A Confluence of Debt

Posted on July 16th, 2015 by David Laidlaw

Between Friday, June 26th, and Monday, June 29th, three events combined to shock the markets. Greece’s Prime Minister, Alexis Tsipras, effectively closed the country’s banking system and called for a national referendum on whether or not the country would remain in the Euro. Secondly, Puerto Rico’s governor, Alejandro Padilla, acknowledged that the island would not be able to pay back the debt it has incurred. Lastly, China’s stock market continued a steep selloff including a loss of over 7%. The aftershocks of these events reverberated in the US causing stocks to drop by 2 to 2.5% for the day on the 29th of June. 

In both Greece and Puerto Rico, governments borrowed beyond the capacities of their respective economies to pay their liabilities. Complacent investors, whether central banks in the case of Greece or individuals and mutual funds in the case of Puerto Rico, have assumed that financial support would keep flowing until sometime after their bonds matured. (The quality of these credits is discussed in greater detail in the piece below).

On the other hand, China’s bear market is the result of the collapse of a stock market bubble. China’s investors, disenchanted with declines in real estate prices, poured money into Shanghai’s equity market over the past couple of years. Stock prices had surged by over 160% from the market’s 2014 low until mid-June of this year. Since June 12th, the market has corrected by over 25% and the government is scrambling to limit the damage. 

Debt has, however, also played a vital role in the Chinese stock market crash. Margin lending by brokers and third parties has allowed investors to leverage their investments well beyond their equity. Macquarie Research estimates margin debt is 2.3 Trillion Yuan ($370 Billion) and has risen 123% since the beginning of this year. This debt is equivalent to 8.5% of the total value of the shares traded on Shanghai’s exchange. On a percentage basis, this level appears to be roughly 4 times the margin lending on the New York Stock Exchange. Borrowing to buy securities is also amplified by peer-to-peer lenders that are providing money to stock market speculators. Therefore, it is very difficult to pinpoint the exact degree of leverage within the Chinese stock market.

Regardless, market losses will produce margin calls that require investors to sell additional securities. This positive feedback loop makes it very difficult to prevent further losses and instability within China’s markets until a bottom is reached.

The above situations exemplify the imbalances that are present in both the global debt and equity markets. Fortunately, there are sectors of significant strength in the US which are supporting the domestic stock market. Our economy continues to create a steady stream of new jobs. The US is on pace to create about 2.5 million jobs in 2015. Inflation and interest rates are still historically low, but it does not appear as though the threat from deflation is as strong as it has been. Further, public companies are still quite profitable. The vast majority of earnings weakness this year has been due to low energy prices and a strong dollar. Adjusting for these impacts would produce strong earnings growth.

Foreign equities have advanced nicely through the first half of the year with the MSCI All Country ex-US (Net) index up 4.0%. However, the S&P 500 has only increased 1.2%. Interest rates are up slightly, causing small losses in investment grade bonds. These muted returns are not impressive by themselves, but the figures are solid nonetheless given the incredible returns in the market since the financial crisis ended over six years ago.