Takeaway for China investors: stock market bubble can “only end in tears”

May 26, 2015

MONOGRAM, today warns of the threat of a bubble in the Chinese stock market, following a rise of 140% in the Shanghai Composite Index in the past 12 months (the best performer in the main 35 global stock markets).

Paul Marson, Chief Investment Officer of Monogram, commented:

If this is not a bubble then it’s hard to imagine what one looks like. The average daily stock market turnover has increased 10 fold in the last year (830 billion Yuan v 80 billion).

Monogram 1

The root cause of this is the expansion of bank balance sheets in China. Over the past four quarters, Chinese bank balance sheets have grown by the equivalent of 35% of GDP – remarkably this is less than the 55% expansion at the start of the crisis.

If [and that is a big and qualified IF] GDP is expanding seven percent then that leaves an enormous amount of liquidity that has gone from inflating the property market, which is now deflating, to inflating stock prices.

Monogram 2

“This is a very unhealthy sign for the global economy. It can only end in tears. Bubbles always leave behind more problems than they resolved.”

“Are we nearly there yet …?”

May 13, 2015

The continuing saga that is the Greek debt crisis and the surprisingly convincing Tory election win in the recent UK elections, once again focuses the spotlight on the sustainability of budgetary positions and prospects for further fiscal policy tightening (“austerity”) in the major economies.  It begs the question, “Are we nearly there yet, or are we still on the road to austerity?”

The question has importance for two main reasons: 1) it tells us about the magnitude of potential growth headwinds and 2) since Quantitative Easing liquefies assets in the banking system, and in the process removes government liabilities from the market, it necessarily diminishes government debt market liquidity.

Chart 1 shows the level of general Government primary net lending/borrowing, that is the net borrowing/lending when interest costs are excluded: the data is a percentage of GDP.

2015.05.13 Blog Chart 1 Pic

The chart also shows, assuming these economies maintain the growth rate of last year and can continue to finance at current exceptionally low levels of real yields, the degree of fiscal policy tightening required (the “shift”), or permissible easing, that would stabilize the net debt/GDP ratio at the level of last year. Several things stand out:

  • While Greece is running a primary surplus (its cyclically adjusted surplus is around 7% versus the current surplus of 1%), albeit modest, as it did from 1994-2002, the additional tightening required to stabilize its debt ratio is 5.9% of GDP.
  • The UK currently runs a primary deficit of almost 4% of GDP (it has run a surplus in 6 of the last 25 years and a deficit now for the last 13 years) and requires additional tightening amounting to 3.7% of GDP, or £66 bn, from the new government in order to stabilize the debt ratio. That would mean some harsh choices – the required shift is the equivalent of 45% of spending on public pensions, 50% of the NHS budget, 73% of the schools budget, 60% of the social   security budget and almost 150% of the defence budget, give or take a few pounds. It is approximately 9% of total UK government spending.
  • Both France and Spain also require sizeable additional tightening in order to stabilize debt ratios, 2.4% and 3.3% of GDP respectively, just shy of €90 bn in aggregate.

Chart 2 illustrates what happens if we extend the analysis to include the US and Japan.

2015.05.13 Blog Chart 2 Pic

  • Japan, with a current primary deficit of 7% of GDP, requires a 4.5% of GDP fiscal policy tightening, at near zero bond yields with Bank of Japan QE amounting to 15% of GDP annually and giving them a current holding of one-fifth of the outstanding debt stock, just to stabilize the debt ratio.
  • Even the United States requires a further 3% of GDP fiscal policy tightening from here to stabilize its debt ratio.

Interestingly, Germany could afford to ease fiscal policy by 2% of GDP under our assumptions and the debt ratio would be stable. That, in our opinion, seems quite unlikely.

Adding the required shift/tightening together for these 10 countries gives us a €800 bn fiscal policy tightening in aggregate in order to stabilize government finances across the board.

That would be an extraordinary headwind to a global economy where the median real growth rate is currently just 2.3% and median core inflation rate is just 1.1%.

Even if you relax the growth assumption in favour of a far, far more optimistic assumption that these economies can grow at the fastest annual rate that they have managed in the last 20 years, the required fiscal tightening is still in the order of €700 bn. Whatever way you cut the numbers, we can safely say we are still on the road to austerity. That means, of course, the risk of a monetary policy “mistake” is severe – at exceptionally low inflation rates monetary policy must accommodate fiscal policy, not fight it.

It is the US… again!

May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.

MONOGRAM CAPITAL MANAGEMENT