China: Social Stability Through Economic Prosperity

Sunday, February 14th, 2010

By Frank Holmes
CEO and Chief Investment Officer

China sees a bubble ahead and is trying to avoid it – is that such a bad thing?

Isn’t this what we expect Ben Bernanke and the Federal Reserve to do here at home – take clear and decisive action to drain off excess liquidity in the economy before inflation takes hold?

The People’s Bank of China did just that after it saw that 1.4 trillion yuan ($204 billion) worth of bank loans were issued in January, more than the total loaned in the three previous months combined.

For all of 2010, the target loan amount is 7.5 trillion yuan, so it’s easy to see why the government might want to slow the pace a bit.

Forbes’ online headline was “China Tightens the Screws,” but let’s have a little perspective.

Barclays Capital predicts that the 0.5 percent increase in bank reserve rates (from 16.5 percent of deposits to 17 percent) will remove 300 billion yuan from the Chinese economy. That’s only 20 percent or so of the amount loaned in January.

And it’s not like cash is going to dry up – the People’s Bank plans to increase the nation’s M2 money supply by 17 percent this year. January’s M1 money supply report showed a 39 percent increase (chart above). Not exactly a screw-tightening.

China’s CPI rose 1.5 percent in January, which is not extreme, and the chart above from BCA Research shows that real estate prices in terms of per-capita income had not entered a bubble phase as of year-end. But perhaps the more telling number was wholesale prices – up 4.3 percent year-over-year and more than double the increase seen in December. This signals that higher inflation at the consumer level could be around the corner.

Markets are taking a hit based on this news – this shows how important China has become to the world economy. It surpassed Germany as the top exporting country by value at $1.2 trillion, and in January its exports were up 20 percent compared to a year earlier. Even better, its imports were up 85 percent year-over-year.

What we may actually have is a classic bull market in the making – one that climbs the proverbial wall of worry, which suggests that investors buy on corrections. The table below shows the standard deviation (sigma) over 10 years for the main stock markets in mainland China and Hong Kong. The weekly sigma for the Shanghai A-share market is plus or minus 5 percent, while its normal quarterly swings can be nearly 25 percent up or down.

It’s nearly impossible to pick exact tops and bottoms – adding to core positions after any correction greater than one sigma is a safer and more prudent way to invest.

Beijing is tending to its economy so it performs over the long term. This is central to its goal of social stability through economic prosperity, and it seems to be working – millions of households join China’s middle class every year.

We all know what can happen when an asset bubble grows huge and then bursts – we’re still recovering from 2007-08.

China is a long-term growth story, and how well it manages that growth will have an impact on all of us. A little caution now should be seen as preventative maintenance, and we all know that when we’re talking about cars or economies, that’s a good thing.

Tags: Bank Loans, Bank Of China, Barclays, Barclays Capital, Ben Bernanke, Chief Investment Officer, China, Chinese Economy, CPI, Decisive Action, Economic Prosperity, Emerging Markets, Excess Liquidity, Federal Reserve, Frank Holmes, Money Supply, Per Capita Income, Social Stability, Target, Wholesale Prices, World Economy, Yuan
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China Is No Dubai Or Enron: Real Estate Rebalance to Buoy Gold

Monday, January 11th, 2010

By Dian Chu, Economic Forecasts & Opinions
The Chinese central bank surprised the markets last week by raising the interest rate slightly on its three-month bills from 1.3280% to 1.3684%. This is the first rate increase since August and signaled an effort by Beijing to reduce asset-price inflation after a record surge in credit.

The news, sparking fears in markets that the central bank may hike benchmark interest rates, sent Shanghai Composite Index down almost 2% in one day. Some Asian and European markets also felt the impact.

Construction & Lending Boom

China’s foreign exchange reserves, the largest in the world, increased $141 billion in the third quarter to $2.27 trillion, on top of the record $178 billion jump in reserves in the second quarter. There is a tremendous amount of capital inflow with a lot of them speculative in nature.

The central bank, which has kept its benchmark one-year lending rate at a five-year low of 5.31% after five reductions late 2008, has allowed a record $1.4 trillion of new bank loans in the first 11 months of 2009. (Fig. 1)

Now, China’s policy makers are seeking to sustain its economic rebound, propelled mostly by the construction boom that has been spurred by its unprecedented fiscal stimulus and loose credit.

New Home Loans up 400%

Investment in real estate development is a key driver of economic growth. Total investment in construction projects during the first 8 months of 2009 has increased by 36.2% year-over-year, while total planned investment in new projects in the same period has risen by 81.7%, year-on-year.

Meanwhile, housing starts nationwide rose a staggering 194% year-over-year in November 2009. And the central bank noted new home mortgages in the first nine months of last year totaled about $139.5 billion, quadruple the amount offered a year earlier.

Home price at 80 Times the Average Income

According to Knight Frank, average prices for new homes year-to-date in November 2009 rose by 68% in Shanghai, 66% in Beijing and 51% in Shenzhen. Beijing’s Chaoyang district, which represents a third of all residential property deals in the capital, a typical 1,000-sq.-ft. apartment costs about 80 times the average annual income of the city’s residents.

The China Daily noted that in terms of house prices as a proportion of incomes, China is now the most expensive place in the world.

Whiff of Dubai …, Maybe

In addition, signaling a move out of deflation, China’s consumer prices climbed 0.6% in November from a year earlier, the first uptrend in nine months; while the Shanghai Property Index of 33 stocks also has doubled in 2009.

The surge in new bank loans and home prices has prompted concerns that some of the money is leaking into property and equity markets, fuelling bubbles that will eventually burst and derail the economy.

Indeed, there is a whiff of Dubai about the Chinese property market at the moment.  By one estimate, the vacancy rate of Pudong, the central business district of Shanghai, is as high as 50%. However, that did not seem to have fazed new skyscraper construction projects nearby.

Neither A Dubai Nor An Enron Be

As indicated in my previous article, China is a communist country with capitalistic power. This is not an economy where price signals always decide business strategy. Despite China Bears such as James Chanos, predicting an economic crash in China, there are some strong fundamentals underpinning the market. (Note: James Chanos’ rise to fame came form a critical short call and position of Enron.)

The U.S. financial crisis was mostly a result of the securitization of mortgages, but that is not part of the China’s market structure. So, the impact of a bursting Chinese real estate bubble would likely be more muted, given the government’s involvement in its market.

As pointed out by Michael Pettis, an economics professor at Peking University, China’s economy isn’t nearly as dependent on real estate as the U.S. economy was. The wealth effect of collapses in the real estate and stock markets isn’t likely to be big enough to affect consumption. Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.

Moreover, in recent years, incomes have mostly risen faster than house prices on average, and homeowner debt levels are low. Urbanization is another power fundamental force. According to the State Council, as many as 400 million people could move to cities over the next two decades. That’s about 322 Dubai’s.

This is not to say there’s not a real estate bubble in China.  Rather, overinvestment and overbuilding is sometimes a prerequisite of an anticipated mass urban migration such as the one China is destined to experience. (See Fig 2: BRIC Real GDP Growth )

Equal Opportunity – Gold & Real Estate

China, still a developing country, lacks a proper social safety net and developed financial markets. So Chinese, individuals and corporations alike, are naturally thrifty. In fact, the Chinese corporate sector has been an important driver of savings growth over the past decade.

With an underdeveloped financial system, companies understandably end up putting retained earnings, or savings, into new investment, which also enjoys state subsidies. Companies in the chemical, steel, textile, and shoe industries reportedly have started up property divisions for a quicker return than their primary business.

Moreover, Chinese traditionally treat real estate as “stores of value”, just like gold. With few other investment options, people put a big chunk of savings into real estate, driving up house prices in plenty of cities.

Government measures and policies including low interest rates, official encouragement of bank lending, and then Beijing’s half-trillion-dollar stimulus, tax breaks and low down payment requirement all have buoyed the real estate investment.

And some of the very same fear factors driving up the gold prices, inflation and a bubble that could burst later in 2010, are also fueling the real estate rush.

Rebalance in Progress

Though housing starts in China spiked 194% in 2009, 90% of the new supply is targeted towards the more lucrative luxury market. Chinese Premier Wen Jiabao told Xinhua in an interview on Dec. 27 that the government would use taxes and mortgage rates to stabilize house prices and take measures to clamp down on house speculation.

To discourage speculation, the State Council, China’s cabinet Sunday issued a notice rolling out eleven fresh measures for the property market, and is re-imposing a sales tax on homes sold within five years. Tighter rules on mortgages are expected to follow.

However, the government is careful not to crack down too hard because construction, steel, cement, and other sectors are directly tied to the real estate. In November, for example, retail sales of furniture and construction materials jumped more than 40%.

For a soft landing, Beijing needs not only to rebalance its economy, but also to rebalance its housing market. This will likely involve changing the incentives to move investments into much-needed low-income housing and other investment vehicles.

Redirection To Gold

The measures by Beijing to rein in liquidity as well as the overheated real estate sector inevitably would re-direct the capital flow into other sectors.  Given the traditional distrust of paper investments by the 1.5 billion Chinese citizens, and China’s continued economic growth (Fig. 2), god is poised to benefit the most from the expected shift in investment since gold shares most of the ”hard assets” characteristics of the real property.

The gold market is already buzzing that the Chinese government was running ad campaign urging citizens to buy gold and silver, while easing the restrictions of holding precious metals by the individual.

China, the largest gold producer, is also set to overtake India as the world’s largest gold consumer. On recent trends, China’s gold purchases have grown 10% from 2008’s record in volume terms, accounting for almost one ounce in every eight sold worldwide.

This trend would likely ensure private gold demand to remain very robust beyond the domestic production, and nudge the global gold market to be less dictated by the Dollar movement.

Base Commodities, Interest Rate & Yuan

At the December Central Economic Work Conference, officials said real estate would continue to be a key driver of growth. So, this is a reassurance that the base commodities will unlikely suffer a drastic decrease in demand from the tightening of the housing sector.

Although the China real estate bubble burst should have a fairly muted overall effect as discussed here; nevertheless, if loan defaults start to rise, China might need to raise cash to keep its banks afloat. In that case, it might sell a chunk of its $2.2 trillion in U.S. debt, which would likely presure the Dollar and drive up interest rates in the U.S.

BNP Paribas said in a report dated Jan. 7. that the Chinese central bank is likely to implement “a series of hikes” in 3-month and 1-year bill auction yields to guide market expectations of a monetary policy shift and may raise the bank reserve ratio in the first quarter.

Meanwhile, some economists believe inflationary pressures might push Beijing to let Yuan appreciate by mid-2010. However, Premier Wen’s recent statement in a Xinhua interview - ”We will absolutely not yield to pressure to appreciate.”, pretty much says that China will most likely keep Yuan firm in the medium term to stabilize its recovery by keeping its advantage on exports.
“I find it interesting that people who couldn’t spell China 10 years ago are now experts on China.” ~ Jim Rogers

Tags: Asset Price, Average Income, Bank Loans, BRIC, Capital Inflow, China, Chinese Central Bank, Commodities, Construction Boom, Economic Forecasts, Economic Rebound, Emerging Markets, European Markets, First Nine Months, Fiscal Stimulus, Foreign Exchange Reserves, Gold, Home Loans, Home Mortgages, Impact Construction, India, Knight Frank, New Home Loans, Price Inflation, Rate Increase, Record Surge, Shanghai Composite Index
Posted in Emerging Markets, India, Markets | No Comments »

Robert Arnott: Too far too fast?

Friday, July 17th, 2009

In his latest newsletter, Robert Arnott, founder of Research Affiliates, and innovator of FTSE-RAFI(tm)Fundamental Indices, asks the question “Too far too fast?,” and provides a comprehensive analysis of the market and his outlook. Here is an excerpt:

The tremendous comeback in financial assets that began in March and extended through the second quarter of 2009 has proved a welcome relief to investors of all types, a blessed batch of showers for our drought-ridden portfolios. The classic 60/40 stock (S&P 500 Index) and bond (BarCap Aggregate) mix advanced 10.2%, experiencing its third best quarter since 1988. As we predicted coming into 2009, in a broadly diversified GTAA context, some of the most dislocated credit categories from last fall-high-yield, emerging market bonds, convertibles, and bank loans- were some of the biggest winners in the fi rst six months of 2009 as all four dramatically outperformed mainstream stocks and bonds.

Undoubtedly, most portfolios are still well underwater (60/40 is still down 21% from its October 2007 high) and likely have many years of catch up. But the respite has allowed investors to assess their portfolios and begin to make asset allocation decisions with an eye toward the future. A thorough exercise of asset class valuations reveals that many once beleaguered asset classes may have come too far, too fast in this recent rally. Accordingly, now is likely a time to take profi ts and to resume our cautious vigilance of 2008.

Read the whole newsletter here.

Hat tip: Investment Postcards

Tags: Asset Allocation Decisions, Asset Classes, Asset Valuations, Bank Loans, Convertibles, Credit Categories, Emerging Market Bonds, Emerging Markets, Fi Rst, Financial Assets, Ftse Rafi, Hat Tip, high yield, Innovator, Portfolios, Research Affiliates, Respite, Robert Arnott, Stocks And Bonds, Valuations, Vigilance, Welcome Relief
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Yale’s Swensen: “Extraordinary Opportunities in Distressed Debt

Monday, January 5th, 2009

Legendary Yale University Endowment investor, David Swensen, says there are extraordinary investment opportunities in the credit world and is “pursuing a recovery” by acquiring distressed debt.

Bloomberg says:

“There are some really extraordinary opportunities in the credit world,” said David Swensen, the school’s investment chief, in a phone interview from his office at the New Haven, Connecticut, university. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels.”

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Among Swensen’s core principles identified in “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (Free Press, 408 pages, $35) is the importance of diversifying holdings while focusing on equities. In a recession, the advantages of diversification get overwhelmed by investors’ selling equities in favor of U.S. Treasury bonds in a “flight to quality,” he said.

“When you have a market in which any type of equity exposure is being punished, it’s going to hurt long-term investors,” he said.

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.

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Until financial institutions resume lending, the economy will remain stagnant, Swensen said.

“I don’t think the Fed or the administration has figured out how to fix credit markets,” he said. “We are going to experience economic and financial stress as long as the credit markets are broken and it’s not until we start seeing the credit markets functioning properly will we be able to see a path to economic recovery.”

Swensen advocates federal guarantees for deposits in money- market funds as a way to encourage investment in the vehicles that buy corporate debt.

Source: Bloomberg.com, January 2, 2009

Tags: Advantages Of Diversification, Bank Loans, Connecticut University, Corporate Securities, Credit Markets, David Swensen, Distressed Debt, Equity Exposure, ETF, Federal Guarantees, Financial Stress, Institutional Investment, Investment Grade Bonds, Money Market Funds, New Haven Connecticut, Term Investors, U S Treasury, U S Treasury Bonds, Unconventional Approach, University Endowment, Yale Endowment, Yale University
Posted in Bonds, Credit Markets, Economy, Markets | No Comments »