Sticking with My Stock Overweight, But Recognizing the China Risk.

Nov 20, 2018 by Gary Gordon


For the last few weeks I have been obsessed with my “investor PTSD” theme and my Skinny Tail Investment Fund stocks – mortgage insurers, homebuilders and airlines.  But my stated purpose for this blog was to help you with asset allocation, or the stocks vs. bonds vs. cash decision.  So I’ll will tear myself away from my obsession and get back to my job, as it were.

Today’s most important economic chart.

My view remains that stocks should be over-weighted and bonds under-weighted.  That view largely hinges on the chart (in my all-seeing and all-knowing view), which shows private sector debt growth and recessions:

 

Sources: Federal Reserve, National Bureau of Economic Research

The last six recessions were all preceded by private sector debt bubbles that reached 6-10% real annual growth.  The excessive growth inevitably led to bad loans, bank credit restrictions and recession.  Today’s private sector debt growth?  2%.  Business debt growth is somewhat faster, consumer debt growth is slower.  As a result, bank loan losses are near historic lows and banks have little reason to restrain credit growth.  I therefore conclude that a recession is not in sight.  Without a recession in view, stocks nearly always outperform bonds.

This call may seem misguided to you because it feels like a recession is due; the last one was nearly a decade ago.  Certainly the media is nervous.  And the stock market has sucked for the past two months, which shows that investors are nervous.  But I’m not fighting the chart.  In fact, while year to date stocks (including dividends) are about flat (after assuming another ugly day today), an investment in a 10-year Treasury declined by 3%.   

The major fly in the ointment – China

Assuming that one chart is all you need to know to invest is certifiably crazy.  I know that; I’m not a complete idiot.  The biggest risk factor to my positive stock outlook is not U.S. debt, but rather China debt.

China is has been on a decade-long massive debt bubble, as this chart illustrates:

 

Source:  Bank for International Settlements

Yes, the US also grew its total debt to GDP ratio from 150% to 250%, but it took us about 25 years (1982 to 2007).  But China did it in less than a decade.  That’s one impressive bubble.

In my book Debt Cycle Investing I presented plenty of evidence that debt bubbles always burst.  If by some inexplicable chance you haven’t read it, common sense should tell you that bubbles have to burst.  “But”, you may be thinking, “China is in the midst of a transformation from a backward rural nation into a modern industrial and technological economy.  Why should the bubble burst?  Why can’t China just grow its way out of its debt burden?” 

Relevant history is the US during its similar industrialization phase from 1870 to 2010.  This chart tracks annual and trend (8 year moving average) real GDP growth during that period:
 

Source: Robert Shiller, cited by Measuringworth.com

Trend GDP growth averaged an impressive 5%.  Yay us.  Yet that boom included two depressions.  Why?  Because booms inevitably breed excesses.  Economic excesses typically show up in capital spending – housing, roads/rails, factories etc. (again, my book presents the evidence).  So let’s see if China has possibly overdone the capex thing:

 

Source:  World Bank

Yikes!  Other Asian countries that rapidly developed, like Japan, Korea and Vietnam, saw nothing like China’s 15+ years of 40% or more of GDP going to capital spending.  I’m sure you’ve seen the media stories, but here are two recent ones to illustrate the excesses:

“Soon-to-be-published research will show roughly 22% of China’s urban housing stock is unoccupied, according to Professor Gan Li, who runs the main nationwide study. That adds up to more than 50 million empty homes, he said.”  (Bloomberg, November 8, 2018)

 “Beijing is trying to kick its habit of using big-ticket infrastructure spending to fuel the economy, a turning point from a growth model that has left many Chinese cities adorned with empty high-rises and underused highways…Premier Li Keqiang told a recent state council meeting that relying on investment was an ‘old road’.” (WSJ, October 20, 2018)

Evidence that China’s bursting is in progress.

Two years ago, pointing out China’s debt excesses would have seemed misanthropic.  Not anymore; even its government is concerned:

“Beijing has begun trying to tamp down the borrowing, worrying that the debts of local governments—which are estimated to amount to 46% of the economy—are a long-term danger…The Finance Ministry has stepped up public naming and shaming of local governments…”  (WSJ, September 17, 2018)

To put that 46% in perspective, the US local government debt is only 15% of GDP.  And it’s not just local governments – Corporate China has been piling on the IOUs:

“China’s central bank is placing new regulations on the financial sector to tame runaway growth, beginning with five conglomerates including Ant Financial Services Group, as Beijing signals its resolve to curb risk even as economic growth slows.”  (WSJ, November 3, 2018)

Critically, investors seem worried by the expanding debt mound.  Fixed income investors show their displeasure by requiring a higher return on the debt:

“The average yield on Chinese dollar bonds in September was 6.1%, versus 4.7% in January, according to the Nataxis China Bond Index…The yield for junk debt was 8.1%, a high last seen in early 2015…”   (WSJ, October 18, 2018)

Tighter regulation and investor pushback are having an impact:

“Chinese banks extended $100 billion (USD) in net new loans in October, central bank data showed on Tuesday, much less than expected.”  (Reuters, November 13, 2018)

Finally, the government knows that slowing business and municipal debt growth will slow the economy, a scary thought even to a dictatorship.  So it appears that the final debt card is about to be played:

“Beijing could enact tax cuts and other measures for 2019 equivalent to over 1% of GDP, according to Ma Jun, a former chief economist at China’s central bank.”  (WSJ, October 25, 2018)

What I don’t know.

The obvious conclusion is that China’s debt bubble is near an end, with dire prospects for its capital spending and GDP.  A recession, even a serious one seems to be in order.  But I can’t answer two other critical questions:

  • When?  Yes, the prognosticator’s most dreaded question.  Human failings cause debt bubbles; human ingenuity has learned how to delay their consequences.  China is apparently already planning one delaying tactic, namely tax cuts.  Likely also are the various monetary ploys of lowering interest rates and quantitative easing.  See Japan for the playbook.  So when could still be years away.
  • What will be the impact on US stocks?  China in recession will clearly reduce US exports and will take a toll on the profits of US companies doing business there, which is a lot of companies.  It is hard to balance the good news of a strong US banking system with the bad China news.

Wrapping up…

My answer to these conundrums is to:

  • Overweight stocks, but also cash.  My suggested stock weighting is 70% versus a 55% norm, but my cash weighting is 25% versus a 10% norm.
Favor safer stocks.  Don’t chase growth.  My Skinny Tail Investment Fund includes only seriously out-of-favor stocks.  They average a 14% earnings yield.  Beats a 3% 10-year Treasury bond yield, no?