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One of my tools in my market analysis toolbox is leadership analysis. In particular, I found that in bull phases, it pays to buy the market leaders (see Momentum + Bull market = Chocolate + Peanut butter). I was playing around with Relative Rotation Graphs, or RRG, the other day and what I found was a surprise. […]
This is another in a series of occasional posts on quantitative analysis. I am indebted to Josh Brown for pointing me to an article by Larry Swedroe, which discusses a study on demographics and real interest rates. While I found that I can derive significant insights from single variable studies like these, the world is […]
Trend Model signal summary
Trend Model signal: Neutral
Trading model: Bullish
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading model component of the Trend Model seeks to answer the question, “Is the trend getting better (bullish) or worse (bearish)?” The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.
Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.
Good news and bad news
The market action last week saw some good news and some bad news. The bad news came in the form of weakness in the Greater China equity markets, but that was offset by the goods news of upside breakouts in Europe and a positive relative strength showing by US small caps. When I net it all out, I remain constructive that equity bulls will see another visit from Santa Claus this year.
First, the bad news. China is slowing again. Real estate prices, which represent the most levered and exposed part of the economy, is rolling over after a brief bout of strength.
The news that broke Friday indicating that Chinese authorities are investigating several major brokerage houses did not help the Chinese stock markets. More worrying is the behavior of the regional Greater China markets. As the chart below shows, three of the five markets of China`s major Asian trading partners have violated their 50 dma, which indicates rising anxiety.
The silver lining is that real-time indicators of economic re-balancing is continuing. My New China-Old China pairs continue to show that consumer related stocks, which represent the New China, are outperforming financials, which is more indicative of Old China (see Two better ways of playing Chinese growth).
Overall, Chinese economic indicators aren’t that bad despite the wobbly regional Greater China stock markets. Consumer spending is rising, which is indicative of re-balancing, and both fiscal and monetary stimulus, as measured by credit growth, are positive (via Ambrose Evans-Pritchard).
There is no need to panic.
Upside breakouts in Europe
By contrast, an unambiguously bullish development for global stock prices came in the form of upside breakouts in Europe. The chart below of the Euro STOXX 50 shows a double upside breakout through technical resistance and the 200 dma.
The UK market, which has a heavier energy weight, also showed a constructive upside breakout through a downtrend. The chart below shows the FTSE 100 in both panels. In the upper panel, I have drawn the trend line through the daily highs and the upside breakout is less clear. The bottom panel only uses closing prices and the breakout is more distinct in that chart.
The better stock market performance in Europe is reflective of improving fundamentals and more stimulative policy. Eurozone PMIs are improving and readings are at a 54 month high:
Moreover, money supply has been growing at a healthy clip and it remains to be seen whether the ECB will take further steps on QE next week, which is a development that Mario Draghi has hinted heavily about.
Better US small cap performance
The so-called Santa Claus rally each year usually occurs either in December or January. One of the explanations advanced for this seasonal effect is a rebound from year-end tax loss selling, which is most pronounced in the less liquid small cap names.
The chart below depicts the small cap SP 600 in the top panel and the relative performance of small vs. large caps in the bottom panel. As the chart shows, small caps have assumed the market leadership in virtually every year since the onset of the GFC. This year, small caps are in the process of staging a relative breakout against large caps, indicating improving relative strength. These readings suggest that another small cap rally is likely this holiday season.
Here is a closer look at the small vs. large cap performance chart for 2015. The breakouts are more evident as we zoom in, both from absolute and relative frameworks.
Improving fundamentals
Equally encouraging for a Santa Claus rally, which I define as a stock market rally led by small caps, is the improving forward EPS revisions across market cap bands. The chart below from Ed Yardeni shows that forward EPS is rising across the board, which is bullish. The latest figures show that SPX forward EPS rose 0.07% in the latest week.
Here is the evolution of forward EPS in the midcap SP 400, which saw a more pronounced upward revision when compared to large caps.
Best of all was the improvement in small cap forward EPS.
The positive earnings outlook is confirmed by Barron’s report of insider activity, which shows that this group of “smart investors” are still buying.
More room for a bull run
Peering into next month, this chart from IndexIndicators shows that the SPX is exhibiting positive momentum, but the market is not at the overbought levels seen in past Decembers. There is more room for the bulls to run.
The latest figures from NAAIM show that RIAs continue to buy stocks. Equity exposure is still recovering from August/September correction levels, which sets up the potential for a FOMO rally into year end should positive price momentum persist, which it is likely to.
When I add it all up, these are all signs that Santa is coming to town this December.
Beware the tax-loss Grinch!
Regular readers know that I have been bullish on late cycle sectors such as the commodity related sectors of the market (see How to energize returns even as momentum fades). While I remain positive on these sectors longer term, I would be tactically cautious about these stocks in the near future as tax loss selling is likely to put downward pressure on them. The chart below shows the performance of small cap stocks, which has lagged large caps lately, compared to the energy and mining sectors. As the chart shows, commodity related names have fared far worse than small caps and therefore they may see further selling pressure during tax loss selling season.
My inner trader will be opportunistically switching out of part or all of his commodity related equity long positions for small caps in days to come. My inner investor remains constructive on energy and materials and he is not concerned about these minor blips.
My bullish stance isn’t without risk, however. In a future post, I will go full “Zero Hedge” and outline the numerous stock market landmines of 2016.
Disclosure: Long SPXL, ERX, NUGT
In Canada, we had our Thanksgiving a month ago (because the growing season is shorter and it makes no sense to have Thanksgiving in November when it’s freezing in much of the country). Nevertheless, in the spirit of American Thanksgiving, I reflected on what to give thanks about.
In light of the events in Paris and Brussels, one silver lining in the world has been the dramatic slide in war deaths in the last half century. We haven’t totally eliminated wars, but in comparison to the horrific carnage of the two World Wars, the modern era`s casualty rate is one thing to be thankful about.
The sheer scale of the human destruction was also dramatically illustrated by this New York Times article which showed that the German Wehrmacht lost more men in a single month in January 1945 than all American losses in the 20th Century.
The triumph of Europe
As I thought about the most recent terrorism threat in Europe, my most encouraging moment was the image of German chancellor Merkel asserting that she was standing shoulder to shoulder with the French. That episode represented a sea-change in European history, as the French and Germans (also Prussians) were the primary opponents of major European wars in the last couple of centuries (see my previous post Lest we forget, or why you don’t understand Europe).
The image of Angela Merkel on stage in support of French President Hollande also illustrated the dramatic triumph of the European Project. In the wake of the Second World War, Western Europeans sought to bind the French and Germans together so that war between these two states would never happen again. They succeeded, first with the creation of the EEC and which later became the EU. If you offered any 1946 European leader a choice between continuing the cycle of death and destruction over the next few generations on one hand, or paying for it in the form of political discord between core Europe and peripheral Europe (Greece, Spain, Portugal, etc.), he would have gladly taken that bargain.
What about deaths from terrorism? This chart shows the history of deaths from terrorism in Western Europe since the 1970. The recent climate has been extremely subdued compared to the turbulent 1970s and 1980s.
Starting with the 1960s, Europeans have had to endure the likes of the abortive Algiers putsch by French officers and the OAS; the Baader Meinhof gang; the Red Brigade (and the murder of popular Italian politician Aldo Moro); events like the Bologna massacre and the Munich Olympics; not to mention nationalist movements like the Basque separatists and the Irish Republican Army. During the same period, the United States had to contend with left-wing movements like the Weathermen and the SLA, as well as the Ku Klux Klan on the right.
Be thankful. Lest we forget.
The ISIS struggle
This picture tells the story of 1000 words: Obama and Putin huddle at a side meeting at the recent G20 Summit in Turkey(!) Undoubtedly ISIS was the main subject of discussion as the Paris attack and the downing of the Russian airliner, not to mention the bombing in Beirut, served to galvanize European resolve against the jihadists.
In connection with that half-hour impromptu meeting at the G20 Summit, this Barron’s interview with Larry Jeddeloh is very timely. I have known Larry Jeddeloh for years and I think he is being overly dramatic, but he does make some good points (emphasis added):
The risk profile for oil prices is changing pretty rapidly. We think the risk of a conflict is going to build very fast now in the Middle East. There is no premium in the oil price whatsoever. There’s a new sheriff in town, Vladimir Putin, and he has an interest in higher oil prices, not lower oil prices. The old sheriff, the United States, had an interest in stable to lower prices.
What follows is highly speculative, but…
What’s going on in the Middle East is the realignment of the petrodollar system. You have the Saudis talking to the Russians about a defense agreement. Deputy Crown Prince Salman, the defense minister, was in Moscow, visiting Putin. They discussed several agreements, including an oil agreement. With the U.S. pullout from Iraq and Afghanistan, U.S. influence over Saudi policy is just about gone. The Russians, on the other hand, need a higher oil price, as do the Saudis, because the Saudis are running through currency reserves at a very rapid rate, and are running a deficit that is nearing 20% of GDP. That isn’t sustainable. The Russians, Iranians, and Syrians are now all on one side of the camp. The Saudis are very concerned that the Iranian-funded, Iranian-trained Houthi rebels in Yemen will hit the Saudi oilfields. The thing to look out for is a deal in which Iran will stop backing the Houthi and, in return, Saudi Arabia stops pumping 10.3 million barrels a day and reduces output. The Russians broker the deal because they can benefit dramatically from a Saudi shift in oil policy. You get a more formal relationship developing between Russia and Saudi Arabia, which together have 21 million barrels a day in production. And they regain control of the pricing mechanism in the next six months. I think the Saudi willingness to over-pump is going to change when the threat to their wells recedes. When the Saudis shift their policy, the oil price will head north.
Regular readers know that I have been bullish on the energy and commodity sector for about a month (see How to energize returns even as momentum fades). The chart below tells the technical story quite succinctly. Oil prices (top panel) have been falling for about a year. The relative performance of the airline group against the market (middle panel) hasn’t behaved as well. Even as oil prices faded in the last half of 2015, the relative performance of airlines has been rolling over. Meanwhile, the relative performance of energy stocks (bottom panel) appear to be making a rounded saucer-shaped bottom. In effect, this is a classic setup for better performance from energy stocks in the months ahead.
Larry Jeddeloh’s comment about the new Russian sheriff in town brings up a parallel analysis of the relative performance of Russian stocks (RSX) against the MSCI All-Country World Index (ACWI) compared to US energy stocks (XLE) against ACWI.
Several thoughts came to mind when I saw the chart above:
It isn’t often that we get to participate in buying stocks at the levels that Warren Buffett’s Berkshire Hathaway bought them at. Most of the time, the public finds out in regulatory filings after the fact and the stocks have already moved up. Here is one exception that I discovered.
In August 2013, Berkshire disclosed that it had invested about $500 million in Suncor Energy (SU) (CNN). The Street got excited because it had also made an investment in ExxonMobil (XOM). Fast forward to February 2015. Berkshire sold its XOM stake but added to its SU position (via CBC).
In the chart below, I have marked the zones when Berkshire bought its SU stake below. Last night`s closing price of USD 27.66 is right about where Buffett had bought his positions. In other words, you and I can buy SU now at roughly the same price as Buffet bought his stake.
Last week, Suncor Energy report its financial results and earnings were above Street expectations. Not only that, it raised its dividend and reinstated its share buyback program. The company has a healthy balance sheet and it is one of the more conservatively capitalized companies in the Canadian oil patch. The dividend yield is just slightly north of 3%.
While I recognize that oil and oil stocks are nosediving, this is the chance to pick up a stock at a level that Buffett bought in at. Opportunities like that don’t come around too often.
Is this investment idea contrarian enough for you?
Disclosure: I have no positions in Suncor, but I may initiate a position depending on how negative the feedback is. So please, either comment at the end of this post, email me at cam at hbhinvestments dot com or tweet me at @humblestudent. Tell me what a stupid idea this is, how SU is a value trap and what an idiot Warren Buffett is to be holding energy stocks when it was obvious that oil prices would be tanking.
The standard practice among portfolio managers is to establish a rebalancing discipline for their portfolios. A typical process would involve the following steps:
These are all sensible rules that have long been practiced in the investment industry. In essence, the strategy involves taking profits on winning asset classes and averaging down on losers as a form of risk-control discipline.
Then I came upon an intriguing paper by Granger, Greenig, Harvey, Rattray and Zou entitled Rebalancing Risk. Here is the abstract:
While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.
You would think that, for example, given the massive losses seen during the Lehman Crisis episode, that a rebalanced portfolio where the investor bought all the way down would see superior returns. Interestingly, that was not the case.
In the paper, the authors compare and contrast a simple drift weight strategy, i.e. not rebalancing at all, with a fixed weight monthly rebalancing strategy. The chart below shows how that the monthly rebalanced portfolio actually showed a higher risk profile than the passive drift portfolio. (There were other examples in the paper, but I will focus on this period for the purpose of this post).
By contrast, they advocate a partial momentum strategy. In essence, this amounts to the application of of a trend following system to rebalancing. The idea is, as the stock market goes down and the bond market goes up, you keep overweighting your winners (bonds) and don’t rebalance the portfolio until momentum starts to turn. As the chart below shows, the portfolio with the partial momentum overlay performed better than either the monthly rebalanced or passive drift weight portfolio.
These are intriguing results and a demonstration of the positive effects of using trend following techniques for portfolio construction. However, I would add a couple of caveats in my read of this paper.
First, three of the five authors work for MAN Group, which is known for using trend following techniques in their investing. While this paper does show the value of these kinds of techniques, I am always mindful that researchers may be “talking their own book”. As regular readers are aware, I extensively use trend following models in my own work, but I am cognizant of the weaknesses of these models.
In particular, these models perform poorly in sideways choppy markets with no trends. As an example, consider this chart of sugar prices for the period from 1891 to 1938. Unless the trend following system is properly calibrated, the drawdowns using this class of model are potentially horrendous.
As another example, try wheat prices for the 1872 to 1944 period:
A second critique of the approach used by the paper is the use of monthly rebalancing as one of the benchmarks. In practice, no one rebalances their portfolio back to benchmark weight on a monthly basis. A more realistic rebalancing technique might be a rule based rebalancing approach of rebalancing either annually or if the portfolio weights drift too far from the policy benchmark.
To be fair, however, the monthly rebalancing approach is an extreme one that does differentiate between a passive drift weight and a more frequently rebalanced portfolio.
In summary, this is an intriguing paper that compares and contrasts the use of price momentum, or trend following, techniques of chasing winners to a value-based rebalancing strategy of buying assets when they are down.
Before going out and blindly implementing a trend-following based re-balancing program, I urge portfolio managers to further study these approach and adopt it to their own circumstances. Your mileage will vary.
I haven’t written much about China lately, but I continue to get questions. So I thought that it was time to summarize my big picture thoughts on China here.
There is much to cover so I will just go through the highlights. There is no question that the risks are rising in China. The best analogy is someone riding around on a motorcycle at 100mph without a helmet. It doesn’t mean that anything bad happens to you. It just means that if you got into an accident, the results won’t be pretty.
The problems of China are intertwined with each other. The biggest challenge has to do with the buildup of debt to finance unproductive assets. Data from the IMF suggests concern over the level of non-financial corporate debt in China:
While most of the debt remains denominated in RMB and therefore China is unlikely to experience a significant currency crisis in a debt crisis, the global financial system remains vulnerable as recent BIS data shows nearly USD 1 trillion in external foreign currency denominated debt. Note that the data only goes to March 2013 and the reading was USD 880 billion. At that rate of increase, it would not be a big leap to imagine that total external foreign currency debt has topped USD 1 trillion today.
So far, we have a picture of someone riding around on a motorcycle at high speed with little protection. As long as the road is clear and the rider remains in control, everything should be all right. But then the road gets bumpy…
The economy is starting to slow (via Sober Look):
What’s more, FT Alphaville reports that the Chinese property market is starting to soften (emphasis added):
They’re from Nomura’s latest on China property stress which, they say, is increasing at pace. Apparently every property market leading indicator at the national level turned down in Q1, and for most monthly indicators the rate of decline accelerated through the quarter. That, says Nomura, means the question is no longer “if” or “when”, but rather “how much” China’s structurally oversupplied property market will correct.
The greater risk to China lies in the pervasive consequences of any property bust. Property investment has grown to account for about 13 per cent of gross domestic product, roughly double the US share at the height of the bubble in 2007. Add related sectors, such as steel, cement and other construction materials, and the figure is closer to 16 per cent. The broadly defined property sector accounts for about a third of fixed-asset investment, which Beijing is supposed to be subordinating to the target of economic rebalancing in favour of household consumption. It accounts for about a fifth of commercial bank loans but is used as collateral in at least two-fifths of total lending. The booming property market, moreover, has produced bounteous revenues from land sales, which fuel much local and provincial government infrastructure spending.
The reason things look different today is the realisation of chronic oversupply. As the property slowdown has kicked in, housing starts, completions and sales have turned markedly lower, especially outside the principal cities. Inventories of unsold homes in Beijing are reported to have risen from seven to 12 months’ supply in the year to April. But when it comes to homes under construction and total sales, the bulk is in “tier two” cities, where the overhang of unsold homes has risen to about 15 months; and in tier three and four cities, where it is about 24 months.
FT Alphaville reported that declining real estate values can set off a negative feedback loop (emphasis added):
More so, the bet is that the property market is just waaay too important and connected to be allowed to correct aggressively. As ASY says, as property transactions slow, more and more liquidity is trapped in the sector, and this inevitably leads to financial failures and knock-ons everywhere else — downstream industries, local government revenues, collateral for bank lending and via wealth effects on consumption to name a few specifics. As UBS note, given that property investment accounts for almost a quarter of fixed investment, construction value-added is 13 per cent of GDP, and there are extensive linkages between property and industrial sectors including steel, cement and construction machinery, the impact on the economy from a drop in construction volume is bigger than that from a worsening household balance sheet and consumption.
Nomura estimate that property investment (including residential, commercial and public housing) contributes to around 16 per cent of GDP, taking into account its direct contribution and that of related industries such as steel and cement. Not a sector to ignore, in other words, particularly as the property correction could snowball in the short run.
This is the kind of bumpiness in the road that the motorcycle rider will have to navigate.
Instead of worrying about whether the rider will crash, Beijing has opted for a long-term solution of reforming the system to allow China to better deal with shocks – sort of building the right kind of road, so to speak. The leadership in Beijing recognizes the risks to China`s growth model. They have made commitments to reform the system. The latest Five Year Plan calls for re-balancing the source of growth from infrastructure driven growth to consumer driven growth, financial reform and greater mobility from the reform of the hukou system of residency.
These measures sound good, but will it be fast enough and robust enough to forestall a crash? Satyajit Das, who foresaw the global financial crisis but have become a permabear ever since (permabears and permabulls are useful because you always want to hear their side of the story – and they can be right), has warned, despite the rhetoric, that the “’talk-to-walk’ ratio is disappointing”:
In effect, the internal contradictions of an economic model where investment drives growth rather than the reverse will become apparent. Wei Yao, an analyst at French bank Société Générale spoke for many when he termed the effort to balance growth and reform as “mission impossible.”
These tensions may drive a process of ‘skewed reform’. For example, the rapid growth of the shadow banking system constitutes de facto reform of the banking system as depositors can obtain higher returns than that available from banks. But this increases risk. The shadow banking system has led to systemic issues, such as a rapid increase in debt levels and complex links with the banking system. Limited regulation has led to poor governance and risk disclosure. It has increased moral hazard as investors unaware of the real risks rely on state owned banks or governments to ensure return of their capital.
Little is likely to change. At the March National People’s Congress, a meeting to rubber-stamp policies, Premier Li Keqiang conceded as much. While stressing the government was committed to structural reforms, he admitted investment remained “the key to maintaining stable economic growth,” targeted at 7.5%.
The main challenge to these initiatives is Party insiders have become filthy rich prospered under the old system and it would be difficult for them to make changes that hurt their own well being:
Policy implementation will remain challenging. Local governments are unlikely to acquiesce to reforms that undermine their power, which is rooted in rapid growth built around property development using cheap land, mispriced utilities and low taxes. The rebalancing in favor of consumption brings the central government into direct conflict with powerful vested interests that have benefitted from the credit-fueled, investment-based growth model.
As Das puts it, Party insiders will have to gore their own ox in order to implement reforms:
As the process left households and ordinary workers with a relatively small share of GDP, economic rebalancing will require transferring an increasing share to this group at the expense of state-owned enterprises, banks and the economic elite.
In effect, reform requires an implicit redistribution of wealth, encoded in the language of reform — financial market liberalization, reform of state-owned enterprises, and labor mobility. This means that any reform agenda will, in all likelihood, face significant opposition from vested interests in the state sector and local government.
As an example of the difficulties of reforming the state sector, FT Alphaville highlighted analysis from Societe Generale indicating that while the private sector was deleveraging and adjusting to new market realities, the state owned sector continues to add debt:
That chart from SocGen shows that even as the state sector continues to leverage up — among industrial enterprises, the liability-to-asset ratio of SOEs jumped from 57 per cent to 61 per cent between 2008 and 2010, and continued to crawl up afterwards — non-state entities saw the ratio falling all the way from 59 per cent to 56 per cent.
Combine that with a low inflation environment — April inflation data came in notably below expectations and a low inflation environment has persisted for about two years — and a very large negative output gap, you get an argument for a debt-deflation scenario, at least in some sections of the economy.
I was digressing. All this talk about a building better road is all fine and good, but what about our story of the rider on the motorcycle riding at 100 mph without a helmet?
The most likely scenario is that should the motorcycle rider crash, he will be revived – but as a zombie.
There is a must-read article at Quartz about the outlook for China. It begins with an interview with Patrick Chovanec where he compares China to Japan of the 1980`s. He stated that China is likely to go down the Japanese road. Consider the similarities of Japan then and China now:
Even comparing headline data, the Japan of the 1980s and China of today are strikingly similar:
- Second-largest economy. In 1968, Japan unseated West Germany (paywall) as the second-biggest economy on the planet. China seized that title in 2010, with its nominal GDP of $5.9 trillion nudging past Japan’s $5.5 trillion.
- One-tenth of global GDP. By the early 1990s, Japan’s economy accounted for 10% of global GDP (in purchasing-power parity terms, via the IMF), a milestone China hit in 2007.
- One-tenth of global trade. In 1986, Japan accounted for 10% of global trade, a level China reached in 2010.
- The world’s biggest banks. By the late 1980s, the world’s five biggest commercial banks, by total assets, were Japanese. Here’s how China stacks up now:
The Japanese and Chinese property bubbles are eerily similar:
Banks issue loans off inflated property values
Japanese banks had traditionally loaned against the value of assets, not the income those assets generated; a property deed was considered the most reliable collateral, explains Wood. That policy came in handy as Japan’s capital markets took off. With big companies relying more on the stock market for funding, banks had to find new customers: smaller companies. Less familiar with these new firms, banks used property as collateral for credit. Soaring property values invited bigger and bigger loans. But because property prices had gone up every year since the end of World War II, banks thought their loans were safe.
In China’s case, banks have been issuing loans off not only inflated, but often falsified property values. For real-estate developers and underground bankers, offering real estate as collateral for new loans is a regular practice, says Victor Shih, professor at University of California, San Diego, and an expert on China’s political economy. But “the method of evaluating the collateral is highly convoluted in China so that collaterals are often valued much higher than market-clearing prices,” Shih told Quartz. “As long as banks and other lenders accept such fictional collateral value, they will continue to lend to distressed borrowers.”
If the motorcycle were to crash, the market-oriented policy is to allow the rider to die. The Chinese leadership has been unwilling to embrace that idea and history has shown that whenever the economy slows or shows signs of stress, Beijing capitulates and comes to the rescue and take steps to socialize losses, which would be counterproductive to their goal of reform, because it would be household sector that would ultimately pay the price (see Will Beijing blink yet one more time?). In our motorcycle analogy, it is the equivalent of reviving the corpse and making him into a zombie by lending to and propping up failed enterprises as the Japanese banking system did throughout their Lost Decades.
With China’s stock market already mired in its epic slump, the thing most likely to trigger a Japan-style crisis is a real estate market collapse. However, China already exhibits more than a few symptoms of a zombie infection. Even without the catalyst of a market crash, it in many ways already seems more like Japan in the late 1990s than the Japan of 1989.Though lending continues to surge, it’s getting harder and harder for China to grow. In 2013, credit rose 10% annually (paywall), much higher than the 7.5% expansion of official GDP. That trend is worsening: China must invest twice what it did in 2008 to generate the same amount of GDP growth, according to Wei Yao, an economist at Société Générale. By her tally, China now owes the equivalent of 38.6% of its GDP in principal and interest each year.
Policy makers appear reluctant to embrace the idea of creative destruction. Rather, they would rather live with the zombification of the economy as evidenced by Societe Generale’s above analysis showing that SOEs continued to pile on debt while non-state enterprises were deleveraging (emphasis added):
But growth won’t revive until credit starts supporting the right businesses or industries. Even though state-owned enterprises (SOEs) tend to be much less profitable than private firms, the big banks are also state-owned. And because China’s credit system is still based on political, and not market, risk, the big state-owned banks still loan to SOEs over smaller companies.
That system, says Hoshi, looks awfully familiar. “In a similar way that the Japanese [lending practices] discouraged new entrants… Chinese SOEs are doing the same thing,” he says. “They’re protected, they’re not that profitable, but they can stay in the market because they’re owned by the state, which reduces the possible profit of new entrants.”
Societe Generale (via FT Alphaville) outlined the similarities between SOE zombification and the pushing on a string effects of QE (emphasis added):
If we treat the debt of SOEs and local government guaranteed corporates just as government debt, China’s situation is, to some degree, similar to the post-Lehman US: rising public debt, declining private sector leverage. Particularly, the state sector as a whole generates sub-par economic return. Loss-making industrial SOEs account for more than a quarter of total industrial SOEs, double the ratio among non-state industrial enterprises. Granting credit to profitless corporates is not too much different from having quantitative-easing liquidity trapped in the commercial banks’ vault.
Indeed, Beijing may be in the process of blinking in the face of weakness, despite statements about they will not engage in large scale stimulus programs. Here is Ambrose Evans-Pritchard’s article entitled “China reverts to credit as property slump threatens to drag down economy” (emphasis added):
China’s authorities are becoming increasingly nervous as the country’s property market flirts with full-blown bust, threatening to set off a sharp economic slowdown and a worrying erosion of tax revenues.
New housing starts fell by 15pc in April from a year earlier, with effects rippling through the steel and cement industries. The growth of industrial production slipped yet again to 8.7pc and has been almost flat in recent months. Land sales fell by 20pc, eating into government income. The Chinese state depends on land sales and property taxes to fund 39pc of total revenues.
“We really think this year is a tipping point for the industry,” Wang Yan, from Hong Kong brokers CLSA, told Caixin magazine. “From 2013 to 2020, we expect the sales volume of the country’s property market to shrink by 36pc. They can keep on building but no one will buy.”
The Chinese central bank has ordered 15 commercial banks to boost loans to first-time buyers and “expedite the approval and disbursement of mortgage loans”, the latest sign that it is backing away from monetary tightening.
Longer term, the Quartz article outlined the challenges facing China:
Japan’s experience explains why the challenges facing the Chinese economy are actually much greater even than avoiding a housing market crash or a financial crisis. China’s leaders may well be able to steer the country clear of either. But pulling off yet another miracle of administrative legerdemain will be perilous if it means China’s leaders further postpone financial reforms—things like lifting the deposit-rate cap, allowing SOE failures, or permitting foreign banks to compete. One thing Japan’s history makes painfully vivid is that the longer China waits, the larger its zombie horde grows.
With the Chinese leadership implicitly signaling to the market the existence of a Beijing Put for the Chinese economy, China is unlikely to see a crash landing. The price for such a policy is a prolonged period of slow growth.
In other words, China is likely to turn Japanese. Just don’t tell either the Chinese or Japanese that, they hate each other.
J J J J J
To read more about our writings on China, click here.
The topic of inequality has been in the news in the wake of President Obama’s State of the Union speech, which focused on that very issue. I refer readers to my previous post on this subject (see Inequality: Does it matter?) where I concluded that it is the equality of opportunity that matters, not so much income or wealth inequality itself.
In this post, I have messages for both the Left and the Right. You probably won the genetic lottery, but you didn’t realize it. It’s time to take steps to correct some of those differences.
Let’s start with the popular perception of inequality about the rich getting richer. There is no question that the owners of capital have derived much of the gains over the last few decades. As Rex Nutting at Marketwatch pointed out, wages haven’t budged very much since 1979:
On the other hand, productivity has skyrocketed in the same period:
It is clear from this simple analysis of who won and who lost. I feel their pain. Down that road lies social unrest.
As an investor, I am concerned about inequality because it retards growth and creates social problems in a society. Andrew Berg and Jonathan Ostry of the IMF wrote a paper entitled Inequality and unsustainable growth: Two sides of the same coin? Here are their primary findings:
We found that high “growth spells” were much more likely to end in countries with less equal income distributions. The effect is large. For example, we estimate that closing, say, half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a “growth spell”. Inequality seemed to make a big difference almost no matter what other variables were in the model or exactly how we defined a “growth spell”. Inequality is of course not the only thing that matters but, from our analysis, it clearly belongs in the “pantheon” of well-established growth factors such as the quality of political institutions or trade openness.
In addition, Albert Edwards (via FT Alphaville) raised his concerns about US inequality, showing that US inequality has reached new heights.
He went on to show that inequality is highly correlated with health and social problems:
Why would you want to put your money in a country with unsustainable growth and rising health and social problems?
Josh Brown wrote that the wealth have a reflexive reaction to the mention of inequality:
Business-minded people hear the word “inequality” and their reproductive organs crawl back up inside their bodies reflexively.
The “I Word” smacks of socialism and it runs counter to everything we learn in free-market capitalism and private enterprise. The way it’s supposed to work is that the winners are separated from everyone else because of how smart, hard-working and, yes, occasionally lucky they are.
To the likes of Tom Perkins, who, in a fit of hyperbole, compared the persecution of the rich to Nazism, I would first point out Howard Marks‘ latest letter in which he attributed the role of luck in his own success.
Buffett’s mention of “people who say, ‘I did it all myself'” reminds me of one of President Obama’s reelection campaign speeches, which included a comment that became a lightning rod: “If you’ve got a business – you didn’t build that. Some else made that happen.”
His remark serves quite poorly when taken on its own. It suggests he thinks that there’s no such thing as individual success, only group accomplishments. It denies the efficacy of hard work and grit. In short it reflects a very un-American view of success.
Marks went on to elaborate:
Clearly Obama omitted a few key words from those last two sentences, perhaps assuming his listeners would carry them over from those that went on before. The addition of just four words (Italicized below) would have made his message more palatable: “If you’ve got a business – you didn’t build that alone. Somebody else provided assistance that made that happen.”
In other words, no one is self-made. Someone was there to assist you along the way. Marks went on to say that success is related to winning the genetic lottery in some way:
It seems like than a coincidence that not only was Bill Gates born in 1955, but his Microsoft co-founder Paul Allen was born in 1953; Sun Microsystems founder Bill Joy and Scott McNealy were born in 1954; Steve Jobs and Eric Schmidt were born in 1955; and Steve Ballmer was born in 1956. Ten years earlier and there would have been no remote computer terminals for them to work at in high school and college; ten years later and the kids born before them would have beat them to the “new, new thing.”
Marks concluded:
The bottom line is simple: it’s great to be in vanguard of a new development. Talent and hard work are essential, but there’s nothing like getting there early and being pushed ahead by the powerful trends in demographics and test that follow.
In other words, there are no self-made men. Hard work is certainly one component, but luck and the right supports systems matter too. In my last post (Inequality: Does it matter?) I pointed out Alan Kreuger’s work where the success of the offspring depends a lot on the social position of the parents:
Alan Kreuger dubbed this the Great Gatsby Curve, shown in the chart below. The x-axis depicts the Gini coefficient, which is a measure of income inequality (the higher the number, the more unequal). The y-axis shows the correlation of wealth between generations as a measure of economic mobility (the higher the number, the more likely an offspring will have the similar income level as his or her parents).
In other words, people won the genetic lottery and they didn’t even know it. Would Bill Gates be where he would be today if he had been born in 1955 (as per Howard Marks) but he was a poor kid in the slums? It is theoretically possible, but the odds were stacked against him. Success no doubt depends on talent and skill, but it also depends on winning the genetic lottery and having access to the right education in the right schools.
A recent paper entitled Marry Your Like: Assortative Mating and Income Inequality suggests that the affluent is well aware of the Great Gatsby Curve and choose their mates accordingly. In effect, they marry within their own class. Here is the abstract from the paper [emphasis added]:
Has there been an increase in positive assortative mating? Does assortative mating contribute to household income inequality? Data from the United States Census Bureau suggests there has been a rise in assortative mating. Additionally, assortative mating affects household income inequality. In particular, if matching in 2005 between husbands and wives had been random, instead of the pattern observed in the data, then the Gini coefficient would have fallen from the observed 0.43 to 0.34, so that income inequality would be smaller. Thus, assortative mating is important for income inequality. The high level of married female labor-force participation in 2005 is important for this result.
In other words, many “self-made” Americans may not have been born to the super-rich, but they did come from middle-class or affluent families who had the resources to made sure that their kids had exposure to the right skill sets in order for them to succeed. The “shadow” Bill Gates who was born in the same year to parents in the slums would not have had the same chance to succeed.
At the heart of the inequality debate is the issue of “fairness”. Why should the children of the rich (or affluent) be able to cruise along while the children of the poor, who are just as smart or perhaps even smarter, struggle? Are we destined for an Upstairs, Downstairs world? That has been the contention of the Left in this debate.
Branko Milanovic, the Lead Economist at the World Bank research group, said in so many words the Left in developed countries won the genetic lottery but they didn’t even know it (my words, not his). The chart below shows who won and lost in the inequality race globally. The x-axis on the bottom splits the world population from the poorest on the left in subsistence economies to the richest on the right, while the y-axis shows the real income growth in PPP terms between 1988 and 2008.
In the thirty years spanning 1988 and 2008, the winners in the inequality race were the middle class in emerging economies, because of the effects of globalization, and the very rich, who engineered the globalization revolution. The losers were the very poor in subsistence economies, who weren’t able to benefit from and the middle class in developed economies, who did not receive the benefits of the productivity gains (see Rex Nutting’s analysis above) in the last few decades.
Milanovic went on to show that the country that you were born matters a lot more now than the social class that you were born into. In effect, the Left of the developed world, who has been railing about inequality, won the genetic lottery and they didn’t even know it!
Milanovic then brought up an intriguing point. Is citizenship a form of (economic) rent? Let’s go back to the previous hypothetical example of the different Bill Gates born in 1955. Bill Gates 1.0 is the actual Bill Gates. Bill Gates 2.0 was the equally talented person born to parents in the slums of East LA in the same year. Bill Gates 3.0 was born to poor parents in rural India in 1955. What kind of headwinds does Bill 2.0 face compared to Bill 1.0? What kind of advantages does Bill 2.0 have compared to Bill 3.0? Did Bill 2.0 win a genetic lottery when compared to Bill 3.0?
Are those on the Left who complain about inequality trying to suppress the fortunes of people in emerging market countries in order to protect their own privileged positions? Just take a look at this long, but worthwhile, video (via The Short Side of Long) about how economic growth in the past few decades have lifted billions out of poverty. Consider the effects of emerging market country growth in terms of rising life expectancy and better living standards. I have a variant on the adage:
Give a man a fish and he’ll eat for a day.
Teach a man how to fish…and he’ll want to buy a boat.
When he buys a boat, it has two effects. First, it raises his own productivity (which means growth). As well, his purchase means greater demand for boats and work of boat makers, which also raises growth. For a real-life example, the aforementioned video details the heart wrenching story of the African couple who scrimps and saves to buy a bicycle and how it raises the family’s productivity and financial circumstances.
Global and local inequality
In conclusion, there are two kinds of inequality, global and local (within country). Both matter.
As an investor, I care about inequality. It’s true that the rich are getting richer (local inequality). Local inequality matters because it retards the sustainability of growth. Globalization, which lessens global inequality, raises growth.
The solutions to inequality are fairly obvious, but politically difficult to implement. At a global level, the effects of globalization should serve to lessen the inequality of opportunity. How we manage the trade-offs is another matter. To close the global inequality gap, Milanovic concluded that either poor countries have to get richer or poor people have to move to rich countries (imagine millions of poor people from Botswana to China flooding into America).
At a local level, it involves better access to education and (yes, *gasp*) tax reforms to reduce the entrenchment effects of inter-generational wealth transfer.
The details of implementation, both global and local, are way beyond my pay grade.
Policy in Europe has generally been done in the back rooms, with the theatre, e.g. PIIGS debt re-negotiations, done in the front rooms. Last year, the markets were panicked because they perceived the backroom elites had lost control of the situation and events were spiraling out of control. Today, it appears that the elites have […]