China, the Global Economy and Investing

Investment Perspective – October 2015

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

In short, China’s economy is large enough that as it slows down (underway now) it will impact on its trading partners, and therefore the global economy. China though, has the resources and the political will to engineer a soft landing.

However, what we may see moving forward is the opposite of what we enjoyed over the last 15 years. 

We saw growth, reducing interest rates and asset prices rising on the back of the increased use of debt – the liquidity bubble. 

Okay, there was also some fundamental economic activity going on too – however it was supported / driven by reducing interest rates and increasing debt.

This is just an inescapable fact.

Another inescapable fact is that returns on investments at some point will more closely reflect the underlying economics. Somewhere, the fundamentals will matter with regard to pricing.  As you know from experience, this can sometimes happen sharply although; it may be something that takes quite a long time to manifest itself.

In the future, the challenge we face as investors is that prices generally are expensive (e.g. share market P/E ratios at 15 – 20 are well above 10 and residential property generally offering yields of aground 5.00% – well less than 10%). At the same time economic activity looks to be broadly slowing around the world. 

Therefore we have the somewhat undesirable combination of high prices and slowing economic activity. 

But to What Extent Does it Matter?

In simple terms, it matters more if we are broadly invested across markets. Whatever I am invested in, the widespread diversified broad investment approach (e.g. kiwisaver) will likely ensure that my returns are reasonably close to what the market offers, particularly over the long term. If you are happy with that then no problem.

In the short term anything is possible as markets and prices lurch to and fro. The impact of a slowing Chinese economy is difficult to measure, however opportunity does not disappear.  As Value Investors we can continue to look for specific opportunity inside the markets (rather than invest across the markets).

I was talking to one of my good clients in Auckland recently about the possibility of slowing returns. She quickly jumped in, pointing out quite rightly “But Peter, won’t there still be investment opportunity in the market that we can find!?”

I couldn’t have put it better myself. 

Even in a broadly slowing global economy with deflationary forces pushing down hard on price rises, there is still opportunity to locate specific properties with good property economics and good businesses with sound underlying business economics – possibly a bit cheaper because of those deflationary forces pushing prices down. 

Although it is difficult to know, this “deflationary funk” could be a long-term structural trend rather than a one-off massive pricing correction or short-term event. That is because central bankers currently have control and continue to roll out their “macro prudential tools” when needed. To be clear, central bank intervention is why we did not have a major global depression starting in 2008.

So, if we continue to seek out specific opportunity inside the market, expensive prices alongside a slowing economic back-drop will have less impact on us as value investors.

My Clients Are All Smart

After all… it takes a rare insight to be a client at WISEplanning!

One of my other very learned clients down in Southland recently mentioned (again very eloquently) that as farmers he and his wife are well used to prices lurching up and down. He reasoned that it was like the jagged teeth on a saw (up down up down up down…). So long as the long-term trend is up that saw tooth movement of prices really does not matter much.  In fact it provides opportunity to buy when prices are cheap.

Like many of my clients, these clients from Invercargill know very well the wisdom of riding through the saw tooth process, keeping an eye on big picture strategy. They are as prudent as anyone I have ever met and yet they spend very little time if any worrying when “the saw tooth” is on the down.

“I have pledged to you, the ratings agencies and myself, to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.“

Warren Buffett – letter to shareholders 2008