Kris:

Hi, I'm Kris Sayce. I'm the editor of Money Morning and Australian Small Cap Investigator. I'm here with my old mate, Greg Canavan. Greg is the editor of Sound Money. Sound Investments. Greg is a 'value investor', and I'll get Greg to explain exactly what 'value investing' means in a moment. Greg also writes for the Daily Reckoning, a free e-letter, twice a week usually on a Thursday and Friday. So, you can read everything that Greg has to say there. So, welcome, Greg. Thanks for coming along.

Greg:

G'day Kris. No worries.

Kris:

Before we get into today's interview, I just thought I'd ask you to explain to the viewers exactly what 'value investing' is.

Greg:

Sure. Value investing is really what I consider to be sensible investing. It's a way of looking at companies as just that, being companies that have operations and assets, rather than looking at them as pieces of paper listed on the stock exchange.

Kris:

Right.

Greg:

When you visualize companies in that way, you'll understand that companies have a value and that value is sometimes different to the price that the stock market will apply to that company. So, really my job as a value investor is to work out which companies have a valuation greater than what their current price is. Which is easier said than done, especially in these sorts of markets where you've got central bank intervention constantly, markets moving around based on speculative activities, based on the hope of more monetary or fiscal intervention. So, stocks can often react to that sort of intervention in ways that you can't predict.

As a value investor you have to be very patient, you have to do your homework, do your analysis, understand what a value is, as opposed to a price, and sometimes wait a long time for those, for value and price to merge together.

So, in this day and age I think value investing is probably not as popular as what it was once was. I think short-term investing, momentum investing, speculation, people think they're investing but they are actually speculating. So, what I try to do is encourage people to view companies as just that, a company, and not pieces of paper on the stock exchange, and most of all be patient.

Kris:

Okay. Cool. Now in your recent China Bust special report, you talk about two high speed trains crashing in western China earlier this year. You say that this is a metaphor for the dangers China, or the Chinese economy is facing. Can you explain exactly what you mean by that?

Greg:

Yeah, sure. In terms of the metaphor, the trains are the Chinese economy going to break neck speed. This really kicked off in 2008-2009. Obviously, people know that we had the global credit crisis around that time. China's economy was very reliant on the consumer economies of the west. When those economies went into recession, China's export model was really, I guess, opened up to be a very one dimensional growth strategy. So, China did huge stimulus. They ordered their banks to lend, and the banks are mostly owned by the state government in China. So they encouraged the banks to lend. That created a massive credit boom, which was in terms of the size of China's economy, that credit boom was even bigger than the US credit boom that bought about the subprime crises and the property boom in the US.

So, it was a massive stimulus. Now what that did was just create break neck growth speed which China's economy will crash from. It won't crash in terms of happening in two months or six months, but I think you're seeing that slow motion train wreck happening right now. There is a lot of optimism that China's having a controlled slow down, that they're managing this deliberately and, of course, Australia's commodity producers are very hopeful that China will come in and do more stimulus to get their economy back growing again. The bottom line is when you have a huge credit boom, you have a bust. It doesn't really matter what you try to do to ignite that bust, history has shown that you go through quite a painful adjustment period and I think China is going through that now.

Kris:

Okay. Now I want to ask you about the stimulus later. Couple of months ago, you interviewed a chap called James White from Colonial First State.

Greg:

Yeah.

Kris:

Now, James does take the opposite view to you on China. If I'm quoting him correctly or getting his argument correct, he's saying that China's growth is sustainable and that the skeptics haven't perhaps factored in the economic benefit of all the infrastructure building and we wouldn't probably address the stimulus there as well. So what do you say to that? What do you say to those analysts who say that China is different and because it's a centrally planned economy, it can prevent the kind of economic busts that we've seen in the west in the last few years?

Greg:

I think that type of analysis ignores history and ignores economics. It's the 'build it and they will come' type of mentality. There is no doubt that a lot of the infrastructure building that has gone on in China, the industrialisation, no doubt that a lot of that is being productive. But in the credit boom of 2008-2009, it unleashed such a huge amount of spending in such a short time frame that there is no way possible, whether you've got essentially centrally planned economy or not, that that can all be productive.

What it does is create over capacity, which means that there is way too much production for the existing population growth or existing natural demand that comes out of population growth. In addition to that China, being a centrally planned communist economy or structure, is very susceptible to corruption. The way that their economic growth is determined is not via organic demand or natural demand but via who's got contacts where.

If you want to build a set of apartment blocks, you need to be in with the local mayor. There are all these sorts of interactions between power brokers in China that determine what gets built. That has got nothing to do with economics and it's got nothing to do with the consumers being given what they demand. It's just all about using the huge torrent of money that comes through the system in whatever way that the power brokers can use it to enrich themselves. I think what we're seeing now is the flipside of that rampant growth. That's why you're seeing uncertainties in the political system; you're seeing economic growth slow a lot quicker than what I think the authorities probably bargained for.

So, even though, getting back to your question, even though I think a lot of that investment will be productive, it will take a long time for China to grow into that infrastructure. One of the points I'd like to make is as a percentage of GDP, investment in China hit 50% GDP, which is an almost unprecedented portion of investment. Most western economies, consumer economies is around about 70% GDP and probably around about 10 to 12% in investment. China hit 50% in investment. The consumption share of GDP is around about 30-35%. So what they're trying to do is rebalance their economy away from investment to consumption and that is going to be a nasty adjustment. Whichever way you look at it, it's going to require a lot slower growth to get that done. And I think people who are still bullish on China don't really appreciate the difficulty of transitioning and rebalancing. I think people who are very confident that China can manage its growth are probably going to question that i n 2013 as this slow down continues.

Kris:

Okay. Obviously anything that involves China slowing is going to have an impact on the Aussie economy and on Aussie companies. So, what does that mean for Aussie investors? The Aussie resources stocks who are in the front line, the big iron-ore firms like BHP, Rio, Fortescue Metals. They've all slumped this year. I think Fortescue must be down the most. Even Rio and BHP have fallen by 40 or 50% or something in the past 12 months. The high Aussie dollar, the slower credit growth as well. So you're seeing an impact on the Aussie retailers last week or the week before, another high street retailer went burst. Last week I think it was Myer said there's seeing slower retail growth, same for David Jones.

Is there a bigger threat to the Aussie economy than just the resources firms and the retailers? What about the banking sector, what about all the money that flows into the Aussie economy, that goes into the banks and is then leveraged up for the banks to lend out into the wider economy? What could be the impact of a slowing China on the Aussie banking system, if any?

Greg:

Well, to bring it back a bit, I think the biggest risk from a big China slowdown is really on the Aussie residential property market, which as you've been writing about sometime and I think many people realise that it's hugely overvalued asset. One of the things that sustains overvalued assets is incomes that can sustain the repayment or the servicing of the debt that supports that asset. When you look at China's influence on Australia's national income, it comes through the 'Terms of Trade'. The Terms of Trade is something that...it's essentially the ratio or the value of your exports in relation to the imports. So coal and iron-ore have shot up in price massively over the past decade, and a lot of the imports have come down in price.

So, the China boom has created a massive boom I guess in national income for Australia, it's given us a pay rise each year, which has enabled Australia to sustain higher asset prices. When I say asset prices, I'm really talking about residential property, which is about the only asset in Australia that hasn't suffered a correction from the GFC that we went through in 2008. A lot of that was to do with the boom that China had, that flowed through to our bulk commodities like iron-ore and coal and boosted up our national income. So, we're on the other side of that boom now, Terms of Trade is starting to come back down. That's going to have an effect on our national incomes, which will have an effect on people's abilities to service these really high debt levels.

I think these things don't happen instantaneously. It's going to take a little bit of time to flow through into the Aussie economy, and I think in 2013, you'll see the effect on the Aussie banks. I haven't done this analysis for a little while but the last time I looked at it, you were looking at around about 60 to 65% of the Australian banks' balance sheet exposed to residential property. So, you're talking about a reasonably high amount of exposure to residential property. Now, because this boom has gone on for so long, people think property is bullet proof. I think the China slow down and the fact that's it's not going to rebound the way a lot of people think is going to flow through to the banks and they'll have problems next year. At the moment, banks have been brilliant defensive assets. They're probably, knocked every naysayer around for the past four or five years, and I've been one of those. But I certainly think China slow down will have a major impact on the banks, and we'll see that in 2013.

Kris:

Okay. Getting back to China directly, it's currently going through its latest leadership change, although, according to the Financial Times the new leader, Mr. Xi I think his name is, he went missing, went AWOL, for two weeks.

Greg:

Apparently he resurfaced on the weekend, though.

Kris:

Yes, yes. I did see that, I did see that.

Greg:

In good health apparently.

Kris:

He's come back to the surface. So do you think the change in the Chinese leadership, first of all, does it matter and secondly, will it have any impact on the Chinese economy or on financial markets, or is it just one drone taking over from another drone and who cares?

Greg:

Look I think it is important but I don't know how or why. Chinese politics is a very complex system. When you have these changeovers of power, which happen very rarely, there's a lot of jockeying for position. I think we're seeing that. Even though his leadership transition is meant to take place in October, next month, I don't think by any means that it's fully resolved. So, can they do anything once they come into power? My view is that China knows that they're in a very unstable economy. They're trying to rebalance away from the investment towards consumption and that is going to be very difficult.

Their overriding concern is to maintain social stability. They don't want people back out in Tiananmen Square protesting over jobs, inflation, that sort of stuff. But it's going to be a very difficult transition for them to make. One of the risks or one of the things that I can see possibly happening is that the transition slow down happens too quickly, the leadership panics and reignites the investment boom, which will only create bigger imbalances down the track and I think bigger problems.

So, it's a very difficult call to make, whether they will do something, I think the underlying motive of the Chinese is to try and re-engineer a rebalancing in their economy. But they need to do that without creating too high unemployment, which is obviously low economic growth hard landing. I think it's going to be a very difficult thing to do.

Kris:

Okay. That brings us nicely onto the final question I want to ask you. The European Union, it's just had the final approval from the German constitutional court. So it looks as though they're...what is it 600 or 700 billion dollar bailout fund?

Greg:

The stability mechanism.

Kris:

Yeah, the stability mechanism. So that's getting ready to go. The US Federal Reserve has just started QE3 or 'QE forever' or 'QE infinity', whatever you want to call it. And China has also recently announced something like 157 billion dollars. Now that seems like a lot of money but when you compare it to China's GDP, it works out at around about 2% of Chinese GDP, which is somewhere between seven and eight trillion dollars. So, even though the number appears to be big, 157 billion dollars, is it going to have much of an impact or any impact at all? If not, do you expect China to come out with another stimulus program and waste more of it savings on wasteful projects, just anything to prevent or try to prevent civil unrest and prevent the economy from crashing?

Greg:

Yeah. To answer your first question, no, I don't think that stimulus package is going to do anything. That was really a PR stunt to say, 'Look we've got some things up our sleeve we can do here.' Those projects are going to be spread over many years. So, in terms of the boost that that gives GDP growth, I think it's not much at all. Yes, I do think they'll continue to announce stimulus measures, but they're not going to announce anything like they did back in 2008-2009.

They simply can't afford to, the banks have already geared up. The banks even though they're not announcing it, they've got huge amounts of bad loans building on those balance sheets, which is effectively the savings that the Chinese have been given and pumped into this unproductive investment. So there's a limit to what they can do. I think that they understand that, and if they really go hard in trying to lower reserve requirement, which is the sort of form of a monetary stimulation from their point of view, it could create bigger and bigger problems down the track.

I think we give the Chinese communists a lot of flak, but I think they're certainly smart enough to realize that if you keep doing this stimulus, they've seen what happens in the west from constant stimulus and constant intervention. I think that their economy is not, in terms of the welfare system set up, it's not in any way positioned to handle a major recession or negative economic growth or something like that. So, I don't think we're going to do anything major. I think they'll just try to manage that rebalancing transition as best as they can. I still think it's going to mean slower growth for Australia and possibly put Australia into a recession for the first time in 20 odd years in 2013.

Kris:

Okay. So you think there is a real chance Australia could go into recession? We managed to avoid it in 2008-2009. So, is there a real chance it could happen within the next 12 to 18 months?

Greg:

Certainly, there is a chance. Yeah, if you look at the boom we've had in the Terms of Trade, that has really benefited our economy while the global economy has slowed down. I don't think, despite what Ben Bernanke tries to do to get employment growing again in the US, printing money doesn't help economies grow. It creates more imbalances and it creates just more dysfunctional economy. So, we're not going to get any boost from overseas.

I think overseas are going to go through a continuing low growth period. If China slows down we're going to slow down, and really the question is whether we trundle along at say 2% GDP growth or whether we slip into a recession at some point. I think people need to be prepared for slower growth in Australia for sure.

Kris:

Okay. Great. Thanks a lot for your time, Greg.

Greg:

No worries, thank you.

Kris:

We'll leave it there. So thanks for watching. Hope you've enjoyed it. You can follow more of what Greg has to say on China and also on the other analysis he does, in the Daily Reckoning twice a week. If you'd like to find out more about Greg's investment advisory service, including this thoughts on what's going to happen to the Chinese economy over the next 18 months, just click on the link and you'll be able to read more about it there. Thanks a lot for your time.