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Dan Alderson

Nian was a fierce dragon that used to rule the land until a magical warrior put a spell on him. Because of this spell, Nian was forced to hide in a mountain under the sea. But in spring Nian came out to fill his empty stomach…

Financial markets are at a pinch point, to use the parlance of novel writing, in which the actions and agenda of the main antagonist are liable to appear. In this edition of the column I thought I’d consider two antagonists lining up to thwart the hero’s journey to glorious credit returns.

For those familiar with the theory of plot structure, a pinch point may seem odd given it’s only one month into the western calendar year. But not so much if you consider that the last plot point really came at the end of Q3 when bears got royally wrong-footed by an ebullient year-end rally.

Other than a slight pause to greet 2024, much of that momentum persisted through January, despite returning doubts about the timing and path of central bank rate cuts. It’s largely the combination of these factors that has brought a rude wake up call now for investors who bought into challenged high yield borrowers with what one buysider described to me as “beer goggles”. 

Central bank policy is definitely an antagonist at this pinch point, but there’s another one that is much less obvious and has been lurking in the background for some time. 2023 was very hard to read, and one big disappointment was China’s failure to deliver on the post-Covid promise it offered as a global growth engine. With Chinese New Year just days away — and often a starting signal for various parts of capital markets — I wonder if this will again be a surprise component.

The impending Year of the Dragon is also this edition’s literary theme (through Virginia Loh-Hagan’s retelling of the story), and presents another worthy antagonist to revisit. In the Chinese zodiac, this mythical creature is associated with authority, prosperity, and good fortune, and 2024 being specifically a Wood Dragon portends evolution, improvement, and abundance.

Thus the surprise could even be to the upside for China itself, but a challenge to central banks’ inflation curbing plans. 

US and European credit spreads have moved about a fair amount since the start of the year, but they’ve entered a range-bound channel. Low 300bps area has set the impasse for bullish sentiment on the iTraxx Crossover index (at 328bps today) until rates questions start to resolve. Loan BWIC activity also appears to be slowing after the early outburst. 

All the while though, the foundations of many a business have been corroded by high rates. Latest CLO research by Bank of America makes worrying observations about the composition of leveraged markets — even though the strategists believe these could be alleviated when rates start to fall. Within the European Leveraged Loan Index (ELLI), constituent downgrades are happening almost eight times as much as upgrades.

ELLI downgrades to upgrades ratio — source BofA / LCD

BofA noted 26% of Moody’s rated CLO collateral is languishing at B3 — or 40% of collateral maturing next year for deals inside reinvestment periods — while the single B minus component of ELLI is the highest since January 2003. 

“Building par by swapping loans for bonds is still possible,” wrote the strategists, “though less attractive when also trying to simultaneously reduce WARF. On average, B3 loans are now trading at 95.8 whilst fixed-rate bonds rated B3 and B1 are trading at 86.6 and 93.6, respectively.”

The problem is that central banks feel like such a well known antagonist it may be easy to downplay their actions (or inaction). But the latest comments of US Federal Reserve chair Jerome Powell and other committee members has entirely dashed hope for a March pivot — the big thesis of credit pros going into 2024. May is the next calendar point in focus and for now is deemed plausible, but how much damage will be done in the meantime? If latest UST daily moves — some of the biggest since the Fed began hiking — are anything to go by, it could be a lot.

There are widely held credits for whom high rates are really starting to bite. A notable bloodbath has been Swedish debt purchaser Intrum. My colleagues Owen, Nathan, Matthew and Emmet have written insightful pieces about that borrower’s problems here, here and here. But an 8.5-point tank in high volume one-day trading of Intrum’s 2026 Senior FRNs to 80.5 followed its downgrade on Monday by S&P, with another two-point drop today (Wednesday). Some buysiders believe this is symptomatic of the sickness hitting a broader array of credits due to lengthening timelines on the rates pivot. 

“Last year a lot of people had beer goggles on when buying things like Intrum and REITs,” says one buysider. “Intrum camouflaged as a debt servicer but it was really an SVP with Scandi funding costs, betting on NPL recovery. That only works if rates are low, so with funding costs going from 2% up to 10% what is it’s reason to exist? It’s been selling the best assets of its portfolio but it hasn’t delevered. Paying down front end bondholders is an attempt to play for time, but it should be converting debt into equity.”

More broadly, pushback by central banks not just on the timing of rate cuts but how many means time is itself a problem for Intrum and a lot of other high yield borrowers. 

“It’s also very likely Donald Trump gets elected US president and that means more US fiscal policy,” adds the buysider. “There’s no way in this environment we are going back to low rates soon.”

The Fed has plenty of other reasons not to cut rates. Inflation is sticky, US stocks are flying high, employment figures are strong and real estate, while arguably on a bad path with regional bank worries resurfacing, is still somewhat resilient. Jerome Powell clearly doesn’t feel the Fed can yet vouch that everything is under control, and currency markets (as well as Europe’s economic struggles) suggest there’s more chance the ECB will pivot first.

EUR/USD slump reflects falling hopes of Fed rates pivot

One thing the Fed hasn’t had to think about too much is China driving another boom in commodity prices. On the face of things, it’s looking far less likely to factor as a global economic growth engine in 2024 than a source of financial calamity. 

The CSI 300 tells a dismal story for Shanghai Stock Exchange traded equities, down almost 20% over the past year.

The slumping CSI and Hang Seng indices couldn’t sit in greater contrast with the new highs being set by the S&P 500. That index continues to be driven in large part by feverish demand for AI/tech companies like Nvidia, which rose another 5% in one-day-trading this week when Goldman Sachs raised its stock price target to $800 a share.

This disparity between the two stock markets would likely be even more stark if it weren’t for the Chinese government’s increasingly desperate interventions to prop up the economy. The latest such announcement came yesterday (Tuesday), when Central Huijin Investment, an arm of state-owned China Investment Corp, said it has expanded its holdings of exchange-traded funds (ETFs). That accounts for the uptick at the end of that CSI 300 chart above.

For the Chinese government to buy up shares — or indeed the yuan currency or other Chinese assets — is not a particularly sustainable policy. The attempts of China’s Securities Regulatory Commission (CSRC) to clamp down on short-selling show there are plenty of investors who think there is further to fall. One sign of distrust surfaced recently through ETFs given Chinese domestic investors are blocked by the government from putting their money directly into foreign stocks. A massive pump by Chinese buyers on the MSCI USA 50 Index ETF in late Januaryproduced a huge disparity with its underlying value, until controls were imposed to stop it trading.

Trust in the government to resolve financial difficulties probably wasn’t helped last week by the spectacle of property giant Evergrande being ordered to liquidate by a Hong Kong court. As the BBC puts it in the article I linked, Evergrande has been the “poster child of China's real estate crisis” with more than $300bn (£236bn) of debt. But it’s been a lengthy collapse and, as discussed in this article last year, it is far from the only big Chinese property company in peril. 

The message from Evergrande’s liquidation is surely that the government will not — or cannot — step in to save companies with direct intervention. A less direct edict may come in the form of local governments, which themselves loaded up on debt during the property building boom, being tasked with finding other developers to complete the Evergrande homes some 1.5 million buyers are waiting for. 

But where to find a safe alternative when debt problems are rife throughout the industry and there is no government backstop? Over the past two years there have been eight Chinese real estate credit event triggers brought before the CDS Determinations Committee, the last of which was Country Garden in November. Real estate firms faced $125bn in bond defaults between 2020 and 2023, according to Visual Capitalist. And research last week by Bondsupermart placed the bond prices of 30 key developers at scary low levels, while saying the default rate of Chinese real estate US dollar bonds has risen above 70%. 

Arguably it is government intervention in markets, beginning 11 years ago in 2013 with the Anti-Corruption Campaign, that has caused so much distrust and capital flight among investors, bringing large sectors of the economy to the sorry state in which they now reside. But that crackdown really stepped up from late 2020, leading to the pulled IPO of Ant Group in October that year, tough restrictions on private tutoring from June 2021, and the delisting of DiDi Global from the NYSE in May 2022.

No wonder the IMF, in its country report last week, said authorities’ attempts to ‘proactively’ contain developer leverage have “contributed to a significant, but needed, adjustment in the property market that continues to weigh on economic activity”. It goes on to predict a 50% drop in Chinese housing demand over the next 10 years. 

A look at these charts shows how much the impact has already been felt, but this could be the tip of the iceberg.

Given this set up, and a thorough lack of optimism for China in 2024 (very different to early 2023), imagine how the global economy might look if this sleeping giant suddenly came roaring back out of the mists. 

Something definitely doesn’t sit right in the Chinese picture, that’s for sure, as the Organisation for Economic Cooperation and Development (OECD) has projections for Chinese GDP growth in 2024 at 4.7%. That’s down from 5.2% last year but still the third highest country on its list. The OECD does note this and its 4.2% projected China growth in 2025 represent “a lower performance than in any of the 25 years before Covid-19, reflecting weak consumer demand and structural strains in property markets”. 

Not bad though when you compare to US projected growth of 2.1%, and a paltry 0.7% for the UK (personally I think that might be optimistic, but dare to dream).

To Macro Prophet readers, Happy New Lunar Year and may the Wood Dragon bring you luck and success!

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