We Are Sometimes Accused of Being Too Optimistic

Not this time. Let’s get right to what could cause the next crisis. China. Time Magazine pointed out in January that the problems of the Great Recession were never really fixed. Financial crises are most often caused by the rapid build up in debt. We saw this with our housing debt blow off in 2005-2008. Ha Jiming, Goldman Sachs Chief Investment Strategist says, “Every major country with a rapid increase in debt has experienced either a financial crisis or a prolonged slowdown in GDP.”

The suspect at the moment is China. The country has followed a development model since 1979 that mirrors the major Asian successes of Japan, Taiwan and South Korea. Government policy protects local industry, the country promotes exports and uses the banks to mobilize domestic savings for capital intensive investments.

And what a recipe this has been for China. Gross Domestic Product (GDP) has grown by 10% plus for three decades. Never in the history of the world have so many people been pulled out of poverty as in China recently. Now things are slowing down. It is mathematically impossible to keep growing 10% per year as your economy gets bigger. It used to be that it took about $1 of investment to create $1 of GDP in China. But the easy and productive investments have been made, so today it takes anywhere between $4 and $7 of investment to increase GDP by $1.

The Chinese, however, like the rest of us want their cake and to eat it too. They realize they need to reform bloated industries, force bankruptcy on many companies and generally become more efficient. But this will lead to big layoffs. They can’t afford this. So they keep stimulating the economy and hoping the laws of Economics don’t apply to them.

As the charts below show, China’s debt has grown exponentially since 2008. Stanley Druckenmiller, a noted New York investor, spoke at the recent Sohn Investment Conference. Since 2012 the Chinese banking sector has allowed credit to grow every year by an amount equal to the entire Brazilian economy. Eventually, he argues, the piper will have to be paid.

Some think that a Japan-like malaise of stagnation combined with high debt is what is in store for China. Others say it will be a “Lehman Brothers moment” where a major institution collapses, sharply affecting the rest of the economy. Or maybe China will just do things its own way, different from us and Japan, but painful still.

In any case all this is important because China is so big today - the world’s second largest economy and the driver of so much growth. The important question for us now is, what should U.S. investors do? Sell and run for the hills? Well, probably not. We have survived downturns before, even the Great Recession of 2008 – 2009, and we have learned that timing never really works. The better advice is to make sure you have allocated your capital appropriately between things that are safe and things that will grow; keep the quality of your assets solid and then, and this is the hard part, don’t let your emotions get the best of you. Stick to your guns and your long term strategy.