Churchouse Letter
April 2014             by Peter Churchouse

Carried Away or Carried Out?

I've been on the end of more than my fair share of investment pitches over the years. Some piqued my interest. Others initially looked exciting but, lost their lustre after getting to those uncomfortable truths that only good due diligence can uncover. Some were just flat-out harebrained.

I always remember one particular pitch. It was for real estate in a booming city that was riding the wave of huge demands for its regional commodity resources. So far so good. The kicker of this idea though, was to use leverage in a different currency (with a lower interest rate) to fund the acquisitions. I blanched. A classic carry trade. And too spicy a trade for me. But something about looking today at the current state of emerging markets reminded of this particular pitch all those years ago...

Low interest rates in the U.S. and Western world have fueled some immense run-ups in emerging market asset prices in this large scale carry trade. This has been well documented. The Fed taper talk of May 2013 led to some significant drawdowns in the emerging markets, and this pattern has only accelerated in 2014 so far.

  • In this issue of the AHA Report we're going to suggest a timeline for what we think will happen next.
  • We reiterate our best EM plays.
  • We give our 2 cents on China.
  • And we have all our recommendations to date summarised for you.

Enjoy the issue,


The Pitfalls and Opportunities of a “Sure Thing” Trade… Dissecting the Anatomy of the Post-Global Financial Crisis Carry Trade

Around eight years ago, an enthusiastic young British chap bounded into my office with a story of riches to be had. The concept was property in Perth, Western Australia, and the narrative was simple and believable. I knew a little about that market. Western Australia was booming, and we had the Chinese and their insatiable demand for commodities to thank. The state’s mining sector was in overdrive with massive investment in new and existing iron ore and coal mines in the northern part of the state. These mines were supplying a flourishing economic machine in China. Manpower was pouring in from all over Australia and New Zealand to service this growth. And of course they all needed housing not only up north in the mines, but also in Perth, the state capital. The housing market was on fire, with prices moving up faster than any other state capital. They eventually peaked at levels higher than Sydney, the most expensive market in the country.

That much I knew, and could buy into. I had more than a passing acquaintance with this scenario.

But my guest had an interesting twist to his story. He happened to live and work in Tokyo. He was extolling the virtue of borrowing 90 percent of the purchase price of the Perth homes in Japanese yen. You could borrow money in yen at around 3.5 percent, while borrowing costs were more like 7.5 percent at the time in Australia. This of course would mean healthy savings on the interest bill. He had bought seven houses in this way. It was a no brainer, he said. And he was about to travel to Perth to buy a few more places.

He was pitching a classic carry trade. Borrow in a low-interest-rate currency to fund the purchase of an asset in a higher-yielding currency. The carry trade had once been the preserve of financial institutions and their trading floors, but throughout the 2000s the concept went mainstream. “Mrs. Watanabe,” your standard Japanese retail investor, was switching her yen savings (earning next to nothing in the bank) to buy higher yielding Australian and New Zealand dollars. Speculators like my British buddy were going one step further by gearing up and using yen to fund their property in-vestments overseas.

Borrowing in cheaper currencies to invest in higher-yielding ones might seem like a slam dunk idea. But carry trades are always characterised by two distinct features:

    Act 1. They produce consistent periods of profitability.

    Act 2. They experience volatile and violent reversals.

I did not even bother to go into my thoughts of the risks to this real estate tactic. As far as I was concerned, this strategy did not adhere to Rule No. 8 in my Rules for Buying Real Estate: Use Debt. But Use it Wisely.

Yes, savings on interest costs can look tempting. But the reality is that a relatively small fluctuation in the currency in the wrong direction can hugely offset the benefits of the couple of hundred basis points you’re saving in interest. If you have income from renting the properties in yen to service your yen mortgage, then there would be some natural hedge to the currency risk. But that was not the case. The properties would be rented in Australian dollars. My friend did not venture into any discussion on hedging his currency exposure by entering into a swap arrangement either for his interest cost exposure or his capital exposure.

I decided to pass on this opportunity given the currency risks, let alone any property-market risks. There’s using debt, and then there’s using it wisely. Applying ten to one leverage with a complete currency mismatch did not strike me as particularly “wise” ...

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