It occurred to me about a week ago that the global finance industry’s relationship with the China Story is a practical example of almost every trend discussed to date in this blog. The way to convey this was elusive but hopefully I’ve McGyvered up a structure this morning.
A few of things to keep in mind off the top. One, consider the economic outlook for China as “in dispute” or “inconclusive” for the purposes of this post. My personal skepticism will become evident, but this is not a result of a personal dissection of macroeconomic factors underpinning the bull and bear cases. Also keep in mind that I am alleging no conspiracy on behalf of the industry. I am assuming sincerity behind all views. Third, a lot of the content below compares China-related sell side projections to those during the technology bubble and, having discussed the analytical limitations of this personal tendency in the previous post “Investor Anthropology”, I will ask you to keep this, my personal potential intellectual blind spot, in mind also.
Vendor Financing: How soon we forget. The fact that the technology bubble contained its own internal credit bubble is now frequently overlooked. Particularly in the telecom equipment space, corporate clients were encouraged to build monstrously large communications networks in order to avoid “falling behind” their competition. For CEOs the decision was made convenient by offers from the equipment companies to provide the financing for network construction. The unraveling of this process was central to the demise of the bubble as the lofty goals of new business models gave way to bankruptcy, ending debt repayment and severely impairing the balance sheets of former high-flying companies like Cisco and Nortel Networks.
There are, of course, limitations to the interpretation of China’s mass investment in Treasuries as the largest vendor-financing scheme in world history. However, the de facto result of current Chinese monetary policy does have similarities to the “here’s the money to buy my gear” pitch by 1990s telecom equipment manufacturers. The policy is designed to support manufacturing and the support of the greenback does improve the ability of Americans to buy Chinese exports.
Extrapolation: Tree Grows to Sky. Earlier this year, I involuntarily attended a client presentation on the growth and investment opportunities in China. About a third of the way through, a slide was displayed charting Industrial Production growth for China, Germany and the U.S. as a percentage of total global GDP over the past decade. Fair enough, very impressive Sino performance. A button was then clicked and these growth rates were extrapolated to 2035 when China was seen overtaking the U.S. My first reaction on seeing this was to sincerely hope that someone from the CFA Institute was in attendance so that the presenter wouldn’t leave the building with his charter. The list of potential hurdles to continued 10% annual GDP growth for China could, and have, resulted in 1,000 page tomes on Amazon. Economists and strategists frequently aren’t in the ballpark with their year over year forecasts, never mind 24 years out. In a straight line.
The prevalence of “tree grows to sky” forecasts for the technology/telecom sectors in the 90s barely needs explication. I talked about it HERE. All we really have to do is recall the terms “New Paradigm” and “information superhighway”.
The extrapolation of growth rates for an investment story takes on an extraordinary degree of momentum, for industry professionals and investors. For investors, Confirmation Bias becomes all encompassing. Portfolios are increasingly dominated by the investment theme, even if they solely consist of broad-based index funds, and everyone roots for their current investments with all the delusions that fandom implies. Nervous investors that sell the trend early, and miss a subsequent rally, are derided by chest-thumping bulls.
Professionally, the pressure to remain bullish is intense. I was in the room in 1999 for a research meeting where the telecom analyst discussed the growing credit issues for one of the big companies. The analyst was asked how bad things could get and they hesitated, looked away and then said something like, “really, it’s a house of cards”. The Institutionally Salespeople immediately went aaaaaaapppppeshit. “YOU CANT SAY THAT! ALL MY CLIENTS HOLD THAT STOCK!”. It was loud and it was brutal and no one wanted to accept the possibility of a 180-degree turn in strategy.
Aside from this, capital markets staffing and compensation trends slowly distort in the direction of sustainable market trends. In the 90s, every firm needed a technology analyst and the poaching of analyst talent was constant and really, really expensive – seven digit guarantees were merely a starting point. In banking, the technology team worked day and night, constantly adding staff members to handle the deal flow. As with any trend, the quality of deals declined dramatically near the end, in part because they could still get done but also because the larger banking team had to keep justifying the high levels of staffing by continuing to bring in revenue.
The China-related sector corollary is the mining and resource sectors and, to a lesser extent, global industrials. Analysts and bankers in these areas increasingly dominate the pay structure and staffing requirements. If Chinese economic growth slows dramatically at some point, it will take a long while before the heads of research departments will admit that the $8 million in annual guaranteed money they paid an oil analyst has basically gone down the drain. And, the head of the Oil and Gas banking team will fight to keep their staffing levels (with bullish outlooks) long after the business has dried up. As with the tech bubble, these are the ways in which a sector-related bull markets become an institutional phenomenon, rather than simply a market call.
The Cockroach Theory or “I know, but story’s still intact”. The vendor financing issues and the increasing number of late 1990s telecom bankruptcies formed good examples of the Cockroach Theory. Stock valuations were another although thankfully that is not an issue in the current market. (There are, however, market breadth-related factors that partially explain this. The 90s was an extraordinarily narrow market because of broader economic conditions). It is always easy to identify cockroaches in hindsight. It is also important to recognize that negative indicators that conflict with an embedded investment story are almost always ignored.
The China Story has its own increasing number of cockroaches. Regional government finances are atrocious and it is more or less consensus that the insolvency of the banking system was, despite government testimony to the contrary, merely papered over in 2004, not fixed. The Sino Forest debacle highlighted extensively dodgy accounting practices and more photos of newly built, empty neighborhoods are posted every week (or worse yet, poorly-constructed 20 story apartment buildings that have just fallen over).
In the end, this is clearly too big of an issue for a now-1000 word blog post, but I hope you see where I’m coming from. Dominant investment themes have characteristic effects both within the industry and on the psychology of investors. The dedication to, and reliance on these trends implies a degree of tunnel vision where potential hurdles are, consciously or not, avoided or ignored. In the case of China, it is less important whether you believe the story is over or not – my favorite source on the subject, Beijing-based professor Michael Pettis, believes the economy will continue on its current path until 2013, fwiw – but that investors recognize when they become too invested in any specific outcome.
Pettis: How do we know that China is overinvesting?
Chovanec: Déjà Vu All Over Again