In this tale of cartographers unintentionally helping to create a landmark, we see an interesting analogy to today’s global economy.

The Federal Reserve and its central bank brethren have moved interest rates to nearly zero as a means of reigniting economic activity. In so doing, they have unintentionally built an ecosystem dependent on low financing rates, which has caused some to claim they have given up on their main mission of price stability.

This newsletter will highlight one example of this low-rate dependency, as well as a potential change in the environment we should all watch, and last, it will touch on an unintended consequence resulting from the low-rate environment.

Evergrande: China’s Lehman Moment?

Headlines have been filled with the news that the largest property developer in China, Evergrande, is struggling with very significant debt and low liquidity. In 2021, Evergrande’s stock price has declined 85% as the markets fear an eventual default. With more than $300 billion in liabilities, should there be a bankruptcy, it would be one of the largest on record.

To put such a default in context, Lehman’s bankruptcy resulted in a bond default of $150 billion. Now, Evergrande’s potential corporate bond default would likely come to less—approximately $200 billion of their liabilities are in buyer deposits and supplier payables—but no matter, the bond default would still approximate $90 billion, almost four times the largest default experienced since 2011.

Currently, Evergrande has missed their September payments on U.S.-dollar denominated bonds. Looking at what’s due in future monthly payments suggests the problem will only get worse.

Many are asking if this is China’s “Lehman moment.” Is this the domino that falls and topples other fragile institutions causing greater value destruction and liquidity constraints? We don’t think this is quite that bad. Lehman was uniquely situated to cause collateral damage because, as a global investment bank, it served as a middleman in transactions amounting to trillions of dollars across the globe. Their default spread across large swaths of global GDP. Lehman’s downfall also happened very quickly, and the U.S. regulators lacked the authority to thwart the collapse.

Evergrande’s troubles are not as far-reaching as Lehman’s, and they have been known for years. Also, China, with its controlled economy, can likely address the property developer’s liquidity issues through its state-owned enterprises.

Just because it is not likely a Lehman moment doesn’t mean the boomtown mentality will hold up within China. Asian property developers, such as Sunac and Greenland (no relation to the country), are experiencing funding shortages while there is concurrently a slowdown in home sales in China. If sales wane, prices likely will fall, too, and the results could be uncomfortable for many.

China’s economy and the wealth derived from it are highly tied to the real estate market. Unlike in the U.S., where housing assets represent about a quarter of household wealth, in China they represent more than 60% of wealth. Housing and the industries tied to it represent about a quarter of China’s GDP. We have discussed the implications of the wealth effect on U.S. consumption, where declining wealth leads to declining consumption. One should assume the same is true for China’s consumers.

With respect to pricing, China’s housing market looks fragile. We were young when it burst, but we still remember the many justifications given for the bubble in Japanese real estate in the late 1980’s, and we hear the same reasons today being used to describe the property situation in China. Economic activity and low rates can create a nice backdrop for optimism, but long-term reality may lead to some sorrow. Chinese home prices as a percent of income are the highest in the world. Low rates allow buyers to think about how much in monthly payments they can afford. However, if rates start to move up, householders’ attention may well move to how much debt they have tied to an expensive asset.

Interest Rates

The push for lower and lower interest rates appears to be in the rearview mirror. The rapid rise in inflation and concerns that it will linger has contributed to global central banks taking the foot off the accelerator and at least modestly tapping the breaks.

Rate hikes are now outpacing cuts (albeit off a low number). Some will see this as a tepid move to a more normal rate environment, but we believe it warrants attention because the global investment markets have become accustomed to easy money. The incremental tightening of money availability may be considered by some to be a radical change. Financial leverage is high and modest shifts in cost of debt and its availability could bring about dislocations to global markets.

The chart above looks at liquidity as defined as the Federal Reserve balanced sheet minus the money that is being placed back with them as a means of finding a safe place to store it. The continued growth in the Fed balance sheet is well known; less publicized is the amount of money going back to the Fed for safe keeping. The purple line is the net liquidity offered by the U.S. central bank. It peaked in April of this year, and we have been experiencing a declining liquidity environment with the rate of decline accelerating.

Keep in mind that the Evergrande troubles were showing themselves long before the modest U.S. liquidity drain shown above and before rate increases were becoming significant.

Blockchains and Digital Assets

The Agloe analogy really hit us as it pertains to the blockchain ecosystem. The unintended consequence of a few cartographers brought about the birth of a real place on the map.

Central banks, in their attempt to stabilize economies, have caused some to create a new town that is independent of central bank dictates. The low-rate environment has brought about concern that governments are in a race to debase their currencies to placate their populaces. The fear has generated a desire by some for an asset that has finite units and therefore a hope that it would retain its value relative to fiat currencies. Bitcoin is the poster child. We are not believers in this fear, at this point, as central banks are still independent institutions that continue to state their main objective of providing price stability. We will see if they can regain trust.

However, the bitcoin phenomenon has birthed a technology idea (blockchain) that has gathered adopters for purposes other than dollar-replacement assets. Blockchain, as a technology, intrigues us as we witness the development of new business models because of it. As personal computers moved computing power to the individual and away from the glass walled mainframes, we see an opportunity for blockchain technologies to drive a continued evolution to decentralization.

The caveat to this intrigue is that we are early, and history has not been kind to the first movers. In the late 1990’s, the internet was promising but nascent. We remember the pitch of many brokers that one should buy a basket of names to participate in the long-term theme of the internet. The idea was to build a portfolio of internet leader that included companies such as JDS Uniphase, Worldcom, Corning, Sun Microsystems, AOL, Yahoo, Cisco, Intel, VerticalNet, Pets.com, Netscape, etc. Many of these were monsters in their respective spaces yet went on to become lackluster performers or outright value destroyers. The returns did not match the enthusiasm and the benefits did not accrue to many of those companies.

We offer this up as an example that optimism on an idea does not always reflect positive future returns to current players. Yet, the optimism is real and some new things are here to stay. Optimism can bring about a new order upon which life is lived. We will continue to investigate the opportunities and threats that may result from blockchain technologies.

We have repeatedly said we are concerned about the perceived insouciance (adjective; free of concern) of the investment community regarding valuation and growth forecasts. With both equity and fixed income markets priced to perfection, according to historical norms, and optimism in an unperturbed growth outlook, the strong momentum of world markets leaves us not in the carefree camp.

The research group of Deutsche Bank runs a monthly survey of institutional investors, gauging their top concerns. The chart below shows that inflation concerns were prominent in May and June as economies around the world re-opened and supply chains were struggling to keep up with demand. Increased caseloads from the delta-variant became everyone’s chief concern in July, however, as worries revived that we would need to revisit past pandemic protocols. (We hope not because our weight is only now moving back to pre-pandemic levels.)

The delta variant appears to be more infectious than the 2020 variants with it too early to understand its severity, leading to concern that our economy’s re-opening process could slow or stall. Thankfully, the vaccines being used in the U.S. and Europe seem to maintain their effectiveness in the face of the delta variant. The chart below is a nice way of seeing just how protective these vaccines, with the risk of dying from Covid dropping by at least an order of magnitude once jabbed.

As vaccination rates among adults in most of the developed world reached well above 60%, perambulating (verb; to stroll) without concern was becoming increasingly prevalent. However, the delta variant’s spread has us checking ourselves. And a slowdown in the re-opening process might be a factor in recent drops in several types of financing activity, including credit impulse and corporate debt.

Credit impulse—a measure of financing activity relative to the size of the economy—is showing a worrisome deceleration. We have seen a significant reduction in financing activity in the U.S. and Europe and, most recently, in China. Some of it may be due to the reduction in fiscal stimulus, as well as supply chains getting back to normal. We are monitoring to see if the burst in economic activity is followed by a bust.This fear has its roots in the high level of debt held at the corporate level. The record level of leverage in the corporate sector has increased the cost of servicing it even with interest rates being so low. The cost of debt is consuming almost 50% of corporate income. Another slowdown could be unpleasant for those already finding it hard to operate.

The concerns we at Auour have do not appear to be shared by others; analysts have shared very optimistic updates for the long-term growth of the firms they cover. In fact, the consensus estimate for the average growth of the S&P 500 aggregate earnings stands at over 20% (per year for the next five years). Keep in mind that history has not been kind to the average analyst’s forecasting ability, though. Their estimates track the strength of the equity market, as seen below, rather than predicting the future success of the firms.

The ebullience (not an AWOTD, but it should be) of the analysts is one thing, but pricing investor optimism into the fastest growing companies is another. The next graph highlights the extreme optimism residing within the equity markets. It shows aggregate market value of the most expensive companies surpassing that seen during the dotcom period. The total value of those companies equals about $4.5 trillion, or 10% of the total value of the U.S. equity market.

The level of optimism about the future growth of a new company, industry, or investment theme can turn into fear quickly. We are seeing that now in the Chinese equity markets, specifically the Chinese internet space. The chart below shows the dramatic underperformance of the overall Chinese equity markets relative to the global index (MSCI All Country World Index), with it underperforming by 30% since the start of the year.

The slide in the Chinese stock market started in February of this year but has accelerated recently as the communist party considers turning the fast-growing online tutoring companies into non-profit entities—banning any for-profit operations. The communications out of the ruling party would suggest this is not furphy (noun; false report). China, for all the opportunities it offers as a market, continues to remind investors that companies exist at the pleasure of the communist party, not the other way around. The graph below highlights the magnitude of the drop within the Chinese technology space relative to their U.S.-domiciled brethren.

We will end with one last graph showing the maximum drop investors had experienced in each year going back to 1980. Last year was on a par with some of the worst. Will that be an isolated occurrence, or is it a sign of increased volatility within markets? We stay in the camp that believes we are going to experience higher levels of volatility, which argues for a strategy to dampen the volatility while we wait for better opportunity.

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