09 Jun 2012 Ariel Investments - May 31, 2012 Commentary ( Portfolio )
At Ariel Investments, we like to bring in thought leaders regularly to share insights that might help us better understand the investing world. Recently, we were lucky enough to host Dr. Robert Aliber, Professor Emeritus of International Economics and Finance at the University of Chicago. Dr. Aliber’s work often focuses on macroeconomic developments. To that point, he has been especially attuned to financial bubbles. Indeed, if you have heard of Dr. Aliber, it was probably either from his appearance as a doomsayer for Iceland in Michael Lewis’s Boomerang or as the author who recently put forward the sixth edition of Manias, Panics, and Crashes—the first five being the work of Charles Kindleberger.
For the last three years in the late spring, the market has tanked on worries that trouble from abroad would crush the economic recovery—fears we have greeted with skepticism given the fresh, real-life perspectives of our management teams. At Ariel, we believe the European sovereign debt crisis will be mostly contained to the region and unlikely to do real damage outside the European banking industry. Against our contrarian bottom- up backdrop, we asked Dr. Aliber how his macroeconomic top-down view compared. We learned that Dr. Aliber thinks the European predicament is overblown, does not see it endangering the U.S. economy, and thinks a worse crisis is actually brewing in China.
As recent headlines suggest, the world’s economic worries remain centered on Greece. Should Greece have to exit the Eurozone, most dread what calamities might ensue. Dr. Aliber points out he went on record in 2010 in a short paper titled “The Devaluation of the Greek Euro.” His overarching point, then and now: the Greek economy is not competitive given its low tax revenues, high unemployment, and very large deficit. The only ways to address the problem are for Greece to become competitive through hard labor, a path in which it has shown no interest, or to devalue its currency. With the latter as the only viable option, Aliber believes Greece will shift to another currency, devalue it, and perhaps return to the Euro later. Since Greece is such a small player in the global economy, he does not think the event will be a cataclysm—and we agree.
Many pessimists acknowledge Greece’s small size but suggest it could initiate a crisis, causing contagion to spread to the rest of Europe and then America. After all, in 2008 the domino’s size did not matter as long as it tipped the next one—Lehman was not very large. Dr. Aliber sees the situation quite differently. Insolvency and illiquidity are two different problems, although they can appear to be similar when trouble looms. Ireland, for instance, suffered a liquidity crisis but the economy’s structure was sound and the country’s assets were real; contagion did not happen nor was it a large fear. Spain is routinely cited as the next domino, but Aliber notes its economy is vibrant. So long as there is enough liquidity, Spain and thus the rest of the Eurozone should be fine.
While today’s headlines focus on Europe’s problems, Dr. Aliber has greater concerns about China—specifically its housing. Where huge imbalances involve great sums of money, trouble can begin. Recently Aliber notes housing prices in the largest cities in China hovered between $500,000 and $600,000 even though annual incomes tend to range from $25,000 to $30,000. While prices are high, occupancy rates and rents are low; a situation he views as unsustainable. He says the slowing Australian and Brazilian economies and falling steel prices underscore weakness in the Chinese economy. He points to the so-called “luo guan,” or naked official, who has money, real estate and family abroad in preparation for a quick exit from the mother country if necessary.
hile some may believe a financial crisis in China might hit the U.S. hard, Dr. Aliber is not so sure. First and foremost, commodity prices would fall, which should be a good thing for the United States. On the other hand, China’s likely solution to a problem would be to increase exports, thereby skewing our already unbalanced trade further. And yet the very big picture still looks good. The U.S. housing crisis, he notes, is ending, and although unemployment is certainly a problem, it is fixable. He points out earnings have been solid the last few years and is not worried about a fall off. The metric to watch, he says, is corporate earnings to GDP. The long-run average is in the 7-8% range, peaking in the low double-digits in the late 1990s and bottoming in the early 1980s. At 9% or so today, he does not believe it will skid anytime soon.