Absolute Return Partners August/September 2015 letter titled, "Doodles From An Eventful Summer."
“There is something deeply troubling when the unthinkable threatens to become routine.”
Bank for International Settlements
Absolute Return Partners: Incidents of the summer 2015
This month’s Absolute Return Letter is a little different. I usually pick a particular subject and discuss it in great detail. However because of the host of issues which popped up over the summer while I took some time off from writing, I will comment on more than I normally do. I apologise in advance if you find my commentary somewhat superficial as a result.
Not only is the style a little different this month. It is also published earlier than usual. There is only one reason for that and that is the recent turmoil in global equity markets which I will certainly comment on.
Rarely have I experienced a summer so full of dramatic incidents. As I go through them one by one in the following, you will see what I mean. Most of the drama unfolded in June and July, but equity markets didn’t seem to notice until mid-August, and then behaved very erratically.
One of my favourite reads is The Credit Strategist by Michael Lewitt. When he published his July letter in early July, he couldn’t quite understand the audacity of the major equity markets around the world which, at that stage at least, chose to ignore the drama unfolding around them. I cannot resist the temptation to quote Michael:
“Please tell me this is all a nightmare and I am going to wake up to the visions of Goldilocks that I keep reading about.”
In addition to his formidable writing skills, Michael is known for his bearish bias but, over the years, he has been more right than wrong, which is why you would only ignore him at your own peril.
Michael wrote the words I quoted above in response to a succession of incidents which unfolded over the early summer months:
- China experienced one of the most dramatic corrections ever when the Shanghai Shenzhen CSI 300 Index lost more than 30%.
- Greece endured a real rollercoaster of a summer, one minute being ‘rescued’ only to fall to new depths the next.
- Puerto Rico went bust. Although bankruptcy has not been officially declared, few would argue that the country is not effectively bankrupt.
- Ukraine balanced on the verge of full blown civil war.
- The Middle East spun further out of control.
- Oil and other commodity prices fell significantly.
In addition to this unpleasantly long list of hiccups, a few other things happened which I will also comment on. Firstly, the Bank for International Settlements (BIS) published its 85th Annual Report, which is a must read for everyone in our industry and, secondly, I came across new evidence to support my long standing bullishness on the U.S. dollar, but more about that later.
Finally two of the grandest in our industry – Jeremy Grantham (founder of GMO) and Bill Gross (now of Janus Capital but for many years of PIMCO) – decided in early August that the summer was over, at least as far as they were concerned.
First Jeremy Grantham went public with a statement saying that equity market are ripe for a major decline in 2016. Only a few days later, Bill Gross did his utmost to outflank his ‘rival’ by saying that the world is lurching dangerously close to outright deflation. Both of those statements deserve a comment as well.
Absolute Return Partners: China misunderstood
Let’s begin in China. Between the 8th June and the 8th July Chinese equity markets went through a rather dramatic correction with the CSI 300 Index falling over 30%, prompting some to argue that it was the sign of a hard landing to come.
I don’t think so and will explain why but, before I do, I probably need to explain what the credit impulse is. The credit impulse is a term coined by Michael Biggs, then an economist at Deutsche Bank, when in 2008 he defined it as the change in new credit issued as a % of GDP. He showed that, in most countries, private sector demand (C+I) correlates very closely with the credit impulse and he argued that the important credit variable in terms of forecasting GDP growth is the change in the flow of credit, not the change in the stock of credit. When you look at chart 1, it is hard to disagree with him.
Chart 1 dates back to 2008, which is not ideal; however, it does offer an unprecedented illustration of the unusually strong link between the credit impulse and domestic, private sector demand (which is highly correlated with GDP growth). Later on in this month’s letter I will look at how the credit impulse has performed more recently.
The reason all this is important as far as China is concerned is that the most recent reading of the credit impulse in China is not consistent with a hard landing. Although the reading did weaken months ago, it has actually strengthened marginally more recently (chart 2). I obviously cannot guarantee that the numbers haven’t been fudged but, assuming you can trust the stats, the Chinese economy is not likely to tank anytime soon. Something else must be driving the fall in Chinese equities.
What could that be? Have China’s banks over-extended themselves more recently? Central planning or not, as we all learned in 2008, a surge in shadow banking can lead to terrible things. Official bank assets in China have grown 3.4-fold since 2008 (from 200% to 290% of GDP), whilst shadow banking activities (off balance sheet lending) have grown 12-fold from just a couple of percent to about 25% of GDP. And the rapid growth in lending activities since 2008 has happened almost exclusively as a result of increased leverage in banks and not because savings have risen.
In fact, according to the People’s Bank of China, so much lending is not classified as lending in China that (i) official loan-to-deposit ratios dramatically underestimate real lending activities, and (ii) one should look at assets instead to obtain a more correct picture.
Or is it much simpler than that? The Chinese affinity for gambling is widely known and is tempting millions of Chinese to the casinos in Macau every year. This has been going on for many years and is not new. What is new is that gambling revenues in Macau have collapsed more recently, while the number of new brokerage accounts have exploded as Chinese equities have soared (chart 3).
I am no expert on China, but it is very tempting to conclude that the Chinese gambling spirit has simply migrated from Macau to Shanghai. The combination of a slowing economy and over-extended banks may have started the sell-off, but the rapid growth in investor participation and the widespread use of leverage may be the true explanation why it has gone as miserably as it has. I will leave that conclusion to people with a better understanding of China than me, though.
Absolute Return Partners: Greece on the run
The month of August has certainly been a bit quieter than June and July were as far as the Greek spectacle goes, but the bad taste in my mouth has not yet disappeared. And, unlike all of those who have criticised the creditors, and in particular the Germans, for being far too harsh on the Greeks, I take the opposite view. Yes, I do feel terribly sorry for all those poor souls in Greece who got caught up in this tug of war through no fault of their own, but the sad reality is that the country as a whole has lived well beyond its means for many years, and you cannot blame the creditors for putting a stop to that – however painful it is.
See full PDF below.