Tag: Economics

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.


Webinar Invitation: Tax-free municipal bonds

Webinar Invitation: Tax-free municipal bonds

Tax Free Municipal Bonds: Are They The Right Investment For You?

The past few months have been very eventful for the municipal bond market: the Bush era tax cuts have been extended, municipal governments are proposing massive budgets cuts, protests have broken out in states like Wisconsin and certain commentators have predicted widespread default. This uncertainty has provided an opportunity for those investors who know what to look for. In this webinar, we will provide an overview of municipal bonds, address many of the recent news events that have roiled these markets and share our approach to finding opportunities in this space.

This web-based presentation will run from 12:30-1:00 pm on Tuesday March 1st. It will include a 20 minute talk and 10 minutes for Q&A.

Please RSVP if you plan to attend as space is limited.

Presented by: Washington Square Capital Management

Speaker: Subir Grewal, CFA: Co-Founder and Principal

Date: Tuesday, March 1, 2011

Time: 12:30 pm, Eastern Standard Time (New York, GMT-05:00)

Discussion Topics:

  • Municipal bond market overview
  • The ramifications of recent legislative events
  • Our selection process and where we see opportunity

To register, please click here.

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).
Retail sales trends this holiday season

Retail sales trends this holiday season


Retailers are in the business of parting consumers from their money and they have been remarkably successful at this over the past several years.  However, we believe this holiday season will turn out to be very tough for most retailers as consumers will continue to maintain tight control over their spending.  Consumer spending levels have been a concern since this recession started.  Most observers predicted consumer spending would fall since households entered this recession with very weak balance sheets, high debt levels and low savings.  Added to this weakness in household finances is the pace and extent of job losses, worse than any we have seen since 1983, with a real possibility that they may be worse than the early eighties.  Consumption usually falls when unemployment rises, because people spend less when they aren’t earning.  However, consumer spending has fallen further during this recession because of something called the wealth effect.  When people feel less wealthy, they tend to spend less.  And as home prices and investment valuations have fallen over the past couple of years, a lot of us (not just those unemployed) have begun to feel less wealthy, and as a result curtail spending.

A key portion of any recovery is the stabilization of consumer spending, and a crucial part of this spending occurs around the holidays.  With this in mind, we have been looking closely at expectations and trends for retail sales over the holiday season.

A recently released ARG/UBS survey polled consumers about their anticipated spending patterns this holiday season is very revealing.  They report that over 50% of survey respondents said they plan to spend less this holiday season on gifts, and most plan to buy fewer gifts for fewer people.  Even children know they have to limit their expectations for Christmas gifts.  ARG estimates sales will be down 2.9% when compared with 2008 (and those were down 2.7% over 2007).

We routinely look for unorthodox sources of economic data to complement traditional sources. One data source we’ve become interested in recently is Google Trends, which provides statistics on what people are searching for on Google.  The Google team has made a number of different “canned queries” available and their research team published a paper earlier in the year examining how Google trends could be used as a measure of activity.  What we found most intriguing were the luxury goods query statistics, which show a year over year decline of over 5%.  Since Google trends measures the proportion of total queries (i.e. it accounts for the fact that the total number of queries on Google is growing) it may simply be that interest in things other than luxury goods has risen, or that more people have found the best online stores and visit them directly.  However, we believe this data may augur poorly for luxury good sales this holiday season, and this view is reinforced by the ARG survey result that consumers are planning to trade down.

So, in our view the prognosis for retail sales this holiday season does not look good.  Where then does that leave us?  The chart below plots retail sales excluding-autos along the red line and retail sales and food services (a much broader measure) along the blue line.  We adjusted for inflation to produce these charts, the nominal numbers look worse since we had some deflation in 2008/2009.  The data is from the census.gov and bls.gov.


Retail sales are declining at a slower pace, but at -3.04% the rate of decline for September’s retail sales (ex autos) remains worse than any other seen over the past 15 years.  The remarkable story though, is in the level of sales, which we plot below.


In real terms, the broadest measure of consumption is in the same range as it was in 2000-2002.  Real retail sales excluding autos and food service are at 2004 levels.  These numbers look far worse on per capita terms since the US population is growing by 2.75 million a year.  What makes this picture even gloomier is that the current levels are being propped up by massive amounts of government support.  Unemployment benefit periods have been extended for the longer-term unemployed, and auto-sales have been propped up with incentives.  We shudder to think where consumption expenditure would be without these supports, yet at some point consumers and businesses will have to confront the reality that this government assistance cannot last indefinitely.

So where does this leave us?  We believe this will be another difficult holiday season for retailers, and the medium-term picture doesn’t look any better.  Consumers have cut back spending to real levels last seen 5-9 years ago, and there is no prospect of a quick rise to pre-recession consumption.  We see a slow, halting recovery over 5-7 years for the following reasons:

  • Unemployment is likely to remain over 6% for 5-7 years,
  • Chastened consumers are saving to repair their personal balance sheets and pay down debt
  • Stimulus spending will have to be withdrawn eventually
  • Federal and state deficits will have to be repaired and higher taxes will eat  into consumers discretionary income.

We now know that we had too many mortgage bankers, home construction workers, and investment bankers than natural growth could sustain.  It may well be true that we had too many retail stores and salespeople.  If retail sales do not recover for years, we will have to become accustomed to shuttered stores in many areas.  Many people formerly employed in retail trade will have to look to other industries for employment.  The big structural question confronting us is how US businesses are going to produce productive employment for these workers and resources.  This will require retraining, and it may require the movement of labor across geographies.   It will definitely take time.

Who is leading this herd?

Who is leading this herd?

The Herd

The extent of the market’s shrinkage in 1969-70 should have served to dispel an illusion that had been gaining ground during the past two decades.  This was that leading common stocks could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market to new high levels.  That was too good to be true.  At long last the stock market has “returned to normal,” in the sense that both speculators and stock investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings.  — Ben Graham in “The Intelligent Investor”

For years, investors have been told there is an easy, simple way to invest, requiring very little effort, by using index funds.  Many amongst us have been seduced into believing that we can safely invest in stocks, or stay invested, as long as we have a long enough time horizon.  This claim is generally based on analyzing the unique market trajectory of the United States, where stocks have outperformed other investments over most long-time periods (20 to 30 years).  Of course, over shorter periods (say 5 or 10 years), returns from stocks have been painfully small or even negative, and as Keynes said: “In the long run, we’re all dead.”

In addition to being told that stocks are the best game in town, investors are relentlessly advised to buy large numbers of stocks, via index funds.  Too many have taken this easy way out and bought stocks without any sound analysis and we fear the market has begun to reflect this laziness.

I have a parable for you, or perhaps a fable.  Imagine market participants as a herd of buffalo on the plain.  The herd moves together, often quickly.  In the past, it has never run off a cliff because enough buffalo are looking around for the tell-tale signs of a drop-off and slow it down.  One morning, a buffalo has the bright idea that since the herd has never run off a cliff (at least not in living memory, or as far back as the data is readily available), it would make sense to simply follow the herd and stop looking for signs of cliff-edges.  Once enough buffalo buy into this strategy and become free-riders, the herd itself becomes less aware.  As a result, the herd has fewer and fewer buffalo actively participating in picking direction, alert individuals get pushed into the center of the herd, effectively blinding them.  This blind herd runs willy-nilly all over the plain, and eventually it will run off a cliff.

Sometimes it makes sense to cut oneself out of the herd in the interest of self-preservation and go your own way, so you can see clearly.

I’d be a bum on the street with a tin cup if the markets were always efficient.  — Warren Buffet

We wrote earlier this year about the debate surrounding the Efficient Market Hypothesis (EMH).  The EMH, roughly speaking, claims all relevant information that is presently known is incorporated into market prices.  For some time now, we’ve viewed the EMH with some skepticism.  Two recent editorials, one by Jeremy Siegel in the WSJ, and the other by Martin Wolf in the FT, prompted us to revisit the subject and reiterate our skepticism about the EMH.  We think part of the reason these two camps disagree is that they are not trying to answer the same question.

The EMH camp asks the question “what are stocks going to do tomorrow”, and says (with some justification) that it is difficult to predict tomorrow’s moves because the sum total of all market-moving “information” is reflected in the price.   In our view, this is not a particularly insightful observation, partly because the question itself is largely irrelevant for an investor (as opposed to a trader).

The Value camp (Ben Graham, Warren Buffet, Jeremy Grantham) believe the right question for an investor to ask is “should we buy stocks today”, or “if we buy stocks today, do we stand a reasonably good chance of achieving an acceptable return”.  We believe this is a far more crucial question.  The value camp has developed numerous mechanisms to measure the value and risk of an investment based on expected returns.

By convincing many investors that “the market is always right” and that evaluating investment opportunities for themselves is not worthwhile, the EMH camp has successfully encouraged many market participants to become lazy.  And if these multitudes ARE the market now, the market itself has stopped evaluating investments on their merits.  This is how markets get to be wrong and their self-correcting nature is undermined.

A public-opinion poll is no substitute for thought. — Warren Buffet

In his article, Siegel says the fault for the bubble is not with the EMH, but with market participants (ratings agencies and investors) who failed to do their homework on their investments.  That’s pretty rich coming from someone who has been telling investors that doing homework is futile because the market already incorporates all known information.  The folks who buy into this notion have stopped looking for information and see no value in doing their own analysis.  I am not suggesting that Mr. Siegel and his friends in the EMH camp were the first to promote laziness amongst investors and unknowingly encourage the markets to run off cliffs.  Many others before them have touted the same tactics, see the quote from Graham we started with.  We’re also certain this won’t be the last attempt to lull investors into believing easy gains are possible from investing in stocks, or houses, or any other asset for that matter.  As we’ve seen over the past year, this is the stuff of which tragedies are made.

China: Investing when faced with questionable statistics and political risks

China: Investing when faced with questionable statistics and political risks

Up until the late 19th century, the academic discipline now known as Economics was called Political Economy. I’ve always liked that term because it implicitly acknowledges that all economic activity occurs within a political and legal framework. Economics, in contrast, sounds technical and removed from the messy world of politics. Of course, politics and economics have always been firmly intertwined and this will continue to be the case until governments and their citizens stop using the political process to influence economic outcomes. We expect this to happen immediately after winged hogs start flying loops outside our office window.

With the possible exception of Russia, China has the highest degree of state involvement in industry of any country in the G-20, and there are signs that this state involvement is growing. The high degree of political influence in economic affairs is a primary reason we have been wary of investment in China. It is difficult for us to justify risking investment capital in Chinese companies when the basic tenets of open markets don’t seem to apply to them: shareholders have limited transparency, substantial ownership stakes are held by sponsors closely allied with the Communist Party, key suppliers and customers are directly controlled by the goverment, and the state plays an active, dominant role in key industries with an explicit aim of perpetuating the rule of the current regime. Political considerations doubtless play a role in commercial decisions and this does not make for an efficient market.

As investors, we are also concerned about the risks posed by outright state appropriation of private assets. The Chinese regime at a national level has not trampled over property rights in the blunt manner that Russia’s has, but at the local level, officials have not been shy to disposses individuals of resources and property they have a claim to. In this context, we are troubled by the arrest of employees of Rio Tinto (a major Australian mining and materials company) on charges that they engaged in trade espionage and overcharged Chinese state-owned enterprises for raw materials. We believe the arrests are linked to two other events: Rio Tinto’s refusal of a major investment by state-owned Chinalco and the controversy over the screening of a film on Rebiya Kadeer at the Melbourne Film Festival. Ms. Kadeer was punished for her activism on behalf of China’s Uighur minority by being thrown in jail and having much of her wealth appropriated by the state. It is difficult to dismiss the scenario that Chinese authorities are using the power of the state to exact retribution or push for an outcome more desirable for Chinalco.

Part of the legal argument for arresting Rio Tinto executives is that China deems many statistics to be state secrets and since so many enterprises are directly or indirectly state-owned, much commercial data on their operations could enjoy similar status. In general, unequal treatment under law, a politicized judiciary and thin protection for private property in China has made us evaluate investments in China with more than the normal level of skepticism applied towards emerging markets.

The second reason we have been skeptical of Chinese asset valuations is that the average Chinese investor has been removed from a free market environment for at least two generations. Numerous academic studies have remarked on long-lasting discrepancies between A and B shares on the Shanghai index. The shares conferred equivalent economic rights, but until 2001 A shares could only be held by domestic investors, while B shares were held only by foreign investors. A shares prices were consistently higher than those for B shares, some have suggested this was due to an information advantage held by domestic shareholders. We feel that part of the explanation is that public markets for securities are still a new experience for Chinese business-owners and investors. The people with the best local knowledge to value assets are operating in an environment with which they have limited experience. Where there is limited understanding of markets and their risks, asset prices can easily be determined by momentum driven investors and purely speculative forces. By no means is this state of affairs limited to China, but it must be taken into account when evaluating the Chinese market for investment purposes.

Amongst other troubling factors are suggestions that the economic statistics coming out of China are unreliable. This seems entirely plausible since the Chinese administration is singularly focused on controlling discussion about the Chinese for propaganda purposes. The Financial Times noted recently that the GDP numbers for the first half of 2009 do not reconcile at the state and national levels and official wage statistics were greeted with incredulity by most. The speed with which GDP statistics are produced is also cause for concern. Provincial and regional officials are evaluated and rewarded on the level of economic growth within their geographies and we feel this incentivizes double-counting and dodgy accounting to create an illusion of higher growth. Given the state-controlled nature of many industries, we feel managers at numerous commercial enterprises have similar incentives. Earlier this year, the National People’s Congress acknowledged that falsification had occured and increased penalities for fabricating data, but the revised law and penalties will not take effect till 2010.

The opening paragraph of the most recent GDP report from the National Bureau of Statistics of China can be paraphrased as “everything went according to plan in all provinces”. We find it difficult to believe this claim when so many things were going wrong in many of China’s largest trading partners. The same report tells us that export activity dropped by almost 22%, and imports fell by over 25% (which matches BDI statistics). This apparently left major export-focused regions unaffected. Broad money supply (M2) on the other hand, grew by almost 30%, which makes the maximum 10% y/y increase in the US look positively responsible. Since bank lending and money supply have risen so quickly, it is likely that some activity is being generated by nervous managers and officials using borrowed funds to meet centrally mandated growth targets.

Along with hard data on a drop in exports, the Economist has reported that commercial real-estate vacancies in Beijing are approaching 25%, a clear sign of over-building. Power generation is amongst the most reliable indicators of economic activity in developing countries where economic data series may not be robust, and by that measure the picture is far murkier than the 7.1% annualized growth rate the GDP stats project. In April, the International Energy Agency noted that Chinese GDP data for Q1 and oil consumption diverged, which is quite atypical. We are also skeptical about claims that consumer demand rose strongly along with wages since the anecdotal evidence suggests unemployment has risen markedly (the official unemployment figures have hardly budged).

Derek Scissors at the Heritage Foundation has a strongly worded piece about the statistical data coming out of China and the impact that bank lending and investment spending have had. I must note that these speculations are not new. As far back as 2001, questions about the quality and reliability of Chinese economic data have been raised by researchers publishing in China Economic Review (see Rawski 2001, Keidel 2001) in particular the use of a value-added method to calculate GDP.

All of the concerns expressed above have led us to be extremely cautious on China as investors. We are well aware that Chinese industry has become a crucial part of the supply chain for many industries world-wide, and that we cannot ignore China in international stock allocations. We also know that most investments in emerging markets carry similar risks which have to be balanced with the opportunities. That said, the mix of opacity, state control, limited local experience with asset markets and a weak judiciary creates a series of risks very difficult for an investment manager to account for, and usually leads us to exit investments in China earlier in a cycle than we would investments elsewhere. The questions revolving around national statistics makes us wary of taking shorter-term macro position and generally skeptical of those who are unreservedly bullish on China.

Consumption, savings and unemployment

Consumption, savings and unemployment

The Grasshopper and the Ants
The Grasshopper and the Ants

Though we remain optimistic about the prospects for US growth over the longer-term, and continue to believe in the diversity and resiliency of the US economy, it is difficult to see much optimism in the short to medium term. Over the past few weeks, we’ve been delving into unemployment statistics at the state and local level to get a better sense of how bad this recession has been for employment.

US unemployment rate (1948 onwards)
US unemployment rate (1948 onwards)

The national unemployment rate in June was 9.4%. With the exception of the recession of 1982-1983 (when it reached 10.8%), this is the worst unemployment rate in the post-second world war period. At a regional level, in nine states, the current unemployment rate is the highest since 1976 (the earliest year data is available at the BLS), and in another eight states (plus D.C.) it is within one percentage point of the record. Amongst those setting records, are two of the largest state economies CA and FL (also those worst affected by the real-estate boom, and a wide-swath of mid-atlantic states, MD, VA, GA, NC, SC. So in 18 of 50 states, joblessness is higher than most people have ever experienced. In absolute terms, more of the labor force is unemployed now (15.2 million) than at any time since 1948.

It is likely that unemployment will continue to rise until early 2010, and the unemployment rate could well exceed that of 1982-1983 and reach 11%. The primary reason for our pessimism about the speed and strength of a recovery is the shaky ground on which US households find themselves. Years of low and negative savings rates combined with falling asset prices have affected the biggest components of US household wealth, our homes and investments. The reverberations of this wealth effect will be felt for many quarters of US consumption and consumer confidence.

Unemployment affects consumer confidence in a way that GDP figures and corporate profits cannot. Continuing unemployment, seeing friends or neighbors out of work for months on end, makes consumers rethink every purchase.

Continued Unemployment Claims (1967 onwards)
Continued Unemployment Claims (1967 onwards)

Since we do not foresee a quick recovery in consumer demand, we believe a quick recovery in unemployment to the 5-6% level is unlikely. In prior recessions of similar severity, unemployment has not returned to the 6% range till 3-4 years have passed. This would suggest a return to full-employment in 2012 or 2013. It may take longer. We believe a structural adjustment is underway, with two sectors of the economy, construction and finance, shrinking to a semi-permanent lower level of activity. Former workers from these industries will need to retool themselves for work in other areas, or may need to relocate to another part of the country. This will take time.

The unwelcome triplet of rising unemployment, falling asset prices, and a financial crisis that has felled many firms that were household names will affect the American consumers’ view of thrift and spending for years to come. We believe the current recession’s affect on US consumer behavior will be long-lasting, as will the US investor’s new-found skepticism towards real-estate, debt and equities. This is similar to how a traumatic episode affects survivors. For an entire generation of Americans, this recession is their first encounter with generally difficult economic conditions and the realities of the business cycle. We believe there is a fundamental shift underway for a generation of Americans, away from a culture of high consumption, towards a new-found frugality.

The grasshoppers are chastened and the ants have been vindicated in particularly dramatic fashion.

The road ahead…

The road ahead…

We read Bill Gross’ monthly letters for his thoughtful take on the big economic and financial questions of the day, mixed in with a dose of humor. The NYT recently published a profile of Gross, whose reputation has been burnished during this crisis. The June 2009 and July 2009 letters are a must read for their colorful description of the long road ahead of us, before the world economy attains some semblance of normalcy.

The ground shifts under efficient market theorists.

The ground shifts under efficient market theorists.

In Hans Christian Andersen’s tale The Emperor’s New Clothes, a pair of confidence tricksters sell the king a suit made of fabric so special, it was invisible…

The more things change, the more they stay the same. For years, the priesthood of academic economics had the entire world convinced that the markets conformed to the “semi-strong” form of the Efficient Markets Hypothesis. Mathematical concepts taught in introductory engineering courses entranced “social scientists” into promoting a tautology that did not conform with even a cursory knowledge of history.

It seems, though, that Efficient Markets Hypothesis might be going the way of the dodo, since it elicits amused smiles from most observers when they hear the name. The Times ran a story this week, Poking Holes in a Theory of Markets, and interviewed the inimitable Jeremy Grantham, whose market views we follow closely. The article’s worth a read if only to get a little bit of a taste of Grantham.

The two bubbles (technology stocks and real-estate) we have suffered this decade have brought into question a number of preconceived notions and assumptions about how the world works. It’s heartening for us to see a resurgence of interest in economists whose work stands apart from the Chicago orthodoxy. It’s good to see a little bit of attention being paid to behavioral economics, Keynes, Schumpeter, and Hayek.

Prices are crucial carriers of information in a capitalist economy, they tell us what the prevailing opinion is in the marketplace. Prices convey to market participants what the odds offered at a racetrack tell bettors. In general the crowd is right about the odds for companies and horses, but on occasion, it is spectacularly, violently, destructively wrong.

Asset prices are useful when they reflect the collective, informed opinion of participants who use independent judgment and analysis to arrive at an independent sense of value. The moment a large enough contingent believes market prices tell them everything there is to know about the world, that there is no purpose in doing their own analysis, and begin to trade indiscriminately, prices become less than useless. Market prices are opinion, and this opinion is meaningful and useful when your market is composed of knowledgeable investors attentive to risk. When the market is taken over by speculators and most participants are too lazy to analyze a security in an intellectually honest way, prices no longer tell you anything but how much punch has been consumed at the party.

Eventually, someone points out that the emperor is naked, and the ground shifts. EMH RIP.