What, Me Worry? The Widening Gap Between Market Risk Expectations versus Reality
Source: Flickr. Alfred E. Neuman from Mad Magazine.
Benjamin M. Lavine, CFA, CAIA, RICP
Co-Chief Investment Officer, 3D/L Capital Management
This week, China Evergrande Group, one of China’s most indebted property developers with an estimated $300 billion in liabilities (making it a ‘systematically important developer’), has, for all intents and purposes, defaulted on its near-term financial obligations. The unfolding situation with Evergrande is helping to drag down other property developers as well as raise concerns that it’s final implosion will further drag down China’s economic growth momentum (property development represents ~1/4 to 1/3 of China’s overall GDP). The current focus of both company management and Chinese government officials is to engage in financial obligation triage or to fund near-term working capital needs, such as the completion of residential complexes so as to assuage nervous deposit holders (lest more social unrest results). Bondholders will have to hold their breadth as to what capital return to expect (if any) following a restructuring.
Much has been written about whether Evergrande’s collapse represents China’s Lehman moment (having occurred, ironically, on the September 15, 2008 anniversary of the Lehman Brothers collapse), but so far, global risk assets (equities, non-Asia credit, commodities ex iron ore) remain sanguine. Even long-time China bears such as Michael Pettis and China Beige Book don’t envision an impending financial crisis unlike what happened with the 2008 global financial crisis following the Lehman Brothers bankruptcy.
What would a China Lehman moment look like? According to Shen Meng, director of Chanson & Co., a Beijing-based boutique investment bank, “…an Evergrande bankruptcy would cause problems for the entire property sector…Debt recovery efforts by creditors would lead to fire sales of assets and hit housing prices. Profit margins across the supply chain would be squeezed. It would also lead to panic selling in capital markets.” Indeed, Asian High Yield bond prices have finally buckled under the weight of Evergrande (Figure 1) while iron ore prices have nearly halved from their post-pandemic peak levels (Figure 2) indicating an industrial slowdown in China.
Figure 1 – Asian High Yield Bonds Feel the Pressure from Evergrande
Source: Bloomberg. Bloomberg Barclays Asia High Yield Total Return over the Last Five Years
Figure 2 – Collapse in Iron Ore Prices Indicating an Industrial Slowdown in China?
However, based on the lack of volatility around the Chinese yuan (which remains near post-pandemic highs versus the U.S. dollar) and China’s broader stock market (ex-property developers and banks), strategists and investors have expressed a more benign outlook; they expect that the Chinese government has no appetite for a Lehman moment and will look to pro-actively restructure Evergrande’s liabilities in order to “keep systemic risk to a minimum.” Whether the government can do so while balancing competing creditor interests (witness the protests from property deposit holders) remains to be seen.
Credit Default Swaps (CDS) for some of China’s marquee lenders such as Industrial Commercial Bank of China (ICBC) (Figure 3) are creeping higher but not indicating systemic stress so far. For now, contagion risk is being kept at bay. Dare we say that Evergrande risk is being contained?
Figure 3 – ICBC Credit Default Swaps Are Creeping Higher But Not Indicating Systemic Stress So Far
And based on what is currently implied with risk asset pricing, investors are behaving as if global economic and financial activity would be somehow cordoned off from a China market collapse or even fallout from China’s increasing economic pressures whether due to regulatory crackdowns (technology, gaming, gambling), rising COVID cases, and, now, property market collapses that threaten to bring down China’s banking system. Besides equities trading near post-pandemic highs and valuations, commodities (led by oil prices) continue to rally to post-pandemic highs (Figure 3) while borrowing costs for the riskiest cohort of corporate borrowers (CCC-rated borrowers) remain at post-pandemic lows (Figure 4). No spillover risk here as investors continue to hold an optimistic outlook of a global recovery from the pandemic.
Figure 4 – What Lehman Risk? Broad Basket Commodities Reach New Highs
Figure 5 – What Lehman Risk? Borrowing Costs for the Riskiest Corporate Borrowers Hover Near Post-Pandemic Lows
Which brings us to this blog’s theme – What, Me Worry? One thing that caught our eye is the growing disconnect between the volatility futures market (elevated fears) versus the broader risk asset complex (what is there to fear about?). Figure 6 displays the implied volatility of U.S. equities (VIX) versus realized 30-day volatility of the S&P 500 Index (leading 1 month). In this chart, we lag the VIX Index by one month versus realized volatility as the VIX typically indicates what near-term risk levels are expected by the options market.
Historically, implied volatility is elevated versus subsequent realized volatility to reflect an inherent risk premium, or the cost of insuring oneself against unexpected spikes in volatility (a.k.a. market corrections), but both tend to track each other over time (i.e. if realized volatility remains low, implied volatility will eventually catch up to that lower risk regime). The few times when the implied/realized spread is negative is when realized volatility spikes (likely caused by a market sell-off), catching the markets off guard – the capital markets meltdown following the March 2020 pandemic shutdown is illustrative of this scenario.
In the chart we circled the growing divergence between the volatility priced in VIX futures versus 30-day volatility of the S&P 500. The VIX futures continue to price in high levels of expected volatility while realized volatility of the S&P 500 continues to drop creating a widening chasm between what is expected in the future versus current reality. The current low levels of realized market volatility seem to be indicating ‘nothing to fear but fear itself’ whereas VIX futures are indicating ‘potential market tremors’ over the next year or so.
Figure 6 – What, Me Worry? Are VIX Futures Climbing a Wall of Worry or Indicating Possible Trouble Down the Road?
Now, granted the implied volatility priced into VIX futures could still be bearing scars from the COVID-19 pandemic, but this growing divergence in expectations versus reality has moved to near unprecedented levels. In other words, there is heightened probability that something has to give. Either VIX futures give up the ghost as implied volatility drops to reflect current reality or realized volatility will spike to catch up to the potential trouble being priced into VIX futures. Note that the last time we saw this level of divergence was back in the summer of 1998 prior to the Russian Debt Crisis and the collapse of Long-Term Capital Management.
Now, if you believe VIX futures are acting too much like a Debbie Downer versus the current market narrative (China is contained, the global recovery remains intact), then you are being served up a matzoh ball of a risk convergence opportunity, as many hedge fund strategies have at their core a bet that realized volatility remains below implied volatility. But a corollary to Murphy’s Law is that ‘Chicken Little Only Has to Be Right Once’, so VIX futures may be indicating trouble ahead that may blind side the markets.
As to China, how the unfolding property collapse unfolds remains to be seen. Back in our 2nd Quarter 2017 Market Commentary, we made the initial comparison between peak China and peak Japan (circa 1989) in the event that China sought to engineer a crackdown on excessive financial leverage similar to what the Japanese financial authorities sought to engineer in the late 1980s. At the time of that commentary, China was targeting excessive overseas investments, including the purchase of trophy properties akin to what Japanese conglomerates were doing in the 1980s.
Back in July 2017 we wrote:
“This latest crackdown by Chinese regulatory authorities to stem the risk of excess financial leverage recalls similar efforts by Japan’s central bank to rein in speculation by tightening monetary policy. Japan’s stock market peaked at around the time of the fifth tightening. Typically, once the dust settles following an asset price collapse, the market suffers from the aftermath of non-performing assets when such assets were deemed ‘money good’ as long as markets had stayed euphoric.
Chinese authorities are hoping to “tamp down credit excesses before they produce a bust like the U.S. subprime crisis…” Will China experience a similar fate to that of Japan as it seeks to “rein in a heady credit boom fueled by so-called wealth management products” tied to stocks and real estate? A larger question concerns which government system is better equipped to tackle excess credit boom-and-bust cycles. The 1989 Nikkei peak and the 2008 subprime mortgage collapse suggest that neither a central-and-control nor a western-style-market regime were better equipped to handle the aftermath. Market collapses from excess credit accumulation result in major short-term pain or a drawn-out malaise due to a zombie financial system weighed down by non-performing assets. Perhaps, China’s experience will be different this time around.”
Long-time China bears such as Michael Pettis seem to expect a long drawn-out malaise will result from Evergrande. With the 2022 Winter Olympics coming up and an upcoming leadership change in 2022 (Will Chairman Xi step down or remain in power?), it seems the incentives are in place for China to ‘contain’ the property market collapse, even if the collateral damage lasts several decades (as in the case of Japan) rather than risking near-term social upheaval.
Regardless, the growing divergence between what is expected in the future versus reality point towards an interesting year ahead.
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By: Benjamin Lavine