Cementing its place at the forefront of Brazilian Construction: Votorantim Cimentos

Brazil’s leading cement maker, Votorantim Cimentos, scrapped its planned IPO in June 2013. They planned to raise US$4.8 billion by listing on both the Brazil and New York stock exchange (in the form of American Depository Shares). The IPO would have offered units instead of shares, with each unit containing one common share and two preferred shares in order to maintain the founding family’s 93% ownership of common shares.

They have pulled out of the IPO citing difficult market conditions. This is true, at least in the short-term. The Brazilian economy is racked with stagnant growth, accelerating prices, and a slipping currency that makes investment dicier. Brazilian economic growth has slipped from 7.5% in 2010 to 0.9% in 2012, with 3% expected in2013. Meanwhile inflation has been creeping steadily upwards whilst the Brazilian Real/US Dollar exchange rate has been decreasing. A lower BRL/USD rate means the benchmark Selic interest rate unexpectedly shot up 50 basis points to 8%, whilst there is large exchange rate risk with one-third of Brazil’s debt in USD.

In the long-term, the Brazilian economy still has strong fundamentals. The Brazilian government has pledged US$700 billion to upgrade the country’s infrastructure and reduce their housing deficit. Meanwhile the 2014 World Cup and Olympics in 2016 also promises to stimulate the economy. More longer-term, Brazil still possesses abundant natural resources, an expanding middle-class, and low political risk. Moreover unemployment is at record lows of 4.9% and Brazil’s debt has been rated investment grade by Moody’s and Fitch since 2008. Therefore, we shouldn’t be too worried about the macroeconomic environment.

Votorantim Cimentos also has good long-term fundamentals. It is a subsidiary of Votorantim Participações, the country's largest industrial conglomerate, contributing 77% of group revenues in Q1 2013. It is also the leading Brazilian cement maker with 30% market share domestically. Globally, it ranks as the number eight cement producer with operations in South America, North America, China, India and North Africa. Its profit forecast also looks good in the next few years, as it has grown at an average of 18% since 2010 and hit BRL1.64 billion in 2012.

The combination of a strong Brazilian macroeconomic environment and a great company within a non-cyclical area would make for a good investment once they finally get around to listing their shares.

 

The Feldstein-Horioka Paradox

It is one of the great conundrums of economics that major economic growth in developing countries, in Asia, Africa and Latin America, is happening now. For much of the post-World War Two period, there was much surprise that poorer countries were not growing faster than developed countries. Then suddenly, in the past 15 years growth rates for developing markets have increased dramatically.

Economic theory suggests that if capital is perfectly mobile investors would invest in countries with the most productive return on capital, which would consequently increase prices until the returns on capital were similar across different countries. In other words, capital flows should act to equalize marginal product of capital across different countries. According to this theory, for example, a saver in Germany will have no incentive to invest in his national economy, but would rather invest in a (most likely) developing economy where there is a higher productivity return on his capital. If this were true, then there should be no relationship between savings and investment within a single country and increased saving rates need not result in corresponding increased investment. Therefore, as developing countries are further away from the global technology frontier, investing in these countries would provide the most productive return on capital. These developing countries can take advantage of existing know-how, embodied in investment capital, and therefore grow quicker than developed countries (who can only grow by innovating – a more time-costly endeavour). However data has shown the opposite.

What a Paradox!

The Feldstein-Horioka Paradox revealed a positive correlation between national savings and national investments. This correlation is a paradox because, if capital truly is perfectly mobile, there should be low correlation between national savings and national investment as investors in one country do not need the funds from national savings and can borrow from international markets at international rates. Equally, savers can lend their entire national savings to foreign investors. In the absence of regulation in international financial markets, national savings would flow to the countries with the highest return per unit of investment. Therefore, national savings and national investments should be uncorrelated.

Adam Smith

The Feldstein-Horioka Paradox goes some way to explaining the conundrum of why major economic growth in developing countries, in Asia, Africa and Latin America, is happening now. The 2000s were the first time in which global GDP growth significantly surpassed the EU and USA. This growth was driven increasingly be emerging economies, a trend that is becoming ever more apparent. And what has helped the emerging economies? Massive amounts of investment capital and the know-how embodied with that capital has facilitated the generation of savings needed for the developing countries to industrialise and catch-up to the developed economies. Further along in the process, countries (particularly China and other Asian nations) have generated large savings which has helped to sustain strong investment.

So then what is the rationale behind the Feldstein-Horioka Paradox? Well Adam Smith postulated that the pursuit of security leads investors to invest at home, and that the pursuit of security (not profit) leads them to promote the good of their national society.

Fitting the Hand – Hartalega Holdings Bhd

Middle-East Respiratory Syndrome Coronavirus

Gloves are hot. With healthcare spending at record levels and projected to increase in the future in line with the world’s aging population above 80 growing at 3% per year, greater awareness and regulation about occupational safety, and the phenomenon of heightened disease paranoia due to virus outbreaks such as H1N1 bird flu and SARS, gloves are definitely an “in” sector. The global glove export market is worth around US$4.1 billion per year, with around 70 billion pairs of gloves exported. Malaysia dominates the world gloves market, exporting 61% of the world’s needs. Thailand follows with 17%, China with 6.8%, and Indonesia with 5%. The global glove market is set to grow at a healthy rate of 8% to 10% per annum, fuelled by demand growth in the two largest import markets, the USA and Europe, despite the financial crisis. Demand is also rising as countries like China, India, Vietnam and Brazil have greater health and hygiene concerns as a substantial middle-class emerges. Demand for lower-end powdered latex gloves is more popular among developing countries with end-users more cost-conscious, whilst powder-free latex and nitrile (synthetic rubber) gloves are preferred in developed countries. 

Nitrile Gloves

As the largest glove manufacturer in Malaysia, Hartalega Holdings Bhd knows what it takes to fit a glove to the hand. The volatile natural gas and latex (the major input for gloves) prices have hit smaller manufacturers harder as they now face higher operational costs. However large glove manufacturers, such as Hartalega Holdings Bhd, have been helped by the prices as they can take advantage of higher selling prices whilst benefiting from their cost economies of scale. Furthermore, Malaysia’s comparative advantage in glove manufacturing is its productive labour with each worker in the sector estimated to be three times more productive than Thai labour and two times more productive than Indonesian labour. Hartalega’s vision is to be the number one glove manufacturer in the world, whilst producing the best and most innovative gloves and being recognized as caring for the community and environment. This vision is behind their targeting replacing natural latex rubber gloves with nitrile gloves, which are safer for end-users. There is huge potential for Hartalega Holdings in Europe as nitrile gloves consumption was only 23% in 2012, with the remaining 77% utilizing natural latex rubber gloves. They already have a headstart on their global competition as they are the world’s largest synthetic nitrile glove producer. In fact, of the 13 billion gloves produced each year, 90% are made up of nitrile gloves. Hartalega Holdings have also invested MYR1.9 billion to develop its next-generation glove manufacturing complex, which will boost its production capacity by more than 300% from 13 billion gloves per year to 42 billion pieces. 42 production lines with 16.5 billion pieces capacity will be finished by 2017 with an additional 30 production lines (12 billion pieces) finished by 2021. The project will also enhance productivity and efficiencies and reduce costs through greater automation and technological innovation.

Hartalega Holdings currently trades on the Kuala Lumpur stock exchange at MYR6.850 per share with a one year return of 58%. Last year they boasted revenues of US$333 million and currently have a market capitalization of US$1.52 billion. They have come a long way since their founding in 1988. In the past five years, its share price has climbed from MYR0.60 in January 2009. Its profits have also grown in tandem, with profit for 2009 amounting to MYR95.5 million and MYR258.4 million for 2012. They now possess 53 production lines and capacity to produce 12 billion gloves annually (out of Malaysia’s 70 billion gloves exported). They were the first in the glove industry globally to:

·         Develop polymer coated powder-free examination gloves in 1994;

·         Use industrial barcoding for product traceability and stock management with RFID Tags;

·         Commercially produce high-stress-relaxation NBR examination and surgical gloves in 2002 and 2006 respectively;

·         Use oil palm empty fruit bunches as biomass fuel to generate heat for production processes;

·         Successfully registered their biomass energy plants to the United Nations Framework Convention on Climate Change or Kyoto Protocol.

Advanced Glove Manufacturing Technology

The company offers the following gloves: examination, surgical, laboratory, clean room packed class 100, atomic power plant, emergency medical service, food grade, and automotive. Their manufacturing process also utilizes world-class production technology. They have patented double former mounting design, their newest high speed production lines capable of producing 40,000 pieces of gloves per hour per line, the highest in the industry. Even at high speeds, the quality of gloves is not compromised by monitoring through the Supervisory Control and Data Acquisition (SCADA) system. The company has also challenged the norm of glove manufacturing as a labour intensive process by utilizing automation to reduce reliance on manual workforce. In 1995, they developed an automatic globe removal system, designed to remove gloves from hand moulds at a speed of 30,000 pieces of gloves per hour. Hartalega’s business is export-driven with Europe and the USA accounting for 28% and 55% of overall sales revenues respectively. With greater revenues, Hartalega Holdings have announced a policy to pay a minimum 45% of its annual net profit as dividends starting from 2012, which is a great sweetener for this investment. Not that it needs one when its profit has increased in Q1 2013 (MYR63 million) by 31% from Q1 2012 (MYR53.4 million), driven by a switch to focusing on producing nitrile gloves.

Malaysian Rubber Plantation

Hartalega Holdings will be the global glove industry’s outstanding performer over the next ten years, particularly once its next-generation glove manufacturing complex begins production in August 2014, with its promised yield of 6% extra profit margin due to better efficiency. This would enable the company to grow its market share as well as have the capacity to edge out lower-margin competitors with lower selling prices. In addition, Hartalega’s 12-month enterprise value/EBITDA as well as P/CF ratios currently beat sector averages by 2% and 9% respectively. Watch out! Here is a company intent on gloval domination.

Human Optimism Ensnares Technology Stocks

Humans are inherently optimistic. It is this precise optimism that is a major driver in the creation of market bubbles. Optimism gets carried away to epic proportions. Furthermore, it is in technology, the gateway to human progress, where human optimism is at its most dangerous. Two previous bubbles are a warning as to the perils of investing in technology stocks.

The British Railway bubble developed in the United Kingdom in the 1840s as a result of great enthusiasm for the disruptive innovation which was railroads and a zealous view on the innovation’s profitability. With the British industrial revolution in full gear, railroads were developed as a means of efficiently transporting large quantities of goods across the country. The first steam locomotive was invented in 1804 and by 1810 there was nearly 300 miles of railroad track in the United Kingdom. An economic slowdown in the late 1830s and early 1840s, high interest rates and anti-railroad protests temporarily slowed the development of railroads as industrialists and investors gravitated toward investing in high-yielding government bonds instead of speculative railroad projects.

Soon after, the Bank of England cut interest rates to stimulate the economy and, by the mid-1840s, the UK’s economy was booming again, driven by manufacturing industries. Railroads captured investors’ imaginations due to the rising share prices of railroad companies and the increasing demand for transporting cargo and passengers by train. Additionally, Britain’s investor class swelled as the industrial revolution propelled an increase in the middle-classes. New business ventures, such as railroads, could now raise capital from this new investor class instead of solely relying upon capital from banks, aristocrats and industrialists. Amidst this investment climate, railroad companies aggressively promoted their shares as virtually risk-free as well as offering promotional deals on their shares which allowed investors to purchase shares with only a 10% deposit while the company held the right to call in the remaining 90% at any time. Investors were seized with excitement over railroad companies’ enormous potential.

In tandem, the British government had a laissez-faire attitude towards regulating railroad development, stipulating no limits on the number of railroad companies and allowing practically anyone to form a railroad company and submit a Bill to Parliament for approval of new railroad lines. In fact, there was heavy conflict of interest with many Members of Parliament heavily invested in railroad companies. Shares in railroad companies continued soaring and investors continued to feed this technology bubble. Many of the nouveau-investor middle-class invested all their savings in them. With ludicrously large amounts of capital available to railroad companies, increasingly audacious and impractical railroad development plans were initiated.

1845 and 1846 were the peak of Railway Mania with myriad proposed railway lines being almost impossible to build and nearly every town wanting its own railroad. Just in 1846 2727 Acts of Parliament were passed incorporating new railroad companies, who all proposed a total of 9,500 miles of new track. Moreover an index of railroad company shares doubled from 1844 to 1846. Yet in 1846 this same index peaked and began dropping rapidly. The cause was the Bank of England’s tightening of monetary policy by raising interest rates in late 1845, which tends to burst market bubbles as capital is no longer as cheap as before and investors shift to the relatively more attractive bonds with higher yields. Furthermore, investors began realizing that most railroads were not profitable or even financially viable. From 1846 to 1850, railroad company shares plunged 50%, a plunge exacerbated by railroad companies exercising their option to call in the remaining 90% of the money they had lent to investors in their promotional scheme.

The bursting of the railway bubble sunk many railroad companies and brought to light revelations of fraud (think of Bernard Madoff, interest rate-fixing scandal, Rajat Gupta, after the 2008 financial crisis). In fact, 33% of railroads authorized by parliament were never even built. Thus railway mania demonstrates how human optimism is caught up in technological advances, yet one positive of the bubble was the development of the UK’s railroad system to become one of the most advanced in the world. From 1844 to 1846, 6,220 miles were built, an important contribution to the UK’s current total of 11,000 miles. Therefore, the railway bubble is comparable to the telecommunications bubble of the late 1990s, as they both left behind valuable infrastructure even after bursting.

A comparable bubble is the Dot-com bubble of the 1990s following the advent of the internet. This bubble saw shares of internet-related companies soar in developed markets as investors engaged in “prefix investing” – investing merely because there was an “e-“ or “.com” in the company name. The archetypical dot-com company’s business model depends on leveraging network effects whilst operating at a sustained net loss (by offering free service or product) in order to build market share. As soon as their brand awareness multiplied they would charge profitable rates for their services. Google and Amazon did not see profit for their first years as they were focusing on expanding brand awareness and their customer base. The globally low interest rates of the time period also helped to increase the mean start-up capital raised. In fact, during the dot-com bubble, many internet-related companies making an IPO raised substantial amounts of money without ever having made a profit, or even any revenue. C-suite executives and employees became instant millionaires when their companies conducted IPOs and companies invested heavily to take advantage of the fervour surrounding this new technology. For example, Nortel Networks over-invested in producing internet network equipment, resulting in their downfall through declaring bankruptcy in 2009. Yet by 2000, the USA’s 370 publicly-traded internet companies had grown to be collectively valued at US$1.3 trillion or 8% of the USA’s entire stock market.

            Many of these companies were listed on the technology-oriented NASDAQ stock exchange. Its composite index peaked at 5,048 by March 2000, double its value a year before. Again, as interest rates rose rapidly (e.g. US Federal Reserve raised them 6 times from 1999-2000), the economy began to flag. This had a knock-on effect for the NASDAQ composite index, a barometer for the health of technology companies. 2001 saw the dot-com bubble deflate rapidly, with many dot-com companies burning through their venture capital without ever having made a profit. The plunge in share values of dot-com companies was exacerbated by the string of frauds (sound familiar) and inadequate financial planning:

·         The January 2000 merger of America Online (pioneer of dial-up internet) with Time Warner (world’s largest media company) turned out to be a failure three years later as they were not able to successfully integrate.

·         WorldCom was found engaging in illegal accounting practices to exaggerate its profits on an annual basis and they eventually filed for the third-largest corporate bankruptcy in American history.

·         Mattel bought The Learning Company for US$3.5 billion in 1999 only to sell it for US$27.3 million in 2000.

·         Similarly, Yahoo purchased GeoCities for US$3.57 billion in 1999 but they closed it in 2009.

·         Boo.com spent US$188 million in 6 months attempting to create a global online fashion store only to go bankrupt in May 2000.

·         Over in Europe, Swiss Think Tools AG had a valuation of CHF2.5 billion in March 2000 despite having no prospects of a substantial product, and subsequently collapsed.

·         Also, InfoSpace’s share price had reached US$1,305 per share by March 2000, which tumbled to US$22 per share by April 2001.

·         Lycos, purchased by Spanish telecoms giant Telefonica for US$12.5 billion in 2000, was sold in 2004 to South Korean Daum Communications Corporation for US$95 million, less than 2% of its initial purchase price.

·         Meanwhile the US Securities and Exchange Commission (merely) fined investment banks, Citigroup and Merrill Lynch, for misleading investors.

The bursting of the dot-com bubble between 2000 and 2002 engendered the loss of US$5 trillion in market value, a bursting exacerbated by the 9/11 terrorist attack on New York’s World Trade Center.

            A few large dot-com companies, such as Amazon, eBay and Google, survived the bursting of the bubble and grew themselves into world-class operators. Despite this, their share prices suffered with Amazon stock going from US$107 to US$7 per share. However in 2010, Amazon’s share price has exceeded US$200 per share. The dot-com bubble was propelled by market over-confidence that companies would turn future profits, widespread speculation in the “new technology” internet companies, and the promotion by venture capitalists to investors that they could overlook traditional metrics (such as P/E ratios).

Tech Bubble 2.0?

Are we now in another technology bubble engendered by human optimism? Some postulate we are in the throes of Tech Bubble 2.0 focused on social networks. Facebook and Goldman Sachs have the same market capitalization of US$75 billion, with Facebook trading at a revenue multiple of 37.5x. Meanwhile Groupon and BestBuy share the same valuation at US$13 billion, with Groupon trading at 26x revenue. Zynga and Whole Foods are both valued at US$10 billion, with Zynga trading at 40x revenue and LinkedIn and jewellery stalwart Tiffany & Co share a US$9.5 billion market capitalization. Skype is valued at US$85 billion, the same as Southwest Airlines with  its 570 aircraft operating 3,400 flights daily. However unlike its dot-com era counterparts, these technology companies do have revenue, just not as much as similarly valued companies. Groupon makes US$16 per user, Skype US$5.10 per user, Facebook US$4, Zynga US$3.40, and LinkedIn US$2.40. Additionally, tech companies today have a relatively large number of potential customers – 2.2 billion internet users (equal to the number of people without toilets globally). This compares favourably to the number of internet users during the dot-com boom – 300 million (roughly equivalent to the number of iPhone users currently). Therefore, the jury is still out on whether we are in another Tech Bubble focused on social networks.

The Education Bubble?

There could be other bubbles out there. China is one – the Chinese stock market has soared despite a weak global economy with Chinese stocks trading at 13 times earnings and just in one month this year, Chinese investors opened 485,000 stock brokerage accounts. Another potential contestant is an emerging market bubble with investors pouring in US$11 billion into emerging market mutual funds – 34 times the total amount invested in US funds – whilst the MSCI Barra index of emerging stock markets has outperformed the Dow Jones Industrials by 20% since 2007. In addition, the education bubble may be bursting as people realize getting a degree may not always be worth the escalating cost – in the USA the amount borrowed by students to go to university grew by 25% to US$75 billion whilst in the UK there has been a drop in the number of students applying to university. Furthermore, future bubbles may manifest themselves in the form of a clean energy or energy efficiency bubble or on a financial note, a life insurance securitisation bubble as investment banks plan to securitise life insurance policies that the retired can sell for cash while they are still alive (sounds like subprime mortgages all over again).

A Bubble in Asian Tiger Economies?

Bubbles can represent a danger, yet there is also something distinctly redolent of the human condition in them. Everything important has been built on the ivory towers of irrational exuberance. Without this manic optimism, investors wouldn’t open their chequebooks and finance these technological innovations. Therefore, bubbles can be perilous, yet they are a specific human condition without which human progress would be incremental.

A Global Property Bubble?

Property will be the most important investment decision many people will make in their lives, yet they may be buying into a property bubble right now that could leave them with negative equity for years to come. Alternatively, holding off from buying could enable speculators to make far more once the global property market deflates. After all market bubbles always burst and then those market prices revert to their starting positions or travel lower.

Firstly, how can we determine the price at which a house ought to be valued at? From a fundamental perspective, we can look at four measures: price to rent ratio (yield), relative prices comparison, affordability, and price to replacement cost.

·         The price to rent ratio is the housing parallel to the stock market’s price/earnings ratio. The ratio indicates the years of rent which would be required to buy such a house. A ratio of around 5 to 10 (20% to 8% gross rental yield) denotes that the housing market is undervalued, 10 to 20 (8% to 5% gross rental yield) denotes a housing market that is relatively fairly priced, and 20 to 50 (5% to 2% gross rental yield) signals an overvalued market. Furthermore when strong future growth in value is expected (such as houses in an area where infrastructure is being upgraded) then relatively weak present earnings can be acceptable. In any case, low price to rent ratios/high rental yield levels push house prices higher. This is because with high rental yield levels, the interest cost of buying a house is low compared to the cost of renting a house. Potential buyers have to pay less interest to get a mortgage from the bank than they pay when renting a house and so many potential buyers will transfer from being renters to buyers. Entrepreneurs will also find it worthwhile to buy houses to rent in order to generate money. Conversely high price to rent ratios/low rental yield levels put downward pressure on the housing market. This is because low rental yield levels mean that the interest cost of buying a house is high compared to the cost of renting a house. Potential buyers will have to pay much more to the bank in terms of interest in order to buy a house than it costs to rent a house. Banks will also be worried about over-lending at loan-to-income ratios, meaning that a slight increase in interest rates will result in a financial crisis for potential buyers borrowing money. Entrepreneurs will also find that buying to let is not the next best alternative use for their cash. Housing markets tend to revolve around a price to rent ratio range, which moves in a circle. From an international perspective ranges will likely be quite similar in different countries as real interest rates are broadly similar. Yet, countries with higher nominal interest rates and countries with weak mortgage markets will have relatively low price to rent ratios (think Eastern Europe whose housing markets are in the process of developing with a concurrent increase in their house prices). As every housing market has a range, when one can imagine a market escaping totally from its range of price to rent ratios this is the sign of bubble mentality.

·         Relative prices comparison is useful as buyers actively seek cheaper and better alternatives, particularly when houses are highly priced. Therefore comparing internationally, Brussels’ property seems undervalued with prices similar to Eastern Europe despite being located in a high-income country. On the other hand, the average urban dweller in Moscow will have a lower real wage than Parisians or Romans and so Moscow’s apartment prices at around US$4,250 per square foot, seem overvalued. Anomalies can last a long time, yet once an economic or currency crisis hits house prices will fall in line with reality.

·         Affordability concerns the ability of the majority of people living in an area to afford property when house prices are so high. To examine affordability we can look at a country’s GDP per capita as a multiple of house prices per square meter. Where a country’s ratio of house prices to GDP per capita is high, houses will likely be overvalued, and vice versa. The GDP per capita as a multiple of house prices per square meter measure is best used to compare countries at the same GDP levels because housing in poor countries tends to be relatively expensive when juxtaposed with the local living standard as most of the people are poor.

·         Price-to-replacement cost is useful to examine because if house prices are much higher than the cost of building then developers are motivated by increased profit to construct more buildings. Yet this profit motivation will ensure increased supply of houses on the market which will put downward pressure on prices. However there is one caveat to this downward pressure on prices – in the case where regulations restrict construction of new buildings (such as Europe). In Europe is inundated with all kinds of building regulations and permits that limit the quantity of new housing supply and means that house prices tend to be above new build costs merely because it is the system.  

·         Housing debt to income ratio (or debt-service ratio) is the ratio of mortgage payments to disposable income. When the ratio gets too high, households become increasingly dependent on rising house fair values to service their debt.

To see what causes a bubble let’s look at the most famous financial bubble in history – the tulip bulb bubble of 1636-1637. These flowers, introduced into the Netherlands from the Ottoman Empire around the 1550s, quickly built up much admiration from the Dutch who initiated a sophisticated derivatives market to trade the tulip bulbs (which would blossom 7 to 12 years later). With their growing popularity, tulip bulb prices rose in unison and the number of speculators in the market increased. From 1634 to 1637, an index of Dutch tulip prices soared from approximately one guilder per bulb to a haughty sixty guilders per bulb. Some merchants sold all their belongings in order to buy a few tulip bulbs to speculate for more profit than they would ever make as a merchant. The tulip bulb bubble increased further and the already expensive tulip bulbs were propelled to a multiple of twenty in a single month in 1636. By February 1637, a single tulip bulb was worth ten times the average Dutchman’s annual income. Successful Dutch tulip bulb traders could earn up to 60,000 florins in a month– approximately US$62,000 in today’s terms. The catalyst for the bursting of the tulip bulb bubble was a default on a tulip bulb contract by a buyer in Haarlem in the winter of 1637, which caused sellers to overwhelm the market whilst buyers disappeared. In just a few days, tulip bulbs were worth a hundredth of their former prices, resulting in panic throughout the Netherlands as dealers refused to honour contracts. The government was eventually forced to step in and offer to honour contracts at 10% of their face value, which far from inspiring confidence sent the market plummeting further. The bursting of the tulip bulb bubble ended the Netherlands’ Golden Age and plunged the country into an economic depression lasting several years.

So is there a contemporary global property bubble? Core properties in major cities around the world have increased in price even though economic fundamentals are weak. One reason is because investors are seeking a safe haven asset class with a good yield but ostensibly low risk. Property prices have therefore been bid up whilst yields have decreased markedly. The most expensive property in the world is currently found in:

·         Hong Kong – US$11,000 per square foot;

·         Tokyo – US$7,600;

·         London – US$5,300;

·         Paris – US$4,400;

·         Moscow – US$4,250;

·         New York City – US$4,100;

·         Geneva – US$3,000;

·         Shanghai – US$2,125;

·         Singapore – US$1,820;

·         Beijing – US$1,600;

·         Mumbai – US$970;

·         Sydney – US$880;

·         Kuala Lumpur – US$500;

·         Dubai – US$425;

·         Istanbul US$122.

Shanghai housing market is sitting on the greatest bubble globally as its market has soared by 525% since 2000. Mumbai (400%), Dubai (300%), and Seoul (205%) are other cities that have experienced major increases since 2000. Meanwhile in developed markets, Brisbane has increased by 210%, Miami by 180%, Los Angeles by 170%, London by 170% and Vancouver by 165%. Many investors continue to pile money into these major metropolises and these cities seem to regard their housing markets as impervious to bursting. However, as the Dutch tulip bubble demonstrates, bubbles always burst. In fact (generally), the greater the bubble, the greater the burst. California’s major cities such as San Francisco, Los Angeles, and San Diego saw their housing bubble burst in 2006 with prices ten times real wages. Other major American cities such as Las Vegas, Phoenix and Atlanta have already had their bubbles burst in 2006 after house prices had increased 130% since 2000 before falling 34%. No other major bubbles have burst back to where home prices are affordable again. House prices should always be a multiple of around five times real wages.

By contrast, Shanghai, for example, looks to be in danger of a major bubble bursting with prices at thirty times real wages currently. What is driving the bubble higher are a range of factors from a fast-growing middle-class, rapid urbanization, the hunt for more yield from investment assets, desire for global investment diversification, and the rise of international megacities. However investors should be warned that it is the most attractive global cities with the scarcest land that are typically the last to reach the peak of their housing bubbles and the ones that will experience the most volatile bursts. In particular, real estate bubbles take longer to deflate (as compared to stock market bubbles) due to prices declining slower as real estate is less liquid.

I would postulate that we are in a global property bubble which is mostly affecting megacities. In the developing world’s megacities, their property markets are being supported by the glut of money floating around. Prices have risen so high (80% since 2008) in Asia’s financial capital, Hong Kong, that the Hong Kong government has instituted a tax duty in order to cool housing price growth. Meanwhile in the developed world megacities, it is the international brand recognition and perceived safe haven status that buoys the housing markets. London’s housing prices have increased 40% since 2008 and central London’s prices are so divorced from reality that the average Londoner would need to triple their salary to £87,000 in order to fund a mortgage for an average priced property. As such, the London housing market is vulnerable to bursting of emerging market bubbles as well as the lack of rising real wages for City of London workers. This is a phenomenon seen all over Europe with high valuations revealing places like Amsterdam have average property overvalued by 45% according to price-to-income and price-to-rent ratios. The boon of the developed world has been the mortgage-borrowing binge which sent property prices soaring, and simultaneously elevated household debts to unsustainable levels (240% of disposal income for the Netherlands). Yet interestingly the UK government seem intent on supporting a housing bubble with their “Help to Buy” scheme, in the form of £12 billion in mortgage guarantees to aid first-time buyers. The only exception is Germany, which avoided the housing boom before the financial crisis and therefore its property is evaluated to be undervalued according to property valuation ratios.

Housing markets are notorious for fulfilling the boom-bust cycle. And there is an ominous feeling that we will begin to see a massive bursting of the global property bubble. In future, the global financial crisis will be remembered hand-in-hand with the ensuing global property bubble that it engendered. The USA, despite being the progenitors of the global financial crisis, will emerge pretty much unscathed from this global property bubble. Despite London and New York boasting comparable international city status, London property has outperformed New York’s with prices 5% over their prior peak in 2007 whilst New York prices are 25% below their 2007 peak. This is clearly not sustainable. The world, bar the USA and Japan, will feel the pain of the global property bubble. China will be particularly hard-hit. Their massive US$586 billion stimulus program to help boost their economy during the global economic downturn successfully staved off the effects of the downturn yet has fuelled their housing bubble, a manifestation of the inflation engendered by stimulus cash, China’s fast economic growth and its burgeoning credit bubble. This high inflation coupled with negative real interest rates and limits on investing in other asset classes incentivized Chinese to purchase real estate as a hedge. Housing prices have increased 800% in Beijing since 2003 and 140% nationally. Meanwhile in Canada and Australia, a commodities export boom drove a sustained rise in the property market as well as mortgage debt with economists hypothesizing that these prices are high to stay. Yet with slowing growth from China it won’t be long before Vancouver’s new-found reputation, of pricier homes than New York City with median prices 10 times median household income, comes crashing down. Furthermore, megacities in emerging countries are experiencing lightning-fast middle-class growth, yet the average household cannot afford to buy a house in a major city within their country.

All this points to a major bust as global housing markets fulfil their natural cycle. The cycle is evident in Japan’s 1991 experience of a housing bubble after prices increased 160% from 1985 and then fell 65%. House prices are still at this level now due to a much smaller generation following a large baby boomer generation. I would guess that developed property markets would follow a similar pattern after the ensuing global property crash. The problem is exacerbated by the experience in the USA after their housing bubbles bursted in 2006-2007 when banks found that many owners held mortgages exceeding the fair value of their homes and therefore shunned holding large amounts of property-backed debt. As the world’s major economy, this is holding back a worldwide recovery and will affect a recovery further in the event that the world experiences a housing bubble.

Shining a Light on Shadow Transport

What exactly is “shadow transport”? Well lets start with the pejorative term of “shadow banking” which conjures up images of special purpose vehicles (SPVs), money market funds without deposit insurance, and collateral debt obligations (CDOs). In short, shadow banking institutions accept relatively illiquid long-term assets in return for issuing shorter-term assets. It is similar to regular banks which take in relatively safe deposits and invest in riskier and less liquid loans. Yet, much of the pejorative finance occurs offshore in order to remove assets from banks’ balance sheets and is therefore not fully regulated.

By contrast, shadow transport happens in full view of governments, and even sometimes with the tacit consent of governments. They are a means to relieve the pressure from bustling cities. How do they relieve this pressure? By adding liquidity to a city’s transport system. Shadow transport encompasses the motorcycle taxis, tuk-tuks, vans shuttling people along motorways and other major traffic arteries, and the pick-up trucks posing as cheap taxis that are mobilized to move people from the government transport hubs (train and bus stations) to diffuse areas off the main road. Interestingly, the demand for shadow transport arose because there was not a costly transportation method to get from a certain place to another in a sprawling city. In other words, it is an unintended effect of a government’s official transport policy that drives the establishment of institutionalised systems of shadow transport which become implicitly sanctioned by governments.

It is mostly a developing city’s phenomenon, yet it is also not a bad idea for developed cities. Even developed cities’ citizens could do with less costly transportation and the opportunity to save time (perhaps the most valuable commodity). Imagine being able to hop off the tube station at Oxford Circus and hop on one of the many motorcycle taxis next to Topshop that could shuttle you to the Chinese Embassy or to Selfridges....

RMB Bloc Ascending

These are interesting times. We are seeing the ascendance of a Chinese RMB Bloc, displacing the once-omnipotent US Dollar. This change has been engendered by China’s increased trade with the East Asian region since its trade liberalization since the 1980s. In particular, China’s share of East Asia’s manufacturing trade has grown from 2% in 1990 to 22% currently. As China liberalizes its financial and currency markets, which it is rapidly doing, the RMB’s appeal will grow exponentially. A reference currency is one which exhibits significant co-movement with other currencies. By this definition the RMB is a reference currency for many other currencies already, yet may also one day supplant the USD as the world’s reserve currency.

A country’s rise to economic hegemony is typically accompanied by its currency becoming a major reference currency. Enter China. Currently, average co-movement of East Asian currencies is 40% higher for the RMB than the USD. In recent East Asian currency history from June 2005 to June 2008, 6 currencies followed the USD more closely than the RMB and EUR whilst 3 currencies followed the RMB more closely and one currency followed the EUR more closely. Fast-forward to June 2010 and the EUR does not have any followers anymore, whilst the RMB has gained an additional four currencies whilst the USD has lost three currencies. June 2010 also coincided with the resumption of RMB floating, which prompted the increase in the number of currencies tracking it as a reference point.

7 out of 10 countries in East Asia are constituents of the RMB bloc because their currencies track the RMB more closely than the USD. This means that they are inclined to follow the RMB’s appreciations and depreciations. So when the RMB moves by 1%, these East Asian currencies move in the same direction by 0.55%, whereas when the USD moves 1% these currencies move in the same direction by 0.35% on average. These countries are South Korea, Thailand, Singapore, Malaysia, Indonesia, and Taiwan. As an example, the Thai Baht and the RMB have appreciated by similar amounts against the USD since 2009. Why do these countries find it more advantageous to ensure their currencies track the RMB more closely than the USD? Because countries that are closely intertwined with the Chinese market in terms of exports or imports and particularly those with supply chains centered on China find it beneficial to maintain a stable exchange rate against the RMB. However, three economies still follow the USD more closely. These are Hong Kong, Vietnam and Mongolia. Yet Hong Kong is now the largest offshore depositor of the RMB and more RMB is flowing through Hong Kong than HKD. Additionally, the advent of the ASEAN free trade community from 2015 will bring more integrated trade with China, whilst Mongolia’s trade with China will soar once their massive gold, coal and copper mines are fully operational in a few years.

 

Even outside East Asia, many currencies are following the RMB closely due to China’s trade dominance. These currencies include the Indian Rupee, Chilean Peso, South African Rand, Turkish Lura, and Israeli Shekel. The global financial crisis has exacerbated European and American economic difficulties and allowed the RMB to eclipse them in some parts of the world as a reference currency. In some ways, the renminbi has displaced the euro as the second most dominant global reference currency in the sense that there are more currencies outside East Asia that track the renminbi most closely compared with currencies outside Europe and the Middle East that track the euro. The movement to make China the world’s most popular reference currency is being spurred by China’s status as the world’s largest exporter, the world’s largest net creditor, and the world’s largest economy in purchasing power parity terms (by some measures). Given suitable financial sector liberalization measures instigated by the Chinese government, a global RMB bloc and its ascension to reserve currency status could be fact by 2025.