Sunday, March 25, 2012

Emerging Markets, China and US Market Structure


Last week’s blog was about reading the tea leaves in terms of the future. This week’s crop of comments is, on balance, more favorable. Combining the old slogans of Goldman Sachs and Merrill Lynch under prior managements, I come out very long-term bullish on investing globally; recognizing there will be problems which equal opportunities. I have grouped this week’s inputs into emerging markets, China, and US market structure.

Emerging markets

These elements were published in an article by Simon Kuper in Saturday’s
Financial Times: The comments in italics are mine:

  • Life expectancy in the less developed countries has gone from 46.6 years to 67.6 years over the last fifty years. While this does mean there are more mouths to feed, it also means more workers, some requiring in-depth training. Perhaps the most important positive is that a more mature population can lead to more mature thinking about leadership.

  • A smaller % of people are living below the global poverty line, particularly in Africa, which is no longer viewed pejoratively as the “hopeless continent.” Some in the investment world are already using this recognition to raise money for investing in the continent.

  • There is an increasing number of countries being guided by the rule of law. This is not our law or our concepts of justice. Nevertheless, rulers are being constrained to act or seem to act within the limitations of local law. This is making it safer for investors, particularly if commercial disputes will be governed by agreement in arbitration conducted within the U.K.

  • Long Term Military Occupation and annexation is slowing. There is recognition that military adventures are expensive and now largely unproductive. We can conquer through consumer goods movements much easier.

  • Fertility Rates have been declining, both in the developing and developed world. This is taking some of the pressure off of societies to find food and jobs for their growing populations. These trends may be going too far in the developed world and China in the long run. The US could be following “Old Europe,” if it does not intelligently manage its immigration policies.


China is a mixture of developing, developed (the second largest) economy, a resurging leading empire, and a controlled governmental experiment. Because of the size of its needs and its dominance of vital imports, China will have an increasing input to the rest of the world. Many of the economic developments within China are based on governmental edicts; progress will be faster than in less controlled and more competitive societies. Because of the speed of development and less marketplace discipline, accidents and mistakes will occur. The central political powers recognize this as an almost certainty and have some plans to alleviate the problems on the first level, there will be quick reactions as shown below:

  • The regulators in the Mainland are discussing with Hong Kong-based financial institutions, their investing Yuan pools into China. These pools are being raised from the Hong Kong market. (The sources of this capital do not seem to matter, but in essence, it was originally sourced within the country and then transferred into the free marketplace in Hong Kong. The key point here is that at this time, China is seeking development capital.)

  • In a parallel move, in a matter of hours it was reported that Chinese authorities delivered permissions to foreign investment advisors to increase, and in some cases double, their investment within the country.

  • Another example of this opening up of the indigenous market was the approval of JP Morgan’s purchase of 19% interest in a local trust company. The majority owner is an arm of the central government.

  • China is changing much faster than the general perception, e.g., food inflation is much more a political concern in terms of the “vegetable basket” for city dwellers than the “rice bowl” for those in the country. In addition, one of the main drivers in residential construction was the increase in per capita living space, from 13 square meters in 1990 to 32 square meters in 2011. Some minor further increase, to perhaps 35 square meters is expected. (This change will not only increase spending, but will also shift but will fill up the new homes with appliances and other goods. Whirlpool* has just cut a deal with a large chain of appliance stores to get favored placement.)

*For many years I have owned shares in Whirlpool. Sales into Asia represent an estimated 4% of their total sales with most of the units are being shipped in from Brazil. This is not a recommendation to buy the stock.

The US market structure

Two very different factoids:
  • Money Supply is growing faster than GDP in the US. The lesson from history is that in time, if this trend continues, as seems probable, the rate of inflation will increase. The American Institute for Economic Research has released a report that the inflation rate could reach 15% by 2014 and that in December M2 grew year over year 10%, and the economy 2.8%. These projections seem alarmist to me, but in institutional accounts I have increased the share of TIPS. (Individuals need to be concerned that they will pay current taxes on TIPS income even though they won’t receive it for many years.)

  • The second factoid is that the Wilshire 5000 is currently only tracking 3,675 stocks. When originally constructed, this stock index was covering just about all of the US traded stocks. Over time through acquisitions, bankruptcies, and going private transactions the field of available stocks has shrunk. One could argue that that has left an adverse selection of securities as the better companies were acquired (often at substantial premiums over current price) and that controlling shareholders believed that their companies were worth more than market prices. The reduction in the number of tradable entities has not hurt, up till now, the performance of small-capitalization funds which for a number of years outperformed their larger “cousins.”** But at some point the actual adverse selection factor could retard the managers’ selection skills. (Unfortunately, we may never know, as it is expected that the “Jobs Act,” (Jumpstart our Business Startups Act) is expected to be passed by final congressional votes, and will significantly loosen the regulations on small companies. There will be good and bad, perhaps fraudulent, small companies going public under these relaxed rules. I am not concerned about individual losses created by these poorly supervised small companies, what I am concerned about is that the losses will be so large in media headlines that people will withdraw from investing in all small companies. This in turn will have, as usual with legislation, created the opposite effect. After the losses become well known availability of capital will be curtailed and thus there will be fewer new jobs created.

**A number of our accounts have positions in small-cap funds.

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