The Demise of “Uncle House”

The inflation psychology which has characterized the last 30 years (even through inflation has been steadily falling) has led to a compulsive desire on the part of investors to acquire bricks and mortar, contrasted with the volatility of “paper assets” such as shares.

Nowhere has this compulsion been more extreme than in China where private citizens have only been able to own property (usually on 30 year leases) in the last 2 decades. The construction boom of the last IO years saw municipal officials, in particular, employing sometimes nefarious means to acquire properties: in one notorious example, in Guangdong province, an official owned more than 23 houses and (before being arrested for corruption) was aptly christened “Uncle House”. That property boom has now definitively ended, not only in China but probably in high priced global markets such as Hong Kong, Singapore, London and New York.

The combination of sky high prices, low rental yields, rising interest rates, and carrying costs (property taxes, maintenance) has finally punctured the bubble. The question for investors is, what’s next? and, what will be consequences of a possible 25% fall in real estate values in China and elsewhere? We have already seen a major correction in commodity prices, of iron ore, steel, copper and energy. The next stage may be a banking crisis (though, like Japan after 1990, there will be a period of “denial”, of putting off the recognition of a deflationary reality when prices fall but transactions dry up).

Much of the flight capital which has left not only China, but Russia, some European countries and the Middle East has been seeking “safe havens” in jurisdictions such as the UK, the US, Canada and Australia, has not been “priceĀ­ sensitive” – but what if a $1 million property turns out to be worth $600,000 and is costing $20,000 annually to service? There may be few buyers, and property is notoriously illiquid. Currency volatility is also a factor for investors.

We expect, therefore, a realignment of focus towards cash flow and liquidity as the leading criteria of investors: shares with steady dividends such as telecoms and utilities (and some internet providers) will be favored. The US dollar will (probably for a year or two) be favored over the Yen or the Euro. An era of competitive devaluation is developing, with the immediate source of deflation being Japan, which seems determined to drive the Yen down towards 150/$ (a rate last seen before the 1985 Plaza accord). This will put more pressure on China, the Renminbi will also fall, and trade tensions will increase. The beneficiaries may be some cheap labour nations in SE Asia as well as India and her neighbors.

The threat of deflation is a global one, but it will more deeply influence higher income nations with rigid labor markets (such as the European Union). A:flexible exchange rate is an essential tool to combat competitive trading pressure. It is easy to predict (but impossible to time) the collapse of the Euro, the end of the HK dollar peg, and the fall of the Renminbi: all may be expected within the next 5 years. Gold may rise out of the doldrums when paper currencies are so volatile and unpredictable.

Our focus is on companies. Recently even the most, stable and apparently predictable franchises (such as Tesco) have had unpleasant earnings surprises. So the successful past business model does not guarantee the future. The internet is undermining all pricing structures (even banks, during the next decade). The capabilities of management will be tested, but we are confident that certain consumer items and services have a constant appeal, and a strong brand, with pricing power.

In our Bamboo Fund, therefore, we are prepared for a deflationary era: we will own strong companies with good cash flow, and dividends (the only tried and tested means of rewarding shareholders). We will generally eschew property, mining, and energy in favor of utilities, telecoms, food and beverage, consumer finance, retail and logistics.

Of course a “Good Deflation” such as was seen in the 1870s rather than the 1930s involves productivity improvements (automation) as well falling commodity prices (food, energy, minerals). It will however impact high cost producers of manufactured goods in Europe and North America, and benefit lower cost providers of goods and services in Asia, for example, India IT services.

We have seen international meetings held in China and South-East Asia in the past week, and it is clear that China’s consumer economy is still the major factor especially driving tourism, and exports, from ASEAN (and Australia). The fall in commodity prices especially oil price is generally positive for consumer demand.

The agreement between the USA and China on “climate change” is also potentially important in switching energy demand from dirty coal to clean burning natural gas (hence Russia’s mega-deal to supply gas to China) – LNG will also become increasingly important in global energy trade (Japan is experimenting with fire ice, or methane hydrate, beneath the sea bed, which could be a game changer, too).

In conclusion, we believe that various elements are falling into place for a bull market in Asia beginning in 2015 with interest rates staying historically low and energy prices falling, both Asian economies and consumers will begin to feel a real boost in confidence for the first time in 6 years, after the financial crisis. Breakthroughs in Free Trade (TPP, APEC) will also be accompanied by free capital movements. The Renminbi has effectively been liberalized for offshore investors to buy this week: and the Hong Kong – Shanghai Stock Exchange deal allows international funds to buy A shares freely, and mainland investors to buy Hong Kong shares. There is the potential for a positive re-rating of risk, and deĀ­ escalation of tensions in East Asia.

Robert Lloyd George
15th November 2014