Deleveraging is the hottest trade in the Chinese stock market
Highly leveraged large-caps are massively outperforming the market composite index.
Debt-burdened State-Owned Enterprises have turned in torrid returns on the Chinese stock market during the past several weeks, as investors show confidence in China’s approach to gradual de-levering.
Asia Unhedged selected from the Shanghai Composite Index a group of large-cap companies with a leverage ratio (net debt to EBITDA) of more than 4. The equity performance of this group of companies was measured by an equally-weighted index. This index of “gray rhinos” blew away the market composite index.
The members of the large-debt, heavily-indebted index are shown in the chart below. Not surprisingly, they mainly are mining and heavy industry firms.
The trend is toward higher earnings and lower leverage, and the most-levered companies are the first to benefit.
For the Shanghai Composite Index universe of companies, the key leverage ratio of Net Debt to EBITDA (earnings before Interest, taxes, depreciation and amortization) will fall from over 4 to a bit over 2 between 2016 and 2018, according to sum of individual company analysts’ forecasts. That’s still high compared to the 2000’s, but represents a substantial reduction. China’s corporate sector appears to be growing its way out of debt.
Higher corporate earnings are the source of the improvement, and higher earnings in turn are due to stronger corporate pricing power. Earnings collapsed in 2010-2012 as as year-on-year change in the Producer Price Index turned negative, and recovered when producer price change climbed back into positive territory.
When producer prices fell, real interest rates rose to the highest level of any of the world’s large economies. High real interest rates were a headwind for growth, and led to China’s economic slowdown of 2014-2015.
The root of the problem was China’s effort to keep the RMB exchange rate more or less fixed to the US dollar while the US dollar rose sharply. Chinese companies had borrowed heavily in dollars, and Chinese authorities feared that a decline in the RMB exchange rate would increase the cost of their debt service. Because of the enormous dollar liabilities of the Chinese economy — perhaps up to US$1 trillion — backing out of the dollar peg was a delicate exercise. During 2016, Chinese companies repaid most of their dollar obligations and replaced them with RMB debt. That caused the celebrated decline in China’s foreign exchange reserves, as the Bank for International Settlements observed in its March 2016 Quarterly Report.
As the dollar rose, China had to maintain high real interest rates to support the exchange rate. Once the People’s Bank of China allowed the RMB to depreciate, though, real rates quickly declined.
This monetary shift brought about the recovery of producer prices and corporate profits, and made an orderly deleveraging of the corporate sector possible.