Originally published August 27, 2018
I simply don't trust the fundamentals of the global economy right now. The system is built on quicksand.
Debt is growing globally and governments are running huge deficits while interest rates are still incredibly low. Looking at almost any metric, stock markets have been more expensive once in the last 100 years - just before the dot-com bubble burst. There is also another risk in a category of its own: China.
A recent Bloomberg report on Chinese real estate noted that from June 2015 through the end of last year, the 100 City Price Index, published by SouFun Holdings Ltd., rose 31% to almost $202 per square foot. That's 38% higher than the median price per square foot in the U.S., where per-capita income is more than 700% greater than in China.
This China story gets more interesting. Most of these apartments are sitting empty because they are purchased as investments. Rental yields in China are 1.5%, while the cost of borrowing (mortgage cost) is around 5%-6%. Chinese consumer debt-to-GDP is much greater than it was in the U.S. during the 2008-09 financial crisis.
Since household real estate lending is 22% of Chinese banks' assets, if you are the almighty Chinese government, you have a decision to make: Do you let real estate prices normalize (decline) and then suddenly discover that your financial institutions are bankrupt, or do you allow (and actually support) the inflation of housing prices?
Predictably, as the Bloomberg report relates: China is ramping up development, and rather than curtail leverage, banks are jumping into the speculative real-estate bubble: mortgage growth is now at 20%.
Which brings me to one of my all-time favorite books, "Margin of Safety," by investing legend Seth Klarman, who writes:
There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don't understand. These are not eating sardines, they are trading sardines."
Applying this to China, when an apartment becomes an unoccupied asset whose sole purpose to be used as a investment or speculation, it turns into a trading sardine. Its price will rise until - nobody knows; but at some point someone will metaphorically open that trading can and Chinese real estate prices will collapse, bringing the banking system and the nation's economy down with them. Simply put, things that cannot go on forever don't - it just feels like they'll go on forever while you're waiting for them to stop.
Today's global investment environment is a game of musical chairs. Investors are up and marching along because the music is playing, hoping they'll be able to grab a chair when the music stops (few will do so). Accordingly, I am investing as if the music might stop any second.
Over the past 10 years it has not paid to be cautious. Low interest rates drove prices of almost all assets higher. Pricier assets made people feel wealthier and thus magically created economic growth. Low interest rates also pushed people into riskier assets, thus creating a mismatch between the assets people hold and their true risk affordability and appetite.
So far, none of this has mattered - the more risk you took, the more money you made. It will matter when risk gets ugly, because investor reaction to it will be more irrational than usual. This is why my firm hedges our portfolios through put options.
The problem with an economy being propped up by artificially appreciated assets is that this pendulum swings both ways. At some point, prices will decline. No one knows what will cause the decline - maybe higher interest rates, maybe a presidential tweet, maybe the implosion of the Chinese economy, or maybe just because stock markets and real estate prices don't grow to the sky. Or it could be triggered by something completely unseen today.
What is clear is that since interest rates are low and global economies are highly leveraged, central banks and governments will not have as much power to help.
This is one reason why my firm's portfolio holds a lot of healthcare stocks, including Walgreens Boots Alliance (NASDAQ:WBA). Healthcare companies have great balance sheets; their business is not cyclical (the demand for its products doesn't fluctuate with the whims of the global economy); and there is a huge tailwind behind their backs in the form of the aging global population. Moreover, many of these stocks trade at highly attractive valuations.