Category Archives: currency effects

Bond Environment, 2Q12 (ii)

April 27, 2012 By in Bond Environment, currency effects, Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , , Leave a comment
This is the second installment of the current bond market outlook of Denis Jamison of Strategy Managers, LLC.  The first installment appeared yesterday.
Free money…
…at least until 2014 according to the Federal Reserve. They just about guaranteed they will maintain the current zero to 0.25% Federal Funds rate until early 2014.
When the financial crisis began to unfold in 2008, the Federal Reserve responded by flooding the monetary system with credit. Now, they have a new gambit in their efforts to push consumers and businesses toward more spending – a low interest rate guarantee. The Fed seems to be taking the role of the real estate salesperson getting you to buy a house you can’t afford by offering a temporarily low mortgage rate or the car dealer looking to reduce inventories by providing zero percent financing. As Yogi Berra said after seeing back-to-back homers by Maris and Mantle, “it’s déjà vu, all over again.” Wasn’t it the mispricing and misallocation of capital that got us here in the first place?
Excess liquidity creates bubbles either in the real economy or the financial markets. Right now, the benefits of low interest rates and surplus central bank credit have flowed to the financial markets and the big commercial banks. Market participants know the Fed is behind the curve on its interest rate policy. Based on a formula derived by Stanford University economist John Taylor, the current short-term interest rate should be 0.65%. That, however, is based on trailing core CPI of just 1.9% and the current unemployment level of 8.2%. It’s reasonable to assume that core CPI will trend higher -CPI including food and energy prices is already 2.7% – and the unemployment rate will gradually respond to 2%-plus GDP growth. If you plug 2.25% inflation and 7.5% unemployment into the professor’s formula, you come up with a Federal Funds target of 1.8%. How we get there from here is anyone’s guess. But it’s very hard to get the air out of bubbles – financial or otherwise – without a pop.
Go Straight Ahead
When you reach $5 trillion, make a sharp left. That appears to have been the roadmap for the federal government’s debt expansion. From 1970 until 2008, the outstanding debt grew about 3.5% yearly and reached about $5 trillion. (In the Fifties and early Sixties, the annual increase was less than 1 %.) Direct federal government debt is now $10.4 trillion or about 68% of nominal GDP. (This only includes public debt outstanding. It doesn’t include the $4.7 trillion of inter-government holdings – otherwise known as the Social Security Trust Fund – theoretically owed by the federal government .) With the government’s debt burden growing at 11% a year and nominal GDP expanding 4% to 5%, debt could top GDP within six years.
That’s the point of no return – the debt trap. From that point forward, the cost of funding the national debt will grow faster than the economy.
There are only two ways to escape the debt trap: budget austerity or currency devaluation. So far, our elected officials appear to be unwilling to address the first alternative – and for good reason. Most of the money is spent on folks who vote. Social Security, Medicare and Medicaid account for 44% of total outlays. The defense budget grabs another 24% and social welfare spending – mostly going to state and local governments – claims another 12%. That’s 80% of the total. (Meanwhile, the small 6% slice going to pay the interest on the national debt will likely balloon over the next few years.) Devaluation is tricky – but much more doable. If inflation can be pushed higher, the nominal value of everything real goes up and the actual value of debt goes down. It’s worth remembering from 1974 through 1981, nominal GDP grew at a 10% annual rate despite two recessions. Little of this growth was real – inflation adjusted GDP averaged just above 2% a year –but it sure lowered everyone’s debt burden.  In that regard, it’s worth citing a quote from Adam Smith, “All money is a matter of belief.”
Keeping a Low Profile
We continue to keep the effective maturity of our clients portfolio’s below that of their benchmarks. This served us well during the March quarter and the accounts tended to outperform their benchmarks. It is worth noting, however, that a bearish stance in a bear market does not necessarily mean you make money. Good relative performance does not mean good absolute performance. During 2011, long-term U.S. Treasury bonds returned nearly 30% and the mortgage market recorded an 8% gain. We expect most of those outsized increases to be reversed this year. Given the low absolute level of coupon income for most bonds, even a small increase in interest rates will translate into a negative total return. The current year promises to be quite difficult for most bond investors.

higher taxes on dividends? –implications for stock markets

February 17, 2012 By in cash flow/share vs. earnings/share, Constructing a Portfolio, currency effects, Current Market Thoughts, Dividends, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

G-7 intervention to stop the yen’s rise: will it work?

March 18, 2011 By in Balance of Payments, comparative advantage, currency effects, Current Market Thoughts, J-curve, Japanese development, Purchasing power parity (PPP) Tags: , , , , , , , , , Leave a comment

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Please take my survey.  Thanks to everyone who has done so already.  If you haven’t yet, I’d appreciate it if you’d do so.  It’s brief, anonymous and will help me focus future posts.

PSI reader survey.

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Will G-7 intervention work?

Yesterday, the G-7 group of major industrial countries announced plans for coordinated intervention in the foreign exchange markets in order to halt the rise of the yen against the currencies of other developed nations.  In the wake of last week’s earthquake and tsunamis, the yen had risen by about 5% against the dollar.  Will the G-7 be successful?

The short answer is “…most likely, no.”

How so?

The main reason is that the major international commercial banks, who are the main forces in the global currency markets, are far larger and have greater financial resources than national governments do.  That might not have been true twenty-five or thirty years ago, but it is today.  Even the G-7 nations acting together don’t have the financial firepower to oppose a concerted move by the banks.  In the past, it hasn’t helped either that governments have typically tried to defend currency values that were politically attractive but economically unsound.

Japan the most skillful government player

I’ve been watching the currency markets as a global investor for over twenty-five years.  Over that time, the country that, to my mind, has the best record in influencing the direction of its currency is the Japan.  Understanding it can’t oppose the banks directly, it has waited until a wave of speculation has almost exhausted itself and then applied enough pressure to send the yen in the opposite direction.

Japan’s present stance is a curious one, though.  The current administration in Tokyo, the Democratic Party of Japan, came into office with the intention of reversing the long-standing (and very outdated) policy of the Liberal Democratic Party of always aiming to weaken the yen in order to help the prospects of export-oriented industries.  Nevertheless, when the original DPJ finance minister tried to enforce the new policy, he was replaced with someone more willing to cater to the Keidanren.  The new minister immediately began selling the yen in what I saw as simply a wasteful attempt to establish his pro-industry bona fides.  That was Naoto Kan, who is now the prime minister.  Who knows what he’ll do now.

A second curious aspect of the situation today is that there’s no good reason for the yen to be a strong currency.  The country’s workforce is shrinking.  The government is ineffective and heavily in debt.  The budget is in deficit.  And the country hasn’t shown any real growth in over twenty years.  Japan’s most “positive” feature  vs. the euro or the dollar is that it’s a known quantity and has less near-term potential for negative economic developments than the EU or the US.

Why has the yen been rising, then?  After the Kobe earthquake in 1995, Japan repatriated large amounts of money invested abroad.  Insurance companies needed funds to pay claims.  Parties–individual or corporate–who had no third-party insurance needed money to rebuild.  this activity drove the yen up by about 20% against the dollar in the months following the earthquake.  It’s probably too soon for this to be happening again.  The yen probably started to rise early this week as speculators began to bet the same thing would happen again.

Interestingly, the yen gave back almost all its gains as soon as the G-7 announced its plans and Tokyo was seen selling the yen aggressively in the currency markets.  To me, this suggests that the big players in the market haven’t decided what to do yet.  In the end, though, it will be the banks, not the G-7, that decide whether the yen strengthens or not.

investment implications

What’s the significance of a rise in the yen for investors?

An appreciating currency has two effects:

–it slows economic growth in local currency terms, and

–it reorients what economic energy there is–away from export-oriented industries, and toward domestic-oriented firms and importers.

If you were investing in Japan and thought the yen would rise, you would overweight domestic firms and underweight exporters and other companies with large foreign-currency exposure.  But the most sensible thing for most people to do, as I suggested a couple of days ago, is just to stay away.  (I own two social networking stocks in Japan, DeNA and its smaller competitor, Gree.  For now, I’m keeping them both.  These are youth-culture special situation stocks that are growing very fast, so I think they’ll be relatively unaffected by problems in the overall economy.  But I wouldn’t advise anyone to follow my lead.)

renminbi as an international currency

December 15, 2010 By in Asian economic development, China, currency effects, economics, emerging markets, Hong Kong Tags: , , , , , , , , Leave a comment

My friend Bob suggested I comment on yesterday’s feature article in the Financial Times on the steps China is taking toward the  internationalization of its currency.  What seem to me to have sparked interest in this topic is the recent renminbi bond issues by McDonald’s and Caterpillar.  But this is only the latest step n a journey that arguably began in 2003.

Here goes:

1.  China sees the enormous economic power that comes from your currency being the form in which the world stores its wealth and the medium of payment used in international trade.  It’s like having your own brand name in front of everyone involved in any sort of commerce anywhere in the world every minute of every day.

It also makes you like the owner of a bank–you can issue yourself a loan any time you want, just by (metaphorically) printing up a new batch of money that you then use to pay your creditors.  It’s the mark of a superpower, one China aims to have for itself as it rises to the pinnacle of world influence.

2.  China is no longer happy holding tons of US dollars.

Why the dissatisfaction?  On some very abstract level I’m sure it thinks that economic power ceded to its rival, the US, is power it doesn’t have itself.  But its real concerns are far more pragmatic.

It’s like the old joke that if you owe the bank $1,000, you’re in trouble; if you owe the bank $10,000,000, the bank is in trouble.  China holds trillions of dollars in US Treasury bonds.  It seems to be convinced–and who could blame it–that the US has no intention of honoring this obligation.  As an American, I’d say something a bit less harsh.  I don’t think Washington is malevolent.  I think it’s clueless.  The last dollar debt crises were in 1978 and 1987, so no one remembers.  As an academic might put it, however, this is probably a distinction without a difference.

This money isn’t as usable as China might have thought.  Virtually every attempt Chinese interests have made to spend its dollars on assets in the US has been blocked by Congress on “national security” grounds.  Some of this may be legitimate.  Most isn’t, in my opinion.  But it’s a fact of life.  And it has the effect of channelling the dollars back into Treasuries–that is, back into the hands of Washington, a borrower who inspires no confidence.

Also, from a Chinese domestic political point of view, the large dollar holdings have a ticking time bomb aspect to them.  Powerful interests in Beijing are responsible for holding and investing the country’s reserves.  No one wants his career wrecked by being the person in charge as and when the world loses confidence in the dollar and these holdings rack up hundreds of billions of dollars in losses.

Looking at Chinese foreign aid to Latin America and Africa, not only does this win local favor but it also helps get rid of large chunks of money that might become a future liability.

3.  For the moment, China has no alternative. Japan never had any interest in having the yen act as a world currency.  Euroland has.  If you remember, China had already begun a couple of years ago to shift its reserve composition away from the dollar, not by selling anything (it owns too much to do so without creating a value-depressing panic), but by focussing on euro instruments for new purchases.  But then Greece announced a year ago that it had been faking its national accounts for years.  This launched the current euro crisis–and gave the dollar a new lease on life.

4.  China’s ideas are colored by having lived through the Asian currency crisis of 1997-98. If you remember, the speculative attack on smaller Asian economies by large commercial banks and hedge funds focussed initially on Thailand, where overleveraging (in US dollar-denominated debt) had created substantial instability.  But toward the end even financially prudent economies like Singapore, and lastly Hong Kong, were also caught up in the turmoil.  The economic “problem” in the latter two cases was only that they were open economies and relatively small–and that international speculators were playing with “house money” they had made in Thailand, Korea and Indonesia.

The lessons  …don’t have an open economy.  Keep strict control of your currency and domestic financial instruments.

5.  China’s defenses created big barriers to use of the renminbi in trade… These included:

–restrictions on who can officially own renminbi

–restrictions on currency flow in and out of China

–restrictions on who can buy renminbi-denominated financial assets, like stocks and government bonds

–restrictions on the exchange of renminbi-denominated financial assets for physical assets in China

–inability to hedge renminbi holdings through currency derivatives

–the fact that the exchange rate is set by government fiat, not market trading.

As a practical matter, trade is relatively easy to deal with.  Let’s say I’m a department store that sources overcoats in China for sale in the US.  If I agree to a renminbi price for the coats, I have a currency risk.  If the renminbi moves up by 20% against the dollar in the time between contract signing and payment for the completed merchandise, I probably can’t raise the selling price of the coats so I may be facing a loss on selling them rather than a gain.  To eliminate this possibility, I lock in a currency rate at contract signing through a hedge.  I can do this, even with the renminbi, but why bother.  Better just to source in dollars.

6. …that China has been addressing, little by little, for some years.

The “why bother” is that China has increasingly signaled that it wants trade to settle in renminbi.  So it has set out to make such settlement progressively cheaper and easier.  In particular:

–in 2003, the mainland allowed Hong Kong banks to accept renminbi deposits

–in 2007, it allowed domestic banks to begin to tap the pool of offshore renminbi by issuing renminbi bonds in Hong Kong (and repatriate the proceeds to the mainland)

–in 2008 with the Hong Kong Monetary Authority, and subsequently with other regional central banks, the Peoples Bank of China set up currency swap lines, that would enable these non-mainland institutions to offer renminbi to local banks (to use in trade settlement)

–in 2009, Beijing allowed renminbi settlement of import/export between Hong Kong plus some ASEAN countries and a number of big trading centers in the export belt of eastern China

–this year, Beijing expanded this program to include all foreign parties and a much larger number of mainland entities.

—–Also, both non-mainland banks and other corporations have been allowed to issue renminbi bonds.  This is what MCD and CAT have done.

As the pool of offshore renminbi the Beijing is encouraging to form gets progressively larger, the costs of doing business–including hedging–in the Chinese currency will fall.  HSBC thinks that within a few years, half China’s trade with emerging markets will be settled in renminbi.  By 2020, the bank projects that its renminbi business in Hong Kong will be as big as all its trade settlement is today.

there is a catch to all this

Once the renminbi leave the mainland, they are only allowed back in to pay for exports.  Otherwise, a holder needs explicit government permission to use the funds in China.  Therefore, internal financial markets are sheltered from any speculative storms that may hit Hong Kong.

So far no one minds.  Global interest rates are low, so there’s little opportunity cost to holding renminbi.  Also, the consensus among individuals is that the renminbi is an appreciating currency, making it an attractive alternative either to HK$ or US$.  In addition, borrowing rates for renminbi are low in Hong Kong than on the mainland.  So firms that can get government permission to transfer the proceeds are better off financing in the offshore renminbi market.

how fast will liberalization proceed?

No one knows.  Some, like the FT, speculate that the fact of liberalization will produce a pace of liberalization that’s faster than Beijing wishes.  I’m more skeptical.  But, since I don’t see any stock that’s a pure beneficiary of a surprisingly sharp pace of liberalization, I haven’t given the matter much thought.



the size of “gray” income in mainland China: the Wang Xiaolu study

November 22, 2010 By in Asian economic development, Balance of Payments, China, currency effects, Current Market Thoughts, economics, emerging markets, Hong Kong Tags: , , , , , , , Leave a comment

I mentioned in my post from yesterday that in looking over the Li & Fung corporate website, I came across mention in Li & Fung’s 3Q10 China Trade Quarterly of a study by a prominent Chinese economist, Dr. Wang Xiaolu, on the size of the underground, or “gray,” economy in China.  Dr. Wang’s estimate of the gray economy in China in 2008 is RMB 5.4 trillion, or about US$ 815 billion at today’s exchange rate.  That would amount to around 30% of aggregate disposable personal income in the Middle Kingdom–an immense percentage.

The study itself, sponsored by Credit Suisse and a followup to a less extensive earlier analysis using 2005 data, can be found on Scribd.

Dr. Wang’s conclusions

Based on 2008 data:

1.  official average per capita income of the top 10% of wage earners in China =  Rmb 43614 (US$6580)   actual income = Rmb 139,000 (US$20,950).

official income of next 10% = Rmb 26500 (US$3990)     actual income = Rmb 54900 (US$8275).

2.  Two-thirds of the gray income is in the hands of the top 10% of the population.

3.  Official figures substantially underestimate income inequality in China, which is in fact even worse than in the US.  On Dr. Wang’s numbers,

–51.9% of disposable income is in the hands of the top 10% of Chinese earners  vs.  47.2% in the US

–7.8% of income is in the hands of the bottom 40% of Chinese earners  vs.  9.6% in the US.

what is “gray” income?

Gray income is money received in exchange for goods and services that is not reported to the government and on which no tax is paid.  Dr. Wang clearly seems to me to be a reformer who wants to call attention to systematic abuse of power by high-ranking officials.  His examples of gray money all seem to revolve around this issue.

His examples include the semi-legal, like:

–excessive bonuses or perquisites for high officers of government-owned enterprises, or

–excessive wedding gifts to the children of politically powerful parents.

They also include the illegal, such as:

–bribes paid to public officials

–excessive costs in public construction

–government officials profiting from land sales they control

–stock manipulation.

Dr. Wang’s methodology

his reasoning

Dr. Wang points out that official statistics on income are derived from interviews from a random sample of Chinese citizens.  Participation in the surveys is voluntary, however .  Dr. Wang maintains that:

1) all citizens questioned under report their income, and

2) many high-income people contacted decline to participate.

Together, these factors create a systematic downward bias to the official numbers.

an illustration

Dr. Wang illustrates that the official figures cannot be correct by pointing out that one can use them to conclude that Chinese citizens saved, in the aggregate, Rmb 3.5 trillion in 2008.  But data from other sources that show the increase in personal bank savings, private property purchases, and private buying of bonds and stock IPOs–in other words, that act as a proxy for the actual amount of money citizens saved during the year–total to over Rmb 11 trillion!

how Dr. Wang proceeded

In general outline,

–Dr. Wang trained a cadre of interviewers and developed a questionnaire intended to develop detailed information about expenditures on necessities like food and, in a more subtle way than the government’s survey, inquire about income.

–He created a list of potential interviewees from the friends and acquaintances of his interviewers, and selected  a subset of about 5000 of these to be actually interviewed.

–Post interview, the questioners graded the survey questionnaire based on their judgment as to the completeness and truthfulness of the answers, rejecting a bit less than 20% of the questionnaires on these grounds.

–He used the data collected from the remaining 4000+ to generate an Engel coefficient for China, that is, a relationship between expenditure on food and total income.  He then applied this coefficient to the government survey data, on the assumption that the information revealed by interviewees about expenditure on food is relatively correct.

is this scientifically correct?

No.  The biggest issue is that here’s no reason to believe that the friends and acquaintances of Dr. Wang’s interviewers are representative of wage earners in China as a whole.

Also, interviewees in the US tend to be less truthful in person-to-person interviews than in internet or mail (in the old days) surveys.  I don’t know what evidence there is in China.  I also don’t know what evidence there is that the cadre of interviewers is good at telling whether an interviewee is  being honest or not.

is this the best information we can hope for?

Probably yes.

investment implications

Even if Dr. Wang’s results are only directionally correct, they imply that disposable income in China is a quantum leap higher than official figures suggest.

If he’s right that the extra income in concentrated among the wealthiest Chinese citizens, then the market for luxury goods there may be much bigger than is commonly believed.  This would be good news for the Macau casinos and for luxury goods producers around the world–including local brands that may develop.

Severe income inequalities are a potentially politically destabilizing social issue.  This is Dr. Wang’s greatest concern, I think.  As Credit Suisse points out in its report that contains Dr. Wang’s findings, Beijing seems to concur.  It has encouraged/allowed large wage increases for factory workers in eastern China.  And it appears to be signaling it wants workers’ unions to take a greater role in ensuring that workers get a greater share of enterprise profits.

This may also be a big reason the Chinese government is opposed to a one-time large appreciation of the renminbi.  Doing so would simply validate the current, potentially dangerous, income inequalities.  Better, say, to encourage a doubling of workers’ wages over the next five years and allow the resulting demand for foreign goods push up the Chinese currency than to let “hot money” portfolio inflows do the job all at once.

a closing note

Credit Suisse points out that Greater China (the mainland, Hong Kong and Taiwan) already accounts for 28% of Swatch’s sales and 20% of Richemont’s.  Booming watch sales seems to be more evidence for the sharp male skewing of Chinese luxury consumption that Bain points out in its latest annual luxury goods survey (see my posts on Bain).

Credit Suisse’s favorite among the Macau casinos is the Galaxy Entertainment Group (0027:HK), on the idea, prevalent in Hong Kong, that the mass market is the best place to be.  That may well be true, although I’m still a bit skeptical.  But Galaxy appears to me to be the weakest of the casinos, however.  CS also thinks that the stocks of property developers stand to benefit as the world begins to appreciate how much income China has.  Myself, although I really like property stocks, I’d prefer something in financial services.

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