July 15, 2015
“If a man takes no thought about what is distant, he will find sorrow near at hand.” –Confucius
When it comes to markets, no one can perfectly predict the future. When we manage our clients’ assets, our focus is on managing risk and limiting our capital investments to situations where the chances of an attractive return appears to be weighted heavily in our favor. With that in mind, we want to discuss some of the investment risks related to recent developments in Greece and China
As a result of the turmoil in Greece and China, the markets are experiencing a period of heightened volatility and traces of forced selling, particularly so among small cap stocks. Whether the current period of elevated volatility turns into a more significant correction remains to be seen.
Because of these recent events, chances are increasing that the Federal Reserve may hesitate before raising interest rates, as it had indicated it would do before the end of 2015. The Federal Reserve continues to be far more worried about deflation right now than about inflation, and we suspect they have taken keen note of recent deflationary developments overseas coupled with similar developments domestically on account of a stronger dollar.
In light of this uncertain and a somewhat artificial economic environment, we have trimmed or sold several equities that, this year, have appreciated to our estimate of intrinsic value. At the same time, we are continuing to seek out attractive returns by finding mispriced, undervalued investments that offer an attractive risk-reward profile. These are fewer and far between in today’s market, but we are still finding investment opportunities.
Let’s look more deeply into the particular situations of Greece and China and how developments in these countries impact our clients’ investments.
The Big Picture: Global Economic Expansion through Debt Leverage
The United States and the broader global economy have not experienced a recession for more than six years, which is a remarkably long expansion. Admittedly, the current economic recovery is muddling along at a tepid pace. Measures to prevent deflation continue today, not just in the United States but around the world. In the United States, interest rates in 2015 remain at the same level as they were in 2009, at zero percent. Meanwhile, in Europe, nominal interest rates are negative. Despite the lackluster nature of the current recovery, six years represents a long time for an economic expansion, and it is hard to argue with the idea that a fair amount of healing has taken place in the financial sector and the real economy during these past six years.
Between 2008 and 2014, global GDP has increased by 21%, but that growth has come at a cost. At the same time, global debt (private and public), already bloated in 2008, has increased since then by $57 trillion, or 40%. This growth in debt leverage since 2008 has been driven in large part by increased government debt on the part of developed countries and a quadrupling in debt leverage on the part of China, the world’s second largest economy.
With increased debt comes heightened volatility, which is taking place today in markets around the world. Similarly, with increased debt comes a greater risk of severe market dislocations, which investors experienced in the U.S. housing market in 2008 and which we are seeing today in the equity markets of both Greece and China.
A Greek Tragedy
Greece’s debt levels have increased dramatically since 2008, and today Greece’s government debt level represent approximately 175% of its GDP, which is unsustainably high. 2 Greece’s economic problems are driven by several factors, but its enormous debt load tops the list. If Greece succeeds in restructuring its excessive debt level, its economy and its citizens will be much better off.
With that said, we are not too concerned about Greece’s impact on the world economy. According to the World Bank, the annual GDP of Greece in 2013 was $242 billion, although it is probably less than that today. To provide context, Greece’s GDP is less than one-half of Chicago’s GDP and comparable to the GDP of the Detroit Metro Area. For this reason, we think Greece is more of a regional European political problem than a systemic risk for the global economy.
As Mario Draghi, the head of the European Central Bank, famously said in 2012, European policymakers are willing to do “whatever it takes” to preserve the Euro. The Euro currency, introduced in 2001, is a critical component of a larger political project that began after World War II, when European leaders decided that the best way to avoid future European wars was to integrate the political and economic systems of various European countries. Indeed, most Greeks, if they had their druthers, would probably elect to remain within the Euro currency bloc (assuming that it would not entail significant austerity measures to do so), despite the harm Greece has experienced by remaining with the Euro.
Thus far, the “Troika” committee (collectively represented by the European Central Bank, the IMF, and the European Commission) has been thoroughly unwilling to allow Greece to restructure its unsustainable debt load. Unfortunately, that unwillingness has created horrible economic problems and a depression in Greece, where GDP has declined by 25% since 2007, where the official unemployment rate is over 25%, and where the youth unemployment rate is over 50%. The Troika’s austerity medicine for Greece has protected Greece’s creditors, but that protection has come at a horrible economic and human cost for the Greeks.
We hesitate to make definitive predictions here, because the situation remains fluid and the eventual outcome depends largely on political decisions. With that said, we will make a couple of observations.
First, it appears to us that a decision that would result in Greece exiting the Euro would create very challenging circumstances for Greece in the short run, but with a better outcome for Greece in the long run. Greece has fared quite poorly compared to other non-Eurozone European countries who have had the flexibility to operate with their own currency. By leaving the Euro, restructuring its debts, and freeing itself from the austere belt-tightening measures imposed on it by the Troika, the Greek economy could have a fighting chance to grow and become competitive once again.
Second, if Greece does leave the Eurozone and it becomes apparent that they are better off for having done so, there is a risk that other Mediterranean countries with high debt levels, like Portugal, Italy, and Spain, could follow suit thereafter, putting into question the entire Euro project. Importantly, these other Mediterranean countries are larger and more economically consequential than Greece. To keep these other Mediterranean countries in line, the Troika is playing hardball and (literally) making life very difficult for the Greeks.
Because we do not know what will happen here, we have put Greece and the European banking system in the too hard to analyze pile. Our clients’ continental European exposure is for the most part limited to multi-national companies that sell products around the world and that should benefit if the Euro declines in value (because their export products will be priced more competitively).
Bear in a China Shop
In contrast to Greece, China is a more important story, in our view. The Shanghai stock market has experienced an enormous margin debt-fueled run-up in the last year, and it looks like the downslope of that sharp run-up is now
underway. The Shanghai Stock Exchange Index increased by a whopping 60% to start the year, but, just since June 12th, the Index has crashed, declining by more than 32% in less than a month, erasing more than $3 trillion in market value. Put another way, the loss in Shanghai’s stock market value since June 12th represents more than nine times that of Greece’s total government debt obligations.
To support the crashing stock market, the Chinese government is pulling out all the stops:
- China’s Security Finance Corporation is lending $40 billion to brokerage houses so that they can buy Chinese stocks.
- The government has prohibited large shareholders from selling their positions for at least six months.
- Local exchanges have allowed over 1,300 different Chinese companies, representing 40% of China’s market value, to halt trading in order to prevent further selling.
- Equity transaction fees and margin requirements have been reduced.
- The Chinese government recently threatened to arrest short sellers.
The Chinese stock market crash is generating headlines at the moment, and, due to China’s importance to the global economy, a recession in China would indeed affect the United States and the world far more than whatever is happening in Greece at the moment. Having said that, the margin debt expansion that has fueled the Chinese stock market recently is just a part of a larger credit bubble which has been developing in China for years.
China’s debt leverage has expanded by four times just since 2007 and, more importantly, the country’s Debt/GDP ratio has expanded dramatically from 158% to 282% (please see chart to the left). With approximately one-half of all of this debt tied to the domestic real estate market, the expansion of debt leverage in China has contributed to rising real estate prices and rising GDP, but it has also exposed China to the risks related to a credit bust should real estate prices meaningfully decline.
It is not just the level of debt in China that is worrying; it is also its rapid growth. Since 2007, China’s banking assets (loans) have increased by $17 trillionTo put this in perspective, the total assets of all U.S. commercial banks amount to $15 trillion, despite the fact that China’s economy is 38% smaller than that of the United States. Generally speaking, periods of rapid credit growth tend not to end well. We are seeing this dynamic playing out in real time in the Chinese stock market, where margin debt expanded during the past year at a very rapid rate.
We do not know when the credit creation party will eventually end in China. It could be that the trigger for China’s credit bust turns out to be the recent stock market peak reached on June 12th. It also could be that China continues to successfully expand its economy by increasing debt leverage for a few more years. Without predicting when the credit boom ends, we will merely highlight the fact that China has been experiencing the largest and longest credit creation party in history, and, for that reason, the hangover could be a doozy.
Unlike Greece, China’s predicament is more difficult for investors to avoid. For starters, China’s economy is the second largest in the world, and if China experiences a significant recession, it will have corresponding knock-on effects for the global economy. In addition, China is the largest owner of U.S. Treasuries. If China needs capital to bail out its banking system, China will likely reduce its positions of U.S. Treasuries in order to support its domestic economy.
We will continue to monitor developments in Greece and China, as well as the rest of the world economy, so that we maintain our ability to monitor important risks and generate strong investment ideas for our clients.
This year we are thrilled to be celebrating our 25th anniversary as a firm. In many cases, we are now working with the grandchildren of our original 1990 founding clients. Whether they have been with us for twenty-five years or for twenty-five days, we remain as cognizant as ever of the seriousness of the responsibility that our clients have entrusted to us, and we are working harder than ever to deserve it.
As a firm and as individuals, our efforts are focused on trying to identify mispriced, undervalued investments which are most likely to generate attractive risk-adjusted returns for our clients’ portfolios. During the last several years, we have been pleased with how our stock picks have performed, even while we have been displeased with how our precious metals positions, purchased as portfolio insurance, have performed. We will continue to strive to do even better. Undervalued stocks are fewer and farther between in today’s frothy markets, yet we have several new investment ideas where we have deployed our clients’ capital and where we believe the potential return outweighs the potential risks.
Since our firm was founded, and continuing through today, we have operated under a strong investment culture where we have always put our clients first. Over the past several years, we have also expanded on that original proposition by hiring dedicated and experienced research analysts, compliance professionals, and portfolio managers to enhance our investment decisions, our trading execution, our compliance procedures, and our client communications.
As a firm, we have never been stronger than we are today. We hope and expect that the next 25 years for our clients will be even better than the last 25 years have been.
Pekin Singer Strauss Asset Management
This commentary is prepared by Pekin Singer Strauss Asset Management (“Pekin Singer”) for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Although information has been obtained from and is based upon sources Pekin Singer believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results.