Book Club Discussion: “The End of Copycat China: The Rise of Creativity, Innovation, and Individualism in Asia”

The CFA Chicago Book Club met on Feb. 17 to discuss The End of Copycat China: The Rise of Creativity, Innovation, and Individualism in Asia by Shaun Rein.  Below is a summary of the discussion based on the reading:

The End of Copycat China by Shaun Rein is a sound read.  We started off our discussion by opening it up to the members of the CFA Society Chicago book club and let each individual share a little bit about them and what they found interesting in the book.

We discussed the innovation cycle which you can isolate into three stages.  The first being the copycat stage.  This is where an emerging economy takes developed economies technology and implements into their own markets to initiate growth.  This is a natural process of economic evolution where there is plenty of low hanging fruit.  When there is plenty of low hanging fruit coupled with poor intellectual property rights, individuals will not have the incentive to innovate hence stage 1 of the innovation cycle.

Stage 2 of the innovation curve is when companies start to innovate specifically for their target market.  For example, stage 2 would involve taking advanced technologies and tailoring to the Chinese people.

Stage 3 is innovation for the world.  There is no longer the low hanging fruit, the advanced technologies have been tailored to the emerging economy, and now companies engage in R&D, intellectual property rights are strong, and innovation becomes the way to new long term sustainable growth.

Pollution was obviously a hot topic.  There was a point when Beijing had an AQI (Air Quality Index) of 700!  To put that in perspective, Los Angeles hovers around 20 and Paris officials will stop half of the city’s traffic if AQI hits 50.  China has an abundance of coal.  70% of their energy needs come from coal.  Increased auto sales have also added to the pollution problem.  They have only recently begun uncovering possible shale formations which they will use U.S. advanced technologies in hydraulic fracturing and horizontal drilling to uncover oil & natural gas.  Alternatives to coal are solar, wind, or nuclear power.  China is in the process of building nuclear reactors to promote clean energy though it is going to take many years to get up to their target.  Solar and wind are both not as stable as coal and given coal is in abundance, coal is relatively inexpensive which further promotes toxic carbon dioxide emissions.  The air can be so bad that many people plan their entire day around the AQI while checking their smart phones like they check the stock market.  E-commerce is soaring because people don’t want to go outside.  They rather hire a delivery guy to bring them groceries than risk going outside.  There are 8-year-old girls developing cancer from the poor air quality.  N95 masks are what everyday people need to protect themselves.  Several marketing strategies result from this.  For one, you start to see designer or Sponge Bob N95 masks on an everyday basis.  Another example is having malls that offer garage parking that allow for consumers to spend the entire day at one location.  For example, having a movie theater, restaurants, shopping, gym, and many other options to avoid having to go outside.  Expatriates described it as living on Mars.  Given the excess natural gas production in the U.S., the U.S. will be at an exporting advantage as the U.S. begins to liquefy natural gas or convert it into methanol to sell to the Chinese to promote clean energy.  The Chinese will be spending billions over the next 50 years investing in clean energy for land, water, and air.

The Chinese are evolving in their brand taste.  They are saying good bye to the flashy giant Gucci and Louis Vuitton logos and focusing more on brands that better represent China and their culture.  In addition, they are saying goodbye to the mainstream brands and moving towards a higher degree of exclusivity.  The knockoffs are starting to fade.  Status seems to be important throughout the history books.  The new status symbol is sending your kids to elite boarding schools in the U.S.

The emerging middle class in China is growing strong at 875M people.  The growth rate is high and they have a higher degree of confidence than the middle class.  They plan on buying houses, cars, and traveling in the future.  There is a changing dynamic going on in travel.  Its seems as though the middle to upper class are looking for places that are more exotic where other Chinese haven’t been.  Think New Zealand, Maldives, Mauritius, or South Africa.  Paris and Rome have become too common just like the mainstream clothing brands.  They don’t want to just copy westerners any longer.  They want brands specific to China.

Food safety is a driver of consumer spending.  KFC in the 90s is a great example.  The Chinese are going to pay a premium for food and health to help offset the issues with pollution.  Stay far away from the street vendors, at least the ones that don’t have anyone in line.


Upcoming Book Club Schedule:

March 17, 2015: Bust: Greece, the Euro and the Sovereign Debt Crisis by Matthew Lynn

April 21, 2015: The Forgotten Depression: 1921: The Crash That Cured Itself by James Grant

May 19, 2015: How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

Sign up for a future book club event.

New Member and Volunteer Recognition

On Jan. 22, 2015, CFA Society Chicago held its annual New Member and Volunteer Recognition Party in the amazing rotunda of the Chicago Cultural Center. Hors d’oeuvres and cocktails were served beneath the world’s largest Tiffany glass dome—measuring 38 feet in diameter! The dome was restored in 2008 to reflectdome its original 1897 splendor that includes Tiffany Favrille glass cut in the shape of fish scales with signs of the zodiac lighted electrically at night. Originally used as the first Chicago Public Library, the dome contains an inscription by British essayist, poet, playwright and politician Joseph Addison which reads, “Books are the legacies that a great genius leaves to mankind, which are delivered down from generation to generation as presents to the posterity of those who are yet unborn.”

Christopher Vincent CFA, Chairman – CFA Society Chicago, welcomed 128 members, staff and volunteers to the evening’s festivities and recognized 48 new members to the Society. Chris discussed the critical importance of volunteering for CFA Chicago and gave a tip of the hat to Alan Meder, CFA, who once displayed his high regard for volunteers by simply saying, “You are a volunteer and volunteers make our organization work!”

Chris went on to say that our job is to be relevant in an industry that is mature and, at times, challenged. He encouraged the members to do this by identifying, leading, recruiting and mentoring new volunteers. He also recognized several of the incredible women leaders within the Society for their amazing contributions including leaders like Kerry Jordan, CFA, CFA Chicago Vice Chair, RMB Capital Management, Joan Rockey, CFA, CFO Castleark Management LLC, and Heather Brilliant, CFA, CEO Morningstar Australasia to name a few.

The volunteers listed below were recognized for their outstanding 2014 contributions in the following areas:

  •  Annual Dinner – Tim Holt, CFA
  • Candidate Services – Rebecca Smith, CFA
  • Career Management – Jenifer Aronson, CFA
  • CFA Women – Marie Winters, CFA
  • Communications – Bob Mudra, CFA
  • Education Seminars – Andy Feltovich, CFA, Garret Glawe, CFA and Tom Hillman, CFA
  • Distinguished Speaker Series – Patrick Bourbon D’Ingrande, CFA
  • Outreach & Member Development – Sitram “Ram” Gundapaneni
  • Social Events – Daniel LeKan, CFA

The evening concluded with a raffle and door prizes from a variety of Chicago favorites including Chicago Marriott Downtown Magnificent Mile, Giordano’s – Famous Stuffed Pizza, Jason’s Deli, Phil Stefani Restaurants, Potbelly Sandwich Shop, The Metropolitan Club, The Standard Club, and Union League Club.

CFA Staff members Larisa Bezak and Kim Augustyn, CMP ensured that only one raffle entry per person was allowed (this is still Chicago after all). And they even provided impromptu childcare for a portion of the program. Thanks again to our dedicated CFA Staff who will do (and have done) almost anything to keep things running smoothly!

Distinguished Speaker Series : James Bullard

James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, spoke to a packed room at the Standard Club on Jan. 16 about Federal Open Market Committee macroeconomic forecasts. His presentation was also transmitted via a live webcast.

The first problem is that all forecasts are required to be based on “appropriate monetary policy assumptions.” But what assumptions are appropriate, asked President Bullard? One could assume that no policy changes occur. Another forecaster could instead include the monetary policy changes that she prefers—and maybe have overly rosy scenarios to show that those policies would work very well. To the contrary, another forecaster could try to incorporate his expectations of the FOMC decisions—and predicting a dire economic situation if he does not agree with the FOMC consensus.

Clearly, there is no perfect way. But this is not an academic endeavor, the speaker emphasized, because these forecasts are necessary to inform monetary policy decisions.

Bullard went over the FOMC forecasts on GDP, inflation, and unemployment for the last few years. There are 12 Fed Presidents and up to seven Governors, providing 19 forecasts. Looking at averages, the FOMC for the last two years got GDP about right, while its forecasts for unemployment were pessimistic and those for inflation too high. The speaker joked that erring on the same side for two years in a row is pretty bad.

The implications for monetary policy, given low inflation and shrinking unemployment, are that there is no change expected to the FOMC rate-raising path because inflation and unemployment balance each other.

Bullard allowed plenty of time for questions. Here is a summary:

  • The FOMC would prefer to arrive at the next recession with a non-zero Fed Funds rate, but if this does not happen they can do another QE. He would prefer to be able to cut rates so he’d rather increase rates in 2015 and if the economy slows down they can always cut.
  • Wages are a lagging indicator because unemployment must move a lot before wages move. Moreover, corporations do not cut wages in recession and therefore are slow in raising wages in expansions.
  • The fall in participation rate is largely explained by demographics. Participation peaked around 2000 and is expected to not increase by a lot.
  • Headline inflation is a better measure than core inflation because food and energy are what people buy every day. If we are concerned about volatility we should use trimmed measures such as the Dallas Fed’s and not exclude stuff that people buy regularly.

Chairman’s Message

I hope you enjoyed a great holiday season, and 2014 was a fulfilling year for your career.  It is the halfway point of CFA Chicago’s fiscal period, which makes a good time for us to review the strategic themes we established in July; and also to tell you about changes underway and upcoming events.

From the staff direction viewpoint, Shannon Curley, CFA, joined us in mid-December as Executive Director of CFA Chicago.  He brings a wealth of financial services knowledge to our organization.  In addition, he has had a distinguished career in the investment management profession.  I encourage you to introduce yourself to him at an upcoming event.

With respect to creating original content for our members, I want to highlight the Career Management Advisory Group’s work.  In particular, Co-Chairs Joan Rockey, CFA, and John Mirante, CFA, and their talented group, have undertaken a long-term project called “Career Map.”  This is an ambitious idea with multiple stages.  Importantly, it is designed to outline the industry jobs and career opportunities in our Chicago market.  Given the mature nature of domestic asset management, creating a taxonomy of companies, industries/asset classes and newly evolving job assignments will have multiple uses, including assisting you in navigating and maximizing your investment career.  More information will be shared as the project develops.  We welcome CFA Chicago members that are interested in participating in this project with the Career Management Group Advisory Group. Sign up today.

Another team pursuing a big agenda is our Education Advisory Group.  Under the direction of Marie Winters, CFA, and Larry Cook, CFA, we will host a Latin American Investment conference this May.  As you know the global nature of our profession warrants our continual search to learn, grow and seek evolving investment opportunities.  I hope you are able to attend this unique, mid-west opportunity to expand your acumen of countries, industries and companies in South America.  I view this single event in the context of a longer term portfolio of seminars which CFA Chicago will pursue over the next decade.

I would be remiss if I didn’t mention CFA Institute’s upcoming first Annual Women in Investment Management Conference in San Antonio, June 2015.  Our society has been at the vanguard of advancing women in finance and has made demonstrable progress in this effort. CFA Chicago Vice Chair, Kerry Jordan, CFA, has been instrumental in this endeavor. Among those speaking at the conference will be CFA Chicago Past Chairman Heather Brilliant, CFA, and CFA Chicago Secretary/Treasurer Carmen Heredia-Lopez, CFA.

Lastly, let me acknowledge our Immediate past Chair Gautam Dhingra, CFA, and his wisdom in leading our Governance & Nominating committee.  The work of our Governance & Nominating group is vitally important, and in great hands as we build a future team of leaders.  If you know someone that would make a great leader – or if you’re interested in serving, please review the nomination process and selection criteria and complete the nomination form. To be considered for the 2014-2015 Board of Directors, complete the nomination form before 5:00 p.m. Wed., Jan. 14, 2014.

A Balancing Act: Career Management and Searching for a New Role

On Dec. 9 the University Club in downtown Chicago was the venue for this event geared toward job DSC_1478seekers in the investment profession hosted by CFA Chicago and the Career Management Advisory Group.

The panel members and moderator consisted of:

Katie Banks – Senior Vice President & Director of Human Resources, Institutional Capital LLC
Danielle Dutcher – Vice President, Global Talent Acquisition, Northern Trust
Laura Pollock – Founding Partner, Third Street Partners
Jim Schroeder – Executive Vice President, DHR International

Jacqueline Benitez – HR Director; Segall, Bryant & Hamill

Jacqueline Benitez served as moderator.  She made it clear that the panel would focus on four key issues when searching for a new role.

  1. Resumes
  2. Networking
  3. Interviewing
  4. Compensation


The consensus of the panel was that the resume should be brief and preferably bullet point. The recruiter should be able to evaluate the resume in less than 15 seconds.  Several of the panelists did not think a “summary” section was necessary, as that information should be found in the cover letter.  All panelists preferred information on resumes that were more quantitative than qualitative. Panelists stressed that for those candidates who have spent many years at the same firm, career progression in the form of responsibilities or job title changes should always be included.


The panelists viewed networking as a practice that should take place throughout a career because you never know when you need your network. One of the most optimal ways to find a position is to network with someone at a firm you would like to work for. Linked-In can also be an essential tool in your network.  It is important to do your homework concerning your target company when networking.  Do not be shy about the using the phone once you find who the key people might be, and if available use a land line.


When answering questions, it is important for the candidate to think not only about the question but also about the audience.  The panelists advised candidates not to be afraid to pause to collect their thoughts prior to answering.  It is a good idea to ask “was that helpful?” at the end of your answer.  The candidate should always have some questions prepared for the interviewer and rehearse answers to questions that the candidate should expect from the interviewer.

The recruiters stressed that conservative dress is very important.  The panelists suggested that women not use a lot of makeup, always wear a jacket, and that heals not be over two inches.  Men are encouraged to wear a white shirt, red tie and dark suit.   It is always a good idea to ask the recruiter about dress prior to the interview.


Most positions will have price range bands that vary with geographical region. Panelists advised that to get the most out of this negotiation it is best to be transparent and confident. If your compensation requirements do not fit into the band, it is important to know that upfront.  Compensation may also feature a significant amount of deferred compensation which is also critical for the candidate to evaluate.

Once you obtain an offer it is important to express your excitement about starting in your new position.  You then should have an “ask” concerning compensation with a reason why you need it.  When negotiating salary, it is important that you be concise and have a number in mind.  Some recruiters will ask for a pay stub from your current job to verify salary.

CFA Exam Study Group Kick-Off Party & Open House

For the 11th consecutive year, signaling the start of another exam preparation season, CFA Chicago and the Candidate Services Advisory Group, along with Kaplan Schweser hosted a Study Group & Exam Preparation Party at the Standard Club on Dec. 11.DSC_1499

The reception gave chance for approximately 60 candidates comprising all three exam levels to mingle over light refreshments.  Patrick Hager, CFA, began the formal agenda with a description of how the Study Group program works, timeline for formation of groups and application for exam scholarship. He emphasized the importance and benefits of the CFA Charter and becoming a candidate member in the Chicago Society. Benefits of membership include the chance to participate in mock exams as well as two scholarship opportunities offered by offered by CFA Chicago.

An important exam reminder shared was to bring a passport to the exam, because a driver’s license is not accepted as a form of identification.

Dr. Tim Smaby, CFA, FRM, who heads the CFA exam DSC_1504section for Kaplan Schweser, gave an informative overview of the CFA Level 1 exam, while also acknowledging the nuances of Levels 2 and 3. He believes it is important for candidates to support one’s preparation by emphasizing practice and performance. In his opinion, too many candidates over-prepare yet under-practice answering questions. Smaby’s advice is to take advantage of the volume of practice questions available once the core readings are completed and to simulate game day conditions in taking practice exams.

Following Smaby’s talk, a Q&A session was held. CFA Chicago members and charterholders Jim Meixner, CFA; Rebecca Smith, CFA; and myself fielded questions from the candidates. After an introduction and each panelist giving their key tip for success, questions were asked regarding exam and study strategies including how to best approach structured response questions on the Level 3 exam.

Learn more about exam preparation and discounts.

Chinese Shadow Banking: Crisis or Correction?

© leungchopan, Fotolia

© leungchopan, Fotolia

CFA Society Chicago recently worked with the Chinese Finance Association and The Paulson Institute to explore the risks and rewards of the Chinese shadow banking system. On behalf of CFA Chicago’s Education Advisory Committee, Peter Cook, CFA, welcomed the audience to The Conference Center in UBS Tower for this exceptional opportunity to hear straight talk from three leading experts on China’s economy—while asking if Chinese shadow banking is “a valuable new source of funding, a replay of US subprime lending or somewhere in between?”

The discussion was moderated by Evan Feigenbaum, Vice Chairman, The Paulson Institute, who holds a PhD in Chinese politics from Stanford University and has served at the US State Department as Deputy Assistant Secretary of State for South Asia and as an adviser on China to Deputy Secretary of State Robert B. Zoellick. Feigenbaum orchestrated the dialogue between Patrick Chovanec, Managing Director and Chief Strategist, Silvercrest Asset Management which manages $16.6 billion on behalf of wealth families and selected institutions and Andy Rothman, Investment Strategist, Matthews International Capital Management, LLC which has $27.9 billion in assets under management with a focus on investments in Asia.

Before joining Silvercrest, Chovanec was an Associate Professor of Practice at Tsinghua University’s School of Economics and Management in Beijing, where he also served as Chairman of the Public Policy Development Committee for the American Chamber of Commerce in China, and advised numerous governments, investment funds, and Fortune 500 corporations on the Chinese economy. Rothman spent 14 years as CLSA’s China macroeconomic strategist where he conducted analysis into China and delivered his insights to their clients and spent 17 years in the U.S. Foreign Service, with a diplomatic career focused on China, including as head of the macroeconomics and domestic policy office of the U.S. embassy in Beijing. You can also follow “Sinology by Andy Rothman” at Matthews Asia.

What is shadow banking?

Shadow banking sounds menacing and even experts disagree on a common definition. Yet, shadow banking is generally understood to include a wide set of “non-bank financial intermediaries.” These alternative financiers include asset managers, money market funds, real estate investment trusts, and leasing companies that provide non-bank lending to a variety of customers. Jamie Dimon, CEO JPMorgan Chase, described shadow banking in his 2013 Letter to Shareholders as follows:

We really should not call them “shadow” banks – they do not operate in shadows. They are non-bank financial competitors, and there is a wide set of them. They range from money market funds and asset managers, mortgage real estate investment trusts and mortgage servicers, and middle market lending funds to PayPal and clearinghouses. Many of these institutions are smart and sophisticated and will benefit as banks move out of certain products and services. Non-bank financial competitors will look at every product we price, and if they can do it cheaper with their set of capital providers, they will. There is nothing inherently wrong with this – it is a natural state of affairs and, in some cases, may benefit the clients who get the better price (p. 18).

As a primer on shadow banking, I’d recommend the 14-page special report on international banking entitled “The lure of shadow banking” in the May 10th-16th edition of The Economist which provides a thorough discussion of the key terms, players, instruments and macroeconomic issues. The report explains that “shadow banking” was originally coined by PIMCO’s Paul McCulley in 2007 to describe the legal structures used by Western banks to keep complicated securitized loans off their balance sheets. As we painfully learned during the financial crisis, many of these securitized loans went bad and had to be bailed out by the banks—and then the banks needed to be bailed out by taxpayers. Today, many regulators view shadow banking as a positive way to shift risk away from banks to other entities that are willing to assume that risk.

Some of the major “private-debt” market players cited in The Economist report include Apollo Global Management, BlackRock, the world’s biggest asset manager with $4 trillion under management, Blackstone, The Carlyle Group, Cordiant, KKR,M&G -Prudential plc and Oaktree Capital. See also Private Debt Investor Magazine. Furthermore, bond markets continue to grow as the largest source of non-bank financing. Peer-to-peer (P2P) lenders like The Lending Club are finding their own niche. And Alibaba, the Chinese e-commerce giant, launched a new money-market fund last June which raised 500 billon yuan ($81 billion) in its first nine months.

Chinese Shadow Banking Instruments

Turning to China, Chovanec explained that four years ago Chinese shadow banking was referred to as “informal lending.” And he pointed out that shadow banking isn’t necessarily from an entity that’s separate from the formal banking system in China. As Rothman noted, “every bank in China is a ‘fake’ bank because they are all controlled by the communist party.” To the extent that the Chinese government bails out its shadow banking system then risk is not properly priced and moral hazard continues to exist. With that in mind, instruments of concern within the Chinese shadow banking system include trusts, entrusted loans and trust beneficiary rights products (TBRs). (See “Shadow banking in China: Battling the darkness” The Economist, 10 May 2014 “Every time regulators curb one form of non-bank lending, another begins to grow” Web. 10 May 2014.)

Trusts: Risky investments promising returns of 10% – 13% with no guarantee of a return on investment or even the return of principal. Often sold through banks, like the China Construction Bank, with an air of respectability, however, investors may generally still believe that the government will step in and protect them in the event of a default. Trusts have fueled the expansion of credit and swelled from 3 trillion yuan at the end of 2010 to almost 11 trillion yuan at the end of 2013. Over $400 billion of trust products are due to mature this year which are primarily secured by property. See the discussion of Jilin Trust, a Chinese shadow bank, which sold securities to Chinese investors backed only by loans to Liansheng Group which owns the struggling Zhuang Shang coal mine in Liulin and is now restructuring 30 billion yuan of debt in “China: A question of trust. Or not, as the case may be.” The Economist, 10 May 2014 p. 13.

Entrusted Loans: Cash rich companies, often state-owned enterprises (SOEs) lend directly to less well-connected firms. These loans often use banks as intermediaries to get around regulations forbidding such lending.

Trust Beneficiary Rights Products (TBRs): Chinese banks set up firms to buy loans from a trust and then sell rights to the income stream from the loans to a bank. Riskier corporate loans look like safer lending between banks and provide a way around the restrictions between banks and trusts. TBRs may be sold to other banks.

The Unstoppable China Growth Story: Evan Feigenbaum

Feigenbaum set the stage by emphasizing, “for all of its successes the unstoppable China story must be more balanced.” He observed that China’s own leaders have recognized imbalances, distortions and structural weaknesses in the economy. Feigenbaum says, “the popular story of China moving from growth to growth to more growth must be moderated.” Chovenec agreed and noted, “lots of legitimate economists question the GDP numbers in China.” There are a lot of truths in the China growth narrative but Feigenbaum points out, “it’s being driven by a state capitalist juggernot.” To that end, Feigenbaum warned, “in China, the politics of reform is an execution challenge of monumental proportions.” He then directed the conversation to Andy Rothman who provided the more optimistic view of China’s economy and shadow banking system followed by Patrick Chovanec who shared a more cautious view.

I would add, as shown below, that China is the second largest economy in the world and its GDP has grown from about $2.5 trillion dollars per year in 2005 to $9.2 trillion in 2013 at a compound annual growth rate of nearly 17.7% over the eight-year period.

Andy Rothman: “The Bull”

Rothman quickly pointed out that China has become a very competitive entrepreneurial economy over a very short period of time. In fact, the rise of private sector employment vis-à-vis state-controlled employment is China’s most important trend and now represents 80% of urban employment. Although China’s GDP growth must inevitably slow, Rothman says remember the “base effect” which means that slower growth on a larger economic base is still a very good thing. And China is already the world’s best consumption story with 9.1% YoY real annual consumption growth between 2009 and 2013. However, consumption was a small portion of GDP due to investment growing even faster than consumption. And Andy noted that investment growth has been slowing, from an average of about 25% for the nine years through 2011 to about 16% this year. He points out that China has more than 150 cities with a population of 1 million or more and the United States has only 9 cities of that size.

Property Market

In regards to the widely publicized stories about Chinese “ghost cities” (See Leslie Stahl’s CBS 60 Minutes report on China’s Real Estate Bubble) where properties are built but lack occupancy, Rothman says it’s greatly exaggerated; there are some failed projects, but the number is not large enough to signal a systemic problem. He also pointed out there is a different business model in China; properties are pre-sold one to two years before completion and then occupancy lags 3 to 5 years as additional infrastructure is completed. And he observes that 90% of new home buyers are owner-occupiers rather than speculators as shown below:

Shadow Banking Scale and Scope

Rothman explained that trust lending was essentially shut down by regulators during the first three quarters of 2014. Since The China Banking Regulatory Commission(CBRC) regulates both banks and trusts many feel the government has the necessary oversight to control trusts. Rothman clarified that there are only 69 trust companies operating in China and they are highly regulated, not allowed leverage and have loan-to-value ratios of 30% at most. Given the scope of the sector, he does not predict a major financial crisis in the trust sector. Some trust products will continue to fail, but given their relatively small size, as well as the absence of leverage and secondary securitization, a systemic crisis similar to that in the US is very unlikely. As shown below, shadow banking in China is just below 20% of broad money liabilities and most “shadow” institutions are Party-controlled, whereas it represents about 60% in the Eurozone and about 100% in the US.

Finally, Rothman notes that the toxic collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), asset-backed securities (ABS) and mortgage-backed securities (MBS), at the heart of the 2008 financial crisis don’t exist in China so he doesn’t predict another “Lehman Moment.”

Patrick Chovanec: “The Bear”

Patrick Chovanec spent more than a decade living and working in private equity in China. He has been a “China bull” but now reports that most of his hedge fund friends are very bearish on China. Chovanec’s concern is that, in the wake of the 2008 financial crisis, China did not adapt but rather continued to engineer a credit and investment boom.

Chovanec asserts that China’s export-led growth model isn’t really about net exports driving growth as much as it is about “turbocharging” investments. The model works like this: poorer countries use their poverty and low wages to tap into gross exports and, given the low domestic consumer buying power, they can then justify more investment in the economy. Significant Chinese imports of machinery and raw materials are then used to meet external demand. It’s the same model used in Japan, Southeast Asia and Taiwan. However, Chovanec points out that if you produce more than you consume someone else must consume more than they produce. So the model can reach its limits as we’ve seen with China’s recent decline in GDP growth as US and European demand has declined. Chovanec feels it’s very problematic for China to continue fueling investment with credit when it can’t tap external demand.

Market Reform, or not?

At first, Chovanec believed that Chinese shadow banking was a positive story that would address issues the formal banking system could not. In theory, since private investors could lose money, there would be more accountability. Therefore, risk should be priced properly and the cost of capital would appropriately reflect those risks.

Yet, Chovanec says, “the PBOC thinks this is market reform and a backdoor method of creating a bond market to move away from bank-centric loans. However, it’s taking place in the context of moral hazard.” Chovanec goes on to say, “issuing lots of bonds does not a bond market make.” Chovanec explains that risk must be priced properly to make a bond market function well. And if the only question people ask is whether or not their investments will be bailed out then they are asking the wrong question. He says, “very few people care about the underlying asset. Instead, they are just investing and expecting those investments to be guaranteed by the state balance sheet—and that creates moral hazard.”

Chovanec is also concerned about the issuance of the corporate bonds, which are held to maturity by the banks, as local government financing vehicles. He points out that they are just like a bank loan without the capital requirements and deposit support behind them. Since interest rates are too low to attract deposits to make loans the trust sector originates the loans, and collects a fee, but is no longer responsible for credit. Chovanec’s concern is that these losses are not allowed to flow through the system and that people need to lose money for the system to function properly.

Property Markets

In the property market, Chovanec questions Rothman’s data that 90% of new home buyers are owner-occupiers. Chovanec believes the figures are too high and says, “selling agents report the data.” He believes real estate is widely used as a speculative investment because the Chinese don’t have alternative investment options. Ultimately, Chovanec says there are “hot zones and dead zones” in the real estate market and many people are speculating on the next “central business district” (CBD). He believes the market-clearing price to move into many of these properties is well below what a lot of people have paid in and they are not profitable for developers.

A Correction Without a Correction

Chovanec thinks the China Banking Regulatory Commission (CBRC) knows the right thing to do but says, “they want a correction without a correction.” Chovanec notes, “the CBRC said they were going to crack down on pooling but pooling has never ended.” Pooling is the practice of paying out on existing investments using money coming in from new investments—essentially a Ponzi scheme. Chovanec maintains that China’s banks have to pool or else default so the CBRC continues to allow pooling. On the bright side, he feels China’s recent Third Plenum, which called for 60 market reforms, is directionally correct.

Fundamentally, Rothman and Chovanec disagree about the level of bad debt in the Chinese economy. Chovanec says there is mounting bad debt that is repackaged, reissued and recycled—causing dead weight. And he feels Rothman underestimates the extent to which the banks are playing with their balance sheets. He points out that cash obligations are not properly reflected on balance sheets and we can only guess at them. In fact, there has not been enough liquidity to meet those needs. And Chovanec points to June and December of 2013 when the interbanking system nearly broke down. He observes leakage to off-balance sheet “stuff” such as interbank loans that are renamed as something else – then brushed under the rug. Chovanec feels all of the banks need to be recapitalized and that the losses can be socialized.

Chovanec doesn’t think there will be a “Lehman moment” in China because “they are all backed by a state-owned bank.” Instead, Chovanec thinks the steady stream of defaults will lead to the creation of a “zombie bank” like The Long-term Credit Bank of Japan (LTCB). Chovanec explained that LTCB sat on bad debt and was an immense drag on Japan’s economic growth. And he quipped, “a loan isn’t bad if you don’t insist on repayment.”

Chovanec maintains that the qualitative story on Chinese shadow banking is even more important than the quantitative story. He reminds us that many people thought the size of the US subprime sector was not too bad but they missed all of the interconnections to other parts of the financial system that were so important. Chovanec explains that nearly all Chinese lending was from banks four years ago and now even businesses and wealthy individuals are making loans and extending credit.

In conclusion, Chovanec believes, “a significant and disruptive adjustment needs to take place to put them [China] on the right path.” He feels an economic adjustment would be a positive thing for China and that it can afford to consume more than it produces. Chovanec wishes that this adjustment had begun in 2010 but instead believes the explosion of financial instruments we’ve seen in China will be problematic.

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Barry Sternlicht was the featured guest at the Distinguished Speakers Series held on Nov. 21 at the Standard Club.  Sternlicht is the Chairman & Chief Executive Officer of Starwood Capital Group, a private investment firm he formed in 1991 focusing on global real estate, hotel management, oil and gas, energy infrastructure, and securities trading.

Using an inordinate number of slides Sternlicht gave a sweeping account of just about everything that related to the global economy.  His remarks covered a range of investment topics including; the domestic housing market, New York City property prices, currencies, quantitative easing, oil prices, global real estate valuations, and the 2015 outlook for the U.S. and global markets.

A subset of Sternlicht’s presentation comments included:

  • The top 1% are getting richer in all markets. This subgroup of the investing population is no longer willing to solely invest in domestic or global markets.  Instead, these investors are now buying up real assets in prime locations – South Americans investing in Miami, Asians investing in New York, Russians investing in London, etc.  These global buyers are pushing higher purchase prices in these ‘world class’ cities.  As a result, buyers looking for reasonably priced real estate will have to look to ‘second tier’ cities.
  • The U.S. government deficit will continue to grow despite the spending bill passed at the start of 2014. Entitlements – Medicare, Medicaid, and Social Security will increase the deficit dramatically over the next decade.  To combat this the retirement age will be raised, and benefits will be reduced.
  • The movement of populations from high tax states to low tax states will accelerate as more baby boomers retire. This will drive real estate growth in those low tax states and provide for slow or even negative growth in high tax states.
  • Growth in retail rents is and will continue to be bifurcated. Luxury retail malls will continue to outperform in terms of high occupancy rates, and growth in rents.  Properties that are not at the A level will likely exhibit slow or flat growth in rents.
  • The Euro zone and Japan will institute their own form of quantitative easing. This will cause the dollar to rise against the Euro and Yen.  The U.S. has promoted a weaker currency over the past several years with lower interest rates and growth in the money supply.  The stagnating economies in Europe and Japan will push policy makers to weaken their own currencies in an attempt to reflate their respective economies with increased exports.  Even so, a greater currency war will be fought over the next several years with many nations fighting to have a weaker currency.
  • The Federal Reserve will keep interest rates lower for a longer period due to a lack of any inflation on the horizon and lower energy prices. In addition U.S. yields are higher than in Europe and Japan, which will cause flows into the U.S. market, keeping the long end of the curve depressed.

Sternlicht ended his presentation by taking questions from the audience and sharing details of his latest hotel and apartment project – the ultra-luxury Baccarat Hotels and Resorts development in midtown Manhattan.  This development underscored several of the points Sternlicht made earlier – premium properties commanding outsized rents, and investing in world-class cities for outsized returns.

CFA Society Chicago Blog Launches

Dear Colleagues,

Today we are excited to announce the launch a new chapter in the history of CFA Society Chicago the – CFA Society Chicago Blog.

The Communications Advisory Group developed this new communication tool, populating it with event news, speaker recaps, society news and more.  As the blog continues to grow, I invite you to submit articles that address current trends and research in the investment industry.  This blog will also be an exciting part of the society’s 90th anniversary celebration, starting in 2015.

Browse the blog and read about our great events. And CFA Chicago members – consider joining the Communications Advisory Group.


Communications Advisory Group

CFA Society Chicago

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Are stocks overvalued?  Not according to Chicago native Jeremy Siegel.  The Wharton professor and author often described as a “perma-bull” took a sanguine view towards the equity markets in his CFA Chicago presentation, saying that while stocks are the most volatile asset in the short run, they have proven to be most stable asset in the long run, producing an average real return of 6.7% since 1802.

When Dr. Siegel delivered his keynote address to the CFA Chicago Society’s annual dinner in 2011, he described stocks as “undervalued”.  Since then, the S&P 500 has returned nearly 63%.  Slightly less prescient was his prognostication regarding bonds, which he believed to be overvalued at the time.  In his booming, enthusiastic style, Siegel spoke highly of stocks, saying that “In every country in the world, stocks have slaughtered fixed income over the long run”.

One of the most interesting anecdotes Siegel told was around his tenuous media relationship with fallen bond titan Bill Gross.  In Gross’s August 2012 Investment Outlook piece, the former PIMCO portfolio manager wrote that “the cult of equity is dying” and identified Dr. Siegel as the leader of that cult.  “I’ve had my differences with Bill Gross over the years,” Siegel lamented to chuckles in the audience, noting that Gross’s ill-timed call preceded a massive run-up in equity prices.

Turning his attention towards the subject of valuation, Dr. Siegel used the price to earnings multiple over a long time horizon to show that the current market valuation isn’t very far from the norm.  Taking the analysis a step further, Siegel stated that removing high interest rate periods from the PE calculation would indicate an even higher average multiple, suggesting that the market could potentially be undervalued even after nearly doubling from the March 2009 low.  Dr. Siegel then issued a rebuttal to his friend Robert Shiller’s popular Cyclically Adjusted Price to Earnings (CAPE) ratio, stating that in 392 months out of 396 months from 1981 to 2013, the actual 10 year real market returns have exceeded CAPE forecasts.  The CAPE ratio even characterized the S&P 500 as overvalued in May of 2009 when the Dow was at roughly half of its current value.  FASB accounting rulings also affect firm earnings (and thus PE ratios) by requiring firms to write down, but never “write up” investments.  This phenomenon was observed in 2002 due to the acquisition of AOL by Time Warner where the subsequent $99 billion write down produced the largest loss in corporate history, further distorting reported S&P 500 earnings.

Lastly, Dr. Siegel addressed the way the Standard and Poor’s aggregates S&P 500 earnings, saying that the earnings number they report can be wildly distorted due to the firm not cap-weighting each company’s share of profits and losses.  Instead, Dr. Siegel offered National Income and Product Accounts (NIPA) as an alternative earnings measure.  When NIPA earnings are used in the Shiller CAPE ratio, the market shows no overvaluation at all.  Attendees were left with plenty of food for thought around markets and valuation, and Dr. Siegel again delivered an excellent talk.