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Executive Summary
1. China’s local debt. China’s “wild west” financial system came to the country’s rescue in the period after the 2008–2009 financial crisis. Local governments provided the lion’s share of the stimulus, amassing huge, opaque debts in so-called “local government financing vehicles” (LGFVs). Through these off-balance-sheet debts, local governments could make up the difference between the social spending and infrastructure investments they needed to make, and the revenues they were able to generate. A recent analysis by S&P Global concluded that there is as much as $4.5–$6 trillion in these LGFVs, a potential source of severe financial instability. We’ve been pointing out the risk for years. These vehicles are thorns in the side of the central government not just because of destabilizing financial risk, but because they have been rife with corruption and have enabled theft by local officials. Still, there is no quick fix by which the central government can wind them down. The plan is for growth, economic transformation, and the gradually increasing tolerance of defaults, to allow a “soft landing” over a period of many years. This is another reason why maintaining growth is a paramount concern for the Chinese Communist Party. Pride and a desire for geopolitical power and prominence may make the Chinese government strike a tough public stance in the trade war. However, even as trade-war and growth pessimism rise in global media, investors should not forget that underneath, the Chinese are highly incentivized to make a deal that will support continued growth.
2. Norway planning to increase holdings of U.S. stocks. The Government Pension Fund of Norway is a global financial giant, with more than $1 trillion in assets, and owning about 1.3% of global stock market capitalization. The Fund has made several changes in recent years — increasing its equity allocation to 70%, ditching emerging-market bonds, and starting to divest from oil companies. The Fund’s manager has just made a preliminary report, indicating that in 2020 it will recommend that the Fund no longer tilt its allocation more heavily towards European stocks, but that it move towards a market weighting. Over the course of time, this could mean $100 billion flowing into U.S. stocks — particularly U.S. tech leaders.
3. Market summary. After the much-watched inversion of the two- to ten-year U.S. Treasury yield curve, financial news was full of recession talk. Over the recessions of the last half century, yield curve inversion has preceded the market top by a median 18 months, with a median 21.1% gain in that time. Although there has been a lot of variability, the initial 2/10 inversion is not an immediate call to “batten down the hatches.” Given the fundamental backdrop, we believe that investors should use seasonal volatility to add to stocks at more attractive prices. We continue to favor a barbell approach emphasizing growth stocks with secular tailwinds on one side, and high-quality dividend-yielding stocks on the other.
In spite of escalations and rhetoric, we do see powerful incentives for both Chinese and U.S. negotiators to reach a deal. We remind investors that they should not discount the possibility of sudden and unexpected progress. The risks are not all skewed to the downside, though that can be hard to keep in view when the media drumbeat turns negative.
We believe that investors should be giving strong consideration to their portfolio’s allocation to gold, gold mining shares, and silver. There are phases of the market cycle where a gold allocation is critical, and we continue to see signs that gold’s rally is responding to the first signs of a “change in the weather.” We believe that investors should use weakness to add to positions.
A Tale of Two Chinas
For the past year, concern about the intensifying trade war between China and the United States has gone hand-in-hand with concern about the health of the Chinese economy. China’s dramatic rise as an economic power over the past two decades, and the deep interdependence of the global economy, means that Chinese economic performance has global ramifications for investors. That in turn means that the health of the Chinese financial system is also a paramount concern. We’ve written about this subject many times over the past few years. Particularly since the 2008–2009 financial crisis, China’s economic progress — like that of many economies — has come at the price of a build-up of financial leverage. As it grows, such leverage eventually creates risks of instability, so we monitor it — trying to see the areas where excesses may result in another crisis.
One of the trouble spots in China’s financial system remains the country’s highly indebted local governments. This hidden leverage recently came to investors’ attention again after an S&P Global analysis suggested that these hidden, off-balance-sheet debts may total as much as $6 trillion. We have been monitoring this area for several years. We brought it to your attention in 2017 with the following background piece explaining where, how, and why this indebtedness has occurred. Given all the stresses and rhetoric of the current trade conflict, we are sharing it again, and updating the current picture.
China’s Debt Binge: What It Is, Where It Came From, and Why
Sometimes China has been a geopolitical boogeyman, with journalists fretting about China’s rise on the world stage and its potential to surpass the U.S. in military or economic power. We have thought those fears to be baseless and have said so for years. China has a long, long way to go before it will be able to challenge the hegemony of the U.S. either militarily or economically, even in its own back yard.
Conversely, it has sometimes been China’s weakness rather than its potential strength that has spooked western observers. The fear here is that China’s decades-long boom has been a powerful stimulus to the global economy, and if that boom falters, it would drag the global economy into recession. A related fear is that China’s boom has been built on unsustainable financial leverage — on a domestic debt bubble that will result in a severe financial crisis.
The Root of China’s Problems
Excessive leverage in the Chinese financial system is a problem, and the authorities know it. This is why they have been working to reduce it for years, though without much success. The Chinese economy has faded and revved again each time the authorities have clamped down, and then loosened up as they couldn’t face the political costs of really reining in the dangers.
China’s rulers have two basic problems. One of them is of recent vintage — it has come about as a result of the country’s phenomenal success in creating growth and alleviating poverty. The other problem is not just old, but ancient — it has been one of the key recurring themes that has shaped China’s history for thousands of years.
Problem number one: growth must be maintained at all costs, or those who have been left behind — the hundreds of millions who are still poor and have not been lifted into China’s middle class — could revolt and overthrow the current rulers. Maintaining growth is a matter of existential survival for the Communist Party. This is why they blink every time financial restraints threaten to slow economic growth too dramatically… and they end up putting the pedal to the metal once again, even as the eventual crash becomes more likely and more severe.
Problem number two: there is a basic conflict between the center and the periphery. A famous 14th century Chinese historical novel, the Romance of the Three Kingdoms, opens with the words, “The empire, long divided, must unite; long united, must divide. Thus it has ever been.”
Here’s how this ancient Chinese problem is currently manifesting. The roots of China’s financial instability lie in a struggle between the central government, which has most of the revenues, and local governments, which bear most of the burdens of social spending. Those local governments were also responsible for most of the funding of China’s post-recession stimulus package. This impossible calculus meant that they had to find money somewhere. They found it by creating opaque “local government financing vehicles” (LGFVs) whose structures and risks were unclear, but which offered attractive yields and a tacit guarantee that the central government would bail out investors. Local governments were not permitted to float enough legitimate, above-board bonds to meet their financing needs. Also, if they were transparent about their financial state, no one would want the bonds.
So local authorities have created much of the problematic leverage in China’s financial system — not just because they’re in an impossible fiscal situation, of course, but because opaque financing affords all the participants lots of opportunities for corruption.
Current Developments: Where Do We Stand?
The pressures which have led to the current worrisome levels of local debt are still at work. S&P Global’s analysis, which concluded that hidden, off-balance-sheet local government debt likely totals $4.5 to $6 trillion, shows that LGFV growth is decelerating in response to the government’s deleveraging efforts, but is still significantly larger than formal local bond issuance.
China is still between a rock and hard place, and with the trade-war related slowdown, the hard place has gotten harder. In the past, some hidden local debt was allowed to be converted into bonds; economic pressure makes that less likely now. Such a move would increase China’s formal, visible debt burden and further shake global confidence about China’s financial stability. That would work against the Chinese government’s big geopolitical ambitions. China will want to counter the trade war slowdown with stimulus… but with local leverage already so high, it will be hard to turn those taps on without raising the risks of a crisis.
As we noted in 2017, the government does not have an “exit plan” for the local leverage bubble, except to grow out of it, gradually allow debt to be restructured into formal local government bonds, gradually allow some LGFV failures to chasten the public’s expectations, and gradually guide the economy into greater reliance on the consumer sector rather than heavy fixed-asset infrastructure investment. Engineering this “soft landing” remains challenging and uncertain.
China may have a long-term view and long-term geopolitical objectives that sometimes make U.S. politics seem short-sighted. But we should not underestimate the near-term pressures China is facing. The long term will not arrive for the Chinese Communist Party if severe financial and economic disruptions lead to political instability. It’s for this reason that we continue to believe that the Chinese are highly incentivized to reach a deal with the United States. When that deal comes, and how much pain they are capable of enduring in the meantime, we do not know.
Investment implications: Hidden local-government debt remains a big problem for China and poses significant risks of eventual financial instability. The central government has no quick and clear path to deleveraging that debt and reducing the risk, but is relying on a gradual deleveraging path supported by economic growth and a gradual shift to a more mature, consumer-driven economy. That need for continued growth means that China is highly incentivized to make a deal that begins to resolve the trade war. On the other side of the table, we believe the U.S. administration is also highly incentivized to make a deal ahead of the 2020 presidential election, in spite of its long-held concern about Chinese misbehaviors. In an atmosphere of mounting pessimism about global trade and economic growth, we believe it is important not to lose sight of these major incentives to resolve the conflict. A partial but significant resolution would likely have a galvanizing effect on global markets.
Norway Moves To Increase U.S. Stock Holdings
The Norwegian sovereign wealth fund (formally, the Government Pension Fund of Norway) was established in 1990 to invest the surplus revenues of the Norwegian petroleum industry. With over $1 trillion in assets, heavily allocated towards equities, it currently owns about 1.3% of global stocks.
The Fund has undergone a number of changes recently, including raising equity holdings to 70%, eliminating holdings of emerging-market debt, and initiating divestment from oil-related stocks. (That may seem ironic, given the Fund’s origins in oil revenues, but it is probably both politically and economically sensible.)
Since 2012, the Fund has been structured to give greater weighting to European stocks than to other developed-market stocks (on the basis of Norway’s greater trade exposure to European companies). That means that it has owned fewer U.S. stocks than it would if it were structured purely on the basis of market capitalization. Last year, the Norwegian government asked the Fund’s managers to review this allocation, and two weeks ago, their preliminary report called for a shift away from the European overweight and to be adjusted towards market weights.
European stocks have underperformed the U.S. for some time, and the sector composition of European and U.S. markets has given the Fund less exposure to big, transformative secular growth themes, particularly in technology and communications.
The managers’ formal recommendations will come early next year, and that will probably result in a gradual influx of about $100 billion into U.S. stocks.
Investment implications: A shift toward market-weight allocations to global stock markets by the Government Pension Fund of Norway will gradually and incrementally increase demand for U.S. stocks — particularly for big-cap tech leaders.
Market Summary
The U.S.
After a somewhat volatile August, U.S. stocks remain in the trading range where they have been for the past several months, as trade worries converge with recession fears. After the much-watched inversion of the two- to ten-year U.S. Treasury yield curve, financial news was full of recession talk. We continue to point out that over the recessions of the last half century, yield curve inversion has preceded the market top by a median 18 months, with a median 21.1% gain in that time. Of course, these are median values; there has been a lot of variability. But the point remains that the 2/10 inversion is not an immediate call to “batten down the hatches.”
Until third-quarter earnings get underway, we will probably experience typical seasonal volatility. We believe that given the fundamental backdrop, investors should use such volatility to add to stocks at more attractive prices. We continue to favor a barbell approach emphasizing growth stocks with secular tailwinds on one side, and high-quality dividend-yielding stocks on the other.
Europe and Emerging Markets
High Brexit drama is already ensuing as the U.K. moves towards the current exit date of October 31. The drama is not highly relevant to investors. A no-deal Brexit, we believe, would provide a buying opportunity for the pound and possibly for UK stocks. But the outcome is highly uncertain; Paliamentary machinations are underway that would result in a further delay. A snap election is possible, which would present the possibility of a Labor government led by Jeremy Corbyn. That would certainly not be constructive for UK markets.
While the U.S./China conflict continues, emerging markets remain in limbo. There are many potential beneficiaries of an intensified manufacturing exodus from China, but the process of building up new supply chains would be prolonged and arduous.
As we noted above, we do see powerful incentives for both Chinese and U.S. negotiators to reach a deal, and in spite of the current apparent impasse, we remind investors that they should not discount the possibility of sudden and unexpected progress. The risks are not all skewed to the downside, though that can be hard to keep in view when the media drumbeat turns negative.
Gold
As we have written many times since last year, now is the time for investors to be giving strong consideration to their portfolio’s allocation to gold, gold mining shares, and silver. There are phases of the market cycle where a gold allocation is critical, and we continue to see signs that gold’s rally is responding to the first signs of a “change in the weather.” We believe that investors should use weakness to add to positions.
Thanks for listening; we welcome your calls and questions.
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Equities Contributor: Guild Investment Management
Source: Equities News
