thinking about 2016

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.

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.

vendor financing and Carly Fiorina

prelude

The leaders in the race for the Republican presidential nomination are both deeply flawed business people.   Both are brilliant marketers.  Both are, paradoxically, running–successfully–on their “records” in business, something that alternately bemuses and appalls the financial community.

The Trump case is complex: excessive use of leverage that all but destroyed the family real estate business in the late 1980s, followed by a successful decades-long struggle to rebuild what was lost.

The Fiorina record is less so:  her tenure at Hewlett-Packard is best summed up by the fact Fortune magazine points out that HPQ stock gained almost $3 billion in market value the day she was fired.

As her poll numbers continue to rise, however, attention is beginning to shift to Fiorina’s tenure at Lucent, a spinoff from ATT that included Bell Labs and ATT’s telecom infrastructure business.  Lucent was a stock market darling in the late 1990s, but collapsed in the early 2000s under an accounting scandal surrounding vendor financing.  Fiorina, who became CEPO of HPQ in 1999, was long gone by then.  But the question is beginning to surface as to what role she played in promoting vendor finance at reckless levels before she left.

So I figured I’d write about what vendor financing is.

vendor financing

I’ve found that a good way of gauging competitive strength is by looking at how quickly a company gets paid for its goods or services.   On the positive end of the conceptual spectrum is the firm that gets paid in full before it makes or delivers stuff.  On the far negative side is the outfit that either gives its products/services away or pays you to take them.

Vendor financing falls much nearer to the negative pole.  It isn’t simply giving customers 180 days to pay.  Vendor financing is long-term loans given to customers by a firm to induce the purchase of that company’s very expensive capital equipment.  In Lucent’s case, vendor financing involved multi-billion dollar deals for telecom infrastructure equipment.

At first blush, there’s nothing wrong with this.

The company providing vendor financing may have a lower borrowing cost than a customer.  So one could argue that this is a relatively harmless way of providing a product discount.  In addition, the fact that a customer doesn’t have to line up bank financing makes it easier for a super salesman to close deals–and lock up clients–in a very short time.  In the land rush to stake out territory in the fast-growing mobile phone infrastructure, it became a staple of dong business in Europe and emerging markets in the 1990s.

Even in its most benign form, however, vendor financing has issues.

It makes company profits look better than they otherwise would be.  Let’s say, for example, my list price is 100, on which I earn an operating profit of 50.  If my customer asks for a discount of 10 to seal the deal, my sale would be 90 and my profit 40.  If I counter with 100 plus cheap long-term financing, then I still show sales of 100 and a profit of 50, even though I’m giving a discount.  The loan I provide simply sits on the balance sheet and has no effect on profits.  So I’ve hidden the discount and inflated my profits.

Like most financial things, vendor financing didn’t remain in its benign form for long.

Telecom vendors soon began offering financing to firms that wouldn’t be able to arrange commercial bank loans.  Then they began to offer loans that would be impossible for customers to repay  …and/or for more equipment than they could ever possibly use.

Lucent was eventually charged by the SEC with accounting fraud.

 

In an extremely carefully written article on the front page of the New York Times yesterday, Andrew Ross Sorkin reports that Fiorina was involved with a multi-billion dollar Lucent vendor loan to a company called PathNet that had less than $1.6 million in annual revenue (shades of Solyndra)–something that came up in her unsuccessful Senate run in California.

the Chinese currency and the Chinese stock market

Throughout my financial career I’ve found that in sizing up currency markets traders from the big banks have always been ten steps ahead of me.

I’ve hopefully learned to live with this–meaning that because I’m never going to outthink them I believe my best currency strategy should have two parts:

–to avoid making future currency movements a major element in constructing my portfolio, and

–to be a “fast follower” if I can–that is, to figure out from a trend change what the banks must be thinking and to consider getting on board if I think the trend is going to have legs.

 

China has moved the price at which it will buy and sell renminbi down by 1.9% yesterday and by another 1.6% today.  Informed market speculation seems to be that another couple of downward moves of the same magnitude are in the offing.

From a domestic policy perspective, China would prefer a strong currency to a weaker one.  As I mentioned yesterday, the country has run out of cheap labor and must, therefore, transition away from the highly polluting, cheap labor employing, export-oriented basic manufacturing that is the initial staple of any developing country.  This kind of business has been the bread and butter of many Chinese companies, some of them state-owned, for decades.  Many are resisting Beijing’s call to change.  The strong currency is a club Beijing can use to beat them into submission.  In this sense, the fact that the renminbi has appreciated by 10%+ against other developing countries’ currencies over the past year, and by around the same amount against the euro, China’s largest trading partner, is a good thing.

On the other hand, the developed world has made it clear to China that if it wants to be included in the club that sets world financial policy, and in particular if it wants the renminbi to be a world reserve currency, the renminbi cannot be rigidly controlled by Beijing.  It must float, meaning trade more or less freely against other world currencies.  So China has a long-term interest in doing what it has started to do yesterday–to allow the currency to move as market forces drive it.

Why now, though?

World stock markets seem to be thinking that a severe erosion of China’s GDP growth is behind the move toward a currency float–that it’s backsliding from a committment to structural reform.

I’m not so sure.

I think what currency traders have concluded is that Beijing has enough money to prop up its stock market and enough to keep its currency at the present overvalued level–but not both.  So they’re borrowing renminbi  and selling it in the government-controlled market in the hope of pushing down the currency and buying back at a lower price.  Understanding what’s going on, and realizing the risks in defending a too-high currency level, Beijing is bending in the wind.  Doing so limits the amount of money that can be made this way, effectively short-circuiting the strategy.

Offshore renminbi, which can’t be repatriated into China, trade about 5% cheaper that domestic renminbi.  That’s where we should get the next indication of how far renminbi selling will go.

As far as my personal stock investing goes, my strong inclination is to bet that renminbi-related fears are way overblown.  I’ like to see markets calm down a bit before I stick a toe in the water, though.

 

 

 

 

 

the Chinese renminbi “devaluation”

devaluation?

Every day the Chinese government sets a mid-point for trading of its currency prior to opening.  The renminbi is then allowed to trade within a 2% band on either side of the setting.  At this morning’s setting, Beijing put the mid-point 1.9% lower than it was yesterday.  This is an unusually large amount and can be (is being) read as an effective devaluation of the currency.

What does this really mean?

background

In the late 1970s, when China made its turn away from Mao and toward western economics, it chose the tried-and-true road toward prosperity trod by every other successful post-WWII nation.  It tied its currency to the dollar and offered access to cheap local labor in return for technology transfer.

Late in the last decade, the country ran out of cheap labor.  So it was forced to begin to transform its economy from export-oriented, labor-intensive manufacturing to higher value-added more capital-intensive output and toward domestic rather than foreign demand.  The orthodox, and almost always not so successful, method of kicking off this transition is to encourage a large appreciation of the currency.  That causes low-end production to leave for cheaper labor countries like Vietnam or Afghanistan.

China, armed with a cadre of young, creative economists with PhDs from the best universities in the West, decided to do things slightly  differently–to hold the currency relatively stable and to boost domestic wages by a lot to achieve the same end of making export-oriented manufacturing uneconomic.  The idea is that this doesn’t bring the economy to screeching halt in the way currency appreciation does.  So far this approach seems to be working–although the shift does involve slower growth and a lot of domestic disruption.

At the same time, forewarned by the immense damage done to Asian economies by speculative activity by the currency desks of the major international banks during the 1997-98 Asian economic crisis, China elected not to let its currency trade freely.

what’s changed?

For some years, China has been upset about the fact that despite being the biggest global manufacturing power, and by Purchasing Power Parity measure the largest economy on earth, it has virtually no say in world financial or trade regulatory bodies.  Those are dominated by the US and EU.  The main reason for China’s limited influence is that its financial system isn’t open.  (The other, of course, is that fearing China organizations like the new US-led Pacific trade alliance pointed excludes the Middle Kingdom.)

So China has been gradually lessening state control over the banks, the financial markets and the currency, in hopes of being admitted into the inner sanctums of bodies like the IMF.

In one sense, this is why China is becoming less rigid in its control of renminbi trading.

why now?

There’s no “good” time to let a currency float.  China doesn’t want to cede control over currency movements at a time when the renminbi might appreciate a lot, since that would be a severe contractionary force.  On the other hand, it doesn’t want the currency to fall through the floor either, since that would result in new export plants sprouting up all over the place.

China is growing more slowly than normal and is experiencing currency outflows as a result of that.  Letting the currency slide a bit relieves some of the pressure–although it may simultaneously attract speculators to try to push the renminbi lower.  So, yes, it is a sign of economic weakness.  At the same time, the loosening comes shortly before the IMF will decide on admitting the renminbi as one of its reserve currencies.  And it follows by a few months Beijing allowing banks to issue certificates of deposit at market rates, rather than at yields set by central planners.  So it’s also a step toward a healthier, more economically advanced, future.

my take

I think worries about the stability of the Chinese economy are overblown.  I also think that traders are using the Beijing move as an excuse for selling that they’ve been wanting to do anyway.  Beijing may have been the trigger for this, but it isn’t the cause.

 

 

 

 

how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.

 

2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.

 

 

 

 

 

Chinese stocks—and related ETFs

I got home late last night and flipped on the TV to watch baseball.  What came on first was Bloomberg TV, where reporters in London (?) and Hong Kong were exchanging near-hysterical comments about the declining Shanghai and Shenzhen stock markets.

The facts couldn’t have been much more at odds with their dire pronouncements.  Yes, the markets were down by 2% – 3%.  Yes, a small number of stocks were limit down.  But the markets were relatively stable and trading was orderly.  Given, however, that the main concern for global investors, as well as Chinese participants in the domestic stock markets, is to have China shrink the still-large amount of margin debt outstanding without a market collapse, overnight market action in Shanghai and Shenzhen  was a very positive development.  As it turns out, although the markets closed down slightly for the day, they were even up at one point.  Volumes were reasonable, too.  Let’s hope this continues.

(An aside:  the Bloomberg TV spectacle I witnessed is one more illustration, if anyone needed it, that the recent shakeup of the Bloomberg news organization is taking it further down the road toward infotainment and away from analysis.)

 

I came across a Factset article this morning discussing the performance of ETFs that specialize in small-cap Chinese stocks.  These have been the center of speculative activity in China over the past year.  But they have also been an area subject at times to protracted trading suspensions for some stocks and to days where some have been limit-up or limit-down with no trade.  The short story is that thanks to fair value pricing the ETFs themselves have experienced no problems.  More on this tomorrow.