Hedging against the next crisis

A Chinese credit bubble could have a damaging domino effect on the Australian economy if not managed properly, Craig Swanger writes. 

The global economy seems to be healing itself slowly. The US economy is coming off the Federal Reserve’s (Fed’s) life support and recent data has pointed to some very encouraging revival. Chinese growth is moderating. The EU and Japan are underperforming but have stabilised their economies for the meantime.

Risks remain however. The EU and Japan continue to battle with stubbornly low growth and an unhealthily low inflation rate. China’s transition to a self-sustaining economic power is inevitable in the long-term, but highly volatile in the short term. The threat of a credit bubble in China, for example, would send global equities into renewed volatility and risk the economic recovery in the US and EU. 

For Australian investors, the implications would be particularly severe, given Australia’s perceived reliance upon the Chinese economy. The impact on Australian equities and the Australian dollar (AUD) could be just as large as that experienced in 2008, and now residential property may well be at risk too.

Flight to safety phenomenon

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Whether caused by concerns about China or the EU or US, crises inevitably see a flight to the US dollar (USD) and away from growth oriented currencies such as the AUD. Over the past 20 years, major financial crises have seen a trough-to-peak rise in the USD versus the AUD of 42 per cent, 28 per cent and 60 per cent respectively, as shown in Figure 1 (corresponding falls in the AUD: 30 per cent, 22 per cent, 37.5 per cent). 

Options for investing in USD

There are two major strategies used by Australian investors to invest in foreign currency, particularly USD.

1. Direct investment in USD 

• Buying spot USD dollars (cash) 
• Pure USD exposure providing full upside benefits in a crisis. Earn 0-0.25 per cent per annum interest, and pay forex spreads of 0.6 per cent-2 per cent.  
• Buying USD ETF from BetaShares, earning no interest, paying 40bp per annum management fee but having much lower forex spreads.
• Buying corporate bonds in USD, earning 3-8 per cent per annum, and forex spreads of 0.6 per cent.
• Options include lower risk ANZ or WBC bonds at 3-4 per cent per annum, QBE bonds at 4-5 per cent, up to higher credit risk options such as Ausdrill or Newcrest at 7-8 per cent.

2. Unhedged international investments

• Investing in unhedged international equities funds:
  This approach reduces the losses from equities in such a crisis, but there will still be losses. USD equity exposures will be largely offset by USD/AUD gains, but US equities only accounts for 40-60 per cent of any international equities exposure. European and Asian currencies will also suffer losses versus the USD in such a crisis, so the net result is likely to be a strong loss.
• Investing in unhedged international bond funds or ETFs: 
  Far more effective, as bonds are likely to perform strongly depending upon the nature of the crisis. Yet still suffers from the fact that 40-60 per cent of the currency exposure is non-US, which will fall in a crisis.

Why hedge now?  

Because wealth management is about wealth preservation too, not just growth. 

The clearest risk to global financial markets at present is a Chinese “hard landing”. This in turn is most likely to be caused by a credit crisis in China, specifically linked to its property market.

Before we examine this issue more deeply, let’s be clear at the outset, China is not expected to have a “hard landing”. The hard landing scenario, the media and economists refer to, is a slowdown in China’s GDP growth from the current 7.5 per cent per annum to 5.0 per cent per annum or less. The base case that almost all economists believe is that the Chinese slowdown will be gradual.

However, investing is as much about wealth preservation as it is achieving the returns that meet our goals. Wealth preservation is particularly important the older we get as most do not have the flexibility to go back to work to recoup losses. Many Australians learnt this lesson the hard way in 2008.

So, a strong investment strategy will cater for the expected future scenario but will also ensure that in the less likely event of a Chinese hard landing, your savings are not severely impacted.

Probability be damned, it is the impact we need to understand.

When economists said the probability of a global meltdown was “1:100”, markets listened and we all suffered losses. The lesson is to focus on the “what if” impact, not the probability, and make sure that your wealth will survive such an event.  

Economists believe the chances of a Chinese hard landing are low, but rising. Morgan Stanley research in February 2014 concluded financial markets are pricing in around a 6 per cent probability of a hard landing. This number aligns to a Standard & Poor’s report in August 2013 where they placed a 5 per cent probability on a hard landing. Importantly they also placed a 20-25 per cent probability on a “medium landing” where China’s GDP slows from 7.5 per cent to 6.8 per cent (See Table 1).

So we need to understand, what would the impact of such an event be on our wealth?    

What would a Chinese slowdown do to Australia’s economy?

In line with the Morgan Stanley and S&P research, the International Monetary Fund (IMF) MD, Christine Lagarde, said in April 2014 that, “they did not believe China was heading for a hard landing”. But she went on to say that, “China’s trading partners should hedge against such a possibility”. In the IMF’s view, Australia is more exposed to a Chinese slowdown than any other country other than Mongolia.  

S&P’s report states that a “hard landing” for the Chinese economy would severely impact Australia’s economy. The S&P report quantifies its expectations of the impact both a hard landing and a medium landing would have. The most critical points are:

1. The impact on the AUD

The medium landing scenario, which they place as a 20-25 per cent probability, has the AUD falling to 80 cents against the USD. This is likely to be driven by two factors simultaneously: global investors facing severe volatility to equity and commodity markets will flee to the perceived safety of the USD; and they will sell off the AUD specifically as Australia is considered to be dependent upon China’s GDP growth for its own growth.

In the hard landing, they see the AUD falling to 65 cents compared to the USD.

2. The impact on Australian banking sector:

A decline in housing prices will hurt the Australian banking sector as they are dependent upon mortgages for their earnings. A severe drop in Australian housing prices will cause losses due to a rise in bad debts. Again this impact will be driven by two factors: a fall in Chinese investment in property, which has driven prices upward recently; and a rise in unemployment, as banks cut staff to reduce costs and offset the increase in bad and doubtful debts.  

As investors in specific properties these impacts will have very different consequences. Unemployment will impact property prices in lower socio-economic regions, while the Chinese investment slowdown will hurt apartment sales and prestige suburb house prices.

However, investors in bank shares will be impacted as any decline in home prices of 10 per cent or more will have a direct impact on share prices, earnings and dividends. Even in the hard landing scenario, we do not believe that the prices of Australian bank bonds will fall by any more than 3-4 per cent. S&P suggests that the hard landing would result in a one notch downgrade of the majors, which is consistent with our view.

3. Interest rates

Any Chinese slowdown will directly impact Australian GDP and unemployment and the RBA will respond by cutting the cash rate further. S&P estimate that in hard landing scenario, the cash rate will fall to 0.5 per cent per annum. This would leave term deposit rates at 1-2 per cent per annum at best.

Don’t dump your Australian bank shares

While a Chinese slowdown will cause considerable volatility for Australian equities, the key as always is to look at the long term fundamentals. Any slowdown will be short term for example, a credit bubble correction. In the long run, China is on an unstoppable trajectory driven by simple demographics and the freeing up of capital markets. Like Nigeria’s rise in Africa, Germany’s dominance in Europe, the US in the Americas, a free economy with a large population will dominate in the long run.  

Furthermore, Australia is not completely dependent upon China. Only 5.7 per cent of Australia’s GDP is reliant on China. This is significant, but not so large that Australia would not recover.  Australia’s banks will take a hit to their earnings, and so bank share prices will fall, but they will recover in time as they did after the 50 per cent falls in 2008.  

Conclusion

What is important is that you can weather the storm that would be caused by a slowdown and the best way to do this is to profit from such a scenario. One way to do this is to simply invest in foreign currencies but the interest rates are very low. Alternatively, investing in USD bonds issued by familiar Australian issuers such as the major banks is another effective way to hedge a Chinese hard landing. 

And for investors exiting equities altogether because of growing concerns regarding China, a long USD position will enable them to profit from their views and earn a strong yield in the meantime. 

Craig Swanger is head of markets at FIIG.