The coming Hong Kong property crash

MACRO IDEAS

Hong kong, the former Crown Colony of legendary tai-pans and the Noble House, is prone to boom-bust cycles of epic magnitudes. I remember visiting Hong Kong in the depths of the property bust in 2008, when one-fifth of all homeowners were underwater on their mortgages and, more recently, when there is a vibrant secondary market for garage space in office towers in Central! Hong Kong property prices have doubled since their post-Lehman lows and even the International Monetary Fund has now warned about a property bubble. The spectacular rise in Hong Kong property was due to the Federal Reserve’s epic monetary printing spree since the Hong Kong dollar is pegged to the US dollar, the legacy of a past Deng-Thatcher era crash in the 1980s.

Of course, Hong Kong property also benefits from the limited supply and a surge in “flight capital” from China, Russia and even North Korea. Like Singapore, the Hong Kong government has been unable to dampen rampant, leveraged speculation in the local property market. However, Knight Frank data suggested Hong Kong prime property has risen by at least 25 per cent since 2014 at a time when a credit bubble in China’s shadow banking system is about to burst and the Federal Reserve has begun to decelerate its $3.2 trillion balance sheet expansions since 2008. This means a property market crash in Hong Kong is now inevitable.

China has some of the world’s highest mortgage and home prices per income ratios at a time when its credit pyramid has never been more extreme (210 per cent credit-to-GDP, trillion-dollar shadow banking Ponzi schemes, ghost cities). Historically, credit shocks in China have an immediate spillover impact on Hong Kong, since rising property values spawn credit growth Frankensteins and systemic banking system risks. Property bubbles distort the competitiveness of even a post industrial services economy. Yet property is the most dangerous, illiquid asset class of them all, a lesson the Gulf learned the hard way in 2008 (and many times earlier, but professional amnesia is an occupational necessity for bankers, property developed and home flippers!). It is entirely possible for property prices to plummet by 50 per cent to 70 per cent when a property bubble explodes due to a global macro shock. Sadly, Hong Kong now faces such a macro shock as China’s credit/shadow banking system deflates and the Fed taper triggers a protracted rise in global liquidity. Is the risk of a property crash priced into the Hang Seng Property index? Absolutely not. When Hong Kong’s property chickens come home roast, I can easily envisage the Hong Seng index fall from its current 22,000 to 17,000.

Financial crises triggered by a property crash can poison a nation’s banking system, corporates and homeowners for at least five to seven years. Five years after the Wall Street subprime crisis, the US economy can deliver barely two per cent GDP growth despite the $3 trillion money printing spree of the Bernanke Fed. Japan was devastated for two “lost decades” after its property bubble peaked and crashed in 1990, when the Imperial palace in Tokyo was worth more than all the land in California.

The 1997 currency meltdown in South-east Asia led to property crashes, bank runs, IMF lifelines and even regime changes from Jakarta to Bangkok, Seoul to Hong Kong. In a world of hyper-kinetic, leveraged, cross-border capital flows when panic spreads at the speed of light across the electronic arteries of the global financial markets, a property collapse in Hong Kong will create havoc, systemic risk and contagion across Asia. Nor will a financial and property market havoc be limited to Asia. As an investor, I cannot forget the malign ghosts of 2008 when the angels of darkness spread misery across the world. It can so easily happen again.

Stock pick

The bullish case for General Motors

General motors once defined Detroit and corporate America with its world-famous Chevrolet, Buick, Cadillac, Pontiac, Hummer and Saturn automobile brands. The 2009 bankruptcy filing and subsequent Troubled Asset Relief Programme bailout by the US Treasury has significantly hurt the consumer appeal of GM. However, GM has reinvented its business model and brand after its Chapter 11 filing. The Pontiac, Saturn and Hummer brands are gone as well as several thousand high-wage union jobs and hundreds of unproductive dealerships. GM now derives almost two-thirds of its sales outside North America. The US auto market is hugely attractive with 16.3 million unit sales and an average fleet age of 11 years, the oldest ever. This means a replacement cycle, coupled with higher bank auto loan growth and stronger global demand, will drive EPS growth for GM. In this case, what is good for GM is definitely good for America.

GM has been a disaster in 2014, down 15 per cent from December 2013, with investor sentiment sour after a profit miss and truck recall. However, I believe the risk reward calculus now favours the GM bulls, even if the shares are probably dead money until the company beats its admittedly downgraded earnings guidance. I see no reason why GM cannot earn $4 EPS in 2014 and therefore its shares now trade at 8.7 times current earnings. GM’s real profit momentum will be due to the product cycle/trucks in North America and the corporate restructuring of Opel in Western Europe. Now that the US Treasury has sold its stake, the new GM CEO Mary Barra could well raise the dividend and shareholder purchases.

GM’s Achilles heel is still its unfunded pension obligations and its underperforming subsidiaries in Brazil/Latin America. However, post-restructuring GM has lower payrolls, fewer assembly plants, fewer but more robust plants and a wider global footprint, notably in China. As global truck/light vehicle demand rises in the next two years amid higher interest rates, GM will benefit disproportionately on both its operating margins and pension funding status.

This “fallen angel” Motown corporate icon lost its allure in the 2009 bankruptcy filing and Obama government bailout. So management will need to sweeten the pot for shareholders if its modest valuation metrics (2.6 times enterprise value/earnings before interest, taxes, depreciation and amortisation) has any hope of being rerated higher. A lot can go wrong with GM, from higher gasoline prices to a new debt crisis in Europe to botched product launches and union relations. My buy/sell zone for GM is 34/40 in 2014.

The shadow banking crisis/PMI softness in China and distress in the emerging markets makes me nervous about Europe’s luxury automakers at current valuations. If China’s Politburo is going ultra-nationalist/crackdown on greed, BMW and Mercedes sales in the Middle Kingdom are vulnerable. Moreover, Russia and Turkey are also key export markets for the German luxury automakers though China is almost one third of all unit sales for BMW. German auto makers tend not to hedge emerging markets currency receivables, meaning a hit to profits is inevitable in 2014.

I had recommended Daimler Benz in this column at €36 is 2012. The shares are now €64 as I write. While trucks/Mercedes will power Daimler Benz, Daimler could well deliver €6 EPS this year. Hence Daimler Benz remains a classic “buy on dip” on any pullback in German equities, ideally down to €54 for a 74 target. The stock market cannot rerate BMW shares with its outsized China risk profile. Consequently, Bavarian Motor Works is no longer Wunderbar until the shares fall to the 68-70 range.

Currencies

King dollar will change financial markets

Mario draghi did not respond to market fears about an European Central Bank stress test or eurozone deflation with the slightest hint of a money-market easing, let above a long-term refinancing operation. This is the only reason that the euro trades at 1.37 and Club Med sovereign credit spreads are near epic lows against German bonds. This euro strength, in my opinion, as temporary as it is totally disconnected from the fragile political, financial and banking balance sheet realities of the Old World. This is the only reason the US Dollar Index has declined for six sessions, though Janet Yellen’s “dovish” testimony to Congress, the snapback in Wall Street risk assets and a fall in volatility across asset classes all played a role. The gnomes of Planet Forex have, paradoxically, bid the US dollar down even as the Federal Open Market Committee has reduced its bond purchases by $20 billion since its December conclave. An opportunity? Yes!

Yellen is no monetary maestro/imperial/big enchilada like Dr Greenspan. She will defer to the consensus of the FOMC and the momentum of economic data. She is not going to unilaterally ease monetary policy now that the jobless rate is 6.6 per cent, just above Dr Bernanke’s 6.5 per cent target to revive rate like watch in the twilight of the QE era. At some point in the next six months, mark my words, tapering morphs into tightening. My call? The mother of all opportunities to buy the US dollar.

The Yellen Fed will be forced to abandon its dovish mindset and do a monetary policy U-turn, to upgrade forward guidance. This is what will happen to Yellen/the FOMC this summer. I believe the financial markets totally discount the possibility of a secular, multi-year, uptrend in the US dollar, the sort of macro mileu where gold falls $700 an ounce and emerging markets currencies are toasted (sounds familiar?).

US GDP growth will rise above three per cent, the shale oil boom has meant the US energy trade deficit is at 20-year lows, US Treasury bond yields could easily rise 100 basis points on the 10-year Uncle Sam note, US consumer net worth has exceeded pre-Lehman levels, housing and Wall Street are on a roll. The world’s excess capital will scramble to find a haven in America, exactly as happened in the late 1990s in Bill Clinton’s second term or in Ronald Reagan’s pre-Plaza Accords first term. These were both eras when the greenback was King Superdollar. I believe we are on the precipice of another such era in financial markets. Dr Yellen is now destined to be the Fed chair who will end QE this autumn, a scenario that is not priced into eurodollar or Fed funds futures.

Sure, the payroll/retail sales data was mediocre in December and January but that was largely due to the impact of winter snowstorms. Currency traders, like French generals, fight the last war. The Dollar Index fell 40 per cent between 2001 and 2008, the era gold rose from $400 to $1200 an ounce. Then came the dollar spike during the panic of 2008-09 and an epic fall as the Bernanke Fed expanded its balance sheet by $3 trillion in central banking’s most spectacular money printing spree. So the US Dollar Index tanked again near its pre-Lehman lows in 2011, even though the euro debt crisis was in full swing.

However, the stars are now realigned for a major rally in King Dollar, particularly against the euro, yen and emerging-market currencies. Extrapolate the logic of Bakken and Eagle Ford shale oil and I see a US current account deficit turn into surplus in the next three years. America’s banking system is the best capitalised in the Western world. Like the early 1980s or late 1990s, the new dollar bull market could last at least four to five years. It will impact every major asset class and the psychology of investors worldwide. Even right here in Dubai.

RESEARCHED AND COMPILED BY MATEIN KHALID. MR KHALID IS A GLOBAL EQUITIES STRATEGIST AND FUND MANAGER. HE CAN BE CONTACTED AT: MATEIN@EMIRATES.NET.AE