2/15/2019
IV. 2018 Annual Letter excerpt - Macroeconomic overview:
(a) We continue to have concerns about the long-term sustainability of China’s economic growth model.
While we think that it would be foolish for anyone to predict an imminent recession in China, the long-term macro risk that worries us most is the sustainability of China’s economic growth, which in recent years has comprised roughly 30% of global economic growth and 50% of global investment. Hong Kong-based investor David Webb outlined China’s quandary in an October 18, 2018 speech (for anyone interested here is the YouTube link):
(5:08) “But despite all the rhetoric about deepening reforms and letting market forces play a greater role [in China], the reality is that the reforms stalled over ten years ago and most of the economic growth that you see in China since then is unsustainable, credit-fueled infrastructure and property investment.
Now you can generate gross domestic product, or GDP, from construction activity, but if the things that you build do not produce an economic rate of return then you’ve just wasted resources on white elephants and increased debt, and the more you have built the harder it is to find economically viable projects. The law of diminishing returns takes hold.
The Chinese government still to this day directly controls vast swathes of the old economy, including banks, energy, electricity, petrochemicals, metals, airlines, shipping, telecommunications, and of course the media.
For sure, the government has created the illusion of market reforms by listing minority shareholdings in most of these sectors but the party cannot bring itself to let go of control and in fact it has been heading the other way, by embedding itself in the articles of association of companies and requiring that the board of directors of a listed company must consult the company’s party committee before making decisions.”
China is indeed an incredible economic growth story: its GDP expanded from 12% the size of the US’s in 2000 to 63% in 2017. But, as with individual companies, there are sustainable (good) and unsustainable (bad) ways for a nation to grow economically—and like Mr. Webb, we worry that China’s economy has since the 2008-2009 global financial crisis expanded largely via long-term unsustainable means, including debt-financed, government-led real estate and infrastructure projects that private investors would largely find uneconomic.
Simply put, government-controlled economies always have a political incentive to over-invest (especially in China, where real estate is an important employment driver and source of government funding) and China’s level of investment is far above average by international standards. In 2017, for example, the World Bank noted that China’s gross capital formation[1] divided by GDP was 44% versus the global average of 24% (source: data.worldbank.org). For Long Game Financial (“LGF”), this raises questions not just about Chinese GDP growth but also about the validity of the base from which China calculates its GDP growth.
Particularly in light of ample investment opportunities that also have limited China risk, we think that our concerns warrant the minimization of client exposure to (1) companies with substantial Chinese business activities and (2) companies exposed to macroeconomic variables that would be negatively affected by a Chinese economic slowdown (e.g., industrial metals). With respect to US exposure, we note that although a Chinese economic deceleration could negatively affect US business and investor confidence, it could also have positive effects such as downward pressure on commodity prices or interest rates.
(b) We believe there are convincing reasons to remain optimistic about the US economy.
As opposed to our open-ended concern about China, we consider the US-centric factors commonly cited as contributing to the S&P 500’s decline in 2018Q4—namely, worries about interest rates, worries about housing, and forced selling on the part of institutions and individual investors—to be largely temporary. Furthermore, although the most recent US recession officially ended in July 2009 (this economic expansion has indeed been statistically long), economic expansions do not “die of old age” (e.g., Australia’s economy has not shrunk in decades) and we believe there are important reasons to remain optimistic about the US economy, including:
1) Per the Federal Reserve, US consumers are wealthier than they have ever been.
US household and non-profit net worth in third quarter 2018 reached an all-time high of $109 trillion. This is a nearly $40 trillion increase from the third quarter 2007 peak of $69.5 trillion.
US household debt service relative to disposable income is less than 10% today. This is a multi-decade low for this metric and a rapid decline from the >13% high reached prior to the 2008 recession.
Record high net worth and record low debt service relative to disposable income mean Americans have the ability to increase their borrowing and spending.
Increased borrowing-and-spending occurred during the end of the last two US economic expansions but we have not yet observed meaningful borrowing-and-spending during our current economic expansion.
As one example, the Urban Institute reports that cash-out mortgage refi volume is currently a fraction of what is was prior to the last recession despite record home equity:
2) Home prices are cyclically high but low interest rates help affordability and in our view the data do not suggest a surplus of housing.
…new home construction remains relatively muted: home permits per capita, despite recovering from the post-financial crisis trough, remain in-line with troughs reached during prior recessions in the 1970s, 1980s, and 1990s (i.e., the red line below).
In our view, these data at least suggest that we should not be too concerned about a supply glut depressing real estate prices. This is relevant because (1) real estate is an important driver of employment and (2) real estate and stocks drive much of the variability in consumer wealth.
3) Unemployment is at a cyclical low, which tends to be concerning—but in our view US leading indicators are neutral-to-positive currently.
Unemployment, broadly calculated, is at a cyclical low.
The KC Fed Labor Market Conditions Index continues to suggest above-average labor market conditions.
Temp employment, a historically useful leading indicator, continues to trend positively for now.
The yield on 10-year treasuries minus the yield on 2-year treasuries continues to decline but it is not yet negative. The slope of the yield curve is a widely discussed leading indicator because recessions have historically followed inversions.
4) US debt markets are currently open for business.
Bank lending standards remain loose, which is positive for small- and medium-sized businesses.
The riskiest subset of below-investment grade corporate bonds sold-off in the second half of 2018—but much of that decline was commodity-price-related and high yield bonds remain within their post-2009 trading range.
5) US oil production is at an all-time high.
Perhaps surprisingly in light of the popular notion of “peak oil” 10 years ago, US crude oil production has never been higher than it is today. This is relevant because declines in crude oil typically lead to lower gasoline prices and thus increase disposable income for consumers.
Increased disposable income is important because consumption constitutes over 2/3 of US GDP (i.e., it is difficult for the US economy and the US consumer to decouple).
6) Market-based measures of forward inflation remain muted.
Ten-year breakeven inflation—i.e., a forward-looking, market-based measure of inflation expectations—continues to remain muted and range-bound. This is important because muted inflation is ideal for most investments.
7) We do not consider the stock market richly valued, especially considering continued historically-low long-term interest rates.
On 2/7/2019 the S&P 500 traded at approximately 16x next-twelve month consensus earnings.
To contextualize recent volatility, in 2018 this figure peaked at 17.5x in September and then troughed at 14x in late December.
Today ten-year US treasury bonds yield 2.65%, which is low relative to their mid-single-digit pre-financial crisis range. A historically low 10-year yield is notable because all else equal, lower long-term interest rates reduce discount rates and therefore increase asset prices.
8) From the “be fearful when others are greedy and greedy when others are fearful” department, redemption activity likely contributed to the S&P 500’s -14% total return in fourth quarter 2018.
According to the Investment Company Institute, net long-term equity mutual fund cash outflows surged in December 2018 to over 2x their monthly peak since 2016 (source: ICI and LGF analysis).
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[1] Gross capital formation, a component of the expenditure approach to calculating GDP, refers to an economy’s gross increase in fixed assets—such as buildings, transportation infrastructure, plant, machinery, and land improvements—during a specific timeframe. In contrast to capitalist economies like the US’s, in China it is government entities that primarily influence investment activity. To a meaningful extent, therefore, China can “manufacture” economic growth.
© 2019 Long Game Financial, LLC