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Why investors should beware the danger signs in China

Stocks have ramped higher throughout February in a historic reversal of January's slide, which was driven by concerns over the health of emerging markets. Specifically, investors worried about currency turmoil in places like Turkey and credit woes in China.

With the Russell 2000 small-cap index moving to new record highs on Wednesday, investors may seem to have moved past that turbulence. If so, they should think again. And this time the trouble is deepening in the mother of all emerging markets

After a reprieve, driven in large part by a bailout of the "Credit Equals Gold #1" credit trust just before China's Lunar New Year holiday, stress has returned to the Chinese banking system.

To understand the root of the problem is to understand just how heavily China has relied on credit to fuel its infrastructure boom since the financial crisis. Total bank assets increased more than $15 trillion to nearly $23 trillion, a jump worth 140 percent of China's GDP. Here at home, U.S. bank assets total roughly $14 trillion.

Much of this money funded overcapacity in industries like coal and steel, at ever higher interest rates, which are now suffering from rapidly falling profit margins as China's economy slows. That's threatening the ability of the companies that issued these bonds to pay them when they mature as profits are throttled. The Credit Equals Gold vehicle was issued by the unlisted Shanxi Zhenfu Energy coal company.

That is causing banks to view each other skeptically, since there is an implicit assumption that the banks that issue these bond vehicles (in the case of CEG #1, it was the Industrial and Commercial Bank of China) will back them up and protect investors if trouble hits.

As I said before, I can't help but see similarities between what's happening in China and the lead up to America's financial crisis.

Stress is re-emerging as inter-bank lending rates in China start drifting higher, represented by the yield on two-year swaps compared with the yield on government bonds. The difference soared to a record on expectations that more loans will go bad and bank balance sheets will look increasingly vulnerable. Already, the volume of non-performing loans is up some 50 percent from the low in 2011.

The catalyst for all this is the Federal Reserve's efforts to pull back on its cheap-money stimulus by tapering its ongoing bond purchase program. The run rate of monthly bond purchases has been reduced from $85 billion to $65 billion since December, but that's caused a cascade effect throughout the global financial system and revealed just how addicted everyone's become to the flow of low-cost credit.

Work by Bank of America Merrill Lynch analysts show a close relationship between the Fed's bond purchases and lending in China, due mainly to Beijing's efforts to control the rise of their currency against the dollar (by selling yuan and buying dollars, increasing China's money supply) and by investors borrowing cheaply in the U.S. to invest, at higher rates, in China.

As this flow is reversed, the dynamic also reverses. Thus, China is suffering from a tightening of credit -- both in terms of lower volume and higher interest rates -- at a time when companies like Shanxi Zhenfu Energy are struggling to meet debt payments. If the cheap money festivities had continued, these companies would simply borrow more to pay old loans.

But they can't. So the music has stopped. 


Stealthily, the selling pressure has returned to emerging market stocks as well with China's Shanghai Composite falling below its 20-, 50- and 200-day moving averages after being above all three last week for the first time since early December.

In response, I'm recommending investors take advantage of the return of China's credit woes via the leveraged short ProShares UltraShort China (FXP) exchange traded fund, which I've added to my Edge Letter Sample Portfolio.

I also advise investors to view the latest surge by U.S. stocks skeptically, using the push to new highs as an opportunity to book profits and raise cash.

Disclosure: Anthony has recommended FXP to his clients.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.

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