The US commercial real estate (CRE) sector is experiencing heightened concerns due to increasing interest rates and diminishing credit availability. In the third quarter, US banks faced challenges from the CRE loans in their portfolios. For instance, Morgan Stanley allocated an additional $134 million for credit losses, in addition to the $161 million provisioned in the previous quarter, attributing this to worsening conditions in the CRE sector. Bank of America saw its nonperforming loans surge by $707 million, reaching $4.8 billion in the third quarter, driven primarily by CRE.

While it might seem like the entire sector is facing turmoil, it is important to note that CRE includes a wide range of assets. Segments like industrial, retail and hotels remain relatively stable, whereas offices spaces are facing substantial difficulties.

JLL reports that the US office vacancy rate has soared to 21%, a peak not seen in over 25 years as of Q3 2023. The imbalance between supply and demand is reflected in the 18.3 million square feet of negative net absorption, contributing to an annual total occupancy loss of 51 million square feet, although the vacancy rate differs significantly between the high-quality segment of the office market and the more obsolete ones.

Furthermore, the Trepp CMBS Special Servicing Rates for offices, which tracks the share of loans at risk of default, surged to over 8%, the highest since May 2017. This increase suggests more challenges ahead.

The sector also faces a huge refinancing hurdle. From 2023 to 2025, nearly $1.36 trillion in CRE loans will mature, a quarter of which are collateralized by office properties. Even with prevailing rates, new lending rates are likely to be 3.5 to 4.5 percentage points higher than existing mortgages.

The combination of high vacancy rates and rising interest rates complicates refinancing efforts. Lenders and CMBS investors have significantly tightened underwriting standards, pushing the loan-to-value (LTV) ratio to around 53%, the lowest in 23 years, and well below the historical average of around 65%.

This shift and higher financing costs could devalue office properties by around 20% for prime buildings and over 60% for lower-quality ones. While public market valuations are resetting, the private market has been slower to respond. A narrowing valuation gap between these markets is expected as risks persist.

The increase in office landlords defaulting on loans is concerning, with some properties falling below their mortgage values, prompting landlords to surrender properties to lenders. Even leading office owners like Pacific Investment Management Co. and Brookfield defaulted on their mortgages earlier this year. Most landlords have managed to maintain their mortgages due to typically long-term office leases, but as more mortgages come up for renewal, we expect an increase in defaults.

The typical capital structure in CRE is around 30% to 40% equity and 60% to 70% debt, with banks owning around 60% of the loans. Therefore, there is concern that the challenges in the CRE, especially the office sector, may trigger another banking crisis.

The basic problem is an oversupply of office space. Solutions like converting office spaces to residential use are being discussed, but only 10% to 15% of US offices are suitable for residential conversion. Government support may be necessary to incentivize and facilitate these conversions. Cities like Boston, New York, Washington DC, Chicago, Portland, Los Angeles and the Bay Area have already started incentivizing office conversions since the pandemic.

In our portfolios, we hold a few positions with exposure to commercial real estate:

IWG, which we talked about in a recent commentary, is the world’s largest provider of workspace solutions. While the growth outlook for traditional offices is in question, demand for flexible workspace has been growing, driven by the structural growth in flexible and hybrid working. Higher vacancy rates at office buildings also allow IWG to negotiate better lease terms with landlords. With a major competitor WeWork fading out of the landscape, IWG is well-positioned to expand its network.

Savills, established in 1855, is a leading global real estate advisor with expertise in various segments including residential, office, industrial, retail, leisure, healthcare, rural and hotel property, and mixed-use development schemes. Its revenue is diversified, with 40% from transaction advisory (30% commercial, 10% residential), and 60% from stable segments like investment management and property management. Despite a decline in transaction advisory business in the first half of the year, revenue growth in property management has kept its business relatively stable. Savills generates over 85% of its revenue from the UK, Asia Pacific, Continental Europe and the Middle East, with less than 15% from North America. Office occupancy rates are higher in Asia Pacific (79%) and Europe (75%) compared to the Americas (50%), suggesting less distress in these regions. Savills has a strong balance sheet to weather the current turbulent times.

The hotel sector, while hit hard during the pandemic, is recovering faster than offices. With international borders reopening and a surge in travel demand, hotel occupancies, especially in cities like London, New York and Tokyo, are improving and contributing to a strong investment outlook supported by fundamental performance.

Melia Hotels, a major holding in our strategies, is seeing strong bookings and improvements in occupancies and RevPAR. The company operates 350 hotels, with nearly 92,000 rooms globally. Despite its quality assets, it is trading at a significant discount to its net asset value, but increasing transaction volumes in the industry at higher multiples may reduce this discount.

We recently initiated a position in Hoshino Resorts REITs (HRR). Sponsored by Hoshino Resort, HRR has an extensive hotel portfolio, including upscale resorts and city hotels. Its flagship hotels managed by Hoshino Resorts show a strong recovery, with RevPAR 20% above pre-pandemic levels.

Despite ongoing challenges in the CRE industry, we believe the resilient business models and strong balance sheets of the companies in our portfolios will help them navigate these difficulties.

Within the emerging market universe, plenty of ink has been spilt on extreme pessimism regarding China and over-the-top optimism around India. Yet, as the following chart shows, small-cap stocks in Mexico have quietly been a top performer in the post-pandemic period.

Mexico’s unforeseen rise 

Growing tension between China and the US has positioned Mexico as an unintended beneficiary due to its geography and the trend among companies to shock-proof their supply chains through nearshoring.

Will this time be different? 

As noted in an earlier weekly, we recently met with companies across various sectors in Mexico and most of the executives we spoke to seemed convinced that the nearshoring wave was sustainable while also being realistic about the challenges ahead.

They have good reason to be pragmatic. The last time the economic stars aligned for Mexico via NAFTA (North American Free Trade Agreement) in 1994, the country delivered mediocre growth of around 2% and watched on the sidelines as China took full advantage of a shift in manufacturing from the West. The question now is if the outcome will be any different this time. 

The nearshoring challenge trifecta 

Mexico’s ascent as a key supplier to the US can be traced to three key events: Trump’s tariffs on China in 2018, the US-Mexico-Canada Agreement (USMCA) that raised the bar for North American product content requirements and pandemic-induced supply chain disruptions. These factors, coupled with deteriorating US-China relations, have led to Mexico surpassing China as a supplier to the US this year.

However, as emerging market investors, we know that structural tailwinds that are attractive and advantageous today don’t preordain good outcomes. Our conversations with Mexican executives at the recent LatAm conference gave us a good reality check on the constraints they face on the ground, from infrastructure and water supply to the political climate. 

Electric dreams, grounded realities

While Mexico generates sufficient power, it struggles with inadequate transmission infrastructure in its north that hinders industrial growth. We spoke to two industrial REIT developers that had to build their own power systems, passing those costs to customers. For perspective, Mexico’s state utility, CFE, built 150 kms of transmission lines in 2022 compared to Brazil’s Electrobras’ 8,679 kms. 

Parched prospects

Water availability is another constraint, especially in Nuevo Leon, home to the populous city of Monterrey and the large, water-hungry beverage industry that includes Heineken and Arca Continental, one of Latam’s largest Coke bottlers that extracts billions of gallons of water under federal concessions. As recently as 2022, Mexico had declared a drought in the state of Nuevo Leon and yet Tesla plans to open a factory there.

The political maze 

The final speed breaker to the nearshoring story could be politics and a volatile security situation by the US border. On the political front, Mexico’s President recently demanded that airport operators in Mexico reduce their tariffs even though they were bound by law via a concession system instituted in 1998. In terms of security concerns, the cities of Juarez and Tijuana, while strategically located across the border from California and Texas, have a history of gang violence and cartels profiting from piracy and counterfeiting.

Mexico’s unique competitive edge 

Despite these hurdles, Mexico offers several advantages, including lower labour costs compared to China, a younger workforce and significant investment in GDP, particularly in nearshoring and public infrastructure projects. 

Unlocking nearshoring potential 

With plenty of natural resources, a faster lead time and shorter distance to market, we think Mexico can continue to benefit from current trends with some policy support. Our Mexican holdings offer three different ways to access the nearshoring theme. 

Grupo Cementos de Chihuahua (GCC MM) – Primarily selling cement in the US, GCC also operates in Chihuahua. It benefits from strong volume demand generated by the region’s growing industrial sector, particularly maquiladoras and warehouses near the Texas border. Recently, GCC expanded its Samalayuca plant and now supplies cement to about 85 projects in Northern Mexico, serving clients like Foxconn, Wistron and Pegatron.

Regional SAB de CV (RA MM) – Known as “Banregio,” this Mexican bank specializes in lending to small and medium enterprises, with a strong focus in Neuvo Leon, its home state and a big beneficiary of the nearshoring trend. With about 45% of its assets in the region, Banregio is poised to benefit from the growth of industries supporting multinational corporations relocating to Mexico, thanks to low credit penetration and an expected easing cycle.

Grupo Aeroportuario Del Centro Norte (OMAB MM) – OMA, managing 13 airports in Central and Northern Mexico, sees its largest traffic accounting for nearly half of its total at Monterrey Airport. Despite recent concerns about tariff cuts, we remain positive on OMA both for its exposure to nearshoring and potential for growth in its commercial business. The company operates six airports closely tied to nearshoring, covering 33.5 million square metres of industrial gross leasable area, about 35% of Mexico’s total.

A crucial crossroads 

The real intrigue lies not in what Mexico has already achieved, but in what it could accomplish moving forward. Will it leverage its current position to create a more diversified, resilient economy, or will it repeat the patterns of the past? As global dynamics continue to shift, Mexico could be a big winner and serve as a blueprint for other emerging markets navigating the balance between risk and opportunity.

WeWork’s downfall and IWG’s ascent 

Last week, WeWork, once regarded as the world’s most valuable start up, declared bankruptcy. This decision followed weeks of speculation. WeWork’s mission of being the leading global co-working community came to an end due to its relentless pursuit of growth. Its initial misrepresentation as a tech company and consistent cash burn from unprofitable leases indicated overambition from the start. This development provides an interesting opportunity for one of our holdings.

With WeWork’s restructuring of its extensive 700-plus-location portfolio, IWG (IWG LN) stands to benefit from less competition and an opportunity to expand its own network. For years, WeWork imposed pricing pressures to attract members. Now, this industry-wide pressure should ease, to IWG’s benefit.

IWG, the world’s largest provider of workspace solutions, began its operations in Brussels over 30 years ago. With more than 4,000 locations across 120 countries, its early entry into the market has been advantageous. The company is currently trading at 5.44x EV/EBITDA, a notable multi-year low. It has demonstrated strong pricing power and momentum, with revenues up 14% in the first half of 2023, totaling a record £1.7 billion. The company has focused on revenue growth and free cash flow generation, which has helped strengthen its balance sheet by lowering net debt.

Several years ago, to boost its top line and margins, the company introduced a capital-light business model. This model is particularly interesting due to the lower CAPEX requirements because of sharing agreements with building landlords for office space renovations. IWG partners with landlords for management, operations and member recruitment in return for a management fee. Additionally, the model includes franchise agreements in two forms. The first involves master franchise agreements, where a partner buys out an existing IWG portfolio and commits to additional office roll outs, paying a franchise fee. The second form involves franchised locations in existing markets, where IWG partners with smaller franchise owners to open new centres in markets that IWG already has presence in. This strategy has gained traction, with 582 new centres opened this year compared to 421 in 2022.

For the last couple of years, IWG was affected by its association with WeWork, trading in parallel despite superior financial performance. Though the pandemic took a toll on the coworking sector, IWG continued to generate strong positive free cash flow and EBITDA margins consistent with the company’s historic levels. In contrast, WeWork was aiming to grow revenues, but showed negative EBITDA margins and free cash flow.

Source: Bloomberg.

Around September 2022, IWG’s stock price finally decoupled from WeWork’s as the troubles continued to brew for the latter. Following Q2 2022 results, it became evident that despite growing occupancy at WeWork offices, it continued to offer price cuts to members to contain retention rates unlike IWG that not only grew occupancy but was beginning to raise prices, a trend continuing to date.

In the current market, which still seems to favour some growth stocks with weak financials, we continue to prioritize companies with healthy balance sheets and promising profitable growth prospects.

Investment opportunities can be found in every industry, though some may be easier to get excited about than others. However, as many astute investors, including Warren Buffett, have noted, “boring” companies and business models can be just as profitable as those flavour-of-the-month stocks. This week, we profile ELIS SA (ELIS FP), a boring company that Global Alpha got excited for.

Based in Europe, Elis specializes in renting and maintaining flat linen, workwear and hygiene appliances. Founded in 1883 in France, Elis operated as a family business for three generations before going through several leveraged buyouts and ultimately going public in 2015. The company has 440 production and distribution centres across 30 countries and a workforce of over 50,000 employees. With 75% of its revenues derived from markets where it leads, Elis is a dominant force.

Elis caters to a broad spectrum of customers, from hospitals needing linen to industrial companies needing uniforms exposed to dirt or chemicals, to small kitchens preferring not to manage towel cleaning in-house. Elis’s full-service solution relieves customers of managing inventory, ordering replacements or cleaning – handling all of the buying, renting and logistics. Customers have the option of variable pricing based on usage and service frequency or a fixed rate, typically under four-year contracts. Revenue is split almost equally between corporate and smaller businesses.

The textile rental market has seen growth, gradually replacing customer-owned textiles in the last decade, driven by cost savings, efficiency, improved hygiene standards and ESG commitments. Elis’s competitive advantage is its scale; its model is most efficient in densely populated areas, optimizing logistics and maintain margins. Elis strategically expands through acquisitions, improving its geographical presence to best utilize its distribution centres. This strategy has been paying off. In 2009, Elis derived 80% of its revenue from France, compared to less than a third today. More recently, it also started operating in Mexico through an acquisition that immediately made it the country’s largest player.

It’s worth taking a moment to explore the sustainability benefits of Elis’s solutions. As companies become increasingly mindful of their energy and resource use, they are also paying more attention to the companies they outsource to. Elis holds up very well under this scrutiny. The company has implemented various initiatives and made commitments to reduce its environmental footprint. For example, it pledged to cut water consumption per kilogram of linen processed by 50% by 2025, using 2010 as a baseline, and it has already achieved a 43% reduction by 2022. The company has also vowed to lower energy consumption by 35%, transitioning its fleet to alternative vehicles and reusing 80% of its end-of-life textiles. None of its clients have the capacity nor the inclination to manage their linen and workwear-related environmental impact as effectively. Furthermore, Elis offers ancillary services that directly help clients in reducing their own footprint, such as reusable scrubs in healthcare facilities that reduce CO2 emissions between 31% and 62% compared to disposable scrubs, or cloth roller hand towels that reduce emissions by 30% compared to disposable paper towels.

What makes Elis an appealing investment for us? It stands out with significant market share, a strong brand and a sustainable competitive advantage. It operates a resilient, non-cyclical industrial service with a business model adaptable to external disruptions. From COVID-19 and energy price shocks to wage inflation, the company has adeptly navigated recent macroeconomic events, maintaining its pricing power and protecting profits. With its strong free cashflow and flexible cost structure, we believe Elis is well-equipped to manage debt, and engage in strategic M&A and share buybacks, positioning it to excel in both bear and bull markets.

While a linen rental business may not intrigue everyone, our focus remains on identifying quality companies at reasonable valuations, no matter the industry.

Last week, our Emerging Markets (EM) team attended a fruitful Latin American (LatAm) conference in New York, hosted by BTG Pactual, the region’s leading investment bank. The event showcased a variety of promising investment ideas and featured rich discussions and robust participation. Hundreds of investors from around the world convened to meet with the c-suite executives and founders of about 200 companies, mainly from Mexico and Brazil.

Keynote speaker Stephen Schwarzman of Blackstone shared his view on the global geopolitical landscape and the current state of the US economy. He underscored the importance of constantly reinventing business models and taking risks in pioneering new products and services as a foundation for business durability.

Throughout the three-day conference, we conducted insightful meetings with 22 companies operating in the consumer, industrial, healthcare, financial, technology, energy, materials and real estate sectors providing a wide view of the LatAm economic landscape. In most of the conversations, we sensed cautious optimism, mainly driven by monetary easing and nearshoring trends. While most developed countries are grappling with inflation, many LatAm nations are in a disinflationary environment. Central banks in Chile, Brazil and Peru have already started cutting rates, with Colombia and Mexico expected to follow suit this year.

Nearshoring is a topic we’ve explored in previous writings, and it was a dominant theme among Mexican companies at the conference. Many see nearshoring-driven demand as structural and sustainable, providing ample growth opportunities across multiple sectors as global supply chains move to Mexico.

However, challenges do exist, such as infrastructural inadequacies, both industrial and residential (e.g., power and water availability, housing supply for labour), erratic political and regulatory climates, bureaucratic complexities and looming uncertainties around the upcoming elections in Mexico and the US. A possible spillover effect of “higher for longer rates” in the US also looms as a source of concern, potentially putting pressure on LatAm currencies amid the decoupling of monetary policies and eventual slowdown of the easing cycle in the region. Another area of concern is the ongoing tax reform in Brazil, well-known for its highly complicated tax system requiring nothing less than a PhD in law to properly understand all of its intricacies.

As for the top picks, we identified several promising opportunities that you might read about in our future commentaries, including:

• Brazil’s largest operator of private oncology clinics and hospitals. The company leverages its strong brand and reputation, running a proven and scalable business model in a massive and dynamically growing market.
• A fast-growing Brazilian athleisure brand enjoying strong brand awareness, a nimble operating model with great economics and ample white space for expansion.
• The leading B2B online solutions provider to micro and small businesses, with a promising new product pipeline, well positioned for the digital transformation in Brazil with still low ecommerce penetration.

We also met with some of our LatAm holdings at the conference, including Odontoprev (ODPV3 BZ), which we initiated after our meeting with its management team at last year’s conference. Founded in 1987 by a group of dentists, Odontoprev is Brazil’s largest dental benefits provider, with over 8.4 million members and a cross-country network of 26,000 dentists. The company offers customized products to corporate customers and off-the-shelf products to SMEs and individuals, while leveraging its exclusive distribution network in a partnership with strategic shareholder, Bradesco. Its industry focus, well-established footprint, brand portfolio and proprietary dental tech infrastructure make it a standout among its peers. The company is run by a strong management team with a sound track record and rich industry expertise. Odontoprev has an asset-light business model and a low capex requirement with negative working capital generating high cashflow, resulting in a strong balance sheet in a net cash position. The company is a proven compounder with a 16% and 22% compound annual growth rate of revenue and net income, respectively, since its IPO in 2006.

The dynamics of EM, particularly in LatAm, are as layered as they are compelling. The investment choices we make today, be they cautious or bold, will have lasting implications.

Japan has been quite cautious with pandemic control. Only on May 8, 2023 did the government downgrade COVID-19 to the same level as seasonal influenza. The country’s Q2 GDP grew 1.2% quarter-on quarter, outpacing market expectations, mainly driven by a rebound in exports and an increase in tourist arrivals. Japan boasts the world’s largest electronics industry and ranks third in automobile production. Real wages have turned positive for the first time in seven quarters and corporate appetite for investment was solid. 

In September, two of our team members participated in investment conferences and conducted company visits in Japan. Business operations in the country are back to normal. Inbound tourism is visibly booming. Making a reservation at a restaurant is a must. In August, about 2.2 million foreign visitors travelled to Japan, representing 85.6% of the visitors seen in the same month in 2019. For context, about 32 million foreign tourists visited Japan in 2019 and spent a record high of ¥4.8 trillion. 

Behind these short-term recovery signs, there are also indications of some long-term structural changes that lead us to believe that Japan is at inflection point and shifting from a deflationary to inflationary environment.  

Japan inflation rate

These structural changes include: 

1. Notable improvements in balance sheets. Historically, Japan’s prolonged deflation was triggered by the 1990s real estate bubble burst. This caused a credit crunch and a liquidity trap, essentially resulting in a balance sheet recession. Now, both property prices and corporate balance sheets have been on a consistent growth path.
   
2. The Yield Curve Control (YCC), having faced challenges, is likely to be phased out in the coming months. Introduced in 2016 by the Bank of Japan (BOJ) to combat deflation, YCC’s objective was to maintain low yields to stimulate consumer and business spending. This approach worked well when inflation was low because investors could enjoy the safe returns of government debt. But with inflation eroding those gains since the spring of 2022, investors have started to sell government bonds, pricing in the chance of a near-term rate hike. To maintain this framework, the BOJ intervened by buying bonds, to little avail. In December 2022, the BOJ doubled the band to allow the 10-year yield to move 0.5% above or below zero. Nevertheless, the 10-year Japanese Government Bond yield recently rose to 0.805%, a decade high. Many economists now expect the BOJ to discontinue the YCC within the next six months. We agree with this view and think the next logical step is for the BOJ to raise its short-term policy interest rate from -0.10% to 0%, given that inflation, largely attributed to wage growth, seems persistent.
   
   
3. Wages are on the rise again, a trend that should continue, driven by a severe long-term labour shortage. Japan may face a shortage of more than 11 million workers by 2040. Wage negotiations, particularly between major corporations and Rengo, also known as the Japanese Trade Union Confederation, are under close watch. The average wage hike was 3.58% in April 2023, the highest in three decades. For April 2024, the estimate is another hike of around 3%. 
   

Japan’s stock market has recently reached a peak not seen in 30 years, with the Nikkei 225 Index up 19% year to date. Warren Buffett’s investment in five Japan-based trading companies provided a vote of confidence, indicating Berkshire might own as much as 9.9% of each of these companies. Many investors are attracted by cheap valuations, the return of inflation and a depreciated yen. 

Early this year, the Tokyo Stock Exchange urged companies to boost their price-to-book (P/B) ratios. Half of the companies listed on the Tokyo Stock Exchange trade at a P/B ratio of below one, compared with just 3% of firms on the S&P 500 Index. As highlighted earlier, businesses now have solid balance sheets, positioning them to enhance shareholder returns. In the fiscal year 2023, the dividends and share buybacks of companies on the Nikkei 225 were at record levels. 

Historically, Japanese small caps have outperformed large caps over the long term. However, since 2018, persistent macro uncertainties have swayed investors towards the relative stability of large caps.  

Japanese small caps outperforming large caps (through Aug 2023) 

Source: Nomura based on Nikkei 

We believe Japanese small caps are poised to outperform, mainly due to three reasons.  

1. Historically, small caps outperform during economy expansions thanks to their better growth potential.  
2. Small caps are expected to have accelerated profit growth in the fiscal year 2024. As of October 6, 2023, the EPS of MSCI Japan Small Caps is expected to rise by 11.6% compared to the 6.5% growth expected for its large peers. 
3. Small-cap valuations are nearing historic lows compared to large caps, the biggest discount in 11 years. 

Source: Nomura, based on Toyo Keizai.

You may be curious about the impact of rising interest rates on our portfolio. Reassuringly, half of our Japan-based holdings are in a net cash position and the remainder carry low debt. A strong balance sheet has consistently been a key factor in our stock selection process. What’s more, to benefit from rising interest rates, this year we initiated a position in Concordia Financial Group (7189 JP), Japan’s third-largest regional bank, because we believe its growth will accelerate in a rising interest rate environment.  

Amid Japan’s profound economic changes, we remain vigilant and adaptive, constantly refining our strategies and insights to help ensure that we navigate this evolving landscape in the best interests of our investors. 

Following my trip to China in May 2023 and my recent commentary from June, I believe it is important to continue to share our thoughts on China, especially in light of recent disappointing economic developments and the new policy measures aimed at addressing its slowing economy.

Have we reached peak pessimism about China?

The real estate sector, along with its related industries, accounts for 20% to 30% of China’s GDP and has failed to rebound as expected. From January to July, real estate investment fell 8.5% year-on-year. Residential building areas deceased by 7.1% and total new construction areas declined by a quarter according to the National Bureau of Statistics.

China’s government has announced a slew of measures in the past few months to stimulate the sector, including:

• Fiscal incentives: The Ministry of Finance on Aug. 18 extended personal income tax rebates for households upgrading their apartment until the end of 2025.
• Mortgage easing: Banks no longer exclude those who have a repaid a mortgage from qualifying as first-time buyers if they don’t currently own a property. Big cities including Guangzhou and Shenzhen adopted this policy on Aug. 30.
• Home-loan cuts: Starting Sept. 25, first-time homebuyers can renegotiate their mortgage interest rates, as announced by the central bank on Aug. 31.
• Downpayment reductions: On Aug. 31, Beijing lowered the minimum downpayment ratio across the country to 20% for first-time homebuyers and 30% for second purchases.
• Urban renewal: The State Council announced redevelopment support for older villages within mega cities. Metropolises including Shanghai and Guangzhou are following up.
• Other measures: These include a nationwide cap on real estate commissions, allowing private equity funds to raise capital for residential property developments, pledging ¥200 billion (CDN$28 billion) in special loans to complete stalled housing projects and extending some of the 16-point plan to address liquidity issues in the sector.

We should soon find out if these measures prove adequate. The Mid-Autumn Festival from Sept. 29-30 followed by a week-long holiday from Oct. 1-6 for National Day is traditionally the busiest period of the year for real estate sales. But what if the bubble continues to deflate? Could it lead to a collapse contained within China or a long stagnation like Japan experienced? Or to something more globally damaging similar to the Great Financial Crisis of 2008?

Will China crash?

Contrary to these fears, we do not see a huge financial crisis in China. The country is a major creditor, most of its debts are in its own currency and the government controls all of the key banks.

The current risk is the elevated savings rate, which could weaken demand.

Is China’s economic situation a repeat of Japan in the early 90s?

China today and Japan 30 years ago share many similarities: high debt levels, an aging population and a property bubble pop after years of growth. But China’s asset bubbles are comparatively smaller. And, in some cases, one could argue that the US also is in bubble territory. The following table is quite telling:

	China	US	Japan (1990 peak)
Property value/GDP	260%	180%	560%
Stock market/GDP	65%	151%	142%
Urbanization rate	65%	83%	77%
Debt/GDP	95%	122%	62%

Source: World Bank and IMF.

Is it all bad? Can China bounce back?

China’s economy was supposed to drive a third of global economic growth this year. Its recent slowdown is sounding alarm bells across the world. According to an International Monetary Fund analysis, when China’s growth rate rises by 1 percentage point, global expansion is boosted by about 0.3 percentage points. Asian economies, along with African countries have been most affected by diminished trade. For example, Japan reported its first drop in exports in more than two years in July after China cut back on purchases of cars and semiconductors. Central bankers from South Korea and Thailand last week cited China’s weak recovery as a reason for downgrading their growth forecasts. The value of Chinese imports has fallen for nine of the last 10 months as demand retreats from the record highs set during the pandemic. The value of shipments from Africa, Asia and North America were all lower in July than a year ago. But is the situation as dire as appears? Some indicators seem to tell a different story.

The price of oil is approaching $100. According to a September report by OPEC, global crude oil demand is expected to reach a record 102.06 million barrels per day in 2023, up 2% from 2022. Demand in China, the world’s second-largest crude oil consumer, is projected to grow by 6% to 15.82 million barrels, an upward revision of 50,000 barrels from August. Official customs data shows that China’s crude oil imports in August reached 52.8 million tons, up 21% from the previous month. This translates to a 31% year-on-year increase and a 25% rise over pre-pandemic levels in August 2019. With overseas travel from China still not back to pre-pandemic levels, further growth in demand for crude oil and petroleum products could be expected as noted by Dominic Schnider, UBS’s head of commodities and Asia-Pacific currency markets.

In terms of metals, China’s refined copper consumption was the second-strongest year to date in August, a month when demand would typically weaken due to hot weather. This was reflected in a 36.6% increase month over month in China’s copper concentrate imports in August.

China’s aluminium imports jumped 38.9% in August from a year earlier, customs data shows.  Imports of bauxite, a key raw material for aluminium, totaled 11.63 million tons last month, up 9% from the year prior. Bauxite imports in the first eight months of the year, at 96.62 million metric tons, were up 11.8% from a year earlier.

In our last commentary on China, we highlighted how it is trying to transition its economy away from real estate, infrastructure and exports to a more sustainable model led by domestic consumption, services and tourism. There is a lot of potential to unleash tremendous growth if Chinese consumers decide to increase their spending.

A study by the Australian Strategic Institute earlier this year showed that China leads in 37 of 44 tech fields, ranging from AI to robotics. China graduates 1.4 million engineers each year and leads the world in patent applications.

Source: World Economic Forum.

Technology fields and leading countries

Source: Australian Strategic Institute.

So, while there is a case for optimism, what if relations between China and its trading partners continue to deteriorate. What if trade barriers go up?

Who could replace China as a global economic engine?

Policymakers in the West may view a China slump as a geopolitical respite, but it raises a significant question: what are the global repercussions if China’s economy were to permanently stagnate?

According to World Bank data, China GDP grew by 263% between 2008 and 2021, while global growth was only 30%. China accounted for more than 40% of global growth during that period. Although some experts have pointed to India as a possible successor, it’s not a given. India’s manufacturing sector has contracted in recent years and private investment accounts for a smaller share of GDP than it did a decade ago.

Could this signal the end of global economic growth?

Global growth by period

1962-1973	5.4%
1977-1988	3.3%
1991-2000	3.0%
2009-2023	65%

Source: Capital Economics

We do not think the China growth story is over and believe the China pessimism is too extreme.

Regulatory risk is nothing new to investors, but it has gained prominence in the current geopolitical climate. Companies globally, especially those with operations or manufacturing facilities in China, are  closely monitoring actions their government might take to undermine diplomatic relations. In the banking sector, the situation with SVB has led analysts to expect stricter regulatory frameworks for regional banks. Additionally, the ongoing Hollywood strikes have spotlighted AI as a contentious issue; actors are advocating for regulations that restrict studios from using their likeness for AI-generated content. And the list goes on.

In the 1990s and early 2000s, a laissez-faire attitude prevailed in developed countries, particularly in the US. It was the proof that the capitalist business model was sustainable, a perception supported by the slow pace of regulation during the quickly developing dotcom bubble and the pre-financial crisis housing market. In a hegemonic global environment, smaller nations found few reasons not to strategically align themselves with dominant powers, leading to accelerated deregulation in many developed countries. However, this framework began to shift as the US-led global world order faced challenges from competing political and economic ideologies.

As the US initiated a trade war with China and raised tariffs on various goods, many allied nations started reassessing their global trade strategies to safeguard their own economic interests. We believe the growing rift between the US and China will eventually force every government to choose sides and evaluate their dependencies on either power. Germany, for example, is reconsidering its longstanding industrial relationship with China and taking steps to reduce that reliance.

Enter the cycle of protectionism. The consequences of protectionism are well-documented: higher prices due to lack of competition, which leads to persistent inflation; weaker economic growth since international trade isn’t fully offset by domestic consumption, and a more fragile labour market as a result. When various stakeholders voice their discontent with a worsening economic environment, democratic governments often respond by enacting policies, introducing regulations or applying other short-term solutions in an attempt to alleviate the problems they created. These often penalize high-performing industries or companies and may involve levying taxes or setting price ceilings. Such changes catch both company management and shareholders off-guard.

Our clients know that Global Alpha uses a bottom-up approach to stock picking. However, our team also recognizes the increasing need in being risk aware about changes in regulatory frameworks, both at the industry and company levels.

A striking example occurred around this time last year with one of our holdings, Norway Royal Salmon (NRS). The Norwegian government unexpectedly announced a 40% tax rate on resources, which included salmon. Although the company had a solid business model and shareholder satisfaction was high, the stock dropped over 20% in a day, making it one of our worst performers for that quarter. Nevertheless, it was widely understood that NRS was set to merge with one of its competitors, Salmar. We believed this merger would provide for shareholders as it would create one of the largest players worldwide in fish farming and significant advantages, especially given that the larger entity could more effectively adapt to this new tax than smaller competitors. As of March 2023, the Norwegian government lowered its proposed tax rate to 35% to facilitate legislative approval, and we remain happy shareholders of Salmar.

Another recent case involves CVS Group (CVSG LN), a UK-based integrated provider of veterinary care. In early September, the UK Competition and Markets Authority (CMA) announced its review of competitiveness in the veterinary sector, causing CVSG stock to drop more than 25%. Investors immediately assumed that CVS, as the largest player in the space, would be the review’s primary focus. However, our analysis suggests these concerns may be exaggerated. Reviews by the CMA do not always lead to material industry impacts, as shown by its review of UK grocers earlier this year. Furthermore, while CVS has been a major player in consolidating the UK veterinary industry, it has not led to unreasonable price hikes. Average increases for CVS products and services hover around 3% net, which is unlikely to be seen as an outlier. There are minor areas, like lack of transparency in cross-selling and customer awareness regarding chain ownership, where CVS might face some hurdles, but we do not anticipate a substantial impact on the business model.

Lastly, it is worth noting that regulatory and policy shifts can provide positive effects. The waste management industry is expected to benefit as recycling becomes increasingly crucial in creating more sustainable societies. Our portfolios include waste management companies like Casella Waste (CWST US) and Renewi (RWI LN). We expect that new recycling requirements across various commodities will improve margins in what has historically been a low-margin industry.

While no one on Global Alpha’s investment team is a policy expert, our job requires us to consider two important angles: the potential threats to a business model arising from policy shifts, and the actual impact on our investment thesis when a regulatory change happens. One reason for our cautious stance on AI investment opportunities is the level of uncertainty regarding when and how governments will implement regulations. Salmon farming and veterinary care may not capture the public imagination like AI does, but we are confident in our ability to navigate regulatory risks in these industries more successfully.