Sunday, May 14, 2017

Implications of China vs. US Timespans


A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 
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A. Michael Lipper, CFA
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