Good morning. A Delaware judge ruled against Elon Musk’s recent attempt to restore his massive pay package through a shareholder vote. Unhedged has made two arguments about this legal fight. One: no take backs. Two: legal or not, this was a very, very dumb package, because it paid Musk on the basis of a share price. The judge disagreed with argument one. But maybe the whole drama will convince boards to think about argument two? Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.
American exceptionalism again
Well, someone came out and said it — the US is in a big, fat bubble. Here is Ruchir Sharma in yesterday’s FT:
Relative prices [of stock in the US] are the highest since data began over a century ago . . . the US accounts for nearly 70 per cent of the leading global stock index, up from 30 per cent in the 1980s . . .
The overwhelming consensus is that the gap between the US and the world is justified by the earnings power of top US companies, their global reach and their leading role in tech innovation. These strengths are all real. But one definition of a bubble is a good idea that has gone too far . . .
America is over-owned, overvalued and overhyped to a degree never seen before.
It is important to emphasise that none of this is a Magnificent 7 phenomenon. Below is a chart of the forward price/earnings valuations of the S&P 500, the S&P 493 (ie the 500 minus the Mag 7), and (just to pick one global example) the S&P Europe 350. Taking out Big Tech makes only a small difference.
Does Unhedged agree with Sharma that the US is a bubble compared to the rest of the world? It sure does. The US is overvalued, possibly significantly. That said, it is not as wildly overvalued as charts such as the one above would suggest, and it would be a mistake to bet on a big convergence between US asset prices and those of the rest of the world in the near term.
Small differences in earnings growth, if they last a long time, make a big difference to what shares are worth. The S&P 493 is currently at a 40 per cent premium to the Europe 350. Expectations on earnings on the former index will grow about 11 per cent over the next year or two; the latter index, about 9 per cent. This may not sound like much. But plug a two percentage point difference in growth rate into the valuation model of your choice, and it can easily justify a valuation difference of a third or so, depending on other inputs such as discount rates — so long as the growth difference is sustained indefinitely.
For the valuation gap to close, something has to happen to make investors rethink that “indefinitely”. With the incoming Donald Trump administration determined to pull every pro-growth lever domestically while imposing tariffs abroad, that does not seem likely in the near term. If and when inflation heats up again, the picture may change. Until then, the US bubble is more likely to inflate further than it is to shrink.
Japanification
Yields on China’s 30-year government bonds have dipped below yields on Japan’s 30-year government bonds for the first time. Is China undergoing “Japanification” — descending into the sort of deflation and low growth that Japan has struggled with since the early 1990s?
The simple (but probably over-simple) answer is yes. After Japan’s asset bubble popped, it entered a balance sheet recession, as corporations, banks and households prioritised deleveraging over spending and investing. China’s current struggle parallels Japan’s experience. A real estate bubble has popped, spending and investment have slowed, deflation has started, and economic growth is flagging. Richard Koo, the economist who developed the idea of a balance sheet recession, has suggested in various interviews that China is starting to fit the pattern.
The similarities should not be overstated, however. We would not call France’s current debt problems “Liz Trussificiation” just because both involved investors losing confidence during a budget battle. Nor are Brazil’s rising interest rates “Turkeyfication.”
Most of the differences between the two make Beijing’s situation appear more dangerous than Tokyo’s was back then. China’s current demographic outlook is worse than Japan’s was. And while Japan’s real estate bubble was bigger, our frequent correspondent James Athey at Marlborough Group noted bad debt is “more prevalent” in China, where real estate was the main investment vehicle for most households, and where debt — often local government debt — has fuelled growth.
The fact that Japan’s yields have risen above China’s is not all down to China. It is also a function of changing conditions — including some reinflation — in Japan. The Bank of Japan has raised rates for the first time in more than a decade.
And, as Lei Zhu, head of Asian fixed income at Fidelity International, told us, China’s government is generally less focused on 30-year bonds, and more concerned with the shape of the curve and shorter-dated securities. Chinese 10-year and shorter bonds are still above Japanese bonds of the same tenure:
China has tools at hand which can fight deflation and boost animal spirits. Real rates are positive, so the central bank has room to cut. And with Chinese household consumption starting from a very low base, unlike in the Japan of the 1990s, a concerted effort to stimulate it could make a big difference.
But in a balance sheet recession, which China is approaching, monetary policy is less effective because investment is so low. And, as Beijing’s slow rollout of its fiscal package shows, the country has limited appetite to make big changes that would boost consumer spending.
China may not be in full-fledged Japanification now. But if the government does not rise to the occasion, and show it’s willing to support the consumer and be fiscally aggressive, Japanification proper is on the way.
(Reiter)
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