Having read two books recently on the Chinese economy (albeit by the same author), here is my understanding of what’s going on:
-China’s growth has been highly dependent on liquidity and cheap capital (not necessarily cheap labor). And the resulting emphasis on investment has come at the expense of the household sector – in the form of too low interest and deposit rates, an undervalued currency that benefits exporters and manufacturers over everyone else, and lackluster wage growth relative to worker productivity.
-In any such setting, the risk of overinvestment and misallocated capital goes up exponentially. Basically, there are losses that will need to be taken at some point, it’s just that the continued investment to keep growth rates up papers it over…for a while. But not indefinitely.
-The imbalances need to be corrected by allowing consumption as a share of the economy to grow. However, in order for that to happen, investment will need to come down and GDP with it. People seem to believe that such a strategy of lower growth will lead to political chaos. But, if the household sector is benefitting, there is no necessary causation.
-Pettis’ suggestion is to have the state sell assets to pay down debt so that the weight of responsibility does not fall on the household sector. But, the subsidized classes, political insiders and party members are not keen to swallow that pill. So, while many in China talk a good game about change, let’s hold off judgment until we actually see what gets implemented.
Tuesday, January 14, 2014
Sunday, January 12, 2014
Avoiding The Fall
The subtitle is China’s Economic Restructuring and the author is Michael Pettis (2013).
Hits on many of the same themes as the other book that I recently read by the writer, but this time he focuses squarely on the imbalances in China and what needs to be done. The basic thesis is that China’s growth is investment-driven, which results in a tendency towards overinvestment and misallocation, leading to unsustainable levels of debt. China has a high savings rate as a result of repressed consumption and a transfer of wealth from the household sector – the enablers are very low interest rates, an undervalued currency, and slow wage growth, all which function as a subsidy to the state and elites. Pettis’ view is that consumption must grow at the expense of the state, otherwise China is headed for a debt crisis. His preferred plan is one where the state privatizes assets and uses sale proceeds to pay down debt, all the while allowing the consumption share of GDP to grow.
His case is pretty solid and he makes some pretty interesting points. Such as, that the question of whether a country borrows in foreign currency is irrelevant to whether a country will face losses, the only thing to focus on is whether the investments that have been made are economically viable. And, as all of it evolves in China, capital flight by elites is an important tab to keep an eye on – as an indicator of rising instability in the banking system and the end of the line for China’s growth model.
Hits on many of the same themes as the other book that I recently read by the writer, but this time he focuses squarely on the imbalances in China and what needs to be done. The basic thesis is that China’s growth is investment-driven, which results in a tendency towards overinvestment and misallocation, leading to unsustainable levels of debt. China has a high savings rate as a result of repressed consumption and a transfer of wealth from the household sector – the enablers are very low interest rates, an undervalued currency, and slow wage growth, all which function as a subsidy to the state and elites. Pettis’ view is that consumption must grow at the expense of the state, otherwise China is headed for a debt crisis. His preferred plan is one where the state privatizes assets and uses sale proceeds to pay down debt, all the while allowing the consumption share of GDP to grow.
His case is pretty solid and he makes some pretty interesting points. Such as, that the question of whether a country borrows in foreign currency is irrelevant to whether a country will face losses, the only thing to focus on is whether the investments that have been made are economically viable. And, as all of it evolves in China, capital flight by elites is an important tab to keep an eye on – as an indicator of rising instability in the banking system and the end of the line for China’s growth model.
Friday, January 10, 2014
The Buy Side
The subtitle is A Wall Street Trader's Tale of Spectacular Excess and the author is Turney Duff (2013).
The writer's personal story of Wall Street, money, drugs and insider trading, with stops at Galleon and in rehab. Quick and entertaining, but basically something that we've seen before.
The writer's personal story of Wall Street, money, drugs and insider trading, with stops at Galleon and in rehab. Quick and entertaining, but basically something that we've seen before.
Thursday, January 9, 2014
Gold Update
I haven’t dwelled on the chart for gold in a while, so here goes…
What I have provided below is the last 6 months for GLD. I see two things that are worth paying attention to. First, observe the downward sloping channel that dates back to August, 2013. It has been a decent gauge for where to buy and sell, and just this past week operated as overhead resistance on price. Second, I drew in a short horizontal line that starts in late November, 2013. It appears to function as the neckline for an inverse head-and-shoulders – if I’m right, then what we need to watch for in coming days is price stabilization around these levels ($117 to $119) and then an attempt to retest the $120 level. If it were to break through, the move should take us up to the $125 level or so – all of which would be significant because of the bullish inverse head-and-shoulders being completed, but also because it would mean a breakout from the channel discussed earlier.
If the question is where do I stand? I am agnostic, but constructive on where price is headed. You know what to look at.
What I have provided below is the last 6 months for GLD. I see two things that are worth paying attention to. First, observe the downward sloping channel that dates back to August, 2013. It has been a decent gauge for where to buy and sell, and just this past week operated as overhead resistance on price. Second, I drew in a short horizontal line that starts in late November, 2013. It appears to function as the neckline for an inverse head-and-shoulders – if I’m right, then what we need to watch for in coming days is price stabilization around these levels ($117 to $119) and then an attempt to retest the $120 level. If it were to break through, the move should take us up to the $125 level or so – all of which would be significant because of the bullish inverse head-and-shoulders being completed, but also because it would mean a breakout from the channel discussed earlier.
If the question is where do I stand? I am agnostic, but constructive on where price is headed. You know what to look at.
Tuesday, January 7, 2014
Family Secrets
The subtitle is Secret Strategies for New York City Multifamily Investing and the author is Peter Von Der Ahe (2010).
As part of my professional transition, I am spending more time thinking about NYC real estate than I have in recent years. And while this book doesn't offer a ton of new information if you have experience in the industry, it does spend some time on the rent regulation laws which comprise a large part of what makes this market both unique and tricky. The insight, for lack of a better word, was not something terribly novel, although it was not something that I had thought about either. Regulated apartments are arguably a hedge in bad times. Given that they operate at below market rents, even if the economy were to suffer a downturn, cash flow for these units should be immune. And while I'm not looking to get into the affordable apartment game, the presence of these apartments should not be a deal killer either.
As part of my professional transition, I am spending more time thinking about NYC real estate than I have in recent years. And while this book doesn't offer a ton of new information if you have experience in the industry, it does spend some time on the rent regulation laws which comprise a large part of what makes this market both unique and tricky. The insight, for lack of a better word, was not something terribly novel, although it was not something that I had thought about either. Regulated apartments are arguably a hedge in bad times. Given that they operate at below market rents, even if the economy were to suffer a downturn, cash flow for these units should be immune. And while I'm not looking to get into the affordable apartment game, the presence of these apartments should not be a deal killer either.
Monday, January 6, 2014
In a Nutshell
In his most recent post, Michael Pettis explains the problem of investment misallocations and too much debt, simply yet brilliantly (his point is about China, but it applies equally everywhere else):
“There may be good reasons for this. If a loan has been made to fund a project whose economic value is less than the economic cost of the investment, economists should treat it as a bad loan whose negative present value must be written down. However if the lending bank believes that the government implicitly or explicitly backs the loan, the bank does not need to write it down.
But while the bad loan might not represent a loss to the bank, it does represent a loss to the country, and the amount of that loss should be deducted before the country’s GDP is calculated. If Chinese banks have not correctly written down the bad debt, however, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down – a fairly large number that may amount to as much as 20-30% of GDP.
But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.
The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.
Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand.”
“There may be good reasons for this. If a loan has been made to fund a project whose economic value is less than the economic cost of the investment, economists should treat it as a bad loan whose negative present value must be written down. However if the lending bank believes that the government implicitly or explicitly backs the loan, the bank does not need to write it down.
But while the bad loan might not represent a loss to the bank, it does represent a loss to the country, and the amount of that loss should be deducted before the country’s GDP is calculated. If Chinese banks have not correctly written down the bad debt, however, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down – a fairly large number that may amount to as much as 20-30% of GDP.
But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.
The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.
Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand.”
Saturday, January 4, 2014
The Great Rebalancing
The subtitle is Trade, Conflict, and the Perilous Road Ahead for the World Economy and the author is Michael Pettis (2013). He writes a blog about China that I enjoy (see sidebar).
The book focuses on trade imbalances as the key input in today’s economic problems. Pettis concludes that many of the prevalent assumptions, about why we are where we are, are simply misguided. Rather than some moralistic tale about virtuous savers and slavish, consuming pigs, the drivers are far more nuanced and caused by policies both foreign and domestic. If you can remember that the current account and capital account must balance to zero, that the difference between total domestic savings and total domestic investment is equal to the net amount of capital imported or exported (i.e., the current account surplus or deficit), and everything that a country produces must be consumed or saved, then you’re ahead of the game in getting it. These tautologies govern internally for a single country and across all countries in a global economy.
Some other interesting takeaways:
-The explanation that the financial crisis came as a result of financial deregulation and abuse of derivatives is to ignore how history provides many examples where those issues were not prevalent and there was still a crisis. A better lens to view it through is one that focuses on imbalances between production and consumption.
-There are several common ways that countries try to raise investment and exports: tariffs, devaluation and consumption taxes. All reduce purchasing power and consumption at the household level, and therefore cause savings to rise in the form of deposits in the banking system, which can then be lent to producers at extremely low interest rates to subsidize exporters.
-The impact of a revaluation of the Chinese currency is net beneficial to the household sector and a problem for the state and manufacturers. Put differently, the state is long dollar assets given its huge reserves, so it stands to suffer if the currency strengthens. By contrast, the average citizen will have more purchasing power. So, to think about it yet another way, the state stands to lose even more the longer that it waits to effect this revaluation as it continues to accumulate dollar assets. (Maybe that’s why they are buying so much gold :) )
-When wages grow more slowly than productivity, there is a wealth transfer from households to producers that causes consumption to decline and savings to rise, and invariably more exports than imports. Unfortunately for the United States, concurrently with that dynamic, there has been a booming stock and real estate market that created a wealth effect, so there was a growth in private debt without the savings.
-China is an investment-driven economy, not export-driven. Consumption has grown, but at a pace slower than GDP, implying that the real driver has been investments. And the state has taken steps towards financial repression in order to subsidize preferred parties and industries. Since consumption is not as high, they have imported demand, but now face a period where global demand is down. The answer should be to transition to internal consumption, but there are many vested interests that want to maintain the status quo. But, the longer the state is in control of how investments are made, the higher the likelihood of misallocations and the more wealth that will be destroyed.
-Pettis tries to answer an important question: “When do countries have too much debt? The short answer is they have too much debt when the market believes they have too much debt.” Not sure Fleckenstein would agree. And if you are an investor, it might be too late at that point to salvage your money. Otherwise, everyone could tippy-top a market.
-Pettis does not believe that it would be a bad thing for the United States if China decided to sell its Treasury holdings, nor that it would necessarily lead to higher rates. As he notes, when China is stockpiling these treasuries, it is in essence exporting capital in order to import demand, thereby allowing it keep unemployment low at the expense of its trading partners. If it gave up that surplus, the U.S.’ trade deficit would stand to go down.
-In his section of forecasts at the end, I think Pettis totally misreads the U.S. situation, arguing that corporate balance sheets have gotten healthy and asset markets have cooled, neither of which is true. As to the former, while cash levels are up, so are corporate liabilities. Moreover, when one looks at market caps (not book values) right now, operating leverage is at even higher levels than in 2000 or 2007. As to the question of whether financial asset markets are in a bubble, I have to assume that this book came out at least 500 points ago on the S&P 500.
Anyway, the rub in all of this analysis, as Pettis points out, is high levels of debt. With all of the talk about trade imbalances, and all the discussion (which I didn’t even really touch on) about what changes need to occur globally, debt inhibits growth. Which basically means there is still more pain to come in the global economy.
In conclusion, this book is full of information and an explanation of important concepts. Definitely worth picking up if these topics interest you even remotely.
The book focuses on trade imbalances as the key input in today’s economic problems. Pettis concludes that many of the prevalent assumptions, about why we are where we are, are simply misguided. Rather than some moralistic tale about virtuous savers and slavish, consuming pigs, the drivers are far more nuanced and caused by policies both foreign and domestic. If you can remember that the current account and capital account must balance to zero, that the difference between total domestic savings and total domestic investment is equal to the net amount of capital imported or exported (i.e., the current account surplus or deficit), and everything that a country produces must be consumed or saved, then you’re ahead of the game in getting it. These tautologies govern internally for a single country and across all countries in a global economy.
Some other interesting takeaways:
-The explanation that the financial crisis came as a result of financial deregulation and abuse of derivatives is to ignore how history provides many examples where those issues were not prevalent and there was still a crisis. A better lens to view it through is one that focuses on imbalances between production and consumption.
-There are several common ways that countries try to raise investment and exports: tariffs, devaluation and consumption taxes. All reduce purchasing power and consumption at the household level, and therefore cause savings to rise in the form of deposits in the banking system, which can then be lent to producers at extremely low interest rates to subsidize exporters.
-The impact of a revaluation of the Chinese currency is net beneficial to the household sector and a problem for the state and manufacturers. Put differently, the state is long dollar assets given its huge reserves, so it stands to suffer if the currency strengthens. By contrast, the average citizen will have more purchasing power. So, to think about it yet another way, the state stands to lose even more the longer that it waits to effect this revaluation as it continues to accumulate dollar assets. (Maybe that’s why they are buying so much gold :) )
-When wages grow more slowly than productivity, there is a wealth transfer from households to producers that causes consumption to decline and savings to rise, and invariably more exports than imports. Unfortunately for the United States, concurrently with that dynamic, there has been a booming stock and real estate market that created a wealth effect, so there was a growth in private debt without the savings.
-China is an investment-driven economy, not export-driven. Consumption has grown, but at a pace slower than GDP, implying that the real driver has been investments. And the state has taken steps towards financial repression in order to subsidize preferred parties and industries. Since consumption is not as high, they have imported demand, but now face a period where global demand is down. The answer should be to transition to internal consumption, but there are many vested interests that want to maintain the status quo. But, the longer the state is in control of how investments are made, the higher the likelihood of misallocations and the more wealth that will be destroyed.
-Pettis tries to answer an important question: “When do countries have too much debt? The short answer is they have too much debt when the market believes they have too much debt.” Not sure Fleckenstein would agree. And if you are an investor, it might be too late at that point to salvage your money. Otherwise, everyone could tippy-top a market.
-Pettis does not believe that it would be a bad thing for the United States if China decided to sell its Treasury holdings, nor that it would necessarily lead to higher rates. As he notes, when China is stockpiling these treasuries, it is in essence exporting capital in order to import demand, thereby allowing it keep unemployment low at the expense of its trading partners. If it gave up that surplus, the U.S.’ trade deficit would stand to go down.
-In his section of forecasts at the end, I think Pettis totally misreads the U.S. situation, arguing that corporate balance sheets have gotten healthy and asset markets have cooled, neither of which is true. As to the former, while cash levels are up, so are corporate liabilities. Moreover, when one looks at market caps (not book values) right now, operating leverage is at even higher levels than in 2000 or 2007. As to the question of whether financial asset markets are in a bubble, I have to assume that this book came out at least 500 points ago on the S&P 500.
Anyway, the rub in all of this analysis, as Pettis points out, is high levels of debt. With all of the talk about trade imbalances, and all the discussion (which I didn’t even really touch on) about what changes need to occur globally, debt inhibits growth. Which basically means there is still more pain to come in the global economy.
In conclusion, this book is full of information and an explanation of important concepts. Definitely worth picking up if these topics interest you even remotely.
Wednesday, January 1, 2014
2014
I had to go back and remind myself of the quick list of predictions that I made for 2013. Overall, not a stellar job. Gold is still in a bull market, but it also suffered horribly over the last 12 months. Japan showed the early signs of what I deem to be big problems, but there was no obvious combustion. There was a taper, despite my best guess, and the unemployment rate moved lower (even if everyone now knows it is a bad measure of success). But, shorting the yen was definitely a winner.
On to 2014…
I think the same themes that I focused on then are in play. We have just moved 12 months closer to the point when everyone else will start to realize it.
-Japan keeps approving more “stimulus” because Abenomics does not do anything except weaken the yen and create cost-push inflation. Wages are stagnant.
-Gold has tested the 2013 low a few times. We’ll know shortly, I think, whether that will hold or $1,000 to $1,100 is the landing spot. Either way, a good value exists in the metal and the better mining stocks. Still, I anticipate that 2014 will be much more generous to the gold bulls than the past two years have been.
-The 10-year closed above 3.00%. That can’t make the Fed happy and is a clear measure of how the bond market is no longer cooperating. Higher rates are bad for housing prices, the stock market, budget deficits, profit margins and all the things that create a desired wealth effect. So, with all of it, I don’t think the Taper is the thing.
-Finally, on a personal note, I expect my endeavors in real estate to evolve.
A happy and healthy new year to all.
On to 2014…
I think the same themes that I focused on then are in play. We have just moved 12 months closer to the point when everyone else will start to realize it.
-Japan keeps approving more “stimulus” because Abenomics does not do anything except weaken the yen and create cost-push inflation. Wages are stagnant.
-Gold has tested the 2013 low a few times. We’ll know shortly, I think, whether that will hold or $1,000 to $1,100 is the landing spot. Either way, a good value exists in the metal and the better mining stocks. Still, I anticipate that 2014 will be much more generous to the gold bulls than the past two years have been.
-The 10-year closed above 3.00%. That can’t make the Fed happy and is a clear measure of how the bond market is no longer cooperating. Higher rates are bad for housing prices, the stock market, budget deficits, profit margins and all the things that create a desired wealth effect. So, with all of it, I don’t think the Taper is the thing.
-Finally, on a personal note, I expect my endeavors in real estate to evolve.
A happy and healthy new year to all.
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