Finally, we have headline scares out of China. Earlier this week markets were spooked about the possible default of the world’s most indebted developer, which is none other China’s Evergrande Group.
Usually, what happens in China stays in China and has no consequences outside of China. This because China is mostly a closed economy and very rarely anything that happens affects anyone else. Except for exporting a little deflation, which is mostly a good thing.
And given that there will probably be a domestic policy response from the Chinese government (as everyone thinks), any implications within China will also probably be limited.
For some strange reason what applies in western economies does not apply to China. The housing bubble in China has been ongoing for many years now, with analysts and economists forecasting a crash, but no crash ever occurred. Even Hong Kong’s real estate market has been an ongoing bubble for the past 20 years or so, but still no crash.
Yet it is terrifying when one looks at just how expensive real estate in China is, and the implications of a possible nonorderly Evergrande default.
The chart below comes from Nordea and depicts housing affordability in China.
The latest data show that the ratio of the median house price to income in Beijing is about 25, about 13 in all of China, and about 21 for Hong Kong. During the US housing bubble in 2008 this ratio was about 7-8.
So, while everyone expects the Chinese government to mediate and somehow solve the problem, one must ask themselves if it is different this time? Especially if government mediation does not happen or, does not happen enough.
The entire construction sector, including commodities like iron, copper, and cement will be impacted. Many products and services that go into construction, like elevators, will also be hit. Consumer behavior will also be impacted as well. And while local banking issues could be managed, and will have no global impact, Chinese consumer behavior will. The consumer in China is simply too big to be ignored, even by many US companies.
So, getting back to the question if an Evergrande default can have global spillover effects, the answer is probably yes, if the unwinding is not orderly. But even with no spillover, the wall of worry of the Chinese housing bubble will continue to be with us.
Assuming the FED and ECB are wrong, and inflation persists, the question is, what should the investment strategy be in such an environment.
The answer is not as simple as it sounds because current generation of fund managers have no experience dealing with inflation. Reason being, above average inflation has not been around for several decades.
But there is also another reason why dealing with inflation today is an enigma. Several decades ago fund managers sold equities and went into fixed income that had a yield. Today fixed income does not offer any yield. Simply put, there is no money to be made in bonds anymore, outside of trading them and hoping to make capital gains. According to Bank of America Corp, about 25% of all global bonds yield below zero, and only about 1/3 of all fixed income yields above 1%. In fact, negative real yields have even been sighted in European junk debt.
So, the question of how to navigate an inflationary environment is not an easy one. This because no matter what the inflation outcome is, yields are not expected to be what they were 40 years ago. The only place to find respectable yields is in emerging market sovereign debt, or high risk plays such as China Evergrande Group, which had a coupon ranging from 8%-12%, but now bondholders face as much as an 80% haircut.
The bottom line is, assuming inflation persists, this is a very difficult and challenging environment to navigate. On the one hand we just don’t know how the market will react, and on the other, bonds are yielding close to zero. Having said all this, I don’t think equities will correct even if inflation persists. If we do see a major correction in equities, it will most likely be because of valuation concerns coupled with another COVID scare than anything else.
The chart below depicts the price of sugar. As you can see, prices today are lower than what they have been in many instances from 1970. And why are sugar prices so low? Because the people who produce sugar have become more productive at it, thus the unit cost of production has fallen, and producers can still make money.
So why has all the monetary stimulus not pushed up the price of sugar much higher, as is conventional thinking? The answer is because commodity prices are supply and demand driven.
When we look at gold, which is supposed to be a hedge against inflation and monetary expansion, it is where it was about 10 years ago. And if we look at platinum, it is less than half of where it was a little over a decade ago.
In fact, monetary expansion has been going on for many years now, and it has not affected inflation by much. In Japan where QE and other central banking tricks were invented, the problem has almost always been deflation, not inflation.
What all this means is yes, we might get persistent inflation, and many inflation components might not be transitory (wadges for example), but at the end of the day prices for commodities are supply side driven and not driven by monetary policy.
So, if one wants to play in the commodity space, analyzing supply and demand metrics for each commodity separately is warranted. Speculation also plays a role, but speculation almost always drives prices short term and not long term. Lumber is a recent example.
The bottom line is that commodities are affected very little, if at all, from central bank policies. At the end of the day, it is supply and demand metrics that shape pricing.
Insofar as financial assets, yes, they are affected by monetary policy. However please note that in this case it is the intent of central bank to try to affect financial assets. This because this category of assets has a direct impact on financial conditions and the economy.
COVID, inflation, deflation, global growth prospects, interest rates and a bunch of other things that I could probably write a book about, all worry me. However, all the above aside, the thing that mostly worries me above all others is the value of the dollar.
Taking a cue from Star Wars, the dollar is something like the force. When there is balance in the force, things work ok, and the galaxy is peaceful. But when there is a disturbance in the force, then all hell breaks loose.
Similarly, when the dollar’s value is balanced, the global economy is growing, and things are moving alone ok. But when the dollar becomes strong, then things don’t work so well. A strong dollar means there are fewer dollars available for the global economy to function properly. It also means companies and countries that have dollar denominated debts must pay more. But it might also mean a headwind for US companies that rely for a big portion of their profitability from global markets.
A higher dollar might also mean market participants are buying dollars as a safe haven trade. And every time this happens, it does not fare well for equities.
So, if we look at the chart above, one can probably say that as long as the EURUSD pair remains above 1.17, risk assets should continue to do well. But if the pair falls and remains below 1.17, then chances are we might see correction.
On the other hand, if we see the pair above 1.22, then chances are risk assets will continue to perform well, and we might see a strong upward move in equities.
The bottom line is that there are countless things that worry me, and countless things that can cause a correction in the equity space. However insofar as the dollar, if it remains at current levels, it will be one less thing to worry about. And if we see the EURUSD pair above 1.22, then we can say with a little more confidence that the Force will continue to be with risk assets.