RGE: China’s Impact on Financial Markets

Wednesday, August 26th, 2009

Nouriel Roubini’s RGE Monitor has just published a report examining China’s direct and indirect influences on global asset markets, and particularly equity, commodity and forex markets. Although the full report is only available to RGE’s subscribers, the abridged version nevertheless provides useful insight as reported in the paragraphs below.

Chinese equities
The Shanghai composite index has fallen almost 20% from its August 4 peak, putting it within the traditional definition of a bear market. Thus far this year, however, the index has risen over 50%, and it has surged even more since its low in late 2008. Yet Chinese equities remain vulnerable given the liquidity outlook and the challenges of using relatively blunt tools to guide asset markets.

Correlations between Chinese and global equities (especially emerging market equities) have increased since 2007. Economies most reliant on Chinese investment, or on the commodities consumed by China, tend to show the most significant correlations. Yet even the markets of Central and Eastern Europe have shown greater co-movements. While Mainland markets are dominated by domestic investors and foreign investment is heavily restricted, they have vaguely led global markets, being among the first to begin to fall from overheated heights in early 2008 and the first to climb in late 2008 following China’s stimulus announcement.

China’s linkages with global markets, to the extent that they exist, seem more macro than financial. The same government policies designed to avoid bubbles and limit further misallocation of capital – including the slowing of credit extension currently underway – could not only restrain frothy Chinese equities, some investors worry, but also suggest that the Chinese and global recovery will be weaker.

Thus steps taken to “fine-tune” Chinese monetary policy and cool overheating in some sectors of the economy, could contribute to more global market volatility. A burst Chinese bubble could reduce Chinese demand and prefigure poor performance in other markets as liquidity is withdrawn. While markets in the US and Europe seem more likely to take their cues from local trends–particularly the corporate earnings and economic growth outlooks than Chinese markets, a slowdown in Chinese demand, could give pause. An increase in exports to China is among factors supporting European exports in Q2.

Chinese equities were looking very bubbly in July and early August, and in our most recent economic outlook, we highlighted developing asset bubbles in China’s property and equity markets as one of several potential risks of China’s stimulus. Chinese liquidity has begun to be less loose, even if it is not yet tight and inflows to Chinese equity markets have slowed from July onwards. Several trends which supported equity markets in H1 2009—record bank lending with few restrictions, the improvement in consumer confidence, the deferral of IPOs—are no longer supportive. Inflows to the Chinese equity market slowed in July 2009 as bank lending slowed and government regulators suggested a closer look would be taken at the allocation of funds. Meanwhile price/earnings ratios are no longer as cheap, having almost doubled from their late 2008 lows. Corporate earnings may stay weak given the difficulty in passing on higher production costs. All of these factors suggest that Chinese equities might have farther to fall.

On the plus side, further correction might have only a limited effect on the Chinese economy, given lower wealth effects than in developed markets. Market capitalization is a much smaller share of GDP and equity investment is a much smaller share of savings. Sentiment is affected. New accounts opened by Chinese retail investors have fallen since their late July peak. The reluctance of retail investors to incur losses could contribute to a boom and bust cycle, negatively affecting Chinese and global asset markets.

Chinese commodity demand
Record commodity imports, particularly of metals, contributed to the commodity price climb in H1 2009 (pumped up by the ample liquidity from zero interest rate policies and quantitative easing). A sustained reduction in Chinese imports of commodities is perhaps the biggest risk to global commodity markets, particularly metals. In fact there is some preliminary evidence that the extensive stockpiling that contributed to the record volumes of commodity imports early in 2009 may be slowing as prices rise. The volume of imports of key metals like copper, tin and aluminum has slowed in either June or July 2009. While this reduction may reflect seasonal trends, with stockpiles filled and costs high, a further slowdown should not be ruled out.

Chinese imports of commodities, especially base metals, grew sharply in the first half of 2009 as China sought to restock depleted reserves and build up new stockpiles. Even the infrastructure-heavy stimulus likely absorbed only some of the imports, suggesting that China might be on the verge of a commodity glut Further purchases, particularly later in Q2, may have extended beyond the official stockpiling to include investors who took physical delivery as a hedge.

Yet, not all of the increased demand is due to stockpiling. Metal processing has been a key part of China’s fiscal stimulus – with any excess production purchased by the government. There have been reports that some of the state metal and grain reserves became net sellers domestically, suggesting the pace of imports might slow. The Baltic Dry Index, a measure of shipping costs that reflects demand for bulk commodities, has fallen from its 2009 highs. Import volumes of several key metals fell in June and July 2009. Should they fall further, and should global stock piles grow, commodity prices could correct from their current levels.

Chinese commodity purchasers are in part price-sensitive. In 2008, Chinese producers made due with cheaper alternatives to expensive ores. Purchases of scrap copper and aluminum rose in July 2009 even as the imports of higher-grade ore and materials fell. While the continued demand for scrap metal does suggest some underlying metal demand from Chinese consumers, they have their price.

Despite China’s role as the largest consumer of many commodities, it has had limited success as a price setter despite its influence as one of the largest demanders of most commodities. Unwilling to accept the 33% negotiated by Japanese companies and their ore suppliers for bulk shipments, China held out for 40-50% reductions – a concession suppliers were reluctant to give. Only one – Fortescue, a relatively small producer, agreed to a 35% price cut.

Unlike metal ore imports, whose volumes have doubled and in some cases tripled from 2008 levels, oil imports have only recently topped 2008 levels. Chinese oil imports did report a sharp increase to 19 million tons in July, well above recent levels, perhaps due to demand from new refineries. Yet end user demand in China and globally has not climbed much even as supply has inched up again – OPEC members have been increasing production. Worse than expected macro news, meanwhile, would likely contribute to a correction, to the $50 range more in line with supply/demand fundamentals.

Yet, liquid financial conditions and the improving “less bad” macro climate may keep commodity prices in their current US$ 70 range, despite weak demand and an increase in storage Should oil prices keep climbing, they could put a damper on the economic recovery and on the revival of energy demand. Yet over the next few years, supply constraints supply, limited investment and high production costs for the new supplies that are entering the market could keep prices elevated and a damper on global growth, especially among the oil importers like China, India and the US
Source: RGE Monitor, August 26, 2009.

Tags: Asset Markets, Bear Market, Central And Eastern Europe, Chinese Investment, Commodities, Correlations, Domestic Investors, Emerging Market, Emerging Markets, Fine Tune, Foreign Investment, Forex Markets, Global Equities, Global Markets, Global Recovery, Government Policies, India, Indirect Influences, Market Volatility, Misallocation, oil, RGE Monitor, Sectors Of The Economy, Shanghai Composite Index
Posted in Emerging Markets, Markets | No Comments »

The Discomfort of Diversification

Wednesday, August 26th, 2009

When Harry Markowitz, an aspiring graduate student, had his article entitled Portfolio Selection published in the Journal of Finance in 1952, he could not have foreseen that his insight into diversification would earn him the Nobel Prize. His idea was simple but profound – “it is not enough to invest in many securities…it is necessary to avoid investing in securities with high covariances among themselves.” Putting eggs in lots of different baskets isn’t enough; one has to select baskets which do not move in tandem.

Proper diversification blends asset classes and investment strategies that have low covariances meaning as some fall in value others will tend to rise. 2008 was a case in point. Although equities plummeted and corporate bonds faltered worldwide, a number of assets and investment strategies experienced positive performance as depicted in the following chart.

Government bonds, particularly longer maturities, managed futures and dedicated short hedge funds and gold all rose in response to falling interest rates, plunging stock prices, and the flight to the safe-haven of the U.S. dollar and precious metals. What these assets and strategies have in common are historically low or even negative correlations to equities; in this light, their strong diversification effect in a year of epic stock losses should be no surprise. Investors with allocations suitable to their risk profiles were undoubtedly thankful.

Six months later, the investment landscape has changed. Stock markets have soared and, as evidenced in the following chart, with the exception of gold, last year’s diversifiers are posting negligible or negative returns.

Yesterday’s heroes have become today’s losers. This experience typifies the veiled corollary of Markowitz’s insight. Proper diversification is discomforting - it entails constructing a portfolio with combinations of asset classes and strategies that will tend to fall in value when others tend to rise and vice-versa. In other words, having some portion of a portfolio invested in today’s losers is an essential element of sound investment management.

Unfortunately, investors are ill-equipped to deal with this disappointing truth. Behavioural finance experts have found that investment decision-making is characteristically marred by cognitive errors including myopia – the tendency to be short-sighted; loss aversion – the predisposition to find losses much more painful than gains; and mental accounting – the tendency to categorize and evaluate economic outcomes in isolated groupings rather than as part of the whole. The result is that many investors react emotionally to any disappointing performance and impatiently sell losers and chase winners, often at the most inopportune times. They forget that the essence of diversification demands a continual exposure to the losing asset classes of the day.

At times, diversification is not just discomforting; it is downright painful. When growth stocks soared in the late 1990’s, many investors found the lagging returns of value stocks and REIT’s intolerable. Yet, as illustrated in the following graph which compares the annualized rolling six-month returns of growth stocks (in red) to value stocks (in green) and REIT’s (in blue), those laggards rapidly became winners as the tech crash pummelled growth stocks while value stocks and REIT’s experienced, for the most part, positive returns.

Investors should know that although diversification works, it is discomforting because it inevitably entails having a portfolio allocation to losing asset classes and strategies. Winston Churchill once cleverly opined, “Democracy is the worst form of government, except for all those other forms that have been tried from time to time.” To borrow his shrewd witticism, we can say that diversification is the worst form of investing, except for all those other forms that have been tried from time to time.

Tacita Capital Inc. (”Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.

Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.

Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.

Tacita research is based on public information. Tacita makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to inform any parties when opinions, estimates or information in Tacita research changes.

All investments involve risk including loss of principal. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Management fees and expenses are associated with investing.

Tags: Asset Classes, Corollary, Corporate Bonds, Gold, Government Bonds, Hedge Funds, Investment Landscape, Investment Strategies, Journal Of Finance, Maturities, Negative Correlations, Nobel Prize, Portfolio Selection, precious metals, Proper Diversification, Risk Profiles, Safe Haven, Short Hedge, Stock Losses, Stock Markets, Stock Prices
Posted in Gold, Markets | No Comments »

George Soros: Reduces Potash and PetroBras, Increases Convertibles

Wednesday, August 26th, 2009

MarketFolly.com reports that according to 13F filings, George Soros’ Soros Fund Management made some notable changes to its portfolio. Among them, Soros completely exited from its positions in Conoco Phillips, Macy’s, reduced each of its holdings in Petrobras and Potash by about two-thirds and increased positions in convertible bonds. Despite the large reduction in Petrobras, it still remains the fund’s largest holding, and Potash remains a 4.4% holding.

Bloomberg reported -  Soros Fund Management LLC, sold 22 million U.S.-listed common shares of Petrobras, as the Brazilian oil company is known, according to a filing today with the U.S. Securities and Exchange Commission. Soros bought 5.8 million of the company’s U.S.-traded preferred shares.

Soros is taking advantage of the spread between the two types of U.S.-listed Petrobras shares, said Luis Maizel, president of LM Capital Group LLC, which manages about $4 billion. The common shares were 21 percent more expensive than preferred today, according to data compiled by Bloomberg.

“He knows he held a voting right in the common shares that would never translate to actual power,” Maizel said in an interview from San Francisco. “He’s just playing the spread.”

Petrobras preferred shares have also a 10 percent additional dividend, said William Landers, a senior portfolio manager for Latin America at Blackrock Inc.

Re: Potash - Bloomberg reported

Soros cut his stake in Potash Corp. of Saskatchewan Inc., selling 4 million shares of the fertilizer producer while investing in Monsanto Co., the world’s largest seed producer.

Hedge Fund managers like Soros are worth watching because their directional votes (positions) often constitute stringently researched decisions, that are beyond the grasp and willingness of most investors.

(MarketFolly.com) Some Reduced Positions (Some positions they sold some shares of)
Petroleo Brasileiro (PBR): Reduced by 68.9%
Potash (POT): Reduced by 65.2%
Macrovision (MVSN) Bonds: Reduced by 48.8%
Walgreen (WAG): Reduced by 22.7%

Removed Positions (Positions they sold out of completely)
Conoco Phillips (COP), Macys (M), Union Pacific (UNP), American Electric Power (AEP), Donnelley (RRD), Smucker (SJM), Kohls (KSS), Occidental Petroleum (OXY) Puts, iShares Mexico (EWW) Puts, and Arch Coal (ACI).

The rest of their sales were positions that were less than 0.25% of their portfolio each, including: Weyerhauser (WY), Coach (COH), Nabors (NBR), Public Service Enterprise (PEG), Crown Holdings (CCK), DPL (DPL), Emulex (ELX), PPL (PPL), Bluefly (BFLY), Frontier (FTO), Vishay (VSH), Northeast Utilities (NU), ICICI bank (IBN) Puts, Commercial Metals (CMC), Airgas (ARG), Formfactor (FORM), Vignette (VIGN), and Teradyne (TER).

It appears that while they reduced the position in Petrobras (PBR) they initiated a large position in Petrobras-A (PBR-A), and also added significantly to positions both new and existing in convertible bonds.

Bloomberg reported that Soros boosted his stake in oil company Hess Corp. to 5.1 million shares as of June 30 from 3.7 million at the end of the first quarter, according to the filing. Hess was Soros’s second- largest holding. He also added to stakes in Houston-based Plains Exploration & Production Co. and bought shares in Calgary-based Suncor Energy Inc. and InterOil Corp. in Sydney.

(MarketFolly.com) Some New Positions (Brand new positions that they initiated in the last quarter):
The major additions: Petroleo Brasileiro (PBR-A), Autozone (AZO), Goldman Sachs (GS) Puts, Interoil (IOC), Monsanto (MON), Vale (VALE) Puts, BPZ Resources (BPZ), and Suncor (SU).

The rest of their new positions were less than 0.5% of their portfolio each: Verizon (VZ), Diodes (DIOD) Bonds, SPSS (SPSS) Bond, Sandridge Energy (SD), Exar (EXAR), Apache (APA) Calls, Pioneer Natural Resources (PXD), Lawson Software (LWSN) Bond, Blackboard (BBBB) Bond, Novagold (NG), CSX (CSX), Brigham Exploration (BEXP), Comcast (CMCSA), CA (CA), Constellation Energy (CEG), Focus Media (FMCN), Wabtec (WAB), Covanta (CVA) Calls, Ultrashort Financials (SKF), Berry Petroleum (BRY), Exco Resources (XCO), and Teradata (TDC) Calls.

Similar to Soros’ Q1 2009 portfolio, their second quarter portfolio is heavily laden with convertible bonds. Seven out of their top 15 positions are in bonds, with LSI and Linear Technology their top picks in that regard. They boosed their Flextronics Bond position by 141%, their Tech Data Bond position by 77% and their LSI Bond position by around 20%. So, they were still liking those names over the course of the past quarter.

Some Increased Positions (A few positions they already owned but added shares to)
Allied Nevada Gold (ANV): Increased by 4,242% (was previously 0.01% of their portfolio and is now boosted up to only 0.45% of their portfolio)
Covanta (CVA): Increased by 1,185.5% (was previously a 0.11% position for them and is now 1.89% of their portfolio)
AT&T (T): Increased by 691% (boosted from 0.05% of their portfolio up to 0.47% of their portfolio now)
Allegheny Energy (AYE): Increased by 259% (from 0.13% of their portfolio up to 0.55% of their portfolio)
Flextronics (FLEX) Bond: Increased by 141%
Plains Exploration (PXP): Increased by 81.8%
Tech Data (TECD) Bond: Increased by 77%
Hess (HES): Increased by 40%
RF Micro (RFMD) Bonds: Increased by 37.9%
LSI (LSI) Bonds: Increased by 19.4%

Here is the latest list of Soros Fund Management Holdings:

Top 15 Holdings by percentage of long portfolio *(see note below regarding calculations)

1. Petroleo Brasileiro (PBR): 9.58% of portfolio
2. Hess (HES): 6.56% of portfolio
3. LSI Corp (LSI) Bond: 5.85% of portfolio
4. Linear Technology (LLTC) Bond: 5.2% of portfolio
5. Petroleo Brasileiro (PBR-A): 4.68% of portfolio
6. RF Micro Devices (RFMD) Bond: 4.42% of portfolio
7. Potash (POT): 4.4% of portfolio
8. Plains Exploration (PXP): 4.25% of portfolio
9. Tech Data (TECD) Bond: 3.96% of portfolio
10. RF Micro (RFMD) Bond 2nd set: 3.7% of portfolio
11. Flextronics (FLEX) 1%10 Bond: 3.2% of portfolio
12. Covanta (CVA): 1.9% of portfolio
13. Autozone (AZO): 1.9% of portfolio
14. Audiocodes (AUDC) 2% 24 Bond: 1.6% of portfolio
15. Entergy (ETR): 1.6% of portfolio

Tags: Blackrock Inc, Capital Group Llc, Common Shares, Conoco Phillips, Convertible Bonds, ETF, Fertilizer Producer, George Soros, Gold, Hedge Fund Managers, Monsanto Co, oil, Petrobras, Potash Corp Of Saskatchewan, Potash Corp Of Saskatchewan Inc, Potash Pot, Preferred Shares, Securities And Exchange Commission, Seed Producer, Soros Fund Management, Soros Fund Management Llc, Voting Right, William Landers
Posted in Gold, Markets | No Comments »