Saturday, October 17, 2009

Best reads of the week that was

Relative to other countries, how much of a problem is the US’s aging population likely to be? In this piece from Niels Jensen that was included in one of the many fantastic emails sent out by John Mauldin, Jensen discusses the potentially severe economic issues that arise when there are many more retired than working age people in a country. While this piece is not right off the presses, it addresses a subject that is more like a slow moving train wreck than a tsunami. Accordingly, for those of you who have not had a chance to read the article, the analysis is still very relevant and poignant.

I think it has been well documented (or speculated) that Japan is a candidate to face a crisis based on the growing age disparity in that country. But I have also come across some rumblings that the US economy might be challenged by similar imbalances in the coming decades. However, Jensen argues that compared to other countries such as Japan or even the mighty China, the US situation does not look anywhere near as dire. While many of you may be skeptical of the merits of a “less bad” scenario, with all of the other looming problems—social security and Medicare for example—the fact that we may not have to worry as much about this as advertised is certainly a minor positive:

Now, with most OECD countries fast approaching the danger zone where an uncomfortably large part of the population consists of old-age pensioners, how do we get out of this pickle? We can't all export our way out of the problem. Somebody needs to buy our products. I will get back to answering this question later, but let's take a quick look at the so-called dependency ratio first. If the ratio is, say, 30, it means that there are 30 people at the age of 65 or older for every 100 people between the age of 15 and 64 (which defines the working population).

Obviously, the higher the dependency ratio, the fewer working people there are to pay for the elderly. At some point the cost of supporting the elderly will reach a level which spells economic disaster, and some of the more exposed countries may quite simply be forced to abandon their welfare standards to cope. More about this later -let's get some data points on the table. In chart 2 below, I have tried to keep things relatively simple. I have assumed, for example, that the fertility rate will remain unchanged going forward. This may or may not be a reasonable assumption. Only time can tell.

The first thing that struck me when I produced this chart was how relatively benign the US outlook is. I read an awful lot of US centric macroeconomic research (my wife thinks too much!) and, more often than not, there is a reference to the bleak future for America given the fact that baby boomers in large numbers will be retiring over the next two decades. However, when you compare the US numbers (a dependency ratio of 19 today growing to 34 by 2050) to most other developed nations, the US demographic challenge suddenly looks like a walk in the park.

No other country is aging as quickly as Japan. Saddled with a large number of old age pensioners already (the dependency ratio is currently 35), the ratio will grow to an astonishing 76 over the next four decades. The Japanese economy has struggled to drag itself out of a slow growth environment for the past twenty years (give or take). The problems in Japan are well publicised and are often blamed on failed policy measures. I just wonder how big a role demographics have actually played in all of this and whether the Japanese mire is a sign of things to come for the rest of us?

Most interestingly, China, which everybody (well, almost everybody) raves and rants about, does not look particularly attractive. Obviously you cannot judge the investment appeal based only on demographics, but if you add to that China's fragile banking system and a construction boom…

Well, at least this is one thing we have on China. By 2050 the percentage of retirement age people in China is forecast to be about 40% of the population versus 35% in the US. (By the way, I almost never rely on forecasts for anything, but this is likely to be more accurate than earnings or growth forecasts because it is based on the easily measurable number of people who are already alive today,) Score one for the good guys!

Sorry to pick on China, but the reviews continue to be mixed: Hat tip to The Pragmatic Capitalist (to anyone who is not yet following this site, I suggest that you start right now) for posting the link to this article in The Economist about potential bubbles forming the global economy. For anyone who reads Zero Hedge or the work of Albert Edwards of Soc Gen, it should not come as any surprise that China’s massive stimulus plan may be stoking a nasty asset bubble in stocks and real estate. The thing about China is that since the government controls the economy and the banks, it can easily manipulate asset prices. So, unlike in a free market system in which asset prices theoretically are controlled by supply and demand fundamentals (I am intentionally not including the current manifestation of the US economy as a free market), China’s control could allow it to keep the bubble inflated until the fundamentals have caught up the prices. Now, I would be careful to believe a “China is different” argument based around the idea that supply and demand no longer matter at all there. But, for investors who are China bears, it is important to remember that especially in China the markets could remain irrational longer than you can stay solvent:

If the government does not act soon to tighten liquidity, share and house prices will become seriously overvalued. But it is much too early to use the “B” word. Start with China’s stock market, described by Andy Xie, an independent economist, as a “giant Ponzi scheme”. Despite a recent slide, Shanghai’s A-share index is still up by over 60% since its trough last November. Yet this is only a fraction of the gain during China’s previous bubble in 2006-07, when the price/earnings ratio jumped to an eye-popping 70. Today the p/e ratio stands at 24. That is high compared with developed markets but well below China’s long-term average of 37 (see left-hand chart). China’s faster trend pace of growth also means that the outlook for corporate profits is rosier than elsewhere. They are already bouncing back: in the three months to August industrial profits were 7% higher than a year ago, after falling by 37% in the year to February.

Bubble suspect number two is the housing market. Average Chinese home prices are nine times average annual household income. In the rich world a ratio of more than four would sound alarm bells; in other Asian countries prices are typically 5-7 times income. The volume of property sales has surged by 85% over the past year and prices of new apartments in Shanghai have risen by nearly 30%. Some conclude that prices have been pumped up by imprudent bank lending and that the market is at risk of crashing.

Along the same lines, included in an email from John Mauldin, STRATFOR weighed in on this exact topic:

A 2006 survey conducted by the National Development and Reform Commission showed that the average ratio between housing prices and income was approaching 12:1 in many large and middle-size cities in China (in Beijing it had reached 27:1). Twelve to one is significantly higher than the World Bank's suggested affordability ratio of 5:1 and the United Nations' 3:1. The problem was compounded by the fact that, of the more than 80 percent of Chinese who owned their own homes in urban areas (generally considered cities with populations of more than 20,000), 54.1 percent were making monthly mortgage payments that constituted 20 percent to 50 percent of their monthly incomes.

Those house price to income numbers are scary, especially when mortgage holders were paying up to 50% of their income to service their debt. With the recent rebound in prices it looks like all the seeds for a real estate bubble are present. Obviously there is no telling how much a crash in real estate prices would affect the China growth juggernaut. But, for a country that apparently depends on 8% GDP growth just to prevent social unrest, the risks should cause potential investors to tread cautiously.

Anybody want stale, left-over municipal bond ratings for dinner? Surprise, surprise, there is more indication that a ratings agency is not fulfilling its duties when it comes to assessing the quality of a piece of debt. Specifically, this article from the NY Times discusses situations in which Moody’s did not revisit ratings on municipalities that issued bonds after the initial review. The damning evidence of complacency comes from a former Moody’s insider named Scott McCleskey, who was the head of compliance from April 2006 to September 2008:

As it turns out, according to Mr. McCleskey, once Moody’s issues these ratings, it rarely reviews them again — leaving them fallow, sometimes for decades. Would you want to own a security that hadn’t been given a sniff test for 20 years? Did you know that if you were a municipal bond investor you might have one of those potential time bombs in your portfolio?

Yet, as Mr. McCleskey warned in his letter, “While a few very high profile/frequent issuers (City of New York, etc.) were receiving some periodic reviews, the vast majority had received none — in some cases there were bonds which had been outstanding for 10 or 20 years but which had never been looked at since the original rating.”

How big a deal is this? Moody’s rates more than 29,000 municipal securities issuers, according to its Web site. And with many governments in increasingly difficult financial straits, investors’ reliance on stale ratings grows increasingly perilous. “Investors may think they are holding investment grade bonds when in fact the issuer is teetering on the edge of bankruptcy,” Mr. McCleskey wrote.

Good thing the financial situations of municipalities are completely stable over time. Just ask Orange County. Or Jefferson County in Alabama. No reason to make sure that revenues can cover expenses and interest payments. The only people who will be hurt are those whose pension funds and insurance companies hold the debt. This appears to be another case in which Moody’s has abdicated its responsibilities. When this is combined with the recent revelation that an analyst was helping investors trade on non-public information, is there any doubt why David Einhorn and Greenlight Capital are short the company?

Are the Spanish banks hiding their losses? In this fantastic piece by John Hempton of Bronte Capital, he tackles the issue of the real value of the assets on the books of the Spanish banks. As many of you may know, Spain is experiencing a severe recession that has led to unemployment rates among young people that is somewhere around 34%. Not unlike the situation in the US, in recent years Spain’s economy had become increasingly dependent on real estate-related endeavors for growth. This led to what we now know was a massive housing bubble that subsequently collapsed and has dragged the economy into a near depression. But somehow, the largest banks seem to be doing alright. For example, BBVA was somehow in a strong enough position to pick up the assets of failed US bank Guaranty Financial. But, many feel as though things may not be rosy as they seem. Take this recent quote from a Moody’s analyst (yes, I realize that anything coming from Moody’s should be taken with a grain of salt, but if the situation is bad enough for even Moody’s to notice, you have to assume the reality is much worse) included in this piece from Ambrose Evans-Pritchard in The Telegraph:

Separately, the rating agency Moody's said this week that Spanish banks face "severe asset quality deterioration" and have yet to make provisions for over half of the €108bn (£99bn) of likely losses over the next five years. The figure could prove much higher if pessimists are right about the gravity of the Spanish slump. Under Moody's "stress scenario" losses could reach €225bn.

"Spanish banks have so far demonstrated remarkable resilience, but Moody's remains concerned that many entities appear to be avoiding recognition of the true scale of asset quality deterioration on their books," said analyst Maria Cabanyes.

Now, let’s take a look at Hempton’s analysis of whether or not the banks are masking the true value of their losses. He starts by looking at the data for US located banks owned by Spanish banks to see if they appear to be under-reporting their losses. In this piece he also discusses the ultra bearish case as outlined by research house Variant Perception and provides his own assessment of the situation:

I really do not know. I am not close enough to the ground in Spain to know – and – frankly – analysing (supposedly) faked data in a language I can’t read from a desk in Australia is unusually difficult. But there seem to be four variants.

(a). The Spanish banks are telling the truth – and this is a storm in a teacup,

(b). The Spanish banks are doing a normal amount of bank over-optimism in the face of a crisis – and whilst the banks are really stretched (but not telling us) the banks are ultimately solvent – and the European experiment is fine,

(c). The Spanish banks are in fact diabolical – and the losses are maybe 15-20 percent of a year of Spanish GDP – in which case a bailout by (effectively) German taxpayers is possible or

(d). Variant Perception is in fact unreasonably bullish – and Spain will collapse economically and socially and we will be thankful if all we get back is someone like the Generalissimo. The modern European experiment will be deemed to fail because a single European Union with a single currency can’t hold together in a crisis because Germany won’t or can’t bail out Spain, Italy and Greece in a crisis.

Instinctively I am in camp (b) above. However I acknowledge all of the above are possibilities…

The main allegation in the Variant Perception report is that the Spanish banks are massively overweight construction loans – and that they are extending those loans rather than allowing default…

Construction loans at almost 50 percent of GDP is a truly astonishing figure. The entire US mortgage market is roughly 10.4 trillion dollars – or about 75 percent of GDP (and as the crisis has shown that seems too large). The idea that construction loans are nearly 50 percent of GDP had me falling off my chair. I tried to confirm this figure (as it felt like garbage). Alas I could not…

All these problems of the same type that Variant Perception alleges in Spain – but none are of the scale Variant Perception alleges in Spain. In other words I can unequivocally support the notion that the Spanish banks are hiding their losses – but support for the notion that these losses are so large that France and Germany will be left “holding the bag” is not to be found in the US data.

In Hempton’s view, it is unambiguous that the banks are not fully disclosing their losses. However, similar to the situation with US banks (for which is there is a mountain of evidence of an extend and pretend policy) it is hard to know whether the eventual losses will be de-stabilizing or not. However, if I were an investor in Spanish banks, I would be worried that the ECB’s monetary policy will not be accommodative enough to help Spain experience a meanigful recovery because of the different position that other members of the Euro Zone find themselves in, relative to Spain. With Germany worried about inflation and Spain clearly facing deflation, how can the ECB cater to both of their interests? It can’t and as long as the situation is Spain continues to deteriorate the banks will only face greater losses.

(Picture courtesy of