Month: September 2014

Why is the Iron Ore Price falling?

The Wall Street Journal has an excellent piece on developments in the iron-ore market – the commodity which has seen a price drop of 40 percent in 2014. Iron ore, remember, is Australia’s main export product. As regular readers know, I have been following the this market due to my bearish stance on China and Australia for the past three years.

The slowing Chinese economy  is seen as the main culprit for the massive drop in the spot price of iron ore (and other commodities). To quote:

Looming over iron ore, and all other commodity markets, is China’s economic slowdown, which has sent prices to multiyear lows for everything from silver to coal.

So far, I mainly agreed thinking that oversupply will become an issue only in the second half of 2014. Turns out I was wrong, as you can see in the chart below:

WSJ_Iron_Ore

Incredibly, neither iron-ore imports nor China’s steel output have slowed down so far, but the price is already down by 40 percent! Now, that’s what I call a supply glut. Quote:

The volume of additional supplies being pumped into the seaborne market, largely from new and expanded mines in Australia’s remote northwest, is declining, but analysts say it may take some time for an oversupply in the market to be absorbed. Shipments through Port Hedland, the world’s biggest iron-ore export facility, were up 36% in August compared with last year, the local port authority said.

The increased volume has more or less counterbalanced the price drop, with the effect of keeping Australia’s export earnings up and its current account within acceptable bounds (around -3 percent of gdp). Can you imagine what will happen to iron ore prices and to the Australian economy once China comes to its senses? Nothing has happened yet…

Disclosure (short AUD and CNY)

 

Observations and thoughts from my latest trip to Asia

I am currently traveling in Asia, so posting has been light in the past few days.
In Singapore I had the opportunity to talk to a few people with good on the ground knowledge of banking business in Asia. Needless to say, most of the deals being done are a derivative of the China play: be it coal mines in Indonesia, where loss making, high-cost miners arise the interest of private equity funds in expectation of a turnaround, or be it exporters all over Asia playing the Yuan carry trade via in-house trading companies – all trades are dependent on China’s mandarins achieving a “soft landing”.  The atmosphere is buoyant, credit standards are low and Singapore is ludicrously expensive.

Singapore, as a global center for trade finance, is natural habitat for CNY carry traders: I was told that trading companies have over the past few years increasingly accepted to be paid in CNY by their customers despite being funded in USD thereby nicely increasing their operating margin (Being long the CNY earns you an interest rate differential vs. the USD). A lot of commodity producers and logistics companies do have their own trading operations located in Singapore. Fittingly, this week Forbes Asia  had a nice story about the turnaround at CWT, a large, listed logistics company from Singapore whose seminal decision in the turnaround was the aquisition of a commodity trader. From the Forbes article:

Then, in 2011 Loi pulled off the deal that has transformed the company, spending $94 million to buy most of MRI Trading, which had been set up by the late Glencore founder Marc Rich. Margins may be very low, but cash flow is very stable. “With MRI we buy and sell commodities rather than being simply a middleman,” he says. “We have become a one-stop shop for customers.” He set up a second MRI headquarters in Singapore to complement the one in Switzerland, ramping up enough to become the world’s second-largest independent trader of copper concentrate; only Dutch behemoth Trafigura is bigger.

Given what I saw during my visit I would be surprised if CWT were NOT heavily long the CNY/USD. Indeed, I was wondering how much of the profit of Asian commodity producers (palm oil, coal, oil…) is due to the positive carry from CNY. Keep that in mind, next time you analyze any Asian conglomerate – I for my part won’t buy any, but I am getting ahead of myself…

I also learned that the rule of law does not really exist in most Asian countries. That might not be surprising in and off itself, but the extent to which local connections hamper ordinary bank business was still astonishing. For example liquidating collateral WITHOUT the cooperation of the debtor in Indonesia is virtually impossible. Once extend and pretend is not a feasible strategy anymore, large losses are in the cards. I had the feeling that these issues were much larger than, say, in Eastern Europe including Russia.

“Ah Indonesia, but certainly Singapore and the Tiger states are different,” I hear you say…

While certainly true that the sort of property rights infringements seen in Indonesia are unheard of in Singapore or Korea, these countries have issues of their own. It seems that corporate governance issues, albeit a problem with most listed companies, exist to an extent that are “unusual” for European or US corporations. Last week’s story about a land purchase by Hyundai illustrates my point:

Yesterday, companies controlled by the patriarch of SouthKorea’s second-largest family run conglomerate won an auction for a plot of prime real estate in Seoul with a 10.55 trillion won ($10 billion) bid, in what one researcher estimated to be the biggest-ever such deal worldwide. Hyundai’s rationale for offering triple the property’s assessed value is that the company will move its headquarters there and develop the area by building a hotel, convention center and a car museum.

Indeed, a hotel and a convention center are certainly reasonable business segments for a car producer to be in… But it gets really absurd if we look closer at the price paid:

The price Hyundai is paying stands out. At almost $130,000 per square meter, it’s more than triple the most expensive commercial block deal, on a square-meter basis, in Hong Kong:Agricultural Bank of China Ltd.’s 2012 purchase of an office tower on the outskirts of the Central business district.

130.000 USD/sqm – or triple the record price paid in the (booming) business district of Hong kong by Agricultural Bank of China, itself probably prone to overpaying! And this without properly informing investors and the supervisory board!

The company’s reaction? Judge yourself:

Asked to comment on concerns over the price, Hyundai Motor said in a statement that the offer was appropriate given factors such as the property’s future value, the company’s strategic plans and the need to create a “global control tower.”

You see: “global control tower” and future value – thank you, no questions anymore…

Conclusions

As regular readers know, it is my opinion that the Chinese credit expansion of the past five years, has affected world markets more than any western central bank policy. This is especially true of Asia, as evidenced by valuations and types of transactions that, I claim, would not be possible in this form in the US or Europe. China affects the surrounding countries’ economies not only via demand for services and raw materials, but also via profits from the (so far) successful CNY carry trade which is largely played via trade finance deals usually exclusively associated with (healthy) real economic activity. As a consequence, operating profits are distorted. Even if companies are indeed operationally successful (as is the case with Hyundai), corporate governance issues loom large and it is questionably to what extent long-term outside investors can participate. I, for my part, see no reason to invest in Asian equities (or currencies) at this moment – the Chinese slowdown is far from priced in.

Goldman proclaims the end of the Iron Age

Interesting developments in the iron ore market:

The iron ore price has just hit a new 5-year low and Goldman is out with a piece in which they conclude that the “end of the iron age” is near. Their analysis is a must read (read here at Zerohedge).

Goldman  basically states that we are shifting from an under supply phase in iron ore (2004-2014) to an oversupply phase which can be expected to last at least a decade. This comes as a result of the huge lags between investment and production – classic “Schweinezyklus“. To quote:

“On the supply side, the capital stock of the iron ore industry in Australia, Brazil and China increased by US$180 billion during the period 2003-12; this will fuel production growth for years to come (Exhibit 22). Now that the market has transitioned to an exploitation phase we expect new approvals for capital-intensive projects to become increasingly rare, largely because the economics of greenfield projects will be challenging in a oversupplied market. However, projects approved in the later stages of the investment phase will support production growth in the years ahead, and low-cost brownfield expansions at Tier 1 producers will remain attractive.”

So far, so good. With the difference that this time the demand picture might be unusually distorted, i.e. could prove to be much more elastic than historically observed due to the China factor. Again quote:

“On the demand side, lower prices for iron ore and steel are unlikely to boost demand in a material way. Instead, the day when steel production in China will peak gets ever closer. In the past decade, the Chinese economy added steel to its economy at a rate three times faster than the US did during the 20th century. On a per capita basis, the average household in China is accumulating steel at a rate equivalent to the purchase of a new car every 8 months (without disposing of its older cars). In other words, the volume of steel stock in China is racing towards the US level of 13 tonnes per person (Exhibit 21). If China is to converge towards the US level, steel consumption will eventually have to stabilize and steel recycling will play a larger role.”

Goldman’s analysts diplomatically choose the wording “…consumption will eventually have to stabilize…,” when in reality it is much more likely that Chinese demand will fall off the cliff once the absurd credit growth of the past decade subsides. I wonder whether any other outcome can be considered realistic given our experience of how investment booms end.

The piece is a must read, but if you time budget is constrained (not a good excuse) I have reproduced two charts that summarize the main point:

Goldman_iron_ore

Chinese steel-stock/capita is already at US levels. And yes, this is despite the fact that americans have several cars per household and despite the fact that there are still millions of hungry peasants in China that are eagerly waiting to move into cities.

The second chart depicts investments in iron-ore capacity per country. Note, how investment has really taken-off after the financial crisis, i.e. after we have already had books touting the commodity (around August 2008 oil hit USD 150/barrel) supercycle for half a decade. I can only speculate about why this is the case – long lead time for mine investments play a role for sure – but I think it also has to do with the fact that China’s investment binge really got out of control as a result of their huge stimulus program during the financial crisis.

Conclusion

A lot of China-derived growth stories (Australia, Indonesia, Brazil, African countries) will unravel and send ripples through the world economy in the next few years. Banks lending to these companies will be hit hard as it is safe to assume that they are overexposed (similar to the big German ship finance banks before 2008). On the other hand I can see how this type of deflation could be a stimulus for European economies that are importers of raw-materials thereby mitigating the effects of the sovereign debt crisis.

Disclosure: short AUD and CNY

 

Basel III, equity derivatives and “idle” Fed reserves

another FT article aroused my interest this week: it says banks are complaining about Basel III having a detrimental effect on equity derivatives trading. Since tighter funding rules would make transactions, such as equity swaps, more expensive they are trying to water down the proposal. From a letter sent to the Basel committee:

“By unnecessarily increasing the funding cost for banking organisations’ equity market intermediation activities, the revised NSFR would also potentially force such activities into the largely unregulated shadow banking system, increasing systemic risk.”

There you have it: shadow banks, systemic risk – all things, bank lobbyists know, regulators are trying to avoid like the plague. After all, it has been “proven” that shadow banks and systemic risk caused the last crisis. Of course, the shadow banks would never have existed, had not the banks themselves turned a blind eye and funded them generously, but that’s another story…

But back to the article. As it is not very specific, I can only guess what it is about (hint: it’s certainly not about shadow banking or systemic risk fears by altruistic bank CEOs)

 A short primer on Basel III

Under Basel III Banks are required to meet certain thresholds that measure the liquidity position of a certain institution. One ratio, the Liquidity Coverage Ratio (LCR), aims at measuring the short Term (up to 30 days) liquidity position of a bank, whereas the Net Stable Funding Ratio (NSFR) tries to capture a bank’s structural funding profile. Since I believe that the banks are worried about the LCR I will focus on this one for now. So how are these ratios defined and what do equity derivatives have to with them?

Basel III ranks assets according to their liquidity characteristics, weights them (similar to Risk weights) and sums them up to arrive at the numerator of the LCR Ratio. Same with the liability side: banks have to calculate their outflows in a stress scenario over a 30-day horizon. The estimated figure becomes the denominator. Divide numerator by denominator whereby Basel III prescribes a LCR Ratio > 1, i.e. banks are expected to cover their estimated outflows in a stress scenario for 30 days, without outside assistance.

( Zerohedge has posted a new article on the workings of Basel III LCR-ratio)

Fine, but what does this exercise have to do with equity derivatives?

Well, if a bank is long or short any derivative you are subject to margining. As with simple margin loans, with swaps or futures you only need a fraction of the money of the notional amount to enter the position, but you need to come up with additional cash as the position moves against you. If you cannot come up with the cash? Well, that’s how AIG failed. So far there has been no regulatory rule telling banks how much cash to hold (in addition to the initial margin required by my counterpart) against these positions for regulatory purposes – they could do as they please (there were rules for the credit risk associated with derivatives, though). Under Basel III, however, banks will be required to specify their potential outflows from such positions for a 30 day horizon under stress and it seems this is causing headaches.

Enter equity swaps

Most banks hold interest rate derivatives in order to steer their balance sheet’s interest rate risk. despite the fact that notional amounts can be very high, the fact remains that the duration of these derivatives usually is in the single digits, i.e. not that large. Further, interest rate movements in the age of the central banker tend to be well contained, i.e. an increase in rates of, say, 100 bp. can convincingly (in the eye of risk managers or regulators, that is) be seen as a shock – hence the cash outflows, in case of an adversarial movement are more or less within a single digit percentage of the notional. Also, banks have been using interest rate derivatives for a long time, their treasuries have in all likelihood already experienced one big rate move or the other, i.e. they should have enough experience with that.

Equity swaps are a different issue altogether: obviously since shocks in equity markets involve much larger percentage changes – i would say anything less than 30 percent is not conservative enough – potential cash outflows are also larger, ceteris paribus. Add to this the fact that, since the financial crisis, equity swaps have grown massively, in line with the growth of synthetic ETFs, and you see how this could potentially lead to nasty outcomes.

The “idle” reserves myth

Although it has toned down a bit, there has been an intense discussion about the huge liquidity reserves that banks hold at the Fed ever since the Fed has started with QE 3. Keynesians have argued that this huge reserve stockpile is the main reason behind the low velocity of money and the main driver of deflationary forces. Since deflation is bad, it is to be avoided at all cost. Consequently, banks need to be incentivized (=forced) to lend out the money to “starving” businesses  in order to kick-start the economy.

Instead, people like James Grant and David Stockman have pointed out that the reserves are not lying “idle” but instead are being used to margin derivatives trades of all sorts and consequently do exert influence on market prices, i.e. the “idle” reserves are an important driver of the current rally. The FT article would suggest they were right and Keynesians, in turn, wrong.

Banks complaining means they are probably overextended

To sum it up: the fact that some banks complain loudly about the impact of Basel III on their equity derivative business means three things:

  1. this is an important revenue driver, i.e. shutting down would hurt the bottom line
  2. complying with Basel III, i.e. putting in proper stress assumptions, would be to costly and kill the business
  3. not putting in proper stress assumptions means banks do not want to account for this risk properly (which sooner or later will hit the bank anyway)

The above points taken together indicate that a substantial amount of bank profits comes from an activity that can only continue in these dimensions if one turns a blind eye to liquidity risk – sounds familiar. Apart from liquidity risk, I would bet that banks are also long equity markets in one way or other, as this activity has been profitable on the back of a huge market advance. Banks certainly claim that they are hedging market risk (they are only “intermediating”), but as Jim Chanos once famously said in his Enron testimony:

“It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets.”

In other words: some large banks are overextended liquidity and, very likely, market risk – potentially in systemic proportions (those reserves at the Fed are huge, after all). To what extent, we will only start finding out once equity markets start falling…

 

 

Two good articles on China and Australia

The FT has a good article on the Chinese banking System: it seems that the bailout of the trust product, whose potential failure concerned markets at the beginning of 2014, came from Huarong, one of the famous asset management companies created at the end of the 90ies to clean up the banks (yes, banking crisis do happen in china). One of these asset management companies, Cinda (1395:HK), IPOed at the end of 2013. Huarong is next to go public. Bailing out failed trust products – what a business model, sounds like a screaming buy!

The next article, also in the FT, is about the new 5-year low in the iron ore price. Iron ore is Australia’s main export product, as discussed recently in this post. The article quotes Rio Tinto’s CEO,  Sam Walsh:

“Now is not a time for the best iron ore producer in the world to take a step back,” Mr Walsh said. “Now is the time for others to really feel the consequences of the price against their operating costs and for them to make decisions.”

Mr. Walsh, as a low-cost producer, is quite confident that his company is better prepared to weather the storm – no doubt a heavy dose of  “Schadenfreude” is also involved.  The article goes on with BHP Billiton, the other mining behemoth:

BHP Billiton is not retreating either, confident that the long-term future of the Chinese steel industry is bright. It expects to increase output by 10 per cent to 225m tonnes in 2015 – when the second wave of new global iron ore supply will jolt the market – but acknowledges that this will keep prices modest. Chief executive Andrew Mackenzie said in August it was “quite unlikely we will see prices north of $100 a tonne and our forecasts are based on that”.

There you have it: an increase of 10% to 225m tonnes in 2015!

Mr. Walsh and his colleague at BHP Billiton certainly have reasons to be more sanguine than their high-cost competitors, such as Fortescue Metals (FMG:AU), but their forecasts still sound to optimistic to me. In other words: nothing has happened yet!