Sunday, April 24, 2011

“Fundamental Risk,” Relative Return and Both in China

The view from Deutsche Bank

In a well written analysis entitled “US Fiscal Challenge: Another Minsky Moment?” Deutsche Bank describes that after a period of growth, there may be excessive risk in US sovereign debt. In this work the authors show a chart ranking the risks of sovereign debt, based on their perception of each country's fundamentals. The rankings, with #1 most risky, are:

1. Greece
2. Ireland
3. Portugal
5. Italy
6. France
7. Spain
8. Belgium
9. UK
10. Japan
11. Austria
12. Finland
13. Netherlands
14. Germany

Few Americans and many global investors act as if they believe these rankings. Many would accept that the US has fundamental problems as recently captured by Standard & Poor’s, placing a one-in-three bet on a downgrade to the US’s AAA debt rating in a couple of years. But to suggest that the US’s fundamental risk is even worse, is shocking. The American view is that each of these country's governments can fall at almost any time due to parliamentary maneuvering. Further, many of these nations have as bad if not worse, housing conditions. All of these governments spend more on what can be called social welfare than the US does. To this leading German bank, despite the existence of the euro, the old deutsche mark block is considered less risky than most other countries. After more than ten years of a shrinking economy, for Japan to be viewed as significantly less risky than the US, is a wake-up call.

Some have heard the wake-up call

I believe the large investors in exchange traded funds (ETFs) are policy type investors who wish to capture the central tendency of some trend. They are not focused on perceived superior stock picking skills, as many mutual fund investors are attempting to achieve. Many of the ETF investors are also more short-term relative performance oriented than most mutual fund investors. ETF investors are often more volatile with their cash flows. One might take the view that their large scale buying and selling is coincident with market moves. In some cases there is an attempt to be early, but usually some momentum has already started. Because of the characteristics mentioned, I view ETF flow movements to be similar to the proverbial canary in the mine as an early warning device. One of the early and better analysts of ETFs is Deborah Fuhr, now with BlackRock, who had some salient points in an article in a recent edition of the Financial Times. While she did not phrase her analysis as a wake-up call, her focus on first quarter net flows into or out of global ETFs indicates that these more volatile investors have recognized the same risky elements as the analysts from Deutsche Bank. She notes that $6.3 billion in net flows went into commodity funds, which I believe includes $3.6 billion into agricultural commodity funds and $1.3 billion into inflation indexed vehicles. She further noted that $1 billion flowed out from Government Bond ETFs and somewhat surprisingly, $2 billion from Precious Metal ETFs. (The latter may well be a change in the way some investors wish to hold gold, as the bullion based ETFs lost assets, but there are reports that some large gold securities holders are converting their paper gold holdings into physical gold, to be stored outside of the US.) I interpret these moves as a reaction first to the fears of inflation devaluing paper currency. Other factors include weather-related crop failures and capacity-limited mining and refining facilities. Both the Federal Reserve and the rapidly growing Chinese economy are sparking the current inflation globally.

China is both a source of risk and return for the world

China is the fastest growing large economy in the world. I suspect for both political as well as data reasons, the rate of expansion in China is understated, though the trend rate remains in double digits. China is becoming the largest factor in world trade. Natural resources are flowing into China from Africa, the Middle East, Chile, Brazil, Mexico, Canada, and Australia. Due to historically low labor costs, China is an exporter of manufactured products to the US, Europe and elsewhere. Higher valued manufactured products and systems are being imported from Germany, Netherlands, Scandinavia, and the US. That was the world in 2010. The world that is now evolving is one with rising wages in China as a political necessity. (A flash point could very well be the independent truck drivers’ strike in Shanghai, purportedly the world’s largest port. The drivers are being squeezed by rising fuel costs and their contracted delivery rates. How quickly and well managed this dispute is handled will show the political sensitivities of the authorities.) A recent visitor to the internal parts of China told me of the major building efforts in the cities of only a few million people as a way to keep the movement of people from the farms to these cities rather than the larger ones on or near the coast that are suffering from the onslaught of people in search of the “good life.” The Chinese government is the most expert of any other government in controlling or at least manipulating its economy. Whether China can seamlessly manage this greatest migration and at the same time convert its society from export driven to consumer spending is the key question. The entire world is awaiting the answer. There is a substantial chance (risk) that something unexpected will cause at least a hiccup. At this point in time a hiccup in China can cause an extreme stomach ache for the rest of the world and its investors.

Get ready for a contrarian bet

A contrarian is always on the lookout for when emotions carry an investment trend too far. The global press will focus on problems within the US. At some point this pessimism will go too far. I suspect sometime over the next five years or so, there will be a major rally in the US dollar. To hedge the dollar now may still be prudent, but to be net short the greenback seems to me to be risky except for those who can be fast, successful traders.

What do you think ?

There is a very good chance that next week’s blog will be delayed by a day. My wife and one of my sons are going with me to the annual meeting, actually a rally, of Berkshire Hathaway. This event will be somewhat exhaustively covered in the press but could be of value in the sense that the various portfolio managers may have a different insight than what is reported. I will share my observations with you the next time.

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