Year of the Fat-tailed Monkey

A fat-tailed distribution is one that exhibits extreme skewness. In other words, it deviates from the norm. For investors, a normal distribution implies an identifiable, and usually slim, likelihood of catastrophe. When the distribution tail fattens, additional undesired risk appears, and with it, the chance of investment failure increases dramatically. As we enter the Year of the Monkey, extreme volatility, low growth and record debt levels dominate the global economy, and with it, the distribution tail is fattening alarmingly.

Bloomberg recently described the distressed debt investment experience of 2015 as “painful.” Investors in energy companies were the first to experience the pain, which quickly spread to chemicals, metals and mining, utilities, retail and health care. The underlying predicament was a lack of economic growth and a failure in markets to recover and rebound after they had crashed. In 2016, we are waiting to see whether this is a short-term over-reaction, or part of a fundamental shift in market behaviour.

A year ago, we warned that China would struggle to transition from an export to a consumption-led economic model quickly enough to maintain growth, and it would re-focus on exports. In 2016, the economy has worsened. Now, the threat of China floating its currency in response, is further amplifying global uncertainty, volatility, and the risk of sudden shocks or unexpected change. In the February 2015 edition of Distressed Debt Insider, we also warned that during 2015, Asian bad debt levels would spiral, that banks would pull back from lending, and that government owned AMCs would stumble once real estate prices faltered. All these predictions have been proven correct.

So, other than maybe shorting the Yuan, where are the returns in a no growth, no rebound environment? Simplistic as it sounds, all investors need to do is understand the market, accurately recognize where they are in that market cycle, identify opportunity, and know how to create returns during uncertainty and volatility. The core problem facing most investors is a track record shaped in rising markets where it wasn’t necessary to navigate treacherous, downside risks. A rising tide raises all boats, irrespective of the captain’s skills, or lack of them! After 15 years of rising prices in Southeast Asia, the local investment world is dominated by players whose sole investment thesis is guaranteed returns from general market price rises.

Many Asian investors, urged on by local banks, have insulated themselves from cooling home markets by investing in overseas, mainly western jurisdictions. Lacking intimate knowledge of their destination, they have followed the herd blindly. In many western cities, prices have been driven up by Asian investors to levels that local investors are not prepared to go to. Cross border investors everywhere must always understand exactly why they are able to buy assets at prices that domestic investors are shunning. Investment in alien markets is a zero sum game, and if the foreign investor cannot identify the loser, it is most likely the investor. For many, unless they have a specific value creation strategy identified, the chances are that their investment will depreciate; the only silver lining being a potential currency hedge.

A cross border investor who hit the headlines in 2015 was Sahaviriya Steel Industries (SSI) from Thailand. They made their first overseas investment in 2011 by purchasing a steel plant in the UK. In 2015, the business collapsed and SSI defaulted on US$1.4 billion of loans, which represents the biggest single Thai credit default since the 1997 Asian Crisis. It could be argued that SSI were unfortunate that energy prices collapsed, but given their industry experience, they were in a better position than others to foresee this situation. Most of the other risks they took in the UK were identifiable in advance, and could have been avoided with better local knowledge and advice.

Investors across all sectors now need to appreciate a fundamental market shift. Fiscal stimulus is now the foundation policy for all the world’s major economies. Low interest rates and limited, or no growth, will prevail. For real estate investors, absent property crashes, and other than in specific sectors or pockets, there will be little or no capital appreciation. Ownership alone will no longer be enough in order to make returns. Owners will need to develop value creation strategies and clear exit plans. They must be sure on whether their investment exit will be, for example, a property management play, redesign, remodeling and repositioning, refurbishment, reducing cost of money strategy, financially engineered yield contraction, or an asset management play. If the ownership strategy is only cross border FX hedging, maybe it would be better just to hold foreign cash.

Investors will also be able to profit from new niche markets such as the swelling Asian cross-border health and retirement markets. Southeast Asia tourism is also transitioning from the premium western visitor to Asian mass market travelers. However, much of the infrastructure in travel, hotels, retail, restaurants and leisure facilities is constructed for the premium market. It needs to be re-engineered or rebuilt to be competitive, creating a window of opportunity for those who react to change best and quickest. Fintech is another gaping opportunity area that will escalate, given Southeast Asian banks’ reluctance to embrace technology at the same pace as their citizens.

Price falls in Southeast Asian real estate markets have been evident for the past two years in many sectors, in tandem with slowing bank lending, and diminishing consumer confidence. Some sectors have remained more resilient or robust though. Where price erosion has occurred, it has been gradual. This inconsistency, and the absence of a sudden crash, has camouflaged the true state of the markets, other than from the more active market participants. Entry mispricing risk therefore escalated substantially during 2015. Widespread real estate price visibility, both up and down, usually trails the market by two years, so broader realization of the true state of real estate markets should become more apparent in 2016.

With burgeoning bad loans in Southeast Asian banks, a bonanza for NPL investors should materialize in the foreseeable future. The scale of this, and exactly when this happens, remains to be seen. The biggest issue for real estate backed loans will likely be pricing, as sellers cling onto outdated historic valuations. In a receding market, appraisals are already out of date by the day they are issued. NPL investors that can understand borrowers and accurately predict behaviour patterns will be able to forecast future collection timing. The most capable investors, who can also identify future real estate trends accurately, and value assets correctly at the time of purchase, will reap the biggest rewards.

Gradual price erosion implies a slow, subdued, future recovery. In this environment, accurate asset pricing is critical, a situation that looks likely to continue for at least a further two years. 2015 was a bad year for distressed investors who suffered the new normal: what goes down does not necessarily rebound or recover to where it was before. At the opposite pole, 2015 was a very good year for distressed investors, who foresaw changing future trends correctly, assessed values accurately, and paid the right entry price. In 2016 and beyond, as the investment herd retreats and competition fades, the remaining, ablest, distressed investors will be the ones that hit the jackpot.

Capital Services Group is an independent asset management specialist with over US$30 billion in loan and real estate asset portfolios managed across Asia since 1998. Our loan servicing platform is highly rated by international rating agencies to include the highest special servicer rating in Asia. 

For more information about our robust Asia-wide platform, please visit www.capserv.com