GMO: China’s “Bubble Economy” is Riskier than it Appears

Edward Chancellor of GMO always does very nice work. His latest on China and the risks to the credit system are no exception.

“For GMO’s asset allocation team, valuations are our first protection against losses. We generally believe that cheaper assets are more resilient against bad economic and financial events, and that if we focus on avoiding the overvalued assets, we should not only achieve higher returns over time, but more often than not do less badly when markets encounter difficulty.

From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and the market has underperformed MSCI Emerging by about 10% over the last three years (ending December 31, 2012). Neither of these characteristics screams “bubble.” And yet, China has been a source of worry for us over the past three years and continues to be one, affecting not merely our behavior with regards to stocks domiciled in China but the entire emerging world, as well as some specific developed market stocks, which we believe are particularly vulnerable should things in China go down the road we fear it might.

China scares us because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models’ estimation of what “normal” is.”

Read the full report here.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. The GMO folks are always one step ahead of the crowd. This article comes at a moment when we hear a lot about how emerging markets are going to save the world …

  2. I own China (FXI) still, but I’m keeping my eyes peeled, because I do think there’s a problem to contend with in the intermediate term… I don’t hear anyone talking about the consequences of developed markets returning to positive real interest rates (or a strengthening USD, for that matter).

    Under these circumstances, hot capital and future FDI will be diverted away from EMs to DMs. While China has done its best to insulate its markets from hot money, it has exposure via exports. However, China’s economic success depends on its transition from exports & fixed capital investments to domestic consumption. I’m more concerned about the effect on richly valued EMs like Thailand, South Africa, Korea, Indonesia & Mexico (in that order).

    Within that context, consider that EM Debt trades with a 6.8% duration (incorporating convexity), which duration risk is better than only US IG Corporates (7.2%) & US 10y Tsy (~9.1%). When I swap quality for High Yield/floating rate bank loans, at least I’m trading interest rate risk for credit risk. I don’t see the value in EMD as this year wears on.

    Local currency EMD is at greatest risk of a correction. USD denominated EMD is at greatest risk of a crisis.

  3. They’ll be fine, they just need a few dozen more trillion of stimulus.

    Simple solution.

  4. @Romeo, Won’t EM equities fall faster, harder than EM Debt? Won’t holders of EM Debt (I own EMB and FNMIX) get a bit of a warning in seeing the EM equities dropping a bit sooner and faster than the EM debt? At least I am hoping to get enough of a warning that way to get out in time if I have to. Why is USD Denominated EM debt at greater risk than local currency EM debt? It would seem to me that a stronger US dollar is what threatens EM more, so I would guess that local currency EM is at greater risk in such an event.

  5. First off, I prefer Chinese broad equity over other EM comers, and I named the specific ones I’m concerned about valuation-wise, were there to be a reallocation of hot money out of EMs: “richly valued EMs like Thailand, South Africa, Korea, Indonesia & Mexico (in that order).”

    Second, I make a distinction between USD EMD and local currency. I gues I was a little unclear there: local currency debt is more susceptible to undulations due to the factors discussed, meaning you’d want to own USD denominated debt onstead of local during a garden-variety correction; however, USD debt is more susceptible to crises were there’s a lot of hot money and excessive valuations.

  6. What is the difference between a bridge to nowhere and a missile?

    Country X builds bridges to nowhere and people fret about wastage, in part because the bridge is a visible sign of wastage.

    Country Y spends and equivalent amount on missiles buried in silos. The missiles will either be used (destroyed) or eventually decommissioned but are not regarded as wastage. This spending is not particularly visible and no one bothers about it. In fact some — incl. people who hate bridge spending — even say it doesn’t go far enough.

    Both examples add to GDP. Shouldn’t the broad test* from an economic perspective always be whether or not this spending is replacing aggregate demand that has fallen in the private sector?

    * notwithstanding that the knowledge that they have missiles might make the populace feel better than the knowledge that they have unused bridges. i.e. the perceptions fairy.

  7. What if unused missiles prevent an attack that would devastate the economy?
    Or, a more practical example, whatever money that is spent on the U.S. Navy and Marines keeps oil flowing through the Straights of Malalacca and the Straight of Hormuz?
    We benefit from that, but so do lots of Arabs and Japanese and Chinese and Europeans who don’t pay for the protection.

  8. As commenter Morgan Wrastler might say (see “Dorks” article), the difference is “HEGEMONY!!!!” ;)

    This is stretching things a bit perhaps, but weren’t the ancient Egyptian pyramids HUGE examples of “bridges to nowhere?”

  9. The Pyramids were probably more like the Cathedral building craze in Europe at the end of the Dark Ages. It got people traveling about, encouraged trade, developed building skills, created market towns.
    In that, I’d say the Pyramids were more like today’s practice of building grand places of worship devoted to our religion of watching young men play football, basketball, baseball and driving cars around and around in a circle.

  10. Johnny, are you a historian, or just interested in history? I notice you often have a historical reference.

  11. Just a history buff. Probably read a history book every week, all over the map.
    You were talking elsewhere about types of economy — barter, debt-driven, etc.
    Another one to consider is the ‘tribute’ economy, in which the dominant power like the Romans demands the Egyptians ship so many tons of grain to rome every year.
    Or the feudal economy, in which case the peasant provides labor and crops to the lord, who then has a residual responsibility to protect the peasant and provide for him in crop failures.

  12. Who am I to disagree … But don’t bubbles usually go until every sucker is in? In a country of a billion people there should be a lot of them and the bubbles should be really spectacular. I am just not seeing it yet.

  13. Could someone please do a sectoral balance for China? I’m still confused about how they can have an explosion of business debt with a trade surplus and public sector deficit. Is there a lot of cash going to households?

  14. A few things (I have not read the GMO note yet):

    From what I’ve read the surplus income from the current account is mostly offset by undocumented capital flight out of China. Also, large amounts of incoming money flows are accumulated by the Chinese central bank and held as foreign exchange reserves offshore. Finally, Chinese households do run abnormally large surpluses, and there could easily be a split in the Chinese business sector where real estate and industrial debt are offset by surpluses in other sectors.

    I’m just spitballing here though. It’s certainly an interesting topic to consider.