Climbing a Narrow Ridge on Debt Mountain

The Chinese corporate, household and public sectors are all leveraged to the hilt. There is little room to wait for a prolonged trade war to ravage the industrial and export sectors further.

China needs a trade deal with the US and it needs it relatively promptly.  Asian economies in general are in an incredibly fragile state with South Korean exports contracting, export-dependent emerging markets clinging on to idle speed manufacturing PMI readings, and Chinese debt service payments coming due after being augmented by consecutive rounds of grandesque fiscal stimulus.

China corporates are now even more leveraged than those of Japan in the early 1990’s before that bubble found its pin. Additionally, household debt in China as a percentage of disposable income has blown past US levels. This can be seen below in the following charts.

04.23.19 china debt record

Base case is some kind of incremental US-China trade deal takes place in the coming weeks. The bar is high for a risk appetite-boosting deal, however, and even a big deal could have negative side effects in the form of higher interest rates we’ve seen inflict the wrath of an angry bear tearing into interest rate sensitive sectors such as housing and autos. A notable deal impasse would absolutely slam risk assets.

We’re back to an awkward yet familiar place where equity indexes are highly reliant upon central bank “cowbell,” a term appropriately coined by macro research shop Hedgeye, but you also have to know a liquidity cannon would be pointing at you on the other side of many risk-off favoring positions moving in-the-money. This places several key asset classes in soggy, wait-and-see ranges.

I see greater risks to the China outlook than appreciated by market consensus as it requires increasing amounts of debt to have marginally less impact on growth, and trade deal prospects have been so heavily priced in that any hiccups on that front could spark significant equity downside on higher volatility.