Having looked at the importance of a firm’s investing process and explored investments in World Wrestling Entertainment and the shale oil boom, I turn my attention to the commodities supercycle.
This year James Chanos, president and founder of New York–based hedge fund firm Kynikos Associates, gave the Valuex Vail attendees an update on the Chinese bubble: It is alive and kicking. Jim estimates that Chinese spending on residential construction is currently running at 20 percent of GDP. He got to that number using simple math: 20 million condos constructed at an average retail price of $80,000 totals $1.6 trillion, or 20 percent of GDP. Just think about this for a second. For the U.S. at the height of the real estate bubble, the comparable number was slightly above 6 percent, and today it stands at less than 3 percent. And China has been building empty cities even though its labor force participation rate (and thus household formation) started to decline in 2012, so fewer families will need new housing.
In his presentation Jim said that Chinese policymakers recognize that the national business model is flawed, but with high off-balance-sheet debt originated by local governments, endemic corruption and nonaccrual accounting (the Chinese record GDP when things are built, not when they are sold), it may be too late to do anything.
Meanwhile, rural-to-urban migration runs at 15 million people a year, but these migrants are in the bottom earning quartile and thus cannot afford $80,000 apartments. And, with the usual Chinese twist, some of the migration occurs only on paper, with bureaucrats changing rural disricts to urban ones. So even fewer condos are actually needed. China is creating its own version of the auction-rate securities that helped bring down the U.S. housing market. Long-term projects are financed by wealth products: High-yielding five-month certificates of deposit not explicitly guaranteed by the government are sold by small banks and trusts, and consumers starved for yield are buying them. This mismatch of duration is dangerous, and the story has a predictable ending. The Chinese banking crisis is one failed wealth-product rollover away. (I’ve written about this in the past, but it is worth repeating that the biggest risk to the Chinese bubble is social instability. A lot of people who are buying these wealth products are being fleeced. What they will do when their savings are wiped out is a big unknown.)
Speaking of the Chinese banking system, on June 20 the interbank lending rate in China jumped to 30 percent. Some of the rise was directly caused by the government as it tried to curb wealth-product lending, but the bulk of the jump was spurred by rumors that Bank of China had defaulted on its interbank loans. The rumor proved to be untrue, and the interbank rate declined, but I keep thinking that there is very fertile ground for this suspicion. Banks probably looked at their own loans and thought, “If your Bank of China loans are as bad as ours, then the rumors may be true.”
At Valuex Vail, Jim provided some very interesting numbers. In Tokyo in 1989, at the height of one of the most grotesque real estate bubbles in modern history, property was valued at 375 percent of GDP. In pre-crisis Ireland that number was 350 percent; in the U.S. in 2007, it was 180 percent. In China today it is more than 400 percent.
At Kynikos, Jim is short stocks tied to global mining capital expenditure. He believes the commodities supercycle is ending, as China is the largest consumer of hard commodities, and entering a nuclear winter (my words, not his). Mining capex in 2013 was twice the 2007 level. Think about it for a second. We had an overcapacity bubble in real estate in 2007 that was truly global, taking in the U.S., Europe and China. You would have thought that when the bubble burst in the U.S. and Europe, capital spending on mining equipment would decline, but China singlehandedly doubled global mining capex.
Jim’s idea for stocks: short Caterpillar. I had always thought of Caterpillar as the poster boy of the Chinese commodities bubble, so I was interested in Jim’s take. He thinks that although Caterpillar at $80 doesn’t look expensive — management projects earnings should hit $10 in a few years, compared with a consensus estimate of $6.84 in 2013 — it is a value trap because its earnings power after the commodities cycle bursts will be a fraction of today’s. Its margins are too high, and its accounting is aggressive. Also, in the near term, competition from Chinese heavy equipment makers will increase because they’ll forgo margin to steal market share. If Cat’s operating margins fall from the current 11 to 13 percent range to 6 percent, earnings will be $3 a share. If you put a price-earnings ratio of 10 on those, you’ve got a much cheaper stock.
During the question-and-answer session, Jim was asked about Japan. He said it has not been his focus, but he pointed out that the weaker yen may not universally help export-oriented Japanese companies’ earnings because a lot of them have been offshoring production for years. So don’t blindly assume that a weaker yen will benefit Japanese exporters. And the weaker yen is certain to annoy Japan’s neighbors, such as South Korea and China, which are competing for the slow-growing global GDP pie.
