Two of Warren Buffet’s trademark quotes “Be greedy when others are fearful” and “Only when the tide goes out do you discover who’s been swimming naked” have been repeated regularly in this column since we began in 2002. The general thesis being, at the points of highest volatility and investor pessimism, be brave. However, the much more difficult, and arguably more important, discipline is the antipode of these: when everyone is being greedy, be fearful.
Bull markets, it is also said, “climb a wall of worry“. Martin Wolf in his weekly Financial Times article states that there are certainly plenty of reasons to worry at present, but markets are no longer climbing, with the MSCI global equity index pretty much marking time in a volatile fashion since early 2014. However, whilst this bull market has probably been more unloved than most, it is very long in the tooth and most valuation metrics are fair to generous at best. Emerging Markets (EM) have had a torrid five years (see comparative equity index chart below), particularly since 2013, where there has been a complete breakdown with the developed world – coupled with serious capital outflows. The currencies of both commodity exporters (including Brazil, Indonesia, Malaysia, Russia and South Africa) and large developing countries subject to rising political risks (Brazil, Russia, South Africa and Turkey) are all at multi-year lows vs. the US Dollar and in trade-weighted terms. The tide has certainly been going out for those mentioned twice above!
Until recently, the big exception to this pattern within EM has been China. This has much to do with the authorities’ own brand of quantitative easing (QE), the scale of which, since the global financial crisis (USD 15 trillion in 2013 alone), has made the US Federal Reserve, Bank of Japan and European Central Bank look quite pedestrian or cautious by comparison. While such numbers are difficult to comprehend, they are certainly easy to see in terms of their effect: the Chinese banking system has expanded 400% in the past 7 years, without any real bad debts or any non-performing loan (NPL) cycle.
A topic in Marc Faber’s Gloom, Boom & Doom Report of December 2015 was that ‘too much capital’ can destroy any good business plan. For example, ‘too much capital’ in the Technology, Media & Telecommunications sector in the late 1990s inflated prices to a bubble and ruined what were generally half decent business plans. In property, we see it all the time, where solid fundamentals and business plans get swamped by developers’ cash chasing the quick buck and eventually bubbles need to be deflated. In farming, good past milk or crop prices lead to everyone wanted to leverage up and take advantage at the end of the cycle. Perhaps one of the best examples is the reinsurance industry, where once no claims have been made for a cycle, everyone wants to invest in reinsurance, catastrophe bonds and the like, driving down premiums (and therefore returns) and decent business plans.
Surely China can be no different? All this capital or cash needed to be invested in the past few years, with central government encouragement and this has undoubtedly created some form of credit bubble in fast-growing companies and real estate. Chinese banks now have US$30tn of assets and a (reported) 1.5% bad debt or NPL ratio. If this increases to just 5%, that’s US$1.5tn and equivalent to half of China’s US Dollar reserves (!). As a random gauge, NPLs in Greece have risen to 30% amid its well-documented crisis. Now all that’s too large to sweep under the carpet, as may have been done in the past. As such it will be instructive to watch the US Dollar / Yuan rate for any signs of deterioration, as a sizeable chunk of the country’s reserves are invested in US Treasury Bonds. We should get a good buying opportunity this year.
The Danger of Too Much Capital