US Economy Ready to Heat Up

Later this week the Bureau of Economic Analysis will report that the US economy wrapped up its 5th consecutive year of GDP growth. Since the average post-war expansion has lasted 5 years, it may feel like the current expansion is getting long in the tooth. However, rather than looking for a recession, I am of the view that the economy is on the verge of accelerating.


The chart above shows that although the economy has expanded in recent years, growth has been below average due to household deleveraging. But there are indications that US households are beginning to borrow again. First, the household debt to disposable income ratio has returned to the lowest levels of the previous decade. And the stronger balance sheet has allowed household liabilities to increase again.

US Debt

When consumers increase borrowing, they are also increasing spending. Since personal consumption makes up two-thirds of the US economy, faster consumer spending can spark faster GDP growth.

In addition to consumption, residential investment is an important driver of economic growth. As I detailed in a recent post, housing starts are set to pick up which can be a tailwind for the economy.

Residential Investment as a % of GDP

In sum, I am expecting consumer spending and housing to help push US GDP growth to 3%+ for the next couple of years.



Buying Nikkei Futures Priced in $USD

I tweeted on Thursday that I thought that there was a greater than expected chance for the Bank of Japan to positively surprise markets and increase its QE program. The BOJ did increase its QE amounts and I tweeted that I bought Nikkei futures as the market exploded higher.

I believe Japan’s 22 year secular bear market ended in November 2012 when the Nikkei rose by 85% in just 6 months. After 17 months of consolidation, Japanese stocks look ready to make another big move up.

Nikkei Long Term Chart-2

My bullishness on Japan rests mainly on Prime Minister Shinzo Abe’s determination to create inflation. As shown on the following chart, Japan has had virtually no inflation over the last two decades meaning that the BOJ has been unable to provide negative real interest rates for the Japanese economy.

Long Term Japan CPI & Interest Rates-2

When Abe was elected, he pushed for the BOJ to increase its inflation target to 2% and named Haruhiko Kuroda as new BOJ Governor. Kuroda, who is cut from the same cloth as Bernanke and Draghi, believes deflation must be fought off with aggressive monetary easing to raise long term inflation expectations. That, he argues, would lower real interest rates and encourage spending.

In fact, Kuroda had been arguing for the BOJ to adopt an inflation target a decade before it set one in January of last year and has spoken in favor of QE for years. And he lived up to his dovish reputation at his first meeting as BOJ governor by announcing that the BOJ was going to double the monetary base within 20 months.

Despite this, economists estimate that Japan’s inflation rate is likely to fall well below its 2% target by next year. The recent drop in oil prices is a further deflationary shock, but gave Kuroda an opportunity to add to stimulus. Last Friday’s BOJ’s announcement of expanding its already enormous QE program makes it clear that he is adamant about hitting the BOJ’s inflation target.

To grasp the enormity of the program, consider that the BOJ is committing to expand its balance sheet by 17% of GDP annually – equivalent to the Federal Reserve implementing QE1, QE2  and QE3 at the same time. As proven by the Fed’s and BOJ’s QE programs, it can force people into bidding more for riskier assets causing stock prices to surge.

Central Bank Assets  (% of GDP)-3

But what makes Japanese stocks particularly attractive is that they are still reasonably priced. They trade for less than 14x forward earnings and 1.3x book value. The recent depreciation of the yen and the fall in energy prices make it increasingly likely that forward earnings estimates will be reached. And if Abe is successfully able to implement the third arrow of Abenomics, structural reform, then Japanese equities could do even better than I expect.

I decided to buy the $US denominated Nikkei futures trading on the CME because I am concerned about continuing yen weakness and the risk of a Japanese government debt crisis down the road. Japan’s debt load is so enormous that I believe it is already insolvent though it will ironically require the BOJ to successfully create meaningful inflation for the markets to get spooked. In the meantime, I expect Japanese stocks to experience a crack up boom. I will track my trade here.

Buying Homebuilders (NYSE:ITB)

My bullish view on single family housing starts (as detailed in a recent post), coupled with the recent sell off in homebuilders caused me to buy the iShares US Home Construction ETF (NYSE:ITB). I tweeted about it late Wednesday night and will track it in my portfolio page using that day’s closing price of $22.17 as my initial price.

Although housing starts stagnated over the past year due to the rapid rise in home prices and interest rates, there are reasons for optimism. According to the Case-Shiller index, year-over-year home price growth has softened from just over 10% late last year to 5.6% in July. In addition, the most prevalently quoted conforming 30 year fixed rates dropped below 4% last week for the first time since June 2013.

As for the state of home buyers, employment continues to grow 200,000+ per month with moderate wage growth, while household debt to disposable income continues to decline.

A potentially positive recent development was the report of a likely deal between Fannie Mae, Freddie Mac and mortgage lenders to loosen lending. This could make mortgages more obtainable for lower income families.

Over the past year, homebuilders’ stocks have flatlined along with housing starts, while significantly underperforming the market.

$ITB Performance vs. $SPY

Despite little growth in new home sales, homebuilders have been able to grow their top and bottom lines by raising prices. So if sales begin to increase again, they could easily grow EPS by 20%+ and achieve 2015 analyst estimates.

As shown in the following chart, the largest homebuilders currently trade for 12x next year’s earnings compared to S&P 500’s 14x its lofty estimates.

Homebuilder Valuations

Looking beyond, past housing recoveries suggest housing starts could increase 15-20% for several years allowing homebuilders’ operating leverage to grow earnings even faster making their stocks attractive long term investments.


Single Family Housing Starts Set to Reaccelerate

In my view, one of the most obvious secular growth stories is the rebound in single family home construction. Although single family housing starts increased off of exceptionally depressed levels in 2011, they have stopped growing over the past year and remain less than half of past cyclical peaks.

Housing Starts

This has resulted in a lot of bearish commentary predicting a ‘new normal’ for housing where starts will never again rise to its historical average. I believe the stagnation in home construction over the past year can be attributed to rapidly rising interest rates and home prices.

Interest rates surged last summer causing the 30 year fixed rate to rise from 3.35% to 4.5% in just 2 months. This resulted in anyone taking out a $300,000 mortgage having to pay roughly an additional $200 a month.

Economists at Goldman Sachs have found that “the effect of monetary policy shocks on [building] permits persists for 3-4 quarters.” Now that interest rates have stabilized and the market has had over a year to digest 4%+ rates, its negative effect should wane.

Mortgage Rates

In addition, home prices were increasing at an unsustainable double digit rate last year which was certain to inevitably cool off demand. This year, however, home price gains are moderating and should continue to slow down leading to more demand.

Home Prices

The National Association of Realtors’ Housing Affordability Index, despite sharply dropping last year, is still at a historically high level. There is room for home prices and interest rates to rise some more without jeopardizing affordability.

Housing Affordability Index

While many housing bears cite tight mortgage lending standards as a reason home sales will struggle to rise, going forward credit can only loosen. In fact, there is evidence that banks are easing credit standards. According to the July 2014 Fed survey on bank lending practices: “a moderate net fraction of domestic banks reported having eased their standards on prime residential mortgages, on net.”

The US population has been growing by 3 million people a year. This population growth would require 1.2 million additional housing units per year. Given that 250,000 homes are demolished each year, roughly 1.5 million homes need to be constructed annually. Instead housing starts have averaged approximately 850,000 per year as household formation rates have collapsed.

As the economy normalizes, there is huge pent up demand for new housing. I expect single family housing starts to return to its historical average of 1.2 million by the end of this decade.


Closing Russia (NYSE:RSX)

Last Friday I closed my long position in the Russia ETF (RSX) at $24.80 which is equal to my initial buying price. As I mentioned in this post, if the RTS index were to have a weekly close below 1220 I would close the trade. As it turned out, the RTS finished the week on August 1st at 1212 for a second false breakdown this year making the triangle pattern unreliable.

Russian Trading Systems-2

I was hoping to wait and sell out at a better price, but the geopolitical situation in Russia seems to be deteriorating and beyond my area of competence so I decided to close the position before the weekend.

My rationale for the trade was based on the chart and valuation. While Russian equities remain extremely cheap relative to other markets and its own history, it can remain so for years. I was hoping the false breakdown would signal that Russian stocks were ready to close the valuation gap, but the unexpected shooting of flight MH-17 along with the increased sanctions between Russia and NATO countries has trumped the chart.



China No Longer a 2014 Risk

In a recent post, I discussed how the current slowdown in the Chinese economy posed a near term risk for global financial markets. However, I am now finding myself less concerned as the improvement in recent data along with increasing government support and accelerating growth in bank lending suggests that the economy could be stabilizing.

As seen in the following chart, the HSBC manufacturing PMI registered weak readings earlier this year which was predicted by the drop in new loan growth late last year.

China New Loans vs. PMI (2)

In response, it appears that the Party has again panicked in the face of slowing growth and in recent months has stimulated the economy through tax breaks, investing in railways, rebuilding urban shantytowns, weakening the renminbi, cutting reserve ratio requirements for most banks, relaxing property curbs, and injecting liquidity into the banking system.

These measures have filtered through the economy causing the PMI to strengthen rather than weaken further as indicated by the lending data. In addition, the high rates of credit growth that occurred in the first half of the year are set to bolster the economy during the second half of the year.

Despite the government’s hope to rebalance the economy away from investment driven growth, in recent years whenever investment growth slows as it did during the early part of the year, it causes higher unemployment. Officials recognizing that a large number of people out of the labor force could be a source of social unrest, immediately stimulated the economy with easy monetary policies to increase credit growth and started new investment projects to reignite job growth.

In addition, FT Alphaville recently noted how little we are hearing of Chinese debt defaults despite being in the midst of a wave of distressed corporate loans and wealth management products that are set to come due. FT Alphaville highlights a Credit Suisse note that the likely explanation is that “a combination of bank rollovers, local government bailouts and asset management companies acquisitions has made the distress of trust funds easier to handle in the near term.”

China Bonds Coming Due

If risks of major corporate defaults and a sharp slowdown in the Chinese economy are taken of the table in the near term, then there is unlikely to be a financial panic occurring this year.

The financial panics that occurred in recent years were due to governments not getting out in front of the problem. In the fall of 2008, it’s unlikely markets would have seized up if the government would have bailed out Lehman Brothers’ creditors as it did with Bear Stearns’ and the Fed cut rates to zero sooner. In 2011, yields on European periphery debt would not have blown out if the ECB had not hiked rates earlier in the year and had not waited until year end introduce the LTRO program.

Technically, Chinese stocks have been strong over the past few months and have recently broken out along with many other emerging markets. This along with depressed valuations and negative investor sentiment could lead to further gains for China’s stock market.

Given that Chinese officials are supporting the economy just when it began to slow, means that China’s Minksy moment has been postponed at the cost of inflating its credit bubble even more. And if there is no hard landing for China in 2014, then global markets should remain resilient and a 15-20% stock market correction is unlikely to occur.

Buying Fiat (Italy: F)

I recently purchased Fiat’s stock listed in Italy after coming across a persuasive presentation by Michael Guichon, a Columbia University MBA student, who presented his bull case for Fiat at the 2014 Ira Sohn Contest. A panel of judges including Bill Ackman, Joel Greenblatt, Seth Klarman, and Michael Price selected Guichon as the winner. Below, Guichon summarizes why he likes Fiat’s stock. I will be tracking Fiat’s performance here.

China Could Scare Markets This Summer

As I explained in a previous post, China has a massive credit bubble that inevitably will deflate. Almost always the onset of debt deflation causes a market panic as disappointed investors run for the exits fearing falling asset prices, bankruptcies, and a sharp economic slowdown.  I believe there is an elevated risk that China could face a Minsky moment in the coming months.

There are several reasons that make me fearful of a China induced market panic this summer. First, new loan growth has been a good leading indicator for economic growth. As shown in the chart below, new loan growth really dropped off in the fourth quarter of last year signalling a deepening economic slowdown in the next few months. Interestingly, new loans picked up significantly in the first quarter, so the economy could experience a temporary rebound in the second half of the year.

China New Loans vs PMI

Second, China’s property market has cooled considerably in recent months and prices are no longer rising. This is important because property serves as collateral for 20% of all loans. As a consequence, credit growth could slow and non-performing loans at banks could spike higher.

China New Home Prices

Chinese corporations were already struggling to manage its debts. Currently, more than one-third of China’s GDP is needed just to service the debt.

China debt service cost by Societe Generale

Third, to make matters worse, a large wave of debt is coming due in the next few months. Though systemically important companies will be bailed out, many others will face default.

China Bonds Coming Due

As a chilling reminder, the US financial crisis began when the initial wave of mortgage resets hit in early 2008.

US Mortgage Resets

The final reason why China could cause a market dislocation during the summer is that Chinese officials seem to recognize the negative effects of the the large scale stimulus implemented in 2009,  and they have openly stated that no large stimulus measures will be forthcoming. Speaking at the annual Boao Forum for Asia on April 10, Premier Li firmly rejected stimulus remedies.

We will not resort to short-term stimulus policies just because of temporary economic fluctuations, and we will pay more attention to sound development in the medium and long run.

I suspect financial conditions will have to get a lot worse before officials backtrack and aggressively stimulate. If so, the following scenario could unfold during the year: economic data from China is reported that badly misses expectations, growth estimates get cut, several companies and wealth management products miss debt repayment deadlines, interest rates fall further on deflationary concerns, the US dollar and Japanese yen surge higher, and stock markets around the world fall by 10%-25% within weeks.

If indeed the Chinese economy disappoints and stocks sell off, I would expect a series of reserve ratio cuts by the PBOC. This monetary easing along with the delayed reaction to the 1st quarter lending surge and mini stimulus announced in April should help the economy to experience a temporary rebound later in the year and halt any market panic.

In the meantime, investors would be wise to raise some cash and hedge their portfolios just in case China causes a temporary panic sell off in global markets.

Buying Russia (NYSE:RSX)

I recently bought the Market Vectors Russia (NYSE:RSX) etf at $24.80. I am bullish on Russian equities based on its terrible past price performance, negative sentiment, dirt cheap valuation, and attractive chart pattern.

After Russia’s debt default in 1998, the Russian stock market went on an explosive run for 10 years appreciating by 50 times. Since the global financial crisis, however, it has been among the worst performers globally declining 50% during the past six years. This is because Russia’s economy has been grappling with slowing growth, high inflation, shrinking current account surpluses, and a weak ruble. The recent tensions with Ukraine have only exacerbated investor antipathy.

As Nathan Rothschild famously said, “the time to buy is when there’s blood in the streets.” It’s hard to find an investment today where that is more applicable than Russian equities. Russia’s incursion into eastern Ukraine and its annexation of Crimea has sparked worldwide concern of potential war. Hillary Clinton, John McCain, and German finance minister Wolfgang Schäuble have gone so far as to compare Vladimir Putin’s actions to Adolf Hitler’s aggressions in the 1930s.

I am no expert on Eastern European geopolitics, however former U.S. Secretary of State Henry Kissinger doesn’t believe the Putin-Hitler comparison is valid. Speaking to CNN earlier this month he says,

“One has to ask oneself this question: He spent $60 billion on the Olympics. They had opening and closing ceremonies, trying to show Russia as a normal progressive state. So it isn’t possible that he, three days later, would voluntarily start an assault on Ukraine.”

“I think at all times he wanted Ukraine in a subordinate position. And at all times, every senior Russian that I’ve ever met, including dissidents like Solzhenitsyn and Brodsky, looked at Ukraine as part of the Russian heritage. But I don’t think he had planned to bring it to a head now. I think he had planned a more gradual situation, and this is sort of a response to what he conceived to be an emergency situation.”

A full blown war could certainly breakout and cause Russian stocks (as well as stocks around the world) to drop further. But a lot of the fear is priced into Russian stocks since they trade at the cheapest valuation relative to the world and to its own history.

Russia Valuation

The chart of the US $ denominated RTS looks like a false breakdown recently took place. If so, it should signal an explosive move higher.

RTS Russian Stocks

What I like most about this trade is that there is a clear stop loss level at the bottom support line. I am willing to own RSX as long as the RTS does not post a weekly close below 1220. I will keep track of the performance of this trade here.

China’s Growth Will Slow for Years

While China’s economy has slowed down from over 10% in 2010 to 7.4% last quarter, economists unanimously believe growth will soon bottom around 7% and maintain that pace for the next several years. As I will discuss, China’s economy is structured in such a way to make that forecast implausible. More likely, China will continue to decelerate for a few more years after which growth will bottom in the low single digits.

China GDP Growth

To understand why, it is important to recognize that the high economic growth rate China enjoyed for years was fuelled by a massive credit bubble that is unsustainable and must burst at some point in the next few years. In fact, debt has now grown to a point which has historically tipped countries into painful recessions.

Credit to GDP during bubbles

Unlike most western countries, where consumption is the largest source of demand, in China it is fixed asset investment which comprises 50% of the economy and rising. Meanwhile, consumption and net exports are continuing to shrink as a proportion of the economy.


To appreciate the significance of this, imagine if investment stagnates during 2014 while the rest of the economy grows at the same rate as in 2013. Then China’s GDP would drop from 7.7% to 3.8% – a sharp deceleration that most would call a hard landing. Therefore, the only way policymakers can rebalance the economy away from investment and towards more consumption without causing a recession is by having investment growth slow at a gradual pace at the same time consumption growth accelerates.

In practice, there are two reasons why this soft landing handoff between investment and consumption is unlikely. First, real estate investments are an especially important sector of the Chinese economy accounting for one-third of total fixed asset investment and 16% of GDP.

Real estate as a percent of gdp-2

And real estate loans make up 20% of total outstanding loans.

Real estate loans as a percent of total loans

The problem is that home prices, particularly in tier 1 cities,  are among the most expensive in the world relative to peoples incomes.

China Home Price to Income

Also, there has been a significant overbuilding of apartments particularly in lower tier cities leading to inventory that will take years to clear out in a normalized demand environment,

Apartment Starts vs. Sales

Home prices have risen strongly over the past decade. but an inevitable correction in the property market, which serves as collateral for property loans, would cause widespread defaults, a banking crisis, a plunge in real estate investment, and a hard landing for the economy. In other words, real estate investment will drop significantly during a downturn.

China Home Prices

A second reason why investment could fall quickly is that credit bubbles require increasing amounts of credit to create each additional unit of GDP. This is because a lot of the borrowed money is being spent on wasteful projects that do not earn enough of a return to service the debt. This is certainly the case in China where credit growth has been exceeding GDP growth for a number of years. Thus, for China to avoid a sharper slowdown, debt has to keep growing at an accelerating pace.

Screenshot 2014-05-14, 1:14 AM


China Credit Growth to GDP Growth

Unfortunately, 38% of GDP is required to service China’s corporate debt annually signifying that businesses are close to reaching their debt capacity.

China debt service cost by Societe Generale

And corporations are becoming less productive despite rising leverage.

China Productivity Compared to Leverage

This trend is not sustainable and in due time should lead to a surge in defaults and nonperforming loans for lenders. The knock on effect is a loss of business confidence leading to declining demand for and supply of credit, and a nasty drop in investment growth.

Most concerning is that China’s economy has already slowed down for three years straight, yet debt-to-GDP has continued to increase. When the economy actually deleverages, growth could decline more meaningfully leading to a financial crisis.

This would be problematic for the rest of the world because China has been the greatest contributor to global growth.

contribution to global growth

To conclude, I believe the biggest risk investors face in the coming years is a China recession. It will be important to monitor how effective Chinese policymakers will be in stimulating the economy and limiting turmoil in financial markets.