subir

Worrisome breeze of protectionism

By subir | September 23, 2009

We believe free and fair trade are not only integral to economic growth, but also essential for a sustained global recovery. Barriers to trade reduce efficiency, inhibit growth, and hurt consumers. We are sympathetic to the argument that countries with weak legal protection for individuals can exploit resources and workers in an irresponsible fashion, but we feel in many cases the benefits from trade can outweigh these concerns and often spur the creation of better institutions and laws. We are also particularly wary of trade barriers being erected at the present time because this is exactly the type of action that exacerbated the economic impact of the crash of ’29, and led to the Great Depression. We’re not there yet, but there are some worrying signs of increasing protectionism. Within this context, we would like to highlight, an article in the Economist about the new US tariff on tires made in China, a report in the New York Times on the union which pushed for this tariff, and Arthur Laffer’s op-ed in the Wall Street Journal on tariffs and the depression, and George Will’s Op-Ed in the Washington Post on the tires tariff.

Executive compensation

By subir | September 21, 2009

The Conference Board’s Task Force on Executive Compensation issued a report earlier today on their findings. They recommend claw-back provisions, tough restrictions on perks and disclosures on fees paid to compensation consultants. The Financial Times, New York Times and Wall Street Journal have articles on the report.

Demographics and Technology

By subir | September 14, 2009

In our view, as long as a society enjoys relatively free markets and the rule of law, long-term economic growth rates are largely determined by two factors: demographic trends and the pace of technological advancement.

In terms of demographics, birth rates high enough to keep a country’s population relatively young, replenish the work force and keep dependency ratios low are crucial to sustained growth. Because of low birth rates, limited immigration and rapidly aging populations, Japan and Western Europe face significant challenges ahead as their population continues to age. Two recent articles on demographic trends in different parts of the world served as reminders of the importance of demographics. The first is an article in the Economist on demographic trends in Africa and another in China Daily about rapid demographic changes in China.

Technological advancement allows a society to produce goods and services with less effort and resources, allowing its population to be more efficient. The classic example is the mechanization of agriculture, which has allowed much of the world to satisfy its demand for food while freeing most of us to pursue careers other than farming. In some cases, technology can even help make demographic transitions easier, for example, Japanese firms have been developing robots to help care for their rapidly growing elderly population.

For us, the impact of technological advancements was underscored earlier this week while reviewing an official statement for a municipal bond initially issued in 1993. The entire 75 page document had been hand typed (on an actual typewriter) and made us realize how far word processing has evolved from the days of the humble Smith-Corona. We can only imagine the amount of effort it required to calculate various tables on a hand-held calculator and the toll repeated revisions must have taken on the typist’s fingers. Inexpensive electronics, modern word-processing and spread-sheets have transformed this process entirely, and let us use our time far more productively. Happily for global growth, the pace of technological progress continues unabated and we fully expect that by 2025 we will look back at 2009 and find much that is amusingly archaic.

China: Investing when faced with questionable statistics and political risks

By subir | August 27, 2009

Up until the late 19th century, the academic discipline now known as Economics was called Political Economy. I’ve always liked that term because it implicitly acknowledges that all economic activity occurs within a political and legal framework. Economics, in contrast, sounds technical and removed from the messy world of politics. Of course, politics and economics have always been firmly intertwined and this will continue to be the case until governments and their citizens stop using the political process to influence economic outcomes. We expect this to happen immediately after winged hogs start flying loops outside our office window.

With the possible exception of Russia, China has the highest degree of state involvement in industry of any country in the G-20, and there are signs that this state involvement is growing. The high degree of political influence in economic affairs is a primary reason we have been wary of investment in China. It is difficult for us to justify risking investment capital in Chinese companies when the basic tenets of open markets don’t seem to apply to them: shareholders have limited transparency, substantial ownership stakes are held by sponsors closely allied with the Communist Party, key suppliers and customers are directly controlled by the goverment, and the state plays an active, dominant role in key industries with an explicit aim of perpetuating the rule of the current regime. Political considerations doubtless play a role in commercial decisions and this does not make for an efficient market.

As investors, we are also concerned about the risks posed by outright state appropriation of private assets. The Chinese regime at a national level has not trampled over property rights in the blunt manner that Russia’s has, but at the local level, officials have not been shy to disposses individuals of resources and property they have a claim to. In this context, we are troubled by the arrest of employees of Rio Tinto (a major Australian mining and materials company) on charges that they engaged in trade espionage and overcharged Chinese state-owned enterprises for raw materials. We believe the arrests are linked to two other events: Rio Tinto’s refusal of a major investment by state-owned Chinalco and the controversy over the screening of a film on Rebiya Kadeer at the Melbourne Film Festival. Ms. Kadeer was punished for her activism on behalf of China’s Uighur minority by being thrown in jail and having much of her wealth appropriated by the state. It is difficult to dismiss the scenario that Chinese authorities are using the power of the state to exact retribution or push for an outcome more desirable for Chinalco.

Part of the legal argument for arresting Rio Tinto executives is that China deems many statistics to be state secrets and since so many enterprises are directly or indirectly state-owned, much commercial data on their operations could enjoy similar status. In general, unequal treatment under law, a politicized judiciary and thin protection for private property in China has made us evaluate investments in China with more than the normal level of skepticism applied towards emerging markets.

The second reason we have been skeptical of Chinese asset valuations is that the average Chinese investor has been removed from a free market environment for at least two generations. Numerous academic studies have remarked on long-lasting discrepancies between A and B shares on the Shanghai index. The shares conferred equivalent economic rights, but until 2001 A shares could only be held by domestic investors, while B shares were held only by foreign investors. A shares prices were consistently higher than those for B shares, some have suggested this was due to an information advantage held by domestic shareholders. We feel that part of the explanation is that public markets for securities are still a new experience for Chinese business-owners and investors. The people with the best local knowledge to value assets are operating in an environment with which they have limited experience. Where there is limited understanding of markets and their risks, asset prices can easily be determined by momentum driven investors and purely speculative forces. By no means is this state of affairs limited to China, but it must be taken into account when evaluating the Chinese market for investment purposes.

Amongst other troubling factors are suggestions that the economic statistics coming out of China are unreliable. This seems entirely plausible since the Chinese administration is singularly focused on controlling discussion about the Chinese for propaganda purposes. The Financial Times noted recently that the GDP numbers for the first half of 2009 do not reconcile at the state and national levels and official wage statistics were greeted with incredulity by most. The speed with which GDP statistics are produced is also cause for concern. Provincial and regional officials are evaluated and rewarded on the level of economic growth within their geographies and we feel this incentivizes double-counting and dodgy accounting to create an illusion of higher growth. Given the state-controlled nature of many industries, we feel managers at numerous commercial enterprises have similar incentives. Earlier this year, the National People’s Congress acknowledged that falsification had occured and increased penalities for fabricating data, but the revised law and penalties will not take effect till 2010.

The opening paragraph of the most recent GDP report from the National Bureau of Statistics of China can be paraphrased as “everything went according to plan in all provinces”. We find it difficult to believe this claim when so many things were going wrong in many of China’s largest trading partners. The same report tells us that export activity dropped by almost 22%, and imports fell by over 25% (which matches BDI statistics). This apparently left major export-focused regions unaffected. Broad money supply (M2) on the other hand, grew by almost 30%, which makes the maximum 10% y/y increase in the US look positively responsible. Since bank lending and money supply have risen so quickly, it is likely that some activity is being generated by nervous managers and officials using borrowed funds to meet centrally mandated growth targets.

Along with hard data on a drop in exports, the Economist has reported that commercial real-estate vacancies in Beijing are approaching 25%, a clear sign of over-building. Power generation is amongst the most reliable indicators of economic activity in developing countries where economic data series may not be robust, and by that measure the picture is far murkier than the 7.1% annualized growth rate the GDP stats project. In April, the International Energy Agency noted that Chinese GDP data for Q1 and oil consumption diverged, which is quite atypical. We are also skeptical about claims that consumer demand rose strongly along with wages since the anecdotal evidence suggests unemployment has risen markedly (the official unemployment figures have hardly budged).

Derek Scissors at the Heritage Foundation has a strongly worded piece about the statistical data coming out of China and the impact that bank lending and investment spending have had. I must note that these speculations are not new. As far back as 2001, questions about the quality and reliability of Chinese economic data have been raised by researchers publishing in China Economic Review (see Rawski 2001, Keidel 2001) in particular the use of a value-added method to calculate GDP.

All of the concerns expressed above have led us to be extremely cautious on China as investors. We are well aware that Chinese industry has become a crucial part of the supply chain for many industries world-wide, and that we cannot ignore China in international stock allocations. We also know that most investments in emerging markets carry similar risks which have to be balanced with the opportunities. That said, the mix of opacity, state control, limited local experience with asset markets and a weak judiciary creates a series of risks very difficult for an investment manager to account for, and usually leads us to exit investments in China earlier in a cycle than we would investments elsewhere. The questions revolving around national statistics makes us wary of taking shorter-term macro position and generally skeptical of those who are unreservedly bullish on China.

Consumption, savings and unemployment

By subir | August 18, 2009

Though we remain optimistic about the prospects for US growth over the longer-term, and continue to believe in the diversity and resiliency of the US economy, it is difficult to see much optimism in the short to medium term. Over the past few weeks, we’ve been delving into unemployment statistics at the state and local level to get a better sense of how bad this recession has been for employment.

The national unemployment rate in June was 9.4%. With the exception of the recession of 1982-1983 (when it reached 10.8%), this is the worst unemployment rate in the post-second world war period. At a regional level, in nine states, the current unemployment rate is the highest since 1976 (the earliest year data is available at the BLS), and in another eight states (plus D.C.) it is within one percentage point of the record. Amongst those setting records, are two of the largest state economies CA and FL (also those worst affected by the real-estate boom, and a wide-swath of mid-atlantic states, MD, VA, GA, NC, SC. So in 18 of 50 states, joblessness is higher than most people have ever experienced. In absolute terms, more of the labor force is unemployed now (15.2 million) than at any time since 1948.

It is likely that unemployment will continue to rise until early 2010, and the unemployment rate could well exceed that of 1982-1983 and reach 11%. The primary reason for our pessimism about the speed and strength of a recovery is the shaky ground on which US households find themselves. Years of low and negative savings rates combined with falling asset prices have affected the biggest components of US household wealth, our homes and investments. The reverberations of this wealth effect will be felt for many quarters of US consumption and consumer confidence.

Unemployment affects consumer confidence in a way that GDP figures and corporate profits cannot. Continuing unemployment, seeing friends or neighbors out of work for months on end, makes consumers rethink every purchase.

Continued Unemployment Claims (1967 onwards)

Since we do not foresee a quick recovery in consumer demand, we believe a quick recovery in unemployment to the 5-6% level is unlikely. In prior recessions of similar severity, unemployment has not returned to the 6% range till 3-4 years have passed. This would suggest a return to full-employment in 2012 or 2013. It may take longer. We believe a structural adjustment is underway, with two sectors of the economy, construction and finance, shrinking to a semi-permanent lower level of activity. Former workers from these industries will need to retool themselves for work in other areas, or may need to relocate to another part of the country. This will take time.

The unwelcome triplet of rising unemployment, falling asset prices, and a financial crisis that has felled many firms that were household names will affect the American consumers’ view of thrift and spending for years to come. We believe the current recession’s affect on US consumer behavior will be long-lasting, as will the US investor’s new-found skepticism towards real-estate, debt and equities. This is similar to how a traumatic episode affects survivors. For an entire generation of Americans, this recession is their first encounter with generally difficult economic conditions and the realities of the business cycle. We believe there is a fundamental shift underway for a generation of Americans, away from a culture of high consumption, towards a new-found frugality.

The grasshoppers are chastened and the ants have been vindicated in particularly dramatic fashion.

U.S. Financial Regulatory Reform: The Investor’s Perspective

By subir | August 17, 2009

The CFA Institute published a report last month outlining broad recommendations for regulatory reform in the US Securities markets. It covers numerous topics that have bubbled into the public discourse, including systemic risk, accounting standards, derivatives regulation, compensation standards, unregulated entities and budget certainty for regulators. We feel the paper is a must read for investors and anyone interested in continued prosperity through effectively functioning markets.

The road ahead…

By subir | July 2, 2009

We read Bill Gross’ monthly letters for his thoughtful take on the big economic and financial questions of the day, mixed in with a dose of humor. The NYT recently published a profile of Gross, whose reputation has been burnished during this crisis. The June 2009 and July 2009 letters are a must read for their colorful description of the long road ahead of us, before the world economy attains some semblance of normalcy.

Peter Bernstein

By subir | June 11, 2009

We note, with sadness, the passing of Peter Bernstein, who taught us so much about the nature of risk and capitalism. Our world is a little smaller now that he is gone.

The ground shifts under efficient market theorists.

By subir | June 11, 2009

In Hans Christian Andersen’s tale The Emperor’s New Clothes, a pair of confidence tricksters sell the king a suit made of fabric so special, it was invisible…

The more things change, the more they stay the same. For years, the priesthood of academic economics had the entire world convinced that the markets conformed to the “semi-strong” form of the Efficient Markets Hypothesis. Mathematical concepts taught in introductory engineering courses entranced “social scientists” into promoting a tautology that did not conform with even a cursory knowledge of history.

It seems, though, that Efficient Markets Hypothesis might be going the way of the dodo, since it elicits amused smiles from most observers when they hear the name. The Times ran a story this week, Poking Holes in a Theory of Markets, and interviewed the inimitable Jeremy Grantham, whose market views we follow closely. The article’s worth a read if only to get a little bit of a taste of Grantham.

The two bubbles (technology stocks and real-estate) we have suffered this decade have brought into question a number of preconceived notions and assumptions about how the world works. It’s heartening for us to see a resurgence of interest in economists whose work stands apart from the Chicago orthodoxy. It’s good to see a little bit of attention being paid to behavioral economics, Keynes, Schumpeter, and Hayek.

Prices are crucial carriers of information in a capitalist economy, they tell us what the prevailing opinion is in the marketplace. Prices convey to market participants what the odds offered at a racetrack tell bettors. In general the crowd is right about the odds for companies and horses, but on occasion, it is spectacularly, violently, destructively wrong.

Asset prices are useful when they reflect the collective, informed opinion of participants who use independent judgment and analysis to arrive at an independent sense of value. The moment a large enough contingent believes market prices tell them everything there is to know about the world, that there is no purpose in doing their own analysis, and begin to trade indiscriminately, prices become less than useless. Market prices are opinion, and this opinion is meaningful and useful when your market is composed of knowledgeable investors attentive to risk. When the market is taken over by speculators and most participants are too lazy to analyze a security in an intellectually honest way, prices no longer tell you anything but how much punch has been consumed at the party.

Eventually, someone points out that the emperor is naked, and the ground shifts. EMH RIP.