November 09, 2012

By Derek On November 9, 2012 Under November 2012

When we started playing together as a band the Dead Sea was just sick.” – Steven Tyler

Observations

The above photo, taken from today’s Wall Street Journal, shows Indian students in India celebrating the US election. When American students gather outside the Indian Embassy in Washington DC to celebrate an Indian election, I will consider moving there.

The US presidential election is finally, thankfully, at long last over. Many believe election uncertainty has been holding the markets back:

Once we get the election behind us, all this political uncertainty about …what our country’s road map is going to be will be cemented.”

This is the view of one PM at Wilmington Broad Market Fund. I respectfully disagree: what candidates say on the campaign trail and what they actually do, or can do, are two very different things. Also, again neither the Democrats nor the Republicans control both houses of the legislature. The latest stats show that $6 bn was spent on the US presidential election, making it the most expensive ever – and nothing has changed! We will still have gridlock, we will still have uncertainty.

As I predicted, Obama won the election and, technically speaking, he won in a landslide. Romney may have received 48% of the popular vote but despite the bombast, in the US the popular vote doesn’t elect the president. That is the job of the Electoral College, a collection of citizens from each state. The number of electors per state is equal to the number of congressmen and senators from each state. Other countries that use a similar system include Burundi, Kazakhstan and Madagascar (yikes). In the UK, the Labour Party elects its leader via a type of Electoral College as well.

Back to the US, 270 electoral votes are needed to win the Presidency. Most of the pundits were claiming a decisive Romney victory with the good governor supposedly garnering over 300 electoral votes. Despite Romney giving it all and “leaving nothing in the locker room,” Obama won 303 electoral votes to Romney’s 206. This was a landslide victory. Not only that, but Romney and Ryan both lost in their respective home states; Massachusetts and Wisconsin. Ouch.

Then markets crashed. Why? Were markets that convinced of a Romney victory? Too bad so may got it so wrong. But the US is not much different today than it was last week. We have the same President and the same division in congress with Republicans still in control of the House and Democrats still in control of the Senate. It is worth noting what Jeremy Grantham, famed investor at GMO talking to Charlie Rose said before the election:

“History speaks pretty clearly that the markets do better with Democrats. Republicans’ ideas of what constitutes fiscal responsibility simply are not good for the stock market. Democrats have many tendencies, but one of them is to look after the workers, and actually that tends to be good for demand and good for markets. These capitalists who are desperate to elect Republicans should study their history books.”

Part of the sell-off may be due to rational fears of higher capital gains taxes around the corner. Obama has also proposed hiking taxes on dividends from 15% to almost 40% for high-income earners. However, all eyes now are focused on the dramatic “fiscal cliff,” off which the US, like Thelma & Louise, is supposedly to drive headlong come January 1 when up to $670 bn of spending programs and tax cuts expire. Some believe the end is nigh and there is a lot of wringing of hands in the media and angst amongst the talking heads concerning this issue.

My view: I see this as a Y2K issue. Remember that malarkey? The whole world was going to just stop in its tracks because computers were so stupid they wouldn’t recognize the new millennium.
Let’s wind the clocks back a bit. Then Deutsche Bank chief investment strategist and main agitator, Ed Yardeni, eagerly took on the role of Chicken Little, running around squawking the world would slip into a “12-month long severe global recession because of Y2K disruptions.” That was funny before, during and (as we all know now) after.

My view: the “fiscal cliff” is in no one’s interest and a compromise solution is very likely to be hashed out even at the last minute. Both Republicans and Democrats have made public statements straight after the election on how they will work together to tackle this. Neither party wants to branded as responsible for the consequences of letting it occur. Time to stop worrying about cliffs and get back to fundamentals.

So how do we play Obama, the sequel? Well, nothing has changed so I would expect reflation trades to do better over the longer term. Short the dollar. Buy Treasuries. More liquidity will continue to flow to emerging markets giving us a helpful rush. Buy EM equities.

Research

Two weeks ago Mirae initiated on the Korean auto sector, highlighting how Hyundai Motors (005380 KS) and Kia (000270 KS) are cheap at 6X PER and are gaining market share in virtually every market they enter. We were blindsided by news that Hyundai and Kia had “mistakenly” advertised higher mileage per gallon statistics for some of the models they sold in the US than was the reality.

Was it like my experiences travelling in Greece, I thought? Every time I got change after eating or buying something and there was a “mistake” – it never was in my favor. Hmmm. Suspicious behavior but the Greeks just kept smiling…

Our autos analyst, YK Kim believes that the errors were unintentional as the actual mileage difference is only 3.7% and after applying the proper correction, mileage for HMC and Kia is still at the top of the industry. Also, the problems only arose with a few models sold in the US and none in Europe. The companies have reacted aggressively and will compensate drivers. YK estimates the total financial cost will only be around 0.5% of operating profit this year.

What about the bigger picture, that of reputational damage? Honda went through a similar problem a number of years ago, except their error was much larger. Many affected drivers never applied for the mileage reimbursements and the total financial outlay was well below what straight line forecasts suggested. People still buy Hondas and the incident has passed from memory.

HKMC has also been taking out full-page advertisements in major newspapers across the US. I saw one today in The Seattle Times, which read, in part, “An Important Message to Our Valued Owners…..” After explaining the cockup and how they intend to atone for it (debit cards for the “lucky” owners), the full pager ends with,

“We work hard to be deserving of your trust, and appreciate the opportunity to make this right for you.”

My view: Sincere statements like this will not be perceived negatively by their customer base and this will pass.

Suzuki just announced they are pulling a Daihatsu, and are exiting the US market. The company’s US subsidiary, American Suzuki Motor Corp, is filing for bankruptcy protection in California. Their expensive and loss making foray into the US market with tinny and tiny SUV car models, such as the Suzuki “Sidekick” has ended badly. The company will take the same engines used in their cars and repackage the technology into more appropriate power hungry applications like fruit juicers and lawn mowers. Suzuki has said in its statement they will also focus selling ATVs, motorcycles, marine outboard engines after emerging from bankruptcy. This is further evidence Hyundai and Kia are expanding their market share in the US at the expense of other players.

This is most likely a good buying opportunity than anything else. As the evidence strongly points to operational error and was unintentional, the correction in the stocks this incident has caused will not last long. Our recommendations remain unchanged (Buy) and I prefer Hyundai over Kia.

Sinorama

China’s transition of power also begins this week and the differences between what happened in Washington and what is happening in Beijing couldn’t be more stark. While democracy in the US is messy, expensive and really annoying, at least it is like a biology class dissection and you get to see what is going on (whether you like it or not).

These differences were well noted in China, as well. There were 24 mn Weibo posts on Wednesday afternoon alone about the US election. One post that enjoyed a lifespan of about three minutes before being swiftly deleted by censors read:

“We are perfectly clear about how the US presidential election works but are utterly ignorant about China’s.”

At the end of the week long Communist Party 18th National Congress we will know what months of secret maneuvering and backroom dealing have dealt the Chinese people. I hope they are happy with the results because they have to live with them for another 10 years.

This Cold War era joke comes to mind:

American to Russian: You know, in my country we have freedom, unlike Russia. I can stand outside the White House and shout, “Down with Obama! Down with Obama!” all day long if I want to.

Russian: Comrade, that shows how little you know about Russia. In Russia, I can stand outside the Kremlin and shout, “Down with Obama! Down with Obama!” all day long too!

Not for All the Gold in China

There is some interesting maneuvering going on in the gold market as well. Since 2007, China has been the world’s largest gold producer starting with around 55 metric tons of annual production in 1981 up to over 350 tons a year now. China’s gold production has been growing at almost 7% per annum for 30 years. They are now, by far, the largest gold producers in the world. The chart below, kindly provided the US Geological Survey, clearly illustrates this.

US gold production, on the other hand, has been falling steadily at about a rate of 2.5% per year. Australia’s has been flat, just like the country.

Some private institutions have calculated that China’s gold production is even higher, around 380 tons a year last year. Why do we care? According to several sources, China isn’t selling any gold. One database cited measured the gold bars under ownership of the world’s largest commodity ETF: GLD. The SPDR Gold Trust ETF is backed by physical gold: for every dollar of shares bought in the market, the equivalent gold bullion is purchased at that day’s price. Current holdings of the fund are 1,332 tons of gold, or US$72 bn. Reportedly, they haven’t seen any Chinese gold. There may be a perfectly good reason for this, I don’t know. However, it seems to me that China is quietly building the world’s largest position in the gold market.

If China isn’t exporting or selling gold are they importing it? Yes. The only way to track that is through HK gold exports, one window through which China can and frequently does use to buy gold. For the first seven months of 2012, China reportedly imported 459 tons of gold through HK, or four times the amount they imported over the same period last year. That is almost the total amount of gold held by the European Central Bank.

But aren’t they just buying gold to index a certain amount of their growing foreign exchange reserves? China’s f/x reserves have been flat at US$3.2 trillion since June of last year. Yet, as we have seen, gold accumulation is accelerating. What about Treasury purchases? Again, looking at the same time period of the first seven months of this year, China’s US Treasury holdings were $1.152 trillion December 31, 2011 and fell slightly to $1.149 tn by end July. No doubt about it, China is very keen to get more gold.

China’s Foreign Exchange Reserves Aren’t Growing

China’s domestic gold production plus what they are importing suggests an accumulation rate of over 1,000 tons per year. If this continues apace, China will soon challenge the US for gold bullion reserves, which I see as a very likely scenario. Then what?

In an era of increasing currency debasement via competitive easing by global central banks, owning the gold market, or a large part of it, will put one in a very powerful position. China probably realizes they can’t “get the money back” they have put in Treasuries and quietly building the world’s largest gold stockpile is a good hedge against the paper losses, in real terms, they will be facing. Once they proportionally hold most of the gold reserves, Beijing will wield clout like never before.

This reminds me of the impact on markets caused by the travels of Mansa Musa, the fabulously wealthy king of Mali. King Musa, a devout Muslim, went on hajj in 1324. To keep him company on his long journey to Mecca across Africa and the Red Sea, he brought 60,000 men and 12,000 slaves, whom, it is reported, all carried 4 lb gold bars. And don’t forget the camel train: there were 80 camels and each carried between 50 and 300 pounds of gold dust. Mansa Musa gave gold to the poor and all the cities along his route to Mecca. Such a sudden and large influx of the precious metal caused an instant collapse of the Mediterranean gold price, as well as that of local currencies for over a decade.

“Gold was at a high price in Egypt until they came in that year. The mithqal did not go below 25 dirhams and was generally above, but from that time its value fell and it cheapened in price and has remained cheap till now. The mithqal does not exceed 22 dirhams or less. This has been the state of affairs for about twelve years until this day by reason of the large amount of gold which they brought into Egypt and spent there.” —Chihab Al-Umari

One must remember The Golden Rule: “Those with the gold rule.” Is China taking the long view regarding gold and what is their end game? My view: I don’t know but this is a very interesting trend and worth watching.

Ruminations

The UBS Purge

I see my former shop, UBS, hogging the headlines again. Moreover, for all the wrong reasons. They have decided to grab the Swiss milk cow by the horns and deal with the money-losing monster bank they created by cleaving off whole hindquarters in one go. While this is an aggressive response to a game where the rules have shifted, I can’t say I feel warm and fuzzy about the reprehensible way they treated their former loyal employees.

Over 100 traders showed up for work Monday morning last week and found their pass cards no longer worked at the elevators. From a bean counter’s point of view this may maximize efficiency regarding personnel redundancy, but it is very bad PR and will backfire. Morale, already low at the constantly battered bank, (UBS: U Be Sinking) will now sink even lower as those left inside the building can surely expect no better treatment at the callous hands of ham-fisted management when their time comes, and they will prepare accordingly.

Aside from the complete lack of sensitivity and dignity (did the bank lose that too with all the money wasted?), actions such the above damage the brand of the bank and any soft power it wants to project. Yes, I know we are talking about traders (recent research shows they are more closely related to humans than even chimpanzees) but I still think this should have been handled better. And forgive me for sounding pretentious, but if nobody says anything at all about it then we are giving our tacit approval to further dastardly deeds dirtily done.

“I see the bad debts arising

I see trouble on the way…”

The funeral dirge accompanying the Chinese economic slowdown continues to grow in volume. An analysis by the FT indicated that 66% of listed Chinese companies have reported a y-y rise in account receivables. Not only is the construction machinery sector rife with bizarre corporate names but it is also here where account receivables are rising very much faster than sales. Sany Heavy (631 HK) reported A/R up 83% ytd, reaching US$3.4 bn. (The stock is down 45% from its January high). Zoomlion (1157 HK) has seen a 69% increase in A/R ytd. Revenues, however, are not keeping pace.

Bad loans at the banks (as reported by the banks themselves) are “steady.” What a relief. Except the “really bad loans” have been rolled off the balance sheet and the “just bad loans” have been rolled over. Banks can kick the can down the road a longer time than listed private sector companies, which is why this latest data is more interesting.

Anecdotal news from the Canton Trade Fair, the largest trade fair in the country by far, paints a similar picture of slower growth. The fair, which boasts over 55,000 booths, concludes this week. Organizers say orders for 2013 are down from Europe by 10% this year and down by a full third from Japan.

China’s new leaders will be taking note and as I have said before, are very likely to enact fiscal policy that stimulates the economy and gets people smiling again. Right now, however, they are busy with other things. Beijing is apparently under “lockdown” as security is increased (even more) for the leadership transition this week. New rules strictly prohibit rolling down the window in taxis (all handles have been removed from passenger doors), purchasing fruit knives or even flying toy helicopters. “Troublesome” ethnic groups like Tibetans and Uighurs are also under careful surveillance. While to an outsider this is nothing short of comical, if you are a Tibetan knife seller with a penchant for toy helicopters, man watch out!

On the Music Shelf:

The Last Page

$$$$$$$

A businessman was confused about a bill he had received, so he asked his secretary for some mathematical help.

“If I were to give you $20,000, minus 14%, how much would you take off?” he asked her.

The secretary replied, “Everything but my earrings.”

Derek Hillen, CAIA
Mirae Asset Securities

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