2017 Q2 letter: A threat to human civilization

posted in: Bonds, Economics, Energy, Markets, Stocks, USA | 0

Dear Friends,

The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.

The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.

Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.

From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the  five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.

Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.

As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.

Data source: Robert Shiller – Yale University

We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.

For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.

Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.

At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.

Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.

Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.

As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.

There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.

Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.

The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.

It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.

All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.

Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.

 

 

 

Regards,

 

 

Subir Grewal, CFA, CFP                                                                                              Louis Berger

Q4 2016 letter

posted in: Events, Markets, Quarterly Letters | 0

Dear Friends,

We hope you have had a good start to the New Year and wish you the best for 2017. As always, in our first letter of the year we have attached a review our 2016 investment themes and a list of our investment themes for 2017.

The fourth quarter of 2016 revolved around politics, with a focus on the US presidential election. In Jan 2016, we wrote there was a “strong possibility one or both major party nominees will be from outside the establishment mainstream”. In retrospect, that looks like an understatement. A series of unusual news stories and the eventual surprising result of the US presidential election led to sharp drops in US equities in early November. Markets recovered quickly and ended the year close to or at their highs. In some ways this is a relief rally, driven by the realization that much of the Republican establishment will support the Trump administration and vice-versa.

The political upheavals of the past few months have not changed the underlying economic realities confronting investors. We are likely at the tail end of a bull-market that is almost 8 years old, and several risks loom on the horizon. Interest rates in the US will continue to rise as the Fed attempts to normalize historically low borrowing rates. This will modify the calculus for investors as interest bearing assets become attractive and rising rates impact the denominator in equity valuations.

The results of the US election have created enormous uncertainty about the US’s future economic policies, particularly with respect to trade. We believe that workers’ concerns about economic insecurity do require political solutions. We are not, however, convinced that protectionist barriers are the answer to job-losses in the US manufacturing sector (the last US experiment with high tariffs, 1930’s Smoot-Hawley Act, likely exacerbated the effects of the Great Depression). Nor do we believe it is in the US’s long-term interests to loosen environmental rules. The incoming administration seems bent on trying or threatening one or both of these approaches.

Roughly 50% of sales for S&P500 companies occur overseas. This underscores the global nature of the world we live in, and the degree to which US businesses rely on foreign operations. The prospect of a full-fledged trade war with major regions or countries should worry investors deeply. Though some investors may have been emboldened by the November/December recovery, we would advise caution given the significant headwinds and uncertainties facing us.

As always, we have published our investment themes for the upcoming year and reviewed our themes for 2016.

 

Regards,

Subir Grewal, CFA, CFP                                                        Louis Berger

2012 Themes: The More Things Change…

Here are our top 10 investment themes for 2012.  These are the topics we think will have the biggest impact on client portfolios in the coming year…

 

1.  Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election. With the ongoing crisis in Europe, the Fed would normally be engaging in further monetary easing, but there is nowhere to go below the current 0.00% target overnight rate. In most presidential election years, the Fed is hesitant to make large moves in either direction, to avoid appearing politically biased. That instinct is especially heightened in an election cycle where Fed policy action and arcane monetary policy debates have unexpectedly become contentious, emotional political issues.

2.  Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors.

3.  Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis.  Though it has been over a decade in the making, things have finally come to a head. All the dominoes (Greece, Portugal, Spain, Italy) are lined up, and we wait to see which the two players (France and Germany) will allow to fall before they stop the carnage. We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.

4.  Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. We would not be surprised if the Euro approached parity with the dollar over the course of the year. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed.

5.  Blue States/Red States: The US presidential election cycle should be the major story in the US in 2012. US and individual state debt burdens will be the most important topic of debate, as the European sovereign debt crisis plays out in the background. American politicians will have to negotiate some cut in benefits for the charmed baby-boomer generation to ensure the financial burden of these programs in coming years does not doom the economic prospects of their children and grandchildren. This negotiation of a new social compact between the generations is the most important issue of our times.

6.  Chinese Math: At the 18th Communist party congress to be held this year, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required as China moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, GDP growth is slowing as labor costs rise, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels.

7.  Revolutionary Times: We were surprised to see the speed at which the political structure of the Middle East has been transformed in a remarkable series of revolutions. Though we have been aware of the demographic pressures that created the basis for these changes, their rapidity has astounded us. As events unfold in the Arab world, something perhaps even more remarkable has begun to happen in Russia. A previously apathetic Russian electorate seems to be flexing its muscle in opposition to a renewed Putin presidency.  We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year.

8.  Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources. And while we’re talking about oil, we would like to reiterate our skeptical view of gold prices, which we believe would be well under $1,000 an ounce if the political and economic future were not as muddy.

9.  Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance). The larger story will continue to be the steady march of the internet into every device and living room, placing a strain on core Internet infrastructure. We heard relatively little about a seminal event that took place in 2011, the last large block of addresses (IPv4 numbers) was assigned and there is no address space on the current infrastructure to accommodate another few hundred million devices. The public discussion has centered around the addition of new top level domain names (like .com, .org), but the addresses that sit behind these are the real concern. A new addressing scheme (IPv6) has been built into most devices for years, but adoption is minimal. We expect this will have to change in 2012, with a few hiccups along the way.

10.  Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis.  We believe there is still too much supply available and US consumers as a whole will be reluctant to financially over-commit themselves given job security concerns and how many were burned by homeownership in the past few years, despite record low mortgage rates.

 

2011 Q1 Letter & upcoming webinars

We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at www.youtube.com/wsqcapital for the benefit of those who were unable to attend. We plan to host three webinars this quarter:

To register for any of these webinars, please visit blog.wsqcapital.com. We will continue to add recordings of future presentations to our page on youtube. Feel free to pass along an invitation to anyone in your circle interested in learning more about these topics.

IRA contributions, Roth IRA conversions

Most taxpayers can make IRA contributions for the 2010 tax year up until the individual tax-filing deadline, which is April 18, 2011 this year.

Roth IRA conversion rules have changed and virtually anyone can now convert a traditional IRA into a Roth IRA. Partial conversions of an IRA account are also permitted. Please contact us if you’d like to discuss specific issues surrounding your circumstances.

Interest Rates & QE2

In prior letters, we have discussed the extraordinary measures the Federal Reserve and other central banks around the world have taken to keep interest rates at historic lows. Short-term rates in the US remain below current inflation levels, which means savers are being penalized for holding cash. This is no doubt due to the actions of the Fed which continues to purchase the bulk of newly issued US Treasuries under its Quantitative Easing program. We estimate short and medium-term rates are 1.5% to 2.0% below where they would otherwise be.

Meanwhile, the flames of inflation have begun to flicker. A combination of increased demand and easy money policies has driven up food and commodity prices. If this trend continues, maneuvering through the obstacle course of rising inflation will take a toll on the global recovery. And as is usually the case, the burden will be heaviest for the world’s poorest who spend a higher percentage of their income on necessities. We are beginning to see some policy action and rate hikes in developing markets. Unless inflation levels stabilize quickly, this will begin to impact global trade. We caution bond investors that future returns are likely to be lower than those in recent years past. We continue to recommend high-quality bonds with 3-5 year maturities.

Budgets and Bluster

The issues facing most developed-market governments are remarkably similar whether we are talking about Greece, Ireland and Spain, or the US, California and Illinois. The long-term challenge involves tackling unfavorable demographics and enacting the painful policy reforms required to tackle the cost of social programs. In the short term, the double-whammy of a real-estate/financial crisis requiring an immense expenditure of government support, followed by a great recession driving down tax revenues have created huge deficits. The exact mix differs: in Ireland the cost of a bank bail-out has supercharged the national debt, whereas in Greece the crisis is compounded by a culture of tax-evasion and protectionism. In the US, the core problem is reforming Medicare and a health-care system that takes in more revenue per person and results in lower levels of health than those in other developed countries.

The imminent congressional debates over the federal budget and the national debt ceiling will bring fiscal issues front and center in the US. As the 2012 election campaign kicks off over this summer, we expect fiscal issues will be key in every race. In Europe, meanwhile, the moment of reckoning for Greece, Ireland and Portugal fast approaches. European institutions will either have to come up with a plan for debt-restructuring or direct support to assist struggling governments in the short-term. Meaningful progress towards the longer term demographic and policy challenges will also need to be made.

 

Nature, Energy and Politics

The March 11 earthquake and tsunami took a terrible toll on the people of Japan. The economic damage is also enormous as a significant percentage of the area’s power generation and distribution capacity has been offline for weeks, impacting businesses and residences across the main island of Honshu. Rolling blackouts have affected many areas, including Tokyo. Two nuclear power generation facilities (Fukushima I and II), with a total of ten operational reactors between them, suffered severe damage. It is now clear that all the reactors at Fukushima I will need to be scrapped. A large amount of fuel from the operating reactors and spent fuel stored at the facility has been damaged and released into the environment. The situation remains critical and the full extent of the crisis is still unknown.

Nuclear power generation requires operational and design expertise far more specialized than other forms of energy production. In general, the industry has recognized this and a great deal of thought and effort has been put into improving design and procedures. We should also not forget that most other forms of energy generation carry their own risks, and often a higher carbon footprint. For instance, the production and burning of coal costs numerous miners their lives every year, and damages the respiratory systems of populations globally. Hydro-electric dams have failed due to design faults or natural disasters causing a large number of casualties. We firmly believe renewable energy must be at the core of any long-term solution to global energy needs. Nevertheless, replacing our current energy infrastructure is a multi-decade project and represents an enormous investment. One step towards that process would be to accurately account for the true health and environmental costs of all forms of energy production. As things currently stand, the conventional energy industry derives numerous economic benefits from tax-breaks, favorable industrial policy and political gridlock in assessing the true environmental cost of greenhouse gas emissions.

With all this in mind, we believe certain modern nuclear plant designs can play a role as a crucial bridge technology. In many fast-growing economies, nuclear power is the only viable alternative to coal and gas for large scale power generation. It is clear though, that the nuclear industry will face tough public scrutiny and a risk re-assessment is underway. We are particularly concerned about the operational safety of nuclear power in countries without a strong tradition of accountability, independent oversight and open public discourse (see China). Some of these concerns are acute for certain developed nations such as Japan, which has few energy resources of its own and relies on nuclear power for 24% of its electricity needs. As a result, we continue to view long-term investments in renewable energy favorably.

Upheaval in the Middle East

Mass protests in the Arab world have captured the world’s imagination since the sudden, largely peaceful overthrow of Ben-Ali in Tunisia. We certainly do not believe every group engaged in protest has benign intentions and recognize that in some countries one repressive regime may be replaced by another. That said, we are hopeful the power of public protest and increasing civic engagement by ordinary citizens will transform the moribund political and economic regimes in the region. For the time being, we expect this part of the world will continue to experience upheaval over the next decade or more. In many of these societies, oil wealth has distorted economies and politics. A demographic bulge is now bringing about rapid change. Investors should remain aware that demographic and political change may cause certain markets to be disrupted over the next decade.

We are positive on emerging markets in the long-term, but advise caution for the present since asset prices have risen very rapidly. Further rises in oil prices could accelerate inflation and lead to a slow-down in global growth, which would impact emerging markets negatively.

 

Regards,

 

Louis Berger                                                                                        Subir Grewal

 

 

Webinar Invitation: Tax-free municipal bonds

posted in: Bonds, Events, Markets | 0

Tax Free Municipal Bonds: Are They The Right Investment For You?

The past few months have been very eventful for the municipal bond market: the Bush era tax cuts have been extended, municipal governments are proposing massive budgets cuts, protests have broken out in states like Wisconsin and certain commentators have predicted widespread default. This uncertainty has provided an opportunity for those investors who know what to look for. In this webinar, we will provide an overview of municipal bonds, address many of the recent news events that have roiled these markets and share our approach to finding opportunities in this space.

This web-based presentation will run from 12:30-1:00 pm on Tuesday March 1st. It will include a 20 minute talk and 10 minutes for Q&A.

Please RSVP if you plan to attend as space is limited.

Presented by: Washington Square Capital Management

Speaker: Subir Grewal, CFA: Co-Founder and Principal

Date: Tuesday, March 1, 2011

Time: 12:30 pm, Eastern Standard Time (New York, GMT-05:00)

Discussion Topics:

  • Municipal bond market overview
  • The ramifications of recent legislative events
  • Our selection process and where we see opportunity

To register, please click here.

Political uncertainty at a critical juncture.

posted in: Economics, Markets, USA | 0

400px-Illinois_Railway_Museum-Switch_1We are frequently amused by the myriad explanations pundits present for any moves in the market. Our view has always been that single day moves are largely inexplicable, and that it often takes investors time to incorporate events into their thought-process, and to translate them into action. An example is the market rose yesterday in the face of much bad economic news. The explanation from pundits was that investors were celebrating the potential victory of a Republican candidate in the Massachusetts special election to fill the senate seat left vacant after Ted Kennedy’s death. Numerous commentators noted that “gridlock in Washington is positive for wall street”. The thinking is that government action creates uncertainty, this leads to businesses spending time and resources trying to compensate for changing rules, and this slows down economic activity and lowers earnings.

Now that we know the results of this special election, we believe investors should be concerned about the Republican candidate’s victory. The US finds itself in a particularly delicate position three years after the bursting of the biggest credit and real-estate bubble in decades. The hesitant stabilization of economic activity and confidence we have seen so far has been brought about by extremely large amounts of government spending and aid. Regular readers will know that one of our concerns has been the manner in which this government support is removed. At this juncture, gridlock in Washington is more likely to bode extremely poorly for the US economy. Congress has to find a way to pass health care reform, renew the term of the Fed chairman, reform financial regulation and evaluate the need for continued fiscal support. Did we forget to mention it has to do all of this in the face of the largest budget deficits since the second world war and a rising tide of populist sentiment in an election year?

Risk assets have recovered dramatically over the past few months in response to a massive, concerted effort by governments the world over to inject liquidity and support aggregate demand for goods and services.  This effort was led by the US and the UK, where the parties in power enjoyed comfortable majorities.  With Scott Brown’s election yesterday and an election looming for Gordon Brown’s Labour party, political certainty is in short supply on either side of the Atlantic.  At this sensitive moment, we believe this is a damaging development and that this uncertainty does not augur well for business or markets.

China: Investing when faced with questionable statistics and political risks

posted in: Asia, Economics, FX, Markets | 0

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.

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

posted in: Markets, USA | 0

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.