Don’t ask the barber if you need a haircut

Don’t ask the barber if you need a haircut

Some analysts say you shouldn’t ask your broker whether or not to buy stocks, as they have a conflict of interest – they will always tell you to buy. So, who should you ask? Perhaps J. Kyle Bass, the man who profited handsomely from predicting the subprime mortgage meltdown. Bass is convinced China will need to devalue the renminbi, which would be bad for equities. We think it may pay to read what he says.

In April 2008, D Magazine, the Dallas city magazine, profiled one J. Kyle Bass in an article entitled, Cashing in on Subprime: “The subprime crisis in the housing market has led to a financial crisis and fears of a recession. If only someone could have predicted it. Someone did. His name is Kyle Bass, and he made about half a billion dollars from it.

In 2011 I read Michael Lewis’s book, The Big Short.   In it Lewis acknowledged Kyle Bass, among others, thus: “A small number of people—more than ten, fewer than twenty—made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market, and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed.”

Since then we’ve been following some of the utterances of Bass who runs the Dallas-based hedge fund Hayman Capital, focused on global event-driven opportunities.  ‘Global events’ encapsulates ‘black swans’ – those events that have the potential to derail markets and the life savings of investors.

Before we head any further, lets discuss the recent history of China.  You might recall that since 2010 here at the blog we have been warning investors that their adoration of China’s “economic miracle” was misplaced.  A quick history lesson is useful here.

Largely unnoticed, China’s exchange rate has been strong since 2004, rising more than 60% and eroding China’s competitiveness against Japan, Europe, Russia, and even some Southeast Asian countries.

As we have been reporting here for years, as the Yuan appreciated and China’s competitiveness eroded, China undertook an infrastructure spending program that was reported here in Australia as being solely responsible for the resources boom and which would be sustained for the next 100 years.  Of course China was merely attempting to maintain politically-determined GDP growth targets in the face of headwinds created by the strengthening currency.

As we all now know policy determinations distorted incentives and misallocated capital.  Returns on investment were unimportant, if not completely ignored.

According to one analyst, in 2005, exports constituted 34% of China’s GDP and investment 42%. A decade later investment had grown to 46%, probably because exports had fallen to 23%.

Importantly, the investment was funded by rapid credit expansion in China’s banking system, which grew from $3 trillion in 2006 to $34 trillion in 2015.  Many of these loans however will turn bad.

For China to achieve the required clawback of its real effective exchange rate, the renminbi will need to devalue.  Such an event would unleash mayhem in financial markets and most investor are not prepared.

Legendary hedge fund manager Kyle Bass is 100% certain this will happen.

Here’s a number of KB’s observations that are worth considering.

In the last ten years China has seen GDP rise 500% but this has been exceeded by credit growth of 1100%.  It now takes seven credit units to generate one unit of GDP.  Bass believes China has reached an “atrophy” level that will have significant implications for the USD/CNY.

For short term traders it matters whether the US Federal Reserve Bank raises rates or not.  But, according to Bass, US monetary policy will be overcome by how many bad loans China has made.  The Fed has nowhere to go after setting accommodative monetary policy at emergency levels for seven years.  With unemployment at just 4.5% wages moving higher, if oil stays around $50, Bass believes we will see “integers” on CPI in the fourth quarter.

According to Bass, the US Federal Reserve will have to engage in some incremental helicopter money but it won’t work and it will trigger inflation but it will be the ‘bad’ cost-push inflation not demand-pull inflation.

Before that however, China will have its “comeuppance”.  Its credit system is coming to a halt.  A non-performing loan cycle has begun, the banks will need to be re-capitalised and it will cause the US dollar to move significantly higher against Asian currencies.

Again, according to Bass, credit excesses in China have already been built.  Asset/Liability mismatches in wealth management products are more than 10% of the system.  In the US before the subprime crisis the asset/liability mismatches amounted to 2.5% of the system and Bass notes; “look what that did”!

China’s credit excesses are now way ahead of any other country in the world ahead of their crises.

Bass believes “we are facing the world’s largest macro imbalance in history” adding, “to this day I cannot figure out why people don’t see it for what it is.”

Here’s how China will unravel according to Bass (keep in mind he is betting that it has already started):

• China Banks will have a loss cycle
• Those banks will need to be recapitalised
• China will then do what is best for China, which will be to devalue their currency.
• China will then export deflation to the world “one last time”.

He adds “if you have any money left, it will be the greatest time to invest in Asia ever.”

He expects China’s unwinding to occur before US inflation emerges, which will be followed by higher rates and a continuation of a rising USD.

In the medium term expect a much higher USD against Asian currencies.

One sign of the Chinese machine breaking down can be seen in the corporate bond market.

In 2014 there was one default.  In 2015 there were 15.  In 2016 to April there were 19 and half were ‘standard enterprises’.

Out of 210 announced corporate bond deals there have already been 150 cancellations.

According to Bass, the Chinese corporate bond market is freezing up and this is relevant because many of these corporate bonds are put into wealth management products – funds from the purchase of which are used to pay the yields promised to prior investors.

Now, companies can, in some cases, arrange a debt-for-equity swap, but the problem for the banks that have sold these wealth management products is how do you put equity into something that is levered 4-10 times and where the investor is trying to make a yield?

According to Bass, a “Chinese comeuppance would not be good for equities” adding he doesn’t own any risk assets.

“China’s current situation reminds us of Ireland and Spain, where construction, real estate, and infrastructure investment activity constituted a disproportionate share of economic activity, government revenue, and bank lending. A cyclical downturn in these sectors will have a profound impact on the Chinese economy just as it did in Spain. In fact, Chinese residential real estate investment as a percentage of GDP, which peaked in 2013, was the second highest in global history, only after Spain in 2006, and 60% higher than the US peak in 2005.”

“Consider the past quarter century: a credit boom in Japan that collapsed after 1990; a credit boom in Asian emerging economies that collapsed in 1997; a credit boom in the north Atlantic economies that collapsed after 2007; and finally in China. Each is greeted as a new era of prosperity, to collapse into crisis and post-crisis malaise.” – Martin Wolf, Financial Times

In summary, J Kyle Bass is “100% certain” that:

1) There will be a loss cycle for Chinese banks, and

2) The Chinese will do things that cause their currency to devalue.

As an aside, for property investors in Australia, keep in mind it is foreign lenders to banks that ultimately influence the rates mortgagees pay on their home loans. If China’s credit market busts – as Bass is 100% certain it will – foreign lenders will presumably raise the cost of capital for Australian banks. What that does to leveraged property buyers who currently spill out on the street at property auctions, time will tell.

To balance these views, it is important to note that some institutions believe China’s bad-loan problems are “not as serious as” Hayman Capital Management’s Kyle Bass claims.

One of those institutions is China International Capital Corp., the investment bank Morgan Stanley helped establish in 1995.

Remembering the advice about not asking a barber whether you need a haircut is timely.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.