Hong Kong riots

a brief-ish history

During the first part of the 19th century the UK’s stores of gold and silver were being depleted (in effect contracting the country’s money supply) to pay for tea imported from China.  London suggested to Beijing that they barter opium from the British colony India instead.  Beijing sensibly refused.  So in 1841 the British army invaded China to force the change.  The UK seized Hong Kong to use as a staging area and kept it once China submitted to its demands.  During a second Opium War (1856-60), launched when China again balked at the mass shipment of narcotics into its territory, the UK seized more land.

In 1898, China granted the UK a 99-year lease over the area it occupied.  This legalized the status of Hong Kong, which remained under the practical control of the “hongs,” a newer form of the old British opium companies, for much of the 20th century.

In the late 1970s Deng Xiaoping made it clear that the lease would not be renewed but that Hong Kong would remain a Special Administrative Region, with substantial autonomy, for fifty years after its return to China on June 30, 1997.  (For its part, the UK parliament decided Hong Kongers would find the climate of the British Isles inhospitable.  So these soon-to-be-former British subjects would be issued identity cards but no other legal protections–citizenship, for example–within the Commonwealth on the handover.  This is a whole other story.)

Hong Kong’s importance today…

The conventional wisdom at that time was that while Hong Kong China’s main goal in triggering the return was to set the stage for the eventual reintegration of (much larger) Taiwan, where the armies of Chiang Kaishek fled after their defeat by Mao.

Today Hong Kong is much more important, in my view, than it was in the 1980s.  Due, ironically, to the sound, and well-understood worldwide, legal framework imposed by the UK, Hong Kong has become the main jumping-off point for multinationals investing in China.  It’s also an international banking center, a transportation hub and a major tourist destination.  Most important for investors, however, is that its equity market not only has greater integrity than Wall Street but is also the easiest venue to buy and sell Chinese stocks (Fidelity’s international brokerage service is the best in the US for online access, I think, even though the prices in my account are invariably a day–sometimes three–old).

…and tomorrow

Mr. Trump has begun to weaponize US-based finance by denying Chinese companies access to US capital markets, US portfolio investors and, ultimately, the dollar-based financial system.  China’s obvious response is accelerate its build up of Hong Kong as a viable alternative in all three areas.  As with the tariff wars, Trump’s ill thought out strategy will most likely galvanize these efforts.

the riots…

Hong Kong has 27 years left to go as an SAR.  For some reason, however, Xi seems to have decided earlier in 2019 to begin to exert mainland control today rather than adhering to the return agreement.  His trial balloon was legislation under which political protesters in Hong Kong whose statements/actions are legal there, but crimes elsewhere in China, could be arrested and extradited to the mainland for prosecution.  This sparked the rioting.  These protests do have deeper underlying causes which are similar to those affecting many areas in the US.

…continue to be an issue

The recent change in Hong Kong’s stock listing rules (to allow companies whose owners have special, super voting power shares) and the subsequent fund raising by Alibaba seem to me to show that Beijing wants Hong Kong to become the center for international capital-raising by Chinese companies.  From this perspective, Xi’s failure to minimize disruptive protests by withdrawing the extradition legislation quickly is hard to understand.

One might argue that Xi, like Trump, is trying to reestablish an older order, purely for the political advantage it gives.  In China’s case it entails reviving the Communist Party’s traditional power base, the dysfunctional state-owned enterprises that Deng began to marginalize in the late 1970s with his move toward a market-based economy (i.e., “Socialism with Chinese Characteristics”).   I find it hard to believe that Beijing is as impractical and dysfunctional as Washington, but who knows.

My bottom line:  I think the Hong Kong situation is worth monitoring carefully as a gauge of how aggressively China is going to exploit the opening Trump policies have haplessly given it to replace the US as the center of world commerce–sooner than anyone might have dreamed in 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

the Huawei issue

Huawei is an integrated Chinese telecom company whose products range from handsets to large-scale transmission equipment.  It’s the leading provider of next generation, G-5, cellular infrastructure, a market where the US has no viable entry.  Washington has successfully put enormous pressure on the big US telecom companies not to buy Huawei products, arguing that its devices may contain hidden back doors that could allow Chinese intelligence operatives to spy on conversations and intercept data.

Despite this, Huawei has established a substantial foothold in small US communities because its offerings are much cheaper and better than competitors’.  American worries/threats appear to be met with shoulder shrugs in the EU as well, on the idea that conversations are already being intercepted by the US, so how much worse than Mr. Trump can China be.

In addition, the administration has:

–placed Huawei on the “Entity List,” thereby designating Hauwei a threat to national security and giving the government the ability to cut off the company’s access to American-made computer chips and other components

–floated the idea that Huawei–other Chinese companies as well–could be denied access to US financial markets–bond, stock and bank lending–as venues for raising capital.  Government-related investment pools may also be barred from owning Chinese securities, including Huawei

–had the Huawei CFO (the daughter of the Huawei chairman) arrested on charges of money-laundering and violating the embargo on Iran–effectively telling the company not to use the US banking system at all.  Ms. Meng is still under house arrest in Vancouver, 14 months after being detained at US request in Canada, fighting extradition.

 

practical implications, as I see them

–although chipmaking has been a Beijing priority for as long as I can remember, the industry has never really developed in China.  I don’t know why.  Washington’s action certainly underlines for Beijing the urgent need to do so.

–my strong impression is that US-based chip companies have continued to supply Huawei from fabs abroad during the on-again, off-again embargo.  Since high-end fabs can be located practically anywhere, the Trump ban on sales to Huawei has likely knocked the US way down the list of locations for new investment

–over the past few years China has slowly been opening its securities markets to foreigners.  The pace of creating an alternative to the US as a source of capital will doubtless pick up after the Trump threats.  Hong Kong, for example, has recently changed its rules to allow companies with multiple classes of shares to list.  And Alibaba has chosen Hong Kong over its prior home, New York, for its latest equity raising.  I think this is just the beginning of China’s move to decrease its reliance on the US

–by weaponizing the dollar-based payment system against national champion Huawei (Mr. Trump has suggested that the charges against Ms. Meng would disappear as part of a trade deal), practical support for the renminbi as a substitute for the dollar must be rising strongly in Beijing.  Implementation is a looong way off, but the seeds have been planted.

on a more conceptual level…

It seems to me that the recent rash of shoot-yourself-in-the-foot economic policy making in Washington makes the US much less desirable as a place for capital investment to anyone, foreign or domestic.  Yes, Mr. Trump is the catalyst, but Washington appears to meekly acquiesce to his economically damaging edicts.

Two saving graces:

–Xi Jinping’s embrace of backward-facing state-owned enterprises as a way of strengthening the grip of the Communist Party over that economy parallels Mr. Trump’s odd desire to relegate the US to the third world.  So China may not be able to exploit fully the huge opportunity Washington is presenting it.

–the obvious move for Beijing would be to ally with the EU against the US.  The easiest connecting link would have been the UK, which, however, is in the process of destroying itself through Brexit.  Is Germany an acceptable substitute?

 

 

 

Keeping Score, November 2019

I’ve just updated my Keeping Score page for November.  Given the absence of mutual fund selling in October, not a bad result.

Trumponomics—good for the economy?

Supporters of Donald Trump tend to excuse his white nationalism, his erratic policymaking, the paucity of his factual knowledge, the whiff of sadism in his treatment of immigrants, the apparent promotion of family business interests…by saying that at least he’s good for the economy.  They typically cite low unemployment, GDP growth and the stock market as proof.

Is that correct?

Yes, unemployment is low.  Yes, the economy is growing at trend–after receiving a boost from fiscal stimulation (the corporate tax cut) last year.  And the stock market did rally on the announcement of Trump’s election victory.  (We can quibble about stock market performance:  though significantly higher today, the US was pretty much the worst market in the world in 2017, when virtually everybody was up–and more than us; since the 20% boost in US corporate after-tax income it’s up another 10%–much better performance than markets where the tax rate has remained unchanged).

But I think this rationalization, offered typically by wealthy beneficiaries of income tax changes, simply deflects attention away from administration policies that can potentially do severe long-term damage to US prospects.  Here are a few:

–tariff wars.  Tariffs can be an important way to give industries of the future breathing room to develop, by insulating them from more sophisticated foreign competition.  The administration, however, is protecting low value-added manual labor jobs against competition from more efficient firms in China.  These tariffs have the perverse effect of retarding manufacturing development here while forcing China to turn to higher value-added work.  The latter is a perennial stumbling block for developing countries, so the excuse of Trump tariffs to force the move to higher value-added industry is a rare gift to Beijing.

In addition, the US has been a prime destination for multinationals’ advanced manufacturing because of the large local market and the experienced workforce.  The possibility of tariffs–and their apparently unpredictable implementation–has stopped this flow.

–retaliatory tariffs.  Tariffs don’t go unanswered. China responded to US levies by shifting purchases of soybeans to Brazil and other countries.   As/when tariff wars end, the soybean market will most likely not revert to the status quo ante; once in the door, other, arguably more dependable, suppliers will doubtless retain market share.  By the way, when the administration withdrew from the TPP, it also made US soybeans more expensive in another Pacific market, Japan.

–restrictions on immigration.  The solution for tech companies who are unable to hire foreign scientists to work in the US because they can’t get visas is to move R&D operations to, say, Canada.  Also, the administration’s white supremacism has made foreigners question whether they will be safe in the US as tourists or students, hurting both industries.  Chinese citizens may also feel it’s unpatriotic to travel here.  A bigger worry:  will this force US-based multinationals to begin to regard themselves as no longer American?

–zero/negative interest rates.  This is a weird situation in financial markets, which, to my equity-oriented mind, is bound to end badly. Ultra-low rates are also trouble for risk-averse savers, including traditional pension plans.  In the US, downward pressure on rates comes both from foreign bond arbitrage and administration demands that the Fed offset tariff damage to growth with looser money policy.

 

Meanwhile, what’s not being addressed:  infrastructure, health care including drug prices, education, retraining displaced workers (where we’re worst in the OECD)

 

 

 

public utilities and California wildfires

public utilities

The idea behind public utilities is that society is far worse off if a municipality has, say, ten companies vying to provide essential services like power and water to citizens, tearing up streets to install infrastructure and then maybe going out of business because they can’t get enough customers.  Better to give one (or some other small number) a monopoly on providing service, with government supervising and regulating what the utility can charge.

The general idea of this government price-setting is to permit a maximum annual profit return, say 5% per year, on the utility company’s net investment in plant and equipment (net meaning after accumulated depreciation).  The precise language and formula used to translate this into unit prices will vary from place to place.

The ideal situation for a public utility is one where the population of the service area is expanding and new capacity is continually needed.  If so, regulators are happy to authorize a generous return on plant, to make it easier for the utility to raise money for expansion in bond and stock markets.

mature service areas

Once the service area matures, which is the case in most of the US, the situation changes significantly.  Customers are no longer clamoring to get more electric power or water.  They have them already.  What they want now is lower rates.  At the same time, premium returns are no longer needed to raise new money in the capital markets.  The result is that public service commissions begin to reduce the allowable return on plant–downward pressure that there’s no obvious reason to stop.

In turn, utility company managements typically respond in two ways:  invest cash flow in higher-potential return non-utility areas, and/or reduce operating costs.  In fact, doing the second can generate extra money to do the first.

How does a utility reduce costs?

One way is to merge with a utility in another area, to cut administrative expenses–the combined entity only needs one chairman, for example, one president, one personnel department…

Also, if each utility has a hundred employees on call to respond to emergencies, arguably the combined utility only needs one hundred, not two.    In the New York area, where I live, let’s say a hundred maintenance people come from Ohio during a blackout and another hundred from Pennsylvania to join a hundred local maintenance workers in New York.  Heroic-sounding, and for the workers in question heroic in fact.  But a generation ago each utility would each have employed three hundred maintenance workers locally, most of whom have since been laid off in cost-cutting drives.

Of course, this also means fewer workers available to do routine maintenance, like making sure power lines won’t get tangles up in trees.

the California example

I don’t know all the details, but the bare bones of the situation are what I’ve described above:

–the political imperative shifts from making it easier for the utility to raise new funds (i.e., allowing a generous return on plant) to keeping voters’ utility bills from increasing (i.e., lowering the permitted return).

–the utility tries to maintain profits by spending less, including on repair and maintenance

The utility sees no use in complaining about the lower return; the utility commission sees no advantage in pointing out that maintenance spending is declining (since a major cause is the commission lowering the allowable return).   So both sides ignore the worry that repair and maintenance will eventually be reduced to a level where there’s a significant risk of power failure–or in California’s case, of fires.  When a costly failure does occur, neither side has any incentive to reveal the political bargain that has brought it on.

utilities as an investment

In the old days, it was almost enough to look at the dividend yield of a given utility, on the assumption that all but the highest would be relatively stable.  So utilities were viewed more or less as bond proxies.  Because of the character of mature utilities, no longer.

In addition, in today’s world a lot more is happening in this once-staid industry, virtually all of it, as I see things, to the disadvantage of the traditional utility.  Renewables like wind and solar are now in the picture and made competitive with traditional power through government subsidies.  Utilities are being broken up into separate transmission and generation companies, with transmission firms compelled to allow independent power generators to use their lines to deliver output to customers.

While the California experience may be a once-in-a-lifetime extreme, to my mind utilities are no longer the boring, but safe bond proxies they were a generation or more ago.

Quite the opposite.

 

 

 

 

 

 

 

the best of all possible worlds/the invisible hand/modern portfolio theory …and stupid stuff

Leibniz

Scientific thinkers of the seventeenth- and eighteenth centuries in Europe described the universe as being like a gigantic, complex, smoothly-functioning watch.  This implies, they argued, that the cosmos must have been made by the supreme watchmaker = God.

G W Leibniz, the inventor of calculus, offered the idea (later lampooned by Voltaire in Candide) that ours is also the best of all possible worlds.  What about war, famine, disease, poverty…?  Leibniz’ view is that though we can imagine a world like ours, only better, that thought-experiment world is not possible.  Put a different way, Leibniz thought that behind the scenes God uses a calculus-like maximizing function for his creation.  The total amount of goodness in the world is the highest it can be.  Were we to make one existing bad thing better, other things would worsen enough that the sum total of good would be reduced.

Adam Smith

Around the same time Adam Smith introduced into economics basically the same idea, the “invisible hand” that directs individuals, all following their own self-interest, in a way that also somehow ends up serving the public interest.  This idea, still a staple of economics and finance, has the same, ultimately theological, roots–that behind the scenes a benificent God is working to create the best possible outcome.

since then

The scientific world has moved on since Leibniz and Smith, thanks to Hegel/Marx (social evolution), Schopenhauer (collective unconscious), Darwin (natural evolution), Kierkegaard (God of religion vs. god of science), Nietzsche (change without progress) and Freud (individual unconscious).

Twentieth-century physicists, starting with Einstein, have suggested that the universe is in fact messier and more unruly than Newton thought.

Nevertheless, the laissez faire assumption of the invisible hand that makes everything ok remains a key element of economic and financial theorizing.

Modern Portfolio Theory

Invented by academics over fifty years ago, MPT is what every MBA student learns in business school.  Its main conclusion is that the highest value portfolio (i.e., the best of all possible portfolios) is the market index.  A cynic might argue that the main attraction of a theory that says practical knowledge or experience in financial markets is useless is that it suits the interests of professors who possess neither.

However, the conclusion is not just convenient for the educational establishment.  It also fits squarely into the 18th century European Enlightenment view of the “invisible hand” guiding the market.

MPT requires a bunch of counter-intuitive assumptions, summed up in the efficient markets hypothesis, including that:

–everyone acts rationally

–everyone has the same information

–everyone has the same investment objectives

–everyone has the same investment time frame

–everyone has the same risk tolerances

–there are no dominant, market-moving players.

Granted all this, one can argue that any portfolio that differs from the market will be worse than the market.

The standard criticism of MPT is that it ignores the bouts of greed and fear that periodically take control of markets.  In fact, even while MPT was being formulated, markets were being roiled by the conglomerate mania of the late Sixties, the Nifty Fifty mania of the early Seventies and the wicked bear panic of 1974, when stocks were ultimately trading below net cash on the balance sheet and still went down every day.

Arguably anyone looking out an ivory tower window should have noticed that MPT had no way of talking about the crazy stuff that was roiling Wall Street almost constantly during that period–and which showed its assumptions were loony.  Nevertheless, theology trumped the facts.

today

In a way, MPT suits me fine.  The fewer people looking for undervalued companies the easier it is for the rest of us to find them.

However, one basic high-level assumption that even professional investors still make is that the economic/political system in the US functions relatively prudently and therefore the economy remains more or less stable.  But in essence this is only a different way of saying the “invisible hand” guides self-interest-seeking individuals in politics toward a socially beneficial result.

I’m not sure that’s true anymore, if it ever was.  For one thing, Washington has relied almost exclusively on monetary policy to fine-tune the US economy over the past generation–encouraging all sorts of unhealthy financial speculation and intensifying social inequality.  Washington has also done less than the ruling body of any other developed country to help citizens cope with dramatic structural economic changes over the past twenty years.  Resulting dissatisfaction has caused the rise to power of newcomers like Donald Trump who have pledged to address these issues but whose racism, venality and stunning incompetence appear to me to be doing large-scale economic and political damage to the country.

This development presents a significant issue for laissez faire theorists in the way deep emotionally-driven market declines do for the efficient markets hypothesis.  As a practical matter, though, the situation is far worse than that:  recent events in the US and UK illustrate, populating the halls of economic and political power with self-serving incompetents can do extraordinary amounts of damage.  Left unchecked, at some point this has to have a negative effect on stock returns.