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Monday, March 12, 2018

Lloyd’s Voyage

By Roy C. Smith

Frisay's news that Lloyd Blankfein would retire from Goldman Sachs at year end was a surprise to almost everyone. He will have served 12-years as Goldman’s CEO, longer than anyone else except Sidney Weinberg (who retired in 1966), and is one of the longest serving CEOs among today’s major banks. Blankfein replaced Hank Paulson as CEO in 2006, having transformed the firm’s Fixed Income, Currency and Commodities division into a trading powerhouse that was arguably Wall Street’s most dominant player.

Indeed, trading accounted for 68% of firm-wide revenues in 2006, and 73% of profits. Goldman Sachs’ return on equity was 33% and its price-to-book ratio was about 2.0. The stock was trading at $170 per share then, more than three times its IPO price in 1999. Blankfein, originally hired by the J. Aron division as a gold trader, took over the FICC division in 2002 and initiated a massive change in the orientation of the firm from traditional investment banking to a wide-ranging trading colossus that operated around the world and around the clock in hundreds of different instruments. 

Extraordinarily for the securities industry, this enormous growth and transition was accomplished without any major acquisitions, or dilution of ownership that such acquisition cause. The expansion was accomplished entirely in house, working with that wonderful Goldman Sachs DNA that is both feared and revered throughout Wall Street and the City.

Blankfein, however, had little time to enjoy his and the firm’s achievements. Soon after taking over from Paulson, he and other analysts noticed that rising housing prices, upon which a boom in mortgages and mortgage-backed securities was built, had ceased and indeed, reversed direction. Realizing that this could mean an end to the boom (or worse) he ordered a reduction in Goldman’s trading inventory, a reduction that was strongly opposed by some of his trading barons. He prevailed in the struggle that ensued, however, which some his counterparts (Citigroup, Merrill Lynch, Morgan Stanley) did not and steered Goldman Sachs through the financial crisis that followed with barely a scratch. Later, however, he had trouble explaining to Congress why the firm periodically adjusts its own exposures to its future outlook, without consulting its trading counterparties that through buying and selling positions are simultaneously adjusting their own positions. In the end, Goldman Sachs agreed to a $550 million settlement with the Justice Department for infractions of this sort.

After the financial crisis of 2007-2008, Goldman Sachs went through a number of regulatory changes that permanently altered its business. After the Lehman failure, the Federal Reserve required Goldman to became a bank holding company, which provided some advantages but many costs and disadvantages as well. Basel III and Dodd-Frank, and their myriad parts and pieces, came into effect imposing vastly increased regulatory compliance costs and greatly limiting the firm’s freedom of maneuver. There was no escaping this – Goldman had about $1 trillion of assets and was clearly a “systemically important financial institution,” so it had to change its business model to accommodate the new limitations.

Twelve years after Blankfein’s succession, Goldman’s total revenues are less than they were in 2006, and for 2017 trading represented only 37% of revenues, nearly half of what they were then. The stock price is about $100 per share higher, but the price-to-book ratio is only 1.46 (after a 20% increase in the stock price in the last six months), and return on equity was 10.8%.  Indeed, most of Blankfein’s tenure as CEO has been spent surviving the crisis and reengineering the firm for a duller, less expansive future. If he is feeling some regulatory fatigue, we can forgive him for looking for something else to do at 63.

It is curious that Blankfein’s retirement announcement should come so close to Gary Cohn’s, his former deputy who left last year to join the Trump team. There may be some wondering whether there will be a job switch, in which Blankfein would follow his Goldman CEO predecessors John Whitehead, Bob Rubin, Steve Friedman and Jon Corzine to Washington, and Cohn would come back to pick up where he left off but enriched and fortified by his White House experience. Don’t count on it – these things are rarely so simple – Blankfein has been more politically active as a Democrat than Cohn was, and in any case may be fearful of losing reputation by association with Mr. Trump’s team. And, though Cohn has had a full-career at the firm, as every Goldman Sachs CEO has before him, the water filled in behind him when he left and others are in waiting.

So maybe, now having been a king, Lloyd Bankfein, will be content to lay back and be a philosopher, author and philanthropist, as his predecessor, Hank Paulson, and friend Michael Bloomberg have done. Why not? He’s earned a good rest and some peace and quiet.

from Financial News,  Match 12, 2018

Wednesday, March 7, 2018

Why The Trump Tariff Increases Are All Wrong

Why The Trump Tariff Increases Are All Wrong

Roy C. Smith and Ingo Walter

It’s hard these days to find anyone concerned with the national interest who hasn’t been raised on the idea that tolerably efficient markets are better than rigged markets. Properly structured, they help ensure that resources are put to best use and the public has access to the best products and services at the best price. And when things like technology or preferences shift, market discipline assures structural change in the economy to redeploy resources from activities of the past to those of tomorrow. Of course there are always winners and losers – for sure in the short term – and adjusting to new realities can be painful, But in the end the system is stronger and grows faster than under any other arrangement that’s ever been tried. Best of all, market-based opportunities and market discipline works with human nature, not against it.

That’s the way it is with international trade and the notion of comparative advantage. People, companies and countries should focus on what they do relatively better than others and acquire what they don’t, each on terms determined by the market. In so doing, their welfare will be higher and its growth will be faster than it would be otherwise. Deviate from this principle, and a price will have to be paid in the form of lower welfare and slower growth.  There’s no way around it.

So what happened with President Trump’s plan to impose high tariffs on steel and aluminum imports? Maybe he and his advisers don’t believe basic economics. Maybe they believe international markets are already rigged, so a bit more won’t hurt. Maybe they think that we’ve done a really bad job getting people in distressed industries redeployed, so they deserve a break paid-for by healthier sectors and the general public. After all, politics is politics. And people who believe they are facing a bleak economic future – really an existential threat - form a powerful voting block. Meanwhile, those who will pay the tab for protection may hardly feel it and must rely on arguments based on the overarching principle of liberal markets. It can be an uneven political battle at times..

But there are plenty of cheaper and more effective ways of addressing the kinds of “fairness” issues that give rise to protectionism. Admittedly the US has had a poor record of walking the talk and successfully and efficiently helping to redeploy resources, notably labor. Farmers say there are two ways to harvest corn. One is conventional way in the cornfields. The other is to go behind the barn and seek-out the few whole kernels left in the hog manure. The Trump plan falls squarely in the second category, an economic blunderbuss that will hit importers, supply chains, exporters, foreign markets that take massive amounts of US exports, consumers - and maybe the US economy as a whole as some benefits of the Trump tax cuts are wasted on the inevitable costs of protectionism.

Much more than steel and aluminum is at stake here, notably the rules of the game that allow the benefits of market economics to work its magic on a global scale, where trade and specialization form one of the key drivers lifting welfare and growth among billions of people worldwide. Since 1937 the US has been the most important advocate of letting global markets do their work. The US has been instrumental in launching every round of global trade negotiations and every President across the political spectrum from Roosevelt to Kennedy to Nixon and onwards has identified America’s national interest fundamentally with freer international trade in both goods and services. The core principles are “non-discrimination” in how market-access is opened to competitors, domestic versus foreign, one country versus another, together with “reciprocity” – we open our markets to foreign suppliers in return for their opening markets to ours. Both can be lumped into “fairness” as in “free and fair markets.”

The fact is that well-functioning markets need rules that anchor its basic principles, along with effective dispute settlement procedures. Again the US was the motive force behind both the General Agreement on Tariffs and Trade (GATT) and later the World Trade Organization (WTO). And when countries want to accelerate the efficiency and growth benefits of freer markets, something that may not be possible on a global basis, they may set up regional trade arrangements like the original European Economic Community (now EU) or the North American Free Trade Association (NAFTA) – not quite as beneficial as freer global markets, but usually better than the status quo. That option has likewise been under Trump policy assault in the case of both the Trans-Pacific Partnership (TPP) and NAFTA.

By ignoring the factual power of globally freer markets, the Trump Administration betrays a critical US legacy based on a core belief in markets that has overwhelming evidence to back it up. It also betrays America’s legacy of leadership in creating the global institutions to make it happen. It puts the US on a slippery slope to some bad outcomes that will gradually become apparent and begin to poison the political chalice.

Does China practice trade fairness market discipline? Hardly. China takes few prisoners in state support for exports and strategic investments abroad, stiff-arming foreign players in its domestic markets when it suits them, or in the murky calculus of state-owned businesses and banks. And there’s not much light between political targeting and competitive targeting in China. Non-discrimination and reciprocity often don’t seem to be in the Chinese vocabulary. But like Japan a few decades ago, China has come under tough pressure from trading partners to play by the all-important rules of global trade. It will eventually feel the effects of the kind of resource misallocation that results from persistently violating the spirit of those rules.

In any case, the Trump tariff increases slam the EU and Canada and Mexcio, among the leading US partners in seeking to assure sustainably accessible global markets. Shooting yourself in the foot is not the best way to change the behavior of others. Or in Twitter-speak “Won’t work. All wrong. Really bad.”

Monday, February 26, 2018

The Real Signal from Anbang's Takeover

By Roy C. Smith

Last week the Chinese government seized control of Anbang Insurance Group, a hyperactive financial conglomerate with assets of about $300 billion, to avoid its collapse. Anbang’s free-wheeling, billionaire chief executive, Wu Xiaohui, who founded auto dealerships in 1996 that grew into car insurance, banking and overseas real estate, was detained by Chinese official last June and has been held in custody since for “economic crimes.”

Anbang, is one of China’s so-called “Gray Rhino” companies founded by China’s first wave of successful entrepreneurs. Others include fast-growing conglomerates such as Fosun International, HNA Group and Dalian Wanda Group that have feasted on cheap debt provided by state banks while spending lavishly to build their empires. (Gray Rhinos are so named after a 2016 book by Michele Wucker about facing obvious but ignored dangers). The companies relied on important connections with government officials for their access to business opportunities and finance, but they may now be an endangered species.

A dramatic failure of any high-flying company is big news. In China, however, big news also contains signals from the government for the people to absorb. What might the signals be in this case?

First, Mr. Wu, 51, in pursuit of Anbang’s interests, seems to have ignored some recent government policy guidance. Anbang was among the first Chinese companies to make major acquisitions abroad, including a $2 billion purchase of the Waldorf Astoria in New York in 2014. This was OK with the government when it happened, demonstrating that Chinese companies could be important players in the global investing world. But things changed after the Chinese stock market crash of 2015, and the government wanted to restrain such acquisitions to conserve foreign exchange and support the yuan. Wu wasn’t listening, however, and proceeded in 2016 to offer over $14 billion for the Starwood Hotel Group, and, in 2017 to discuss the purchase of 666 Fifth Ave., a troubled New York office building owned by Trump son-in-law, Jared Kushner’s family. Both deals were abruptly halted in mid discussion without explanation, presumably under Chinese government pressure.

Second, Anbang’s means of securing finance for its various acquisitions is not fully known but is thought to come from the sale of “wealth management” products, a lightly regulated, non-bank “shadow banking” activity that has grown substantially despite government efforts to more closely manage the country’s credit system. Wealth management products began as higher-risk bank loans that banks wanted to sell in order to comply with tightening government rules. Brokers would buy the loans and resell them at interest rates higher than banks offered to depositors. Thus, the loans were removed from the banking system, but became hard-to-manage liabilities in the Chinese financial system as a whole. Just as the government began to show concerns about the rapid rise in all of the different forms of asset management products (which rose to $15.4 trillion by 2017), Anbang appears to have started selling its own wealth products (i.e., loans) on a large scale.

Third, Mr. Wu is not an ordinary oligarch. He is married to the granddaughter of the legendary Chinese leader Deng Xiaoping and has served as a financial advisor to her wealthy mother, Deng’s daughter, who is one of China’s premier “princelings.”  Mr. Wu is said to be close to a number of other princelings (children of high ranking Chinese Communist Party officials), some of whom are thought to be owners and directors of Anbang. As a privately-owned company, Anbang does not disclose details of its ownership.

China’s leader, Xi Jinping, now deemed to be as powerful as Deng ever was, is also a princeling, though apparently not connected to the Anbang princeling set. Indeed, the Anbang case is a good opportunity to warn other princelings not to assume they can rely on their special positions and influence to do things that otherwise would be contrary to government guidance. Indeed, the Anbang case illustrates that princelings (even almighty Deng princelings) can be brought down just like anyone else if they fail to shown appropriate loyalty and obedience to the Xi regime.

Finally, there is the question of why the government took over Anbang the way it did, instead of quietly propping it up or letting it fail. China’s insurance regulator said government officials would run the company for one or two years, until it had been restructured.  Though there was some indication that Anbang’s financial position had soured, and this may have triggered a wave of wealth product redemptions, this does not appear to have been visible in the market before Mr. Wu’s arrest. Some sort of regulatory assistance, together with management changes might have been enough to save the company, but even without assistance it is not clear that Anbang’s failure would threaten China’s financial system, which has tradable financial assets of about $30 trillion.  Anbang may not have been too-big-to-fail, but it’s debt investors have been bailed out.

The answers are not clear, but (a) Chinese bankruptcy practices and laws, revised in 2007, are relatively untried and undeveloped and a $300 billion failure may be more that the government feels comfortable handling – and, not being able to do so might make China look bad, (b) Anbang debt and equity losses might have been considerable -- and would be concentrated uncomfortably on the middle class purchasers of the wealth products and smaller banks and other non-bank lenders that Anbang utilized, but most important, (c) such losses might trigger a general panic in China’s financial markets (many observers believe banks and shadow lenders are under-reserved for losses after a decade of easy monetary policy) and through contagion become a national liquidity crisis?

Thinking of such a possibility must remind officials of the 1989 financial collapse in Japan, the Asian Meltdown in 1998, and the US financial crisis of 2008. Any sort of similar crisis in China could be very destructive to its economy.

So, it is much easier for the government to simply take over Anbang, like the US took over Fannie Mae or AIG, to avoid a market reaction. Investors get paid, the system holds together, life goes on and all the important signals get sent.

However, the most important signal may be that China’s financial system is too weak, overextended and vulnerable to collapse to be left to the free market, so the government has to intervene frequently to hold it together. Thus, the government has committed itself even more so to being the country’s interventionist economic manager and Mr. Xi’s promise when he first took office to let free markets pay a “decisive role” in China’s economy is even more remote than ever. Denial of market forces requires authoritarian forces to replace them. If this continues to be so, China’s long-term future is surely much bleaker than many observers now think. Perhaps it too is becoming a Gray Rhino.

Saturday, February 24, 2018

One Cheer For New York's Subway

Ingo Walter

For a habitual subway user in Manhattan since 1970 - and a maybe a dozen other cities around the world from time to time - the drumbeat of subway criticism can get a bit much. Words like crumbling, obsolete, filthy, rat-infested and unreliable roll as easily off the tongues of hassled straphangers as the above-ground chattering classes in their limos and Ubers. Politicians join the chorus when it suits them, talking a good game during short political cycles while earning a solid F for securing their legacy by creating and maintaining vital investments with 75-100 year time-horizons.

And even when useful projects actually get done (there are only two in my lifetime, both unfinished), completion schedules can span generations and leave behind eye-watering cost overruns – capital deadweight that produces exactly nothing of value yet saddles taxpayers with massive debt service for years to come. In short supply today is the kind of far-sightedness that helped create New York’s bridges and tunnels, its parkways, its world-class water system, and of course the original subway infrastructure. And there’s today’s serviceable PATH, finished in 1908 under William G. McAdoo, later Secretary of the Treasury under Woodrow Wilson. (“Let the public be pleased.”)

But wait! Are things really so bad that we need to rebuild from scratch? In some ways they’re even more challenging. It’s a good bet that reimagining a world-class subway system that can secure the City’s future will be the biggest brownfield transport project ever undertaken. It requires reconfiguring and reengineering century-old layouts intertwined with all kinds of critical gas, heat, electric power and communications utilities that have accumulated like barnacles on a ship’s hull over the decades.  Don’t believe it? Look down an open manhole sometime.

Along with rebuilding most of the system’s stations and yards, any serious rehab has to happen while close to 6 million testy passengers have to be moved around the City every day. In all kinds of ways, greenfield subway projects (or greenfield superimposed on brownfield) have it much easier in places like Singapore, Paris, Shanghai - and even London - extending or developing brand new high-speed and local lines on time and on budget, even in the most ancient of cities. Passenger are not unreasonable by nature, but morale does reflect the likelihood of seeing real benefits before they pass from this earth.

Maybe the constant criticism is also overblown in the broad scheme of things. It’s hard to complain about the small part of the subway layout I normally use in Manhattan - especially with a good memory of the way things used to be.

Gone are the graffiti-covered windows blocking the view of station stops, the piles of onboard trash, and even some of today’s clunkers have started new and improved lives after an amazingly attractive renovation, just like an old Boeing 777 after a D-check.

Gone are the aggressive and often physical panhandlers and the omnipresent platform stench that would drive people and companies to seek civilization elsewhere. Even the new generation of (sometimes talented) subway gymnasts has been toned-down. Many conductors, agents and transit police now make an effort, and it shows. Passengers with plenty to gripe about are mostly civil and offer seats to those who obviously require them. And there’s no need to worry anymore about misunderstood eye-contact with fellow passengers, thanks to today’s electronic substitutes for Prozac.  

Except for the glaring omission of efficient subway links to the airports - virtually unique among today’s important business and financial centers - visitors from overseas can get used to our system with a bit of practice. It’s New York, after all, and there will be some good stories to tell when they get home.

So there’s always a bright side, and today’s subway ecosystem has one too. There are plenty of people who deserve credit for things not being even worse, much worse. Sustainability is a different issue. Pendulums swing, and there’s no guarantee that we won’t revert to the bad old days rather than a bright new dawn.  The City has to play the cards it’s been dealt. In New York there’s not that much “greenfield” around to accommodate big new projects that move the needle, and “brownfield” is disruptive and expensive.

On top of that, nobody wants to pay - something that the subway shares with big infra-structure projects around the world. Well thought-through and executed, these projects are enormously productive year after year over decades and sometimes centuries – to the point where even huge development costs fade into insignificance. But the costs fall on people in the here and now, while the benefits are widely dispersed over space and time. So the former don’t want to pay and the latter can’t easily be made to pay. Think a New York subway renaissance will run a deficit in cost-benefit terms? Pure nonsense. So we end up with enormously socioeconomically profitable projects that cannot be financed.

There are plenty of solutions. Tax those who don’t pay but benefit most directly, like landowners and developers enriched by the subway - taxes that may in part get passed along to residents and businesses in higher rents and ownership costs. Those who benefit most directly are made to pay, but nonetheless are better off. Or go for a broader tax net that covers all of New York’s residents and visitors with a permanent City subway tax and hotel surcharge.

Don’t use the subway? Too bad. Your limo battles less traffic the more people do. Commute from the burbs and walk to work? Too bad. The value of the subway is baked into your home value and your ability to resell it. Want to make it progressive? Add features like a nonresident vacancy tax on all those unused luxury condos owned as a bolt-hole by foreigners and finance bigger discounts for the poor and the elderly. There’s plenty of revenue elasticity in a “city of the future” like New York.

New York’s subway is a hidden treasure . All it takes is visionary political leadership, disciplined execution and management, and imaginative financing to unlock it for the future prosperity and vibrancy if the City.

Friday, February 9, 2018

What is the Market Selloff Telling Us?

By Roy C. Smith

The US stock markets plunged 10% this week. The decline was echoed in Europe, Asia and in many emerging markets. Is this the bursting of an over-priced stock market bubble, with more to go, or just an overdue but sharp correction to a fundamentally healthy economy?

Periods of sharp stock market declines can set off panics that can spread to stocks in other countries and to other asset classes, including those not normally correlated with stocks.  If the sell offs are powerful enough, they can generate enough uncertainty in the real economy to cause recessions, as they did in 1990, 2000 and 2008. Is this one, one of those?

The trouble with bubbles is that they are always called “trends” until they burst. Investors love trends – when everyone can agree that these technology developments, or those improved economic indicators confirms their belief that the prolonged market rise is justified by underlying fundamentals.

In November 2017, Goldman Sachs published a report on the global economy entitled “As Good as it Gets,” in which it predicted global GDP growth for 2018 to be 4.0% (and US GDP growth to be 2.5%, since increased to 2.8%) due to a virtuous alignment of positive factors around the world. Many other analysts, including those from the IMF agreed. The world was finally, after many years of stimulus, cheap money and Quantitative Easing, emerging from the last of the Great Recession that had smothered economic performance since 2007.

Surely this is an event worth celebrating with a bit of market exuberance, especially in the more exciting tech areas. But the celebrating really began long before the consensus on the world economy was formed. Indeed, it all seemed to begin with the election of Donald Trump in November 2016. From then until the peak in prices last week, the NASDAQ 100 index is up 47.8%; the Nikkei 225, up 42.7%; the S&P 500, up 37.8%; Euro Stoxx, up 24.3%, and even the Brexit-burdened FTSE is up 15.5%.

Yes, the election encouraged investors to look to a market driven by deregulation, tax cuts, tougher trade policies and an infrastructure boom that might lead to growth rates in the US of 3% to 3.5%.  But not long into the Trump Administration, there were many signs of political disorder and ineffectiveness that some analysts said brought the “Trump Bump” in the markets to an end. However, the markets were continuing to rise -- not so much because of what Trump might do, but because of what he most likely wouldn’t, i.e. dissolve the health care system, create trade wars, or launch missiles at Korea or Iran. The markets could live with the disorderly parts of Mr. Trump, these analysts said, because of the overdue recovery coming through, and Mr. Trump’s pro-business side that was driving the tax bill passed at the end of the year. The market’s supporters were saying that prices were high, but not too high, because US corporate profits were up by 10% in 2017 and the tax bill would add to them.

Still, many economists were skeptical. Even on a “dynamic scoring” basis (counting incremental growth to be created by the tax cuts), the tax bill would still require at least $1 trillion of new federal borrowing over a decade, and its timing of the stimulus was all wrong and sure to increase inflation, interest rates and fiscal drag.  Then, just to emphasize this end of things, Congress further doubled the stimulus last week in passing its bi-partisan two-year budget that added an additional $1.5 billion of unfunded spending. This will boost the fiscal deficit to around 5% of GDP, and total federal debt to around 110% of GDP, the highest level since World war II.  

Indeed, those who read the Good as it Gets report thoroughly discovered that Goldman’s optimism runs out after 2018, and that for 2019, US GDP growth would drop to 1.8%, even after the benefits of the tax cuts, which, the report said, would increase GDP by no more than 0.3% in 2018 and 2019, but disappear thereafter. 

This would suggest that the markets may have risen more than they should have – animal spirits had got the best of them, as often happens. A correction was overdue and has occurred, but it takes a 20% drop over two months to mark an official bear market and we are still a long way from that. But if the spirits roil up a panic, more lasting damage might occur.

John Maynard Keynes said that panics were not so much the result of bad reasoning by individuals as by the way markets are organized and driven by groups of professionals trying to figure out what other professionals will do. The global market capitalization of equity securities today is around $80 trillion, which means a sudden increase in volatility (the 1-day VIX jumped on Feb. 5th from 11% to 37%) can shake loose a lot of profit taking, portfolio repositioning or flight to safety. The nine-year bull market was built on low volatility in a risk-adjusted environment in which stocks returned more than bonds. This may be reversing, as we return to a more normal economy with 2% to 3% inflation and higher interest rates. Normal economies are supposed to be good for business in the long run.

But if the US GDP growth is to slide back below 2% next year, maybe we shouldn’t count on returning to normal just yet.  Is a bout of low-growth with inflation out there waiting for us next?

First published in Financial News, Feb. 6, 2018

Thursday, January 18, 2018

Chinese Financial Control Dilemmas

by Roy C. Smith

The Wall Street Journal recently reported that “China’s housing market has defied gravity and government regulations for two years, floating on a tide of bank loans and speculation. Until now.” 

Housing prices in Beijing and Shanghai, having shot up 30% to 40%, respectively, since 2015, have fallen sharply as a result of government controls imposed last year, and are now dropping below their 2015 levels. From the government’s point of view, the good news is that its firm hand can deflate bubbles and cause markets to behave as it wants. The bad news is that heavy-handed controls can have adverse consequences of their own, and market forces can make them worse.
Despite its authoritarian controls, China is not exempt from such market-driven crises. Indeed, in 2014, after a year of monetary easing and government pressure to grow the economy and encourage stock prices so companies could refinance loans, a major effort was made to increase margin loans which grew, in aggregate, to as much as $2 trillion. So, China’s second stock market bubble in a decade suddenly began to form - the Shanghai Composite Index of stock prices rose 150% from November 2014 to a cyclical high of 5,166 in June 2015, before the bubble burst, dropping prices by 43% in a matter of a few weeks. The government intervened forcefully – requiring government controlled investors to buy stocks, and encouraging further margin buying – and the rout was halted, but the market has not fully recovered since then. Investors, fearing the unpredictability of government intervention, chose to invest in residential real estate and other assets instead, moving the speculative destination to other sectors.
Indeed, China’s 250 million “middle class,” aided by continued easy money, piled in again to residential real estate.  There have been other bubbles in real estate over the past several years, but the so-called middle class, which includes China’s growing millionaire class as well, is much larger now than before. There are now approximately $4 trillion residential mortgages outstanding. Since the stock market crash in 2015, these folks have upgraded their residences and bought additional homes as investments. According to the WSJ, “mortgages made up as much as three-quarters of all new loans in 2017.” According to Moody’s Investor Services, the housing sector generates about a third of China’s economic growth.
But the sudden price downturn has affected the resale values of all housing and the value of collateral held by banks. As we know from our own experience after house prices unexpectedly started to decline in late 2006, an avalanche of mortgage problems hit the US housing market and resulted in a major crisis. Underwater mortgages tend to be abandoned, property developers fail, and banks have little choice but to write them off. As a crisis develops, all forms of marketable credit instruments are questioned, and investors run to safer ground. Too much of this and banks get into trouble and may then either fail or have to be bailed out by the government.
If the government has to intervene to forestall a crisis (there is no indication that this is the case in China as yet), then it may have to direct investors to purchase mortgages and other debt instruments, whether they want to or not. It will also have to change mortgage availability and other policies back to what they were before. This, or course, weakens China’s efforts to improve the role of market pricing in its economy, something most analysts agree is necessary for the country to transition to developed status. Doing so also covers up the weakness of many assets on the books of Chinese financial institutions and kicks the can of having to deal with them into the future, where the problem non-performing and risky debts will only be much larger.
Indeed, China already has a large amount of questionable loans on the books of its banks ($30 trillion in assets), shadow banks ($9 trillion) and in the high-yield investment portfolios of middle class investors. Fudging over the mortgage sector could add a considerable sum to this dangerous accumulation of toxic assets. From such accumulations, financial crises arise.
Market-driven crises may be triggered by well-meaning government controls in a fully-self-confident, authoritarian system with little regard for markets. China’s marketable financial assets are about $30 trillion today, but markets are dependent on retail and speculative investors more than institutional ones. Government intervention is the solution to crises, but such periodic intervention can destroy market integrity, which weakens the economic system.
Just as the announcement of housing price declines surfaced, China announced that its annual growth rate for 2017 was 6.9%, up from 6.7% for the prior year. The news was met with considerable skepticism by international observers who considered the results to be managed. The government wants to convey a picture that it is on top of things and all is well, others see an economy that continues to be in slow decline despite many efforts by the government to prop things up.
Growth continues to be essential to the Chinese government. Only with growth can it hope to meet the expectations of its billion or so people who have not yet entered the middle class, and provide the resources required to deal with its aging population and to support its overseas and military agenda. For China, growth means continuous intervention.
Ironically, such intervention promotes price volatility in financial assets that periodically passes capital losses on to the middle class.  It is this group that the government must depend on to be the engine of consumption as the country transitions from an export-led economy to one that is more consumer-led. It is difficult to achieve such long-term objectives, however, when the government has to intervene in the short-term to prop up (and maintain) the weaker elements of the system.

Thursday, December 21, 2017

Season’s Greetings to Global Bankers from Rosy Scenario

By Roy C. Smith

It's a happy time of year, made more so by a Goldman Sachs global economic forecast (entitled “As Good as It Gets”) that predicts 4% growth in 2018, up from 3.6%. It was 5.4% in 2010. Still, all around the world economies are growing again, inflation is lagging so rates are still low, and market analysts all want us to stay fully invested in equities despite the roaring global bull market and all-time highs of the last year.

Indeed, many investors are happy to explain away the rallies (S&P 500, MSCI and FTSE 100, as just catching up to where we ought to be after finally escaping the low-growth grip of the Great Recession. “Total real return” from the S&P 500 index (i.e., including dividends, and adjusted for inflation) from 2000 until now was 3.1%, up from 2.3% through November 2016, so Mr. Trump did make a difference. Even so, the total real return trend line from 1980 until now was 7.9%, so we still have more catching up to do, don’t we?

Overall, the rallies in the US, Europe and Japan have ignored politics and their many antics and implications, despite their being constantly in the news. Mr. Trump is now treated by investors as we treat teen agers – ignore what they say, but watch what they do. As Rosy often points out, Mr. Trump has never been nearly as bad for the world economy as he declared he would be (China, North Korea, NAFTA), and his aggressive domestic agenda has lagged far behind his promises. Investors in Europe also seem to have retained their sangfroid, despite the excitement of Brexit, Catalonia, the amorphous German coalition, uncertain Italian elections, and some backsliding in Austria, Poland and Hungary. Investors are showing confidence in their private sectors, not their governments.

Mr. Trump’s tax bill is a needed political victory with some modest economic benefit. Gary Cohn, Mt. Trump’s chief economic advisor, says growth next year will be 4.0%, but Cohn’s old firm, Goldman Sachs, forecasts tax cuts will increase GDP growth by only 0.2% for only two years, leading to an annual US growth rate of about 2.5% in 2018. But Goldman also says growth will slow again in 2019 (to 1.9%) due to labor and other constraints. Rosy and some other economists believe the momentum from the 3.1% average growth in the second and third quarters of 2017 will carry over into 2018. This must justify the 20% S&P 500 return for this year, doesn’t it?

Brexit remains a mess, but with the $50 billion “divorce settlement” behind it, the rest should fall into line.  Negotiations don’t really have to fall off the cliff, do they? Rosy thinks Mrs. May’s weak coalition will collapse, Labour will get in, and the Brits will have another referendum, only this time explaining the pros and cons more effectively.  Surely, if they understood it better, with the Tory ideologues pushed to the sidelines, the great British people would vote to remain. Recent polls show the opposite result, however.

Rosy says we should relax about Russia and China. Putin is troublesome but unimportant economically. China is important, but its slowing growth rate has stabilized around 6.5%, which is still very strong, and the much-feared credit collapse hasn’t happened. Xi Jinping has established himself as supreme leader and is using his vast centralized power to promote large showcase projects and to manage the economy smoothly, despite increased interference and bullying of the private sector, sheltering of inefficient state-owned enterprises, suppression of migrant workers, and being under huge pressure to improve health care and pension services. China’s stock market was up only 6% in 2017; Rosy thinks it may be a buying opportunity.

Bank regulators are easing up a bit. The terms of Basel IV are now set, though they won’t come into effect until 2027. It has a new capital requirement for “operational risk,” to include large settlements from prosecutions. Banks now seem well enough capitalized and controlled by stress tests, so some of the rest of the pressure applied after the crisis can be relaxed. But, there is nothing going on to repeal or reform Dodd-Frank - the effort to reform it passed by the House of Representatives has gone nowhere in the Senate. Nevertheless, the stock market rally has lifted the prices of US banks, but only JP Morgan (+130%) and Wells Fargo (+70%) are significantly ahead of where they were a decade ago. Citigroup (-85%) and Bank of America (-45%) are both still significantly behind.

However, the stock prices of the top four European capital market banks (Barclays, Credit Suisse, Deutsche Bank and UBS) are all still about 75% below their prices of a decade ago, with most trading well below book value. They are lagging way behind their US competitors and are a long way from returns on equity greater than their cost of equity capital.  Even Rosy acknowledges that their long term economic viability is doubtful.

Rosy has believed for years that each new year will be the one in which a lagging US or European bank will split itself up into more manageable segments, and each year she has been wrong. Maybe 2018 will be different; the new CEOs of Barclays, Credit Suisse and Deutsche Bank have learned how hard it is to be a competitively-significant, globally-integrated investment bank. With stock prices trading well below book value, spin offs still make sense for them.

All in all, Rosy says things will be great in 2-0-1-8. Drink up. It’s as good as it gets.