China's upcoming (or already present) hard-landing and credit/commodity crunch should be no surprise to anyone: we have been previewing it since 2010, and - just like the upcoming crash in the S&P and all other "developed" mareets - was always just a question of when, not if.
However, knowing the endgame and trading it correctly, with the timing so uncertain, are two vastly different things.
To be sure, anyone who bet that the Chinese economic crash would lead to a plunge in the stock market, has long been bankrupted by China's plunge protection aka "National" team, which unlike the Fed/Citadel spoofing/ETF buying joint venture, is hardly shy about making itself apparent.
Alternatively, playing the commodity crunch would have been a fool's game until Saudi Arabia was politely asked by Kerry to crush Putin's oil empire, and then decided to also destroy its biggest competitor, the marginal US shale producers, by fracturing OPEC and pumping so much oil that even the Saudis can no longer "make up for it with volume" and are now forced to issue debt [12]to fund the country's depleting fx reserves.
Which is why we remind readers that what may be best China crash trade, not only in terms of total possible profit, but the best trade in terms of upside/downside, was one we laid out in collaboration with Manal Mehta last March in an article titled, appropriately enough "Is This The Cheapest (And Most Levered) Way To Play The Chinese Credit-Commodity Crunch [13]?"
Here are some excerpts [13]of what we said 17 months ago in an article laying out Glencore CDS as the best way to trade the inevitable China blow up:
The economic slowdown in China is hammering prices of some raw materials, driving down industrial commodities from copper to iron ore and coal - exacerbated by the vicious cycle of credit-collateral-contraction. What is the cheapest way to play continued stress (with potentially limited downside)?
The diversified natural resources company Glencore has a huge $55 billion of debt, is drastically sensitive to copper (and other commodity) prices, and its CDS remains just off record tights.
[14]
Is Glencore the most exposed to a decline in commodities prices? – A trading giant rated BBB with over $55bn of debt and heavy exposure to commodities. A downgrade to below investment grade would be catastrophic to Glencore’s trading business.
Company’s 12/31/2013 presentation says a 10% decline in Copper Prices would reduce EBIT By $1.2bn!
[15]
As of 12/31/13, Glencore had $55.185 billion in Gross Debt.
By 3/12/2014, Copper has declined to a 44 month low, 12% decline in YTD 2014
Glencore reports Net Debt of $35.882bn, which is $55.2bn of gross debt minus $2bn of cash minus $16.4bn of "Readily Marketable Inventories." Nowhere do they define what’s included in the Readily Marketable Inventories and whether or not the RMIs are hedged. The firm is still highly levered for investment grade even if RMIs can be converted into cash at stated value.
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At 170bps and with 155bps as a floor for the last 6 months, it seems like a cheap protection play on further Chinese/Commodity contraction
To be sure, the fact that going long GLEN CDS had limited downside was by far the most appealing aspect of the trade. As for the maximum upside, well that's the real question.
As we reported earlier today in "The Next Leg Of The Commodity Carnage: Attention Shifts To Traders - Glencore Crashes [16]", after sweeping the Chinese crisis under the rug, today - at long last - the first day of reckoning for Glencore emerged, leading to a 10% crash in the stock price following the company's report of abysmal first half earnings and just as bad guidance.
But more importantly, after trading at what we postulated was the rough floor for the CDS at 150 bps for over a year, in the past month Glencore CDS have exploded higher, and at last check was trading 315 bps wide, about 150 wider from the March 2014 levels...
[17]
... with the likelihood of a major gap wider when the rating agencies downgrade the company from investment grade to junk, which in turn would trigger an unknown amount of cascading collateral calls and an accelerated liquidity depletion, which would then further hammer Glencore's bonds, and as a result, send its default risk, and CDS, surging.
But even absent a credit-risk crashing downgrade, one can see that Glencore CDS is cheap when simply comparing it to the price of its most important commodity, copper.
As a reminder, and as we highlighted in 2014, a 10% drop in copper reduces Glencore's EBIT by $1.2 billion. Copper, currently, is at six and a half year lows and has now broken its 15 year support line. What happens next for the "doctor" which has now lost all technical support is anyone's guess.
But what is certain is that if the market realizes just how levered to copper Glencore truly is, and decides to price its bonds and CDS to account appropriately for the implied risk, then the one trade which over a year ago we said is the "cheapest and most levered" way to trade China's "Credit-Commodity Crunch", is about to pay off big as seen in the chart below.
[18]
So is 700 bps, or much wider, in the cards for Glencore CDS? We don't know, but we would certainly take it.
