if you’re an Over My Shoulder subscriber. If you’re not, learn how to become one.)

After walking through the numbers and comparing WeWork’s current $20 billion valuation with comparable companies, Grant says investors have essentially gone insane.
The list of investors’ concerns around WeWork belong to a bygone era when those lending a company their precious capital (and foregoing a risk-free return) used to require that company’s assets and liabilities bear some relationship to each other.
Negative cashflow also used to be ‘a thing’ and ‘strategic challenges’ once raised an eyebrow or two.
Not anymore.
Instead, in a world of yield-seeking and minimal due diligence, the combination of a (relatively) juicy yield and the appearance on a company’s register of superstar names like Masayoshi Son is all that’s required for what once counted as material aspects of a company’s business to be forgotten.
Grant isn’t the only skeptic, either. Developer John McNellis ran the numbers and reached this conclusion:
If, instead of merely subleasing 14 million feet, WeWork owned 14 million feet of office buildings at a valuation of say $500 a foot, the company would be worth $7 billion or roughly one-third of its self-touted value. And that $7 billion valuation would presuppose owning all of those buildings free and clear of debt.
McNellis also highlights something important from the bond disclosures.
WeWork neither signs nor guarantees its own leases; rather, for each lease it signs, it creates a single purpose entity [SPE] with very limited capitalization; i.e. its leases carry almost no financial exposure to the parent company. These entities are known as SPE’s (“Screwing Probably Expected”).
So, if WeWork’s renters disappear, the first victims will not be WeWork, but the property owners who leased space to WeWork. They may have little recourse. But they’re probably leveraged themselves, so the losses will flow upstream, eventually to the banking system. And we know where that ends.

Unraveling Dream
Here’s the truly scary part: WeWork isn’t unusual. The landscape is littered with similarly tenuous corporate borrowers. It is the inevitable consequence of a free-cash decade. Here’s Grant Williams again.
Ten years into the ongoing laboratory experiment being conducted by the world’s central banks, everywhere you look there are multiple examples of the kind of lunacy those policies have fomented by reducing the cost of capital to virtually zero and forcing investors to take risks they would ordinarily avoid in order to find some kind of return.
WeWork is one example of a company for whom, in the face of rapid growth, massive negative cashflows aren’t a problem, but there are plenty of others. Uber, AirBnB, SnapChat and, of course, Tesla have all captured the imagination of investors thanks to lofty dreams, articulated by charismatic CEOs—but the day things turn around and the economy begins to weaken or, God forbid, investors seek a return on their investment as opposed to settling for rolling promises of gigantic, game changing revenues to come, it is over.
Look, I’m all about “lofty dreams.” I have them myself. I admire entrepreneurs who take risks and break new ground. They are the key to economic growth.

Building a business is the single best and most effective way to create personal wealth. But it’s also true that most of those dreams are simply dreams and will never come true. A few who bet on them win big, but most lose some or all of their investment.
Adam Neumann at WeWork has convinced investors that his office space rental company should actually be viewed as a technology company. We are creating a “community” he says. Whatever that is. There is a successful and larger competitor whose valuation is roughly 10% of WeWork. But then, they are in the office space rental business, not the “creating a community/building the future” business.
A long line of businessmen and women seemingly have the gift to convince investors to buy unrated paper that is unsecured with no assets behind it. The problem is that unraveling dreams tend to be contagious. Investor psychology is fragile, so the collapse of one high-profile dream can bring lesser-known ones down, too. I think we’re approaching that point.
Yet something interesting and a little counterintuitive is happening. You might think the yield on bonds issued by risky companies would rise as the cycle matures. That would be consistent with investors demanding more compensation for their risk. But it hasn’t happened that way.

After spiking higher during the 2015–2016 oil bust, when many shale drillers had serious problems, yields dropped in 2017. Not by coincidence, that’s also when the Federal Reserve began hiking rates every quarter. Fearing capital losses, Treasury investors relaxed their credit standards and created more demand for junk bonds, which sent those yields lower. That’s my theory, at least.
We’re seeing classic end-of-cycle behavior: throw caution to the wind and plunge capital into the market’s riskiest corners. This artificially-induced buying is propping up companies that would otherwise succumb to the fundamental forces arrayed against them.
Nor is it simply a junk-bond problem; the investment-grade corporate market is becoming measurably riskier. Here’s a Dave Rosenberg chart that my friend Steve Blumenthal shared recently.

Source: On My Radar

Almost half of investment-grade companies are rated BBB, just one step above junk, up from just one-third in 2009. When the economy breaks, some of those companies will run into trouble. Some of those will get downgraded, which will force many funds to sell them, thereby intensifying the liquidity storm I’ve described.
A few companies will probably default. Bondholders may have little recourse to recover their principal, having accepted covenant-lite conditions and taken on leverage themselves.

Source: On My Radar

Leveraged lenders will be in a pickle when the defaults begin, but they won’t be the only ones. It all flows downstream. Whoever extended credit to leveraged loan buyers will be in trouble, too. That’s how problems in one market spread to others.

Covenant Lite

Let’s explore what we mean by the term covenant lite. Borrowers can become extraordinarily creative.
Covenant-lite loans is a type of financing that is granted with limited restrictions. Traditional loans generally have protective covenants built into the contract that protect the lender, including financial maintenance tests that measure the debt-service capabilities of the borrower. The issuance of covenant-lite loans means that debt is being issued to borrowers with less restrictions on collateral, payment terms, and level of income. Covenant-lite loans place less restrictions on the borrower in terms of requiring collateral and a certain level of income. Covenant-lite loans are also referred to as cov-lite loans. (Investopedia)
Some covenant-lite loans let the borrower repay with freshly issued debt—in essence, printing their own money. Others allow them to borrow even more money, perhaps pledging assets that should have gone to the company, in order to let the firm’s initial private equity investors pull out equity. This effectively transfers additional risk to bondholders.
The closest comparison I can imagine is the dot-com run up to 2000, and the debt is still growing. While high-yield bond issuance dropped somewhat over the last few years, leveraged loans at the same companies are up 12% since 2014.
There is a lot of overlap in the companies that issue high-yield bonds and issue debt (loans), and it is no coincidence that the rapid increase in leveraged loans has coincided with a period of decline for high-yield debt. Since the end of 2014, the US high-yield market has shrunk by 3.7% while the loan market has grown by 12.7%.
In aggregate, the combined size of the US loan and high-yield bond markets has been broadly stable since 2014 (chart 2). Again, this is very different to the wave of mega-leveraged buyouts (LBOs), which expanded the high-yield and loan markets in the 2005–2007 period.
Chart 2: combined size of US high yield and loan markets

Source: BofA Merrill Lynch, Janus Henderson Investors, as at September 30, 2017

My data sources show different amounts of high-yield bond issuance, but all show a lot of it. Looking at just the Morningstar high-yield category, I see $1.4 trillion in mutual funds and almost $650 billion in high-yield ETFs. Some of these funds are well-managed and some are so large they buy anything (maybe including WeWork) because they need to invest their incoming cash.

Those numbers don’t count high-yield bonds held outside of funds and ETFs. As this National Association of Insurance Commissioners chart shows, the insurance industry has $240 billion worth of high-yield debt which represents 5.9% of their total bond investments.

Source: National Association of Insurance Commissioners

Then there are pensions, foundations, and endowments that have their own exposure to high-yield bonds.
The difference is (this is a big generality) institutional investors are typically buying specific bonds, so they don’t quite get the exposure to some of the extreme jumps. Further, they can hold to maturity, making liquidity less of an issue.
The roughly $2 trillion in high-yield bond funds and ETFs get marked-to-market every day. This means individual investors can see their values go down as well as up. If losses make enough of them begin to withdraw, it will force those funds to sell into a shrinking market, putting further pressure on valuations.
In a plunging market, you don’t sell what you want, you sell what you can

Funds have to meet redemptions. That means increasingly lower-rated bonds remain for investors who don’t move early. Valuations drop and it just cascades.
A decade ago, we saw a subprime mortgage debt crisis bleed into the rest of the markets. I think this time, the high-yield debt crisis will have the same result. Next week, we will look at The Second Act. Later on, we’ll get to emerging market debt and perhaps even worse, the non-corporate grade bond market in Europe—and don’t get me started on the problems in China.
This is a long story and we’re still at the beginning.

Cleveland, Philadelphia, Grand Lake Stream, Beaver Creek, and Boston

Shane and I are mostly home for the summer, where I intend to spend more gym and writing time. At some point, we will take a quick two-day trip to Cleveland to go through the Cleveland Clinic’s executive health checkup program with our friend Dr. Mike Roizen. We are trying to arrange a few other meetings there which has the schedule unclear at this point.
In August, I will take my traditional Camp Kotok fishing trek with many friends and my youngest son at Grand Lake Stream, Maine. Later that month, Shane and I will go to Beaver Creek, Colorado for an Ashford board meeting. We also plan to visit Woody Brock at his summer home in Gloucester and then drive down to Newport, Rhode Island to spend a few days with Steve Cucchiaro and his fiancée, Jama, on their catamaran. That’s actually a pretty relaxed travel schedule for me.
This weekend, some of the clan will gather as Amanda Mauldin Porter, her husband Allen, and their two young daughters (my granddaughters) will be here from Tulsa. Much of the rest of the family will come by to see them.
Much is happening in my business and writing life that I will be able to talk about in a few weeks. It should “buy” me significantly more time each week to do what I like: reading, research, writing, and thinking. That will hopefully improve the letters and other research. Maybe it will even open some opportunities for you. We will see….
It’s time to hit the send button. I have committed to finishing the letter much earlier each week, so it can reach your inbox early Saturday morning. This has forced me to completely rework my life schedule, but after being in the rhythm for a few weeks, I realize how much more fun (and productive!) I am without a deadline hanging over me. My partners have urged me to do this for years, but I couldn’t get out of my scheduling rut. They finally presented irrefutable data showing I needed to finish earlier, so I rescheduled my life. Best thing I’ve done in a long time.
Your here to help you get through to the other side of The Great Reset analyst,

John Mauldin
Chairman, Mauldin Economics

Opening the gates

Chinese travellers of all sorts have become ubiquitous

China’s decision to let its people travel abroad freely is changing the world. James Miles argues that it is changing China, too

“THIS COMRADE IS politically reliable and has no criminal record.” Applicants for a Chinese passport once anxiously awaited these words. Scrawled on a form by a bureaucrat, they meant an end in sight to weeks or months of torment that involved queuing through the night, being sent from pillar to post in pursuit of documents, having your loyalty to the Communist Party checked, being grilled about your purpose and sources of funding, and having to slip cigarettes to sullen officials. Not many people got to see those precious words, or the four Chinese characters that followed them: tongyi chuguo (permitted to go abroad).

Aspiring travellers in Communist-ruled China had to run this Kafkaesque obstacle course until the early 1990s. But in the past quarter-century a country once almost as paranoid as North Korea about keeping its people within its borders has dramatically changed course. Whereas for much of the 1980s the number of trips abroad taken by Chinese citizens was in the tens of thousands a year, the current figure is well over 130m. The reasons for travelling range from tourism and study to business and migration. By 2020 the total could reach 200m a year, officials estimate—the equivalent of nearly one in seven of the country’s population.

Much has been written about how China’s rise as a global economic, political and military power is changing the world. This special report is about another side to the story: the extraordinary number and variety of Chinese people who are going abroad—and then mostly returning. It will examine the effect of this unprecedented flow on the travellers themselves, on their host societies and ultimately on China itself.

Since the 1980s people have been moving around the globe in ever-growing numbers. The reasons have ranged from the collapse of communism in the Soviet Union and eastern Europe and the opening of borders in the European Union to the growth of middle classes across the developing world and the flight of millions from conflict and poverty. But China’s contribution to this mass movement has eclipsed all others.

Its people are making a striking difference the world over. On university campuses in Sydney Chinese students fill lecture halls and research labs. In California’s Silicon Valley Chinese scientists make up a big share of tech firms’ brainpower. In the medieval Italian city of Prato thousands of Chinese toil in clothing factories. In small towns in Namibia Chinese traders peddle cheap wares. Big-spending tourists from China snap up luxury brands in Mayfair in London and the Champs Elysées in Paris.

Forty years ago, when Deng Xiaoping “unfastened the great gate of reform and opening”, as officials often put it, it was far from clear that this would ever happen. Deng’s idea of opening was warily to admit some foreign tourists and businesspeople and, on an even tighter rein, journalists. He saw this relaxation as an economic and diplomatic necessity. A more normal relationship with the West, including visits by Westerners, was an essential salve for China’s Mao-battered economy. 
Deng also saw some benefit in sending more Chinese students to universities abroad to acquire technical know-how at state expense, but he never envisaged an outflow on the scale seen since. “There are those who say we should not open our windows, because open windows let in flies and other insects,” Deng reportedly said in 1985. “But we say, ‘Open the windows, breathe the fresh air and at the same time fight the flies’.” As it turned out, swatting insects took up a lot of his time.

Fortunately for China, the Communist Party was sometimes prepared to take risks. This was evident in three main areas. The first was reforming the economy. In the 1990s leaders ignored the complaints of conservatives and pushed ahead with the closure or sale of tens of thousands of state-owned enterprises. With the rapid growth of private business, the shift of many state employees into these new jobs and the migration of tens of millions of people to find work in cities, the party lost much of its once all-controlling network of workplace cells (it is still struggling to build a new one). But the reforms helped to catapult China into the ranks of global economic powers.

The second big risk was taken by Deng’s successor, Jiang Zemin: embracing the internet. Mr Jiang may not have realised in the 1990s how much this new technology would change the world (who did?). But it was still a gamble for a party that was determined to control the spread of information. And it paid off: China became a global leader in information technology, and the party remained in power. 
The third gamble was to open the country’s gates and allow people to leave. The exodus started haltingly but steadily gathered pace. Since 2007 the number of visits abroad made by Chinese people has more than tripled. To cash in on China’s tourism boom, many countries have greatly eased their visa requirements. Some have also opened their doors to rich Chinese migrants by giving them permanent residency, at a Price.

Bonanza or excess?

For many people in host countries, the growing presence of Chinese people is a bonanza. But it is also fuelling resentment, sometimes tinged with racism. Residents of Australian cities fret about soaring property prices, which they attribute to Chinese demand. In parts of Africa people grumble about competition from Chinese shopkeepers or construction firms. Italians sound off about a perceived threat to their textile industry from Chinese migrants, many of them illegal.

Political and security fears come into the picture, too. Across the West concerns are growing that universities rely too heavily on fee income from Chinese students, exposing the institutions concerned to the risk of espionage in high-tech labs and ideological interference by the Chinese state. In February the director of America’s FBI, Christopher Wray, called China “not just a whole-of-government threat but a whole-of-society threat”. Noting the activities of what he called China’s intelligence “collectors”, he said that “it’s not just in major cities; it’s in small ones as well. It’s across basically every discipline.” Some governments worry that having millions of its citizens abroad will encourage China to boost its military power.

Western politicians might show more enthusiasm about this wave of Chinese visitors if they thought that the travellers, once returned home, would transform their country with liberal ideas they had picked up abroad. But evidence of this is scant. As Xi Jinping, China’s leader, clamps down ever harder on civil liberties, flexes his muscles in the South China Sea and squeezes foreign firms for intellectual property, a more global China does not seem to be getting any easier for the West to deal with. And for its people, familiarity with Western ways appears to be breeding mainly contempt.

Yet this report will argue that it is far too early to assess the full impact on China of this large-scale movement of people. It will look at the tens of millions of Chinese tourists who are flocking to Western countries every year and sending back images and accounts of their impressions to countless millions back home; the hundreds of thousands of students who head annually to Western universities for their first taste of intellectual freedom; the tens of thousands who head abroad to eke a living in factories, shops and restaurants (and dream of making a fortune); and the hundreds of thousands of wealthy Chinese who shuttle between two rich worlds—the affluent suburbs of Western cities, where they snap up expensive properties, and the boomtowns of China, where they fill boardrooms.

Travellers returning from abroad, and the ideas they bring with them, have played a crucial role in the country’s tortuous history, especially since the 19th century. The recent flow has been greater than anything seen before. In the long run, Deng may turn out to have been right to worry about political flies.