October 23 – October 29, 2015

China’s Economic Transition. Sovereign Wealth Funds – How can we reduce costs and increase returns? Corporate Profits Peaked?

This week three key themes that stood out were 1) how China’s economic transition from an investment-led economy to a consumption-led economy is by no means going smoothly as highlighted by The Wall Street Journal’s China’s Central Bank Moves to Spur Economic Growth and The Economist’s Debt in China – Deleveraging delayed 2) continuing on the reduction of petro-dollars in the investment markets how sovereign wealth funds are restructuring themselves to reduce costs while seeking out higher return investments (see The Financial Times’ Asset managers suffer as oil funds withdraw cash and Qatar fund backs Brookfield’s $8bn Manhattan West project), and 3) was a well written article (Peak Profits – The age of the torporation) in The Economist illustrating that corporations (or at least those that currently make up the major indices like the S&P 500) may have passed their profit peaks.

*Note: bold emphasis is mine.

China’s Central Bank Moves to Spur Economic Growth. Lingling Wei. Wall Street Journal.

First, before China entered into its Fifth Plenum this week and removed it’s one-child policy (changed to a two-child policy), the People’s Bank of China (PBOC) cut its benchmark one-year lending and deposit rates by 0.25% points (to 4.35% and 1.5% respectively), reduced banks’ reserve requirement ratios by 0.5% points and is removing caps on deposit rates that commercial banks can offer.

With the intention of lowering corporate financing costs and pumping liquidity into the economy, this

…was the sixth time since November that the Chinese Central bank has cut interest rates and the fourth across-the-board reduction of the amount of deposits banks are required to hold in reserve.

Zhu Chaoping, China economist at UOB Kay Hian Holdings Ltd., estimates the reduction in banks’ reserve requirements will pump about 680bn yuan ($108bn) worth of funds into China’s banking system.

“Taking such a rare action again means the real economy is performing poorly,” said a senior official at the PBOC. “A lot of companies have seen their profitability falling sharply and that’s a key reason why we took the action again today.”

Profits at Chinese industrial companies are down 8.8% in August year-over-year (the biggest monthly fall since 2011).

By loosening controls on deposit rates now, the government is attempting to inject market competition into a politically powerful state-run banking sector that has favored big state companies over a more dynamic private sector.

However, removing the deposit-rate ceiling also

“Removes one of the last remaining hurdles to satisfying the technical criteria set by the IMF” for designation of the yuan as a reserve currency. – Eswar Prasad, a Cornell University professor and former IMF China head.

The barrage of easing measures since late last year has had some success in getting more credit flowing in the economy. Chinese banks issued 1.05tn yuan of new loans last month, the highest on record. However, as credit continues to expand while growth slows, China risks a further buildup in debt. An analysis by consultancy McKinsey & Co. shows that China’s debt load increased by 282% of GDP last year from 158% in 2007.

Nice transition into:

Debt in China – Deleveraging delayed. The Economist.

It’s pretty simple, credit continues to grow faster than the economy so debt load to GDP will continue to increase.

China’s economy grew by 6.9% in the 3rd quarter, yet bank loans increased by 15.4% compared with the same period in 2014.

China’s overall debt-to-GDP ratio is continuing its steady upward climb (at 160% in 2007, now more than 240% – 161tn yuan ($25tn)). It has risen nearly 50% points over the past four years alone.

The question remains, what debt-to-GDP ratio becomes too high, and specifically for China (they have a much longer leash than a sovereign that doesn’t control its monetary policy, i.e. Greece, and then there is the whole +/- $3.5tn in reserves)? As Jim Chanos, famed short seller of Enron and founder/president of hedge fund Kynikos Assoc., pointed out in ValueWalk’s Jim Chanos: China Debt Surge Echoes 1990s Japan “we have an economy addicted to credit.”  While the country doesn’t appear to be facing an “imminent collapse,” it is on a trajectory similar to the one Japan was on before its asset-price collapse in 1991 “but on steroids.”

However, surprisingly the weighted interest rate on existing Chinese liabilities has fallen from roughly 6% to 4.5% this year.

Investors are lending to companies as if they were becoming safer borrowers, even as their liabilities increase.

Yang Chen of Bank of America Merrill Lynch notes that some investors are buying bonds with borrowed cash, believing that the government will wade in to spare them from any big defaults – as it has done in the past.

Wait… this seems vaguely familiar.  What’s that term…moral hazard.

Second,

Asset managers suffer as oil funds withdraw cash. Madison Marriage and Chris Newlands. The Financial Times.

Global asset managers are facing a double hit to their fees, as sovereign wealth funds withdraw billions to support their oil-dependent economies – and switch to a cheaper in-house investment approach.

Of the world’s 50 sovereign wealth funds, which collectively oversee about $6.5tn, one-third have reported a reduction in their invested assets. Of those affected, half derive their capital from oil, according to data provider Prequin.

The Saudi Arabian Monetary Agency, the world’s third-largest sovereign fund with $661bn invested – has withdrawn about $70bn from external asset managers.

Azerbaijan’s oil fund, which oversees $37bn of assets, has said in its annual report that it intends to bring the management of all of its assets in-house. It currently has $662m managed by State Street, the US financial service group, and $664m with Swiss bank UBS.

The Abu Dhabi Investment Authority – the second-largest sovereign fund globally with $773bn of assets – has also grown its in-house teams. It reduced its allocations to investment managers from 75% to 65% last year – in effect, a $77bn outflow from external fund houses.

State Street had outflows of $65bn in the second quarter of 2015, which it blamed partly on clients’ need for cash “due to lower commodity prices.”

Now consider this in conjunction with the efforts for transparency and to reduce fees at the likes of giant pension funds ala The California Public Employee’s Retirement System (Calpers) and the “Canadian model” of brining management in-house (the $125.2bn Ontario Teacher’s Pension Plan and the $54.7bn Ontario Municipal Employee’s Retirement System internally manage about 80% and 88% of their assets respectively) and you can see that the investment management field is under assault.  However, don’t misunderstand. Investors (individuals, pension funds, sovereign wealth funds, etc.) will continue to invest with hedge funds.  Ben Carlson of the blog A Wealth of Common Sense covered this extremely well in his October 11, 2015 post “Why People Invest in Hedge Funds,” so I won’t cover it here, basically investors invest in hedge funds because it’s too hard not to.

Hence,

Qatar fund backs Brookfield’s $8bn Manhattan West project. Henry Sender. The Financial Times.

Qatar Investment Authority is taking down a 44% stake in Brookfield’s $8bn Manhattan West real estate project – a 7m sq ft mixed-use development in NYC, west of Pennsylvania Station (part of the Hudson Yards area).

QIA’s investment comes as many sovereign wealth funds have been putting money into real estate at an earlier stage in than in the past – taking on development risk in pursuit of better returns.

Lastly,

Peak Profits The age of the torporation. The Economist.

For the second quarter in a row the sales and profits of members of the S&P 500 are expected to fall; for the three months to September they are forecast to be 3-5% lower than in the same period last year. Half of big listed American firms now have shrinking profits.

Worldwide earnings per share have stopped growing, measured in dollars. In local-currency terms sales growth has stalled in Asia, slowed in Europe and is expected to collapse in Brazil.

Earnings are high relative to two yardsticks: the S&P 500 earnings per share are 28% above their ten-year average and in America profits are stretched relative to GDP.  Further, the three general methods that have worked in the past to generate growing profits are no longer as easily available.  Specifically, 1) globalization – emerging markets are sputtering, the U.S. dollar is strengthening, and years of joint ventures in China have built competitors that better understand Chinese consumers and are better able at serving them, 2) finance – no longer the driver of profits it was up until 2007-2008, think of the finance arms of GE and GM, and 3) since 2007-2008 wages have been suppressed – there is definitely political pressure to change this.

If the share of domestic gross earnings paid in wages were to rise back to the average level of the 1990s, the profits of American firms would drop by a fifth.

So the quick fix has been share buy-backs (running at $600bn a year in America).

IBM spent $121bn on buy-backs over the past decade, twice what if forked out on research and development. Walmart spent $60bn on buy-backs.

Or cutting costs.

Even for Brazilian firm 3G which specializes in buying mature firms and cutting the “fat,” sales at its most recent target, Kraft are falling at a rate of 5% a year.

For all their obsession with growth, big listed firms appear paralyzed. They long to expand, yet also want to protect peak profits, restrain wages and investment, buy back shares and hold armfuls of excess cash on their balance-sheets.

Other Interesting Articles

Bloomberg Businessweek

The Economist

CNBC: America’s best malls have this tenant in common 10/23

FT: Investing in oil is a slippery slope 10/23

FT: China funding UK to build white elephants 10/23

FT: ‘Deflationary boom’ in prospect as China slows 10/26

NYT: A Global Chill in Commodity Demand Hits America’s Heartland 10/23

NYT: Greenland Is Melting Away 10/27

ValueWalk: Venezuela Selling Its Gold As It Runs Out of Cash 10/29

WSJ: How Global Easing Makes the Fed’s Job Harder 10/25

WSJ: Why It’s Not So Easy for China to Ease 10/26

WSJ: Sam Zell Edges Out of Apartments 10/26

WSJ: Morgan Stanley Makes a Comeback in Real Estate 10/27

WSJ: In China’s Alleyways, Underground Banks Move Money 10/27

WSJ: London and Hong Kong at ‘Risk of House Price Bubble’ 10/29

Special Reports

Bank of America Merrill Lynch: Transforming World Atlas – Investment themes illustrated by maps

Howard Marks – “Inspiration from the World of Sports” Memo – made available on www.marketfolly.com

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