Assessing China Risks

September 29th, 2014

Highlights

  • One of the most important challenges for investors is to assess China’s long-term prospects. A recent analysis by a prominent China watcher, Professor Michael Pettis of Peking University, reshapes the debate about whether the economy is headed for a “soft landing” or “hard landing” and offers several insights.1
  • Pettis contends the choice policymakers confront is deciding between a “long landing” strategy, in which China’s growth is allowed to slow over several years to 3%-4% without unemployment surging, versus targeting higher growth of 6%-7% that is unsustainable and likely followed by a collapse.
  • Pettis claims Chinese policymakers understand this dilemma, but it is too early to tell which direction they will take. Conventional wisdom holds that slower growth could be socially disruptive, but Pettis contends that eliminating artificially low interest rates will transfer income from inefficient companies back to households, thereby supporting higher consumption.
  • My reaction is that the scenario Pettis outlines is plausible in theory, but it is highly questionable whether overall growth could fall to 3%-4% without unemployment surging and China’s policymakers responding. Even if his favorable outcome unfolds, the global economy and world equity markets would feel the fallout of markedly weaker Chinese growth.

Reframing the Debate about China’s Growth Prospects
Most analyses of China characterize the debate about its growth prospects in terms of whether economic growth will slow moderately to 6%-7% (the “soft landing” scenario) or more substantially to 3%-4% (the “hard landing” scenario). The prevailing view is that the former outcome is the most likely over the next few years as policymakers seek to buttress the economy. However, a vocal minority foresees the bursting of a property bubble that will result in financial disruption and much weaker growth.

Michael Pettis, a former Wall Street investment professional turned professor at Peking University, contends this is a false dichotomy. In his view, the Chinese economy has only been able to maintain 7%+ growth due to rapid credit expansion, and he believes the economy is now running up against constraints on how much debt is sustainable.

“Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing.” It is not an alternative.”

For the time being, Chinese policymakers are clinging to the official 7.5% target growth rate and are likely to deploy added stimulus should the property sector weaken further. However, Pettis is hopeful the government will eventually adopt a “long landing” strategy in which China’s growth rate is allowed to transition over time to 3%-4%, while household income grows at a faster pace of 5%-7%. If this transition can be achieved, it would imply that income is transferred away from inefficient companies back to Chinese households, thereby lessening the risks of rising unemployment and social disruption.

Implications of Ending Financial Repression
For this transition to occur, the Chinese government will have to embark on reforms to end so-called “financial repression.” This term refers to policies in which rates that depositors receive on their bank accounts are set well below market clearing levels, which enables banks to provide cheap loans to Chinese businesses, many of which are state-owned.

Pettis notes that financial repression was vital to mobilize savings in the early stages of China’s transition from a poor, agrarian based economy to a more industrial economy. Over time, however, the artificially low interest rate policies contributed to a loss of investment discipline, as inefficient firms were able to obtain cheap financing, which in turn contributed to an enormous misallocation of capital over the past decade. Pettis estimates that over the latter period as much as 5%-8% of GDP was transferred from households to borrowers, which explains why the growth in household income lagged the growth in GDP. (Note: Estimates by the IMF are within a comparable range.)

Pettis sees the low interest rate policies coming to an end, as President Xi appears committed to the process of financial reform. The official lending rate has risen to 7.5% while nominal GDP growth has slowed to 8%-9%. As a result, it is more difficult for borrowers to justify investments in non-productive projects. Also, as the resource transfer from savers to borrowers shrinks, economic growth is likely to transition from being investment-led to consumer-led. At the same time, Pettis acknowledges there are borrowers that are effectively insolvent and which may still receive ongoing support from the Chinese government.

One challenge President Xi faces is vested interests in the Communist Party that are opposed to economic reform. Pettis acknowledges this, but also notes that President Xi is China’s strongest leader since Deng Xiaoping, who pioneered the country’s transition to a more market-oriented economy. He observes:

“China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one to two years be able to get credit growth under control, before debt levels make an orderly adjustment impossible.”

My Take: Insightful but Unlikely
Pettis’s analysis is both insightful and worth considering, because it challenges conventional thinking about China. His main insight is that by eliminating distortions in capital markets, policymakers can achieve the objective of rebalancing the Chinese economy away from reliance on investments in favor of consumption, and he makes a strong case that the costs of financial repression outweigh the benefits.

That said, I find his favorable outcome, in which growth slows to 3% without unemployment rising, to be very difficult to pull off in practice. It assumes that China’s policymakers have the wherewithal to engineer a controlled slowdown, even though this is rarely the case. Consider some of the dynamics involved; when businesses are forced to cut back on spending due to lack of available credit, some will respond by shredding labor and others may become effectively insolvent, which would create strains for financial institutions. Pettis acknowledges these possibilities, but does not offer a compelling rebuttal. His scenario envisions a wealth transfer to households boosting consumption, especially of services, which tend to be more labor intensive, and he observes the government could mop up unemployed workers by putting them into make-work-jobs. At the same time, he acknowledges this response would not fundamentally address China’s debt problem, but simply roll it forward.

One issue Pettis does not discuss is the impact that substantially lower Chinese growth would have on the global economy and financial markets. Currently, world markets are priced for only a marginal slowdown in China’s economy. Therefore, if China’s growth were to be cut in half in the next few years, world equity markets would likely feel the fallout at some point, with emerging economies that have close trading ties with China taking the biggest hit.

1See Michael Pettis’ blog, China Financial Markets, “What does a “good” Chinese adjustment look like?” September 2014.

How to Better Anticipate and Manage Future Crises

September 4th, 2014

Remarks delivered at the Bretton Woods 2014 Conference: The Founders and Future hosted by the Center for Financial Stability on September 4, 2014.

Thank you for the opportunity to address this topic. It has been an area of interest for me since the 1970s, when I worked on developing an early warning system for detecting debt problems of developing countries at the U.S. Treasury and the Federal Reserve. Thereafter, I worked with financial institutions that had considerable exposures to domestic and foreign markets. My perspective is that of an investment professional whose job is to assess opportunities and risks.

I will begin by saying the task of identifying financial crises is not easy for investors. If it were, they would be fewer and less severe. For investors to do a better job in the future, they will have to overcome the following obstacles:

(1)   Lack of adequate and timely information on exposures of borrowers and lenders. The financial system appears as a “black box” for investors, and while regulatory bodies have the authority to peer inside this box, their track record of identifying potential problems has been poor.

(2)   Lack of a conceptual framework for thinking about financial crises. Until recently, they were considered to be episodic rather than systematic, and with the principal exception of the Bank for International Settlements (BIS), economists did not focus on the credit cycle and its determinants.

(3)   Lack of economic policies to promote financial stability. Investors take their cue of what matters from policymakers; consequently, if policymakers appear unconcerned about financial stability, they will be similarly inclined. Read the rest of this entry »

The U.S. Expansion: Does Slower Growth Spell Longer Expansion?

August 14th, 2014

Highlights 

  • The U.S. expansion is now five years old, matching the post WWII average duration while being considerably slower in terms of growth. Skeptics cite this as evidence that the business cycle is living on borrowed time, while optimists believe the subdued recovery will prolong the expansion. A research note by J.P. Morgan sides with the optimists and concludes that the expansion should run for another 2-4 years. 
  • Fed Vice Chairman Stanley spelled out the complexity policy makers face in a speech this week. First, they must understand why aggregate demand has been unusually weak, and whether this is temporary or ongoing. Second, they must also assess the extent to which the economy’s productive potential has been lowered by declines in labor force participation and factor productivity. 
  • The view that the current expansion is likely to be prolonged is an important component of our investment strategy. While the debate about the economy’s long term potential will not be resolved for years to come, we still expect economic growth to accelerate in the next 1-2 years, as fiscal drag lessens. If so, this should underpin profit growth and the stock market while bond yields rise. 
  • One risk to our outlook is the Fed could tighten monetary policy prematurely. However, the bigger risks are geopolitical developments that could undermine recovery in Europe and/or lead to an oil supply disruption in the Middle East. 

The Case for a Prolonged Expansion

This quarter marks the fifth anniversary of the economic expansion that began in mid-2009. Based on post-war experience in which expansions have averaged five years, the current one would appear to be long in the tooth. However, when one considers the amount of slack resources in the economy and the lack of excesses, this is less evident. Read the rest of this entry »

Markets at Midyear: Waiting for a Breakout

July 8th, 2014

Highlights

  • The first half of 2014 was unusually calm for financial markets. The main surprise was a 50 basis point drop in Treasury yields. Returns for investment grade and high yield bonds were about 5.5% each, while the S&P 500 Index posted a total return of 7% as it set a new record high.
  • Looking ahead, investors are unsure when market volatility will return. We continue to believe the most likely outcome is higher U.S. bond yields, as the economy regains momentum and inflation edges upward. Further stock market gains are likely to be moderate, considering how far the market has advanced in the past five years.
  • The main risks lie outside the United States, especially in the Middle East. The wild card is the prospect of an oil supply disruption that could boost oil prices and weaken the global economy.
  • We are moderately underweight in duration and overweight in credit risk in bond portfolios. For balanced portfolios, we continue to maintain a moderate overweight position in equities versus bonds.

Calm Markets Despite a Poor Start for the Economy

The most prominent feature of financial markets in the first half of this year is how calm they have been. U.S. stock market volatility, as measured by the VIX, is the lowest since the onset of the Global Financial Crisis in mid-2007. The market has not had a pullback of 10% or more for two years now. Similarly, corporate bond yields and spreads versus Treasuries are down to pre-crisis levels and currency markets have been unusually quiet. The main reason is that investors are comfortable with the fact that the Federal Reserve is not in a hurry to raise short-term interest rates, even as it winds down its bond purchase program.  Read the rest of this entry »

Falling U.S. Bond Yields: The Market Surprise for 2014

June 3rd, 2014

Note: Fort Washington Investment Advisors, Inc. (Fort Washington) is pleased to announce the appointment of Steven K. Kreider as its new Chief Investment Officer, succeeding Nicholas P. Sargen in the role effective May 30, 2014. After a long and successful tenure as Chief Investment Officer, Mr. Sargen will remain with Fort Washington and continue to serve the company as Chief Economist and Senior Investment Advisor.  In his role as Chief Economist Nick will continue to update his blog with current market and economic information.

Highlights      

  • Last week’s decline in Treasury yields took the 10 year yield close to 2.4%, the lowest level in a year. The move primarily reflects technical factors, as well as ongoing concerns about global weakness, especially in Europe.
  • The cumulative 60 basis point decline in bond yields this year also reflects revised expectations about U.S. monetary policy. Previously, market participants expected the federal funds rate to rise to 4.5% over the next five years; now they are pricing in the funds rate to peak at 3.5%.
  • We expect bond yields will move higher in the balance of this year as the U.S. economy regains momentum. Accordingly, we are maintaining an underweight duration position in fixed income portfolios.

What’s Behind the Decline in Yields?

Until the past few weeks, Treasury yields had fluctuated in trading ranges, with the 10 year yield centered about 2.7%. During May, the market broke out of its range, as yields fell by 25-30 basis points. The decline sent the 10 year Treasury yield near 2.4%, the level where it was a year ago. This has surprised many investors, including ourselves, considering that recent economic data suggest the U.S. economy is recovering from its first quarter slump and the Federal Reserve is continuing to scale back its bond purchase program. Read the rest of this entry »

Markets in Equilibrium: Anticipating the Next Move

May 6th, 2014

Highlights 

  • Our assessment at the start of 2014 was that U.S. stock and bond markets were reasonably priced, and their prospects depended on how the U.S. and global economy fared, and on Fed policy developments. So far, the principal surprise has been a 40 basis point decline in Treasury yields, which is an enigma for many investors. 
  • One year ago, when yields were roughly 100 basis points below current levels, they surged when the Fed announced it was contemplating winding down its bond purchase program. But it is unlikely the Fed will surprise investors again, and investors are comfortable that quantitative easing will be completed by the fourth quarter. 
  • Meanwhile, the strength of the U.S. economy is likely to be the key market driver in the balance of this year: Should the economy grow in the neighborhood of 3% while monthly payroll gains average 200,000+, Treasury yields are likely to resume their upward trend. Accordingly, we are underweight in duration in fixed income portfolios, and have closed out high yield positions for tactical reasons. 

Market Lull: How Much Longer?

Following a bond rally and stock market sell-off in January, U.S. financial markets have settled into narrow trading ranges in the past three months: The yield on the 10-year Treasury has been centered about 2.7%, while the S&P 500 Index has fluctuated around its level at the beginning of this year. The initial moves reflected investor concerns about a U.S. slowdown, as well as political and economic developments in several emerging economies. More recently, investors have shrugged off weaker-than-expected U.S. GDP growth in the first quarter, fears of an economic slowdown in China and other emerging economies, and heightened tensions over Ukraine. These developments suggest financial markets are in a state of equilibrium, which is likely to continue until there is a major market surprise.  Read the rest of this entry »

Marking Time

April 15th, 2014

In the wake of last year’s 100+ basis point rise in U.S. bond yields and 32% return for the stock market, financial markets took a breather this past quarter: The S&P 500 Index returned only 1.8%, roughly matching the Barclay’s Aggregate Index.  January witnessed a stock market sell-off of 4%-5% and a dip in bond yields amid concerns about the U.S. economy and emerging markets.  However, the market subsequently recouped its losses in February and went on to post a record high in March, as investors shrugged off economic data as being influenced by severe weather.

In the meantime, investors are assessing what is in store for U.S. monetary policy with Janet Yellen as the Federal Reserve’s Chair. At her first FOMC press conference, she surprised market participants by suggesting the Fed could raise short-term interest rates as soon as six months after it completed its current bond tapering operation. This triggered a rise in the front end of the Treasury yield curve. However, investors reassessed the interest rate outlook when Yellen subsequently clarified that labor market conditions are far from normal while inflation is well below the Fed’s target.  Read the rest of this entry »

Palm Beach Forum Panel: Moving Beyond Bubbles

April 7th, 2014

Remarks delivered at the Palm Beach Strategic Forum, April 7, 2014.

Mr. Chairman, thank you for the opportunity to address this session on evolving global risks and asset bubbles. My perspective is that of a Chief Investment Officer for a U.S. financial institution. This topic has become of paramount importance in the wake of the 2008-09 Global Financial Crisis and ensuing test of the euro-zone. However, it should be recognized at the outset, this was not an isolated event; there have been a series of global crises over the past 25 years that have affected policymakers and investors alike.

In my remarks, I will first examine the factors that have given rise to asset bubbles and why financial crises have become more prevalent in the past three decades. I will then consider what policies are being created to lessen the risks of financial crises and what investors can do to be protected. 

What Are the Causes of Asset Bubbles?

There are two basic approaches to this question in the literature. One approach is non-economic, and views asset bubbles as being caused by irrational exuberance, while the alternative approach links bubbles to economic factors such as excessive credit creation and unstable international capital flows: Read the rest of this entry »

Is the Fed in Play (again)?

March 24th, 2014

Highlights 

  • At  her first FOMC press conference as Fed Chair, Janet Yellen surprised market participants by suggesting the Fed could consider hiking interest rates as soon as six months after it completed its current tapering operation.  This would move the timetable for Fed tightening to the second quarter of 2015.  Previously, the market had been pricing in the first rate hike in the second half of the year.
     
  • At the same time, the Fed’s FOMC policy statement dropped the 6-1/2% unemployment rate and 2-1/2% inflation rate thresholds.  Henceforth, guidance will be more qualitative and less quantitative.
     
  • Our own take is that market participants had become complacent that the Fed was unlikely to tighten before the second half of 2015.  This left the front part of the yield curve vulnerable to the surprise announcement.
     
  • We are unsure exactly when the Fed will begin raising rates and are focusing on the economy and jobs creation.  Bond yields will likely move higher this year as the economy gains traction, with the 10 year Treasury yield headed for 3.5%. 

The Fed Alters its Guidance

Prior to this week’s FOMC meeting, market participants expected the Fed would continue to taper its bond purchase program, but investors were unsure whether the Fed would alter its forward guidance about tightening monetary policy.  The bond market’s initial reaction to the FOMC minutes was neutral, as the minutes confirmed the Fed would scale back bond purchases by an additional $10 billion per month to $55 billion.  Read the rest of this entry »

U.S. Stock Market Rally Celebrates Its Fifth Anniversary

March 11th, 2014

Highlights 

  • The stock market celebrated the rally that began five years ago with the S&P 500 Index reaching a record level last week that is 2.8 times above the low in March 2009.  The rally rivals that during the expansion from mid-1982 until the October 1987 crash, and is exceeded only by the technology-driven boom in the second half of the 1990s that ended in a bust. 
  • In light of these experiences, we consider the possibility that the stock market’s gains may be unsustainable.  Compared with these two prior experiences, we conclude there is less risk of a market collapse today, because valuations are not at extreme levels and there is little evidence of inflation or a credit bubble. 
  • That said, we believe the period of supra-normal returns is over; henceforth, we expect returns that are more in line with normalized profit growth of 7%-8% over the long-term.  The main risks we contemplate are the possibility of earnings disappointments and the potential for contagion in the emerging markets. 
  • Meanwhile, we continue to maintain a moderate overweight of stocks versus bonds in balanced portfolios. 

The Rally in Perspective

This week marks the anniversary of the U.S. stock market rally that began when the S&P 500 Index fell to a low of 666 on March 9, 2009.  While the market reached a record level above 1880 last week, very few professional investors anticipated how powerful the rally would become.  Moreover, the vast majority of retail investors missed it altogether as evinced by net outflows from equity mutual funds over this period. For this reason some pundits have called it the most “unloved” rally in history.  Read the rest of this entry »