Thursday, January 25, 2018

Crawford & Company: 2-Year Update; Slow But Steady Progress

We recently posted an update on a company that we've followed for a while, Crawford & Company. The turnaround has made substantial progress in reducing costs. Overall revenue growth continue to be tepid as growing business lines are offset by declining ones. We think it'll still take more time for the CEO to make more progress on improving sales. Read more on Seeking Alpha..

Monday, December 12, 2016

What's going on in China?

I'm not a macro follower, but the current situation in China is interesting.

Following years of trade surplus, China has accumulated the world's largest stockpile of foreign currency reserves. At its peak in 2014, China held almost US $4 trillion of reserves. However, over the last two years, reserves have declined to $3 trillion.

This could be caused by a combination of weaker trade flows, stronger US$, and major capital outflows. Since China is running an annual current account surplus of over $500 billion, capital outflows may have exceeded $1 trillion annually over the last two years. Should this continue, China's reserves would be depleted in only a few years. The decline in reserves has also affected the RMB which fell from a peak of 6 RMB/USD to 7 RMB/USD today.

China seems to be aware of this and has taken action to clamp down on outflows by reinforcing capital controls. New measures included banning large overseas M&A, clamping down on dual currency credit cards, stopping large cash transfers, etc.

See: What China has done to stop massive amounts of cash from fleeing the country

One has to wonder how effective these controls will ultimately be in such a large economy.

Why is this happening anyways? I think there may be two reasons, both of which are driving down returns of domestic RMB assets. As returns decline in China, it makes sense to sell RMB assets to invest overseas.

1) China is in a real estate bubble fueled by massive credit expansion
2) Over-investment in fixed assets and a slow economic transition to consumption-based economy

In China, the lack of investment options forces savers to invest in ever greater quantities of real estate, driving prices up and returns down. This has become a Catch-22. The country is wary of letting prices drop, which may lead to mass unrest. Yet, elevated prices cause poor capital allocation to proliferate.

At the same time, outflows will likely continue as long as the huge pricing discrepancy exists between domestic Chinese assets, like Tier-1 city real estate, and foreign assets. Why hold real estate in Shanghai at a large premium to prices in the US or Australia or Canada?

It's hard to say how this will end. China's response seems to be to clamp down on outflows and adjust the currency downward to sustain exports. The reserve figures and exchange rate suggests this may not be enough.

The consensus is that China is led by extremely capable leaders and has multiple levers to control the economy. This may or may not be true. If that was the case though, how did China end up in this situation in the first place?

Thursday, October 13, 2016

Canada's Policy Dilemma

You may have seen on the Toronto / Vancouver Housing page that home prices in these two cities have increased rapidly. Home prices are likely fueled by a combination of very low interest rates, loose lending standards and greed/reflexivity.

As home prices (and household debt) reach stratospheric levels, it becomes clear that any interest rate increases would strain the entire system. The authorities now face an interesting dilemma. On the one hand, a weak economy and low commodity prices need support from lower interest rates. Meanwhile, prices for certain asset classes like residential real estate have increased steadily. (Or dramatically, in Vancouver and Toronto.)

To a certain degree, higher prices (due to low rates) make sense. The carrying cost of a large mortgage at low rates is similar to that of a small mortgage at high rates. There are two fears though. One is when rates increase. The second is whether the principal repayment is at risk as mortgages get ever-larger and incomes remain stagnant.

Recently, the government stepped in with a series of targeted measures to slow price increases. The new rules were largely aimed at closing tax loopholes on foreign buyers and increasing requirements for mortgage insurance. Pushing more risk from the government-owned mortgage insurer onto private lenders should improve lending standards.

There is a certain irony to these measures though. If they work as intended and residential real estate activity decline to normal levels, the Bank of Canada may have to cut rates further to juice the economy.

Sunday, June 12, 2016

Lower Bond Yields, Lower Earnings, Higher Equity Prices?

Another sign that I have no idea what's going on with Mr. Market these days (or ever):

Bond prices continue to go higher, driving yields lower. Some are already trading with negative yields. This might be due to central bank influence, general risk-aversion, or lower inflation (or growth) expectations or a combination of such.
Corporate profits continue to drop. The latest figures show that trailing-twelve month profits peaked at 106 in Q3 2014. Most recent figures were ~86.5 for Q1 2016. That's close to a 20% drop.
On the other hand, US equity markets are making new highs. Looking at the S&P 500, you wouldn't have noticed the decline in profits. In fact, since Q3 2014, the S&P has actually gone up another 100 points or so, gaining well over 5%. Equity markets seem to believe that either discount rates will go lower, or earnings have stabilized and will rebound from this point. (Both of which are possible.)

One explanation might be the central bank's actions pushing investors toward riskier assets. Holding all else equal, this make sense. By effectively reducing the risk-free rate, and hence, discount rate, asset prices should go higher.

In this case, however, all else may not be equal. That's because the reason for all this monetary stimulus is that economic conditions are weak. So while discount rates are lower, the expected earnings growth may also be lower. Given the two adjustments, it's unclear to me whether equity prices should be higher, lower, or flat.

Sunday, April 24, 2016

Another Global Housing Bubble?

In 2007, excessive debt led to a housing boom and bust of extraordinary proportions. Household debt in a handful of countries peaked in 2007, at the height of the boom. The countries (ex. US, UK, Spain) that went through the crisis have somewhat de-levered their household balance sheets. Household in many other countries, unscathed by the crisis, have continued their relentless borrowing.
For example, Australia, Canada, Norway and Netherlands have household debts far higher than the U.S. at its peak. There are likely structural differences for the different levels of debt such as regulations, lending practices, interest rates, etc. But how much is too much? At some point too much debt will increase the risk to the entire financial system. One argument for higher debt is that interest rates remain low. The servicing costs of debt is relatively stable despite much higher borrowings. On the other hand, household debt is typically used for consumption or to buy a house, not the most productive use of capital given the low returns on rent. As more and more money gets tied into illiquid, unproductive assets, who ends up paying off the debt? Will the principal ever be repaid?

Even as the world recovery remains tepid, the housing markets in many of these countries caught on fire, fueled by debt-driven demand. Take Canada, a country whose economy is closely associated with the U.S.. With commodity prices facing severe overcapacity and weak export demand, the country's GDP growth has been weak. Yet, housing prices in the country's two main cities, Toronto and Vancouver, have been extremely strong with prices growing by double-digits year-over-year.

Foreign demand has certainly played a role in driving up prices. Yet, it's probably disingenuous to attribute all of the price action to foreign capital. Just looking at the base rate, with millions of households in these two cities, the prime buyers of Vancouver and Toronto real estate remain the residents of these cities. But how can locals afford ever increasing prices with relatively stagnant wages? Hint: credit growth. Consumer in Canada has continued to grow at around 6% annually, or double the rate of GDP growth mainly due to lower interest rates. As such, the carrying costs of owning a house in these two regions have been relatively flat despite the higher debt levels. The question remains, unless wages pick up significantly, how will people afford to repay the debt?

I suspect that, most probably won't. The repayment of debt will likely be shared by society. At some point, too much debt changes from a household problem to a systemic problem. (They will in the traditional sense, but because their wages got a boost from higher inflation.)

In Canada, around 50% of mortgages (mostly high LTV) are insured by the CMHC, a government entity. Mechanism like these help de-risk the system in the event of a financial crisis. However, it means that the costs of a potential debt crisis will be borne by all members of society.

The fall-out will likely be even lower rates and a depreciation of the currency, which decreases real purchasing power so that nominal wages can stay flat or rise moderately. Or higher inflation to boost nominal wages, even as real purchasing power stays flat, which will erode the value of liabilities over time.

This leads to a dilemma for the investor. Do you remain financially prudent even though you will borne the costs of society's excessive leverage, or do you become financially imprudent to try and benefit from the eventual fallout?

Friday, March 25, 2016

Quantitative Easing and High Asset Prices

As you are aware, since the global financial crisis, central banks around the work have embarked on an unprecedented amount of monetary easing. During the crisis, a shortage of liquidity in the financial system caused central banks to step in with monetary stimulus to provide liquidity and restart the financial system.

The global economic shortly fell into a severe recession, which was followed by increased monetary stimulus to try to increase nominal growth. Political gridlock surrounding fiscal stimulus and structural reform has made it extremely difficult to ease economic conditions on that front. This became part of the reason for continued and increased monetary stimulus.

Monetary policy was aimed at lowering interest rates, ideally below the rate of inflation/nominal growth, (ex. 10Y German/Japanese Gov. Debt) which increases asset prices (ex. S&P 500) and pushes investors into riskier assets. By elevating asset prices, the idea was that, it will repair overly-indebted balance sheets and force investors to consume or invest in the real economy.

Interestingly, while asset prices have continued to rise, economic activity has failed to match its pace. There's probably a lag between monetary stimulus and real "main street" economic activity. After 7 or so years, you have to wonder whether things are working and when activity will truly pick up.

I also wonder, whether there are negative aspects to the distorting effect of elevated asset prices. One potential pitfall may be the creation of asset bubbles. There's already plenty of talk of extreme housing prices in many parts of the world including Hong Kong, Sweden, Canada, Australia, etc. Would a negative feedback loop also exist? For example, as expected returns from assets become lower (due to the elevated prices), people may try to save even more in order to have enough for their retirements. Secondly, stimulus works to generate demand, but it may also have a supply-side effect. Lower rates may stimulate more output and capacity than demand.

Another question is whether central banks can continue easing. In a recent G20 speech, Mark Carney, Governor of the Bank of England made a few points that I'm would like to emphasize here:

"However, the effect of QE on the wealth channel cannot last forever. Monetary neutrality means real asset prices are not boosted indefinitely by such policies; their economic effects must ultimately unwind."

"Said differently, unless an improvement in fundamentals boosts the underlying cash flows of these assets, real valuations will fall back. That structural policies have not boosted real growth sufficiently is a better justification for the re-pricing in risk markets than any loss of confidence in the power of central banks."

This puts the investor in a tough spot. Some central banks have hinted that they will support asset prices until economic fundamentals pick up and start to reflect the elevated asset prices. Yet, if fundamentals remain weak over extended periods, the market may adjust downward regardless of central bank support.

You have to make the choice of either:
1) Purchasing expensive financial assets due to explicit central bank support, but face the risk of central banks withdrawing support, or real growth failing to pick up.
2) Not purchasing expensive financial assets, but face the risk of continued asset price appreciation and miss out on a potential recovery. And also, potentially unfavourable movements in inflation or currency as monetary policy flows through these other channels.

Not sure, what the best choice is. This post really raises more questions than answers.


Monday, December 28, 2015

Crawford & Company: Cost-Cutting Unleashes True Earnings Potential In 2016

We recently posted an investment report about Crawford & Company for SeekingAlpha's Best Ideas for 2016. Here's a synopsis:

Crawford is our best idea for 2016. Weak performance over the past two years has depressed share prices. The newly appointed interim CEO intends to remove almost $50 million in mostly redundant costs that will substantially improve the company's bottom line in 2016. Shares could be worth up to 100% higher as the market prices in the improved cost structure and profitability.

Read More on SeekingAlpha..

Happy Holidays!