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Conservative Lending

Consensus still believes Australian banks are among the most conservatively run institutions in the world.  Funny how easily these “conservatively run” banks can get caught up in America’s past time.  This particular piece from News.com.au brings to light some questionable lending practices in place about a year ago, or right around the peak of the Australian housing bubble:

  • Mortgage House will offer a home loan equivalent to 105 per cent of the property’s value.
  • The company also offers a 99 per cent loan-to-value ratio loan
  • Westpac raised its LVR for new customers from 87 per cent to 92 per cent.
  • ANZ also last week raised the maximum LVRs from 95 per cent to 97 per cent for existing customers, and from 90 per cent to 92 per cent for new borrowers.
  • Commonwealth Bank has left its LVRs unchanged, at 97 per cent.

It’s worth noting that these LVR’s are substantially different than the “average” LVRs the bank’s claim on their current books.  As we learned in the states, “average” doesn’t mean a whole lot, if say, half of your loans are “money good” . . . while the other half are something less than “good.”  Time will tell.

Disclosure: At the time of publication, the author was short various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.

Posted in Australia, Macro.

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By Christopher Pavese – October 23, 2011

A Bulldog named Ben

A good friend recently suggested that I name my next dog John Hussman, considering how often I send around blips from Dr. Hussman’s weekly commentary.  Great idea except I’ve already negotiated this one with Jill years ago – the next pup in our house will be a Bulldog named Benjamin Graham. Hope Ben can get along with Stella okay.  She is definitely more of a momentum investor!

Despite the harassment, I decided to take the risk and share another except from Hussman Funds Weekly Market Comment.  We’ll explore this one in detail as there is a lot of meat here.  Be forewarned – this turned out to be quite a lengthy post.  So here is a quick summary of the material to follow:

  1. Denial
  2. Deja Vu All Over Again
  3. Europe’s Banks
  4. The Fallacy of Forward Earnings
  5. Bad Estimates
  6. Setting the Record Straight
  7. Bottom Line – Too Much Leverage

Denial

 “Last week, the financial markets mounted a striking shift back to the “risk-on” trade, as investor concerns about a recession were abandoned, and Wall Street came to believe that Europe will easily contain its banking problems. Accordingly, downside protection was largely discarded (as reflected by a plunge in the CBOE volatility index), price-volume action reflected eager short-covering, and investor interest shifted strongly away from defensive sectors to speculative ones. For defensive investors, it was admittedly a difficult week, as the markets suddenly became convinced that no defense was needed, and treated defensive investments accordingly.

“From my perspective, Wall Street’s “relief” about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI’s own (and historically reliable) set of indicators, “We’ve entered a vicious cycle, and it’s too late: a recession can’t be averted.” Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.”

Here is a picture of the most recent picture from ECRI.  The interview with Lakshman Achuthan Hussman refers to is available here. We think an important point lost on the consensus is the frequency of recessions.  John Mauldin has discussed this at length as well.  The bottom line is that during an extended deleveraging process, economic volatility is higher than “normal” which means recessions are more frequent than “normal” when you are dragging along at “stall speed.” More frequent recessions, more volatile economic growth . . . higher risk premiums, lower equity prices.  We’d also recommend taking a moment to read this interview, available at GuruFocus, with Fairfax CEO, Prem Watsa to get a feel for the possibilities here.  “That second leg can be vicious, and we might well be entering that second stage.”

Deja Vu All Over Again

“The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a “denial” phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high”

In addition to the economic similarities, here’s a look at the current set-up is from a technical standpoint, compliments of The Chart Store:

Source: thechartstore.com

 Europe’s Banks

“At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis.”

Here’s a great illustration of the extent of Europe’s problems in one concise chart.  Per the folks at Credit Writedowns, “The size of the largest four banking institutions in France, for example, represents over 300 percent of the country’s GDP.”

The Fallacy of Forward Earnings

 “While many Wall Street analysts continue to view stocks as cheap on the basis of forward operating earnings (which reflect expectations of a continued economic expansion and the maintenance of record profit margins indefinitely), the use of forward P/E multiples is a valid shorthand for discounted cash flow valuation only when profit margins reflect a level that is actually likely to be sustained over several decades. Even then, the benchmarks typically applied to forward operating earnings are actually based on historical norms for price-to-trailing net earnings.”

Here’s one of the problems with “forward earnings” in a nutshell.  We will discuss the second momentarily.  For now, suffice it to say that profits are extremely high and have always reverted to trend historically.  Perhaps this time is different, but it never has been, so we’d caution those betting it is.  In fact, if indeed this time is different, we’d suggest that the major trend change ahead is best signaled by the Occupy Wall Street movement.  The largest driver of profit margins today is clearly employment – meaning there is very little of it.  The share of profits making its way to corporate balance sheets rather than their employees has been increasing for a generation.  The result is record income inequality at home and abroad.  This is precisely why we have America’s next generation unemployed and sitting outside the Financial District as if it were Tahrir Square.  Again, my bet is that if indeed “this time is different,” the difference will not be in favor of profit margins, as the pendulum is likely to swing back towards labor over time. I suspect that income inequality across the globe does not end well for any of us. This is definitely something worth monitoring.

Bad Estimates

 “Investors should recognize that P/E multiples are simply a crude shorthand for legitimate valuation calculations (specifically, the careful discounting of a whole stream of future cash expected to be delivered into investor’s hands over time). P/E multiples subsume a whole set of assumptions regarding the entire future path of growth rates, profit margins, return on invested capital, and other factors. The common practice of valuing the stock market based on “forward operating earnings times arbitrary P/E multiple” is not only misguided – it’s an utterly disappointing display of Wall Street’s willingness to dumb-down the investment process. As investors have discovered through more than a decade of zero returns, the constant abandonment of intellectual effort comes at a cost over the long-term.”

The second issue with forward earnings multiples is simply that they are WRONG.  The chart below, initially posted at The Big Picture shows S&P operating earnings (red line) and their 12-month forward forecasts shifted ahead one year. Bottom line according to James Bianco, “If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong.”

Source: Bianco Research

The second chart shows the difference between the forecasts and actual releases. The shaded areas highlight official recessions. Bianco notes, “Wall Street is one of the few places where practice does not make perfect. Notice that every subsequent recession sees larger earnings error rates than the previous recession. During the 1990/1991 recession, top-down forecasters (strategists) were too optimistic by 10%. Bottom-up forecasters (adding up the 500 company forecasts) were too optimistic by 25%. During the 2000/2001 recession, top-down forecasters were too optimistic by 25%. Bottom-up forecasters were too optimistic by 23%. During the 2007/2009 “Great Recession”, top-down forecasters were too optimistic by 39.6%. Bottom-up forecasters were too optimistic by 40%. Also notice the difference between the top-down and bottom-up forecasts. Current strategists are getting significantly worse at predicting earnings than their 1980s and 1990s counterparts.”

Source: Bianco Research

Consensus expectations, particularly bottom-up, are still wildly optimistic.  Bulls continue to point to “excellent” company fundamentals to support their thesis, completely missing the fact that they are staring in the rear view mirror.  Top down forecasts are less rosy but are yet to bake in recession which I think is a given at this point.  Equity analysts rarely lower estimates, recommendations, etc. based on in-house forecasts. They wait until they are told by management, which by definition, is too late.  Company fundamentals still appeared “excellent” in H1-08 as well.  Until they didn’t. By the time management admits the economy has turned, we are typically closer to the recovery.  According to research performed by Ned Davis, the S&P has actually declined historically when earnings expectations have been this lofty.  The time to get bullish is only once consensus has baked in the drop in forward earnings.  Not before.

Setting the Record Straight

One last point on valuation that drives me mad.  This one is almost as popular as forward earnings. Take a look at the illustration below. If you can determine any relationship between the “earnings yield” on stocks and interest rates, please give me a call.  Because outside of the brief period in history that an illusion of a relationship appeared – which happens to coincide with the time period that most investment managers in the business today have operated – there is no relationship between expected returns on stocks and expected returns on bonds. The consensus would also have you believe that as interest rates and inflation come down, PE’s should go up.  Ask the folks in Japan how this has worked out for them.  The fact is, today’s models worked great in an environment of increasing leverage.  No one has thought to look at how they would perform as that leverage is unwound.  The impact on economic growth, financial asset prices, inflation, etc. is profound and few have yet to grasp this change.

Source: GMO

Consider a few simple examples to help illustrate why this is utter nonsense. First, suppose I am willing to sell you a quart of milk for $10 but offer you a gallon for $30.  Does that mean the gallon is cheap or that it is a good buy at today’s price?  If you answered yes, and you are a long-only investor, good luck. Alternatively, suppose you can buy a dollar today for 50 cents. Tomorrow, you pay two dollars for that same dollar. Is the level of the ten year treasury, or any interest rate for that matter, a significant determinant of how those investments work out for you? If you answered no, you are on your way to separating fact from fiction. Now please press mute on your remote control the next time you hear anyone comparing the yields on stocks to interest rates on bonds. Chances are anything else they have to say is not worth listening to.

Bottom Line – Too Much Leverage

 “This is a good opportunity for investors to review their tolerance for significant losses. My impression is that this may be the best opportunity to reduce risk that investors are likely to see for a while.

“As of last week, the Market Climate in stocks remains negative, but has deteriorated significantly from the more benign negative levels that we’ve seen in recent weeks. Generally speaking, the worst market plunges tend to feature three things – overvaluation, negative market action, and a short-term overbought condition.”

A quick look at just how overbought this market is in the short term.  As a general rule, overbought conditions should be sold in bear markets. In case you were wondering, this is a bear market.

Source: thechartstore.com

“You rarely see the three together, because establishing that sort of condition requires a strong rally against both overvaluation and negative internals. That’s about where we are, though we can’t rule out a modest extension for a bit – mostly because advisory bearishness is reasonably elevated as of last week. That said, the drop in the CBOE volatility index late last week suggests an abandonment of bearish views, and more generally, just as early shifts toward advisory bullishness at the beginning of bull markets are often accurate and followed by further gains, early shifts toward advisory bearishness at the beginning of bear markets are also often accurate and followed by further losses. Overall, market conditions remain negative . . . “

Contrary to popular belief, the market is NOT cheap here. There are pockets of value if you look hard enough.  But broadly speaking most major stock averages are not cheap. The chart below shows the S&P 500 trading at over 20x normalized earnings, relative to a long-term average closer to 16x. The current multiple is not that far off from where the market traded in the mid-60s prior to a bear market that lasted for almost two decades. You can feel comfortable hitting the mute button on your remote control whenever you hear someone claim that the next ten years look good for stocks, based solely on the fact that the last ten years were poor.  Will they ever learn?

While many of our indicators are pointing to excessive pessimism, which may well be supportive of further rally, it is worth noting that AAII’s measure of Bullish Sentiment has rebounded sharply back to levels last seen in July, when all was still well in the world.

Putting it all together, the immediate future is not so bright for the buy-and-hold type today.  While there are certainly values to be found in the large, multinational franchises that historically traded at premiums to the market, I am also growing concerned that this is more of a consensus belief today. Groupthink is dangerous. When everyone crowds into the same trade, the crowd is rarely right. One of the factors which made the 2008 crash so devastating was the forced liquidation driven by excessive leverage in the system. Once the crowd started selling, they all sold. We run from one side of the boat to the other, and back again. As they say, financial memory is notoriously short.  But even we are surprised by speculators’ willingness to jump back on the leverage train after being so badly burned three short years ago.  The amount of leverage in the system today is back at dangerous levels – it is declining, but prior market bottoms did not occur until these debts were entirely wiped out. I just hope this doesn’t mean that owners of risk assets and retirement plans get wiped out for the third time in ten years.  Be careful out there.

Posted in Macro, Portfolio Strategy, Valuation.

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By Christopher Pavese – October 20, 2011

The Development of Greek Government Debt . . . A Timeline.

Posted in Macro.

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By Christopher Pavese – September 14, 2011

You Lick Mine First

This week, the German Constitutional Court ruled that Germany’s role in supporting the EU’s periphery was not unlawful.  The market’s knee-jerk reaction was to blast higher on the news, as the alternative would have been a total disaster.  Upon closer inspection, it appears that smooth sailing into the future is far from certain. The court stressed that the decision was not a “blanket” approval for future bail-outs and demanded that the German Government “ask permission” of the Budget Committee before handing out any more cash to their southern neighbors.  At the end of the day, this means that future bail-outs will be even more difficult to execute as the process is slowed further by administrative tape around afternoon siestas.

This is important.  Time is quickly running out for the EU. The lack of a comprehensive solution after two years of “can kicking” means that the periphery’s disease has infected the core and the odds of a disorderly default have increased substantially. Rather than proactively addressing the challenges in the region – restructuring debt, recapitalizing banks, promoting growth, etc. – policymakers have waited for market’s to force their hand and only then, did they plug another hole in the periphery with their finger.  With one year Greek debt within spitting distance of 100% yields, they are now running out of fingers.  With Italian and Spanish yields back on the rise, the holes are getting too large to plug.  Something’s gotta give.

Unfortunately, this is not just a government debt issue.  The debt overhang encompasses households, corporations and financial institutions as well. Many European banking systems are two to three times larger than their respective economies.  European banks have raised roughly half the capital raised by US banks since March 2009 and are much more reliant on volatile wholesale funding, particularly with deposits steadily drifting to Swiss safe-havens.  So yes, we adamantly agree with new IMF Head, Christine Lagarde’s tough message, “Banks need urgent recapitalization. … If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization — seeking private resources first, but using public funds if necessary.” If it is not addressed, the coming sovereign debt crisis will make Lehman look like a walk in the park. It is actually quite sad that most folks in Europe are ready to throw her under the bus for even hinting that banks might be a tad undercapitalized.  If European banks held sufficient capital, one would think that they would have written down the value of impaired sovereign debt on their balance sheets.  That is not the case.  As the FT highlights in, Auditors Under Fire Over Greek Debt, these banks are marking their books more or less arbitrarily, with write-downs ranging from more than 50% to less than 20% on Greek debt.  These are not obscure, difficult to value assets.  They are government bonds.  The price of which is crystal clear, yet the range of carrying values is as absurd as the perception that these banks are solvent.

Source: Financial Times

While the rest of the world has put all its chips on the creation of a “Eurobond,” the German Court appears to have shattered those hopes for now, stating that the German Parliament “is prohibited from establishing permanent mechanisms . . . which result in an assumption of liability for other states’ voluntary decisions.” Granted, this could change quickly should markets begin to riot, but speculating on the outcome of backdoor politics has a success rate only matched by economists. It is difficult to handicap American politics. Next to impossible to do so for the multiple constituencies across Europe. But for some background on the Germans, we can turn to one of our favorite financial author’s, Michael Lewis, who explains, It’s the Economy, Dummkopf!  The full Vanity Fair article offers fantastic insight into the German people and at a minimum makes for entertaining weekend reading.  Per Lewis, “Germans longed to be near the shit, but not in it. This, as it turns out, was an excellent description of their role in the current financial crisis.”

For better or for worse, the Germans now own Europe.  They have essentially accomplished economically, what they failed to accomplish militarily decades ago.  The geopolitical implications of this shift in power are of great consequence.  This analysis from the folks at Stratfor provides additional insight into the origins of the Eurozone and implications of the “New Europe.” Lewis makes an excellent point that for the Germans, the Euro isn’t just a currency.  It’s a device for flushing the past. “There is a common German expression . . . which translates directly as “Lick my ass.” To this hearty salutation the common reply is “You lick mine first!” Fitting, given German public-opinion polls against the Greeks. Get the popcorn ready.  We are approaching the grand finale of this slow motion train wreck.

Posted in Macro.

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By Christopher Pavese – September 9, 2011

The Midas Touch

Our first post on this site in October 2009 quoted Mark Twain, who once said, “A gold mine is a hole in the ground with a liar on top.”  That may or may not have some truth to it, but it certainly hasn’t prevented that hole along with that liar’s balance sheet from appreciating significantly in value since then!  With most of “the street” now looking for gold to surpass the $2000 market in the short term, we thought it made sense to review what we wrote at the time and consider what may have changed since then gold was trading around $1000 per ounce.

“Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”. 

“It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed.  Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today.  Gold should move higher because investors throughout the world are becoming increasingly apprehensive holding fiat currencies.  At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive.  But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging.  Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.”

It would seem that some things never change.  In fact, it is quite obvious that the world’s apprehension toward fiat currencies has only heightened and may soon reach “the tipping point.”  Milton Friedman once advised that “US Dollars have value because everybody thinks they have value. Everybody thinks they have value because in everybody’s experience they have had value.”  We wonder what “everybody” thinks today?  We think that this is more than a dollar problem.  All major currencies have depreciated in the past decade when measured against the world’s oldest store of value – gold.

Our friends at Wikipedia tell us that Debasement is the practice of lowering the value of currency. “It is particularly used in connection with commodity money such as gold or silver coins. A coin is said to be debased if the quantity of gold, silver, copper or nickel is reduced.”  For example, the value of the denarius in Roman currency gradually decreased over time as the Roman government altered both the size and the silver content of the coin. Originally, the silver used was nearly pure.  From time to time, this was reduced. The denarius continued to shrink in size and purity, until by the second half of the third century, it was only about 2% silver. One reason a government will debase its currency is financial gain for the sovereign at the expense of citizens. By reducing the silver or gold content of a coin, a government can make more coins out of a given amount of specie. Inflation follows, allowing the sovereign to pay off or repudiate government bonds. However, the purchasing power of the citizens’ currency has been reduced. Another reason is to end a deflationary spiral. Debasement lowers the value of the coinage, causing inflation. Over time, it may even lead to a new coin being adopted as a standard currency. Note that last part, “To end a deflationary spiral.”  It’s a doozie.  We discussed it at length in our last two Broyhill Letters.  Lucky for Bernanke, he doesn’t even have to bother with “shaving coins.”  He can just hit the print button on his keyboard like a Monetarist Monkey.

Clearly, gold prices are stretched to the upside here.  As one technical analyst put it, “I have written reports on commodity markets since the 1970s and my experience has been that, when a tight upward price channel is broken decisively to the upside, the odds are 90% of the time the commodity will decline back toward the top of the channel or re-enter the price channel. The problem is that the other 10% of the time the move turns parabolic which I would define as a burst to 2300-2400 by November.” I don’t know about you, but we’d sure like to be there if the move turns parabolic!  The good news is . . . we can, and we can do it with a large margin of safety today.

While gold has risen from $250 to over $1900 in the last decade the percentage gain in the gold mining stocks has been about a third of the metal’s rise.  This extremely disappointing performance is only more frustrating when we consider that gold miners should outperform gold by a wide margin in bull markets.  This divergence has left the Gold/XAU ratio at historical extremes, indicating that gold stocks are exceptionally cheap. In addition to dirt cheap valuations, the macroeconomic backdrop for gold shares is now exceptionally strong, presenting a combination of factors that support a large allocation in portfolios.  In an article written by John Hussman in October 1999, we can see that in the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. Don’t look now, but more than a decade later, today’s backdrop is extremely powerful.

Gold equities are relatively flat this year compared to double digit gains in precious metals. The reasons for their underperformance is well known and well discounted in today’s price.  Profit margins were squeezed due to higher energy costs, but oil prices are now lower and should continue falling as economic growth grinds to a halt. The free cash flow generated by the miners is soaring with gold prices at record highs. Virtually all of the major producers are raising dividends. Gold is still a completely under-owned asset class representing less than 1% of global financial assets and institutional investors are drastically underweight. Eventually, the “smart money” will be forced to buy gold. Recall that the University of Texas recently took delivery of $1 BILLION in physical gold bullion. Net gold purchases by governments year to date have totaled 200 tons, nearly triple last year’s purchases.  Prior to that, the world’s central banks were net sellers for the past decade! But outside of the few paranoid “Spam and Shotgun” types, most committee-driven institutions are more likely to jump on the gold stock bandwagon then to stockpile bars of gold that don’t generate income or cash flow for their investors. Once the gold stocks begin to outperform as the natural forces of mean reversion assert themselves, the momentum investors won’t be able to resist the Midas Touch.

Disclosure: At the time of publication, author was long SPDR Gold Trust Shares, Market Vectors Gold Miners and Market Vectors Junior Gold Miners, although positions may change at any time.

Posted in Gold.

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By Christopher Pavese – September 8, 2011

Arms of the State

Last weekend, Barron’s ran a story titled China’s Banks: Worse Than you Think.  The article highlights the concerns expressed in Red Capitalism, written by Carl E. Walter and Fraser Howie.  If you haven’t already read it, we urge you to do so.  If you are pressed for time, and would prefer to spend your day watching the movie rather than untangling the web of the Chinese banking system, you are in luck.  The series of videos below offer a spectacular insight into the Chinese banking system and the politically driven economy’s history of reform, or lack thereof. In addition to Carl E. Walter, the interviews also include insights from Victor Shih, author of Factions and Finance in China: Elite Conflict and Inflation, another “must read” for those closely linked to the Chinese economy. For those that cannot spare a few hours to read the books, or even imagine listening to an hour long discussion between academics and economists, we have provided the cliff notes below.  We believe that this chain of events, described by Carl Walter, sums up the risk to the Chinese growth model quite succinctly:

“If the economy continues to misallocate capital, high earning loans will increasingly be replaced by low yielding paper from the MOF. The banks will no loner have the ability to lend. If they can’t lend, growth slows. If growth slows, unemployment increases. If unemployment increases, the people are not happy and we have a larger problem in China.”

And before finally moving on to the notes, Michael Pettis recently provided us with some arithmetic on investment growth:

“Command economies tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. No matter what your expectations were for future Chinese GDP growth, the arithmetic of rebalancing meant that you had to assume a sharp slowdown in investment. In the past, China has had rapid GDP growth driven largely by even more rapid increases in investment. The result is that investment has become a gradually larger share of GDP and household consumption a gradually smaller share.  This has gone on to the point where China is seriously unbalanced and urgently needs to adjust. In fact, given weak global conditions and rising Chinese debt, adjustment is only a “choice” for a few more years at best. After that, economic adjustment will be forced onto China. Weak foreign demand and anger on trade will prevent China’s trade surplus from driving growth, and excessive domestic debt will prevent investment from driving growth. In that case, GDP growth will drop sharply to some level well below the household consumption growth rate. This is what rebalancing means – that household consumption growth outpaces GDP growth.

“No matter how optimistic you are about Chinese growth over the next five to ten years, you have to believe that investment growth rates will decline sharply, maybe extremely sharply. It is hard to put together a plausible scenario in which China rebalances and investment rates don’t come sharply down. Even the most optimistic outlook for China requires that investment growth rates drop by at least a quarter. Slightly more realistic scenarios require that investment growth rates drop by more than half. And of course, if my prediction is correct – that Chinese growth will slow to 3% – a rebalancing China will see investment growth drop by at least two thirds and probably a lot more.”

Part I

  • Every decade for the past sixty years, the banks have gone bankrupt.
  • These banks were recently listed in Hong Kong, and now have international institutions as shareholders.
  • The banking sector has always been the pillar to China’s investment driven economy.  The money supply is greater now than anytime before.
  • China’s banking system didn’t exist in 1949.  The new government put in place a centrally planned economy with a passive banking system working with Russian advisors until everything “blew up.”
  • After a series of crises, the Asian Financial Crisis catalyzed the awareness in the government to strengthen the weakest link in their economy, the banks.
  • “These things aren’t banks.”  There were no audits.  They had no general ledgers.  And they didn’t have any capital.  Nor did they need any capital in the context of a centrally planned economy.
  • In the late 90s, there was this transformation where the government tried something different.  There was major hesitation towards privatizing the banks.
  • Most emerging markets don’t have complete control of the banking sector.  What you have in China is a closed system, very different than other emerging markets.
  • One of the reason the stock exchanges were created in 1991, was to concentrate the trading of government bonds. Gradually, banks became the primary investors in government bonds.
  • It is inconceivable that the Chinese government would permit any banks to encounter a liquidity problem.  If they did have one, we’d never know about it.
  • Things began to change prior to the crisis, but it all went out the window after Lehman crashed, as the party ordered banks to lend to drive growth.
  • Things are now frozen in time. The banks have stopped in their tracks. Interest rate reform is gone.  The bond market is a joke.  And foreign exchange is not going to appreciate much do to export concerns.
  • Right now, nobody sees the problems.  These banks have “super” market capitalizations so they are the clear global “winners.”
  • The Olympics marked the peak of Chinese development.

Part II

  • Once you engage in an entire year (or two) of carefree lending, you rack up a huge amount of potential non-performing loans.
  • In 2009, all the banks received an order to lend.  In the space of four weeks in February 2009, they approved $2 trillion in investment projects!!
  • Local governments did not borrow directly.  They created private enterprises, Local Government Financing Vehicles (LGFVs), to hide the debt off the central government balance sheet.
  • The central government is the key for confidence.  They must show that they are a conservative, responsible fiscally strong entity, by moving debt off balance sheet.
  • It is impossible to ignore the debt of the local governments and bank balance sheets which ultimately belong to the sovereign.
  • Bulls believe that future growth will be driven by consumption, but consumers are being taxed in every direction by government policy.
  • Household depositors, the foundation of the system, are being paid 3% on their money, as dictated by the government.  With inflation over 6%, this is financial repression.

Part III

  • The last ten years have seen two rounds of inflation. This one has been the worst.
  • It is clear that they are throwing insane amounts of money – $10 trillion per year for two years or 30% of GDP growth – to cover the problem and drive investment growth which is over 50% of GDP.
  • The government is less concerned with inflation and much more worried about the effects of a credit crunch, because this would uncover the structural issues.  Inflation helps to cover this up.
  • PBOC has implied that total LGFV loans outstanding was $14.4 trillion at year-end 2010.
  • The real estate bubble in China has been driven by over-borrowing by SOEs which have too much money, which ultimately flows into real estate.
  • Last time they “cleaned up the banks” we saw 20% recovery rates on $440 billion!!
  • The most likely vulnerability is capital flight.  The risk is not on the asset side.  This can be covered up for a long time.
  • On the liability, side depositors have the ability to withdraw capital and we are beginning to see that.
  • It is no longer difficult to move money off shore, but right now they can make more money in real estate onshore. What happens when this changes?

Part IV

  • Before they move the bad assets to asset management companies, the banks have to admit there are non-performing loans.  They are not even willing to do this now.
  • New loans to cover up bad loans are being made on a massive scale in China now to avoid recognizing NPLs.
  • You can continue taking these loans off bank balance sheets, but it ultimately ends on MOF balance sheet instead.
  • Everyone has known this model has been in place forever.  It will go on for a long time becuase there is no alternative.  Investment growth is driven by bank loans.
  • The system is extremely prone to event risks.  The longer this financial profligacy continues, the more these problems are hidden, the bigger the problem will become over time.
  • The status quo will continue unless there is some kind of crisis and new leadership.
  • If you believe that exports will no longer be the big driver of growth, then you are dependent on the banks to fuel investment growth, which by definition, must also slow.

Pop Quiz: What does a Chinese Shipbuilder, Telecom Company, Oil Producer, Railway and Food Group have in common?  See today’s FT article, China Groups Fuel Growth of Shadow Banking, to find out!  We couldn’t make this stuff up if we tried.

Posted in Macro.

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By Christopher Pavese – September 7, 2011

Big Boy Pants

“Though Wall Street gurgles an audible “goodie, goodie, goodie” at every prospect of Fed intervention, it would be best for the Street to collectively put its big-boy pants on and realize that economic growth is not something that the Fed can sprinkle out of Ben Bernanke’s cans of fairy dust.

“At the point our nation recognizes that the pattern of repeated bubbles, crashes, and misallocation of capital is not solved by the Fed but is instead caused by the Fed, it will become clearer that the best path to economic recovery is to shift attention toward debt restructuring, real investment, useful infrastructure, and the creativity and work ethic of real human beings. Until then, we will have an economy built on speculation and paper, stacked into a flimsy house of cards.”

-  John Hussman, Weekly Market Comment

Dr. Hussman’s full comments are definitely worth a read this week as he puts to rest a number of questions regarding an imminent downturn, the Greek race toward default, the probability of recession and those “sticky” profit margins.  You can access his weekly comments here.  After reading them this morning, I opened a package on my desk which contained additional reading material for the week – our friend Francois Trahan’s new book, The Era of Uncertainty.    The dedication alone assures it will be a practical resource rather than Wall Street gurgle.  It reads, “To Ben Bernanke . . . thanks for the material.”

I’m sure we’ll have more to share on this one as I make my way through it.

Posted in Policy, Portfolio Strategy.

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By Christopher Pavese – September 6, 2011

The Debt Ceiling

We are working on a number of pieces which will be posted in coming weeks.  In the interim, please consider this thought provoking question from a family friend:

Let’s say you come home from work and find there has been a sewer backup in your home, and you have sewage up to your ceilings.  What do you think you should do…raise the ceilings, or pump out the shit?

Posted in Letters & Links.

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By Christopher Pavese – August 24, 2011

Quote of the Day

“If you take a fierce man-eating tiger and put him in with a lot of sheep, you can’t blame the tiger for eating the sheep. And that’s the nature of the tiger. And that’s the nature of Wall Street.”   – Carl Icahn

Posted in Letters & Links.

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By Christopher Pavese – August 10, 2011

Remain Calm . . . All is Well

Posted in Letters & Links, Macro.

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By Christopher Pavese – August 5, 2011