The China Syndrome

Twice within the first week’s trading in 2016, Chinese stock markets were halted by a 7% “circuit breaker” designed to pause trading to allow panic selling to calm. When it became clear that denying investors liquidity for their shares was feeding panic, not calming it, Chinese officials wisely suspended the circuit breaker yesterday, on Thursday, January 7, 2016. Friday, Chinese markets inched higher, and most world markets followed.

China’s market problems immediately spread to the rest of the world. Here in the U.S., we had the worst first four days of trading in a new year since 1950. (Both 2008 and 1991 saw sharper declines, though they took five and six days respectively.) Those first four days alone officially qualify as a market correction for both the Dow and the NASDAQ, though not for the S&P 500.

There are several lessons here:

For years, there has been a disconnect between financial markets and the real economy, driven by monetary stimulus and access to easy credit. Rising stock prices became the self-fulfilling justification for further rises, largely decoupled from economic fundamentals. China’s problems with bad debts and malinvestment have been visible for five years or more, but the Chinese stock market continued to rise, finally peaking in June of 2015 after an astonishing 150% over seven months.

Though the combination of public and private borrowing, combined with cheap and easy money, can drive speculative excesses for shockingly long periods, they cannot do so indefinitely. In China, in Japan, in Brazil and Greece, we see again and again the ultimate consequences of stupid public- and private-sector investments fueled by borrowed funds. (Put another way, both Tom Friedman and Paul Krugman are idiots, though Krugman’s idiocy is fueled by ideology, not genuine stupidity.)

A heavily indebted world awash in cheap money is unable to generate sustained economic growth at a pace sufficient to lift incomes. More debts and more liquidity will not solve a problem caused by the destruction of both financial prudence and the possibility of rational price discovery. Durable prosperity depends on the action of free markets, with capital flowing toward projects with the highest economic returns. Empty, roofless cities in China, a train to nowhere in California, billions diverted to the private pockets of public officials in Brazil–none of these can provide a solution to stagnant global growth, but all can absorb capital, attention, and human creativity that would earn much higher rewards chasing genuine progress.

To return to robust global growth, we need a return to more normal interest rates and a reduction in the size and regulatory scope of government. (Who in the U.S. political system understands this? Certainly Fiorina, probably Paul and Cruz, perhaps Kasich and Rubio. Clinton? Surely not Trump or Sanders.)

Enough economic commentary. What are the implications of China’s meltdown for investment strategy?

For much of the last two years, our portfolio strategy has been defensive while U.S. stock prices (at least through mid-2015) continued to advance, with that advance highly concentrated in speculative tech stocks. We under-performed. Now that markets are falling sharply, our diversified, cash-heavy portfolios are holding value better than stocks in general.

We live in an interconnected global economy. That means there is no safe place to hide, while still earning positive real returns. (In a low-inflation world, you can hide in cash, but it surely will not provide returns sufficient to buy lunch, gas up the car, or put a roof over your head.) Here is the good news: globalization also means we have the ability to flow capital toward areas of genuine economic opportunity, across national borders, and between industries and asset classes.

There is a fundamental difference between 2007 (the market peak before the 2008 financial crisis) and today. Back then, nothing was either absolutely or relatively cheap. Today, there are huge divergences from historical price relationships, particularly between growth and value (value is cheaper than at any time since 1929, with the exceptions of 1998 and 1999), and between U.S. and foreign stocks. (U.S. stocks are more expensive than foreign developed-market stocks by a larger margin than we’ve ever observed, going back to the creation of the MSCI EAFE Index in 1969.)

Our long-term strategy remains the same. Avoid permanent impairment of capital; don’t own stupid, over-priced assets. Own more of those quality assets that are cheap according to robust historical measures. If the market crashes and they get really cheap, buy more.



The Beginning and End of Big Europe?

The Second World War in Europe ended 70 years ago Friday before last. VE Day (Victory in Europe) preceded by three months VJ day when Japan surrendered, and humanity’s most destructive conflict finally ended. The end of the war was the beginning of the postwar project of European reconciliation and integration. A collection of brilliant statesmen began the planning of what ultimately became the European Union. Their purpose was to so completely integrate Europe’s major powers (Germany, France and Britain), in particular economically, that it would ultimately become impossible for them to go to war with each other.

Since 1945, the European project has faced many challenges, starting with the Soviet post-war domination of Eastern Europe, which led to the Cold War and the creation of NATO. Despite the East-West tensions and the Iron Curtain dividing Europe, European economic ties became ever-stronger, with Great Britain acting as the grumpy cousin who did not want to play nice with the rest of the family. The European Economic Community was formed in 1957, the Western powers won the Cold War and the Berlin Wall fell in 1989, the EEC became the European Community in 1992, the common currency of the Euro began to circulate in 2002, and the European Union was formed in 2007.

Around the turn of the 21st century, the project began to hit some bumpy patches in the road. First, several countries said “No” in various languages to steps toward closer integration. Much of their discomfort arose out of recognition of the fundamentally undemocratic character of the EU’s emerging super-bureaucracy. But the most significant challenge to the EU since the adoption of the common currency in 2002 has been the slow-motion disintegration of Greece.

We know now that Greece never qualified for its 2001 admission to the Eurozone, defined as those countries using the common currency for all transactions, because it did not meet the explicit “convergence criteria” defined by the EU in the Maastricht Treaty. The Greek government engaged in deliberate fraud, cooking the national books with the aid of American investment bank Goldman Sachs, in order to conceal current account deficits far beyond those permitted by the convergence standards. (Greece reported a 1.5% deficit in 2003, below the required 3% threshold, but the real deficit was over 8.5%.) Athens used the benefits of membership to borrow lots of money at preferentially low rates, which was spent largely on social benefits for Greek’s public sector workers and retirees, and also received a great deal of development aid.

In 2010, Greece’s financial manipulations were revealed. It became clear that large amounts of Greek debt, borrowed under fraudulent pretenses from European banks, would not be paid on time if at all. At the beginning of the crisis, there was a real risk of contagion. Banks are leveraged entities, and writing off billions in loans, even to tiny Greece, could have endangered the European financial system, in a manner similar to how bad mortgage loans substantially decapitalized the U.S. banking sector in 2008-2009.

That is no longer the case. A Greek exit from the Euro, either on purpose (“Grexit”) or by accident (“Grexident”) would be a disaster for Greece, but it seems likely it would be an economic non-event for the other members of the EU. So why is Europe, ably led by Germany’s Angela Merkel, going to so much trouble to try to keep Greece in the Union, if not for economic reasons?

The reasons for retaining Greece within the EU are geopolitical and ultimately spiritual. Having gone 70 years without any armed conflict between major European powers is a blessing almost beyond price. If any member of the EU leaves, even one as feckless and underdeveloped as Greece, it calls the entire European experiment into question. The fact that Greece is cozying up to brutal, expansionist Russia is an immediate reminder of past tensions and conflicts.

How long can Merkel’s desire to keep intact Europe’s experiment in peaceful coexistence continue to trump everyone’s frustration with Greece’s serial follies? (Not least that of German voters, few of whom relish the prospect of providing perpetual subsidies to Greek pensioners and civil servants.)

Not, I suspect, much longer. Either Greece will substantially roll over on its refusal to reform its dysfunctional statist economy, or they are likely to be outside looking in by midsummer.