Debt cycle looks at real estate, is the big turning point here?

Abstract

● Historical-level "divergence" and the significance of the major turning point - Is the macro-micro anomaly a short-term phenomenon or a precursor to the opening of a "new investment paradigm"? We have repeatedly pointed out the following "divergences" earlier: ① Three major anomalies in global asset classes: US bonds, gold, ERP; ② The transformation of domestic social financing and real estate era: social financing, real estate, ROE. This is an important signal of the "new investment paradigm" resonating globally. "US bond rates higher for longer, Chinese bond rates lower for longer" will have a long-term profound impact on global asset allocation, and the "global barbell strategy" will be the best response. Recently, Chinese 10-year/30-year government bond yields hit new highs, Southeast Asian stock markets strengthened, and the Nasdaq continued to hit new highs.

● The debt cycle is the background for our above judgments and also an important consideration for long-term judgment on real estate.

● First: What indicators do we use to identify the stages of the debt cycle? We believe: The three major indicators of "total debt/GDP", "debt/GDP", and "debt/GDP YoY" can accurately determine the stage. The turning point of "total debt/GDP" can be seen as a peak sign of a debt cycle.

●Second: When did China's current long debt cycle begin? We believe: The 2008 "Four Trillion" policy was the starting point of this cycle, and in the past nearly 10 years, there have been three rounds of leveraging cycles.

●Third: What stage has China's current long debt cycle reached? We believe: The "total debt/GDP" of China's private sector (enterprises and residents) has already started a downward trend. Currently, it is in the stage of transitioning from "passive leveraging" (total debt/GDP↓, debt/GDP↑) to "deleveraging" (total debt/GDP↓, debt/GDP↓) gradually.

●Fourth: What guidance does the positioning of the debt cycle provide for the major turning point in house prices? We believe: Experiences from the US subprime mortgage crisis and Japan's 90s debt crisis suggest that during the contraction phase of the debt cycle, after the household sector moves towards deleveraging (total debt/GDP↓, debt/GDP↓), the process of "accelerated" deleveraging (debt/GDP YoY↓) transitioning to "decelerated" deleveraging (debt/GDP YoY↑), house prices will gradually stabilize and rise.

●Fifth: How is the leverage status of residents in various cities in China currently? Looking at the data from various cities in recent years, "household loan balance/GDP" remains high but has not significantly declined, while "debt repayment amount/GDP" has generally decreased in the past two years, indicating that overall leverage is being orderly digested. Overall, cities with lower rankings in "household loan balance/GDP" and larger declines in "debt repayment amount/GDP" have a relatively advantageous leverage digestion, with Beijing/Shanghai/Guangzhou/Chengdu/Suzhou/Chongqing being more typical.

● Risk Warning: Domestic economic growth falling short of expectations, geopolitical conflicts exceeding expectations, and global liquidity tightening at a steeper rate than expected

Introduction: Under the Debt Cycle Perspective, Where Will Real Estate Go?

When phenomena that surpass historical norms repeatedly occur, it often confirms the prelude to the changing times.

Previously, we have repeatedly pointed out① three major anomalies in global asset classes: US Treasury bonds, gold, ERP; ② the transformation of China's social financing and real estate era: social financing, real estate, ROE. This is an important signal of the "new investment paradigm" - the iterative framework of global asset allocation. It confirms the "new investment paradigm" we proposed in June 2023: after 22 years, global decoupling in anti-globalization (geopolitics, supply chain, financial markets), debt cycles, and AI industry trends have led to a divergence in asset pricing anchors - US Treasury bond rates are higher for longer, Chinese bond rates are lower for longer, and global funds are chasing assets with certainty premiums.

We believe that the "global barbell strategy" is the best response to global asset allocation under the changing times of anti-fragility. Recent performances of assets at home and abroad have provided many confirmations: China's 10-year/30-year government bond futures main contracts hit new highs, stock markets in Southeast Asia performed strongly, and the Nasdaq continued to hit new highs, among others.

The debt cycle is the background for our above judgment. In this article, we want to use the framework of the debt cycle to answer: Is the turning point for real estate here? To answer this question, we need to clarify the following points:

First: What indicators do we use to position the stages of the debt cycle? We believe that: "Debt repayment amount/GDP", "Total debt/GDP", and "Total debt/GDP YoY" are three key indicators that can accurately determine the stages. Among them, the turning point of "Debt repayment amount/GDP" can be seen as a sign of the peak of a debt cycle.

Second: When did China's current long debt cycle begin? We believe that: The 2008 "Four Trillion" policy marked the starting point of this cycle, and from 2008 to 2016, there were three obvious leverage cycles.

Third: At what stage is China's current long debt cycle? We believe that: The "Debt repayment amount/GDP" of China's private sector (enterprises and residents) has already started a downward trend. Currently, it is in the stage of transitioning from "passive leveraging" (Debt repayment amount/GDP↓, Total debt/GDP↑) to "deleveraging" (Debt repayment amount/GDP↓, Total debt/GDP↓) gradually.

Fourth: What guidance does the positioning of the debt cycle provide for the major turning point in housing prices? A significant decline in housing prices usually points to high leverage debt issues. Experiences from the US subprime mortgage crisis in 2008 and Japan's debt crisis in the 90s suggest that during the contraction phase of the debt cycle, after the household sector moves towards deleveraging (Debt repayment amount/GDP↓, Total debt/GDP↓), the process of "accelerated" deleveraging (Total debt/GDP YoY↓) transitioning to "decelerated" deleveraging (Total debt/GDP YoY↑), housing prices will gradually stabilize and rise Fifth: What is the current leverage ratio status of residents in various cities in China? Looking at the data from various cities in recent years, the "residential loan balance/GDP" is trending flat at a high level but not significantly decreasing, while the "debt repayment amount/GDP" has generally decreased in the past two years, indicating that the overall leverage ratio is being orderly digested. We calculate the horizontal comparison of "residential loan balance/GDP" in various cities, as well as the decline in "debt repayment amount/GDP" during the period from 2021 to 2023. Overall, cities with lower rankings in "residential loan balance/GDP" and a greater decline in "debt repayment amount/GDP" have a relatively advantageous leverage digestion, with Beijing, Shanghai, Guangzhou, Chengdu, Suzhou, Chongqing, and other typical cities in the first-tier and near-first-tier cities.

What indicators do we use to identify the debt cycle stage?

According to Ray Dalio's "Debt Crisis," we can use the two major indicators of "total debt repayment amount/GDP" and "total debt amount/GDP" to identify the 6 stages of the long debt cycle evolution.

At the peak of a debt cycle, the increasingly heavy debt burden (rather than the level of total debt) is often the last straw that breaks the camel's back. Therefore, the turning point of total debt repayment amount/GDP can often be seen as a sign of the peak of a long debt cycle.

1. Expansion stage of the debt cycle—

Early stage, bubble, peak (actively leveraging stage): Total debt repayment amount/GDP↑, total debt amount/GDP↑. In the early stage of the debt cycle, the total debt repayment amount/GDP and total debt amount/GDP often rise synchronously as the private sector actively leverages.

2. Contraction stage of the debt cycle—

(passively leveraging stage): Total debt repayment amount/GDP↓, total debt amount/GDP↑. Entering the contraction stage of the debt cycle, to reduce the debt burden, the growth rate of debt expenditure by the private sector has often slowed down, but with the nominal GDP growth rate declining faster and the phenomenon of issuing new debt to repay interest may exist—> leading to "passive leveraging" (total debt amount/GDP continues to rise). The decline in total debt repayment amount/GDP is mainly contributed by the downward loan interest rates. In this stage, as economic downturn pressure increases, it is often accompanied by the introduction of loose policies, where total debt repayment amount/GDP= current loan interest rate * (total debt amount/GDP).

Moderate deleveraging, gradually moving towards normalization (deleveraging stage): Total debt repayment amount/GDP↓, total debt amount/GDP↓. With further stimulus fiscal and monetary policies being introduced, debt pressure is further alleviated + economic growth gradually improves—> total debt repayment amount/GDP and total debt amount/GDP begin to decrease simultaneously. With policy support, when the deleveraging of leverage ratio (decrease in total debt amount/GDP) is more achieved through economic growth, painful deleveraging will transition to moderate deleveraging, moving towards the normalization stage of the cycle

On the basis of Ray Dalio's "Debt Crisis" simplified model, how to more sensitively grasp the turning point of the long debt cycle?

We add the "Debt-to-GDP YoY (leverage ratio YoY)" on top of the two major indicators "Debt-to-GDP" and "Debt-to-GDP" to construct a three-dimensional indicator quadrant:

How to understand the economic significance of the leverage ratio YoY? In simple terms, it represents the amount of money the real economy obtains beyond what is needed for production, reflecting the degree of improvement/deterioration in credit margins of the real economy. An increase in the leverage ratio YoY can represent both "acceleration" in leveraging up and "deceleration" in deleveraging, both essentially indicating an improvement in credit margins; while a decrease in the leverage ratio YoY can represent both "deceleration" in leveraging up and "acceleration" in deleveraging, both essentially indicating a deterioration in credit margins.

Early stage, bubble, peak (actively leveraging up stage): Debt-to-GDP ↑, Debt-to-GDP ↑, leverage ratio YoY ↑ —> "acceleration" in leveraging up, improvement in credit margins;

(Passively leveraging up stage): Debt-to-GDP ↓, Debt-to-GDP ↑, leverage ratio YoY ↓ —> "deceleration" in leveraging up, deterioration in credit margins;

Moderate deleveraging, gradually moving towards normalization (deleveraging stage):

Early stage: Debt-to-GDP ↓, Debt-to-GDP ↓, leverage ratio YoY ↓ —> "acceleration" in deleveraging, deterioration in credit margins;

Mid-late stage: Debt-to-GDP ↓, Debt-to-GDP ↓, leverage ratio YoY ↑, "deceleration" in deleveraging, improvement in credit margins.

(I) The Starting Point and Evolution of China's Current Long Debt Cycle

From the perspective of the long debt cycle, the starting point of this round of leveraging up was in 2008.

(1) In the early stage of the cycle, although debt growth is strong, it generally does not outpace income growth. Debt growth is used to support high-income economic activities, and the balance sheets of various sectors are relatively healthy, with overall matching between money growth and economic growth. Enterprises, governments, banks, etc., all have enough room to increase debt;

(2) When entering the phase of cyclical reinforcement, debt growth starts to trend higher than income growth, and the rise in leverage ratio (increase in debt) leads to accelerated asset return rates and economic growth rates, a process that usually reinforces itself. Increased borrowing expenses can boost income, support stock valuations, and the value of other assets. However, the leverage space of various sectors is also being consumed.

We anchor the occurrence of this major turning point in China around 2008 using the indicators "Private Sector Credit-to-GDP" and "M2-to-GDP", marking the starting point of this current long debt cycle. **

China experienced three relatively obvious leverage cycles from 2008 to 2016. Starting with the "4 trillion" policy in 2008, China initiated the beginning of this long debt cycle, going through three typical leverage cycles in the following decade, showing two main characteristics: first, the main force behind leverage in each stage was different; second, the rise in leverage in some sectors had a certain degree of passivity (mainly in the corporate sector). The division of time periods and the ranking of the increase in leverage in various sectors are as follows:

First cycle (2008-2010): Corporates > Households > Government. Stimulated by the "4 trillion" policy, corporate leverage increased the most, while household/government leverage changes were relatively small. (This ranking is based on the increase in leverage, the same below)

Second cycle (2012-2013): Corporates > Government ≈ Households. During the "steady growth" period, corporates remained the main force behind leverage, followed by government borrowing to boost leverage.

Third cycle (2015-2016): Corporates > Households > Government. With the real estate market "raising prices to reduce inventory," households actively leveraged to buy houses, and the rise in corporate leverage had a certain degree of passivity.

Now let's take a closer look:

First cycle (2008-2010): Corporates > Households > Government. The stimulus of the "4 trillion" policy ultimately led to an increase in corporate leverage, with infrastructure construction becoming the main focus at that time. New corporate loans, infrastructure construction growth rates, and the year-on-year growth of existing social financing all significantly increased from 2008 to 2010. During this period, the leverage ratio of non-financial corporations rose from 97.9% in 2008Q1 to 120.5% in 2010Q4 (an increase of 22.6 percentage points), while household/government leverage trends were upward but with significantly smaller increases, rising by 8.5 and 3.5 percentage points respectively. With the stimulus of increased debt, GDP growth also improved significantly.

Second cycle (2012-2013): Corporates > Government ≈ Households. The background of the leverage increase in this cycle was the continuous reinforcement of the "steady growth" policy in 2012, with the corporate sector still experiencing the most significant increase in leverage. At the same time, government borrowing and financing were also significant during this period, with rapid growth in non-standard project financing by government financing platforms and trust loans from 2012 to 2013.

It is worth noting that the increase in corporate leverage in this cycle had a certain degree of passivity. The contraction of the denominator of the leverage ratio was one of the important factors leading to the increase in corporate leverage during this period, as evidenced by the simultaneous decline in GDP growth and asset turnover rate of listed companies, especially the clear inverse relationship between the latter and corporate leverage Therefore, one of the factors that contribute to the increase in leverage ratio is the increased downward pressure on the economy and the decrease in corporate turnover rate.

We have discussed this issue in a previous report: After 2012, the overall leverage ratio of the corporate sector in China has been rising, but the asset-liability ratio of listed companies from a micro perspective has remained stable. Regarding the "divergence" between these two, we believe that the rise in corporate leverage ratio from 2012 to 2017 is mainly attributed to the downward shift in the economic growth rate and asset turnover rate. With the downward shift of the GDP growth rate after 2012, on one hand, it has slowed down the expansion of the denominator of the corporate leverage ratio, and on the other hand, it has also reduced the speed of corporate asset turnover, leading to a passive increase in the corporate sector's leverage ratio.

The third round (2015-2016): Corporates > Residents > Government. In terms of magnitude alone, the corporate sector still experienced the largest increase in leverage ratio in this round, but the resident sector was the main active liability sector. The important feature of this round of leveraging is that the corporate sector's leveraging is clearly passive, while the resident sector actively leverages to buy houses against the backdrop of real estate price increases and destocking.

Residents actively leverage: Under the monetization of shantytown renovation and the background of real estate price increases and destocking, there was a period of rising house prices. Residents' active borrowing to buy houses was more prominent during this period, with a significant increase in medium and long-term loans for residents (and a significant increase in the proportion of personal housing loans in resident sector debt).

Corporates passively leverage: In October 2015, the central government proposed deleveraging, and in 2016, it issued a landmark document "Opinions of the State Council on Actively and Prudently Lowering Corporate Leverage Ratio". Corporate new loans and asset-liability ratio decreased, confirming that corporate active liabilities were actually decreasing during this period. However, GDP and asset turnover rate continued to decline during this period, and the contraction of the denominator was an important factor driving the passive increase in corporate leverage ratio.

Learning from history: How did Japan's long debt cycle in the 1990s unfold?

By combining the two major indicators of "total debt/GDP" and "debt/GDP", we can clearly identify the different stages of Japan's long debt cycle in the 1990s:

1. Expansion stage of the debt cycle—

Early stage of the debt cycle, bubble, peak (active leveraging stage): Total debt/GDP ↑, debt/GDP ↑. In the mid to late 1980s, the Bank of Japan continuously lowered interest rates, leading to a "credit boom" and the private sector strengthening its voluntary leveraging scale, causing both total debt/GDP and debt/GDP to rise simultaneously, giving rise to an asset bubble 2. Contraction Phase of Debt Cycle -

(Passive Leveraging Phase): Debt-to-GDP ratio decreases, Debt-to-GDP ratio increases. In 1989, Japan's monetary and credit environment tightened, the asset bubble burst, leading to a self-reinforcing economic contraction. In the 1990s, in order to reduce the debt burden, the private sector in Japan voluntarily slowed down the pace of credit expenditure, but the GDP growth rate declined faster, coupled with the objective phenomenon of taking on new debt to pay interest - leading to a continuous rise in the Debt-to-GDP ratio, resulting in a "passive leveraging" situation. In the 1990s, Japan did not effectively achieve "deleveraging".

Moderate Deleveraging, Gradual Move towards Normalization (Deleveraging Phase): Debt-to-GDP ratio decreases, Debt-to-GDP ratio decreases. As we mentioned in section 24.2 "A Comparison and Outlook of Debt Cycles in China and Japan", after the debt crisis erupted, due to Japan's relatively late launch of large-scale fiscal/monetary easing policies, delayed government handling of bad debts, and compounded by demographic issues, Japan's debt resolution process progressed very slowly, with the economy in a long-term slump, making the deleveraging process exceptionally difficult. It was only after 2000 that Japan's household debt-to-GDP ratio began to decline. With the introduction of Abenomics in 2012, the Japanese economy significantly improved, and the deleveraging process relied more on economic growth. The painful deleveraging transitioned to a moderate deleveraging phase, gradually moving towards normalization of the debt cycle.

What stage has China's current long debt cycle reached?

The Debt-to-GDP ratio of China's private sector (enterprises and residents) has started to decline, indicating that China has passed the peak of this debt cycle and entered the contraction phase. Currently, China is transitioning from "passive leveraging" (Debt-to-GDP ratio decreases, Debt-to-GDP ratio increases) to "deleveraging" (Debt-to-GDP ratio decreases, Debt-to-GDP ratio decreases).

In recent years, China's private sector has shown characteristics of "passive leveraging". How to understand its implications? On one hand, to reduce debt pressure, the debt growth rate of China's private sector has been declining in recent years; on the other hand, China's nominal economic growth rate has also been gradually slowing down - to a certain extent, the decline in the nominal economic growth rate has offset the contribution of the debt growth rate contraction, resulting in a slight increase in the Debt-to-GDP ratio, showing the characteristics of "passive leveraging".

Looking ahead, what conditions are needed for the true deleveraging of leverage levels (Debt-to-GDP ratio decreases)? Relying on a combination of fiscal and monetary policies: On one hand, it is necessary to effectively promote the debt resolution process; on the other hand, it is necessary to promote the transformation of the "debt-driven investment model", relying on new quality productivity to drive economic growth - leading to a decrease in the Debt-to-GDP ratio, achieving true deleveraging of leverage levels. When the deleveraging process relies more on economic growth, the debt cycle will further move towards a moderate deleveraging, gradually normalizing phase

Debt Cycle and Real Estate: Is the Major Turning Point Here?

(I) "Debt Cycle" is an Important Consideration for Long-term Analysis of Real Estate

The essence of real estate is as a tool for economic debt expansion, and a significant decline in house prices typically points to high leverage debt issues. Looking at the experience of real estate cycles in mainstream countries globally, a significant decline in house prices is a rare phenomenon. In typical "long debt cycles" overseas, such as the "Great Depression" in the United States in the 1930s, the "Subprime Mortgage Crisis" in the United States in 2008, and the bursting of the asset bubble in Japan in the 1990s, house prices have experienced long cycles (over 5 years) and substantial adjustments (falling by over 30%).

As residents are the true end consumers of real estate, the interpretation of the debt cycle in the residential sector provides good guidance for the real estate cycle. Experiences from the Subprime Mortgage Crisis in the United States in 2008 and the debt crisis in Japan in the 1990s: during the contraction phase of the debt cycle, after the residential sector moves towards deleveraging (debt repayment amount/GDP decreases, total debt/GDP decreases), the "accelerated" deleveraging (total debt/GDP decreases year-on-year) transitions to "decelerated" deleveraging (total debt/GDP increases year-on-year), the marginal improvement in residents' credit willingness, and house prices gradually stabilize and rise.

Under the Experiences of Japan and the United States, What Guidance Does the Turning Point of the Debt Cycle Provide for the Turning Point of House Prices?

The debt cycle framework has well deduced the evolution of house prices in the United States after the 2008 Subprime Mortgage Crisis: "accelerated" deleveraging -> "decelerated" deleveraging, leading to a gradual stabilization and rise in house prices.

After the Subprime Mortgage Crisis, the Federal Reserve in the United States, in conjunction with the Treasury Department, quickly implemented a large number of innovative policies, effectively promoting the monetization of debt and significantly boosting the economy -> by 2008, the United States gradually moved towards the "deleveraging" phase (debt repayment amount/GDP decreases, total debt/GDP decreases).

During the "deleveraging" phase, near the turning point from "accelerated" deleveraging (total debt/GDP decreases year-on-year) to "decelerated" deleveraging (total debt/GDP increases year-on-year) (early 2012), house prices in the United States began to gradually stabilize and rise.

The debt cycle framework has similarly well deduced the evolution of house prices in Japan after the 1990s: "accelerated" deleveraging -> "decelerated" deleveraging, leading to a gradual stabilization and rise in house prices. After the bursting of the asset bubble in Japan, due to the relatively late launch of large-scale fiscal/monetary easing policies in Japan and the additional population issue, Japan's deleveraging process was exceptionally difficult. It wasn't until after 2000 that the Japanese household sector truly achieved "deleveraging" (debt-to-GDP ratio down, total debt-to-GDP ratio down).

Within the debt cycle framework, the pattern of Japanese house prices is similar to that of the United States. During the "deleveraging" phase, transitioning from "accelerated" deleveraging (total debt-to-GDP ratio down year-on-year) to near the inflection point of "decelerated" deleveraging (total debt-to-GDP ratio up) around 2006, Japanese house prices began to gradually stabilize and rise.

The current Chinese household sector is currently in the stage of transitioning from "passive leveraging" (debt-to-GDP ratio down, total debt-to-GDP ratio up) to "deleveraging" (debt-to-GDP ratio down, total debt-to-GDP ratio down) gradually. When China enters the "deleveraging" stage, it will further transition from "accelerated" deleveraging (total debt-to-GDP ratio down year-on-year) to "decelerated" deleveraging (total debt-to-GDP ratio up).

What is the current leverage ratio status of residents in various cities in China?

We use two core indicators, "residential loan balance/GDP" and "debt repayment amount/GDP," for calculation. (The latter is the annual repayment amount of residential loans)

Firstly, looking at the single indicator of "residential loan balance/GDP," there is a significant differentiation in leverage ratios among cities. In the statistically significant first-tier and near-first-tier cities, Beijing has the lowest "residential loan balance/GDP," with data for 2023 at 58%, followed by Shanghai (67%). Among near-first-tier cities, Tianjin has the lowest (68.2%), followed by Chengdu (68.4%), Suzhou (69%), Chongqing (74%), etc. The significant differentiation between regions shows the necessity of comparing cities.

Considering the decline in both "residential loan balance/GDP" and "debt repayment amount/GDP," we believe that Beijing/Shanghai/Guangzhou/Chengdu/Suzhou/Chongqing and other cities have a relatively advantageous leverage ratio digestion.

Looking at the data from recent years in various cities, "residential loan balance/GDP" has remained high but not significantly decreasing, while "debt repayment amount/GDP" has generally decreased in the past two years, indicating an orderly digestion of overall leverage ratios. We compare the horizontal comparison of "residential loan balance/GDP" in various cities and the decline in "debt repayment amount/GDP" from 2021 to 2023. Overall, cities with lower rankings in "residential loan balance/GDP" and larger declines in "debt repayment amount/GDP" have a relatively advantageous leverage ratio digestion, with Beijing/Shanghai/Guangzhou/Chengdu/Suzhou/Chongqing and other typical cities in the first-tier and near-first-tier cities

Four Risk Alerts

Domestic economic growth falling short of expectations (exports dragged down by overseas demand exceeding expectations, difficulty in restoring confidence in real estate consumption, "steady growth" policy measures falling short of expectations, etc.). Geopolitical conflicts exceeding expectations (Russia-Ukraine conflict continues to disrupt energy supply). Global liquidity tightening slope exceeding expectations (Fed's easing falling short of expectations, ECB rapidly raising interest rates, BOJ shifting from loose monetary policy) and so on