Enters Plutus, the Greek God of Wealth

Johann Wolfgang von Goethe was not a particularly prolific writer. The genesis of his magnum opus took over 30 years. Nowadays, Goethe might even be considered a mere “one hit wonder”. But what a hit it was! Written against the backdrop of the Age of Enlightenment and the Romantic period, Faust[1] is regarded by some as the greatest work of German literature. Faust marks the origin of the pact with the devil mythos, from which so many derivatives took their inspiration afterwards. Yet aside from the play’s main theme and its central character’s deal with Mephistopheles, there is a side story in Faust Part II which is particularly interesting in light of recent policy decisions.

The story revolves around an emperor whose realm is afflicted by economic problems. In an early scene, at a reception at the court, the emperor is acquainted with an unlikely duo consisting of Faust, disguised as Plutus, the Greek god of wealth, and Mephistopheles, disguised as the emperor’s fool. Later in the evening, Plutus tricks the intoxicated emperor into signing a paper note. Unbeknownst to the sovereign, Plutus and the fool promptly print unlimited copies of the paper note which are then circulated throughout the empire, thereby eliminating economic problems. Later on, the emperor realizes that the shortsightedness of Plutus’ solution has created a false sense of prosperity in the realm, which in turn enabled greed and corruption, ultimately leading to a compounding of the economic problems that prevailed and bringing the realm on the verge of rebellion.

We think there are striking parallels to be drawn between the money printing metaphor in the play with what happened in the last few months. In effect, by resorting to an unprecedented monetary expansion effort in order to avert an economic crisis that would rival the Great Depression, central bankers have turned into a modern version of Plutus.

While we understand that there may have been no other choice, in their attempts to reduce short-term damage, central bankers, whose recent policy actions included massive intervention in the investment grade credit sector, have now socialized large swaths of the financial sector, the consequence of which has been the extreme distortion of the value of a broad range of financial assets. In doing so, they have made a remarkable entrance disguised as Plutus and consummated their own Faustian bargain. Even if the long-term outcome of this bargain may not be as tragic as in Goethe’s play, we prefer to be invested conservatively and to be diversified across a broad range of risk factors rather than chase the financial assets whose value may have been the most artificially inflated.

ONE COUNTRY TWO SYSTEMS NO MORE

Hong Kong’s current crisis can be traced to the implementation of the 1990 Basic Law, a constitutional law whose purpose was to give effect to the 1984 Joint Declaration between China and the United Kingdom that guaranteed the continuation of Hong Kong’s capitalistic and social freedom system for 50 years following its return to China in 1997.

Article 23 of the Basic Law stipulates that Hong Kong is responsible for enacting laws to prohibit treason, secession, sedition and subversion against the Chinese government and bar foreign organizations to conduct political activities in the region. Indirectly, it meant that Hong Kong’s retained its independence but that China would ultimately dictate policy around security and foreign relations. Unfortunately, since its return into China’s lap, Hong Kong has tried and failed repeatedly to implement Article 23 due to public outcry. Its latest attempt, in June of last year, was met with daily widespread protests and demonstrations lasting through late fall.

In retrospect, the COVID-19 pandemic provided the distraction that China needed to force the implementation of the missing legislation. To this point, diplomatic attempts to dissuade China from asserting more direct authority over Hong Kong have fallen into deaf ears. Similarly, since China has waited over two decades for this moment, we don’t think that calls for sanctions from countries with assets in the region will have an impact. In fact, a series of recent events suggest that China is less preoccupied by the image that it projects on the international scene than it was 30 years ago, in the aftermath of the Tienanmen Square events. Notably, China is particularly emboldened when it comes to pushing the limits of public international law in the South China Sea.

This is an adverse development which few had foreseen. The widely held view was that Deng Xiaoping’s thoughtful “one country, two systems” formula was beneficial for China as it could draw inspiration from Hong Kong’s British heritage in the transformation of its state-controlled economy to a market economy. Evidently, China viewed the situation differently, which raises questions about what comes next. Firstly, what will China’s tighter grip mean for foreign companies operating in Hong Kong? Secondly, are Trump’s United States willing to militarily guarantee the Taiwan’s independence if China’s policy towards Hong Kong sparks the nationalist fervor on the island? Thirdly, how will China react should foreign countries offer fast track visas to the highly skilled citizens of Hong Kong who see China as a menace and choose to emigrate?

Answers to these questions could have potentially serious geopolitical consequences. For this reason, our strategy is to approach China and the broader Asian region without taking too much directional risk. As such, we think that this in an area where hedge funds, whether they focus on equity or credit markets, interest rates or currencies, are worth considering. This is a key research focus of ours as a result.

DEAD SHOPPING MALLS RISE LIKE MOUNTAINS BEYOND MOUNTAINS

The title of this section is a line that we stole from a song by the internationally acclaimed Canadian indie-rock band Arcade Fire[2] . While the decline of the suburban shopping malls had already been chronicled, as COVID-19 rampaged through the world, forcing business closures, their problems only worsened. In retrospect, Arcade Fire was prescient.

The reason we mention the shopping mall situation is because the broader commercial real estate sector – publicly listed Real Estate Investment Trusts (REIT) aside[3] – typically comprises a core portion of ultra-high net worth (UHNW) investors allocation to alternative investments and that many UHNW are attempting to assess whether the recent carnage witnessed in the space as an opportunity to increase their exposure. After all, they argue, from a Canadian investor’s vantage point, the commercial real estate sector, has been largely immune to recessionary shocks in the past three decades and until the pandemic hit, it had generally outperformed both equity and fixed income over relatively long periods.

While these arguments are undebatable, they are backward looking. To this point, we believe that there are fundamental reasons that underpin the weakness experienced by commercial real estate since March. Firstly, in many sectors, rent collections are at risk. In effect, while such risk appears contained in the traditionally more defensive multi-family residential sector as well as the industrial and storage sector, it is particularly acute in the hospitality, office and retail sectors. We further suspect that even the student housing sector could face problems if college and university campuses do not re-open this fall and that foreign students are frozen at the border. To date, real estate owners and operators have engaged in proactive discussions with their tenants, which have led to the implementation of various rent relief measures. Nevertheless, these measures are temporary and since the commercial real estate sector has not directly been targeted by government and central bank measures to date, we wonder how long can these voluntary measures last and what happens when they expire. Secondly, we note that a many nonbank real estate debt providers such as mortgage REITs, specialty finance companies and hedge funds have significantly curtailed their activities or effectively exited the space. As such, capital for development and repositioning projects has become scarce and more expensive. Ultimately, we think it will cause many commercial real estate owners, operators and developers to prioritize debt reduction over distribution payments and that major expansion projects will be postponed.

To summarize, while the opportunity to uncover unique assets which will generate superior outcomes given the depressed valuations may very well be real, the level of uncertainty is unprecedented and the risks of making a costly mistake by increasing exposure too early is high. With that in mind, until we overcome the COVID-19 pandemic, we consider it prudent to focus on the most defensive sectors, use only conservative amounts of borrowing and more importantly, borrow on conditions that cannot be unilaterally amended by the lender. Reassuringly, while we did not deploy capital in the space anticipating a global pandemic, our recently completed investments appear well positioned to withstand the negative influence of the pandemic. To this point, to date, there has been little deterioration in vacancy and rent collection metrics and developers indicate that construction projects remain on time and on budget.

Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer

[1] Johann Wolfgang von Goethe, Faust Part I, published in 1808, and Part II, published posthumously in 1832.

[2] Sprawl II, the Suburbs, released by Merge Records in North America in 2011.

[3] We do not consider publicly listed REITs as alternative investments. We view REITS as equity market investments.