•••

Chinese real estate developers have been dropping like flies. They spent the last few decades binging on debt and are loaded up with it. The country is now battling to prevent debt deflation, where asset prices fall as debts rise. Can China stop the economy from circling the drain and avoid a deflationary spiral? The answer will depend on whether the government can prop up the real estate market enough.

The Chinese economy is drowning in debt. The country's debt levels are dizzying but stagnant. Private sector borrowings are a whopping 228% of gross domestic product (GDP). Most of which is on corporate balance sheets—non-financial companies owe 166% of GDP.

Borrowing more and more was a standard part of China's playbook. The government, wanting to boost asset prices, encouraged everyone to do so. But houses got too expensive, and many families couldn't buy. The government wanted to change that. So, in August 2020, it introduced the Three Red Lines policy to rein in real estate borrowers and lenders.

That policy restricted how much money developers and banks could borrow and lend. Yet, developers relied on an ever-increasing debt model. They and their customers needed the ability to borrow ever-increasing amounts. Without it, they've felt the pinch.

Now, Chinese property firms are struggling. There are two reasons for this. First, they're stunningly levered. Chinese real estate firms are responsible for most of the country's corporate debt. The total debt-to-equity ratio for the sector is 330%, much higher than the 31% total for the non-real estate sector. By comparison, American real estate companies are at 75%, and the global total is 109%. Second, profitability has tanked, pressuring their ability to repay. Developers' returns on equity have fallen to -5 %, while all other sectors are doing fine.

Chunky losses have squeezed developers' ability to repay their lenders, and many are now in default. A massive $125bn of bonds are now in default across China's $175bn dollar-bond market. Struggling real estate firms are a sign of property market struggles. If asset prices fall as developers close up shop, credit will collapse. That could trigger a long and painful debt deflation.

The Chinese have felt these tremors across their economy. The housing market has started to crack as the impact of deleveraging hits. House prices have fallen 8% from their 2021 peak, while new home prices are down 12% since last year's first quarter. Property investment has also dropped 9% in the past year. Falling property prices make home shoppers and investors less keen to jump in. That, in turn, pulls down prices and new home sales, putting developers and sellers under more pressure and forcing them to sell assets to raise cash.

Xi Jinping, China's leader, has rolled out his stimulus gun to defend the economy from the debt deflation dragon. The government will provide 1trn yuan ($137bn) for affordable housing and urban renovation. The People's Bank of China, the country's central bank, will shoot this low-cost money into the economy in phases using the country's banks. The money will fall on households to prop up home prices and sales volumes. This 16-point plan, as they've called it, will reverse most of the credit tightening that the Three Red Lines policy caused. It will make it easier for everyone to borrow for real estate.

The government won't stand by as the property market burns—stimulus was always on the way. China's real estate market is too big to fail. It's the driver of the country's economic growth and household wealth. Property is 30% of China's GDP, making it the biggest contributor to the world's second-largest economy. According to the China Household Wealth Survey Report, real estate is also responsible for 70% of household wealth, as Chinese families have limited investment options. There are too many people in too big an economy for the country's leaders to stand by.

It'll be challenging to tame China's debt dragon. But, if the government can prop up the real estate market long enough, the tide will turn, and the sector will re-inflate. If not, it's all fire and brimstone for the foreseeable future. ■

Chinese real estate developers have been dropping like flies. They spent the last few decades binging on debt and are loaded up with it. The country is now battling to prevent debt deflation, where asset prices fall as debts rise. Can China stop the economy from circling the drain and avoid a deflationary spiral? The answer will depend on whether the government can prop up the real estate market enough.

The Chinese economy is drowning in debt. The country's debt levels are dizzying but stagnant. Private sector borrowings are a whopping 228% of gross domestic product (GDP). Most of which is on corporate balance sheets—non-financial companies owe 166% of GDP.

Borrowing more and more was a standard part of China's playbook. The government, wanting to boost asset prices, encouraged everyone to do so. But houses got too expensive, and many families couldn't buy. The government wanted to change that. So, in August 2020, it introduced the Three Red Lines policy to rein in real estate borrowers and lenders.

That policy restricted how much money developers and banks could borrow and lend. Yet, developers relied on an ever-increasing debt model. They and their customers needed the ability to borrow ever-increasing amounts. Without it, they've felt the pinch.

Now, Chinese property firms are struggling. There are two reasons for this. First, they're stunningly levered. Chinese real estate firms are responsible for most of the country's corporate debt. The total debt-to-equity ratio for the sector is 330%, much higher than the 31% total for the non-real estate sector. By comparison, American real estate companies are at 75%, and the global total is 109%. Second, profitability has tanked, pressuring their ability to repay. Developers' returns on equity have fallen to -5 %, while all other sectors are doing fine.

Chunky losses have squeezed developers' ability to repay their lenders, and many are now in default. A massive $125bn of bonds are now in default across China's $175bn dollar-bond market. Struggling real estate firms are a sign of property market struggles. If asset prices fall as developers close up shop, credit will collapse. That could trigger a long and painful debt deflation.

The Chinese have felt these tremors across their economy. The housing market has started to crack as the impact of deleveraging hits. House prices have fallen 8% from their 2021 peak, while new home prices are down 12% since last year's first quarter. Property investment has also dropped 9% in the past year. Falling property prices make home shoppers and investors less keen to jump in. That, in turn, pulls down prices and new home sales, putting developers and sellers under more pressure and forcing them to sell assets to raise cash.

### Mainlining stimulus

Xi Jinping, China's leader, has rolled out his stimulus gun to defend the economy from the debt deflation dragon. The government will provide 1trn yuan ($137bn) for affordable housing and urban renovation. The People's Bank of China, the country's central bank, will shoot this low-cost money into the economy in phases using the country's banks. The money will fall on households to prop up home prices and sales volumes. This 16-point plan, as they've called it, will reverse most of the credit tightening that the Three Red Lines policy caused. It will make it easier for everyone to borrow for real estate.

The government won't stand by as the property market burns—stimulus was always on the way. China's real estate market is too big to fail. It's the driver of the country's economic growth and household wealth. Property is 30% of China's GDP, making it the biggest contributor to the world's second-largest economy. According to the China Household Wealth Survey Report, real estate is also responsible for 70% of household wealth, as Chinese families have limited investment options. There are too many people in too big an economy for the country's leaders to stand by.

It'll be challenging to tame China's debt dragon. But, if the government can prop up the real estate market long enough, the tide will turn, and the sector will re-inflate. If not, it's all fire and brimstone for the foreseeable future. ■

•••

Walter Schloss, a famed value investor, was well known for buying stocks that traded far below book value. “I really have nothing against earnings except that, in the first place, earnings have a way of changing… I find it more comfortable and satisfying to look at book value.” Thanks to this strategy, Schloss returned 21% a year, on average, for 28 years—an incredible result. So, have low price-to-book (PB) value stocks outperformed? The simple answer is yes. But should you sell everything and buy low PB stocks? That depends on whether you want outperformance, can handle volatility, and can stick it out through the cycles.

A simple equal-weighted portfolio of low PB stocks outperformed the market. Consider you built a portfolio of the bottom 10% of American stocks arranged by their PB ratios, and you rebalanced this each year. From 1927 to 2022, this portfolio—I’ll call it the value portfolio—compounded at 19% a year. A $100 investment back then would have become $2.2bn in 97 years.

That is a far better result than the market, which grew at 10% a year. It’s also miles ahead of the opposite strategy, which I’ll call growth, in which you bought the most expensive 10%. That low-PB strategy was, in effect, what Schloss did. But he operated when it was hard to get company data. If you could get the data, though, that approach was much less work than many other sophisticated strategies. And you likely would’ve done much better.

Still, you needed the gumption to bear gut-wrenching volatility. While the value portfolio produced killer returns, it was the most volatile. The standard deviation of annual returns was 43%. That’s 13 percentage points higher than the growth portfolio’s volatility and 24 percentage points more than the market’s.

For most non-robots, it would be difficult to handle this return whiplash. An incredible 205% return in 1933 was soon followed by a life-questioning 59% loss in 1937. But if you could stick it out for the long run, the value portfolio was the way to go. Its Sharpe ratio, calculated as the annual extra return above bonds divided by the volatility, is the highest of the three portfolios. With a 21% average excess return and 43% annual volatility, the value portfolio’s Sharpe was 0.5. That’s higher than the market’s 0.4 ratio and much better than the growth portfolio at 0.2. Indeed, the growth portfolio was a stinker. Not only did it give much worse returns than the market, it also had higher volatility.

Still, the value portfolio’s outperformance was cyclical. It didn’t always beat the growth portfolio or even the market. Over that almost century, the value portfolio underperformed the market on a ten-year basis three times. First, in the 1950s and ‘60s. Then again, early in the ‘90s. And most recently, it underperformed since 2015. As with volatility, cyclicality is challenging to handle. Well-meaning investors might abandon hope and sell their value stocks only to see them take off.

Stay the value course. It works.

This essay was originally published in Valuabl. Valuabl is a twice-monthly newsletter with expert financial analysis in a straightforward style. Subscribe here: https://valuabl.substack.com/

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•••

Investors want practical ways to boost their returns and reduce risk. Yet, they often overlook passive, diversified asset allocation strategies. By analysing return data for American stocks, bonds and real estate equity from 1890-2022, we can see what would have worked in the long run. It turns out that real estate is the top dog. On a risk-adjusted basis, it outperformed stocks and bonds. But by diversifying across all three asset classes instead of holding just one, investors would have significantly boosted their risk-adjusted returns. Looking forward, a simple mix of the three would be easy to manage and will likely do well.

Over the past 130 years, real estate equity (based on Robert Shiller’s index) has crushed both stocks (Shiller composite index) and bonds (10 year Treasuries) on a risk-adjusted basis. Real estate's Sharpe, the ratio of annual returns to volatility, was 1.2. That's twice as high as the Sharpe for stocks and 1.5 times that of bonds. When it comes to risk-adjusted returns, real estate is the top dog.

Over that time, real estate investors got 10% per year on average, including equity capital gains and net rents, with 8% volatility. That was better than the 5% per year return with 6% volatility that bondholders, who received capital gains and coupons, got. And much better than stocks, which returned 11%, including capital gains and dividends, with 18% volatility.

Even though real estate returns were a percentage point lower than for stocks, the volatility was ten percentage points less. That's a massive difference in the risk taken. Real estate has produced stock-like returns with bond-like volatility over that time—a stunning and counterintuitive result.

Broad diversification reduces risk without hurting returns much. Over those 130 years, these three assets' returns have had little correlation. Stocks and bonds shimmied in the same direction, with a +0.2 correlation. As did stocks and real estate (+0.2 also). But bonds and real estate have had a slightly inverse relationship with a -0.1 correlation.

At a broad level, these three asset classes are almost independent return streams. By combining all three, investors will outperform any one of them on a risk-adjusted basis. A simple strategy of having 45% in real estate, 45% in bonds, and 10% in stocks boosts risk-adjusted returns considerably. In fact, the results for this Everything Portfolio are remarkable.

Without combining assets, the best you could have done was to put it all into real estate. The Sharpe would have been 1.2, and you would have lost at most 13% of your money once every ten years. But, by combining assets, the Sharpe jumps to 1.5, and you'd have lost at most 5% of your money once every 14 years. In contrast, the most challenging strategy would have been to go all-in on stocks. You'd have gained a small bump in returns but would have more than tripled your risk. And you'd have lost money a third of the time with a maximum drawdown of 43%—a brutal storm the weather.

As there are now so many exchange-traded funds, this strategy would be simple to implement today. That’s in stark contrast to 1890. It would also take just a few minutes of periodic management. Further, reducing drawdowns and volatility makes it much easier to stick to. This result also shows that diversification is vital. The returns studied were not individual securities but rather broad asset classes. That indicates that passive, diversified investment works well. Moreover, these returns are far better than those of almost all active fund managers. How many investors could do 8% yearly for 130 years and lose 5% at most? Almost none.

Including real estate is the key to this portfolio's success. There's no denying that real estate has done well. Its incredible performance flies in the face of traditional financial theory, which says there's an almost linear relationship between risk and return. But real estate is unique. Real estate does so well because it sops up the spillover returns from the rest of the economy. When industries innovate and produce more, society gets richer. As a result, wages and incomes rise, and landlords can raise rents. Regardless of what happens, landlords get paid first, as people need places to live, work, and be. That gives real estate stock-like upside, with bond-like downside—an attractive proposition.

Without real estate, as in the popular 60-40 portfolio of 60% stocks and 40% bonds, you're stuck with the same returns but have to bear much more risk. By comparison, the Everything Portfolio made 8% per year with 5% volatility, while the 60-40 portfolio did 8% with 12% volatility. That's the same return but with more than twice the risk.

For families worldwide, that real estate investment was usually their house. Then, by investing the rest of their money in stocks and bonds, they achieved a variation of this Everything Portfolio. Real estate may be in a bubble, but investors can get rich while sleeping easy by adding a healthy spoonful to their portfolios.

For its citizens, there is no peace in the Middle East. Yet, financial markets seem oddly cool about it all.

•••

It's been a horrible week for peace lovers. The escalating brutality in the Middle East has consumed the news cycle and political debate. Social and traditional media has lit up with mostly divisive and simplistic opinions. People are on edge about what's next. But financial markets have reacted with remarkable placidity.

Since Hamas's brutal attack, Israeli government bond yields have gone sideways, hovering between 4.2-4.3%. The shekel, Israel's national currency, is also effectively unchanged—it has dropped 1% against the dollar. You would think that markets would be reeling with almost 2,300 dead and over 8,000 injured. Instead, they're nonplussed. Why? The Bank of Israel announced it would sell $30bn in foreign reserves to prop up the currency while providing $15bn to support markets. That has stabilised the currency and bonds. It will also help ensure the country can buy weapons and goods from foreign companies.

Although global markets have had a somewhat muted reaction, weapons manufacturers have benefitted. Investors have added 6% to aerospace and defence firms' collective market caps globally. In contrast, the MSCI Israel ETF, an index of the 117 largest companies in Israel, has fallen 8%. For such a dramatic escalation, these seem like small movements. But they're historically normal. In the week following the September 11 attacks, the S&P 500 index of big American firms shed just 6%. While punters are pontificating wildly, traders have been far more equanimous.

As of publishing, none of the big three ratings agencies have stepped into the fray yet. Neither Moodys, S&P, nor Fitch have made any announcements. But they're usually slow to react and will want to monitor what unfolds before saying anything.

The world will be watching, waiting, and commiserating this grisly ordeal.

•••

During the peak of the 2021 crypto boom, Gary Vaynerchuk, an entrepreneur famous on social media, bought a non-fungible token (NFT) of an ape wearing an orange hat for $5.9m. Two years later, it was worthless. A report from dappGambl, a crypto-gambling platform, shows this is the norm. Their research demonstrates that 95% of NFTs created are worth nothing. Sure, punters will always get caught up in speculative manias. But the NFT craze will never return.

First, huge losses will keep people away. Of the more than 73,000 NFT collections dappGambl looked at, almost 70,000 had a market capitalisation of zero. That means more than 23m people have worthless NFTs. Speculative assets, like these blockchain offspring, depend on price momentum to produce a return. With so many punters nursing wipeout losses, the NFT-as-an-investment culture is dead.

Second, without rising prices, there isn’t enough demand. Of all the NFT collections produced, 79% remain unsold. That is to say, their creators published them, but no one bought them. It wasn’t just tech enthusiasts, either. Celebrities from Snoop Dogg, a rapper, to Bella Hadid, a model, jumped on the bandwagon. With every man and his Snoop getting in on the action, a glut of low-quality supply followed. In fact, artists created five times as many NFTs as people wanted to buy. That puts downward pressure on prices and reveals they are not scarce commodities.

Third, the environmental impact of creating an NFT is brutal. It takes an average of 83kg of carbon emissions to make a single NFT. That’s the same as the average American home emits in four days. Of the 248,000 NFTs in existence, 196,000 have never sold. That means the total emissions from creating these unsold, worthless tokens is the same as 2,048 homes would produce in an entire year. What a waste.

As our societies become more climate-aware, the scale of NFT waste will come into focus. If heavy losses and limited price action don’t turn punters off, this surely will.

Mortgage rates have gone from 1.3% to 3.9% in the last two years—and taken a bite out of demand.

Lower prices mean households are poorer and can borrow less.

Is the house-of-cards collapsing?

•••

Qantas, Australia's largest airline, was created by a small group of pilots in outback Queensland. Now, it's the biggest and most hated airline down under. The Flying Kangaroo, as locals call it, is mired in scandal. The share price has fallen, and the boss has quit. That raises the question: With the company facing so much turbulence, is now a good time to buy the stock? While the shares look cheap, the answer will depend on how much special treatment you think the airline will continue to get.

The company is stuck in a sticky quagmire of selfish-looking scandals. The ACCC, Australia's consumer watchdog, has accused the airline of mis-selling tickets. They say Qantas sold tickets for over 8,000 flights that the company had already cancelled. That is illegal and means fines. It also hangs a dark cloud over the integrity of their financials.

Pundits have criticised the company's lobbying efforts. They took A$2.7bn of government subsidies during the pandemic with no stipulation to repay. But, on the back of this, announced A$2.5bn in profit before tax, a record. There's a funky smell in the cabin—and some talking heads think the company should pay back the money.

There are also accusations of poor working conditions and horrid customer service. The firm owes refunds, but customers say they've been left in the lurch. As a result, the public and press have ratcheted up the pressure on the company, and rivets have started to pop. Alan Joyce, the company's former boss, was the first to go. The Irishman announced last week that he would leave immediately, bringing forward his retirement by a couple of months.

His replacement, Vanessa Hudson, the CFO under Mr Joyce, has taken control of a nose-diving plane. Qantas faces hundreds of millions—or even billions—in fines. These fines and problems will continue to tug on the firm's value for the foreseeable future. Still, the shares look cheap.

My modelling assumes the regulator slaps the company with a A$750m fine, and profit margins will decline to their long-term average. I suspect the airline will always receive special treatment from the government and customers, and that will show up on the bottom line as slightly higher-than-industry-average margins. As a result, I value the shares at A$7.30-7.70 each, with a 38% upside from their current level. The shares are cheap in 89% of the scenarios I modelled. That suggests some margin of safety. But, the value depends on what happens to profit margins. And rising costs and disgruntled consumers should squeeze these.

However, my assessment is downbeat compared to the 17 analysts covering Qantas. They've put an average price target of A$8.10, with a 50% upside and a Strong Buy rating on the stock. In the past, Qantas-covering analysts have been decent forecasters. The shares have done better in the 12 months after they said it was cheap than otherwise.

If you believe Qantas will continue to produce margins above the global industry average of 4.6%, then the shares look cheap. The firm's privileged position in a captive market makes this likely. But if you think margins will drop to or below the average, the stock is fair value or even expensive.

Regardless, Mrs Hudson is flying into the wind. The company has a fleet of dusty old planes that need upgrading, and jet fuel prices are rising. On top of this, consumers have turned against the company. According to Skytrax, an airline reviewer, Qantas is now the 17th best airline in the world, down from 5th last year. And, given its mistakes, the firm is in regulators’ crosshairs.

Mr Joyce has a lot to answer for. There are likely more problems than we're aware of. Either way, his A$22m golden parachute will give him a soft landing, even if the stock doesn't recover. His legacy is more Spirit of Alan than Australia.

It's getting harder to borrow money in America. Two-fifths of banks, as weighted by how big they are, are tightening lending standards.