by William Smead, Smead Capital Management
Warren Buffett describes the stock market’s purpose as being “a wonderfully efficient mechanism for transferring wealth from the impatient to the patient”. We are reminded of this by a series of news reports and commentaries on subjects greatly influenced by basic economics. In today’s missive, we consider what the law of supply and demand says about China, oil, and housing in the USA.
Question number one: will China’s proliferating debt and Swiss cheese banking system lead to a deep recession/depression and economic cleansing in China?
In a recent report titled, Feeding The Dragon, GMO’s Edward Chancellor explains the frailty and danger in China’s financial system. Here is his list of problems:
• Excessive credit growth (combined with an epic real estate boom)
• Moral hazard (i.e., the very widespread belief that Beijing has underwritten all bank risk)
• Related-party lending (to local government infrastructure projects)
• Loan forbearance (aka “evergreening” of local government loans)
• De facto financial liberalization (which has accompanied the growth of the shadow banking system)
• Ponzi finance (i.e., the need for rising asset prices to validate wealth management products and trust loans)
• An increase in bank off-balance-sheet exposures (masking a rise in leverage)
• Duration mismatches and roll-over risk (owing to short wealth management product maturities)
• Contagion risk (posed by credit guarantee networks)
• Widespread financial fraud and corruption (from fake valuations on collateral to mis-selling of financial products)
At Smead Capital Management we believe it is not a question of whether China will face a hard landing, it is a question of when. Despite three-plus years of warning from Chancellor, Michael Pettis of Peking University, Jim Chanos, Andy Xie, and others, most investors in the US assume they are wrong or just ignore the risk. Such a myopic view brings to mind Federal Reserve Chairman Alan Greenspan’s 1996 remarks to The American Enterprise Group, where he warned that markets were suffering from “irrational exuberance”. He was referring to the building enthusiasm for tech stocks and the US stock market in general. The tech stocks and the S&P 500 index didn’t crack until March 10, 2000. However, it would have been wise to heed his warning; US Stocks suffered two 40 percent bear markets, a lost decade, and just recently approached early 2000 levels.
All uninterrupted economic booms culminating in unbalanced use of fixed asset investments have busted in recorded economic history. China’s version of economic boom will be no different, in our opinion. Standard and Poor’s reported on the $2.5 trillion of stimulus loans made by the four largest Chinese banks from 2008-2011. They estimated that 30 percent of those loans won’t be repaid. It means that $750 billion of loan write downs are attached to buildings and other infrastructure projects, which have little rent to service debt. If China’s four largest banks admitted their existing level of non-performing loans and marked them to the market, we believe they would have negative net worth already. It is interesting that when your regulator is your owner (the government), a blind eye is applied to delinquent loans and property with no rent to service your debts.
Question number two: Will a massive increase in oil supplies, record-setting gas mileage improvements in autos and China’s eventual bust cause a big decline in oil prices?