The Valor Blog.
Investment News and Views, Direct from Our Team.

Betting there will never be another recession…

The recent Australian GDP data release and ensuing commentary highlights the fact that assets in Australia are currently priced as though there will never be another recession. Whilst the predictability of recessions is difficult, the certainty that they occur at some time in the future is absolute.

At Valor, we prefer to price in the worst case scenario and hope for the best. If we think more about what could go wrong, rather than what could go right, we believe we have a greater probability to protect our clients capital over the long term. The secret to creating permanent wealth is to do everything in your power to avoid losing money.

“Those that cannot remember the past are condemned to repeat it.” (George Santayana)

In 1991, unemployment reached 11%. Unemployment is currently under 6%. There is less permanence in the current situation than many would care to believe.

Whilst we are not “permabears” at Valor, we are permacapital protectors. Permabears don’t buy fund management businesses as we did during 2009 to 2012. We are now selling those businesses at many multiples of our purchase price. Permabears are unlikely to outperform their peers during strong markets by the large margin that we have over the last few years. We remain confident on businesses that we own to perform substantially better than the average business over the long term.

We have a very strong belief that Australia will grow over the long term at quite reasonable rates. We are also very bullish on the worlds best businesses throughout good times and bad. Paying very high prices for assets on the assumption that there will never be a recession is something that we think very foolish.

Banks, miners and property are all priced as though there will never be another recession here or in China. We are not predicting that a recession will start on a particular date, however if you analyse the risks to the current economic models of Australia and China, you begin to build a picture of extreme fragility.

China is borrowing at around 4 times the rate of its economic growth. Much of this debt is going into sectors of overcapacity. There is no planet where this is sustainable over the long term. Whilst China may have invented the abacus, they have not reinvented mathematics or economics. When China slows its credit growth to more normalised levels closer to GDP growth, it will slow dramatically. Australia will follow.

There are only a handful of people in the world who truly believe that China’s growth is unsustainable. The great majority of economists and investors (the same bunch who didn’t prepare for the GFC) are fiddling with decimal points in their prediction of China’s economic slowdown. A dramatic move from 7.5% down to 7.3% with great confidence in their forecasts is totally ridiculous. China cannot grow at anywhere near these rates unless credit growth remains at current levels or actually increases. Credit efficiency has deteriorated from around 100% efficiency 7 years ago to closer to 20% efficiency today. For current growth to continue, credit efficiency will likely deteriorate further.

Lets assume that credit growth (total social financing) continues to grow at 25% greater than nominal GDP for the next 10 years. Using the estimated figures of total debt to GDP of over 200%, then total debt to GDP in 10 years time will be around 1100%. At this point in time, China’s total debt will be approaching the size of the entire world economy!!! Whilst these assumption are not likely to be anywhere near accurate, it demonstrates the ridiculous nature of assuming the Chinese model is sustainable. Whether debt to GDP grows from 200% to 500% or 200% to 1100%, no one can predict. What these very rough projections are attempting to illustrate is that neither 500% nor 1100% debt to GDP is ever likely, therefore we strongly believe that Chinese growth anywhere near the current levels is likely over the coming decade.

There is a point in time where China’s credit growth must slow dramatically. When this happens, China buys less of Australia’s minerals and Australia is at significant risk of its first recession in 23 years.

We have no idea when this is likely to happen, but we are absolutely certain that Australia will one day have another recession. Preparing for increased probabilities over the coming years means reducing debt, avoiding overpriced assets dependent on debt based growth (banks and property), avoiding mining companies and holding spare cash to take advantage of more rational prices. Having a meaningful amount of your portfolio exposed to international businesses is also likely to be prudent. The great Australian parachute of the Aussie dollar is likely to once again cushion the blow of a significant slowdown in our biggest trading partner, which must happen in the next few years for their economy not have a disastrous crash.

If we are wrong on China’s slowdown in the next few years, then their debt will reach levels the world has never seen and a fall from these precipitous heights could be a trigger to social unrest or worse, the beginning of a war with its neighbours. These two scenarios are currently very low probabilities, however as China is borrowing around $300 billion USD per month, their potential outcomes are increasing in likelihood at a rapid rate! Let us hope for the sake of many peoples lives that China does not continue to grow anywhere near 7.5% because if they do, the outcome could be worse than the Tiananmen Square massacre of 25 years ago.