#102: Trillions in Off-Book Debt

A quick housekeeping note. I have finally made the WordPress breakthrough I needed to progress the research portal. Last night, I came up with a nested tab idea that I think is pretty cool. I also learned a bit of CSS code as well. Feeling happy and productive will share it all pretty soon .

S2N Spotlight

Last week, I wrote in letter #98 China is Down but not Out I made the case to go long China and short the USA, feeling the relative performance has gone too far, and based on negative China sentiment and extreme USA euphoria, the relative performance might pullback. I got some pushback from my brother in law Dani who listed a host of economic and policy reasons why he felt China’s economy is sick.

My response was 100% in agreement with Dani on all his points, I will touch on a few shortly. However, I still believe in the trade that Shanghai / Hang Seng will outperform the USA over the next 12 months. Let me share my simple thesis.

In the chart above, the S&P 500 has made a 315% return over the last 25 years, and the Shanghai Stock Exchange Composite Index has only achieved 87% despite the Chinese economic miracle. What is interesting is that China was outperforming until around 2018, so the dramatic underperformance has happened in only the last 5 years.

I am including a chart of relative performance with Hong Kong and its Hang Seng Index, which is a close proxy for Chinese corporate prosperity. As you can see, it is virtually identical, only worse.

Just because a ratio is extreme doesn’t mean it is going to mean revert. I was going to do a detailed statistical analysis of the ratio and show why the statistical probability is in favour of the trade. However, the truth is, nobody has a clue as to when or if the ratio will normalise. In this game, the best you can do is take a probable bet. I use the sentiment reflected in letter #98 as part of my reasoning.

This chart on demographics shows why China faces a really big uphill battle to thrive as an economic powerhouse through the rest of this century. Their one-child policy reaps short-term benefits but comes at a very high economic cost.

If you look at the base of the China population pyramid now and later in the century, there is a very small workforce expected to carry the burden of supporting the elderly. A big red flag indeed, but not an immediate concern for the trade. The graphic below is from the Wall Street Journal (WSJ).

In today’s WSJ, there is a brilliant article about the Trillions of Hidden Debt.

“At the heart of the mess are the complex state-owned funding vehicles that borrowed money on behalf of local governments, in many cases pursuing development projects that generated few economic returns. The deterioration of China’s real-estate market in the past three years meant local governments could no longer rely on land sales to real-estate developers, a significant source of revenue. 

Economists estimate the size of such off-the-books debt is somewhere between $7 trillion and $11 trillion, about twice the size of China’s central government debt. The total amount isn’t known—likely not even to Beijing, say bankers and economists—because of the opaqueness surrounding the financial arrangements that allowed the debt to balloon. As much as $800 billion of that debt is at a high risk of default, economists say.”

This is pretty hectic stuff, but I remain undaunted for the short to medium term. This may make the subprime crisis small-fry. However, the difference is that the debt is owed indirectly by a sovereign, not a company in the traditional sense of the word. So there are more defensive options, which I believe will be used. Whatever is used will have consequences; there are no free lunches here.

S2N Observations

I was reading an article about Trump-enomics and they mentioned that the current budget deficit to GDP was 6%. I quickly spun up a chart as I wanted to plot how this number behaved over time. This is the most current data going back to 1980. The deficit is -5.6% to GDP with an average of -3.9% for the period. As you can see, we have only seen a surplus for a short period at the end and beginning of the millennium.

Trump enjoyed a nice bounce (+31%) in his stock, Trump Media and Technology. Check out how much revenue ($3.7 million) this company generates while enjoying a $7.7 billion market cap. That is revenue, not profit. The company lost $110 million last year.

Barry, if you haven’t bought natural gas yet, you did well to miss it. You can see in the performance table below that natural gas is down -16.8% this month and is trading at 35-year lows. I am usually the ultimate contrarian, but even this has me scared to buy.

Performance Review

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