2013 Second Half Investment Outlook China Last December, I predicted that, despite a pick-up in business activities, the China economy was merely bottoming, not having bottomed out. That was viewed as pessimistic by many others in the time. Now that half a year has passed, the economy turns out to be even worse than our prediction. Economic indicators now suggest that the economy is losing steam quickly. GDP growth rate in China has been dropping for two consecutive quarters, from 7.9% in Q4 12 to 7.5% in Q2. Export and industrial production growth has deteriorated faster than expected, resulting in reduction of business activities (as shown by the weak PMI readings). The long-expected recovery of retail sales growth has yet to be seen. Fixed asset investments, despite growing at a relatively high rate, have diminished in strength to drive economic growth. What concerns me the most is that China has already entered into deflation. The PPI has been negative for 16 consecutive months. The manufacturing PMI has been bouncing between 49 and 51 for 14 months. Even the service industry has stopped expanding as shown by the latest non-manufacturing PMI. Together with the tepid growth of electricity consumption, I am now certain that the supply side of China economy is in deflation. Although the CPI remains positive in value, the reading has probably failed to reflect the reality. It is likely that the statistics collectors have not taken into account the aggressive promotional activities such as discount, bonus portion and freebies offered by retailers. Had those factors been considered, the resultant CPI reading might have been much lower than the published one. If history is any guide, deflation could be a lot more damaging to an economy than inflation. Deflation means corporations are unable to raise product prices amidst over-capacity and falling demand. That would lead to margin contraction and earnings decline, putting downward pressure on wages and employment. Income expectation and consumer confidence would be eroded as a result. Deflation also increases real interest rate which discourages investments. As a result, the economy may risk entering into a downward spiral similar to the situation in Japan of the past 15 years. As the economy is entering into deflation, monetary policy should be accommodative in theory. Unfortunately, that has not happened. Policy makers seem to have been misled by different noises and remain in a tightening stance. The June incident of cash crunch in the China interbank market reflects that the policy makers have not been able to read the actual economic picture. There is increasing risk of policy mistakes as the government ventures to re-structure the economy going forward. I believe that the full year GDP growth for 2013 will likely come in at the lower end of 7-8% range unless the policy directions change to a more accommodative course by lowering interest rates or required reserve ratios. The US In recent months, the global financial market has been overwhelmed by the discussion of potential tapering or exit of expansionary policy by the Federal Reserve. The market is guessing when and how the exit will start as various news flows come in. I believe investors have overly concerned about this issue. There are basically three possible scenarios in the US economy, as follows. 1. The economy recovers as expected and unemployment rate goes firmly below the 6.5% threshold. 2. The economy does not grow as fast as policy makers would like to see and inflation is subdued or goes lower. 3. The economy remains sluggish but inflation surges because of excessive liquidity. Under the first scenario, the Fed would drain excessive liquidity from the system. The drainage will likely be gradual and subtle for the fear of distracting the delicate economic recovery. That may cause some volatility in the equity market in the short run as the equity risk premium narrows. However, economic recovery will boost corporate earnings, which in turn offers support to stock prices, in the longer term. As liquidity conditions become less favorable, the financial and property sectors may underperform. Income-driven sectors such as technology and consumer may take the driver seat and continue to drive the bull market upward. Not a big concern under this scenario. If the second scenario turns out to be the reality, the Fed may continue its expansionary policy or even increase the magnitude of asset purchases. That will bode well for the stock market especially the financial and property sectors. Not a big concern under this scenario, neither. In the third scenario, the Fed would be forced to exit before the economy recovers. That may cause a massive correction in the global financial market. However, in a free economy like that in the US, this scenario is highly unlikely. According to economic theory, GDP growth and inflation do not go in opposite directions. In other words, we seldom see economic contraction and high inflation at the same time except in certain transitory periods. There has been only one episode in recent economic history that was featured by low growth and high inflation – the Oil Crises in 1970s. But the Oil Crises were largely caused by geopolitical tensions which involved many human factors. And we do not see such scenario coming up in the near future. For the moment, most of the Fed policy makers believe the first scenario as more likely, hence some hawkish comments lately. In fact, no one can be sure which scenario will come true in the near future. The third scenario is highly unlikely as discussed. The remaining two scenarios may have equal chance of happening. No matter whether the first or second scenario turns out to be the reality, it will not result in a massive correction. The recent investor concern has probably been over-done. The good news is that such fears are being digested by the market even before any move the Fed makes. Japan Six months ago, I had overlooked the many political and policy changes in Japan and took a bearish view on the Japan economy. After re-assessing the economic and monetary policies put in place by the new government and central bank, I have been encouraged by the economic development there. Despite many doubts about the effectiveness of the Abenomics, we believe that Japan stands a good chance to succeed in reviving its economy. There are two major concerns about the expanded asset purchase program. First, it may overshoot the 2% inflation target before any economic benefits can be reaped, which will force the central bank to raise interest rate earlier than expected. That would drive up bond yield which in turn increases the government’s interest burden and induce a massive sell-off of sovereign debts. Second, the currency depreciation may not be able to generate the desired effect of export growth. Instead, it may heighten the people’s living expenses as imported goods become more expensive. While these concerns look valid prima facie, they are unlikely to happen (at least not to happen abruptly). Even a massive asset purchase program may not necessarily lead to high inflation, if the situation in the US in the past 4 years is any guide. CPI in the US has been down-trending since Q3 2011 even though the Fed scaled up quantity easing. Inflation is determined by economic activities and productivity growth in the long run. Quantity of money plays a role if the velocity of money (speed of money circulation) is held constant. If economic activities are subdued and demand for goods and service is sluggish, circulation of money may lose speed. Even pumping a large quantity of money into the economy will not necessarily spur inflation if the money does not flow fast enough. That explains why the Japan economy has been in deflation for 9 out the past 14 years despite close to zero interest rate. What the central bank is doing now is to increase the speed money is pumped into the system. That may help drive down real interest rate, which will stimulate investments and consumption. As economic activities and business transactions increase, velocity of money will pick up speed and result in monetary expansion. That will be good news as it will end deflation. A mild inflation will stimulate further investments and consumption. As this virtuous cycle continues, the economy may be able to regain growth momentum. If the economy recovers, tax revenue will increase which can in turn strengthen the government’s credit worthiness. Even if the central bank has to hike interest rate to curb inflation expectation at a later stage, it would unlikely induce a massive sell-off of sovereign bonds. Moreover, as long as the central bank commits to be the buyer of last resort, speculation in the sovereign bond market will unlikely occur in the first place. The experience of the EU debt crisis serves as a good example in this regard. The concern on the effectiveness of currency depreciation in stimulating exports has also been overdone. Japanese goods are often of better quality than those produced in emerging markets but they have not been competitive globally in the recent 20 years. The issue is not about quality, but pricing. On average, Japanese goods are 30-40% more expensive than those made in China of the same category. Despite their better quality and durability, Japanese manufacturers has lost market share to their peers in emerging markets who can offer lower price. If the Yen depreciates 40-50% from the level of 80, price of Japanese goods will drop 30-40% in USD term. That will bring them at par with the goods produced in emerging markets, and it will change the game entirely. Furthermore, the cost structure of Japanese manufacturers is quite different from their peers in emerging markets. While raw materials account for a large portion of production costs in emerging markets, they are less so in Japan. As such, the impact of cost inflation from imported raw materials has probably been exaggerated. Europe Now that the EU debt crisis has been over, the economy is undergoing a painful path of structural adjustments. I expect the recovery will be slow and bumpy. Responding to the situation, the ECB has lately announced that it will commit to accommodative policy and near-to-zero interest rate for as long as the economy needs to recover. The announcement marks an important change of policy stance. We believe the EU is entering into a prolonged period of ultra-low interest rate. Should the economy remain sluggish, we may see a European version of “QE Infinity” in the future. Against this backdrop, we may be able to find investment opportunities in the European financial and property sectors. Investment Strategy Based my latest economic outlook as discussed above, I will pursue the following investment strategies. 1.Focus on sectors that present structural opportunities and special situations. 2. Diversify our investments to companies listed outside the Greater China markets. With respect to the first strategy, there are two sectors that we believe will see blue sky. The first one is the technology, media and communication (TMT) sector. We see a second revolution underway in the global information highway following the one seen in 1990s. Unlike the first revolution which was driven by the millennium bug problem, the current one is powered by the emergence of mobile internet. The rapid growth of mobile internet will change the way people communicate, work, play, consume and live. In 3 to 5 years of time, we may be living in a very different world. As user behaviors change, the entire industry landscape of the TMT sector will also change. A new generation of technology and internet giants may emerge as a result. At the moment, we see many interesting companies in this sector each possessing niche function with strategically important value. Other than organic growth opportunities, there may also be many mergers and acquisitions as the industry players are finding ways to empower and enable themselves in mobile internet. Another sector that I feel upbeat about is the new energy sector including natural gas, solar energy and distributed energy systems. The rapid technological advancement in natural gas (including shale gas) production will significantly lower the cost of energy. That will in turn increase productivity, boost economic growth and contain inflation risk. It therefore offers policy makers further incentive for developing the natural gas industry in the long run. Technological advancement has also made other sources of new energy more viable and usable. For example, the production cost of poly-silicon has dropped so rapidly that it may bring the cost of solar energy to par with that of conventional energies in the near future. Lowered cost will boost the demand for solar energy, and bring the industry to the next stage of growth. As for the second strategy, I believe diversifying away from the Greater China markets serve at least three purposes. First, it helps balance systemic risks across different economies and markets, as the US and Japan economies are recovering and China economy is losing steam. Second, many industries have been globalised with players located in different parts of the world. Diversification across markets helps us to understand the entire value chain of a certain industry and identify the best investment opportunities along that value chain. Third, there are many great companies in the advanced economies such as the US, Japan and EU. It helps us understand the possible evolution of Chinese companies that we are currently invested in.
Posted on: Wed, 07 Aug 2013 09:48:16 +0000
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