Geopolitical Developments: China’s Newfound Anti-Capitalism Will Soon Sink Irrational Exuberance

While the payrolls report is pushing the market higher this morning there are increasing signs a correction is soon to come, as bullish exuberance is hitting overbought levels. The volatility risk premium is pointing to a range-bound market over the next few days, while my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought one positive factor for US stocks. The US yield curve is falling and in the current context that is bullish. But there was also one negative factor across global asset classes. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to be range-bound over the next few days until the market focuses on a reason to head lower.

The most recent catastrophe for property developers in China has yet to hit the US equity market but it’s just a matter of time now that the news flow is targeting the financial infrastructure. Not only is the Chinese Communist Party (CCP) targeting the prior beneficiaries who ran the property developers but now the credit rating firms are being questioned as they blithely downgrade these developers as their most vulnerable hour. Bloomberg notes: “As downgrades escalate, traders panic. To meet their own compliance requirements, private banks rush to slash loan-to-value ratios of the degraded companies, triggering margin calls and prompting wealthy clients to sell at a loss. In this high-yield bond world, a lot of holdings were bought on credit by the ultra-rich who can borrow cheaply. In recent days, to justify their actions, the firms pointed to developers’ mounting refinancing risks. But have they thought that this wave of downgrades may make it even harder for the issuers to refinance? On average, there is a 3 percentage point price drop to the issuers’ bonds two days after a rating action, according to HSBC Holdings Plc, which looked at 36 recent downgrades.”

The problem is not with the credit ratings firms, who were the bogeymen of the GFC when they did engage in sloppy practices that were widely known. Today the problem is more that investors lack shrewdness and rely on these firms instead of properly valuing firms. Bloomberg further notes: “Granted, China’s real estate developers are complex. Pinched by Beijing’s strict debt diet, developers did a lot of shadow banking, guaranteeing private bonds that are not on their balance sheets. Nonetheless, Fitch’s Oct. 4 decision to cut Fantasia’s ratings, complaining that “in a recent call” it heard “for the first time” about the existence of a $150 million private bond, is not good enough. We all know how to read balance sheets. We need ratings firms to dig up the dirt for us. ”

This is impractical since these firms are in the business of monitoring, and monitoring is not a normal behavioral function for people. No emotions can be harnessed to monitor something on a daily basis for an indeterminate time, unless survival or deep pleasure are involved. Credit ratings firms will always be late in downgrading firms and it’s up to investors to go long and short in anticipation, rather than expecting the impossible. Placing more reliance on these firms is another route to statism, where risks are managed by state regulations and quasi-regulatory bodies, raising costs of doing business and deterring economic dynamism. The result is eroding confidence which hits the markets in punches that lead to corrections and bear markets.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), FedEx (FDX), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a small net short position in S&P 500 (the levered inverse ETF SPXU).