In assessing China, I think it’s important to distinguish carefully between the course of the mainland Chinese economy and the fortunes of China-related stocks.

the economy

background

The foremost goal of the Beijing government is to keep the ruling Communist Party in power.  This translates into the economic objective of avoiding possible social unrest by keeping employment high and unemployment low.  That’s quite a trick when you’re managing the transition from a rural, agriculture-based society to a more urban and manufacturing-oriented one.

In addition, China dedicated itself to creating a Western-style market-based economy in the late 1970s when it realized the country was too complex for central planning to work.  Again, hard to do when three-quarters of your industrial base was zombie-like state-owned corporations, when being a businessman was a felony and where citizens preferred to bury chuk kam gold trinkets in the back yard rather than use banks.

Complicating the situation further is the fact that high corporate or local/national government officials are Party officials whose chances for personal promotion are directly related to aggressively growing the areas they control, whether doing so makes long-term economic sense or not.

results

At the same time, all the mid-level national economic officials I’ve met–who actually implement policy–have been highly sophisticated, well-trained (mostly from the US or UK), competent and dedicated to creating healthy and balanced growth.

Given the large size of the Chinese economy and the paucity of tools to make economic policy, the best they’ve been able to do is to lurch between two extremes, overheating and stalling (the latter meaning unemployment is rising–a combination of new entrants to the labor force and layoffs)–and gradually lessen the amplitude of the cyclical swings.

where we are now

When the developed world appeared to be coming apart at the seams in 2008, China allowed a particularly strong domestic lurch to the upside.  For the past two years or so, Beijing has been trying to force an economic slowdown to rein in that expansionary impulse.

Policymakers have most recently been signalling their belief that slowdown has gone far enough and it’s time for faster expansion again.

China stocks

By and large, non-citizens can’t buy or sell stocks in the domestic market.  I’m not sure it makes much economic difference whether the local bourses go up or down.

Hong Kong is the natural market where the best and brightest of the mainland list their shares.

Over the past six months, Hong Kong stocks have sold off much more heavily than, say, the S&P 500, in response to worries about the Eurozone and potential global economic slowdown.  Since bottoming in early October, they’ve only rallied back in line with the S&P.  As I see it, so far there’s no anticipation of a better mainland economy this year in Hong Kong stock prices.  Many stocks there look cheap to me.

what to do

Personally, I think it’s important for all but the most risk-averse investors to have some exposure to the Chinese economy.

The most conservative way to do so is to hold companies listed in the US or Europe that have significant businesses in China.  Luxury goods retailers like LVMH, Tiffany or Coach are possibilities.  Casino companies like Wynn and Las Vegas Sands make all their money in Asia.

Discount brokers like Fidelity offer international trading services that allow foreigners to buy stocks in Hong Kong directly and cheaply.  Most investors will likely find it easier not to do research themselves, however, and buy an ETF or an actively managed mutual fund that specializes in Hong Kong or Greater China.

Price action in December and early January is often hard to read because of tax-related selling–losers in December, winners in early January.  Still, I’ve been a bit surprised that Hong Kong stocks haven’t done better than they have, given that the most recent economic news out of China, the EU and the US has virtually all been positive.

I don’t think this means that the positive case for the Chinese economy and for Hong Kong stocks is incorrect.  It may just take more time for negative emotion–from investors located in Europe, I think–to exhaust itself.  I’ve always thought that “buy on weakness” is pretty lame advice.  But it’s probably the right approach in this case.

I believe the qualitative story

To recap:  The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth.  The companies listed may be the politically connected dregs of the local economy, not the stars.  Financial statements may not be reliable.  Corporate management may not have shareholder welfare as a primary goal.  The regulatory playing field is probably heavily tilted toward insiders.  It’s ugly out there.

Firms may not find it easy to raise money under these conditions.  Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.

Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets.  Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.

This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.

I agree.

…the quantitative?

It’s the quantitative stuff that I have problems with.  Specifically,

1.  starting with a quibble…

McKinsey projects that global financial assets will be worth $371 trillion in 2020.  It’s not $370 trillion.  It isn’t $372 trillion, either.  The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%.  All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead.  Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day.  Why isn’t McKinsey aware?

…or maybe not

The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…).  That’s 3.3% of projected financial assets in 2020.  How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?

2. using local GDP to forecast corporate profits

McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP.  Three reasons why I think this is a mistake:

–many parts of the local economy may not be represented in the stock market.  On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation

–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy.  Private equity and trade acquisitions winnow the elderly and the infirm from the herd.

–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total.  In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy.  In the US, the best guess of S&P is that foreign earnings make up about half the total.  The figure is rising.

My conclusion(s):  the method McKinsey uses will understate corporate profits, and thereby the size of future equity market.  This is not new news.  Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades.  In other markets, it’s been a key subject for much longer.

3.  we live in a post-internet world

It isn’t just the internet, either.  Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business. 

–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories

–for many industries, today’s capital spending = servers and software, not machine tools and buildings.  The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity

–e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service. 

–the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries

in developing economies, too

There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure.  But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do.  For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.

My point:  in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one.   I don’t think it’s right, though.  In fact, the more I think about it, the odder it sounds.

A final thought on this subject:  as prices change, behavior adjusts.  If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.

The McKinsey Global Institute just published a research paper titled: “The emerging equity gap:  Growth and stability in the new investor landscape.”

The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies.  No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.

its conclusion

The study’s conclusion:  by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms.  To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.

If this is correct, companies may:

–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)

–issue equity on less favorable terms to the firms,

–use capital more efficiently, or

–expand more slowly.

I’m going to write about the McKinsey study in two posts.  Today’s will outline the McKinsey argument.  Tomorrow’s will have my thoughts.

the McKinsey argument

1. qualitative

Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.

the developed world

aging

A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging.  This list of median ages (from the CIA) illustrates this point.  Starting with Monaco, the Florida of Europe, median ages by country range as follows:

Monaco     49 years old

Germany     45

Japan     45

Italy     44

Sweden     43

UK     40

Spain     40

US     37

China     36

world median     28

Indonesia     28

India     26

Many African and Middle Eastern countries fall in the late teens or early twenties.

Why is this important?

As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have.   This increasing risk aversion means they are less willing to buy equities.

pension plan shifts intensify this trend

In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees.  They’ve done this by substituting defined contribution pension plans for defined benefit ones  This shift is now under way in Europe.  Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have.  In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.

the emerging world

Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities.  Two reasons McKinsey thinks so:

–most citizens are too poor to want to take the risk of holding equities, and

–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners.  So they’re not places you’d really want to put your money.

2.  quantitative

In the report, McKinsey attempts to estimate, on a country by country basis:

–how much equity money corporations will need through 2020, and

–the amount that investors are likely to allocate to equities over that period.

equity needs

McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.

It assumes that aggregate assets and earnings will grow in line with nominal GDP.  It applies a valuation multiple to them that’s derived from a two-stage present value model.  McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.

investor allocations

This is a complex process that McKinsey only describes in outline, even it the appendix to the report.

Basically, the consulting firm projects, country by country, future disposable income.  It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant.  For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.

the results?

McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020.  However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”

According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans.  Europe will face a funding deficit of $3.1 trillion.

The real potential problem is in emerging markets.  China is in the worst shape, facing a potential financing deficit of $3.2 trillion.  Other emerging markets face a total funding deficit of $7.0 trillion.

That’s it for today.  My thoughts tomorrow.

Asian stock markets sold off on the news.  That was on the worry, I think, that the North Korean government would stage a military provocation to “demonstrate” Kim Jong-il’s leadership ability–as it did when he was being introduced as heir.

investment implications

Other than in national intelligence agencies (which don’t share their information), the outside world knows very little about North Korea.  It’s an unruly client state of China, formed artificially at the end of the Korean War–separation along social and cultural lines would have been east vs. west.  It’s very poor.  It has big armed forces, but little industry.  It has nuclear weapons–and missiles capable of delivering them at least as far as Tokyo.

I think the most likely outcome from the leadership transition–temporary saber-rattling aside–is continuation of the status quo.

It is possible, however, that the absence of a dictator fully in control of the country will prompt a push in North Korea for reunification with South Korea.  This is something that both sides have talked about, off and on, for twenty years.  And there would be some pressure in the South for reuniting communities that have been apart for half a century.  Having seen the decade of economic stagnation that followed the reunification of the former East and West Germanies, however, I think Seoul would regard this as at best a mixed blessing, or as the best of a number of unfavorable choices.

This is the only outcome from Kim Jong-il’s death that I can see as having major investment implications.

I’ve always found South Korea a difficult place to invest in.  Lots of local quirks, including sprawling family-owned conglomerates (chaebols) with opaque operating procedures, and unpredictable (to me, anyway) intrusions of government into company operations.  So I’ve only occasionally owned companies like Samsung Electronics or Hyundai Motor, despite the excellence of their products.

I don’t think reunification would change government or corporate behavior at all.  Nevertheless, it would likely spawn enormous construction projects in the North, as well as the shifting of labor-intensive industrial production away from the South and the expansion of low-end Southern retail concepts there.  These moves could generate huge profits for the companies involved and would last a long time.

This prospect would most likely merit making the research effort to identify the beneficiaries.  In fact, the economic positives of reconstruction would probably be so powerful that a less-than-level playing field for foreigners might not matter that much.

I didn’t know until I was reading the Wall Street Journal this morning that Hong Kong had depository receipts (DRs).  But COH just issued one.

Sure enough, checking with the Hong Kong Stock Exchange website, HDRs have been permitted in that market since mid-2008.  Not many takers so far, however.  The HKSE lists Vale, the Brazilian iron ore company, with two HDRs; SBI, a Japanese internet-based financial, has one.  And now there’s COH (6388 is the Hong Kong ticker symbol).

what they are

The basic idea behind a DR is to provide a simple way for a domestic investor to buy a foreign stock without having to set up a brokerage account in the foreign country or to deal with foreign exchange, either in buying and selling or in receiving dividends.

The buyer doesn’t actually get a share of stock, however.  Instead, he gets an IOU (the receipt) from some financial entity, usually a bank, that holds the real shares in a depository account.  The bank handles all the necessary administrative details, like foreign exchange and the sometimes messy business of meeting the foreign country’s securities and tax regulations.

ADRs

The company whose stock underlies the DR may use the DR issuance to raise capital in a new market, where investors may well pay a higher multiple for shares than would be possible in the home market.  In the biggest DR market, the US, I’ve found this often the case–and regard it as a bad sign.  In my experience, seeing a mature company launch an ADR means it has lost its allure for more knowledgeable home market investors.  (Another important factor in ADR issuance in particular is that it circumvents the more stringent disclosure and reporting requirements that the SEC has for US-based companies.)

In the COH case, however, the firm has not created 6388 to raise new funds–after all, operations are generating $1 billion in annual net cash.  It has created a DR to raise its public profile in Greater China.

their Achilles heel

The bane of DRs, in my opinion, is low trading volume and potentially Grand Canyon-wide bid-asked spreads.  I’ve found the problem especially acute in cases, like this one, where the operating hours of the home and DR exchanges don’t overlap.  According to the HKSE website, trading in 6388 over the past five days has only totaled about US$11,000.  The bid-asked spread shown is about 2% (my experience in the US is that the spread for a stock like this could be more like 10%).  December is usually a dreary month for investors, so January will probably give a better read on volume.

worth watching

Nevertheless, COH has probably gotten more publicity in China through the HDR listing than it would have been able to buy with the money it spent to create its HDR.  The phenomenon itself it worth watching, as well.   Two reasons:

–we may ultimately reach a tipping point where having a HDR acquires a cachet that exerts a positive influence on the home market security price, and

–pioneers like COH may have a leg up on obtaining an eventual listing on a mainland exchange.

Today’s ft.com contains a commentary from Lou Jiwei, chairman of the mainland sovereign wealth fund, China Investment Corporation.  In it, Mr. Lou argues that global economic recovery can’t come from developing countries alone.  Developed nations must expand as well.  To help this latter effort along, the CIC is preparing to participate in Western infrastructure projects as  “investor, developer, operator and contractor.”  Projects could be in “energy, water, transport, digital communication, waste disposal…”  The CIC’s first stop will be the UK.

In a companion article, the FT says that a proposed high-speed rail line between London and northern England has caught China’s eye.

Why?

Why do this?  …and why the UK, of all places?  After all, it isn’t that long ago that China was demonizing the UK for invading China in the mid-eighteenth century to force the mainland to accept opium imports from British colony, India.

I can see several reasons for the CIC proposal, aside from the salutory effect infrastructure spending may have on Western economies:

–infrastructure projects can provide higher returns for China’s massive foreign currency holdings than government bonds will.  China is such a super-size investor that liquidity may not be that different,

–successful infrastructure upgrades can buy public goodwill and political influence,

–reversal of the “normal” flow of equity investment funds from developed to developing is a sign of China’s increasing importance in the world economy,

–Chinese industrial and service companies may have a greater chance to win contracts for such projects than they might otherwise,

–the UK is small enough that Chinese spending can have a significant, highly visible impact,

–the UK may be a showpiece.  It could provide entrée into the Eurozone and ultimately to the US,

–the UK is apparently willing to accept Chinese money and not raise spurious “national security” objections to prevent mainland investment.

investment considerations

CIC-backed projects could provide a mild–mostly psychological–boost to the UK.  It’s possible that private investors may be allowed to invest side-by-side with the CIC, as well.

Better transport… alternatives could take business away from direct competitors.  Better rail links, for example, might be bad for commuter airlines or for delivery trucks.

On the other hand, better overall infrastructure support could lure industrial or service businesses from elsewhere in the EU.

So far, however, we don’t have enough information to act on.

My conclusion, based on the prior two posts on this topic, is that–like Japan–Europe by itself is too small in the global terms for its problems to derail economic progress elsewhere.  Market volatility, yes; global recession, no.

In a nutshell, that’s my base case.

Nevertheless, even an investor who is not directly involved in Europe nor compelled by customer mandate to invest there faces two issues:

–the fact of continuing European selling of equities, both in Europe and abroad, as EU investors rebalance their portfolios and make themselves more liquid in response to developments there, and

–the possibility that the European financial situation is much more dire than we now suspect and/or the global banking system will transmit part of that damage to the rest of the world.

what to do?

I’m writing under the assumption that we’re not yet anywhere near either the end of the EU crisis, even though it has been dragging on for more than a year.  Nor am I willing to bet that we’re at or near the low point in stock market terms.

These are very important assumptions.   As a result of them, I want to protect myself from bad news coming out of Europe  I don’t think we’re at the equivalent of late-March 2009 for Europe.  So I don’t want to bet against the prevailing sentiment and hold already severely beaten-down beneficiaries of the dissipation of storm clouds.  But–as with everything in the stock market–I could easily be wrong.  So I’ve got to keep these assumptions in the forefront of my mind.

Three cases:

–a professional equity investor with a US-style mandate from institutional clients to remain fully invested.  Here the portfolio composition is straightforward.

One choice is to “neutralize” the EU by looking exactly like the index and trying to achieve outperformance elsewhere.

That’s the conservative choice.  My personal preference would be to underweight Europe, avoid the banks and choose stocks that are listed in the EU but which have the largest part of their operations in other parts of the world.  I’d look for growth names and avoid companies that depend on a robust worldwide economy.

–an EU-based balanced (i.e., a portfolio of stocks +bonds) investor, maybe with predominantly high net worth individual clients.  This investor will have a strongly European focus.

He is probably being required by the rules set up in his contracts to sell stocks because his bond losses have made his equity allocation too big.  He’s probably also being bombarded by negative news–and by customer inquiries about whether his strategy (no matter what it is) is too aggressive.  So he’s feeling the need to become increasingly more defensive.

He is probably selling stocks in peripheral markets, especially if they have done well; selling smaller capitalization stocks to buy larger; selling growth names to buy defensives like utilities and consumer staples. He is probably heavily tilted toward large cap names in northern European markets.  He probably has raised some cash (this may give him emotional satisfaction, but won’t affect his returns unless he’s raised a huge amount).

I think much of the selling in places like Hong Kong, and even the US, is emanating from Europe, and from the kind of professionals I’ve just described.  I think such selling will prove to have been the wrong move, but I suspect that I would be doing some of the same if I were in the position of this investor.  Ideally, I’d have the same strategy here as in my first case.

The world may also have to wait for this guy to run out of stuff to sell before markets take on a healthier tone.

–you and me.  …or rather, what I’m thinking/doing now in my own portfoli0.

The sound bite form of my central case is, as I wrote above, that Europe is the new Japan. That’s probably too pessimistic, but it’s going in the right direction.  Once the market settles down, there’ll be the opportunity to pick stocks (I do own one individual stock in Europe now through an ADR–IHG).  But there’s no rush.  In the meantime, I’m content to watch from the sidelines.

My guess is that worries about contagion through greater exposure by US banks to Europe than we now know about–or that bank hedging won’t work at all–is wildly overblown.  But I’ve never been a fan of banks in any case–and I know very little about financials, so I’m happy to continue to avoid them.

I’ve begun to take some profits on big multi-year winners and reinvest the proceeds into semi-defensive stocks.  DeNA (2432:JP) and WYNN are examples of the former; INTC and (believe it or not) LVS are instances of the latter. Part of this is pure tactics, not strategy.  Part of this is that the slow growth emphasis I’ve had for a couple of years has worked too well for too long, so I should probably reduce my heavy emphasis.

These are only changes on the margin, however.  I still think that we’re in a slow-growth world where there isn’t enough demand to satisfy all the firms in a given industry.  This means the important distinctions to make are between best of breed vs. the rest, and between niche players that serve hot spots of demand vs. everybody else.

I think continuing troubles in Europe will offset the good news coming from the US economy, at least until the situation in Italy and Greece develops further.  Therefore, the overall environment hasn’t changed much, in my opinion, other than short-term volatility is increased.  And, unless there’s a very compelling counterargument, everything in Europe is now in the minus column.  But most of it was already there, anyway.

During this latest iteration of the Eurozone existential crisis, we’ve dropped from 1350 on the S&P 500.  We’ve visited 1074 and seen 1284, both within weeks of one another.  We now seem to be generally moving sideways, but bouncing between 1215 and 1270.

What is the market saying?  This trading pattern says to me that the market is highly emotional but no one has a clue to figuring out what’s going on in the Eurozone.

thoughts on Euroland

As a first step toward developing a (hopefully) intelligent stance to take toward the Eurozone in building an equity portfolio, I thought I’d try to list the points I feel confident about.  That may be enough for me to use;  at the very least, I may be able to highlight what other information I really need to know.

Here goes:

1.  Matters would be worse on Wall Street if the US economy weren’t recovering.  While not thrillingly optimistic, the view of Jim Paulsen, Wells Fargo’s chief investment strategist, is an interesting–and, to me, a completely plausible one.  He terms the current sluggish recovery as normal for the US in today’s world.  It only looks bad when we compare it with recoveries from thirty or forty years ago, when economic circumstances were very different.

2.  The Eurozone won’t be generating much economic strength for years, I think.  If so, as investors we should regard Europe as a special situations market and be very choosy about what stock we own.  If we take it as given that we don’t want much exposure, our biggest concern has to be that the economy there gets bad enough that it punches a hole in the bottom of the world’s economic boat.

Why do I think European prospects are dim?

–Japan hid the banking problems that resulted from its late-1908s speculative bubble for a decade.  Its economy stagnated during that time.

–The US fixed the worst damage to its banks almost immediately and the economy began to perk up 18 months later.

–Euroland?  So far, it has followed the Japanese example.  The result has been little growth and creation of the only negotiating chip places like Greece and Italy have.  Even if the EU recapitalized its banks tomorrow, we wouldn’t see the positive economic effects until 2013, at the earliest.

3.  Euroland’s investment importance comes from the accumulated wealth its citizens hold, not its size or growth prospects. 

How so?

Look at the Eurozone’s (small) size.

Using Purchasing Power Parity calculations from the World Bank (I got them on Wikipedia), global economies break out as follows:

Brazil, Russia, India, China         25% of the world

US, Canada, Mexico          23%

Eurozone          15%

rest of EU          5%

Japan          6%

everybody else          26%.

I draw two conclusions from this list:

–Euroland isn’t that big in world terms any more.  The fate of the “other” 85% is hugely more important than what happens in Europe.

–One possible outcome for the Eurozone is that it fades into insignificance in the way that Japan has during the past two decades.  I’m not sure this is the most likely outcome, but it’s a good possibility.  After all, the EU has many of the same cultural rigidities that have helped to sink Japan, and it hasn’t fixed its banking system.  Japan’s economic collapse didn’t stop the 1990s from being a very profitable decade for investors elsewhere.

4.  The worry isn’t a deep recession in Europe–it’s uncertainty about unanticipated consequences.  At least, I don’t think it should be about Eurozone recession.  According to the Conference Board, a US-based economic consultant, the world is likely to grow by about 3% in real terms (that is, after subtracting inflation) in 2012.  The agency thinks  the EU is most likely to grow by 1%;  its “pessimistic” scenario has the area little better than flat for the next half-decade.

What does Europe mean for overall world economic expansion, in the Conference Board’s view?  Realistically, nothing.  In the base scenario, the EU chips in .15% to world growth–more or less a rounding error.

Let’s assume that somehow the bottom falls out of Europe next year and the Eurozone has a horrible recession where output shrinks by 5% in real terms.  That would subtract .75% from world expansion.  The globe would still grow, but by 2%+ instead of 3%.

That’s it for today.  More on this topic tomorrow.

Interestingly, Hong Kong-based analysts didn’t take this as an unambiguously good result.  They point out that, although Golden Week in early October was a rip-roaring success this year, the year on year growth of the market for the month as a whole was the lowest since January.  That’s obviously correct.

They conclude from this that Macau’s wealthy Chinese customers are feeling the pinch of the mainland’s efforts to slow economic growth, and are gambling less as a result.  A corollary, not so clearly spelled out, is that casinos are posting gambling winnings as revenues today that will ultimately have to be written off as uncollectable receivables.  That may also be true, although the bond rating agency Fitch says there’s no evidence of any of this so far. Fitch, in fact, estimates that the Macau gambling market will grow by at least 20% next year, double the rate that the more pessimistic analysts are calling for.

One notable feature of recent months’ results is the market share shift toward the companies with newer casinos, located in Cotai.  This suggests there’s gambling space in other, older casinos that is going unused.  There are any number of explanations for why this may be happening, like transportation bottlenecks that prevent visitors from reaching Macau, or casinos turn away “iffier” credits.  But it’s also possible that we’re reached a phase of market maturity where simply getting to Macau and gambling anywhere isn’t enough.  Some gamblers may be choosing not to go to Macau unless they get a minimum level of service.

If so, we should expect a more sedate rate of growth than the 45% or so we’re experiencing now.  But the more important investment issue may well be to separate winners from losers.  That’s certainly been the case so far in 2011, as Galaxy and China Sands have left other casinos in the dust–especially SJM and MGM.

areas of current strength

Bain’s estimates current growth prospects by category as follows:

hard luxury (jewelry, watches)     +18%

accessories          +13%

luxury goods in general     +10%

apparel          +8%

perfume/cosmetics          +3%

art de la table          +3%

cyclical forces…

As you’d expect, more expensive items, those sold through wholesalers (who stop buying, period, in recession and turn all their efforts into converting their existing inventory into cash) and those with a large percentage of aspirational buyers all fare the worst in an economic downturn.  Luxury watches are the prime example.  Anything sold through department stores might also qualify.

Men’s apparel is also highly cyclical.  For whatever reason, women continue to buy luxury goods during a downturn.  True, they may trade down a bit and space their purchase farther apart.  But men tend to stop dead in their tracks.  One reason is that big traditional men’s categories like business suits and formal wear are expensive and easily postponable purchases.  Another is that women control the purse strings in most households around the world.

So it’s no surprise that this year watches, expensive jewelry and men’s apparel are all doing extremely well.

Maybe the unusual strength of luxury goods indicates there’s some pent-up demand being met.  In any event, luxury buyers are clearly signalling with their wallets that, for them,  the economic downturn is a thing of the past.

…and secular

who

The traditional picture of a luxury goods buyer is: female, older, from either Europe or Japan.

That’s changing.  Increasingly, customers are younger, more casual,  and male.  These may be trends in many geographies.  However, the main reason theses attributes are appearing on the radar screen is that they describe the Chinese luxury goods consumer.  At 20% of the market, Chinese buying is already very big, and it’s growing very quickly as well.

where

For at least the past decade, makers of luxury goods have been upping their own retail presence.  They are doing this so they can capture the wholesale-to-retail markup.  It also gives them greater control over their brand image and their inventories.

Nevertheless, the luxury goods industry is still predominantly wholesale.  But Bain thinks that the percentage of industry sales through wholesale channels will have shrunk in 2011 to 72% of the total from 75% just two years ago.  This comes despite the business cycle strength of department stores.

online

Internet sales comprise only 3% of total luxury sales at present.  But the category is expanding very rapidly.  Bain thinks online sales will be up by 25% this year, to €5.6 billion.

Online has two segments:  full price and off-price.

Full price is is growing faster than overall luxury sales and comprises about two-thirds of all internet business.  But it’s being left in the dust by off-price, which is one-third today but which amounted to only 20% of online sales four years ago.  Private “flash” sales are the fastest growing part of off-price.

outlets

Off-price non-internet sales amount to about €10 billion, or 5% of the overall luxury market.

Outlet sales grew by 22% last year.  Bain projects them to expand by another 13% in 2011.  That’s faster than the overall luxury goods market, despite the return to health of the full-price market and the consequently smaller amount of unsold merchandise sloshing around in the system.  (Although Bain doesn’t talk about it, part of the answer to this apparent contradiction is that luxury goods companies also produce low-end “outlet only” merchandise.)

This isn’t news.  Outlets are a long-standing, mature channel in the US and Europe.

What is noteworthy is the rapid growth–around a +30% clip–that’s just starting in off-price sales in Asia and Latin America.

brand proliferation, company consolidation

Over the past ten years, the market share of the top five luxury brands has shrunk from 26% of the market to 21%.  In contrast, the share of the top five luxury goods companies has risen from 30% to 35%.

To me, this means market power is shifting from the owners of iconic individual brands to companies that are sophisticated enough provide a common platform–supply chain, support for in-house retail, dealing with consumer preferences in many different geographies–on which a group of disparate brands can operate in an increasingly complex global environment.

More and more, these technology and management factors will be the keys to success.  This also implies that these factors will increasingly be the selling points used to convince acquisition targets to join a luxury conglomerate.  The recent sale of Bulgari to LVMH is a case in point.