The Greek Tragedy and a Chinese Fire Drill

Greece had been edging towards an exit of the Eurozone.  Global market risk, while elevated from the news, had generally suggested that the direct outcome of this event would be limited / falling well short of anything that would constitute a genuine crisis.  China, on the other hand, has emerged as a much more substantial issue with the weakness in the local Chinese market spilling into Hong Kong and global equity markets.

Until matters stabilize in China this will certainly continue to be the main driver of financial markets, and even the impact of a favorable end to the Greek mess would likely be overwhelmed by a continuation of the intense liquidation of Chinese equities.

Greek Tragedy;

  • The Greek people voted overwhelmingly against accepting the June 25 plan offered by its creditors. The “No” vote doesn’t necessarily mean Greece will exit the Eurozone but the potential had increased. This was a shock to the markets in that it was assumed the people would vote yes.
  • Eurozone leaders made Greece surrender much of its sovereignty to outside supervision in return for agreeing to talks on bailout to keep Greece in the Eurozone. Greece won conditional agreement to receive possible 86B euros ($95 billion) over three years, along with an assurance that euro zone finance ministers would start discussing ways to bridge a funding gap until a bailout – subject to parliamentary approvals – is finally ready.
  • That will only happen if Tsipras (Greek Prime Minister) can meet a tight timetable for enacting unpopular reforms of value added tax, reduced pensions, budget cuts, new bankruptcy rules and an EU banking law that could be used to make big depositors take additional losses.
  • Tsipras accepted a compromise on German-led demands for the sequestration of Greek state assets worth 50 billion euros – including recapitalized banks – in a trust fund beyond government reach, to be sold off primarily to pay down debt. The Greek Parliament approved the first round of measures required by the creditors, including changes to pensions and taxes, despite 21% voting against and some violent protests.  Greek banks open again, but capital controls remain in place. The Greek government repaid 2 loans to the IMF and ECB so far.
  • Market volatility could remain higher in coming weeks, but longer term, the crisis in Greece may not turn out to be a major global market event. Greece does not heavily impact the global economy and financial markets.  Any indirect effects are likely to be limited and temporary.

We believe the danger with Greece is not financial but psychological.  Uncertainty may trigger more unraveling and lead to contagion within the European Union.  Spain, which is also very anti-austerity, is facing an independence movement from one of its wealthiest regions, Catalonia.  The independence vote is scheduled for September 27th.  Spain, without the Catalonia region, would have problems fulfilling its current debt obligations.


Chinese Fire Drill;

  • The Chinese government had unlocked its previously closed stock market (called A-shares) to locals early in the year and Chinese stocks had been up over 140% from January to June 2015. The problem was that it was fueled mostly by margin accounts (leverage) and unsustainable market fundamentals.  Since June 2015 the A-Share market has fallen over 30% and entered into an official bear market correction.  Margin calls resulting from leverage accelerated the sell-off.
  • A method of tracking the degree to which this unwinding of positions has progressed is to use total margin debt [Marketfield Fund July 2015]. Total margin debt had declined -36.2% from its June 18th peak.  To put this in perspective October 2008 saw the greatest one month decline in NYSE margin debt at -22% in the 55 years of published data.  A decline of this magnitude and speed is obviously highly unusual and does at least suggest that we have made a full transition from extreme positive to negative sentiment.
  • There is also some comfort in the fact that margin only needs to be unwound once. Even the worst bear markets exhaust their down legs sooner or later.  If it were not for the mishandling of this affair by the Chinese authorities, we would be fairly confident that we were close to at least a bottom.
  • On a positive note the PBOC (China’s Federal Reserve) has been much more willing to supply liquidity. Interest rates, which can be volatile at the best of times in China, have remained calm. This is very important since it is our best evidence that stress remains contained in the local equity market rather than their financial system as a whole.
  • The stock market wealth affect in China is smaller than most assume, as stocks represent less than 15% of household financial assets and equity issuance accounts for less than 5% of total social financing,” writes HSBC Chief Economist for Great China, Qu Hongbin in July 7 note to clients.
  • It’s worth adding that China’s stock market is a fraction of the US stock market. For most Chinese households, consumption is driven by income growth not fluctuations in their assets, according to Qu Hongbin. Most people put the bulk of their wealth in cash rather than stocks.
  • The Chinese markets stabilized somewhat last week (+5%) although they remain very volatile from a day to day perspective (off 8% over weekend).

The Hong Kong market has been pulled into the epicenter of the crisis by the regulatory response. Recently the HSCEI index traded at a P/E of 8 and a Price/Book value of ~1 (just above parity). Unless this develops into a genuine economic catastrophe these represent very deep and long-term attractive metrics historically.

We are much more confident in the ability of the Hong Kong market to regain the losses of recent weeks once the crisis has run its course than the more damaged mainland market.  The Hong Kong authorities have acted in a far more mature manner and kept the market structure open during some of the worst sessions in modern history.