Tag: emerging markets

The real risk is China, not Greece – 2015 Q2 Letter

The real risk is China, not Greece – 2015 Q2 Letter

Two inflection points long in the making appear to have arrived simultaneously over the past few weeks. In Europe, negotiations between Greece and Euro-zone countries that have lent to Greece appear to have broken down; and in China, the stock market has taken a remarkable tumble. In itself, the Shanghai market’s steep fall is not surprising or remarkable (this was a market which had risen 150% over the previous year), but it is interesting in terms of what it portends for other markets and factors in China.

The various actors in the Greek/Euro crisis have indulged in brinksmanship for a number of years. The ECB, Euro-zone countries and the Greek government have stumbled from one crisis to the next, taking action only when forced to do so. And when they have acted, the result is to defer rather than reach resolution. It is clear to us that no final resolution of Greece’s sovereign debts can be made without some debt relief. The Greek economy has shrunk enormously under the weight of uncertainty and austerity policies. None of the modeled targets for growth have been met and Greece’s debts are now a larger multiple of Greek GDP (180%) than ever before, largely because of the sharp decline in GDP. A sudden growth spurt may solve that, but given high unemployment, it is difficult to see that materializing without some level of debt relief to lower the amount of the outstanding loans and interest payments. In reality, the only thing that has been achieved thus far is that Greek loans have been moved from the balance sheets of European banks to the balance sheets of European nations. European (and international) banks that lent to Greece, knowing the risks, were bailed out. There has been no such deliverance for Greece itself, and, despite frantic 11th hour negotiations, we do not expect one in the coming days.

A crucial factor that has made the crisis much worse for ordinary individuals in Greece is the absence of a pan-European deposit guarantee scheme. Bank customers in the US have enjoyed a federal guarantee for their deposits since the 1930s. This guarantee currently applies to the first $250,000 on deposit at an FDIC covered institution and has been the primary reason the US has avoided widespread bank runs by retail customers for the past 80 years. In contrast, deposit guarantees and guarantee funds in Europe are run at the member state level. So Greece guarantees the deposits in its banks up to 100,000 Euros. Of course, Greece (unlike the US federal government) has no ability to actually print Euros on demand. That means most bank customers treat its deposit insurance with justified skepticism. Greek banks too cannot count on the European Central Bank to lend to them freely in a crisis. There is an emergency lending facility, but it works through the member state central banks and let’s just say relations between Greece and the ECB are not exactly amicable at the moment.

These two factors taken together explain the phenomenon of Greek pensioners queuing for hours to withdraw the maximum amount permitted from their bank accounts each day (60 Euros). They do not trust the funds will be covered by deposit guarantees and Greek banks are limiting withdrawals, afraid they will run out of Euros.

As a study in contrasts, we have Puerto Rico, which is facing a similar government debt crisis, largely brought on by similar factors (mismanagement, misstatement of financial data, etc.). Yet, the impact is limited to the government’s ability to issue more debt and the value of its bonds. Puerto Rico’s bank will face no runs and will continue to function even if the government runs out of money. They are regulated and insured at the federal level. So, though Puerto Rico’s debt crisis is very serious, and will likely require some level of write downs, its banking system continues to hum along and is not at risk. If the European Union had a similar bank deposit guarantee system, we believe the Greek crisis would not have been as severe.

Lastly, what makes the Greek case significant and holds the market’s attention is not the size of Greece’s debts, which at around 300Bn are large, but not enormous. A 30% write-down of those debts would be 100Bn, some individual banks took write-downs in the 30-70Bn range during the financial crisis. Clearly Greek creditors (EU countries for the most part) could survive a 30% write-down.

What concerns the markets is that the Greek crisis lays bare an uncomfortable truth. The European Union is both unable, and unwilling to act decisively or with coordination in a crisis. The reasons are myriad, but to us, it has been particularly striking to hear World War I and II era rivalries and events repeatedly invoked by some commentators and even senior politicians. A skeptical observer might say that the institutions created to avoid the recurrence of war on the European continent seem to be hell-bent on re-living them. In contrast, though, we in the United States have had the traumatic experience of reliving civil war-era animosities over the past few weeks, those fervently invoking a North/South divide are firmly in the fringe and have been for at least a century. The same cannot be said of Europe.

We have been wary of asset prices and debt burdens within China for a number of years. Some of those concerns have bubbled to the surface in the last few weeks as the Chinese domestic market has endured a series of dramatic losses with many stocks hitting their down limits and several have halted trading entirely. Companies can also ask to suspend their own shares and many have. Most observers have expected such a crash since the on-shore Shanghai market has risen over 75% this year. What was underappreciated is how much of this rise has been driven by large numbers of first-time retail investors, many of them buying stock on margin (borrowed money). The conditions appear to resemble the state of the US market on the eve of the 1929 and 2000 stock market crashes. In certain ways, there are broader parallels with 1929. China is at roughly the same stage of relative development with the US that the US was to the UK in 1929. China has also seen massive investment in capital infrastructure with declining returns, not unlike the US investment in railroads in the 20s. Lastly, there are large quantities of questionable loans on the books at Chinese banks. Taken together, this story is much bigger and could have much wider repercussions than that just a few down days in a large emerging market.

The final consideration is political. Though there is a lot of tittering at the prospect of the Communist party attempting to support the stock market, this is driven by legitimate fears of political unrest if a severe downturn were to materialize. Coupled with factionalism within the party, such a downturn could make for a very volatile period in China, politically speaking. The impact is likely to be felt across commodity sectors (where China remains a major consumer), and a risk of contagion to other markets. In the short term, we expect the US markets will be seen as a relative safe haven. Though clearly, as one of the three largest economies in the world, any Chinese downturn will affect global market values.

On balance, we view the bursting of the Chinese equity bubble and antecedent effects as more significant than the Greek debt crisis. In terms of wealth impact, they certainly are — the Chinese stock market has lost over $3Tn over the past few weeks. That is ten times the amount of outstanding Greek debt. Margin balances owed by Chinese investors are larger than Greek debt. The real concern, though, is that the stock market bubble in its rise and fall, may lead to a bigger reckoning of Chinese financial institutions which are holding real-estate and provincial debt. As the real-estate sector has slowed, demand for land, which constituted a crucial source of funding for Chinese provinces, has dried up. Both real-estate developers and Chinese provincial government debts are looking very weak and they are widely held by Chinese banks and investors.

In general, we recommend appropriate caution for investors. Though the US markets may appear to be isolated from events in Europe and China, and might even benefit from some short-term “flight to safety”, they will eventually be impacted, and current valuations stateside do not bode well for that reckoning.

We continue to believe that investors will be well served to reduce exposure to risk assets in their portfolios and move some money into short term bonds and cash while awaiting a better buying opportunity.

2012 Themes: The More Things Change…

2012 Themes: The More Things Change…

Here are our top 10 investment themes for 2012.  These are the topics we think will have the biggest impact on client portfolios in the coming year…

 

1.  Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election. With the ongoing crisis in Europe, the Fed would normally be engaging in further monetary easing, but there is nowhere to go below the current 0.00% target overnight rate. In most presidential election years, the Fed is hesitant to make large moves in either direction, to avoid appearing politically biased. That instinct is especially heightened in an election cycle where Fed policy action and arcane monetary policy debates have unexpectedly become contentious, emotional political issues.

2.  Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors.

3.  Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis.  Though it has been over a decade in the making, things have finally come to a head. All the dominoes (Greece, Portugal, Spain, Italy) are lined up, and we wait to see which the two players (France and Germany) will allow to fall before they stop the carnage. We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.

4.  Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. We would not be surprised if the Euro approached parity with the dollar over the course of the year. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed.

5.  Blue States/Red States: The US presidential election cycle should be the major story in the US in 2012. US and individual state debt burdens will be the most important topic of debate, as the European sovereign debt crisis plays out in the background. American politicians will have to negotiate some cut in benefits for the charmed baby-boomer generation to ensure the financial burden of these programs in coming years does not doom the economic prospects of their children and grandchildren. This negotiation of a new social compact between the generations is the most important issue of our times.

6.  Chinese Math: At the 18th Communist party congress to be held this year, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required as China moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, GDP growth is slowing as labor costs rise, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels.

7.  Revolutionary Times: We were surprised to see the speed at which the political structure of the Middle East has been transformed in a remarkable series of revolutions. Though we have been aware of the demographic pressures that created the basis for these changes, their rapidity has astounded us. As events unfold in the Arab world, something perhaps even more remarkable has begun to happen in Russia. A previously apathetic Russian electorate seems to be flexing its muscle in opposition to a renewed Putin presidency.  We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year.

8.  Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources. And while we’re talking about oil, we would like to reiterate our skeptical view of gold prices, which we believe would be well under $1,000 an ounce if the political and economic future were not as muddy.

9.  Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance). The larger story will continue to be the steady march of the internet into every device and living room, placing a strain on core Internet infrastructure. We heard relatively little about a seminal event that took place in 2011, the last large block of addresses (IPv4 numbers) was assigned and there is no address space on the current infrastructure to accommodate another few hundred million devices. The public discussion has centered around the addition of new top level domain names (like .com, .org), but the addresses that sit behind these are the real concern. A new addressing scheme (IPv6) has been built into most devices for years, but adoption is minimal. We expect this will have to change in 2012, with a few hiccups along the way.

10.  Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis.  We believe there is still too much supply available and US consumers as a whole will be reluctant to financially over-commit themselves given job security concerns and how many were burned by homeownership in the past few years, despite record low mortgage rates.

 

10 themes for ’10

10 themes for ’10

  1. Who’s Hiring? We expect to see the US unemployment rate peak in 2010 at 11%.  While seeing a peak will certainly be an encouraging sign, we don’t believe this will be followed by a rapid economic recovery creating the millions of jobs necessary to lower the unemployment rate down to pre-recession levels (5%).
  2. I’m fine with fixed returns: The credit crisis of ‘08-‘09 saw many individual and institutional investors badly burned by overexposure to riskier assets like stocks, commodities and real estate.  While there has been a strong recovery in many risky assets over the past 10 months, we expect investors will continue to re-allocate towards less volatile investment classes, such as bonds, with a trend towards a classic 50% stock 50% bond allocation.
  3. Collecting from sovereigns: 2009 ended with warning signs emerging from Dubai and Greece that there is a potential for default or credit deterioration among sovereigns that have over-extended themselves.  We expect to see a number of credit downgrades for developed nations as their persistent deficits, long-term pension/health-care liabilities and weak growth come into focus.  2010 may well see a sovereign nation default on foreign-currency debt obligations.  We expect the US Dollar and US treasury credit to strengthen in any ensuing flight to safety.
  4. Reading tea leaves at the Fed: On December 16, 2008, in an effort to encourage banks to lend and provide liquidity for the financial markets, the Federal Reserve lowered interest rates to effectively 0%.  This rate held throughout the entirety of 2009.  We expect this run to end in 2010 with the Fed raising interest rates in 4th quarter of the year.  We expect the Fed to tighten rates to the 1-2% range and then pause for a few quarters.  This will likely result in the yield curve flattening since long term yields will not rise as quickly.  Unlike many other market commentators, we do not expect high inflation despite large increases in measured money supply.  A sharply lower velocity of money and reduced money-creation via private sector credit will dampen inflation.
  5. Pay me my money down: Continuing the trend from 2009, we believe paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order.  This will disrupt a strong recovery in corporate profits, particularly retailers (which rely on consumer spending to drive growth), as some businesses will misjudge the new environment.  However, this is very good for the long term health of the US economy.
  6. A cold year for growth: We expect the US economy will see almost negligible growth in 2010.  Margins will continue to contract for US businesses and profit growth will remain slim. The expiration of stimulus programs and slim prospects for their renewal in a mid-term election year will reduce aggregate demand.  Cost cutting and efficiency measures will continue to be necessary to offset top-line deterioration.
  7. Arranged Marriages: With margins slimming, interest rates at historic lows, the unemployment rate in double digits and the US consumer cutting spending, we see corporations increasingly turning to mergers and acquisitions in order to grow market share, particularly in the cash rich tech and energy sectors.
  8. New kids on the block: Emerging markets proved to be more resilient to the global recession than developed economies.  We expect growth in emerging markets will continue to out-pace growth in developed economies.  But this growth will not be enough to offset the stagnation in developed economies or lead to a robust global recovery.
  9. Red alert: We believe there is continued risk for a massive correction in China.  We remain skeptical of the veracity of the economic data released by the government and don’t see how the white-hot level of growth can be sustained when China’s main trading partners (namely the US, Europe, Japan) continue to suffer from the effects of the global credit crisis.
  10. Fool’s gold: We believe certain commodities are poised for a sharp sell-off over the next year.  Highest on our list for a correction are gold (which only has value if others think it does) and oil (many Iraqi and South American fields coming online and low growth implies low energy use).