May 14, 2019

Coming off last week’s white-knuckle ride in the stock market – thanks to China reneging on the terms of the trade deal – market tension surrounding the “deal or no deal” situation with China has warmed up a few notches. China’s poker face isn’t working. Any idea of taking President Trump to task on the eve of the deadline date, in hopes of the U.S. conceding to China’s “new terms”, was badly misconceived.

While the higher 25% level of tariffs will be applied to $200 billion of Chinese imports and, at a later (so far unset) date, on the approximately $325 billion of all other Chinese imports, the Chinese government expressed “deep regret over the development” and pledged to take “necessary countermeasures.”

I’ve never been convinced that China would disarm its government-backed espionage and its widespread practice of IP theft. In China, there are more military-uniformed hackers working 24/7 to steal U.S. technology than there are in the entire U.S. Marine Corps. And clearly, the lack of innovation in China means that agreeing to stop stealing U.S. technology and agreeing to eliminate the forced transfer of our technology to gain access to their market is to totally compromise their ability to keep up with the U.S.

To this point, it’s my view that there will be no transparent deal, where terms and conditions are verifiable and violations are held to account. If this is the harsh reality of what lies ahead, then there are few choices other than to apply heavy pressure to China’s economic and financial system. China could manipulate the Yuan lower, but that could precipitate a massive flight of capital out of China, as was the case in 2015.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

According to the Institute of International Finance (IIF), China’s debt-to-GDP ratio is over 300%, highest in the world, even though this figure is hard to quantify due to the opacity of the data. It is estimated that about one-quarter of this debt is tied to real estate. The IMF noted in an April 2018 report that “a crisis in China’s housing market would be of considerable global concern.”

I think this is where the real trouble lies for China, if the tariffs remain in place over the long term.]

Expect No Gain on Trade without Real Pain

Chinese investors in domestic real estate have been on a buying spree, with 69% of buyers in 2018 purchasing their second or third home, with over 50% of those purchases being bought for investment purposes. Trade tensions and capital outflows are already having an impact. In Beijing, the vacancy rate for investment properties is approaching 20%. Home price-to-income ratios are way out of whack. In Shenzhen, the home price per square foot (PSF) is around $760 vs. $636 in Silicon Valley, one of America’s priciest markets. The big difference is that the average salary in Silicon Valley is about $84,000, whereas the average salary in Shenzhen is just over $15,000. Housing bubble, anyone?

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

It’s difficult to get one’s arms around China’s real estate market in that not only is 25% of the country’s GDP tied to construction but 80% of the nation’s wealth is invested in domestic property holdings at a time when it is estimated there are 65 million vacancies. From the chart above, real estate sales tanked 44% in early January. That was met with local governments removing some restrictions and relaxing requirements. Normally, this would look like a red flag – and sound like a canary in the coal mine.

However, the latest read on home prices in China show that average prices of homes in 70 cities increased by 10.6% year-on-year through March 2019, up from a 10.4% rate in February. This marked the 47th straight month of Chinese real estate price increases, and the strongest annual gain since April 2017.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

Some analysts argue that the binge real estate buying of the past three months was in anticipation of a U.S./China trade deal being consummated. Buyers leveraged heavily into what was perceived to be a re-acceleration of the Chinese economy. That may still be the case if a deal comes together in due course, but there seems to be some conflicting data at work here. Consider the ratings on their real estate debt.

The average rating for the debt of China’s largest real estate developers has been downgraded to CCC, with Moody’s rating the debt of 51 out of 61 Chinese property companies rated as “junk.” While many investors follow the Shanghai Composite Index as a measure of China’s economy, it might prove more insightful to keep an eye on the China Real Estate Invesco ETF (TAO) as a more accurate barometer.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

President Trump has had plenty of experience with junk debt and bankrupt real estate and has a pretty good understanding of how punishing a leveraged real estate portfolio can terrify overleveraged investors!

If the trade war lowers China’s GDP growth rate from 6.4% to 5% (or below) and their real estate market undergoes a 2008-2009 reset, similar to what occurred in the U.S., then (and maybe only then) will the pain be sufficient to force long-term and constructive change with China at the negotiating table.

About The Author

Bryan Perry

Bryan Perry
SENIOR DIRECTOR

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry

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