Daily Agenda: China Default Rattles Domestic Markets

ECB mulls cutting off banks in Greece; DuPont and Verizon announce quarterly results, Spain issues negative-yield sovereign debt.


While earnings season continues to dominate headlines for U.S. and European markets, investors in China are fixated on a bond market default. Baoding Tianwei Group Co., a company owned and operated by state-owned China South Industries Group Corp., defaulted on an interest payment for domestically issued bonds today. The company, which produces power transformers, now has the dubious distinction of being the first Chinese state-owned enterprise to fail to pay creditors, sending a signal that Beijing is willing to allow companies it controls to rise or fall on their own merits. To date, the only recorded defaults in the nation have been private companies, primarily in the so-called shadow banking segment. For investors used to the assurance that creditors belonging to the central government are a safe bet, the prospect of more defaults as key industries struggle with slower growth in China is sobering.

Greek banks risk ECB cutoff. Reports in media outlets attributed to sources within the European Central Bank today indicated that bank policymakers are discussing contingencies for tightening access to emergency funding for Greek banks. Numbers show deposits in Greek banks declining by nearly $8.2 billion in February alone, as savers in the Mediterranean nation steel themselves for a potential exit from the 19-nation currency.

Spain joins the negative yield club. In a treasury auction today, the Spanish government sold three-month bills with a –0.29 percent yield. This marks the first time that Spanish sovereign debt has been priced in negative territory, as ECB bond purchases and low inflation continue to drive euro-denominated markets higher.

Sentiment mixed in Germany. ZEW economic sentiment indexes for April released today registered at weaker than forecast levels. The headline economic expectations index measured in at 53.3 versus 54.8 in March, the first sequential contraction since this past October. Meanwhile, the current situation measure leapt to 70.2 in April from 55.1 the previous month, marking the highest reading since 2011.

Earnings season continues. Verizon Communications registered quarterly earnings well above consensus forecasts at $1.02 per share, versus $0.84 the same period last year. Wilmington, Delaware–based DuPont Co., whose executives are currently engaged in a proxy battle with activist hedge fund firm Trian Fund Management, reported net earnings that beat analysts forecast despite dropping significantly from the same period in 2014. The chemical industry giant guided full-year projections lower on concerns over the impact of a strengthening U.S. dollar. Yum! Brands’ first-quarter financials will be released after equity markets close in New York and will be of particular note for investors trying to gauge global consumer discretionary demand.

Portfolio Perspective: China Is Nearer the End Than the BeginningSean Darby, Jefferies

China cut the reserve ratio requirement by 1 percent, the biggest such by the People’s Bank of China in its history. The move probably follows the 4.6 percent year-over-year drop in March producer price index readings, as well as drop in food prices, which might have heightened deflation fears. Although there was some slippage in economic data in March, some of the macro numbers, such as weak trade data, can be explained by seasonal effects — a late Chinese New Year — on exports and the impact of lower commodity prices on imports. Moreover, labor market conditions are not weak, so the authorities have not been forced to loosen fiscal policy substantially.

The biggest drag on growth is still coming from the real estate sector, with inventories of unsold residential units climbing 24 percent year-over-year. The reserve ratio requirement cut is likely to mean more liquidity. The easing is also likely to mean further flows through the Shanghai-Hong Kong Stock Connect into Hong Kong. It seems that the excess liquidity created by the U.S. Federal Reserve is now being augmented by money from China as the capital account is liberalized.

Investors are wondering whether there is any precedent for any such change in money-market operations and the effect on asset prices. There are two examples. Firstly, as countries joined the euro and left behind their legacy exchange rates such as the Italian lira and the Irish punt, long bond rates converged. This was a multidecade phenomena and sovereign bond yields converged to those of the Bund. The second example is post the 1997–’98 Asian crisis as central banks broke from their U.S. dollar pegs. After months when money markets were experiencing significant volatility, the money-market rates began to drop as central banks moved away from shadow U.S. pegs to more open market operations. The result was a huge build-up in foreign-exchange reserves from countries such as Thailand and Indonesia.

Hong Kong’s money market could experience the same process as Europe. In a sense, Hong Kong’s money markets have been subsumed by China’s excess liquidity. China’s foreign-exchange reserves and money supply is many times greater than that of Hong Kong. In this sense, asset prices such as stocks could see multiples far higher than in previous economic cycles purely on the ability to arbitrage between the two systems. Ultimately, in our view at Jefferies, mainland-listed China A and Chinese companies’ internationally traded H shares, which are traded in Hong Kong — as well as the B shares will converge.

Sean Darby is the chief global equity strategist for Jefferies in New York.