The View

Next killing in markets is betting on the big short

PUBLISHED : Monday, 08 June, 2015, 10:53am
UPDATED : Tuesday, 09 June, 2015, 10:07am

The next great killing in financial markets will likely be made by betting not on what will go up, but on what will go down.

US bonds and Chinese equities are top of the list for short-sellers. Call it a strange rivalry among superpowers, but many investors expect one of these two countries will host the next market crash. Or if Janus Capital’s Bill Gross is right, both will blow.

A crash in US bonds would be a much bigger financial event, but also a less likely one, in the sense that pundits have been calling for this one for years, to no avail. Bonds have been on a bull run since the early 1980s, but recent gyrations in US treasuries are raising the “end of the era” talk once again.

There is much debate as to why US government debt has become so widely owned in the past 35 years, pushing bond yields to a succession of record lows. But the leading theory is pretty straightforward: too much savings and too little investment.

The “global savings glut” hypothesis puts a good amount of blame on the trade surplus countries like China. A massive trade surplus by definition shows a nation is earning more than it is spending, creating an excess of savings which gets parked in banks and bond.

Meanwhile, economic growth is structurally slowing in the ageing developed worlds so investment activity is tepid, and often outsourced to places like China anyway (see chart).

Whatever the cause of low yields, the result is that cheap money often finds its way into financial assets like equities, property and riskier bonds.

“Money has stopped correlating with inflation/nominal GDP,” Matt King, credit products strategist at Citi has written in past research. “Money correlates with asset price inflation instead.”

This is the modern curse of central bankers: cheap money boosts bubbles not growth. It isn’t working, say many pundits. The gig is up.

“The 35-year bull market in bonds and in stocks is ending,” Gross said recently, although he added that the worst bond bubble is in Germany – and that higher global bond yields would ultimately be a good thing.

Not a man known to suffer from a dearth of opinions, Gross also has strong views about Chinese equities. China A-shares are heading for a crash, he says.

Gross’ theory seems to be based on the simple idea that what goes up, must come down. Or at least what goes up in the stunning fashion that China’s equity market has in the past year.

He’s certainly not alone in calling Chinese equities as an obvious shorting opportunity. Some tech stocks are trading on valuations not seen in equities since the global internet stock boom. Credit Suisse in a recent note calculated that Chinese equities are 25 percent overvalued on a fundamental basis, as well as vulnerable to volatility after such a phenomenal surge over the past year.

The thinking is similar for both the US bonds and Chinese equities– these are overvalued markets, all they need is a catalyst to spark a panicked rush for the exits.

In China the key catalyst would be a sign that Beijing will stop tolerating the bull market. Indeed, one could argue that the equity bull market is based on the expectation that Chinese policymakers are so desperate for a growth catalyst – such as an exhilarating expansion in brokerage business - that they will allow this thing to keep going.

At any rate, with growth slowing, the Chinese central bank will continue cutting monetary rates to boost growth. And as happened in the OECD, cheap money might not always guarantee growth, but has been pretty reliable in inflating financial bubbles.

As to the US, for a long time bond bears said the fuse would be lit by either a jump in inflation after years of easy money, or a sell-off based on default fears. They were always wrong.

Instead the catalyst looks to be a simple case of modest policy success. The Federal Reserve is expected to raise policy rates this year, a sign the US economy is stronger and deflation conquered.

When yields rise, the value of bonds fall. Any reversal in such an over-owned and expensive asset class has the potential to turn very painful, if not panicked.