“When the going gets weird, the weird turn pro” Hunter S Thompson, Fear and Loathing on the Campaign Trail ‘72.
What is a market?
There is a tendency among observers to see financial-market outcomes as the result of the innumerable decisions made by fundamental investors. Securities deemed to be trading at a price above their fundamental value are sold, while those securities deemed to be trading below their fundamental value are bought. It was the approach espoused by Benjamin Graham, made famous by Warren Buffett and subscribed to the world over.
For a moment, consider what a market is and how it operates. In the most generic terms, a market is a place where people go to do business. Buyers and sellers transact, and the price moves to facilitate the greatest volume of business. As the market auctions higher, it will eventually reach a price too high to facilitate trade. Buyers then step away and sellers step forward, and the price stabilises before declining in search of a level at which buyers and sellers will once again transact. The obverse is true in selling auctions.
Financial markets, in their essence, are exactly the same as any other market. In today’s financial markets there are many approaches to determining whether to buy or sell a security. As such, it is wrong to interpret financial-market outcomes as indicating the aggregate opinion of fundamental value. Rather, they are simply a function of the aggregate supply and demand at each price.
The supply of securities is determined by companies and governments, changing through time as these institutions issue and repay obligations. The demand side, however, is more opaque. Intuitively, the demand for securities comes from savers: those who refrain from spending all of their current income can use the surplus to invest in the hope of earning a return that will increase the purchasing power of their savings. This applies not only to individuals but also to companies and governments.
But in recent decades there has been another more and more important source of demand: it has become increasingly common practice to use leverage to increase exposure to financial securities. The ways in which this has been made possible range from hedge funds accessing a line of credit from a prime broker to institutional investors taking exposure through futures and the use of options. Over time, this practice has also become increasingly accessible to the retail investor.
For several decades there has been a secular increase in the demand for financial assets, not only owing to a growing pool of savings but also because of the increased use of leverage to increase exposure to financial securities. This long-term increase in demand could not have happened without a corresponding decline in interest rates. Directly, lower interest rates reduced the cost of using credit to increase exposure to financial securities, thereby reducing the hurdle rate for using leverage. Indirectly, the decline in interest rates has coincided with historically elevated rates of bank credit growth, which has translated into an increased pool of aggregate savings.
In recent decades, far more often than not, the demand for financial assets has outstripped supply. It should come as no surprise then that, almost without exception, the aggregate price level of financial assets has continued to increase. This has gone hand in hand with a continued expansion of valuations, whether price-to-earnings multiples, price-to-sales multiples, or bond yields. It has also affected non-financial assets, with a steady rise in house prices as a multiple of average incomes. From this perspective, the secular advance of asset prices is in large part a function of a secular expansion of liquidity which, in turn, has been dependent on falling interest rates. But what happens if rates stop declining?
Coming to the boil
Energy prices were in the spotlight for much of 2021 as coal, liquefied natural gas and power prices reached all-time highs, while the oil price reached levels not seen since 2014. This coincided with power rationing, blackouts and factory shutdowns occurring in China and Europe, with impacts on supply chains from food processing to the transport of goods and fuel deliveries.
Tightness in energy markets appears unlikely to go away any time soon, and governments have been stepping in to deal with the issue. Spain, for example, announced a windfall tax on utilities and a cap on consumer bills. Similarly, Italian prime minister, Mario Draghi, announced that his government would subsidise consumers’ energy bills. A number of factors have contributed to the spike in energy prices, from supply-chain disruption, years of subdued capital expenditure and geopolitics, to the impact of the move to green energy sources.
However, other commodities have come under pressure in recent months. Iron ore, for instance, experienced significant downside volatility as markets were gripped by concerns over the impact of developer Evergrande’s debt crisis and the broader Chinese property sector, as well as the Chinese government’s continued push to move its economy away from debt-driven construction towards consumption.
Having led the global economy out of the 2020 recession, China struggled to maintain its standing with investors over the course of 2021. In particular, equity investors have become increasingly frustrated as various high-profile businesses and industries have been subject to a tightening of the regulatory screws. The most conspicuous crackdown has been the antitrust investigations into China’s large technology companies, including Tencent and Jack Ma’s Ant Group which owns Alipay, an app that has more than one billion users. Meituan, Huarong Asset Management and the entire online education industry have also been the focus of regulators. It is possible to explain each in terms of idiosyncratic factors but there does appear to be a common thread: any institution that is deemed to wield too much power and influence, or is at odds with the Chinese Communist Party (CCP) or its objectives, is at risk. It has become increasingly clear that the ultimate objective is that of common prosperity.
The goal is to create an olive-shaped society with a wide middle class and few at the extremes of wealth or poverty. By distributing wealth more evenly, the CCP hopes that more Chinese will have the spending power to drive the economy and reduce China’s reliance on Western capital and know-how, creating the foundation for a new stage of growth. The CCP has had phenomenal success at raising living standards in recent decades, but with economic growth moderating, social pressures are increasingly coming to the fore. Many young Chinese feel that upward mobility is diminishing. Well-paying white-collar jobs can be hard to find, which is increasingly problematic for a well-educated workforce. Despite an end to the one-child policy, many families feel they cannot afford to have more children, adding to a looming demographic crisis. As Xi Jinping told officials in January: “Achieving common prosperity is not just an economic issue; it’s a major political matter bearing on the party’s foundation for rule. We cannot let an unbridgeable gulf appear between the rich and the poor.”
And so, as economic growth slows, Beijing is seeking to restructure China’s economic model for a third time in as many decades. The economic and market consequences of any pivot are likely to ripple across the globe for years to come.
It is probable that we have already begun to see the consequences of China’s shift in policy objectives in the rapidly declining fortunes of Evergrande. Evergrande has been the biggest player in the biggest industry sector in the second-largest economy in the world. As such, it was the poster child for the rapid growth of China’s property industry.
Real-estate investment is, and has been, a very important driver of the overall Chinese economy. It has grown from a 5% share of GDP in 1995 to over 13% in 2019, of which over 70% is residential. Incorporating industries downstream and upstream of real estate, the sector makes up 29% of Chinese GDP (comparable internationally only to Spain and Ireland before the global financial crisis) according to Peak China Housing, Rogoff & Yang, August 2020. In the years following the financial crisis, the property market has been the fulcrum of China’s economic cycle. The government has intervened numerous times to influence the residential real-estate market. Using tax, mortgage rates, mortgage quotas, controls on secondary-market listing prices and other tools, it has attempted to steer the residential property market between boom and bust.
It is increasingly clear, however, that Beijing is unwilling to pump the property sector to fuel economic growth. Since 2017 the consistent message out of Beijing has been that houses are “for living in, not speculation”. This is not only consistent with the theme of common prosperity, but also the stated objective of reducing leverage and financial risk. In 2020, the People’s Bank of China and the Ministry of Housing imposed three red lines on property developers that required them to control their debt levels. Evergrande remains firmly in the red group.
For many years, investors have worried about the imbalances and latent risks brought about by the rapid growth of China’s property industry and the credit expansion that has underpinned it. While we have concerns about the risks latent in China’s bloated aggregate balance sheet, we do not yet see evidence that Evergrande’s problems are translating into rising systemic risk. Beijing has form with respect to dealing with credit issues, and at the time of writing, it appears to be managing the situation. There will, of course, be losses, but the bigger question relates to the broader market and economic consequences of Beijing’s pivot away from using the property sector to manage economic growth.
Shifting tectonic plates
In recent years we have regularly noted that the consensus that prevailed before the global financial crisis across much of the world with respect to how economies and financial markets should be managed is being steadily eroded. China always stood apart from this consensus but nevertheless became increasingly integrated into the global economy and financial system through its period of rapid economic growth after joining the World Trade Organisation in 2001. With the shift in China’s policy objectives – in particular as it no longer appears to be using the property sector to manage economic growth – it is increasingly probable that China’s economic growth will slow significantly from here.
China has been the main driver of global growth since the global financial crisis, so a sustained slowdown there will affect global growth and the fortunes of many companies around the world, both directly and indirectly. As such, investors can add the evolution of China’s economic model to the list of factors with which they must grapple.
The rapid expansion of bank credit has led to China accounting for over 50% of the increase in the world’s money supply in US-dollar terms since 2009, thus making it the primary source of incremental liquidity. The impact on assets over this period has been clear, with Chinese individuals and institutions major buyers of everything from property and global equities to fine art and cryptocurrencies. A slowdown in China’s credit growth will see its contribution to the secular bid for assets wane. It will also affect non-financial asset prices, with China by far the largest consumer of many commodities.
The first-order effect of a slowing China would therefore appear to have the potential to be disinflationary. However, the erosion of the pre-financial crisis consensus has played out in the form of a move towards increased government intervention within economies in the West, a willingness to use central-bank balance sheets to finance fiscal deficits, and growing apathy towards globalisation in favour of national interests. Taken together, these developments are likely to lead to higher inflation over time, and it is probable that slower global growth will see a further move in this direction as governments seek to boost economic growth domestically.
The pendulum continues to swing from the policy prescriptions of supply-side economics to demand-side economics. With it, there is a growing probability that the secular decline in interest rates has come to an end, which will have major implications for the secular bid for assets. Combined with a probable uptick in the inflation rate, which will eat at nominal returns, we think it probable that trustees spoilt by double-digit or high single-digit annual returns and benign inflation over the most recent decade are likely to have to get used to lower real returns, as they become squeezed from both sides.
We also think that investment managers will have to think harder about what will make a portfolio perform well in a more challenging climate. Change generally throws up great opportunities, but it will be important to be open-minded through this evolution to identify those opportunities.
Ultimately, charity portfolios will need to incorporate flexibility, and the ability to take advantage of a changing opportunity set, underpinned by a sound risk-management framework. As always, experience of different market cycles and the ability to reassess the outlook, should the evidence change, remains key.
Alan Goodwin is head of charities at Newton Investment Management
Charity Finance wishes to thank Newton for its support with this article