5 October 2021 - Stanford Brown
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5 October 2021
Investment markets take a breather in September
Australian shares - In last month’s report we noted that the Australian share market was not likely to extend its long run of
eleven consecutive positive months (the longest since the middle of World War 2), because record dividend payouts would
reduce share prices when they went ex-dividend. In the end, the local market ended 2.5% lower in September. Banks were
up a little, but the big miners were down – with most players following their commodities prices – iron ore (down -26% due
to China’s construction slowdown and steel curbs), gold (down -8%), but fossil fuel producers were boosted by strong price
rises in oil (+10%) and coal (+32%). For the 2021 year to date, the local market is ahead 11%, or 15% including dividends.
International shares – Global markets were down in September (with the exception of Japan, assisted by a weaker Yen).
Most of the global tech-based giants were down (with the exception of Tesla and Netflix), and most other sectors were also
weaker for the month. There were several contributing factors – including a revival of inflation fears, US debt ceiling /
shutdown concerns, and slowdown in China, heightened by the ‘Evergrande’ crisis. We cover these in this edition.
Interest rates – Short term rates remained at their covid-era zero/sub-zero levels, but central banks everywhere have
continued to prepare the market for rates starting to return to more ‘normal’ levels once inflation has taken hold and full
employment has been reached. Toward the bottom of the left chart, inflation is now running well above target levels (likely
to be temporary, recovering from last year’s negative inflation). Unemployment rates have also been falling, but are still well
above ‘full employment’. The US Federal Reserve and RBA have well-signalled their program to scale out of QE asset buying.
Norway was the first ‘developed’ country to hike rates, but several ‘emerging’ markets including Brazil have also started.
Bond markets – Despite central banks being extremely cautious and careful to flag their intentions, global investors suffered
another ‘inflation scare’ in September, selling off bonds, which hurt returns on fixed rate bonds. We have very little fixed rate
bonds in portfolios. Instead we favour high-grade floating rate bonds, which benefit from rising inflation and interest rates.
Market Snapshot - Sep-2021 Market Snapshot - 2021 YTD
-40% +10% +60% -50% +0% +50% +100%
Share markets Share markets
Global (S&P Global BMI) -4.1% Global (S&P Global BMI) 10.0%
US (S&P 500) -4.8% US (S&P 500) 14.7%
Europe (Stoxx50) -3.5% Europe (Stoxx50) 13.9%
Japan (Nikkei 225) 4.9% Japan (Nikkei 225) 7.3%
UK (FTSE100) -0.5% UK (FTSE100) 9.7%
China (FTSE China50) -4.5% China (FTSE China50) -17.1%
Australia (All Ords) -2.5% Australia (All Ords) 11.4%
Australian shares CBA 4.2% Australian shares CBA 27.1%
CSL -5.9% CSL 3.6%
BHP -17.5% BHP -11.4%
Westpac 0.7% Westpac 34.2%
NAB 0.4% NAB 23.1%
ANZ 1.1% ANZ 24.6%
Macquarie 9.2% Macquarie 31.4%
Wesfarmers -7.0% Wesfarmers 10.6%
Woolworths -5.7% Woolworths 0.1%
Telstra 2.3% Telstra 31.9%
Fortescue -28.8% Fortescue -36.2%
Goodman -6.3% Goodman 14.6%
Transurban -0.4% Transurban 3.7%
RIO -10.6% RIO -12.0%
Woodside 22.5% Woodside 5.0%
Global shares Apple -6.8% Global shares Apple 6.6%
Microsoft -6.6% Microsoft 26.8%
Amazon -5.4% Amazon 0.9%
Facebook A -10.5% Facebook A 24.2%
Alphabet A -8.1% Alphabet A 52.5%
Telsa 5.4% Telsa 9.9%
Berkshire Hath B -4.5% Berkshire Hath B 17.7%
NVDIA -7.5% NVDIA 58.7%
JP Morgan Ch 2.3% JP Morgan Ch 28.8%
Johnson&Johnson -6.7% Johnson&Johnson 2.6%
Netflix 7.2% Netflix 12.9%
Samsung Elec (Korea) -3.4% Samsung Elec (Korea) -8.5%
Taiwan Semicon (Taiwan) -5.5% Taiwan Semicon (Taiwan) 9.4%
Alibaba (China) -11.3% Alibaba (China) -36.4%
Tencent (China) -4.1% Tencent (China) -18.2%
Commodities Iron Ore (USD/t) -26.5%
Commodities Iron Ore (USD/t) -26.0% +140%
Thermal Coal (USD/t) 32.2% Thermal Coal (USD/t)
Copper (USD/t) -6.1% Copper (USD/t) 15.4%
Oil WTI (USD) 9.8% Oil WTI (USD) 55.2%
Lirhium Carbonate 50.4% Lirhium Carbonate
Gold (USD) -4.3% Gold (USD) -8.1% +232%
FX FX
AUD:USD (change) -1.8% AUD:USD (change) -6.4%
AUD TWI (change) -0.7% AUD TWI (change) -4.1%
US Dollar Index (change) 1.7% Bond US Dollar Index (change)
Interest rates
4.8%
Interest rates
Australian cash (change) +0.00% yields up Australian cash (change) +0.00%
US 3 month (change) +0.00% US 3 month (change) -0.05%
Australian 10 year (change) +0.32% Australian 10 year (change) +0.47%
US 10 year (change) +0.19% US 10 year (change) +0.56%
Australia Inflation (annual)
Inflation (annual)
US
3.8%
5.3% Inflation Australia
US
1.8%
1.4%
UK 3.2% above UK 0.6%
Europe 3.0% Europe -0.3%
Japan
China
-0.4%
0.8%
target Japan
China
-1.2%
0.2%
Unemployment rate Unemployment rate
Australia 4.5% Australia 6.6%
US 5.2% Needs to US 6.7%
UK 4.6% UK 5.2%
Europe
Japan
7.5%
2.8%
fall further Europe
Japan
8.1%
3.0%
China 5.1% China 5.1%
OWEN OWEN
This month’s edition is all about housing. First we look at Australia, as housing the is largest asset class owned by Australians,
and it is being propped up by a mountain of debt at ultra-low interest rates, which are set to rise soon.
We also look at housing in China. For the past two decades, housing construction has been the engine of Chinese growth that
has taken it from poverty to the second largest economy in the world (largest by some measures). The Chinese housing
market is teetering on the edge of a crisis that presents risks not only for Australia (as it’s largest export supplier), but it also
has potential domino effects across global markets, including shares, bonds, interest rates, commodities and currencies.
Stanford Brown, Investment Markets Report, 5 October 2021 2Australian house prices surging back above pre-covid highs
Prices have surged well above pre-covid levels, despite lock-downs, high levels of under-employment, and jobs uncertainty.
Real Median House Prices - since 1970
2020-1 Capital City
virus median prices (real)
Log scale stimulus
$ boom
$1,250,000 2010s Sydney 50%
QE boom
$1,000,000
Melb
2003-7 Canberra
1990-1 recession
45%
1981-2 recession
1974-5 recession mining /
1977-8 recession
credit boom Brisbane
$750,000 Hobart
Darwin 40%
Late 1990s Adelaide
$500,000 1980s dot-com boom Perth
deregulation 35%
boom
30%
2020 virus recession
Interest
rates,
$250,000 Inflation
25%
2008-9 GFC
20%
Mortgage Interest
Rates 15%
Inflation Cash
Rate (variable rate)
$100,000
10%
5%
50,000 0%
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
2025
2030
source: ABS, RBA OWEN
The next chart shows the Sydney housing market pulse in more detail. The blue line tracks the number of house sales per
quarter, swinging widely between 16,000+ house sales per quarter in the booms, and then halving in the slowdowns. The
green/red bars in the lower section show the annual rate of growth in median prices. It is currently running at 24% growth.
Sydney Housing market - since 2002
18,000 Covid lock-downs +90%
2020 2021
Number of House sales per qtr
16,000 +80%
House
sales 14,000 +70%
per
qtr 12,000 +60%
2001-3
10,000 house +50%
price
boom pre GFC post GFC
8,000 credit house price 2012-5 rate +40%
boom rebound cuts + house 2020-1 ?? 2022
House price
6,000 2004-6 property 2008-9 sovereign price boom 2014-5 Virus lending annual
+30%
GFC lending
finance collapses debt crisis curbs 2017-8 stimulus curbs growth rate
Annualised lending
growth 4,000
rate curbs +20%
in Housing
lending
2,000 +10%
House price 0 +0%
growth rate:
-2,000 -10%
-4,000 -20%
Dec-2017
Dec-2001
Dec-2002
Dec-2003
Dec-2004
Dec-2005
Dec-2006
Dec-2007
Dec-2008
Dec-2009
Dec-2010
Dec-2011
Dec-2012
Dec-2013
Dec-2014
Dec-2015
Dec-2016
Dec-2018
Dec-2019
Dec-2020
Dec-2021
Dec-2022
House prices by Aust city source data: RBA, ABS OWEN
Prices slowed/contracted during the 2001-5 property finance collapses, the 2008-9 GFC, and the 2010-11 sovereign debt
crisis. More recently, prices were also brought down by government-imposed lending curbs – first with the 2014-5 curbs and
then with the 2017-8 curbs. In recent editions we have been predicting another round of lending curbs to bring down prices.
New Zealand and several other countries have introduced lending curbs in recent months to try to slow runaway house
prices fuelled by debt at ultra-low interest rates. In Australia, the regulator APRA is likely to do the same very soon.
The black dotted line in the lower section of the last chart is the annual rate of growth in housing lending. To the right we see
that in 2021, lending growth shot up again to levels that are above those right before the 2014-5 lending curbs, and above
the level right before the 2017-8 curbs. Direct lending curbs are dressed up in a fancy name these days (‘macro-prudential
policy’), but they are nothing more than old-fashioned pre-deregulation lending controls in the 1950s to 1970s. Direct lending
controls are better than general interest rate rises, because they affect the volume of money for the lenders, not the price of
money for everyone else, including business borrowers, who should be borrowing more, not less.
Stanford Brown, Investment Markets Report, 5 October 2021 3House prices rising – but why?
House prices are rising because buyers are paying more for them, of course. But where does the extra money come from?
In 1900, the median house price in Sydney was A£890 (A$1,780), and the Australian capital city median house was A£730
(A$1,460). In the most recent figures (ABS June 2021) the Sydney median was $1,187,500 and the capital city median was
$888,000. Over 120 years, that represents average price growth of 6.1% pa for both Sydney and the capital city median.
The extra money buyers pay today has come either from their own pockets (higher incomes), or from other peoples’ pockets
(debt). If we strip out inflation from each of these, we can separate the sources of house price growth into three
components: (i) real wages growth above inflation, (ii) real growth in the level of debt above inflation, and (iii) inflation.
The next chart breaks out the overall growth in median capital city house prices into these three components, by decade
since 1900. The three bars in the middle show the summary periods. Column ‘B’ shows the overall average contributions
since 1900; column ‘A’ is for the period 1900 to 1980, and column ‘C’ (and the pie chart) is for the period since 1980.
Contributions to House Price Growth - since 1900
+16% Since 1980
13.8%
12.8%
A B C Real Wages Inflation
+14% 12.0%
+12% 10.5%
11.1% ↓↓↓
Real Debt
+10% 8.3% per head
+8% 5.3% 6.1%
2.3% 5.3%
+6% 3.6% CPI inflation pa
+4% 2.0% 2.9% Real growth in housing debt per head pa
3.7% 3.4%
+2% Real Wages growth pa
0.1%
1.4% 1.2% Nominal house price growth pa
+0%
-2% 5.8% 3.3% 3.8%
-4% -1.8%
1900s
1910s
1920s
1930s
1940s
1950s
1960s
1970s
1980s
1990s
2000s
2010s
2020s
1900-1980
Since 1900
Since 1980
Source data: ABS, RBA, AHS/Vamplew, Stapledon OWEN
House prices by Aust city \ yr
More than half of the overall growth in house prices has been due to inflation, but this has remained relatively flat over the
whole period. CPI inflation has averaged around 3.6% pa from 1900 up to now, and also for both the pre-1980 era and the
post-1980 era. This may come as a surprise because the pre-1980 era included the WW1 and post-WW1 inflation spikes, the
WW2 and Korean War inflation spikes, and the high inflation 1970s. However, the pre-1980 period also included periods of
deep price deflation: in the post-Federation drought years, the early 1920s, and in the 1930s depression.
With inflation being the same during the pre-1980 and post-1980 eras, the differences in the house price growth picture are
in the other two components – wages and debt. Wages in Australia grew by an average of 1.4% pa above inflation in the pre-
1980 era, but this has fallen to 1.2% pa above inflation since 1980. This not insignificant 12% fall in the rate of real wages
growth above inflation has been the result of several forces at work in the post-1980 era, including: dismantling of industry
protection, privatisation of government businesses, deregulation, globalisation, declining union membership, automation,
technology, outsourcing of work to low-wage countries, casualisation, and the ‘uberisation’ of jobs. These are here to say.
By itself, declining real wage growth should reduce the rate of real house price growth (because people have relatively less
money to spend), but this has been more than offset by a dramatic rise in housing debt. The red bars in columns A (pre-1980)
and C (post-1980) show that real (ie after inflation) level of housing debt per head of population did not increase at all from
1900 to 1980 but, since then, it has grown by 3.4% pa above inflation. Since 1980, three-quarters of the growth in real house
prices has come from increases in debts, and only one quarter of the growth has been due to higher incomes.
Will house prices continue to rise? Looking at the outlook for each of these three components of house price growth –
For inflation - we estimate around 2-3% pa in the coming years, which is lower than the 3-4% average since 1900.
For real wages growth – we are unlikely to see a reversal of the post-1980 trend of lower real wages growth. Although we are
starting to see signs of a return to protection and re-onshoring of some jobs in some industries (deemed critical since covid),
it is unlikely to reverse the effects of technology, automation, casualisation and ‘uberisation’ of work.
For debt – house prices can only keep on rising at the same rate if buyers keep increasing their level of housing debt. We
consider this next.
Stanford Brown, Investment Markets Report, 5 October 2021 4House price growth driven mainly by increase in debt
The next chart shows the growth in Australian capital city median house prices since 1900 (maroon line), and the three main
components of price growth – real wages (green line), real debt per head of population (red line), and inflation (grey bars).
+80%
Real Growth in House Prices, Wages & Housing Debt - since 1900
+75%
Real Housing
Annual inflation rate Debt per Head
+70%
Real Av Weekly Earnings (100 base in 1900) Slower rate of growtth
10,000 of debt since GFC
+65%
Real Median House price (100 base in 1900)
(log scale) +60%
Real Housing Debt per person (100 base in 1900)
1981-3
recession +55%
1955-1970 - low inflation +
high growth in population, +50%
Real Median
housing and wages - resulted House Prices
1,000 in higher real debt levels +45%
1930s deflation resulted WW2 + Korrean War
in increase in real debt inflation reduced real +40%
Real Wages
load per person debt load per person
+35%
Annual CPI
100 base inflation
in 1900 +30%
rate
100 B. After 1980s bank deregulation - +25%
↓
mid-1980s House price growth well ahead of
wages growth - funded by increase in
A. Before 1980s
bank
debt levels, with declining interest rates +20%
deregualation
bank deregulation -
House price growth +15%
CPI Inflation rate reflected wages
growth +10%
(annual): 1930s
depression
10 +5%
+0%
Korean low inflation since 1990-1 recession
WW1 WW2 War 1970s- 1980s
inflation inflation inflation inflation -5%
-10%
Source data: ABS, RBA, AHS/Vamplew, Stapledon
1 -15%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
House prices by Aust city \ yr
OWEN
Up until the 1980s (box ‘A’), house prices (maroon line) followed wages (green line) in almost in lockstep, which is logical
because people can spend more money on housing only if they have more money to spend. However, from the 1980s
onward (box ‘B’), house prices and wages started to diverge onto different paths. What happened in the 1980s?
First, real wages growth (green line) slowed, as a result of the factors outlined in the last story – removal of protection
barriers, privatisation, deregulation, globalisation, declining union membership, automation, technology, outsourcing,
casualisation and ‘uberisation’ of jobs. Despite the RBA pining over illusory wages growth, the trend will not reverse.
Second, the key turning point in the 1980s was bank deregulation, in particular the removal of government controls on
interest rates, lending volumes, and the entry of foreign banks. Banks have only been regulated in Australia since World War
Two. Prior to that, the banks operated a tight cartel that constrained lending to prevent speculative lending sprees. Their
over-zealous conservatism was a result of the 1893 property/banking crash when half the banks in Australia closed their
doors and many never re-opened. Lessons from the 1880s speculative lending binge that ended in the 1893 bank collapses
kept the surviving banks ultra-prudent for the next 100 years. Alas, memories only last so long, and the banks went mad
again in the 1980s post-deregulation lending binge that ended in Westpac and ANZ’s big losses, and the failure of the State
Banks of Victoria and South Australia, Pyramid, and numerous other lenders, in Keating’s 1990-1 ‘recession we had to have’.
Third, inflation and interest rates fell (grey bars), allowing much larger loans per dollar of repayment. For example, in the late
1980s, I had a $240k, 25-year ‘principal and interest’ mortgage. In 1989 the rate was hiked up to 18% (inflation was 8%). This
increased repayments to $3,640 per month, which was more than half of my net income. This year, my daughter bought her
first house, borrowing $475k from ANZ at 2.0% ‘interest-only’ with repayments of $791 per month, which is a small fraction
of her net income. At the same age as I was, she borrowed twice the amount of my loan, but her repayments are one fifth of
what mine were. Inflation and interest rates are much lower now, and the structure of her loan was not available in the
1980s. Also, a single female would never have obtained a loan in the 1980s without a husband, guarantor or co-signatory.
This huge expansion of debt (red) at lower interest rates, pushed up house prices (maroon) at a greater rate than wages
growth. The chart only shows official housing debt, but there is now a sizeable amount of ‘bank of mum & dad’ debt on top.
Every dollar ‘bank of mum & dad’ money pushes up prices by another dollar – creating an upward spiral fuelled by ‘FOMO’.
The 30-year boom in house prices rising well ahead of income growth is nearing an end. House prices can continue to keep
on rising at rates above incomes only if interest rates continue to decline further. Interest rates have not only ended their 30-
year decline, they are now certainly more likely to rise than fall from here. The only question is when - and it will be soon.
(We have not discussed some other elements in housing – population/immigration, home ownership and supply constraints
– we cover these in future editions. The most importantly, Australia’s heavy reliance on immigration took a hit in the lock-
downs, but is likely to remain favourable for housing in the medium term, especially from China, Hong Kong and Taiwan).
Stanford Brown, Investment Markets Report, 5 October 2021 5China builds another ‘Sydney CBD’ every 3 days!
In China, it is also a story of ‘growth by debt’, but the implications are very different, and much more immediate.
In the five minutes you will take to read this story, China will build the equivalent of one 50-story apartment block.
Chinese construction activity has been the single largest component in China’s incredible economic growth since the start of
the 21st century. In just two decades, more than half of China’s 1.4 billion people have been ‘urbanised’ – shifted from farms,
villages and obsolete factory towns, into hundreds of newly built cities. It has been the largest mass migration in human
history. It also lifted one billion people out of poverty, making it by far the greatest increase in aggregate wealth in history.
The construction of these new cities – including all of the residential apartments, factories, warehouses, offices, shopping
centres, restaurants, hotels, schools, hospitals, train stations, airports, government buildings, etc – has also been the main
driver of global commodities demand and prices, and also the largest contributor to the growth in Australia’s export
revenues, government tax receipts, and corporate profits. Not just from mining, but also across a host of other industries
exporting directly or indirectly to China.
As Chinese construction activity is so critical for Australian investors, and Australia’s prosperity as a whole, we track it closely.
Construction activity tends to be highly cyclical in nature – driven not just by supply and demand, but also by interest rates,
lending policies and government controls to try to slow speculative bubbles and boost employment.
Here are the broad numbers - Since the turn of this century, China has built a total of 30 billion square metres of floor space
(in apartment blocks, offices, schools, etc). That is the same as the land area of Belgium, or half of Tasmania. Annual
construction has averaged 1.5 billion square meters per year, but the pace has increased over time, and is currently running
at about 2.3 billion square metres of floor space per year, or about 200 million square metres of floor space per month.
These numbers are so large they are incomprehensible, so we have come up with a more meaningful unit of measurement of
construction – a ‘Sydney CBD’.
Sydney’s ‘Central Business District’ - from Circular Quay in the north to Central Station in the South, from Darling Harbour in
the west to Hyde Park in the east - contains about 20 million square metres of building floor space – including every floor in
all of the office blocks, apartment blocks, hotels, shops, restaurants, hospitals, car parks, etc. It took 230 years to build all of
this in Sydney, and much of it has been re-built, some several times over.
At China’s current rate of building of around 200 million square metres of floor space per month, it means China is building
the equivalent of ten ‘Sydney CBDs’ worth of buildings per month, or one ‘Sydney CBD’ every 3 days!
Floor Space Number of
constructed
per month
Real Estate Construction in China Sydney
CBD's built
(million sq m) per month +350%
300
↓ ↓ +325%
Rolling 12 month
250 Iron ore price construction 12 +300%
200 10 +275%
8 +250%
150 Monthly construction starts: 6 +225%
100 4 +200%
50 2 +175%
0 +150%
0 2013 covid
stimulus 2016 stimulus
2010-11
revival stimulus +125%
Annual
-50 stimulus
revival
2021
growth
+100%
2014-5 rate
2012 slowdown - 'Three
-100 post 2001 urbanisation boom slowdown 'China hard 2020 Red ↓
+75%
2008-9 landing' covid Lines'
Annual
-150growth GFC scare +50%
rate in
construction: +25%
-200
+0%
-250 -25%
source data: China National Bureau of Statistics
-300 -50%
Dec-2004
Dec-2000
Dec-2001
Dec-2002
Dec-2003
Dec-2005
Dec-2006
Dec-2007
Dec-2008
Dec-2009
Dec-2010
Dec-2011
Dec-2012
Dec-2013
Dec-2014
Dec-2015
Dec-2016
Dec-2017
Dec-2018
Dec-2019
Dec-2020
Dec-2021
Dec-2022
IINV \ China Nat Bureau of Stats
OWEN
Stanford Brown, Investment Markets Report, 5 October 2021 6One ‘Sydney CBD’ of buildings is the equivalent of 400 fifty-storey blocks with 1,000 square metres per floor. China is building the equivalent of one fifty-storey building every 5.4 minutes, working 12 hours per day, seven days per week. The chart shows Chinese construction since 2001, when China joined the World Trade Organisation, which accelerated its urbanisation, industrialisation and export booms. In the upper section, the blue line shows monthly construction, and the red line shows the 12-month average rate, in millions of square metres per month. The red scale to the right shows construction rising from a little over 1 Sydney CBD per month initially, to around 10 Sydney CBDs per month in recent years. The rate of building activity has been increasing over time, but there have been several cyclical slowdowns and stimulus rebounds along the way, highlighted by changes in the rates of growth in construction in the lower section of the chart. The chart also shows iron ore prices (brown dots) which follow the ups and downs in construction activity. (The exception to this pattern was the iron ore price spike in 2019-20 after the Vale mine disaster and then covid lockdowns took Brazil out of the market. Australia overtook Brazil as the world’s top iron ore exporter, and China’s largest supplier). As Chinese construction cycles are the biggest driver of commodities prices, export revenues, mining company profits and dividends, two key questions for investors include: • Where are we now in the current cycle? • Can Chinese construction continue on its upward march forever, or will it slow? On the second question – China is probably past its peak growth rate and into a new phase of slower growth. A major milestone was reached in 2019 when China passed the point of 50% of its population being urbanised, and the pace is likely to be slower in the latter stages of urbanisation and construction from here. A second reason for slower growth is demographics. China’s population is aging rapidly and will soon start to decline. This is a consequence of Deng Xiaoping’s ‘one-child policy’ from 1979. The policy was abandoned in 2016, but it has not halted the trend, nor is it likely to, despite a host of programs and incentives to try to increase birth rates. Throughout human history, there has been a persistent trend for birth rates to decline as societies urbanise and increase in wealth. A third reason for slower growth is the fact that all of this construction activity has led to a huge over-supply of residential housing blocks. Construction has run well ahead of demand. There are several estimates of the extent of the over-supply, but it appears there may be up to some 90 million units – either completed and vacant, or un-completed and abandoned by failed property developers. This surplus equates to around 500 ‘Sydney CBDs’ worth of buildings, or about 5 years’ worth of construction in over-supply. Here is an example of 15 abandoned apartment blocks being blown up after the bankruptcy of the developer and numerous failed government revival attempts https://www.youtube.com/watch?v=M9b9V2mUzjU The existence of debt turns over-supply from a mild headache (lower prices and returns), into a potential financial nightmare (fire sales and price collapses causing bankruptcies for highly geared developers, lenders and buyers). This highly leveraged over-supply crisis places a dampener on our first question: – ‘Where are we now in the current cycle?’ The chart on the previous page highlights several cycles of construction slowdown and stimulus re-boots along the long term path. First there was the slowdown in the 2008-9 GFC, that was ended by the 2009-10 stimulus boost; then the 2011-12 slowdown ended by the 2013 stimulus boost; the 2014-5 China ‘hard landing’ slowdown ended by the 2016 stimulus kick- start; and the ‘long’ 2017-19 boom. That ended with the 2020 covid lockdowns, when construction activity fell by 45% in early 2020. Activity rebounded sharply and rapidly with the stimulus boost, cities re-opening and vaccine roll-out. We are now into the 5th slowdown phase. From the start of 2021, property developers have been subject to harsh government-imposed leverage limits – known as the ‘Three Red Lines’. The government finally came down hard on developers that are highly leveraged and completely reliant on high growth rates forever, and also heavily reliant on debt to fund their persistent negative operating cash flows. The government was also trying to slow the speculative housing boom to reduce prices for lower wage earners as part of Xi’s ‘common prosperity’ plan. This sudden and savage de-leveraging drive in 2021 triggered a rapid contraction in construction. Thousands of developers are unable to borrow more to pay workers and suppliers to complete their projects so they can collect payments from purchasers. There is now mounting pressure for more stimulus and support to avoid a potential domino effect of collapses of highly-leveraged property developers. This brings us to the ‘Evergrande’ crisis that has been dominating headlines and rattling markets in recent weeks. Stanford Brown, Investment Markets Report, 5 October 2021 7
Evergrande
Evergrande Real Estate Group is (soon to be ‘was’) one of China’s big-three property developers that drove China’s
construction boom, and economic growth, for the past two decades (the big-three being Evergrande, Vanke, and Country
Garden). Evergrande started out in 1996 as Hengda Group in Guangzhou (Canton) and rapidly expanded across China. It also
bought up a string of other businesses in a wide range of related and unrelated industries, including a soccer team called
Evergrande, which inspired the name change for the group, Hengda to the much more attractive sounding ‘Evergrande’.
Evergrande listed in Hong Kong (3333.HK) in 2009 after raising US$720m. Its share price peaked in 2017 at HK$30 (making its
founder and 70% owner, Xu Jiayin, the third richest billionaire in China), but it is now down 90% to just HK$3 per share.
The company has been posting nice-looking accounting profits but in reality it has always made operating losses, and has
relied on an ever-increasing pile of debt. It’s latest annual report shows liabilities of RMB1.95 trillion (US$300b) but only
RMB350b (US$54b) of equity, so it is leveraged up 5.5:1. That’s if you believe the accounts. In reality, the assets are almost
certain to be over-valued (for example they don’t include the heavy discounting of unit prices to shift unwanted stock), and
their liabilities are also bound to include a host of off-balance-sheet debts, contingencies and side-deals. In reality, the
company almost certainly has negative equity and is insolvent because it can’t raise more money to complete developments
so it can collect payments from unit buyers.
Of its 800 current construction projects all over China, about 500 have been boarded by suppliers due to non-payment of
debts owed. Even on its fancifully over-stated accounts, it is in breach of the government’s ‘Three Red Lines’ rules on debt
(Maximum 70% liability-to-asset ratio excluding advance receipts; Maximum 100% net gearing ratio; and at least 1 times
cash-to-short-term debt ratio), so it is prevented from borrowing more to pay suppliers or complete projects.
On 15 September the company announced that it had hired advisers to work through its debts, and that it would not be able
to make repayments of interest or principal from 21st September. It was trying to sell off businesses, and was discounting
units by up to 40% to try to raise cash, but with little success. In the last week of September it missed interest payments due
to foreign bond holders, and it has also reportedly missed payments on debts owed to Chinese banks (most of which are also
listed in Hong Kong, and controlled by the government). The government’s forced deleveraging rules have certainly hit hard.
Evergrande has been considered ‘too big to fail’ because of its sheer size and scale in such a critical industry in China’s
growth, and its huge impact on employment, suppliers, and home buyers.
In a liquidation there are strict rules dictating the order in which different classes of creditors and investors are paid. In this
case it will probably be determined more by politics. Here are the main types of creditors/investors and how they may fare:
• Chinese (government controlled) banks are owed about US$35b that we know about. They probably have the best
security and they can repossess construction sites. Even if they can find other developers to buy them, it will probably
require lending more money for completion. The banks are highly leveraged themselves and therefore vulnerable to
losses. They are also inter-connected to other banks, so the banks will be favoured to lose least in the Evergrande mess.
• 1.5 million depositors on apartments under construction are owed at least $25b (their deposits are liabilities until
completion). The government is unlikely to allow such large numbers of buyers to lose money. The only option will be to
allow the completion of the units, meaning more money must come from somewhere. Competing developers are not an
option at that scale, so the only way out probably is the government putting in more money to fund completion.
• Local suppliers probably make up the largest proportion of the liabilities. The government will be keen to avoid losses
here, given the potential knock-on effects on employers and other development companies.
• Around 80,000 retail investors are owed about $50b in Evergrande’s ‘Wealth Management Products’ (WMPs). This has
become a popular form of ‘shadow banking’ finance for many Chinese companies, including property developers. WMPs
are like money market trusts that pay ‘interest’ of 5-8%, which is well above the low rates paid on bank deposit
accounts. The government does not like WMPs as they take away a cheap funding source from the government
controlled banking system, so it may not mind WMP investors being taught a lesson. Evergrande WMP investors have
been rioting in the past month and this has probably unnerved the government. Despite WMP investors probably
ranking lower than unsecured balance sheet creditors (like suppliers and unit deposits), the government will want to
avoid the civil unrest that might break out if they were left with nothing.
• Domestic (‘on-shore’) bond holders are owed around $10b – although ranking higher than WMPs, these are mainly
owned by institutions (Chinese funds), and the government may decide they can afford to take losses.
• Foreign (‘off-shore’) bond holders - owed about US$16b. The government has shown no interest in helping foreigners.
• Shareholders rank last in the order of payment if there is anything left. In this case the shareholders are 70% owner-
founder Xu Jiayin and foreigners via Hong Kong. Xi has no interest in saving foreign shareholders, nor local billionaires.
He has demonstrated increasing hostility toward both over the past year (eg. Alibaba, ANT, Didi, TAL, New Oriental, etc).
Stanford Brown, Investment Markets Report, 5 October 2021 8What Lies Ahead?
One common question doing the rounds over the past month has been: ‘Is Evergrande China’s Lehman moment?’ The short
answer is ‘probably not’. When the US government and Federal Reserve allowed Lehman Brothers to fall into bankruptcy in
September 2008, it triggered a ‘global financial crisis’ in which every bank in the world suddenly refused to deal with each
other for fear of what they were holding on their balance sheets, because the US sub-prime crisis had suddenly revealed that
‘AAA’ rated bonds were far from ‘risk-free’ as they were dressed up to be.
In the case of Evergrande, the amount of Evergrande’s debts to the Chinese Banks is very small (around 0.1% of Chinese
loans, but even if we multiply that by ten for a contagion effect, it is still insignificant). The security they hold is not complex
derivatives made up of toxic sub-prime debt dressed up as safe ‘AAA’ bonds. The security they hold is construction sites in
China – probably worth a lot less than they once were, but very transparent and simple. They have not packaged up the
Evergrande debt (nor the construction sites) into complex derivatives and sold them around the world to other banks.
Allowing a bankruptcy and liquidation fire-sales of Evergrande assets would certainly create knock-on effects to other
Chinese developers, suppliers, and unit buyers, but that is an unlikely outcome.
The most likely outcome is that the Chinese government will take over the company and pump in more money (directly or by
instructing other government-controlled firms to inject money) to complete the units and pay suppliers, and then collect
payments from the buyers on completion. Shareholders will certainly be wiped out, and probably so will foreign bond holders
and possibly domestic bond holders as well. The Chinese banks (which are essentially just another arm of the Chinese
government) will be paid out of the proceeds of sales of completed units.
There are two very recent Chinese ‘too big to fail’ precedents - HNA Group in January this year, and Huarong in August.
HNA started out as Hainan Airlines and diversified into a host of other businesses – mostly on debt via a complex web of
tricky deals and structures. It collapsed at the start of 2021 after several restructuring efforts failed. The government took
back the main asset – Hainan Airlines – sold off the other assets and businesses and wiped out the billionaire founders.
Huarong Asset Management was another ‘too big to fail’ rescue. Huarong was actually one of the main ‘bad’ banks set up by
the Chinese government in 1999 to take over bad debts from other government-controlled banks when they collapsed after
their orgy of bad lending in the state-sponsored credit-fuelled speculative bubble of the 1990s. Huarong was majority
government-owned but it also went on a mad spending spree into unrelated businesses. Its Chairman Lai Xiaomin refused to
toe the Party line so he was rounded up, charged, convicted and executed in January 2021. Huarong defaulted on its bonds in
March, so the government took over in August, directed other government-controlled firms to chip in more money (Citic
Bank, China Life, China Insurance Investment), and handed operational control to Citic (government-controlled).
Likewise, in 2019 the government bailed out mid-sized Baoshang bank, and handed it over to China Construction Bank, also
government-controlled. You see the common thread here – government control of almost everything. This is a plus in a crisis.
On the subject of defaults – the seemingly never-ending US debt ceiling saga has been back in the news in recent weeks. The
current US debt ceiling suspension was due to expire on 30 September, but the Republicans have been playing hard ball over
Biden’s $3.5trillion spending package. Treasury Secretary and former Fed Chair Janet Yellen stated in a Congressional hearing
this week that the spending package would be funded by ‘revenue measures’ (tax hikes – ouch!), and that the spending
would be ‘deficit reducing beyond the next ten years’ (double-ouch!). At the last minute, the House approved a bill to extend
the suspension to 3 December, when Congress will have to deal with it all over again. This raises the prospect of a US
government shut-down (again!), and also the prospect of the US government defaulting on its debts (again!).
We have written many times about previous debt ceiling crises, previous government shutdowns (eg. in 1995-6, and 2012-
13), and even previous US government defaults (yes, the US government has defaulted on its own treasury bills in the past).
See for example:
• on previous US government shutdowns - https://www.firstlinks.com.au/us-government-shut-done/
• on previous US government defaults - https://www.firstlinks.com.au/us-government-previously-defaulted-risk-free
The most recent government shut-downs were accompanied by the usual yawns – museums and national parks were closed,
and government staff went on ‘furlough’ leave for a few weeks (that will hardly be noticed this time compared to the Covid
lockdowns). Legislators soon returned to the negotiating table and extended the ceiling because they wanted to get paid!
Meanwhile the vaccine roll-outs are progressing steadily around the world, and in Australia finally, providing hopes of a
restoration of some freedoms by Christmas. It would not be Christmas in Australia without transport strikes and wharfie
strikes, so it is encouraging to see they are getting in early – it demonstrates confidence in the coming easing of lock-downs!
Happy investing!
Ashley Owen, CFA
Chief Investment Officer
Stanford Brown, Investment Markets Report, 5 October 2021 9Ashley Owen Chief Investment Officer CFA, LLM, BA, Grad. Dip Applied Finance Ashley is one of Australia’s leading portfolio managers of diversified investment funds for long term investors. His mission is to manage portfolios that provide investors with confidence that their investments will generate the wealth they need to live the life they wish to lead for the rest of their lives – for themselves, their families and as a legacy for future generations. His primary focus is protecting investors from losses and risks, rather than chasing high returns from the latest hot funds or fads. Disclaimer Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. This report is current when written. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances. When considering a financial product please consider the Product Disclosure Statement. Stanford Brown is a Corporate Authorised Representative of The Lunar Group Pty Limited. The Lunar Group and its representatives receive fees and brokerage from the provision of financial advice or placement of financial products. The Lunar Group Pty Limited 2020 ABN 27 159 030 869 AFSL No. 470948 Stanford Brown, Investment Markets Report, 5 October 2021 10
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