“Cyber is just morphing constantly and is probably the No. 1 risk that the whole system faces—not just financials, not just investment firms, not just financial services more broadly, but the entire corporate infrastructure,” he says.
Of course, you need only look at Sony, Anthem, or Equifax to get a sense of the scenarios that worry the McNabbs of the world. And defending against a WannaCry-like ransomware scenario doesn’t come cheap. “Our budget [for cybersecurity] has been multiplied by 10 times over the last seven or eight years,” McNabb says from his office in Malvern, Pa. “I don’t see any end to that. In one sense that’s a shame, but there are a lot of bad actors, so you’ve got to be willing to do it.”
While cyber requires constant vigilance, McNabb’s a little more passive—ahem—about the markets. “Valuations are starting to get pretty rich,” he says. “You certainly worry about a flash point. A 10 to 15 percent move in equities would not be unprecedented in history from these kind of valuations. And whether that happens in 6 months, in 12 months, or in 18 months … sooner or later it’s going to happen. To deny that and think some policymakers can navigate things so that we never have another correction again, that won’t happen. The markets need to cleanse.”
How do you say “Que será, será” in Pennsylvania Dutch? — Rachel Evans
China, China, China
Kyle Bass, the founder and chief investment officer of Hayman Capital Management LP, earned his reputation as a Cassandra when his misgivings about subprime mortgages, which he shorted, proved correct. He’s had his eyes on China for the past few years. Now he has a new noneconomic catalyst that could finally put a ball in motion: President Trump. “The politics are likely to accelerate the economics,” he says.
Bass says China, the world’s second-largest economy, is overstating the health of its banking system, and doing so for political reasons. “You can’t grow your banking system 1,000 percent a decade and only grow your GDP 500 percent and not have a loss cycle,” he says. “When you’re moving from an export-led economy to an internal consumption-based economy, you have to remember that all the loans in your banking system were lent to your old economy and are going to have to be restructured.” About 20 percent of China’s banking system is nonperforming, he estimates—a far cry from the official low-single-digit number.
Bass isn’t the only China bear, of course. Zhu Ning, deputy director of the National Institute of Financial Research at Tsinghua University in Beijing, raises similar themes in his 2016 book, China’s Guaranteed Bubble: How Implicit Government Support Has Propelled China’s Economy While Creating Systemic Risk. The huge amount of debt burdening the Chinese financial system, coupled with an overheated property market, poses broad risks to an economy that the rest of the world looks to for growth, he says. And any popping of asset prices could drag China into the kind of lost decade that Japan experienced in the 1990s, when debt-fueled growth and a red-hot property market screeched to a halt, Zhu says. “The government should allow zombie companies to default or go bankrupt,” he says. “It’s surprising to see the number of bankruptcies in China is even lower than that in Netherlands or Belgium.”
China’s hope, according to Bass, is that the country’s nominal gross domestic product will grow fast enough to rescue the economy from its massive banking problem. “And what I’m saying is that’s not going to happen,” he says. “If you’re going to use your FX reserve pile to maintain stability in your currency, and if you’re going to continue to lie about where you are from an economic and asset perspective in your banking system, then sooner or later economic gravity is going to take over.”
While Bass has been betting against China for years, he says the addition of Trump is an especially big X-factor, given the potential for his imposing sanctions on entities doing business with North Korea in an effort to “change the subject” from his domestic drama. That prospect would damage global trade—hurting the Chinese economy—inflicting “pain on their banking system a little bit sooner than it otherwise would have experienced.” And should the relationship between the U.S. and its biggest trade partner worsen, the knock-on effects for countries such as North Korea, Russia, and Taiwan could become catastrophic. “So financially speaking, it may be not as bad as 2008,” he says, “but kinetically speaking, it may be worse.” —Katia Porzecanski and Judy Chen