The Pendulum, Having Swung, Now Swings Back
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Long term big picture trends in political, social and economic life can be likened to the pendulum in that old grandfather clock your parents might have had standing in the hallway. The world today is at the end of one of those 40-50 year swings of the socio-economic pendulum. And it is about to swing back in the other direction.
The beginning of the current swing of the pendulum was formed out of the 60’s-70’s era. That was an era where excess returns in western economies went to LABOUR. The western world was largely ruled by labour unions. Since that time excess returns have swung very much in favour of LAND and CAPITAL. Home ownership has probably been the greatest source of wealth creation for western middle classes, and the world has come to be ruled more by bankers than labor unions! (Please forgive a hint of the tongue in cheek). The world of trade and finance has been largely deregulated, and globalisation has dramatically deepened and broadened international trade, finance and capital flows.
The 1960’s and 1970’s was a period of rigid labour markets where union power dominated the economic environment in many western countries. Trade was dominated by complex walls of tariffs, taxes and restriction. Working in unionized industries ensured high incomes relative to non-unionised industries. It was a time of short working weeks, long lunches, and a never ending stream of worker perks negotiated by unions. Personally I was a beneficiary of such union dominance, something that my own children have never had – they may have had other benefits that were very foreign to us in the 1960’s.
For example, as a teenager I worked in numerous summer jobs including working as casual “seagull” labour on the wharves in New Zealand – a highly unionized and powerful labour pool. One day’s work on the wharves as a 17 year old produced as much income as most normal professional jobs produced in a week. For several summer seasons I variously worked in the freezing works during the lamb killing season – a highly important part of the country’s export business. I worked cleaning sewers and digging holes in New Zealand’s largest timber and forestry mill. One season I ventured to Australia and worked as a roughneck and motorman on oil rigs in the outback. All of these jobs were extremely well paid and a few weeks work allowed me to save enough money to get through another year of university education. I was extremely grateful for this cash, the opportunity and indirectly, I suppose, for the power of the unions that made it possible. But I could also see that this was unsustainable.
Europe and the UK in particular, were in a similar shape. When we arrived in the UK in 1975, having spent three years in Africa, the last year of which was spent driving from South Arica to Europe, the country was in a horrendous state.
Although the UK Labour Party’s Harold Wilson was technically Prime Minister, in reality the country was controlled by the unions, most particularly the coal miners union. Wilson was in charge but not in control! Arthur Scargill and his cohorts effectively controlled the country.
Britain had not long emerged from the scourge of the three day working week, and was under an IMF program. YES! An IMF program, like some third world banana republic – which it effectively was. The UK government and Bank of England had lost control of money to the IMF. Any Briton wanting to slip across the Channel to France for a holiday was allowed to take only Stg30 with him, and required BoE approval to expatriate any more cash than that. As a foreign national my bank account was not subject to such rules and on several occasions the small consultancy company I worked with looked into using my account to funnel small amounts of cash offshore to fund small projects in the Middle East and Africa. How demeaning!
Coming from Africa where people largely did an honest day’s work, we found the Brits a pretty idle lot by and large, forever expecting society to heap them with handouts of one kind or other. Scams of all sorts were the norm, all designed to rip cash from “the government”. A culture of “the world owes me a living” was the prevailing norm. A typical day at the office would involve arriving about 9:30 a.m., spending half an hour making a coffee and discussing last night’s football game. A bit of work, and a tea break about 11. The 1 – 2 hour lunch would start around 1230, with a meat pie washed down more often than not, with 3 pints or so of beer. The afternoon would be punctuated by a tea break around 4pm, and by 5:30, books would be closed, and the front door locked. The effective work day in most London offices I estimated to be not more than 4 – 5 hours per day.
I am not sure things were that much different on the Continent.
This was clearly an unsustainable state of affairs.
It all changed with the election of Margaret Thatcher in late 1979 and Ronald Reagan’s rise to the presidency in the US. And so began the swing of the pendulum back in a different direction.
Over a series of years, the unions were de-fanged, the social services scams tightened up, markets deregulated, trade opened up, and the City given a totally new lease of life through “Big Bang” in the mid 1980’s. Britain became a much more rewarding place to live both socially and financially. The effects of all this rippled around the world and Asia proved to be big beneficiaries of the opening of trade, pulling down of trade barriers, opening up of capital markets, deregulation of capital flows and so on. Hong Kong rapidly became home to more than 330 foreign banking operations, and its financial markets simply took off. Singapore benefited similarly.
China’s emergence from economic serfdom in the 1980’s would not have been possible without the massive changes being made in transforming western economies from slaves to unions to a more results oriented economic framework, most particularly under the leadership of Margaret Thatcher and Ronald Reagan.
All of this coincided with China’s emergence from the economic stone ages, and indeed most surely gave China a huge leg up in its quest to shake off the effects of 30 years of economic mismanagement.
By the 1990’s the balance of economic power had shifted massively away from the unions and labour, to a model where capital and land were receiving the lion’s share of economic returns. This continued at pace all through the 1990’s into the new millennium, with emerging markets benefiting massively from liberalisation of trade and huge capital inflows from the more developed world. This liberalization, deregulation and globalisation has lifted millions out of poverty, no doubt. But the pendulum has also possibly swung too far, just as it had in the 1970’s, in the other direction. Some of the finer points of the economic model that has got us where we are may not be sustainable.
Whereas in the 1970’s the unions needed to be de-fanged, today it is perhaps the power of banks that need to be brought into some new balance. I cannot pretend to proscribe what that new balance might be and the process by which it gets there, but we should be in no doubt that the wings of the soaring global financial houses are going to be clipped in one way or other. The blame game and political realities make it relatively easy to execute in the current mood in western societies.
But as with most great social and economic trends, a lot of good has come about. Liberalisation of trade and capital flows has produced enormous benefits to millions – the policy challenge is to not reverse the benefits by yielding to the very politically easy temptation to slide back into protectionist policies and a ‘beggar thy neighbour’ culture.
A Framework for the Next Swing of the Pendulum
As the pendulum swings back the other way, what are likely to be some of the big picture impacts, and what might be implications for markets?
- A wave of re-regulation of banks is likely, that will probably force banks to separate more clearly their high risk investment banking/proprietary capital trading activities from the more “mom and pop” commercial banking activities. A return to a Glass-Steagall kind of regime that was broken down in the late 1990’s may be in store. Capital ratios will be increased and bank gearing will likely be lowered more or less permanently. Expectations of Return on Equity (ROE) of banks will be lowered, as will earnings growth expectations. The brouhaha about banker’s pay is a convenient political drum to beat, but ultimately is an issue to be decided by shareholders. Financial stocks are unlikely to be the leaders they have often been in recent years.
- While we talk of de-leveraging the global economy, in fact there is probably much less actual deleveraging than we think. Private sector debt in the west is simply being absorbed by the public sector, by the tax-payer. All those homes that were bought with large mortgages by people who could not affords to pay for them, are now falling one way or other into the jurisdiction of the state. The same is increasingly going to be the case for commercial real estate. Genuine deleveraging will take time OR governments will find it convenient to allow inflation to reduce debt burdens. The spectre of rising inflation may prove a driver of the gold price over the coming few years, and a fall of bond prices.
- To do all this fire-fighting, and to inject stimulus into the economy to underpin economic growth and jobs, governments are obviously creating massive budget deficits and will need to issue sovereign paper to pay for it. Chances are that the cost of this debt will rise if buyers of debt lose confidence in the ability of governments to fund their largesse. Sovereign bond yields for many countries will rise, prices to fall.
- High government deficits spell tax increases, tendencies of which we already see in many western countries. Higher taxes are almost inevitable and will act as a brake on economic growth. Expect domestic consumption to remain muted and economic growth to be sub-par. Corporate earnings growth will likely also prove to be subpar.
- The combined effect of these forces is likely to produce volatile currency movements, and the power of the US$ as reserve currency may weaken somewhat over time as countries such as China may feel bold enough to price trade in their own (or other?) currencies.
- Emerging markets in Asia have the ability to stimulate domestic demand in the short term. That should compensate at least partially for the impacts of slower export demand. Growth may continue at levels considerably higher than that of the developed world, but perhaps a bit lower than the heyday of recent years.
- Leaderships of major emerging market economies will be emboldened to make their voices heard on the global stage and will likely promote their own social, economic and political agendas more forcefully. China and India are likely to be at the forefront of these moves, with Russia coming at it from another direction. Political uncertainty will likely rise.
- The savings rich/reserves heavy countries of Asia will likely grow their economic and political influence through a steady process of asset acquisitions around the world, most particularly in the resources field but increasingly in “brands” and technology. This will be met with increasingly xenophobic sentiment and political resistance, underpinning a potential protectionist sentiment shift.
- Political and economic power will inevitably swing away from the west to a greater or lesser extent, with emerging countries calling more of the shots than at any time in the past.
- Asia is likely to be a relative winner in this swing of the big picture pendulum through its ability to engineer relatively higher domestic economic growth even in a world where growth in the west is subpar. High savings rates may come down, stimulating greater growth of local demand.
How Insecurity Transforms to Hubris
We have all probably noticed from time to time how people, companies, countries, sometimes become “too big for their boots”, and set themselves up for a fall. The path by which this happens is a common enough one, and familiar to most who have watched organizations/countries go through the steps from insecurity to hubris.
China’s track over the past couple of decades stands out as one that is well down this path. It was not that long ago that China took the bold and courageous decisions to join the real world, rejecting its failed socialist economic model that perhaps had united the country in some ways, and shaken off the shackles of feudalism, but had singularly failed to deliver the growth, opportunity and social advancement that was common enough in many other parts of the developing world. As it gingerly stepped on to the world stage with experimental reforms of core aspects of economic and social organization, it did so from a position of some insecurity. As its tentative reforms bore fruit, they were spread throughout a society that was very willing, ready and able to take advantage of the opportunities being put in front of it.
China has managed this massively important journey in ways that have been little short of exemplary. It has tended to introduce reform in limited ways to test how things might work, and then expanded them across the nation once the bugs have been ironed out.
The process by which the setting up of the special economic zone in Shenzhen in the early 1980’s, for example, was the first major experiment with building export industries and encouraging foreign investment inflows. Its success was then repeated elsewhere.
There are many examples of such experimentation being tried, tested, then applied on a much wider scale. Examples can be cited in banking, stockmarkets, housing, education, immigration, asset management, foreign capital inflows/outflows, and to a limited extent currency.
As waves of apparent success in these endeavours have grown, China has grown increasingly confident in its own skin.
A similar process occurred in Southeast Asia in the 1990’s. This was an era of very significant capital flows from the high labour cost zones of North Asia (Korea, Japan, Taiwan) to the much lower labour cost zones of SE Asia and also China. The mantra of intra-Asian trade was the by-word for success. North Asia continued to manufacture the high tech “bits” which were shipped to new factories in SE Asia for assembly and then export to the rest of the world. SE Asian countries became increasingly confident and even vocal on the world stage, at a time when many western countries were struggling out of a debt induced recession of the late 1980’s/early 1990’s. It seemed that Asia could do no wrong. The mid 1990’s carry trade encouraged and increased the investment flows. Japanese savers in particular were eager to park cash in Thai, Malaysian, Indonesian banks, getting a double digit interest rate. Companies, bent on rapid expansion, but wary of high local interest rates, sought out borrowing from lower interest rate sources such as Yen, Dollar, Swiss franc. Very clever they believed! And of course there was little currency risk because Asian currency regimes were tightly pegged to the US$. Yeah—Right!
Does this all sound a bit familiar?
Many Asian Markets Have Surpassed “Hubris” Levels of Mid 1990’s – Thailand is the Stand-Out Underperformer of the Group
Asia’s confidence quickly became arrogance, and then hubris. The media touted commentary about “The Asian Way!” – a culture propagated by many but particularly by Malaysia’s then Prime Minister Mahathir.
Everything seemed rosy in the garden – an endless growth nirvana, stretching effortlessly into the future, propped up by an ethos that seemed to say “we know how to run economies and society better than you guys in the west, with your indulgent ways, pussyfooting leadership, indolent lifestyles”.
By 1996, Asia had gone through confidence and arrogance and was entering the hubris stage. As with most societies entering the final stages of such a cycle, debt would prove to be the Achilles heel of a great many companies and individuals. Great swathes of the cash that had flowed into Southeast Asian banks found its way into real estate. Property development was rampant, with companies routinely running debt/equity ratios of 150% and more, with big chunks of their debt denominated in US$/Yen/Swiss francs. Ouch!
Even a casual day or two of research in these countries demonstrated that the building boom was a time bomb about to explode and that the rigged exchange rate regimes would not survive. Banks I visited in Bangkok had little clue about where the loans that they were advancing were in fact going. “Industrial Purposes” was the most oft cited, much of which I suspected was in fact funding the millions of square meters of new office, retail and residential space that was springing out of Bangkok’s ground.
July 2nd 1997 was the day that the Thai authorities finally succumbed, letting the Baht float, and unleashing a wave of Asian contagion around the entire region. Few countries went unscathed, driving most of the region into recession that took years to overcome.
One might argue that the western banking system entered the final rounds of hubris in 2007, but I see precious little public humility out there so far.
I would argue that China is somewhere between the arrogance and hubris stage right now. It seems increasingly emboldened by its ability to have sidestepped the full rage of the global financial crisis. China is patting itself on the back that it has not opened its economy to the full force of capitalism. It has retained control of most aspects of the economy, most notably the currency, and capital flows. Maintaining a growth rate of about 9% in 2009 will be seen as vindication of both its broader economic control mechanisms as well as its short term monetary and fiscal stimulus programs. Its apparent success in dealing with the fallout of the global financial crisis is now being manifest in a more strident tone of rhetoric in the international arena, with a decidedly negative tone emerging in Sino/US relations, its intransigence in dealing with global issues such as climate change, weapons controls.
China’s thwarting of global financial market fallout has been achieved by standard Keynsian policy responses – pump prime a potentially ailing economy through injections of government spending, and fiscal stimulus. It is largely through massive injections of new bank lending and direct fiscal stimulus through infrastructure investment that China has managed to keep growth above 8%. All of this is very creditable but one cannot help wonder if all of this debt creation is not a big beast that will come back to bite at some point down the track.
Victor Shih of Northwestern University puts it well in his article in the Wall Street Journal (Feb. 9, 2010):
“The Chinese Government has financed much of an enormous stimulus package through thousands of investment entities created by local governments. If Beijing doesn’t soon recognize this problem and put a stop to it, banks in China, which have provided the bulk of the funding, may soon face delinquent loans that rival even China’s enormous fiscal and foreign-exchange capacity”.
Mr. Shih notes that after Beijing announced its much reported $588 billion infrastructure stimulus plan in 2008, local governments proceeded to push out around $4 trillion of projects over the coming few years, with Beijing supporting such endeavours as well as the bank lending to support them. Some 8,000 local authority created “investment companies” were set up to take on these projects, and the bank loans for them. Shih’s work indicates that such local investment entities have borrowed around $1.6 trillion (probably an underestimate – ed. note) between 2004 and 2009, and that other estimates suggest such entities borrowed something like $735 billion – $880 billion in 2009 alone. The borrowing by these locally sponsored entities (and this does not include private sector borrowing, mortgage finance etc) represents about 70% of China foreign exchange reserves.
So how do these local authorities finance and repay all this borrowing? Silly me! By real estate and land sales of course! Doesn’t this sound depressingly familiar – the Asian financial crisis of late 1990’s, and the current real estate lending induced mess that the western world is in.
China’s central authorities are caught between the proverbial rock and a hard place.
By encouraging massive monetary and fiscal stimulus to bolster the economy, they have encouraged the creation of massive debts at the local authority level, a considerable amount of which has gone into property development of various kinds. This has fuelled a rapid rise in property and land prices. The principle source of cash that local authorities have to repay these loans is through land sales. Huge incentives therefore to see real estate market sustained.
Elements of Beijing’s leadership see very clearly the risks of the toxic mix of debt and real estate prices, and wants to bring the excesses of the property market into check. But this runs huge risks of pushing loans into default if the property market falls off.
China will probably look to take a leaf out of western books by looking to establish vehicles and mechanisms to absorb what is likely to be an inevitable flood of NPL’s a couple of years down the track. Maybe China should be looking to employ Mr. Geithner and some of the high flyers from the TARP/TALF programs, not to mention Fannie Mae and Freddie Mac!
China is setting itself up for a possibly humbling retreat from its current posture of arrogance bordering on hubris.
Property as an Uncorrelated Asset Class – Or Is It?
For most in the industry, property for years has been viewed as a local industry, driven by very much local forces at both a national level and even at a city/regional level. Property trends in San Francisco have often been very different from Dallas, Chicago, Miami or New York. London has often moved rather differently from Edinburgh, Sydney from Melbourne or Perth and so on.
Within the property sector, often residential property might behave rather differently from office or retail in the same country or city.
In the past there has been no particular reason to think that property in Thailand should behave in a similar fashion to say Tokyo or Hong Kong. Similarly the traditional view has been that property stocks are generally an uncorrelated asset class across borders, and that even property stocks focused on different parts or sectors of the property market within a city or country can behave differently.
Investors also assume that trends in the physical property market will be reflected in the performance of property stocks in that market. To a large extent experience bears this out but not entirely.
There are often quite large leads and lags between property stock performance and physical property market performance. Often property stocks will anticipate movements in physical property well before they actually happen. But it is rare for property stocks to rise over a sustained period of time without some corresponding upward movement in the physical market.
We have found that turning points in Hong Kong’s property stocks occur quite close to turning points in physical property, while for Singapore the lead times are typically somewhat longer. In Japan, they can be longer again, sometimes making for a painful wait.
But coming back to the issue of cross border correlation of property markets and property stocks, we are seeing the traditional notion of property being an uncorrelated asset class increasingly put to the test in recent years. In previous cycles in Asia/Pacific region, there has been considerable lack of correlation across markets. Some markets may have been in a rising or declining mode, more or less simultaneously, but it has usually been possible to find other markets in the region doing the opposite.
For example, in the late 1980’s/early 1990’s property markets in developed countries such as Japan, Australia and New Zealand plummeted into a terrible funk on the back of excess debt, speculative bubbles, and over-building. At the same time many other markets in Asia were turning up in a rapid fashion on the back of rapidly rising economic growth, much engendered by the rise of intra-Asian trade, in itself fueled by outflows of investment capital from north Asia to southeast Asian countries. The carry trade of that time also partly fueled the boom.
So while the property markets in developed countries swooned for some years, those in many Asian markets were racing rapidly into bubble territory. During this period investors in property stocks did well to shun one, and binge on the other.
The Asian financial crisis which erupted in mid 1997 saw a reversal of fortunes, with Asian property markets paying a big price for their excesses, and those of developed markets staging modest recovery. Again, a significant divergence of performance of property and property stocks across the region.
The Current Global Financial Crisis Has Produced Closely Correlated Property Performance Around the Region
The current era has seen a synchronized downturn in the sector, right across the region. This has been a very correlated cycle in both property and property stocks since the onset of the global financial crisis in 2007.
There are significant changes in the property industry and the financial world generally that are perhaps fundamentally changing the traditionally uncorrelated nature of the property sector across countries. It is becoming a much less local industry, and becoming much more subject to global capital flows and macro forces.
Here is my take on some of these.
Early 1990’s – Americans Discover a World West of San Francisco
During the early/mid 1990’s US institutional investors finally discovered a whole new world of investment opportunities existed west of San Francisco across the Pacific. American money had been slow to find its way to Asia – British and European money was way ahead of the Americans. But American flows proved substantial and market changing.
Stock markets were the first home for American investment in Asia, with property stocks often representing a big part of allocations given their large role in local listed securities markets.
North Asian capital flowed at the time to southeast Asia and China in a surge of factory and commercial property development aimed at taking advantage of lower labour costs and rising domestic demand in these countries. This proved to be the first wave of significant cross border capital that found its way into real estate development.
These flows were augmented by the carry trade of that era, with investors in low interest rate countries (Japan) pouring money into deposits in high rate environments such as Thailand, Malaysia, Indonesia and Philippines. Interest rates of 12% plus seemed attractive to Japanese savers more used to receiving a paltry 0.5% or less on their savings. And pegged currencies to the US$ seemed to make currency risk low.
On top of that, borrowers in Asia were quick to source bank lending (or other forms of borrowing) from low interest rate environments such as Switzerland, US or Japan.
Much of these carry trade flows and direct offshore borrowing found its way into property development and investment, the first time that foreign capital had played a significant role in the regional real estate markets.
One would have thought that Asian borrowers might have learned a lesson from the Australian experience of just a few years earlier when Australian property companies had so disastrously embarked on the same trade! The trials and tribulations of the likes of Alan Bond and Christopher Skase seemed to escape Asian borrowers at the time.
Late 1990’s -Private Equity Real Estate Investment Starts to Makes a Big Mark
The late 1990’s/early 2000’s saw a whole new wave of foreign players into the Asian real estate markets, largely in the form of big specialist private equity real estate funds, most sponsored by large US investment banks. They brought large amounts of capital and new ways of looking at real estate investments. First targets were Japan, with HK and China following later. This stampede was soon added to by non real estate players such as traditional private equity funds and hedge funds who saw the opportunities being exploited by the early arrivals.
Development of Regional REIT Industry Has Encouraged Cross Border Real Estate Investment Flows
The development of the REIT industry in the region proved an encouragement for regional money to move within the region. Australian funds, together with Singaporean property companies led the regional charge into cross border investment, with much of this investment being targeted at property that might eventually find its way into a REIT to be listed somewhere such as Australia, Singapore, Hong Kong or Japan. Companies such as Macquarie and Babcock and Brown from Australia, and CapitaLand Ltd (CATL.SI) and Mapletree from Singapore have been at the forefront of this cross border regional real estate activity. China and India are about to launch REIT codes, and this will likely promote even further institutionalisation of the real estate industry as well as further cross border capital flows.
It is worth noting that REIT industries often grow out of the ashes of previous excesses and distress. Australia’s REIT industry, and that of the US truly took off after the property crashes/S&L problems of the late 1980’s in those markets. Japan’s REIT industry was started in the past decade in the depths of the post bubble property era. Even Singapore’s REIT industry was started in the wake of the Asian financial crisis in a time of stress (not so much distress) in the local property industry.
It is possible to postulate that the increase in global capital flows and liberalization of financial markets in recent years has led to a much greater degree of correlation of property markets and property stocks than has been the case hitherto.
For example, see Figures 6 – 9. During the 1990’s, before the Asian financial crisis, and before the advent of large cross border capital flows into real estate, there was a marked divergence of performance between the major regional property stock indices. The bursting of Japan’s property bubble in 1990 saw property stocks decline by around 73% over the coming few years, Australian property stocks did pretty much nothing, while Hong Kong’s property sector soared by around 600%, and Singapore’s property sector also saw returns in a similar league. For property focused investors this was the mother of all switch trades!
Since the end of the Asian financial crisis, markets have been much more closely correlated, and even more so since the current global financial crisis kicked in during 2007. Even though Japan was not so directly caught up in the Asian crisis, its property sector continued its downward trajectory, along with pretty much everything else in Asia. The Australian property sector, by contrast put on about 25% in the period up to 2003 when stocks bottomed in Asia at the end of the SARs episode. Post SARS, in an era of unprecedented cross border capital flows in real estate, all major regional real estate stock indices have soared and crashed together.
What now remains to be seen is whether this pattern of close correlation that has been established in recent years is going to be a permanent feature of the industry, or whether it will revert to its more traditionally less correlated patterns.
I cannot claim to know definitively the answer to this, but can only suggest that we closely look at both global forces that may influence trends in the industry (global liquidity, interest rates, regulatory changes, banking industry changes, trends in private equity, hedge funds) and local dynamics such as demographic patterns, local supply/demand forces, local interest rates, central bank policies, regulatory changes.
For example, there are common threads running through the industry regionally right now.
The globally coordinated response to the US sub-prime initiated financial crisis has produced a massive flow of capital into the real estate industry in many parts of the region, to the extent that more governments than not are concerned not about deflation, but the emergence of asset bubbles, real estate being upfront and centre in this.
It is this concerted policy pressure around the region (Japan being the main exception) to reign in possible excesses in real estate that leads me to maintain a cautious view of short term prospects for property stocks around the region.
Property stocks in Australia/New Zealand and Japan have enjoyed much more modest rallies than in other parts of the region, and the risk of bubbles forming and ensuing policy action is much less than other parts of the region. This could be the seeds of a decoupling of property stock performance in the region. Property stocks in these markets are now reasonably priced, with the worst problems of credit issues now behind. They also sport high dividend yields and most have resolved the worst of their debt issues that rose to the fore in 2008. Vacancy rates have probably peaked in most markets, and supply prospects are modest, suggesting that a possible upturn in rentals and values may not be that far away.