2nd Quarter 2015

The S&P 500 returned 1.2% for the first half of the year. Energy languished while Healthcare, particularly Biotech, continued to be the best performing sector. The Utilities Sector, 2014’s best performer, is so far the laggard of 2015, returning -10.7%. Growth outperformed Value and Low Quality outperformed High Quality. This outperformance of growth and lower quality stocks is typical for the latter innings of a market cycle. Foreign stocks outperformed the S&P 500, with the MSCI EAFE Index of developed markets out- side the US returning 5.9% and the MSCI Emerging Market Index returning 3.1%. This outperformance occurred despite the continued appreciation of the US Dollar relative to the Euro and Yen. Japan continued to dominate performance of developed markets as Prime Minister Abe’s reforms appear to be driving an economic recovery in the country which has been marked by two decades of economic stagnation. China, which will be dealt with in detail below, was the largest driver of performance within the emerging markets, returning 12.6% year-to-date through June 30. Chinese equity markets have been declining since April, and our emerging market managers have been underweight the country’s 23% weight in the MSCI Emerging Market Index.

Worry about China, not Greece

While the drama surrounding the insolvency of Greece dominates press coverage, the stratospheric rise and collapse of Chinese equity markets over the past twelve months, reminiscent of the late 1990s tech bubble in the US, reveals the imbalances in China that pose a real threat to the global economy. After the 2008 Financial Crisis, China recognized that the recession in the US and Europe threatened its export-based economy. With Chinese wages rising at a 12% annual rate and the looming demographic collapse caused by the 1978 implementation of the One Child Policy, the country was losing its labor cost advantage to Southeastern Asian rivals such as Vietnam. To maintain China’s high rate of economic growth, China embarked on a massive program of real estate and infrastructure development. The Chinese government’s near complete control over the country’s financial system eased the implementation of this policy. Government regulations control where Chinese citizens can invest and the rates banks charge for loans and deposits. Once China’s high savings rate was redirected through the banking system into cheap loans for real estate developers, the boom began. Generating economic growth through construction is simple as every Yuan spent on materials, labor and equipment flows straight into GDP growth calculations. Since 2007, China’s total debt level, as a percentage of the country’s GDP, increased 80%. At 282% of GDP, the Chinese economy is now more highly levered than the US, with most of the debt owed by businesses and local municipalities. Nearly half of that debt is related to real estate.

The problems begin when the assets cannot generate revenue to cover the cost of the construction financing. Last year data revealed that approximately 20% of the housing units in China were vacant and encumbered by $674 billion of mortgage debt. Perhaps concern over the real estate market explains the Chinese government’s attempts last year to ignite a stock market boom by lowering margin requirements and encouraging small investors to buy shares. The combination of neophyte investors and margin borrowing delivered predictable results – a parabolic upswing beginning last summer that more than doubled the value of the local A-share market followed by the current sharp declines. The Chinese government sounds increasingly desperate as they attempt a series of policies ranging from blaming the miniscule amount of short sellers to directing banks to allow more margin borrowing, going so far as to let speculators put their houses up as collateral to buy more shares. The total amount of margin borrowing may be double the official number of approximately $350 billion if non-bank, ‘shadow’ loans are included. By comparison, at its peak in 2006, the total amount of US subprime residential mortgages outstanding was just over $600 billion. A June 30 Bloomberg article reveals that some Chinese speculators are paying interest rates as high as 22% on these unofficial margin loans.

A cynical view, which unfortunately usually proves correct in finance, is that China attempted to ignite a stock market bubble to paper over the cracks appearing in the real estate sector. Pumping up equity valuations allows the government to unload and recapitalize debt-laden State-owned enterprises, sparing the embarrassment of bankruptcy and restructuring.

Debunking Some Myths about China

China’s purchases of US Treasury Bonds constitute a burden on the US economy. This is contrary to the usual narrative which goes something like this: Industrious Chinese households must save a substantial portion of their income because the country lacks a social safety net. Profligate US households consume Chinese goods beyond their means and run up large debts. To bail out the US economy after the collapse from the 2008 Global Financial Crisis, the US government had to borrow money from China, rendering us even more in hock to the country.

The problem with this narrative is that it confuses cause and effect. The Chinese household savings rate is among the highest in the world, but the high overall Chinese savings rate results from the combination of high household savings with the high savings rates of the government and corporate sectors. China invests more than it consumes. The country therefore depends on foreign demand to balance its lack of internal consumption. Chinese purchases of US Treasury Bonds constitute a primary mechanism by which China suppresses the value of its currency and subsidizes its exports to the developed world. The Chinese government learned this studying and improving on the export-driven economic growth model employed formerly by Japan and Korea. A capital deficit lies on the other side of the national accounting ledger to a trade surplus. In other words, China must export capital to maintain its trade surplus. Furthermore, the trade surplus is a symptom of over-investment and under-consumption. The cost of this trade surplus comes at the expense of Chinese households, increasing their cost of imported goods and raw materials. The exportation of Chinese capital forces the US savings rate downward and increases the value of the dollar, making US exports less competitive. If China stopped purchasing US Treasuries and instead converted the dollars received from trade back to Yuan, the US trade deficit would decline and the dollar would weaken, making the cost of US manufactured goods cheaper for foreign buyers. The Chinese economy would be the primary victim, as the higher cost for exported goods would cause the manufacturing sector to contract and increase unemployment.

Don’t Worry about Chinese Purchases of US Treasury Bonds

Plenty of reasons for worrying about the global impact of an implosion of the Chinese debt bubble exist, but the impact on US government borrowing is not one of them. In bad times, capital flocks to US Treasuries, driving yields down. If the Chinese economy falls into a sharp deleveraging-driven recession (and history demonstrates convincingly that recessions coming from debt-driven financial panics are seldom mild) then a global recession will likely follow. China is the second largest economy in the world and heavily interconnected to the global economy. The S&P 500 offers scant refuge, with nearly half of the revenues of the index coming from outside the United States.

We have been worrying about an implosion of the Chinese economy for nearly five years now. One can find articles written in 2010 providing dire warnings about the amount of speculative real estate lending in China. It may be that circumstances have passed the point of no return and a Chinese panic and bust are headed our way, or officials can manage to buy a few more years of relative prosperity through financial shenanigans. If China suffers a ‘hard landing,’ it will likely result in a global recession. The Chinese government has the ability to borrow in order to recapitalize potentially insolvent SOEs, banks and municipalities. The result would not be global economic Armageddon, simply a volatile period such as investors should expect as a normal part of an investment cycle. The emerging market managers we work with remain significantly underweight the over 20% weight of China in the MSCI Emerging Market Index. None of them own stocks traded in the local A-Share Market where most of this activity is taking place. Owning well capitalized, high quality businesses and avoiding margin leverage remains the key to dealing with stock market volatility. Sadly, far too many first time Chinese equity investors, who can ill afford the loss of their hard earned savings, will learn this lesson the hard way. They will also likely not soon forget that their government urged them to do this.

– By Stephen C. Browne, CFA, CIO


Comstock News

WilliamWe are pleased to announce William R. Berger, CFA, CPA has joined the firm. Bill serves as Managing Director to assist with our growing clientele. Bill has over 25 years of experience in the money management, trust and investment advisory business. He spent 15 years managing equity and balanced portfolios for high net worth, mutual fund, and institutional clients around the world. He has also spent more than a decade providing investment advisory services to ultra-high net worth clients, including the design of asset allocation strategies for complex multigenerational families using a broad range of traditional and alternative assets.

Prior to joining Comstock, Bill served as Senior Vice President of Sentinel Trust Company and Senior Portfolio Manager/Principal of Vaughan Nelson Investment Management. Bill holds a Master of Business Administration degree from The Wharton School, University of Pennsylvania and a Bachelor of Science degree from Miami University. He is a CFA® charterholder and Certified Public Accountant and member of the Houston Business and Estate Planning Council, Houston Estate and Financial Forum, and the CFA Institute.

Please visit our website to learn more about recent changes to the Comstock Team and updates to our organization structure.


This firm is not a CPA firm.

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