Shaping a portfolio for 2014 (iii): outside the US

For an equity investor, the two most important geographical areas outside the US are Greater China and the EU.  Japan is arguably a third, although in today’s world it’s more a cautionary tale about the horrible consequences when an aging population, inflexible businesses and dysfunctional government conspire to retard change.

China

An impending once-a-decade leadership change in the Communist Party slowed the Chinese economy this time a year ago.  Business and government both kept a low profile while waiting to see what the new administration in Beijing would bring.

Handing over the reins this time also came at a delicate point in Chinese economic development.  The mainland has reached the limits of its ability to expand based on exporting products made with cheap labor.  To grow in a healthy way, it must shift more toward domestic demand, consumer spending-driven expansion.  This change is notoriously difficult for any developing economy to achieve, both because the forces eager to maintain the status quo are so powerful and, especially in the case of China, the move entails loss of direct control by the elites and the empowerment of individual consumers.  Not fun for the CCP.

For the new leadership, so far so good.

For investors, the thing to focus on in the near term is that growth in the mainland is accelerating–although GDP gains will likely stay at “only” +7% or so real.  It doesn’t hurt, either, that demand from the US and the EU for Chinese exports is rising again.

The mainland stock markets are no longer the dumping grounds for the shares of toxic state-owned enterprises that they were a decade ago.  Nevertheless, I think the two best ways to gain exposure to China are either to buy China-oriented stocks listed in Hong Kong, or to get indirect exposure through US- or EU-based multinationals with a large share of their earnings growth coming from China.  Either way, having a piece of the mainland in an equity portfolio will be a good thing next year.

EU

Taking a long-term view, the EU population is older than that of the US and substantially less mobile.  The economy there grows more slowly.  The lack of a common banking system is one of a number of severe structural flaws in that union which the EU is struggling to overcome. Although the EU was only on the periphery of the US home mortgage debacle that caused the Great Recession, its “austerity” approach to countering the effects of the downturn made the EU’s problems worse–and longer-lasting.

Still, the EU has its moments.  This is one of them, in my view.  The EU economy passed its economic low point a number of months ago.  It will be expanding, although probably slowly, for the next several years.  In a sense, it’s where the US was in, say, 2010.  In addition, the EU will be aided by mutually reinforcing  expansion in China and the US.

So having some EU exposure will be a good thing.

The key issue for investors, I think, is whether the euro will be strong vs. the US dollar or weak.  In the former case, the best stocks will be domestic demand-oriented EU firms and US companies with large EU exposure.  In the latter, the stars will remain the export-oriented multinationals based in the EU that have outperformed over the past several years.  I think the euro will be strong–not overpoweringly so, but enough to tilt portfolio selection toward strong-euro beneficiaries.

Japan

Abenomics will face its acid test in 2014, I think.  If Abenomics is only about currency depreciation and deficit spending without the “third arrow” of structural change, it will end in tears.  That’s my diagnosis.  On the other hand, I’ve been completely wrong so far, missing about the huge extent of the rise of weak-yen beneficiaries over the past year or so.  As I see it, weak yen = great vacation destination, but nothing more.  For the sake of Japanese citizens, I hope I’m wrong again.  For the first time in a long while, I own nothing in Japan.

 

 

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