China losing control as stocks crash despite emergency measures

Margin debt on the Chinese stock market has reached $1.2 trillion. 'We suspect that it’s a matter of time before banks may have to face the music,' Bank of America says

By Ambrose Evans-Pritchard

8:11PM BST 27 Jul 2015

The red Yangtze river flows through Chongqing

The red Yangtze river flows through Chongqing. There has been a bloodbath on Chinese markets, with the Shanghai Composite index falling 8.5pc on Monday despite emergency measures to shore up equities Photo: China Foto Press / Barcroft Media

Chinese equities have suffered the sharpest one-day crash in eight years, sending powerful tremors through global commodity markets and smashing currencies across East Asia, Latin America and Africa.

The Shanghai Composite index fell 8.5pc despite emergency measures to shore up the market, with a roster of the biggest blue-chip companies down by the maximum daily limit of 10pc. The mood was further soured by news that corporated profits in China are now contracting in absolute terms, falling 0.3pc over the past year.
The violence of the moves unnerved investors worldwide, stirring fears that the Communist Party may be losing control after stoking a series of epic bubbles in property, corporate investment and equities to keep up the blistering pace of economic growth.
Brent crude prices slid to a five-month low of $53.34, re-entering a bear market. The DB-UBS commodity index fell to 2002 levels, obliterating the gains of the resource "supercycle".
The FTSE 100 fell 1.27pc to 6.497, dragged down by mining groups and energy companies. All of the year’s advances have been wiped out.
Mark Williams, chief Asia strategist at Capital Economics, said the Chinese authorities appear to have been testing the waters to see what would happen if they stopped intervening. The market verdict was swift and brutal.

“They have got themselves into a very difficult situation. They have put a lot of credibility on the line to shore up prices and this credibility has been badly damaged,” he said.

The Shanghai index looks poised to test its 200-day moving average, now just below 3,600, a crucial support level watched with trepidation by China’s authorities.

The Chinese media reported on Monday night that the state regulator is ready to intervene with yet more stock purchases. It has already bought an estimated $250bn of equities and has borrowing lines for a further $450bn if necessary.

Western banks say they are coming under heavy pressure from Chinese officials to refrain from negative comments. They are effectively gagged if they wish to do business in China.

“Large parts of the market are closed, and those stocks that are still trading are selling off regardless of support measures. Clearly something very serious is happening,” said one economist.

The long-standing assumption that the Chinese authorities know what they are doing has been shattered.

The government’s heavy-handed measures include a ban on short sales and on new share issues, as well as pressure on the 300 largest companies to buy back their own stock, and forced purchases of stocks by brokerage houses.

Many investors are effectively trapped with margin debt used to buy the stocks. These liabilities cannot be covered without selling the stocks. The longer the market remains partially frozen, the more likely it will lead to extreme stress.

David Cui, from Bank of America, said $1.2 trillion of stock holdings are being carried on margin debt. This is 34pc of the free float of the Shanghai and Shenzhen stock markets. “When the market ultimately settles at a level that can be sustained on fundamental reasons, we expect that the financial system may wobble, due to high contagion risk,” he said.

“Most leveraged positions may suffer from losses ultimately, likely in trillions (of yuan). The risk is that the unwinding of the leverage will be disorderly: due to implicit guarantees behind most shadow banking products, investors could easily panic,” he said.

Mr Cui said the brokers and trusts have barely 1.6 trillion yuan ($260bn) to absorb losses and may be overrun. “Given the particularly thin front line of the financial institutions, we suspect that it’s a matter of time before banks may have to face the music,” he said.

This in turn risks setting off a “bank run” on the shadow banking system as investors lose trust in wealth management funds, fearing that their deposits in the $2.1 trillion industry no longer have an implicit guarantee.

Bank of America said the Chinese state may have to swallow the losses from the stock market fiasco in the end but this would have a clutch of toxic side-effects.

The authorities still have a nuclear trump card up their sleeve. They could cut the reserve requirement ratio (RRR) from 18.5pc all the way down to 5pc – as in the banking crisis in 1998 – or even to zero.

This would allow the big state banks crank up lending, injecting $2 trillion to $3 trillion into the economy, putting off the day of reckoning with another cycle of growth.

Premier Li Keqiang is clearly reluctant to pull the credit lever again. One of the reasons why Beijing talked up the stock market was to try to shift reliance from debt to equity, though the policy got out of hand as margin accounts flourished.

The debt to GDP ratio has already doubled to 260pc since 2007, reaching $26 trillion, more than the US and Japanese commercial banking systems combined.

Credit is stretched to dangerous levels and is losing its potency. Wei Yao from Societe Generale said it took $2.50 of credit to generate $1 of extra GDP before the Lehman crisis. This has jumped to $5.50 as the economy reaches credit saturation. This is very little gain, at great risk.

Ray Dalio, a long-time China bull at Bridgewater, issued an extraordinary mea culpa last week, saying he had misjudged the Chinese boom and viewed the equity crash as a turning point.

“We did not properly anticipate the rate of acceleration in the bubble and the rate of unravelling, or realise that the speculation in the markets was so big by the established corporate entities, as well as the naïve speculators. We should have,” he said.

Mr Dalio said the stock market crash is in one sense a minor matter – given that most Chinese do not own stocks – but it is coming at a very delicate moment, and has been a psychological shock. The combined effects of a bursting property bubble, an equity crash and a wave of debt restructuring at the same time have reached critical mass. “Negative forces on growth are strong and self-reinforcing,” he said.

It has hit at a time when the Chinese exchange rate is soairing - due to the dollar peg - and may be 15pc overvalued.

There are still optimists. Wendy Liu from Nomura said the boil has been lanced and Chinese equities are now cheap. “This is the best time to buy. It looks like an ordinary correction to me,” she said.

She compared the sell-off to the mini-panic in June 2013, when Shibor interbank rates soared to 30pc. “Everybody was bearish on China and thought it was going to blow up. I think we are going through a similar situation,” she said.

For the rest of the world, it is a tense moment. China consumes 50pc of global coal, 43pc of industrial metals and 23pc of grains, according to World Bank data.

Brazil, Russia, South Africa and a string of commodity states face a double-barrelled stress test.

The Chinese are freezing imports just as the US Federal Reserve drains worldwide dollar liquidity and prepares to raise rates, calling time on emerging markets that have together borrowed $4.5 trillion in US currency.

The Brazilian real fell to a 12-year low of 3.38 against the dollar on Monday. The South Africa rand hit a record low of 12.69. The Russian rouble flirted with the danger line of 60. It was the same story across much of the emerging market nexus.

“One by one the dominoes are starting to fall,” said Societe Generale.

Depression’s Advocates

J. Bradford DeLong

JUL 24, 2015

George Segal breadline sculpture

BERKELEY – Back in the early days of the ongoing economic crisis, I had a line in my talks that sometimes got applause, usually got a laugh, and always gave people a reason for optimism. Given the experience of Europe and the United States in the 1930s, I would say, policymakers would not make the same mistakes as their predecessors did during the Great Depression. This time, we would make new, different, and, one hoped, lesser mistakes.
Unfortunately, that prediction turned out to be wrong. Not only have policymakers in the eurozone insisted on repeating the blunders of the 1930s; they are poised to repeat them in a more brutal, more exaggerated, and more extended fashion. I did not see that coming.
When the Greek debt crisis erupted in 2010, it seemed to me that the lessons of history were so obvious that the path to a resolution would be straightforward. The logic was clear. Had Greece not been a member of the eurozone, its best option would have been to default, restructure its debt, and depreciate its currency. But, because the European Union did not want Greece to exit the eurozone (which would have been a major setback for Europe as a political project), Greece would be offered enough aid, support, debt forgiveness, and assistance with payments to offset any advantages it might gain by exiting the monetary union.
Instead, Greece’s creditors chose to tighten the screws. As a result, Greece is likely much worse off today than it would have been had it abandoned the euro in 2010. Iceland, which was hit by a financial crisis in 2008, provides the counterfactual. Whereas Greece remains mired in depression, Iceland – which is not in the eurozone – has essentially recovered.
To be sure, as the American economist Barry Eichengreen argued in 2007, technical considerations make exiting the eurozone difficult, expensive, and dangerous. But that is just one side of the ledger.
Using Iceland as our measuring stick, the cost to Greece of not exiting the eurozone is equivalent to 75% of a year’s GDP – and counting. It is hard for me to believe that if Greece had abandoned the euro in 2010, the economic fallout would have amounted to even a quarter of that. Furthermore, it seems equally improbable that the immediate impact of exiting the eurozone today would be larger than the long-run costs of remaining, given the insistence of Greece’s creditors on austerity.
That insistence reflects the attachment of policymakers in the EU – especially in Germany – to a conceptual framework that has led them consistently to underestimate the gravity of the situation and recommend policies that make matters worse.
In May 2010, Greece’s GDP had fallen by 4% year on year. The EU and the European Central Bank predicted that the first bailout program would drive Greek GDP down by another 3% below 2010 levels, before the economy began to recover in 2012.
By March 2012, however, reality had set in. With GDP headed to 12% below 2010 levels, a second program was put in place. By the end of the year, GDP had fallen to 17% below 2010 levels. Greece’s GDP is now 25% below its 2009 level. And while some predict a recovery in 2016, I fail to see how any analysis of demand flows can justify that forecast.
The main reason the forecasts were so wrong is that those making them chronically underestimated the impact of government spending on the economy – especially when interest rates are near zero. And yet the clear failure of austerity to restart the economy in Greece or the rest of the eurozone has not caused policymakers to rethink their approach.
Instead, they seem to be doubling down, on the theory that the deeper the crisis, the more successful the push for structural reforms will be. Such reforms are needed to boost long-term growth, the thinking goes, and if that growth does not rapidly emerge, it is because the need for them was even greater than originally thought.
This, sadly, is the story of the 1930s as well. As the American commentator Matthew Yglesias points out, Europe's major center-left parties at that time recognized that what was being done was not working, but nonetheless failed to offer an alternative. “It was left to other parties with less worthy overall agendas – Hitler, for example – to step in and say that if the rules of the game led to prolonged spells of mass unemployment, then the rules of the game had to be changed.”
Today, Yglesias adds, Europe’s center-left politicians similarly “don’t have a strategy for changing the rules, and they don’t have the guts to tear up the rulebook.” As a result, austerity reigns, and dissent is left to populists like France’s Marine Le Pen or Italy’s Beppe Grillo – whose economic proposals seem even less likely to be effective.
One would have thought we were capable of learning from the past, and that the Great Depression was important enough in European history that policymakers there would not be repeating its mistakes. And yet, at the moment, that is precisely what seems to be happening.

Emerging market currencies crash on Fed fears and China slump

Brazil faces a 'perfect storm' as the country as the country slides deeper into recession, the politics go haywire and the Fed prepares to raise rates

By Ambrose Evans-Pritchard

9:48PM BST 24 Jul 2015

Christ the Redeemer statue, Brazil

Brazil's real plummeted to a 12-year low of 3.34 to the dollar Photo: Alamy
The currencies of Brazil, Mexico, South Africa and Turkey have all crashed to multi-year lows as investors flee emerging markets and commodity prices crumble.

The drastic moves came as fears of imminent monetary tightening by the US Federal Reserve combined with shockingly weak figures from China, which stoked fears that the country may be sliding into a deeper downturn and sent tremors through East Asia, Latin America and Africa.
The Caixin/Markit manufacturing survey for China fell to a 15-month low of 48.2 in July, with a sharp drop in new export orders. Danske Bank said the slide “pours cold water” on hopes of a quick recovery from the slump seen earlier this year.

Brazil's real plummeted to a 12-year low of 3.34 to the dollar, reflecting the country's heavy reliance on exports of iron ore and other raw materials to China.
The devaluation tightens the noose on Brazilian companies saddled with $188bn in dollar debt taken out during the glory days of the commodity boom. The oil group Petrobras alone raised $52bn on the US bond markets.

Mexico’s peso hit a record low of 16.24 against the dollar. The country’s foreign exchange commission is mulling emergency action to defend the currency, despite the extreme reluctance of the Mexican authorities to meddle with market forces.


Colombia’s peso collapsed 5.2pc to a historic low on Friday, a huge move in a single day.

Similar dramas played out in Chile and a string of countries deemed vulnerable to the combined spill-overs from China and the US. The MSCI index of emerging market equities fell to 1.8pc to 36.92 and may soon test four-year lows.

Bernd Berg, from Societe Generale, said Brazil faces a “perfect storm” as the economy slides into deeper recession and corruption scandals spread. New worries about political risk may soon push the real to 3.60, a once unthinkable level.

There is mounting concern that President Dilma Rousseff could be impeached for her failure to stop pervasive malfeasance at Petrobras.

Brazil’s travails come just as the US nears full employment and the Fed prepares to raise interest rates for the first time in eight years. issuing what amounts to a "margin call" for emerging markets that have borrowed $4.5 trillion in dollars.

Mr Berg said Brazil’s debt may be cut to junk status over coming months. This would be a humiliating blow for a country that thought it had escaped the endless cycle of debt booms and populist misrule, and saw itself as a pillar of a new BRICS-led global order.

In South Africa, the rand plummeted to a record low of 12.68 to the dollar on Friday despite moves by the central bank to defend the currency. It raised rates a quarter point to 6pc on Thursday.

South Africa is one of a growing number of emerging market states that has lost its room to manoeuvre and is being forced to tighten monetary policy into the downturn, compounding the effects of the commodity slump.

Such countries cannot ease policy or resort to stimulus to cushion the blow because this would risk capital flight - and potentially a classic rush for exits. Such synchronized “pro-cyclical” tightening is hazardous for the world as a whole since the emerging markets now make up roughly half global GDP and – until this year - four-fifths of extra growth.

Stephen Jen, from SLJ Macro Partners, said China’s downturn is proving to be “hard on the outside, soft on the inside”. It may be manageable for China itself as the country shifts from heavy industry to service-led growth, but it is brutal for those countries that have been feeding on the Chinese construction boom.

“China can handle the soft landing; it is the other countries that rely on China’s growth that we worry about,” he said.

Growth in emerging markets – excluding China – has fallen to 0.1pc. These countries are on the brink of recession. They are now being hit on two fronts at once since the Fed shows no signs so far of backing away from a rate rise in September, probably the first of many.

The complicated “feedback loops” that created an interwoven American-Chinese boom in the last decade – and greatly flattered the emerging markets nexus - are now going into reverse with a vengeance. Mr Jen said the weaker countries face “acute risks of a ‘sudden stop’ in capital flows” when the Fed pulls the trigger. “We expect a violent sell-off in some EM currencies this year,” he said.

Traders say Turkey may be first in the firing line. Turkish companies and banks have $120bn of short-term foreign funding that must be rolled over within a year. When combined with the country’s stubborn current account deficit – still 5.7pc of GDP – the funding gap is $170bn.

This is more than six times larger than the central bank’s foreign reserves.

Turkey was able to get away with this as long as the political system was stable. But a spate of terrorist attacks and a splintered electoral landscape have exposed the underlying dangers. Aberdeen Asset Management said it is slashing its holding of Turkish debt. “The risks surrounding the country are now much too high,” it said.

The lira weakened sharply to 2.75 against the dollar on Friday and looks likely to test record lows. Yields on 10-year Turkish bonds have jumped 50 basis points this week to 9.48pc.

Ilan Solot, from Brown Brothers Harriman, said the geopolitical temperature is rising fast and the Turkish lira is likely to take the strain. “We think the tail-risks emanating from Turkey may be greater than many appreciate,” he said.

Barron's Cover

Berkshire Hathaway’s Bright Future

Warren Buffett has positioned Berkshire Hathaway to prosper long after he steps down as CEO.

By Andrew Bary           

July 25, 2015 2:52 a.m. ET

Warren Buffett is coming off one of the biggest investment coups of his long career with the closing of the Kraft Foods’ purchase of Heinz Holdings earlier this month.
Photo: Chris Goodney/Bloomberg News
Buffett’s Berkshire Hathaway invested $4.25 billion for a 50% equity stake in the $23 billion leveraged buyout of Heinz two years ago, along with a partner, Brazil’s 3G Capital. Berkshire made a second $5 billion equity investment with 3G when Kraft unveiled its deal for the ketchup maker in March. Berkshire (ticker: BRKA) now is sitting on a 25% stake in the new Kraft Heinz  (KHC) -- some 326 million shares -- worth $25 billion based on Kraft’s recent share price of $77, resulting in a gain of almost $16 billion. That’s a stunning profit in just two years. (3G has a similar gain.)
The Heinz score rivals anything ever achieved in the private-equity industry. It also demonstrates that Buffett, who is celebrating his 50th year at the helm of Berkshire this year, is still going strong ahead of his 85th birthday in August. Berkshire is his baby, and the company is better than ever despite the lackluster performance of its big equity portfolio, which is dominated by four stocks: American Express (AXP), Coca-Cola (KO), International Business Machines (IBM), and Wells Fargo (WFC).

Wall Street isn’t giving Berkshire much credit for the Heinz killing and for its many attributes, notably a torrent of earnings from a widely diversified set of businesses led by insurance, railroads, utilities, and manufacturing. Operating earnings may total $19 billion after taxes this year, up 18% from 2014 and more than double the 2006 total.

Berkshire’s Class A shares are down 6% this year, at $213,000, trailing the Standard & Poor’s 500 index, which has gained 1%. The company’s Class B shares, equal to 1/1,500 of the A, have fallen a similar amount, to $142. The stock looks attractive, trading for less than 1.5 times its March 31 book value of $146,963 a share.

“I’m scratching my head about Berkshire,” says Jay Gelb, a Barclays analyst. “The earnings power is stronger than ever, the company has done a series of attractive acquisitions, and it just closed on Kraft. None of that is reflected in Berkshire’s valuation.” Gelb carries an Overweight rating and a price target of $259,500, 22% above current levels.

Downside appears limited, given the company’s rising book value and its willingness to aggressively repurchase stock at 1.2 times book value, backed by a formidable balance sheet with $58 billion in cash, or $44 billion of net cash after subtracting $14 billion of debt. The net cash position is equal to more than 10% of the company’s market value of $350 billion.

Barron’s has written frequently about Buffett and Berkshire over the years, including a bullish 2012 piece when the shares fetched $128,000, or 1.1 times book value (“Buffett’s Latest Bargain: Berkshire Hathaway,” Nov. 12, 2012). Buffett declined to comment for this article.

BUFFETT CONTINUES to hunt for what he calls elephant-sized acquisitions that could total $35 billion or more, although he hasn’t done any big deals besides Heinz in the past few years.
The company wants to keep a cash cushion of at least $20 billion. Book value, which is steadily rising each quarter, may get a one-time boost from the Kraft deal of $6,000 a share, by our calculation. By the end of next year, book value could hit $175,000.

Whether the Kraft gain is reflected in book value depends on the accounting treatment, according to New York tax expert Robert Willens. Berkshire hasn’t yet disclosed the tax treatment.

Berkshire historically has been valued based on book value, although Buffett focuses on what he calls intrinsic value. The challenge is that Buffett doesn’t reveal his estimate of Berkshire’s intrinsic value, telling investors that book value is a “crude but useful tracking device for the number that really counts, intrinsic business value.” Buffett has stated that intrinsic value “far exceeds” book value because the current value of key businesses, including Burlington Northern and auto insurer Geico, is much higher than book, or carrying, value on Berkshire’s balance sheet.

Buffett even offered investors guidance on purchasing Berkshire in his 2014 annual shareholder letter released in late February. He cautioned investors not to pay an “unusually high” price of nearly two times book value. Any purchase “modestly above the level at which the company would repurchase its shares, however, should produce gains within a reasonable period of time.” That price is 1.2 times book, or an estimated $180,000 currently.

The last time Berkshire traded at more than twice book was in the late 1990s, and that turned out to be a bad time to invest. A purchaser in late 1998 at $70,000 a share would have seen the stock trade at the same price more than a decade later in 2009.

“Berkshire is cheap, and the risk-reward is favorable,” says David Rolfe, chief investment officer at Wedgewood Partners, a Ladue, Mo., firm that counts Berkshire among its largest holdings. “Buffett is giving you a road map on valuation, and we’re closer to 1.2 times book than two times.”

IN HIS ANNUAL SHAREHOLDER LETTER, Buffett endorsed Berkshire shares in what was probably his most expansive discussion ever about the company and what he views as its unmatched strengths. He prefaced his comments by offering shareholders the same advice he would tell his “family, if they asked me about Berkshire’s future. First and definitely foremost, I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments. That’s because per-share intrinsic business value is almost certain to advance over time.”

Gelb sees Berkshire’s after-tax operating earnings rising to $11,924 a share in 2015 from $10,071 in 2014, an increase of 18%, and increasing another 7% next year to $12,757 a share.
Burlington Northern’s profits are up despite pressure on its crude-oil-by-rail business. The company is addressing service problems that plagued its network last year. Its margins are below those of its chief railroad rival, Union Pacific (UNP).

BERKSHIRE IS VALUED at 18 times projected 2015 earnings, in line with the S&P 500. But profits are growing faster than the overall market. The price/earnings ratio doesn’t capture the value of Berkshire’s $113 billion equity portfolio. The earnings reflect only the dividends it receives. Berkshire is also sitting on a lot of cash that is earning almost nothing. A large, cash-financed acquisition would likely boost earnings.

Why doesn’t Berkshire trade higher? There are a couple of reasons. The first is Buffett’s age. Even given his good health, it would be impressive if he were able to still run the company at 90. It’s very rare to see a 90-year-old, which is what he would be in 2020, heading a large public company.

Buffett is irreplaceable. His combination of investment and management skills is extraordinary.
He’s comfortable assessing and buying a raft of asset classes, including stocks, bonds, and commodities. He also has engendered the loyalty and trust of longtime investors and of his stable of corporate managers of Berkshire subsidiaries.

Some of the investment opportunities that Berkshire has received in the past may not be available to his successor -- including the willingness of private companies to sell to Berkshire and the desire of public companies to get the Buffett imprimatur and vote-of-confidence from a Berkshire investment. Without Buffett, it’s doubtful whether General Electric (GE) or Goldman Sachs (GS) would have sought investments from Berkshire during the financial crisis.

And many investors fear that the company simply is too large to generate high future returns. It will take bigger and bigger deals to move the needle at Berkshire, so the argument goes, and Berkshire is handicapped in buying companies because it won’t participate in auctions. With Buffett, it’s often a take-it-or-leave-it offer.

Another concern is that Berkshire, with its 80-plus subsidiaries, becomes difficult to manage after Buffett.

Berkshire’s longtime vice chairman Charlie Munger addressed this in a companion shareholder letter in the annual report. He wrote that the “combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if 1) Buffett left tomorrow, 2) his successors were persons of only moderate ability, and 3) Berkshire never again purchased a large business.”

“There will be big challenges,” says Nomura analyst Cliff Gallant. “Buffett is the biggest CEO out there. But Berkshire is about value creation and he has positioned the company in stable businesses with competitive advantages for the foreseeable future.”

Berkshire’s unique conglomerate model, in which profits are recycled into new acquisitions, amounts to a virtuous circle. The company has evolved into something far greater than Buffett’s investment vehicle.

“Value creation is more about the success of the operating units than Berkshire’s investments,” says Gallant. The equity portfolio amounts to a third of Berkshire’s market value of $350 billion, which ranks it fourth in the U.S stock market, behind only Apple (AAPL), Google (GOOGL), and Microsoft (MSFT).

It’s a good thing that Buffett has focused on purchasing entire companies rather than equities in the past decade, because his stock-picking skills have eroded. His portfolio is filled with winning stocks of a decade or two ago that are no longer so dominant. He has missed the boom in tech and health-care stocks in recent years.

OF BERKSHIRE’S FOUR LARGEST HOLDINGS -- American Express, Coca-Cola, IBM, and Wells Fargo -- only Wells Fargo has beaten the S&P 500 over the past three and five years (see table). IBM, a $13 billion holding, is worth less than Berkshire paid for it, mostly in 2011, and has lagged behind the market by 60 percentage points over that span. Coke is still below its 1998 peak. Berkshire liquidated a longstanding holding in Tesco (TSCO.UK), the British supermarket chain, at a loss last year. One reason Buffett may have stuck with some of these longstanding holdings is an aversion to paying capital-gains taxes.

Berkshire has done better with a series of acquisitions, notably the Burlington Northern railroad, which is probably worth $70 billion, or twice what Berkshire paid for it in 2009.

In his annual letter, Buffett noted that the company’s “Powerhouse Five” noninsurance businesses -- Burlington Northern, Berkshire Hathaway Energy (the company’s large utility operation), Lubrizol (chemicals), IMC (machine tools), and Marmon (manufacturing) -- had a record $12.4 billion of pretax profits last year and could add $1 billion to those earnings in 2015.

Only one of them, the utility business, was owned by Berkshire a decade ago, and three of the other four were purchased entirely for cash; the fourth, Burlington, was largely bought for cash.

THE NET RESULT over the past 10 years has been a $12 billion increase in profits from those businesses but just a 6% rise in Berkshire’s share count. “That satisfies our goal of not simply increasing earnings, but making sure that we also increase per-share results,” Buffett crowed.

Buffett is obsessed with per-share profits and expanding the per-share value of the company -- an approach that all CEOs should emulate. To avoid dilution, Berkshire usually avoids the issuance of stock for acquisitions. Since he took control of a then-struggling textile maker in 1965, Berkshire’s share count has risen just 60%, a tiny increase given the company’s growth since then.

Then there are Berkshire’s formidable insurance operations, led by Geico, reinsurer Gen Re, and specialty reinsurance operations. Fast-growing Geico, now the No. 2 auto insurer behind State Farm, could be the best-run insurer of any kind in the country. The specialty-reinsurance operation, which has long provided protection against catastrophes such as earthquakes and hurricanes, has made billions of dollars for Berkshire over the past three decades under the brilliant direction of Ajit Jain. As Buffett has written to shareholders planning to attend the annual meeting in Omaha: “If you meet Ajit, bow deeply.”

“In effect, the world is Berkshire’s oyster,” Buffett wrote, noting that it “is perfectly positioned to allocate capital rationally and at minimal cost.” Jain’s catastrophe-reinsurance operation, for instance, is doing less business now because alternative sources of coverage, notably catastrophe bonds, are undercutting traditional reinsurance. Berkshire is putting its money elsewhere. The company is investing heavily in both Burlington Northern ($6 billion of capital expenditures this year) and utilities ($6 billion).

Buffett remains Berkshire’s largest holder with a 19% stake worth $65 billion, even after giving away billions of dollars of stock to the Bill & Melinda Gates Foundation and other foundations.

When Buffett made his initial donation to the Gates Foundation in 2006, he called Berkshire “an ideal” investment for a foundation. Yet it doesn’t appear that any major foundation or college endowment has heeded that advice. Berkshire has bested the S&P 500 since 2006, returning 10% annually, versus 8% for the index. Endowment and foundation chiefs would rather put money in high-fee investments like private equity than invest with Berkshire, whose overhead costs are trivial. Buffett still takes a salary of just $100,000 a year.

THE POST-BUFFETT LEADERSHIP structure is taking shape. Two investment managers, Ted Weschler and Todd Combs, who now oversee about $14 billion of the Berkshire equity portfolio, probably will take full control of investments. Buffett’s son Howard will become nonexecutive chairman and an as-yet-unnamed Berkshire manager will become CEO.

Speculation has centered on two executives, Greg Abel, the head of Berkshire Hathaway Energy, which owns a group of electric utilities and two natural gas pipelines, and Jain. Munger even singled out the pair in the annual letter.

Our bet is that Abel gets the nod. There are several reasons, including age -- he’s 53 and Jain is 64 -- and experience. He’s headed a conglomerate and is comfortable in the public eye, while Jain has a relatively small staff and he’s shunned the spotlight. Abel was just appointed to the Kraft board, in what may be a move by Buffett to give him experience outside the utility business and further groom him for the CEO job.

Berkshire can’t possibly replicate its 20%-plus annualized performance of the past 50 years, but the next half-century should still be impressive. With its ample earnings power and strong balance sheet, it’s likely to remain an above-average company capable of high single-digit annual shareholder returns for the foreseeable future. With or without Buffett, Berkshire probably deserves a place in investors’ portfolios. 

Deflation Is Winning - Beware!

By: Chris Martenson

Sunday, July 26, 2015 .

Plane in dive

Expect the ride to get even rougher

Deflation is back on the front burner and it's going to destroy all of the careful central planning and related market manipulation of the past 6 years.

Clear signs from the periphery indicate that a destructive deflationary pulse has been unleashed. Tanking commodity prices are confirming that idea.

Whole groups of enterprises involved in mining and energy are about to be destroyed. And the commodity-heavy nations of Canada, Australia and Brazil are in for a very rough ride.

Whether the central banks can keep all of their carefully-propped equity and bond markets elevated throughout the next part of the cycle remains to be seen. We know they will try very hard. They certainly are increasingly willing to use any all tools at their disposal to keep the status quo going for as long as possible.

Whether it's the People's Bank of China stepping in to the market to buy 10% stakes in major Chinese corporations in a matter of weeks, the Bank Of Japan becoming the majority owner of key ETFs in the Japanese markets, or the Swiss National Bank purchasing $100 billion of various global equities, we see the same desperation. Equity prices are being propped, jammed and extended higher and higher without regard to risk or repurcussions.

It makes us wonder: Why haven't humans ever thought to print their way to prosperity before?

Well, that's the problem. They have.

And it has always ended up disastrously. History shows that the closest thing that economics has to an inviolable law is: There's no such thing as a free lunch.

Sadly, all of our decision-makers are trying their hardest to ignore that truth.

First, The Fall...

So how will all of this progress from here?

We've always liked the Ka-Poom! theory by Erik Janzen which we explained previously like this:
One of the models of the future that I favor is the Ka-Poom theory put out by Erik Janszen of back in 1999. 
Basically it states that the end of a bubble era begins with a sharp deflationary event (the 'Ka' part of the title), but ends in a highly inflationary blow-off, (the 'Poom'). 
It's a one-two punch. Down then up. 
The reason you get the deflationary portion is simply because bubbles always burst.  
They are seeking a pin from the moment they are born. 
The logic for the inflationary secondary reaction is that the central banks always respond to deflation with more money printing. Ironically, this is a doomed attempt to stem the damage caused by their prior money printing efforts. 
They never learn. 
So that's what we're looking for here at Peak Prosperity: a deflationary crunch savage enough to scare the central banks into opening the monetary spigots even wider. But this next time, we think they'll seek to goose economic growth by giving money directly to the people as well as non-bank corporations. 
And we think that deflationary bust has already begun. Our record-high stock markets simply somehow haven't gotten the memo yet.
So that's it: prices first go down (Ka!) and then they rocket back up (Poom!). When it's all over some years down the line, many of the world's fiat currencies (Yen, Euro, Bolivar, Real, and maybe a few Pesos and the Rupee, too) will be damaged or dead.

Dreams are dashed. And those who are mentally unprepared and emotionally unequipped will have a very hard time adjusting.

This predicted implosion has to happen. It's a mathematical result of the grave errors made by central banks and government busybodies, who mistook the low volatility and easy gains of the virtuous portion of the money printing cycle for actual success.

Goaded on by their great fortune, they simply doubled down over and over again; seeking the same bang for those freshly-printed dollars (or yen, euros, and yuan). Of course, their efforts progressively resulted in diminishing returns. Yet they completely ignored charts like the one below, which explains much if you just stop and think about it for a couple of seconds:

GDP Increase from each new dollar of debt
Source: BMG Bullion

This chart says that between 1947 and 1952, when the middle class was expanding like crazy, each new dollar of debt increased the GDP by $4.61. Today, that number is $0.08(!). We can flip this, to say that it takes $12.50 of new debt to boost GDP by $1.

Clearly this is an unsustainable trend. What's been the response from the central banks? Why to encourage more debt, of course! We need more GDP, they say, and new credit formation is critical to that process!

Well, what else would you expect a banker to say? Note that the central banks are deadly mute on topics like the role of cheap debt in fostering mal-investment, to say nothing of the importance of net energy and functional ecology to the human experience.

Central planners may have a lot of power because of their access to and use of the magic printing press. But their knowledge of the real world is horribly immature, if not entirely wrong.

From The Outside In

The way things tend to work is that trouble begins on the outside and works its way towards the center. The weaker periphery elements get clobbered first, the strongest last. So it's Greece before Spain, and Spain before France. It's the poor before the middle class, and the middle class before the rich.

We can already see the signs of this process in play, but it's now accelerating.


In January 2015 the Mexican peso, stung by falling oil export revenues, breached the 15-to 1-level against the US dollar for the first time since the 2009 crisis. Today, it's 16.12-to-1:


Meanwhile, the Brazilian real has declined by a stomach-churning 45% in the past 12 months versus the dollar:

BRL per 1 USD

Where one Brazilian real used to be worth 45 cents a year ago, it's now worth just 30 cents. All of the hedge funds that tried to get rich off of the fat 12.5% yield that Brazilian 10-year debt offers just got their heads handed to them as a result of the plummeting currency exchange ratio.

Why is Brazil tanking so hard? It's due to a combination of challenges: corruption scandals, poor trade prospects (as commodities collapse) and growing political risk. But the big one is that it's 'miracle' economic growth has crashed into a brick Wall.

Puerto Rico

Similarly, Puerto Rico is in dire financial straits. There are huge haircuts coming for investors in Puerto Rican bonds and -- like Greece -- many years of economic hardship for the island's populace:
More than half of all muni bond funds have investments in Puerto Rican tax-exempt bonds, even though the sunny Caribbean island is an economic basket case. Its outstanding municipal debt of $72 billion amounts to $30,000 for each of the commonwealth's residents, almost three times average annual per capita income.  
Puerto Rico's ratio of debt to gross domestic product is more than triple that of any other U.S. state or territory, and the island's economy has been mired in recession for nine years. 
    Source: Kiplinger
How does a small island nation even borrow 3x average annual income per capita? It turns out it's remarkably easy in the free-money liquidity fest offered up by the Fed. It was only a year ago that yield starved "investors" (more properly called speculators) placed $16 billion in bids for $3.5 billion of newly issued Puerto Rican junk muni bonds.


In even worse shape is Venezuela. It's so far down the road to financial ruin that it's almost certainly gong to be the next victim of hyperinflation.
Inflation in Venezuela signals default impending
Jul 16, 2015 
Venezuela is about to earn another ignominious distinction. 
Long home to the world's highest inflation rate, the country now is set to become the site of the 57th hyperinflation event in modern recorded history, says Steve Hanke, professor of applied economics at Johns Hopkins University. While the feat may be little more than a formality in a country where Hanke calculates annual cost-of-living increases already run at 772 percent, it's the latest sign a debt default may be closer than previously thought. 
With Venezuela's currency losing 32 percent of its value in the past month in the black market, according to, and falling oil prices throttling the cash-starved nation's biggest revenue source, the government may run out of money to pay its debts by year-end, according to Societe Generale. Derivatives traders have ratcheted up the probability of a default within one year to 63 percent, compared with 33 percent just two months ago.
Things are about to get even more dire for the people of Venezuela. Already suffering acute shortages of consumer staples, they're about to experience the same type of horrific monetary devaluation that Zimbabwe did.


China is anything but a peripheral country, but the import/export numbers suggest that China is slowing down hard and ripe for a crash. Instead of trying to gracefully manage its transition from an industrial economy to a consumer economy, China is simply plowing ahead following the same script that fostered its growth in the first place.

Loans are being hurriedly pushed out the door to support everything from the stock market to real estate. Despite these efforts, lots is going wrong, as evidenced by the vicious bursting of China's stock bubble and the heavy-handed government rescue efforts that have followed:
Half the shares traded in Shanghai and Shenzhen were suspended. New floats were halted. Some 300 corporate bosses were strong-armed into buying back their own shares. Police state tactics were used hunt down short sellers. 
We know from a vivid account in Caixin magazine that China's top brokers were shut in a room and ordered to hand over money for an orchestrated buying blitz. A target of 4,500 was set for the Shanghai Composite by Communist Party officials.
Caixin says the China Securities Finance Corporation - a branch of the regulator - now owns an estimated $200bn of Chinese stocks and has authority to buy a further $500bn if necessary to prop up the market. 
This use of "brute force" - in the words of Peking University professor Michael Pettis - has done the trick. Equities have recovered. How could they not do so, since selling was illegal, and not to buy was also illegal?
Source - AEP Telegraph
We get the following interesting chart, from this same article which supports the idea that China's rate of economic growth has slowed sharply and is well below the officially-stated rate of 7%:
Vhina Activity Proxy

Throwing lots and lots of new money at the problem of slowing growth and collapsing equity prices is exactly backwards from what should be done.

The problem is not that equity prices are falling, it's that they are too high compared to earnings (70x trailing earnings!).The problem is not that real estate building and sales are slowing down, it's that too much was built and prices are already far too high (20x median income or higher!).

Assume The Crash Position

In Part 2: Assume The Crash Position, analyzes how if deflation does indeed take over and swamp the official efforts at damage control, quite a lot of fantasy wealth in today's stock, bond and real estate markets will be destroyed. This means you want to be positioned away from risk-based financial assets right now -- with stocks and low & junk grade bonds are right at the top of that list. Cash and short maturity sovereign debt of good countries will be much better places to hang out while the storm rages.

Like it or not, things are getting interesting again. The prudent move here is to watch developments very closely, position yourself defensively, and be ready to react nimbly, if necessary. After years of suppression, the forces of reality are threatening to overwhelm our managed global "markets". And it's about damn time.