It is festival time in Edinburgh. That means that everyone who lives here is currently struggling with a brain addled by too much comedy, too much music and a few too many heavy drinking guests up from London. We aren’t all thinking entirely clearly.
However, as is usually the case, a few gems emerge from the chaos. For me this year, there have been two. The first was the Sorries, a duo inspired by folk group The Corries, who are worth visiting just for the lyric “Alex Salmond says we will keep the pound if we get independence. I hope we are keeping more than one or the tax will be horrendous” inserted into a well-known Scottish song.
The second was Kate Dimbleby singing the songs of Dori Previn. This was notable for the right reasons, but also for a point Kate made about success along the way. If you are always a loser she said, winning is very special, but if you are always a winner losing is exceptionally hard. I suspect that I was the only person in the bar who looked up from their martini to think of the Chinese economy at this point, but it did ring something of a bell.
China’s been the accepted winner in the global economy for so many years now that it has become practically impossible for either its leaders or all too many investors to see that it could be something of a failure. Ask them about the credit bubble, the over-investment and the misallocation of capital, and they’ll tell you it’s all under control – that the Chinese government is more than capable of transitioning the economy so that urban consumers take over from exports as the main engine of growth with no trouble at all.
All forecasts of growth rely on fast-rising household consumption – at worst you can get the experts to admit to the possibility of a temporary lull in growth while everyone decides which washer dryer to buy.
They may be right. Sometimes they are. However, look at the facts, not the dream, and the danger seems clear. A recent note from Morgan Stanley points out that the credit boom in China that has been under way since the great financial crisis claimed the rest of us in 2008 has boosted total credit from 150% of GDP to more like 220% of GDP. They then conclude that an amazing 10% of total credit is “high risk”.
You can make China’s problems sound as complicated as you like (and your average analyst needs no encouragement to do so), but it boils down to a pretty familiar story. Spectacular sounding growth has been driven by an explosion of credit that has allowed spending of all sorts to hugely outrun GDP growth. This spending has not created the sustainable income sources to service the credit.
Analysts who visit Beijing and Shanghai tend to come back having seen little evidence of China’s lost decade in the making (all credit bubbles are followed by credit busts and years of deleveraging). But venture further, as Ann Stevenson-Yang of J Capital Research does, and it’s definitely there. In recent research, she looked at retail sales. She didn’t get the answers the optimists might have liked. Instead, she found everyone from luxury to mid-range footwear retailers saying that their revenues were down 15-20% year-on-year.
The picture in spirits (previously much drunk at government banquets) is also “unrelentingly negative” with distributors claiming sales down 60%-odd for some brands and inventories rapidly losing value.
There are bright spots of course. One is rising auto sales. However, delve a little deeper and you will see that this is less about rebalancing to consumption than the “crack of credit”. Everyone’s offering 0% financing now, and in some cases, buyers end up with their car for free. How? The buyer pays for the car, but with the guarantee of the money back in two years. The seller invests the money in the shadow banking system, where he hopes for returns of 60% a year or so before selling up and giving it back. Not bad.
But as Stevenson-Yang notes, in the past, this kind of thing has “not ended well”. If you are getting 60% on your money (or even hoping to), you are not in an investment, but in a pyramid scheme of one kind of another. And if you live in a country where any meaningful part of growth is built on such pyramid schemes, you are living on the edge of a crisis.
What does all this mean for your portfolio? Most analysts are still unrelentingly optimistic about luxury goods sales in China. I really wouldn’t hold any stocks that reflect this view. If you want to be in China, you might want to wait to see just how cheap stocks get as it gradually sinks in just how unbalanced the Chinese economy really is. Not long now.
In the meantime, if you are in the mood for buying something, I refer you back to Russia: a market about which people are not over-optimistic but over-pessimistic (it’s the market loser no one will accept has the chance of ever being a winner).
Jon Dye of Ruffer pointed out to me, over a brief festival coffee break this week, that Gazprom will soon move to use IFRS accounting standards. It is also mandated by the government to pay out 25% of its profits as a dividend. This will give it a yield of 8%. It also trades on a very cheap price/earnings (p/e) of under three times. That’s far less than a fifth of the price of, say, luxury goods firm Richemont.
Everything in Russia feels risky, but I’d be very happy to bet that anyone investing in Gazprom will be a lot better off in five years than anyone betting their pension on luxury goods sales in China.
• This article was first published in the Financial Times.