Sunday, June 4, 2017

Signs of Enthusiasm, China Concerns, Centurions are Coming


Because I like to think about different timespans as an improved way of managing money, I look at different stimuli in terms of impacts on those timespans. The focus of most commentators is on the short-term, which can be described as until the next performance reports all the way out to the rest of the market cycle. Some focus on intermediate periods that follow after the current cycle. And very few will focus on the long-term needs in terms of their responsibilities. Nevertheless, it may be useful to arrange some of the stimuli that bombard us each day.


On the very day of the publication of the statement of President Trump  “Pittsburg Not Paris,” the three major US stock indices went to new highs. The enthusiasm for stocks is global with five markets showing 2017 gains of over 20% through Friday: NASDAQ +27.06%, Bovespa +25.57%, Hang Seng +24.87%, IBEX 35 +22.31%, and FTSE 100 +21.9%. While a number of the gainers are being driven by advances in Emerging Markets, it is not as usual supported by or led by commodity prices.

Based on past history, two cautionary notes should be observed. The first is a reported statement from an old friend and "bubble watcher" Jeremy Grantham: "The US market has entered an era of permanently higher valuations." (A look at history questions whether any valuations can be permanent. This is Bull Market talk.) The second was noted in Barron's based on the work of Bespoke which commented that April margin balances were the fourth consecutive month of record levels. Bespoke observed that the last two bear markets have occurred after margin balances have peaked.

At the moment I view all of these inputs as cautionary signs. In the past, important peaks have been the result of greater amounts of enthusiasm with higher performance numbers, new "geniuses" and considerable leverage. I am not predicting this, but at prior peaks I have seen a number of mutual funds that reported gains of +100% or more. At this time we do not see people changing their lifestyles and marriages based on their new theoretical wealth.

China May Dominate Intermediate Periods

The generally accepted view is that China will become the globe's number one economy within the foreseeable future. My own opinion is to always be cautious about generally accepted views, they have proven to be wrong too often in the past. In addition, the Chinese economy and society are highly leveraged operationally and financially and things can go wrong. At the moment, I feel confident that China will become the most important variable in determining future investment policies around the world. With those thoughts in mind I will summarize two important inputs. The first is from our friend Byron Wien's reaction to his recent trip to Asia (including China) speaking with institutional investors. The second are the views expressed by the portfolio managers and investment strategist with which I visited recently.

Byron Wien's China Briefs

  • Capital formation is growing 4% with inflation at 3%.
  • Leverage is the major problem with total social and financial borrowing  250% of GDP.
  • Interest payments are 14% of GDP.
  • Shadow banking interest rates are 14%.
  • Regulators will permit banks to convert non-performing loans into equity.
  • Return on equity for private companies has dropped from 18% to 9%.
  • Equity market valuations are high at 20x with meager growth.
  • Middle class expected to reach 60% by 2020 from 43% in 2015.
  • Population is rapidly aging and expected to reach 370 million in 2050 vs. 170 million in 2015.
  • Healthcare expenditures are 5.5% of GDP.
  • Life Insurance covers 2% vs. 10% in developed markets.
  • The solution to excess industrial capacity and jobs is "One Belt One Road."

Matthews Asia's Mindset

In response to the expected downgrade of China's credit rating, Moody’s* points out that the bulk of the excessive leverage exposure is in the largely State Owned Enterprises (SOE). I believe most of these loans are held domestically by government owned or controlled banks. The key social issue is jobs. Luckily the majority of employees work for private companies that are profitable. Actually the private companies are growing their earnings, but the periodic waves of speculation have been reacting to both global and internal political trends depressing their prices. (This is just the opposite of India, the best performing large market this year, where earnings have not met expectations. The enthusiasm for the current political and monetary conditions has driven the stock market higher.)

*Held in the private financial services fund I manage

Matthews Asia sees future opportunities in both Micro caps and some of the under-followed "A" shares. In its portfolios that invest in China, Matthews Asia is investing in both the creation and the use of technology applied to health care and related aging needs. With China being such a big part of Asia's future, one would assume that in the long-run Matthews Asia believes that China will be a positive for Asian investing.

My long-term concern about China is that the global history of railroad and port building with too much leverage can create unexpected volatility.

"Beware of the Centurions" in the Long-Term

If my memory of military history is correct, in the conquering armies of Rome the key maneuvering units were comprised of one hundred men commanded by a Centurion. It was the Centurion that transformed a diverse group of undisciplined men into a well trained disciplined military unit. We are entering an era when an increasing number of people will be at least 100 years young, and we and they are unprepared for this transition. A thoughtful piece by John Mauldin alerts us to the demographic fact that increasingly we will be dealing with people that pass the century mark. As individuals and as a society we are not prepared for this change. For example when Social Security was initiated in this country it was based on the belief that men would retire at 65 and die at 67. This was conservative in that people born in 1930 had a life expectancy of 56 for men and 62 for women. Compare that with life expectancy for those born in 2007 to be 103 and 104 respectively, in the US. This is a global phenomena with six other developed countries’ expectancies in the same range. Japan is the leader with 107 years.

One of the unspoken conceits of investors is that they are not the average person. To the extent that they can prove that by being wealthier, the top 20% on average in terms of wealth, are expected to live five years beyond the average. The poorest are expected to die two years earlier than the average. I can understand the distinction because of diet, less risky manual labor, and quality of health care. I don't know what assumptions are built into these projections as to the developments in medicine, agriculture, working conditions, and psychological health. Further my basic training at the Racetrack and the US Marine Corps questions trusting averages but has a distaste for being in the middle of any group.

Regardless of the projections, as societies we are not doing a very good job of caring for the present seniors. Fundamentally the reason for this is we have insufficient dedicated capital. This is a global problem impacting all the developed world and many of the developing countries. Almost every government-sponsored pension plan is underfunded to meet the present retirees, let alone prepared for the Centurions.

Strange as it may seem, I see this is an opportunity for investment gatherers and managers. As Centurions grow in number, increasingly they will exercise their votes at both the local and national levels. I expect at some point we will evolve into a two level tax system where there will be charged a higher level for consumption spending, perhaps some type of VAT, and a lower bracket for retirement spending. Whether any unused capital can be passed on without a tax, I don't know. Further our laws and practises will react to some concept of age discrimination in favor of utilizing the best people for the job in one form or another. Unless we do something, the Centurions will weigh heavily on our productive capacity.

Critical Investment Question: Rank which is most important to you and your investments: (a) short-term market outlook, (b) impact of China, or (c) providing increased retirement capital. Please share your thoughts with me.
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A. Michael Lipper, CFA
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