Risk from China's Real Estate

As a risk manager, I am used to pointing out risks and scenarios that end up not being realized. I know how it feels to see risks and vulnerabilities remain unresolved -- for years. At this point, however, with China we might see the tipping over the edge, and a yawning gap on the way down.

Here is a chart of property prices in various versus household income. The chart is no secret, and its importance as a metric is likewise well known.

Bad enough, but if we adjust earnings for inflation to look at real earnings, we are in uncharted territory. This chart shows smoothed inflation-adjusted earnings yield.

It is below the 2000 and 2008 levels, even below the worst levels during the 1970's, when there was a huge inflation tailwind.

The counterargument is that with low rates, discounted future earnings count for more. But as I have argued elsewhere, this Finance 101 approach to valuation works for a class assignment, but not for serious valuation. The risk premium on earnings looking out 20 years is going to dominate the effects of an interest rate that is a percent or so lower than the recent past.

Thanks to Ned Davis for highlighting the real earnings yield.