“New World Order”: Foreign Affairs

The July/August 2104 issue of Foreign Affairs contains an interesting conceptual economics article titled “New World Order.”  It’s written by three professors–Erik Brynjolfsson (MIT) , Andrew McAfee (MIT) and Michael Spence (NYU)–and outlines what the authors believe are the major long-term trends influencing global employment and economic growth.  I’m not sure I agree 100%, but I think it’s a reasonable roadmap to start with.

Here’s what the article says:

the past

Globalization has allowed companies to exploit wide wage differentials between countries by moving production from high-cost labor markets close to consumers to low labor cost areas in the developing world.  Former manufacturing workers in high-cost areas enter the service sector to seek employment, depressing wages there.

This period is now ending, as relative wage differentials have narrowed.

now

Relative labor costs are at the point where manufacturing plant location is determined by other factors.  These include:  transportation cost, turnaround time for new orders and required finished goods inventory.  This implies that manufacturing can be located closer to the end uses it serves.  However, globally higher labor costs also imply that new factories will be much more highly mechanized than before.  Robots replace humans.

As a result, wage growth will remain unusually subdued.

the future 

Although returns to capital have avoided the erosion that has befallen labor over the past generation, this situation won’t last.  Long-lived physical capital is being replaced by software (note:  the majority of investment spending done by US companies is already on software).

Software doesn’t have either the total cost or the permanence of capital invested in physical things.  Software can be moved, it can be duplicated at virtually zero extra expense.  To the extent that software replaces physical capital as a competitive differentiator, it makes the latter obsolete.  It, in turn, can be made obsolete by the innovative activity of a small number of clever coders.

Therefore, the authors conclude, returns on invested capital (especially physical capital) are already beginning to enter secular decline.

Where will future high returns be found?

…in the innovative activity of talented, well-educated entrepreneurs.

education

This brings us to a major problem the US faces.  It’s the relative slippage of the domestic education system vs. the rest of the world, and an increased emphasis on rote learning (No Child Left Behind?).

The trio dodge this politically charged issue–they do observe that there’s a direction relationship between the quality of a community’s schools and the affluence of its citizens–by asserting that online learning will come to the rescue.  A child stuck in a weak school system will, they think, be able to in a sense “home-school” himself to acquire the skills he needs to succeed in the future they envision.

my take

What I find most interesting is the presumed speed at which the authors seem to think transition will occur.

–Is it possible that we’ve reached the point where there’s no available low-cost labor left in the world?  If so, this is a dood news/bad news story for low-skill workers.  On the one hand, downward wage pressure will stop.  On the other, robotization is going to take place at warp speed, making it harder to find a job.

Relocation of factories will also have implications for transportation companies, warehousing and even the amount of raw materials tied up in company inventories.

–Does software begin to undermine hardware so quickly?  Certainly this the case with online retailing and strip malls.  But how much wider is this model applicable?

–If the key to future growth is young entrepreneurs, then the sooner we as investors reject the Baby Boom and embrace Millennials the better.  This, I think, is the safest way to benefit in the stock market if the New World Order thesis proves correct.

 

 

the curious case of Chow Tai Fook Jewellery (HK:1929)–Tiffany (TIF), too

…toss in Wynn Macau (HK: 1128), as well.

Chow Tai Fook

Chow Tai Fook is a Hong Kong-based jeweler that IPOed there last December.  The company’s main business is chuk kam (24 karat) gold objects, the stuff that’s sold by weight, not market up by 100% (or more) over direct costs.  It’s not only decoration, but you can bury it in the back yard if you’re wary of banks.  And you can wear your wealth to work, in case you find out you have to flee the country right away.   (You wouldn’t chuckle if you’d lived through 1940-1960s China.)

The firm has expanded from the SAR into the mainland, and from chuk nam to high-end “fine” jewelry designed to flaunt your wealth, not hide/preserve it.  In recent years, the latter has become an increasing percentage of Chinese jewelry consumption.

a December 2011 IPO

The IPO was anything but a rousing success.  The stock was priced at HK$15, to raise US$ 2 billion.  But it came to market just as Beijing’s efforts to slow down the domestic economy were causing affluent mainlanders to cut back consumption.

The issue closed on day one at $13.80–and headed south from there.  It finally bottomed some months ago at HK$8.40.  Ouch!!

…so, what’s curious?

Here’s the thing.

The economic evidence over the past few months is that China is slowing further, despite signals from Beijing of its change to a more expansive government economic policy.

The EU is a mess.

US industry is slowing down and the “fiscal cliff” is getting closer.  Burberry and Tiffany have revised down earnings, in large part because of disappointing sales in China.  So too have tech companies like Intel.

Nevertheless,

since July 27th,

Chow Tai Fook share are up by 26.5%–vs. the Hang Seng index up 6.9%

BTW, Wynn Macau shares are up by 30.0% over the same time span

TIF began rising a little earlier in the month, but has gained almost 25% from its low–compared with about an 8% rise in the S&P 500.

why this good performance?

It’s a little like the case of Benjamin Button, whose body went through the opposite of what nature usually does.

Possibilities:

–If this were ten or fifteen years ago, I’d say investors are seeing through current weakness and beginning to discount in advance the recovery that the government policy change will likely bring.

But reacting to government cues is not the winning strategy it once was.  That’s partly because the economic problems the world faces today are more structural than cyclical.  Also, the rise of hedge funds has reoriented markets sharply in the direction of short-term trading than they have ever been.

Besides, luxury goods makers like Hermes and LVMH haven’t experienced the same stock price lifts.

–new bets on China?  But, if so, why no response from Hermes, LVMH or Coach?  Also, why would UK-US (lower-end) jeweler Signet be having better stock performance than the other three?

–influence of EU investors?  My impression has been that a lot of the damage to Hong Kong stocks during the middle months of 2012 was due to panicky selling by EU-based investors.  The clear new bullishness emanating from Europe may be resulting in portfolio managers plowing back into Asia.  That might explain why 1929 or 1128 are doing well.  But why TIF?  …or why SIG and not LVMH?

–minimizing exposure to the EU?  For aesthetic reasons, I like this better than “bets on China,” because it’s a more sophisticated wager–one based on avoiding a bad experience rather than necessarily having a good one.  Still, why TIF?

You could build a “synthetic” TIF-ex-the-EU, by combining SIG +1929.  Not a perfect replacement, but if the main idea is to avoid the EU probably an acceptable one.

my take

I’m sure there’s a method to the apparent madness.  At this point, however, I don’t know what it is.

I could say that professional investors are shifting their portfolios toward secular growth areas (as opposed to more cyclical ones) where they see profit growth will be the strongest next year.  Yes, that’s true, but it’s what most managers always do.  So it’s flirting with tautology.  The crucial question is why jewelry and casino gambling?

Is there something special about these two areas?  …or is there something awful about everything else?

One thing I am convinced of is that solving the puzzle correctly can bring investing rewards.

I own 1128 and 1929 but none of the rest of the names I’ve mentioned here.  I have no burning desire to add to any–although if I can figure out what’s going on I might develop one.

If someone were forcing me to buy  one of the names, it would probably be 1929.  The fact that it’s the most speculative of the stocks is not a coincidence.  I should knock off the caffeine instead.

a turning point for the Chinese economy

Last Thursday, David Pilling, a columnist for the Financial Times, wrote about the views of Victor Fung, the chairman of the Hong-Kong based supply chain management company Li & Fung.   This is presumably the result of an interview with Mr. Fung, although the article doesn’t say. There are three interesting points in it.

Victor Fung himself is an influential political and business figure in Hong Kong, and a senior member of the Fung family, which has substantial commercial and property interests in Greater China, including the Hong Kong-traded Li & Fung (HK: 0494).  0494 sources garments and other manufactured items, mostly from China, but also from other developing countries, for wholesalers and retailers in the US and Europe.

The three points:

1.  The Foxconn incident signals a change in the way manufacturing is done in China.  If you recall, about half a year ago, Foxconn, a Taiwanese assembly company, had a period of labor unrest in a manufacturing complex in southern China.  Workers protested poor working conditions that had induced a number of employee suicides inside a factory town.  Under pressure from US customers like Apple, Foxconn agreed to, among other things, a 30% wage increase.  The Shenzhen plant continues to have problems, though.

Mr. Fung sees this as marking a decisive turn in manufacturing in Guangdong province in southeast China, which it doubtless is.  This isn’t new news, however.  It’s an illustration of economic forces that have been in motion for the past several years (see my post on China’s economic development model.)

In short, eastern China has run out of cheap labor and has to shift to making higher value-added products there to continue to prosper.  Manufacturers can also move labor intensive operations–as Beijing would like to see happen–to western China, where plenty of unskilled workers are still available.  That would foster greater political stability and help address the sharp income imbalances between the more affluent east and the more rural, agriculture-oriented, and poorer, west.  The gating factors, as I see them, are the availability of reliable transport for finished products to the eastern ports, and infrastructure, like continuous electric power.

More interestingly, Mr. Fung also says that:

2.  Beijing is encouraging the development of labor unions.  A first glance, this seems very odd for a government constantly worried about labor unrest–after all, that’s what Tiananmen Square was all about.  And for a socialist country as well, where criticizing the owner of a factory (that is, the government) could be seen as a political crime.  But the factories in question are typically controlled by some sort of partnership between a regional/local government and a foreign manufacturing company that has the technical know-how.  Beijing has little control over either party.  Unions may be a way to get some.

Also,

3.  For the first time ever, some Chinese clients have asked Li & Fung about sourcing shoes and garments for sale in China from countries like Bangladesh or Vietnam.  The clients are presumably domestic retailers or wholesalers who currently get their wares from unaffiliated factories in China.  This development is good news for Li & Fung, but puts another source of pressure on eastern China manufacturers to lower their costs.

In general, China factories have two possible responses:

–they can lower costs, i.e., move west; or

–they can try to get Beijing to impose tariffs or other protective measures against garment imports.

Given that this would run counter to the central government’s plan to shift labor intensive manufacturing west, I think there’s little chance of the latter happening.  But this is an area to watch.

my thoughts

Developing countries have invariably had difficulties when they have reached the point where all the available unskilled labor is used up.  Typically, the companies that use unskilled labor have developed considerable political power and are also incapable of migrating their firms to higher value-added tasks.  Such firms vigorously defend the status quo.  As a result, they often form an immovable roadblock that destroys the possibility of economic progress for years (think: Malaysia).

China is in a much better position than most.  The country still has lots of unskilled labor left.  And the current administration in Beijing isn’t particularly beholden to the Guangdong-Hong Kong manufacturing interests that, in theory at least, have the greatest interest in defending the status quo.

For an investor, it seems to me the implications of all this are simple.  For someone like me, observing from halfway around the world, there’s no reason to take the risk of owning manufacturing-related companies that derive a significant chunk of their profits from eastern China.  It’s better for now to have less exposure to specific industries/geographical areas in China, and more to the general positive effect of increasing incomes.  Financial services, though not often my favorite sector, comes to mind.

By the way, in poking around the Li & Fung website, which I haven’t done in a while, I stumbled across mention of a study on the gray economy in China which I think has investment implications.  More about this tomorrow.

World Trade, Supply Chain Constraints and Stock Markets

Manufacturers are starting to have supply chain problems

An article in today’s Financial Times points out that global manufacturers are beginning to have trouble getting component parts from suppliers, especially in IT-related areas like semiconductors.  The newspaper calls this difficulty a “threat” to global economic recovery.  It’s not, in my opinion.   Quite the contrary.   This development will prolong the period of strong growth for industrials and enhance the profits of suppliers.

world trade has been a long-term growth industry

There are two reasons for this:

–since WWII and picking up steam over the past twenty or thirty years, world governments have tried to promote world trade, in the belief that closer economic ties will foster overall growth, as well as promote prospects for world peace.  In particular, governments have tried to coordinate and stabilize interest rate and exchange rate policy, and to work to dismantle legislative barriers to trade.

–generally speaking (and I know there are lots of special cases), as real GDP rises so too does real personal income.  As income rises, discretionary income (what’s left after taxes and necessities) grows at a faster rate.  People spend a portion of their discretionary income and save the rest, the proportions of each varying from country to country.  As the amount spent (not necessarily the proportion) rises, consumers tend to allocate an increasing amount to imported goods.

Put this all together, and we come up with:   consumer discretionary spending rises (and falls) faster than GDP, and spending on foreign-produced goods moves fastest of all.  So in a generally expanding economic environment, trade-related industries tend to be high-beta beneficiaries.  In fact, over the past twenty years, world trade has declined in only two–2001, when the Internet bubble popped, and 2009, when the sub-prime mortgage crisis hit.

the Great Recession impact

The contraction in 2001 was by a mere .2%, according to the World Trade Organization.  In 2009, in contract, the fall was a whopping 12.2%, the worst experience since 1975.

Why so bad?  In the aftermath of the Lehman collapse, bank financing for imports and exports came to a standstill, as financial institutions worried about the solvency of their counterparty banks in other countries.  Armed with supply chain management computer systems, companies were able to understand the falloff in their businesses that the financial crisis was causing much more quickly than before.  Also, having had the experience of not reacting fast enough or decisively enough after the internet bubble burst, firms were much more aggressive in cancelling orders and shrinking inventories.

a sharp bounceback in 2010

The WTO estimates that world trade will expand by over 7% this year, despite lackluster overall growth in the developed world.  They’re pencilling in +5% or so for 2011, as well.  So trade seems to be continuing its high-beta role–something we can confirm on a micro level by listening to recent reports from transportation companies like FDX.

Why supply shortages already?  If we do the simple arithmetic and say 2008 world trade was 100, the decline in 2009 dropped it to 87.8 and the anticipated bounceback in 2010 will return it to 94.4.  So, all other things being equal, there should be at least some spare capacity in the world’s supply chain system.  But, as the FT highlights, big companies like Siemens or Caterpillar are telling us, for them there is none.

How can this be?

–Maybe world trade growth will be higher than 7%+.  Yes, but it would need to advance by almost 14% to get back to 100.

–Clearly, some industries, like component makers for cellphones or PCs, are expanding at an extremely fast rate, so shortages in these areas shouldn’t be too surprising.

I suspect, though, that both manufacturers and suppliers have, as I have done, concluded that a slow-growth world would not result in any demand for new supply capacity.  So manufacturers have directed all of their business to their most trusted suppliers, without worrying too much about the fate of the second tier.  Suppliers, in their turn, have opted not to take the risk of adding more capacity (virtually no one does this in a recession, anyway).  The result is now that industry has exhausted the first tier supply capacity–and the second tier has either gone out of business, can’t get trade financing or has shifted to support different, less fickle, industries.  (Personally, I’d bet most heavily on the going out of business possibility.)

what does this mean?

More demand for components and constrained supply should result in higher component prices, at least in the short run–meaning until suppliers decide to invest in new capacity or until manufacturers’ design teams find a way to work around shortage components.

It also means that many industrial companies are effectively capacity constrained.  So the very strong figures they are currently reporting understate the true demand for their products.  Record backlogs mean the present high level of revenue and earnings will be sustained for longer than one would have expected.

To the extent that companies all long the supply chain decide that they must keep buffer stocks to guard against temporary shortage (and they are doing so), these two positive effects will be intensified.

This means, I think, that industrial stocks will be better performers for longer than the markets think.  It also means that the eventual consumer recovery way also be a bit better than expected.