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.

Wednesday, April 27, 2016

The Condensed Wealth of Nations

I recently read a condensed version of the Wealth of Nations. The book was written by Eamonn Butler and published by the Adam Smith Institute. I wanted to read the original but it would have been a challenge given its epic length and older language.

This condensed version was excellent. It captured the key points of the original such as the specialization of labour, benefits of trade, role of the invisible hand and others while using modern day vocabulary. For example, capital is used instead of "stocks" as in the original. To enhance your understanding and provide a flavour of authenticity, the author also included some of the Adam Smith's well-written prose.

One point I found especially interesting was Adam Smith's writing on wealth and money. In his days, most people believed in mercantilism and that wealth is derived from the amount of "money" (aka gold or silver). This of course led to hoarding and trade restrictions. Countries didn't want their gold leaving their borders. Adam Smith accurately noted that wealth comes from the value of the products and services that someone produces. Money was just a way to measure that wealth and to make transactions more efficient. (Rather than having to barter all the time.)

The irony is that, some 200+ years after this book, in an age of fiat currencies, many people and countries continue to believe in mercantilism.

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?

Monday, April 18, 2016

Spy the Lie: Three Former CIA Officers Reveal Their Secrets to Uncloaking Deception

As the title suggests, this book was written by three former CIA officers trained in polygraph testing and interrogations. They've developed a technique to help you detect deception and potentially uncovering the truth by asking the right questions and listening for certain responses.

The conventional wisdom is that you should be looking at the subject's global responses, such as how their eyes move, how they sit, the manner of their speech, to determine whether they are telling the truth. The author's suggest otherwise. That's because most people have idiosyncratic behaviour so responses to questioning vary widely. A lot of these behaviours tend to be "noise" instead of "signal".

Instead, the authors focus on the contents of the answer along with a narrow set of behavioural cues that are correlated with deception. The key is to look for a "cluster" of these deceptive responses and behaviours following a question and to continue with the line of questioning until you reach the truth.

Interestingly, I found that their method has similarities to investing. Sometimes, it may be better to focus on the key drivers of an investment thesis than to look at every aspect. By tuning out the "noise", it might make it easier to identify good investments. This could also be part of the reason so many research analysts can know so much about a company but not know whether it's a good investment or not.

Finally, while reading this book made me aware of the techniques, I am far from becoming a lie-detector. Achieving that type of competence will require years of training and practice. Again, more similarities to investing.

Friday, April 1, 2016

How to Fail at Almost Everything and Still Win Big

This is a fun book by Scott Adams, the creator of the Dilbert comic strips. The book is meant to provide some meaningful and practical advice for success and share some of the author's experiences.

The big emphasis was on using a system rather than setting goals to achieve success. A system is similar to a set of routines or "best-practices". By having a good system, success will come to you. For example, rather than setting a goal of "good health", you should create a system where you have to exercise actively. This way, you ensure that the goal is achieved without even intending to do so.

The book also has many practical life advice, such as improving your personal energy through diet and exercise or learning a list of necessary skills (ex. learning basic psychology, writing, communication, etc.) to improve your odds.

Surprisingly, I found a lot of the advice is relevant for the investor. As an investor, your personal abilities are critical to investment success. The book has helpful tips on increasing personal energy. The most important of which is to have systems that enhance your diet, sleep and exercise. Having more energy can potentially help enhance investment results through clearer thinking and better research stamina.

In addition, investing is a highly process/system driven activity. Having goals, ex. "achieving xx% returns" can be detrimental since you can't control how markets behave over the short-term. By sticking to a good system, ex. buying stocks at a discount to NAV, you are more likely to achieve investment success over the long-run.

I did find that some advice, for example, "affirmations", strayed a bit into the superstition. His constant emphasis on the "diversity ceiling" and ability to self-diagnose and cure some of his diseases are also somewhat hard to believe.

That said, most of the advice was useful. A lot of was just common sense, but some would call it wisdom. After all, common sense is almost an oxymoron in real life. After reading the book, I've created a long list of things to do/learn. Time to get started.

Analyst