The London Brief - September 30th, 2021

The London Brief

September 30th, 2021

Xu Jiayin, the Chairman of China real estate firm Evergrande, sent a letter to its 125,000 employees urging them to unite. The company would soon “walk out of the darkness.” With $305 billion of liabilities and a company on the brink of collapse, he’s somewhat right that it’s less about darkness and more like an exploding supernova.

This quarter’s brief talks about the ‘domino theory’ and Evergrande, the impact of zero-COVID policies, China’s relations with the West, my latest thoughts on inflation, a dissection of the decline of liberalism and its impact on markets and a summary of the key technologies of the future.

Everdebt

China Evergrande has developed 876 projects on 293 million square metres of land with properties in every Chinese province. When China imposed new rules to control developers’ debt, such as forcing real estate companies to stay within a certain debt to income ratio, Evergrande found itself unable to meet interest payments.

Evergrande is part of a larger issue. Banking assets sit at $50 trillion alongside a complex web of shadow banking assets. According to the Bank of International Settlements, credit to China’s non-financial sector saw double digit growth over the past five years and sits at $35 trillion. Total credit to firms and households is now 287% versus 178% ten years ago. Real estate accounts for around 30% of all outstanding loans in China, versus Japan’s 21%-22% during its bubble period. The total debt of developers is $2.8 trillion or about 18% of GDP according to Morgan Stanley. Chinese firms have issued $1 trillion worth of dollar bonds. According to the Rushi Advanced Institute of Finance, condo prices in the southern city of Shenzhen are 57x the average annual income and 55x that of income in Beijing. Even at the height of Japan’s bubble economy in 1990, Tokyo condos were only 18x the average annual income. According to Ken Rogoff of Harvard and Yuanchen Yang of Tsinghua University, residential investment is 15% of GDP and including construction and related industries, the total rises to 29%.

This suggests that Evergrande could create a cascading effect that works its way into the Chinese economy and creates a deep malaise. Some housing developers are slashing prices to generate cash flow to fund operations. They are cut off from debt markets suddenly attune to the risk of lending to these developers. Provincial authorities are calling them malicious price cutters and trying to mandate the size of the discounts. Rhodium Group, a consultancy, said in Shenzhen real-estate transactions fell for four consecutive months to 2,423 in August compared to 8,376 in 2020. Local governments have tried weaning themselves off land sales since the issues from 2018, including more tax revenues and municipal bond sales, however, government statistics show that land sales have grown and now are 8.3% of GDP versus less than 7.0% in 2018. Smaller cities would have to drastically cut spending without this revenue source. In 2019, for individuals, housing represented 60% of total assets versus financial assets that are only 20%. Mortgage debt is 76% of total household liabilities. Many of these homeowners have paid for homes to be built by developers in advance with pre-sale revenue as a source of funding for developers rising from 39% to 54% according to Natixis.

Citigroup’s head of pan-Asia trading strategies has done a ‘domino’ analysis on China. He sees Evergrande as the first domino that could spiral into a deeper crisis that could ultimately impact global financial markets. Note he believes the dominos may not fall in order. The domino analysis is as follows:

Domino 2: Companies Similar to Evergrande. A significant number of companies are borrowing above 20% rates and can no longer fund from the dollar funding market. These companies can either default, they can try to sell assets, they can go to government banks to borrow money (but this route is currently closed until January) or they can go to the government. Today there are 35 “significant” companies, as per the strategist’s definition, and 13 are saying in the dollar funding market that they should not be refinanced. This is like the sub-prime equivalent; one has gone down, and the others are feeling the knock-on effect. These companies are 12.5% of the current market cap of the property sector. The amount of market cap that has been lost is $250 billion and including Evergrande is $500 billion to give some scale of numbers.

Domino 3: Minsheng Bank. In 2008, Bear Stearns imploded due to subprime debt. Citigroup is watching Minsheng Bank, which has lost over half of its market cap over the last few months. It is currently modelling a 20% probability of default. It could create contagion effects within the banking system.

Domino 4: Small Banks. There are a bunch of banks in China that are very similar to Northern Rock, a small bank in the UK which imploded due to its exposure to subprime debt and a balance sheet that was wrong-sized. These banks have low transparency but create exposure to larger banks and insurers. If more property developers go supernova these banks are vulnerable.

Domino 5: Ping An. This is a private insurer with a lot of problems. They own a property company called China Fortune Land. 5% of the investment portfolio is leveraged 10x. The CEO and company are under regulatory investigations. They issued wealth management products for Hong Kong tech shares. These have been sold to millions of people across the investor base of Ping An. They could see their savings wiped out and China may force Ping An to make them whole. Ping An is systemically important. The dollar bonds only widened out 40 bps last week, but it shows the market knows there is a problem.

Domino 6: The Equity Market. There are $300 billion worth of margin loans. If an insurer like Ping An went into stress, there could be more share selling on other banks creating a cascading impact that triggers margin calls.

Domino 7: Big Banks. ICBC and other systemic banks interface with international markets. Their equity prices could plummet and their CDS could widen. Regulators and the banks have been assessing their risk exposures optimistically much like Morgan Stanley and other large U.S. banks did during the subprime crisis.

Domino 8: The Credit Market. If China bank CDS blows out everything else blows out too and credit contracts dramatically. With $50 trillion of bank assets, that’s a lot of contraction.

Domino 9: The RMB Breaks. Chinese banks would have to go on a worldwide hunt for dollars, which would lead to pressure on RMB and volatility and potentially force China to break its peg.

Domino 10: The Crisis Goes Global. European, Korean and Indian banks with yuan exposure could collapse and start to create an international contagion impact.

While Citigroup does not believe this will happen, he thinks markets are not pricing in the contagion scenario aggressively enough. Other strategists think China has enough flexibility and firepower through its reserves to act like a circuit breaker once enough wealthy people and oligarchs have lost money. Andrew Garthwaite of Credit Suisse said China is not a systematic risk. He notes that property prices are not yet falling (need to fall another 20% from here given the low LTVs). China also has net foreign assets, a current account surplus and a modestly closed capital account. This gives them the ability to print money and bail out developers or the contagion impacts. The domestic bond market is stable. One hedge fund noted that banks have used up government quotas for lending to property firms this year and they will be out in the market from January with new loans. Other investment firms have spoken to regulators. They say they are well apprised of the risks such that there is a belief Evergrande will be a one-time thing. Fidelity thinks Evergrande’s turbulence will only knock of 100 bps from China’s growth. The currency markets are indicating that there is no fear of contagion with the yuan trading stable.

Citigroup’s strategist counters, however, with his view that while the Chinese government can fire-break the market, he questions whether they will in the short-term. If there is no policy urgency to do anything, then the market will simply get weaker, and the dominos will fall until the government implements the fire-breaker. But will it be at Domino 9 or Domino 2? So far China’s command economy suggests they will allow this crisis to continue to teach people a lesson. In addition, China’s ‘Zero Covid’ approach is likely to depress growth, which may further exacerbate the impacts of policy inaction. Beijing’s “Common Prosperity” program forces companies to curtail rent increases pressuring revenues. Goldman warned that the cap in rent increases could spill over to the broader Chinese property sector. If China reacts at a later domino, then it’s possible the policy flexibility is less than we think because $50 trillion of banking assets is much larger than $3.2 trillion of foreign currency reserves.

It’s something to watch. Right now, the market is firmly under the belief that “China got this”, which may prove to be too complacent.

Zero-Tolerance COVID

Zero-tolerance COVID protected populations and led to low death counts from the virus. However, as more facts come out on the vaccines, it’s becoming clearer that a zero-COVID stance is no longer tenable.

Mark Purcell of Morgan Stanley gave an informative presentation based on six recent studies published and discussed in recent weeks. He used to work at AstraZeneca. He also analysed a seventh study from South Africa and CDC data. His main conclusions are:

• A pre-print cohort study in Israel, shows there is 4x-8x more protection if you’ve been infected versus the vaccine; natural immunity is more important and lasts a long time.

• The risk of hospitalization post infection is 13.2% for unvaccinated individuals, 2.0% for the Pfizer vaccine and 1.5% for those taking AstraZeneca.

• Vaccinated and unvaccinated individuals affected by Delta show a similar viral load. This suggests that the reduction of transmission with vaccines may only be 30% to 40% and raises questions about the effectiveness of vaccine passports.

• Countries pursuing ‘zero COVID’ policies could be disrupted by Delta because the variant is able to achieve high viral load even in vaccinated individuals.

• Protection against the infection with the Pfizer/BioNTech vaccine is beginning to wane in the face of the Delta variant based on data from U.S, the UK and Israel. AstraZeneca and Moderna’s vaccines seem to be more durable, but the ZOE Study group data suggest a linear decline in protection from Pfizer and AstraZeneca.

• Glaxo is testing a third vaccine that will use a different approach from both mRNA and AstraZeneca that could also help.

• Mixing and matching vaccines does not do harm and it also seems to be another way to boost effectiveness.

• In the 4Q this year, longer-term data on T-cell immunity will be out on the AstraZeneca vaccine.

• The majority of the severe COVID cases in Israel are the unvaccinated.

• A CDC July-August study shows that vaccine efficacy against hospitalization is 95% for Moderna and 80% for the Pfizer vaccine which suggests that providing 3x more copies of the SAR-COV2 spike protein seems to be more effective.

• The combination of lower levels of population immunity to flu, and greater difficulty in predicting the key flu strains in circulation this winter mean that this season could be much worse. Deaths could be 1.1x-2.2x normal in the UK from flu with an estimated 80,000 hospitalizations and potentially 50,000 deaths.

What does this mean? In the UK, over half of children have antibodies and scientists believe about 60% have been infected. In Israel, only 20% were infected prior to the delta variant. This is probably why Israel is seeing a sharp spike in cases from the Delta variant. In Australia, only 1% was infected. In New Zealand, they will achieve vaccinations by the middle of November, but after that if they open and the delta variant spreads, then there could be significant disruption. China has to make a decision about how to handle re-opening. Their vaccine is less effective, and their population is especially fearful about the virus.

It also means that people who don’t take the vaccine are not necessarily evil. If vaccines cannot stop cases from developing and lose effectiveness, everyone taking the vaccine will not mean COVID goes away. It can reduce your probability of hospitalization by a factor of 90% so it would be worthwhile to take it, but ultimately, it’s a personal choice and hospitals have been better able to cope with COVID surges. We allow people to smoke and over-eat; that obviously impacts mortality. But we believe that it should be a personal choice. It might help convince more people to take the vaccine if politicians at least respect the choice and seek to educate on its benefits with the data, rather than feed conspiracy theories with hyperbole.

China’s Relationship with the West

I attended a talk with the U.S.-China Business Council about the bilateral relationship. Domestic politics within both the U.S. and China are preventing the leaders from building a personal rapport or a willingness to concede on points. The theme of a Common Prosperity within the CCP has led to less financial investment into China. Venture capitalists have seen valuations coming down given that listings cannot be done outside of China. However, on the foreign direct investment side, Xi’s “Common Prosperity” has not changed much. The council thinks this is no coincidence in terms of what China prefers in terms of investment. Between now and China’s next party congress, there will be no smooth sailing; each will pursue its own interests and not like each other. But for U.S. businesses China is a good market, profitable and is unlikely to change much in the near-term. Both sides want to keep economics and trade going. The Council is tracking 550 China-related pieces of legislation proposed in Congress last session. Currently legislation is on track to exceed that number in this session of Congress. In contrast, there were only 130 pieces of legislation related to terrorism, showing where most legislative fear lies. In the National Defence Authorization, China featured prominently in terms of procurement including expanding semiconductor production, modifying human rights sanctions and an intelligence review of supply chains.

Outside the U.S., China also has tensions with the West. Three out of four directors on the Cambridge Centre for Chinese Management receive funding from Huawei. Collectively Huawei gave £40m of grants to 20 UK universities. An honorary fellow of the centre praised Huawei’s “ability to transform the intellectual elite into a band of soldiers with the same set of values and resolve”. The UK government is now looking to restrict this funding. On another front, Wikimedia claimed a pro-mainland China group infiltrated the Chinese language site of Wikipedia to “promote the aims of China, as interpreted through whatever filters that may bring to bear.” Wikimedia had been investigating infiltration for a year, but threats to volunteers’ safety “led us to prioritize rapid response.” They have banned editors after it appeared they had ties to a Mainland China group. Japan is also likely to become less pro-China after its election. Beijing is watching the fate of LDP Secretary-General Toshihiro Nikai, who long has maintained close ties to Beijing. However, younger members of the LDP are unhappy with his dictatorial style so he is unlikely to retain the position regardless of who becomes the leader, and there is a growing faction of hardliners in the LDP.

Inflation is Here

On the inflation front, ultra-low interest rates continue to distort markets, although it’s been this way for so long, most would not consider it so. One example is that Goldman noted that in 2012, in the U.S. there were 11 VC-backed companies who achieved unicorn status (a valuation over $1 billion). In 2020, about 175 companies reached unicorn status and in 2021 and year to date, 299 companies have achieved that feat. There were 8,000 VC deals closed in the first 6 months of year in the US totalling over $150bn. Late-stage valuations for privates were a tick below $1bn and up 9x vs 2013 averages.

In the NY Fed’s August Survey of Consumer Expectations, the bank said that respondents see inflation a year from now at 5.2%, up from 4.9% the prior month. Three years from now, it is expected to be at 4.0%, up from 3.7% in July. Both readings mark record-highs for data that goes back to 2013. The report also found big increases in some of the most important costs Americans face on a regular basis. Food prices are seen rising by 7.9% a year from now, rent by 10% and medical care costs by 9.7%.

Further distorting the labour market are unemployment benefits. Currently there are now five job offerings for every four unemployed Americans. As an anecdote, Toyo Tire and Kubota face a labour shortage in the U.S. Toyo Tire decided to cut production in its main factory. Kubota cut lawn mower production and smaller tractor production. Inventory is now only 2 months compared to 6.5 pre-COVID. I spoke with someone at an Aramark comparable, which hires lower-skilled labour for jobs like security, ticket collection, laundry and food services and he notes that many employees are at home milking their unemployment checks. In some cases, people earn more on the checks than working. A contract manufacturer I spoke to in Illinois has fifty people he normally employs and 27 are claiming unemployment benefits. He calls them each day about whether they want to work and they say “not yet” as they watch Netflix on their couch. Another company in laundry services, noted that people join, work a day and then quit claiming unemployment benefits. The jobs creation number disappointed in September, but if those unemployment benefits did not exist, there is a good chance that it would not have. In October most of these benefits were phased away; I am expecting a sharp boost in employment as people give up their binge-watching; however, it could make it look like we are over-heating.

Liberalism and Markets

The Economist in a September 4th article summarized liberalism as requiring “you to defend your opponents’ right to speak, even when you know they are wrong. You must be willing to question your deepest beliefs. Businesses must not be sheltered from the gales of creative destruction. Your loved ones must advance on merit alone, even if all your instincts are to bend the rules for them. You must accept the victory of your enemies at the ballot box, even if you think they will bring the country to ruin.” Populists denigrate science and the rule of law. They spread conspiracy theories about the deep state and potentially resort to force when the outcome doesn’t fit with their narrative.

However, on the other side of the spectrum, the illiberal left restricts freedom of speech, uses a caste system of victimhood “which those on top must defer to those with a greater claim to restorative justice… The results are calling-out, cancellation and no-platforming.” The illiberal left is a reaction to events such as the global financial crisis, George Floyd’s police killing and Trumpism. A prominent political scientist for the Great Awokening is Ibram X. Kendi who says, “Capitalism is essentially racist; racism is essentially capitalism.” In Australia, Ziggy Switkowski was run out of Melbourne’s RMIT University where he held the role of chancellor after an online union petition signed by hundreds of people called for his resignation after he joined Crown Corporation’s board of directors. “When the National Tertiary Education Union first learned of Ziggy’s appointment at Crown Casino we assumed he would be stepping down as chancellor of a university. In fact, it’s quite disgusting. Universities are not corporations, and they are certainly not casinos.” A political scientist at Sarah Lawrence College published data showing that administrator liberals outnumber conservatives by 12 to 1. Suddenly he faced a campaign by activists to revoke his tenure. About 49% of Democrats support cash reparations for slavery and 41% endorse de-funding the police. President Biden embraces policies of a $4 billion fund to pay off the debts of only non-white farmers, and a proposal that 40% of benefits from climate-change investment go to disadvantaged communities. One lesson in California’s ethnic studies program is to “dispel the model-minority myth” about Asian-Americans saying that to dwell on their success is wrong. When doing math problems, the curriculum suggests having a debate about gender norms in the word problems. The governor of Oregon proposes ending high school graduation requirements in reading, writing and maths until 2024 to promote equity for non-white students. Corporations are embracing identify politics. Facebook promises to hire 30% more black people into leadership positions by the end of 2023. Target has pledged to spend $2 billion with black-owned businesses by the end of 2025. Walmart has set up a Centre for Racial Equity and will give $100 million to “address the drivers of systemic racism.” However, these companies expect people to look the other way when they assert their monopoly power. Salesforce champions a surtax to fund homelessness services in San Francisco but avoids paying federal taxes. 70% to 80% of right-leaning academics and doctoral students in Britain and America say their departments are hostile environments according to Eric Kaufmann of Birkbeck College, London. 40% of millennials favour suppressing speech deemed offensive to minorities, compared with 27% of Gen X, 24% among baby boomers and 12% amongst the oldest cohorts.

Authoritarian governments look at ‘wokism’ and say the West is broken rejecting many of the liberal principles discussed in the first paragraph. In textbooks, Xi Jinping tells eight-year-old children “Button the First Button of Life Correctly” which means that schools and families should teach the first lessons of life well so that children do not end up out of line with peers. Xi policies will limit children to three hours of video games per week limited to one hour per day. China’s use of the surveillance state means that it will be able to monitor compliance. China also asked video game companies to end their focus on profits. Dictates have been issued to media companies to not promote effeminate men; K-drama is now effectively banned. There are now 18 Xi-thought research centres. The new rule of law centre teaches that the party leads the judiciary and that ideas like the separation of powers or judicial independence are Western-inspired heresies. In Russia, certain universities were given some space to pursue liberal ideas. For instance, the Higher School of Economics (HSE) was considered Russia’s first and most successful post-Soviet university. Its liberal bent was tolerated as Russia believed that having a cadre of Western thinking would help with technology and modernizing the state. Now Nikolai Patrushev, the secretary of the Security Council of Russia and a key idealogue of Russia’s new isolationism says, “the destructive liberal political forces [of the West] are paying particular attention to the educated and successful young people in prestigious universities.” All lectures and discussion clubs will now be under state control.

The London Brief is focused on markets, so the discussion above may seem out of place, but it is becoming increasing difficult to separate the political from the economic. In early August, portfolios with China exposure faced significant losses as the Chinese state focused on Didi and tech companies that were seen as promoting liberal ideas. A more activism FTC with academics that do not believe in capitalism are making decisions on mergers that could have a negative impact on individual stocks and broader markets. Changes in tax are coming. In short, attacks on liberalism are attacks on the status quo, which generally are not good for markets.

Interesting Technologies of the Future

Haim Israel of BAML identified fourteen future technologies that could change markets over the next decade. The ones I thought that were interesting are:

• 6G – this is the next generation of telecom networks after 5G. You may be thinking, are we already at 6G when we haven’t rolled out 5 yet? But by 2028 expectations are that 5G networks will hit full capacity. While they will be super-fast and potentially allow for autonomous vehicles, it will probably be 6G. It’s more infinite data transmission characteristics make such technologies truly viable. To give you a sense of speed, at a speed of 1 terabyte per second, you can download 142 one-hour 4K movies in 1 second or the entire NY Public Library in 20 seconds.

• Metaverse – Snowcrash by Neil Stephenson was published in 1992, but now it comes true. Through AI goggles, we can create a 3D world interacting in virtual reality with digital currencies. Who needs real people? Only cyber viruses too; not the corona sort. Ariana Grande, Marshmello and Travis Scott all gave performances at Fortnite concerts.

• Emotional AI – tech has been working on interpreting emotions and providing personal devices that can give you relationships. Many politicians could use a friend; this could help. More practical applications are helping to train teachers, where the AI pretends to be a student. Gartner already says your personal device knows more about you than your family. An average person is subjected to 5,000 branded messages per day. 12 will be remembered and 90% of those that click will be because of emotional.

• Brain Computer Interfaces – one experiment was able to show how one human could control another’s human’s hands. Patients with ALS have used minimally invasive BCIs to text, bank, shop and email online. Mozart’s the Magic Flute was able to do something similar; it was an early BCI. China is using it to see when children may not be paying attention to Xi Jinping thought.

• Bionic Humans – a recent experiment implanted an artificial cornea into a blind man’s eye allowing him to see. Now we can create cyber-humans like Robocop and the Six Million Dollar Man (although with inflation it might be more like the $6 billion dollar man).

• Immortality – there are now several firms specializing in anti-ageing. I invested in one myself called Life Biosciences co-founded by David Sinclair. They are funding 40 different scientists throughout American universities to explore new research from 2015 on senescence cells and other things they discovered about cells when they could see things around the atomic level. I have no idea if anything these scientists do will turn out a marketable product, but the risk to reward seemed fantastic to me. It could solve income inequality. For instance, how much would Stephen Schwarzman pay to live a few more years. Quite a lot I’d say. By reallocating the wealth of the super-rich to Life Biosciences and its investors, we can suck out excess liquidity from the market and inhibit inflation.

• Synthetic Biology – genetically engineered organisms that can be used in farming, electronics, consumer care and drug manufacturing. It’s similar to the killer bees in that episode of Black Mirror, where all the natural bees have died off so artificial bees were created to pollinate plants. Unfortunately, some evil guy hijacked the bees and turned them into a killer weapon, but hopefully that won’t happen. By 2030, scientists believe we will have eaten, worn, used or been treated by something synthetic. The TAM is thought to be $1 trillion.

• Wireless Electricity – charging without cables and driving electric cars around. That way when you are stuck in traffic in England because there are massive queues around gas stations, you can at least get a charge.

• Holograms – this will require 6G, but in the future holograms will shoot out from your smartphone. ABBA plans to do a hologram tour. Siri can look like someone. You may also need autonomous cars, so people don’t keep looking at holograms on their phones when driving.

• Flying Cars – electronic vertical take-off and landing crafts. You could take a EVOL from the airport to a meeting in central London and hop back to the airport again. It seems like every second SPAC business is one these companies. One of them has to work. At least three aircraft will start operations by 2023.

• Carbon Capture Storage – if we can’t help ourselves from burning fossil fuels, perhaps we can suck carbon out of the air and turn them into rocks. This is what a new CCS facility does in Iceland. Currently it can turn 4,000 tons of carbon a year into limestone. Only 35 billion more tons to go. By 2030 BAML thinks $25 billion of new investments and $100 billion of cumulative investments could be made in this area. By 2040-2050, they believe it could be a $1 trillion cumulative investment opportunity.

• Nextgen Batteries – quicker charging batteries. If the wireless thing doesn’t work, maybe a better battery is all you need. In China, they have stations that swap the batteries. CATL developed a power pack that can last 2 million kilometres (1.24 million miles) and more than six years. The Tesla 4680 cylindrical cell EV battery technology can supposedly be charged in ten minutes.

• Green Mining – rare metal miners reduce CO2 by targeting the seabed or utilizing land with low fertility. Europe has 10,000 kilometres of mineral-rich ocean land. DeepGreen (another SPAC) says deep sea mining could produce metals with 70% less CO2 emissions.

• Ocean-Tech – before we go to Mars let’s focus on a more hospitable environment. The market for the ocean economy could hit $3 trillion. Ocean Energy Europe says ocean energy can provide 10% of Europe’s energy needs.

End Note

Kim Jong Un lost up to 20 kilograms according to the South Korean National Intelligence Service. They do not seem to get much insight into the nuclear program, but at least they know the next diplomatic gift to give the “great leader” is a Peloton.

According to a survey by the Lending Club of 28,000 Americans, 60% of millennials earning over $100,000 per year say they are living pay-check to pay-check. This is because they are HENRYs, which stand for high earner, but not yet rich. They prefer comfortable and often expensive lifestyles. Income increases have not kept up with the exponential increase in living costs. 40% of clients at Stash Wealth, a financial firm that works with this demographic, have student loans with an average balance of $80,000. Many of this same demographic supports higher taxes and more active government, which seems a bit of a paradox.

As a technical note, I’ve decided to switch the brief into a quarterly format so I can find enough things to talk about to keep the brief more relevant.

Cobham, Surrey

October 3rd, 2021