the EU today: structural adjustment needed

Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.

How should an equity investor proceed?

There are two schools of thought, not necessarily mutually incompatible:

–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd.  This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention.  If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services.  These will almost certainly outperform the market.

The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.

–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well.  The result is that they don’t do as well as similar companies elsewhere.  I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.

It may be that the local market is offended by brash upstarts.  It may be that local portfolio managers deal only in book value and dividend yield as metrics.  It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock.  One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.

 

The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time.  Because of this, and because of Brexit, the UK assumes greater importance for me.  So, too, Hong Kong, as an avenue into mainland China.  And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.

 

A final thought:  one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices.  Both areas have relatively old populations.  If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade.  I don’t think this is correct, but as investors we should all be attentive to possible signs.

 

Make in India?

I’m not sure exactly why I’m on a foreign markets/economies kick, but I think I’m pretty close to the end of it.

India and me

I’ve been fascinated/horrified by India economically for over twenty years.  On the one hand, the country has lots of potential, based on a huge internal market and a large, well-educated workforce.  On the other, economic success for India continues to rely on how favorable the monsoon season is.  The country’s leaders are clearly aware of, and dismayed by, the fact that nations they may regard at any given time as peers soon leave India behind in the dust.  But not that much has changed over the time I’ve been observing.

“Make in India’

“Make in India” is the marketing slogan the Narendra Modi administration has chosen to promote foreign direct investment, a time-honored tool for simulating economic progress through technology transfer.  Think:  Japan, Korea, Thailand, Malaysia, China…  The road map is clear.  The only question is whether a country has the political will to make the journey.

rules for success

I thought I’d try to list in this post, loosely in order of importance, what’s needed to attract foreign firms to create a business in a developing country.  They are:

–a large pool of trained, or trainable, workers

–roads and ports, to get output from the manufacturing site to market

–sources of electric power, clean water and telecommunications

–a stable legal system, so the rules of the game are clear at the outset and the goalposts don’t get moved after a firm has committed capital

–protection for intellectual property.  A generation ago, multinationals dealt with this crucial issue by sending to the Third World only the tools to make machines that were already obsolete in the First.  By and large, that’s no longer a viable option.   Because in today’s world technology transfer means not only how to organize and run a business but also current trade secrets, protection of intellectual property is more crucial than ever.

–it’s always nice to have a large internal market, so that the success of a factory doesn’t depend solely on export orders

–it’s also nice to have an eco-system of available suppliers and support industries grouped nearby.

How does India stack up?

It has a large internal market and a big pool of potentially available workers.

The physical infrastructure has never been great, in my experience   …and India has never seemed to me to have effectively in made infrastructure development a high government priority.

India has always struck me as distinctly unwelcoming to newcomers, and to foreign enterprises in particular.

Mr. Modi says he wants to change that.  Whether he will be able to is another question.  So, too, is whether he really means what he says.

 

 

 

Shaping a Portfolio for 2016: emerging markets

your father’s emerging markets…

I started working in emerging markets in 1984.  At that time, the most important were Hong Kong and Singapore.  If one were feeling adventurous, Thailand, Malaysia and even Indonesia (shudder!) beckoned.  Taiwan and Korea were also on the list, but not easily accessible to foreigners.

At that time, there was a certain equivocation in the “emerging markets” term.  Yes, the stock markets were relatively rudimentary and overlooked by investors in the US and the EU.  But the economies of the big ones, Hong Kong, Singapore, Taiwan and Korea, were all advanced, with living standards for the average resident somewhere between those in Europe and the US.

With the notable exception of Indonesia, the 1980s-style emerging markets were all oil importers (Malaysia and Thailand have large reserves of natural gas, and export LNG, but that’s a different thing).

Back in the day, investing in Hong Kong was all about the then-colony, now SAR, with exposure to the mainland limited to the successors to the nineteenth-century opium traders and a few small manufacturers with operations on the mainland.

Mexico was the notable emerging market not in the Pacific.

 

…and today’s

China is now, of course, the emerging markets behemoth.  Direct access to foreign portfolio investors isn’t seamless.  Nor, in my view, is it desirable.  However, the investment significance of Hong Kong has radically shifted, from a focus on the physical place to the access its China-related listings allows to the mainland.

Perhaps more important for today’s economic situation, however, the emerging markets arena has expanded to include much more of Latin America (think: Brazil or Venezuela)–and, after the fall of the Berlin Wall, Russia and Eastern Europe as well.  Some thrill-seeking investors have tiptoed into the Middle East as well.

Two strong net effects:

–the emerging markets category contains many more emerging economies, with less stable politics, and

–today’s emerging markets are heavily weighted toward exporters of natural resources, especially oil.

for 2016:

China is several years into a transition from being an export-oriented manufacturer to being a domestic demand-oriented service economy.  The way I look at it, China is doing better than the consensus thinks–and will continue to do so in 2016.

The rest of the emerging markets arena is a mess.  Economically, that’s mostly because so many countries depend on mineral exports.  From a stock market point of view, it’s that plus the high weighting of natural resource issues (including banks that finance them) in the local indices.

My guesstimate is that Greater China will show 6% real GDP growth in 2016.  As a group, the rest will be in the minus column.  I have no idea what the net result will be.  I’m planning on it being mildly positive.

Until the oil price begins to recover–mid-year at the earliest, I think–I don’t see this as a time to hold an emerging markets index.  Individual stocks or a China fund/ETF is the way to go.  Other than China, developed markets, rather than emerging markets, are the place to be.

 

 

 

 

 

 

 

 

is the e-commerce market in China saturated?

I’ve recently begun receiving emails again from the Fung Business Intelligence Center, an arm of the Hong Kong-based, garment-oriented logistics company Li and Fung.  One of the latest poses the question that’s the title of this post.

The answer:  yes  …and no.

Yes, the market in the developed areas of China is close to saturation today.  However, rural areas of the Asian giant remain relatively unexploited, both by internet and traditional bricks-and-mortar retail.  FBIC thinks that the rural sector, which now makes up about 10% of Chinese e-commerce revenue will be at least as large as the urban sector in as little as 10 years.  My back of the envelope calculation is that rural e-commerce growth will add at least five percentage points annually to what overall e-commerce expansion would otherwise be.  Presumably, some Chinese e-commerce players will be more adept at wooing this business than others, meaning their rural business could add 10% or so to annual sales growth.

The FBIC report, which is relatively short, is well worth taking a look at.

the Fed’s rate rise dilemma

It’s looking more and more to me as if the Fed is being paralyzed into inaction by worries about two possible negative effects of beginning to raise rates now.  The dilemma is that the current zero interest rate policy is playing a large role in making each situation worse.

 

The IMF is arguing that economies in the emerging world are too fragile at present to withstand even a small rate rise in the US.  The agency points out that many emerging economies are very dependent on dollar-denominated natural resources, and therefore are being hurt badly by the current slump in demand for minerals.  In addition, many have borrowed heavily in US dollars to finance industrial (read: natural resources) capacity expansion.  Even a small rise in US interest rates, the IMF says, could spark a sharp upward spike in the value of the dollar against other currencies.  This would further dampen demand for natural resources.  At the same time it would make the local currency cost of dollar-denominated loans skyrocket, possibly into impossible-to-repay territory.  In other words, the Fed could trigger an emerging market crisis similar to the one in smaller Asian countries in the late 1990s.

Of course, what made natural resources firms so foolish as to create wild overcapacity?   …one big reason has been the availability of cheap (by historical standards) dollar-denominated loans.   What has prompted (and continues to prompt) US investors (among many others) to take the risk of lending crazy-large amounts of money for projects in places they know nothing about and for projects they didn’t understand   …years and years of low interest rates on Treasury securities and other safe alternative caused by the Fed’s intensive-care low rates.

 

The Fed has carefully studied the failure of Japan in the early 1990s to reignite economic growth after its economic meltdown in late 1989.  The key factor there, in the Fed’s view (mine, too, for what that’s worth) was that the country tried to remove policy stimulus too soon.  The Fed knows that it has already used up all its economy-healing power, so the country would be reliant on Washington for fiscal stimulus to rescue us in the event it makes a similar mistake.  But we all know that Congress has a poor track record for corrective action in crisis and is particularly dysfunctional now.  So the price to the economy of acting too soon could be very high.

How is it, though, that Congress has been able to ignore its economic responsibilities for so long?  …it’s at least partly due to the fact that the Fed continues to cover for lack of legislative action by running a super-easy monetary policy.  The Fed is an enabler.

 

my thoughts

Neither threat to policy normalization–the potential effect on emerging markets and the lack of an economic backup–is going to go away.  Arguably, the situation will deteriorate the longer the Fed waits.  I think the Fed should start the normalization process now.

thinking about China: deflating a stock market bubble

For most of the 30 years I’ve been watching China-related securities, the mainland stock markets have been an afterthought for virtually all foreign investors.  The same for the authorities in Beijing, as far as I can see.  They seem to have regarded the equity markets as a vehicle for funding moribund state-owned enterprises that no bureaucrat in his right mind would give money to.

The mainland markets have gradually morphed over the past decade into something more interesting, as smaller, more innovative firms elbowed their way in.  But the market remains very hard for foreigners to gain access to, and is arguably still not worth the trouble.  The real action remains in Hong Kong.

 

Last year, faced with a bubble in the domestic property market created by a flood of investment money with no place else to go, Beijing decided to redirect this flow of funds to the Shanghai and Shenzhen stock markets.

In solving one problem, however, Beijing created another.

The issue was partly that the mainland exchanges were going through the roof in US-internet-bubble fashion.  In addition, however, the rise was fueled in large part by borrowed money.  Worse, this consisted not only of official margin lending but also by huge amounts of sub rosa margin disguised as either uncollateralized borrowing or debt secured by businesses or property.  No one knew how large this total debt was–only that it was gigantic, and that inexperienced retail equity investors had leveraged themselves to the sky because they had taken government encouragement as a guarantee against losses.

 

As/when the market peaks and begins to decline, margin loans come due.  When speculators can’t add more money to margin accounts (as is inevitably the case), this triggers forced margin selling that feeds on itself and turns into an avalanche of downward pressure.  Once selling starts, it can be almost impossible to stop.  Of course, as soon as potential buyers realize what’s going on, they withdraw and wait for the market to hit bottom.

This precarious development in Shanghai/Shenzhen is not a unique phenomenon.  The same thing happened in 1985 in Singapore/Malaysia, in 1987 in Hong Kong, and in 1997-98 in many smaller Asian markets.  In hindsight, Beijing could possibly have averted the crisis by raising margin requirements and by cracking down on unofficial margin loans by financial institutions.  But it didn’t.

Beijing seems to me, however, to have followed the standard protocol for dealing with a mammoth overhang of margin selling and restoring order to the market, namely:

  1.  identifying and cutting off borrowing sources

2.  prohibiting short sellers from exacerbating the problem by speculative selling

3.  buying enough stock, either directly or indirectly, to reduce forced selling to a level that the market can handle unaided

4.  allowing the market, once functioning again, to clear by itself.

The way I look at it, we’re in #4 now.

One other comment:

in the US, the rise and fall of the stock market is regarded as the most powerful leading indicator of future economic performance.  I don’t think that what’s going on in Shanghai/Shenzhen stock trading has much macroeconomic significance.  Rather, the China stock market fall is an obstacle that every emerging market encounters on the way to stock market maturity.

 

 

 

 

 

 

 

 

 

 

more on oil

As I was thinking about this post, I knew that oil is a complicated subject and that there’s a risk of getting lost in the details.  So I decided to sketch out the structure of the post carefully on paper before I began to write.  Several pages of notes later, I abandoned the attempt, in favor of extreme simplicity (I hope).

oil

Like any other mineral commodity, oil is subject to boom and bust cycles.  We’re now in bust, meaning that supply is structurally higher than demand, exerting continuous downward pressure on prices.

As with any other commodity, prices will stay low until supply and demand come back into balance.  The slow way for this to happen is for demand, now at about 93 million barrels per day and growing at 1%+ per year, to expand.  The fast way is for prices to stay low enough, long enough for high-cost producers to go out of business.  As I see it, adjustment will primarily come the fast way.

Oil is peculiar, though, in two respects, both of which argue that prices will stay low for a considerable time:

–many major oil producing countries (e.g., the Middle East, Russia) have relatively simple economies that are radically dependent on exports of oil for government income.  Over the past year, OPEC oil output has actually risen by about 1.5 million barrels per day, despite the expanding glut.  This indicates that, unlike prior periods of oversupply, the group has no desire to try to moderate the downturn.

–the long-term geological damage to a big oilfield from turning the taps off and on can be great.  So producers are more hesitant than in other industries to do so.

the catalyst

Arguably, what has upset the pricing applecart is the unanticipated surge in oil production in the US, which was 5.6 million barrels per day this time in 2011 and is 9.5 million today.  Hydraulic fracturing is the reason for this.

where to from here?

US oil production is still averaging more than a million barrels per day higher than in 2014.  However, the steady month by month march upward of output figures may have been broken in May, when liftings were about 200,000 barrels a day less than in April.

My guess (and I’m doing little more than plucking numbers out of the air) is that at $50 a barrel or below, new fracking projects won’t get started. Under $40 a barrel, some wells may be shut in.  If a production falloff comes solely through the former mechanism, we’re probably a year away from a meaningful (translation:  more than a million barrels, but after that, who knows) decline in fracking output.

That would likely mean a higher oil price then than now, IF (…a big “if”) OPEC nations desperate for cash don’t up their production further.

what I’m doing

I have no desire to buy oil stocks today, because I think we’re not that far along in getting supply and demand back into balance.  In the early 1980s, for example, the entire process from top to bottom took about half a decade.  I’m also thinking that there might either be another sharp price decline, or simply a further sharp selloff in oil stocks before the current oversupply is over.  I’ve just started to think about what I might buy if either were to happen.  One thing is certain, though.  It won’t be the big oils, or tar sands, or LNG.

more than you ever wanted to know

When I started on Wall Street as an oil analyst, oil and natural gas sold for roughly the same price per unit of heating power.  Natural gas has been less than half the cost of oil on a heating equivalent basis for many years, however, because it isn’t in widespread use as a transportation fuel and because it takes a pipeline to deliver it to customers.  Natural gas is already being substituted for coal in power generation.  Will it ever have a dampening effect on the ability of the oil price to rise?