Dear Valued Clients,
The past year and a half have been quite a challenge for many, and we hear regularly about people’s desire to return to a normal way of life again. While ‘normal’ might not be within immediate reach, we are quite encouraged to be seeing many of you face to face again. It feels great! We are pleased to connect with you in whatever method fits you best, but I can report that the entire Cribstone team is fully vaccinated. If you are comfortable coming in, we would love to see you. Alternatively, Zoom meetings remain a feature of our day-to-day experience.
As many of you are aware, Tina Korske has been an invaluable member of our team for more than a decade. In fact, you have probably heard me reference on multiple occasions that Tina plays a big part in leading Cribstone on a day-to-day basis. Tina and I had been discussing her eventual retirement for the last six months or so, contemplating the right time to hire her successor so that we can ensure that we can have a good amount of time to overlap the two. Unfortunately for us, Tina has needed to accelerate her retirement plans due to health challenges for her mother, and while we all feel a little empty without her here, we are also excited for Tina as she begins a new chapter in her life with her husband, Larry. When the time is right for Tina, we will be hosting an event to honor and thank her for the wonderful contributions that she made to both Cribstone and you, but in the meantime, should any of you wish to reach out with a note or card, please send them along to our Augusta office at 7 North Chestnut and we will make sure she gets it.
Tina played an important role in helping us find a new member of our operations team. Joining Maranda Marsh in operations is the new Director of Operations Caroline Palmatier. Caroline joins us from Stone Coast Fund Services, a leading provider of accounting services to hedge funds. She is a graduate of the University of Maine and originally hails from Presque Isle. Caroline resides in Brunswick with her husband Mason, who operates Little Dog Coffee Shop, and she will work primarily in Cribstone’s Brunswick location. Please give her a call and say hello!
Also joining our team this month is Trent Blossom, Cribstone’s newest Wealth Advisor. Trent is returning to Maine after a more than ten-year hiatus. Trent and his wife Emily met while they were students at Bowdoin, and are quite excited to be returning to our wonderful state to raise their family. Trent has been managing a large team of internal sales and service staff at mutual fund company MFS Investments in Boston. When the pandemic struck, he hit the books and earned his Certified Financial Planner (CFP) designation, and set a plan in motion to join a firm that fits his ethos. We are very pleased to be that firm. Trent will be engaging with many of our relationships in an effort to make sure we provide the depth of service to you that you have come to expect from Cribstone!
In prior quarters, we have communicated with you about the pace of economic recovery and the commensurate impact that our economic growth has on investment opportunities. More recently, we have had some conversations about our inclusion of foreign investments in the portfolio. As investors, we are believers in the benefits of diversification which leads us to own foreign stocks in conjunction with domestic equities. Within the foreign markets, we see particular opportunities for growth in the Emerging Markets (EM).
EM equities have seen significant volatility year-to-date, down over 3% as of the beginning of October but nearly 14% since the peak back in February. For that reason, we thought we would provide you with some commentary on EM in this quarterly letter. Part of this drawdown in EM equities has its roots in China. Regulatory actions in China’s Internet sector have resulted in more than $1 trillion market cap loss since mid-February. More recently, investor focus has shifted to Evergrande Real Estate Group and the $60 trillion China property sector which is linked to ~20% of Chinese GDP and represents ~62% of Chinese household wealth.1
China has recently enjoyed considerable economic momentum without the need for large policy stimulus, primarily due to robust domestic activity as a result of easing lockdowns and strong demand for Chinese exports from other countries. That combined with a relatively low GDP growth target of “above 6%” offered policymakers a rare opportunity to implement regulatory tightening and structural reforms, as they have done time and again in the past.
As part of this effort to manage potential risks in the economy, Chinese regulators instituted the “three red lines” (3RL) regulation last year. This requires the largest property developers to be measured on three credit-related metrics each month. Failing to satisfy even one of these metrics, as was the case initially for a number of the developers, would lead to constraints on borrowing and the need to restrict land acquisition activity.
Evergrande has felt some of the most intense pressure from these new regulations. Activity has slowed sharply in recent months, the value of its shares has fallen, and prices for its offshore-listed bonds now hover around 25 cents on the dollar, implying a significant probability of default. Credit spreads for other developers have risen very sharply as well, leading to lower sales due to uncertainty about whether projects will be completed, which further compounds the financing pressures. There is hence an intense market focus on how the government will limit spillovers to the broader property sector and the overall Chinese economy.
Market estimates of Chinese bank exposure to Evergrande vary from $30 – 60 billion in loans, which is a relatively small portion of the total $27 trillion Chinese bank loan book. In addition, despite being China’s second-largest real-estate developer, Evergrande accounts for ~0.01% of the MSCI China market cap, with the real estate sector overall representing approximately 2%. Furthermore, unlike the US, Chinese homebuyers need to make at least a 30% down payment for first-home purchases, with a far higher bar for second homes. Mortgages are also recourse loans in China, which implies that banks can go after borrowers’ other assets in the event of mortgage defaults. This reduces the risk of a vicious cycle where house price declines trigger mortgage defaults and foreclosure sales which in turn lead to further house price weakening.
Given these factors, a risk of financial contagion in China from a failure of Evergrande appears limited. However, market participants expect policymakers to become more supportive in the medium term, as they have done in the past, given that the property sector remains a meaningful contributor to economic activity in China. Indeed, news reports published in mid-September suggest a possible restructuring and recapitalization of Evergrande, with the involvement of state-owned entities.
In terms of our outlook, we are maintaining our exposure to EM equities. EM and volatility are no strangers: apart from 2017, every calendar year since 1998 has posted an EM equity drawdown of at least 10%. Such instances tend to provide opportunities to enhance returns over time. Furthermore, the long-term thesis for investing in the region remains intact. Over 85% of millennials reside in emerging markets and are expected to drive significant growth in consumer spending going forward. Earnings growth for EM equities is projected to outpace the US by ~30% over the next couple of years, while valuations on both prices to book (~2.1x for EM vs ~4.5x for US) and price to earnings (~14.8x for EM vs ~21.8x for US) remain attractive.
In these uncertain economic times, we continue to focus on what’s most important: helping you achieve and maintain financial strength. That’s not always an easy task when there seems to be a lot of economic noise. Our planning and investment decisions are centered on our long-held principles and beliefs in the economic markets and systems, but we remain ever vigilant to what is occurring in the here and now. We recognize, however, that trading based on short-term beliefs can be a very painful experience. Markets, at times, can produce very irrational results. We hope that our discussion on EM provides perspective into our process, and look forward to seeing you all soon.
Scott Upham, CIMA® CPWA®
Contributions were made to this letter by Amyn Moolji, CIO & COO, & Jeffrey Burch, Director of Wealth Management.
1 Data sources for facts and figures described here include Goldman Sachs research and Bloomberg News
Cribstone Capital Management (“CCM”) is an SEC-registered investment advisor located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC-registered investment advisors. CCM may only transact business in those states in which it is notice filed or qualifies for an exemption from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website at www.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operation and fees is available from CCM upon request.