November 30, 2012

By Derek On November 30, 2012 Under November 2012

I owe much; I have nothing; the rest I leave to the poor.” – Francois Rabelais


This week the US Treasury Department released its semiannual report on global exchange rates, the upshot of which is again the US has declined to label China a “currency manipulator.” Meanwhile, back at the Fed, the US central bank continues to print money by buying $85 bn a month in long term Treasurys and mortgage bonds. In four years’ time, the Fed has stuffed almost $2 tn worth of this paper into its mattress. The next Fed meeting is in two weeks’ time and markets expect an announcement that these programs will continue.

The printing of enormous amounts of money is causing prices of some hard assets to soar; gold has doubled in dollar terms since QE began. According to the US Department of Agriculture, the price of farmland has risen 28% in just two years. Most currencies are now appreciating against the dollar, particularly those in emerging markets. The Rmb has appreciated 12.6% against the dollar after adjusting for inflation since mid-June 2010, according to the Treasury. But, they add, “Further appreciation is warranted.” The world’s biggest currency manipulator, the United States, is working hard to make sure this happens.


How a Flying Shark is Good News for Japanese Bar Girls

Spot the Difference

China has finally landed an aircraft on its paper mache aircraft carrier, Liaoning. This is a big deal because an aircraft carrier without any aircraft, as we wrote in an earlier issue of EMI, is well, just a big boat with lots of karaoke parlors and no threat to anyone. Now, the game is slowly changing.
In what was surely a nail-biting exercise in aeronautical ability, China landed one of its indigenous fighters, the J-15 “Flying Shark” on Liaoning over the weekend. Tensions were high as national prestige was at stake. In fact, tensions were so high the senior engineer, Mr. Luo Yuan, died of a heart attack on the spot after witnessing the successful landing. He was 51 years old and oversaw the development of the J-15 fighter.

While a step forward (aside from the loss of Mr. Luo), China is miles away from having a fully operational aircraft carrier with real airplanes taking off and landing regularly without requiring a defibrillator. The Chinese J-15 is a copy of the 20-year old Russian Su-33 and despite the hopes of patriots across the country, according to regional defense experts, “is not a game changer.” The engine, arguably the most important part of a fighter aircraft, still has to be purchased from Russia. But China is working towards all these issues and is making steady progress.

Either way, flashing pictures around of a Chinese made jet (despite the Russian engine) taking off and landing on a Chinese aircraft carrier (despite the Russian ship) will have made a deep impression on China’s neighbors. How is a “Jack Sprat,” like the Philippines going to seriously stand up to China over the Spratlys? More importantly, Japan has the most to lose here and will have to jack up defense spending and cozy up closer to the US. Good news for Roppongi bar girls.


We have written about why the Rmb is not and will not become a reserve currency like the US dollar. My view is based on the fact that an open capital account with no meddling is a pretty clear prerequisite and that is pretty clear something Beijing will never sign up for. An open capital account also means ripping away the groin level fig leaf hiding the debt bomb in the banking system. China does not want her privates exposed to the cold.

Respected economist and finance professor at Peking U, Michael Pettis, has written (here) why he thinks the idea of China wanting the Rmb to be a reserve currency is ludicrous. This is due to the costs it places on the issuing country by forcing the US, in today’s case, “to choose between higher debt and higher unemployment whenever a country takes steps to force up its savings rate or…to force up its current account surplus.”

He goes on to cite John Maynard Keynes who also believed that with the current global currency system, the country with the reserve currency would face an “unbearable burden” – unless there were strict rules preventing surplus countries from failing to adjust when the surpluses got too high. There are no “strict rules” and this is just the situation the global economy faces now with China. The cost to the US is of borrowing ever more to finance its deficit or cracking down and watching unemployment soar. As the imbalance grows daily so does the burden to the US, a burden that China will not tolerate. Reserve currency status for China: Not until the water buffaloes come home.

Flash Splash

HSBC’s “flash” PMI numbers of 50.4 for November are encouraging as it is the first time in over a year that shows manufacturing in China is expanding. Equally important, the new export order index hit 52.4 – the highest level in two years. Christmas seems to have come late this year and one hopes the data points are not one-offs. Domestic investors in China, as ever, continue to remain unimpressed with the Shanghai market this week closing below the psychologically important level of 2,000 – the first time since the depths of despair witnessed during the financial crisis four years ago. Without any positive signals of support for growth coming from Beijing the funeral dirge continues unabated.

Canary in a Coal Mine

HK-listed China bank shares have rallied despite growing signs of stress within the system. The WSJ ran an article this week on the “Hidden Risk of ‘Shadow Finance.’” The newspaper highlighted the story of a very indebted mine operator, one Mr. Wang “Trust Me” Pingyan who owned a private mining company to which the banks would not lend. So, he turned to private investors, mainly trust companies, for cash. Wang was a busy fundraiser and garnered almost $800 mn, which he used to buy up competitors. Coal prices are soft and his investors are now getting the (mine)shaft as the reality of default sets in.

The outlook for coal producers next year, according to our commodities team headed up by Henry Liu, is just middling. Henry is forecasting 2013 contract thermal coal prices to remain flat and spot prices to decline 5%. Next year the NDRC will remove itself entirely from coal contract price negotiations, letting the free market give a shot at price discovery. Henry doesn’t believe this will have much impact on the coal miners either way. The power balance between producers and consumers, such as IPPs, has shifted in the weak demand environment to the consumer side. Hard times for Mr. Wang’s investors.

While state banks are hesitant to lend directly to the private sector they are not shy about charging fees to funnel trust product cash to the same. Banks make it on both ends as these trust products are sold to their HNW clients producing fee income.

According to Sanford Bernstein, the trust business, or what is being called “shadow finance” in China, has grown to $3.2 tn and accounts for fully one-third of the country’s bank lending, up from just 5% in 2008. The sector is barely regulated and not well understood – likely the attraction for banks and clients alike. Banks have been enjoying nice fee income from it and can get around lending quotas imposed from above by using client money to fund the private sector. However, in an investment-driven economy such as China, a lot of over investment or malinvestment occurs and default risk is high. The question now, in the case of Mr. Wang, is who is left holding the bag?

Looking at recent bitter experience in Hong Kong, the Lehman minibond fiasco was a result of six years of selling structured notes to an unsophisticated client base. Some estimates of client numbers range as high as 40,000 different investors, of whom 60% were retirees. Such was the recipe for disaster. Years of noisy protests followed Lehman’s collapse and they still continue as banks such as STAN and in particular, Citi, were and continue to be targeted by ripped-off geriatrics. Appeasing the masses required some reimbursements and write-offs, the impact of which is short term but the damage to reputation is much longer lasting.

China banks will be facing the same social pressures and the sums are much, much larger. Reputational damage is in the offing and just enough pensioners protesting they lost their life savings through products they didn’t understand will force authorities to make the banks eat it. The Hong Kong example will cited as precedent. Analysts and investors should view “fee income” at the banks more than just a new profit stream but rather as a large liability.

Broad Town, Changsha

In more wacky news from China, Hunan’s Broad Group, a private maker of central air conditioning, has announced plans to build the world’s tallest building in Changsha. If that isn’t eye-catching enough the news gets more bizarre. Not only does Changsha, a pleasant enough city notable for its entertainment industry, not need such a building but Broad plans to build the project, “Sky City One” in 90-days. 90-days, complete, turnkey, move in ready.

The plans call for prefabricated construction to make the self-imposed deadline. This allows for offsite manufacturing of repetitive structural elements which leads to greater efficiencies and less time required on-site. Sky City One will be a mixed-use building “combining luxury apartments, low-income housing and business and retail.” Broad obviously believes people with money will pay up to live next door to those without, I see.

This “city within a city” is waiting for local government approval before Broad starts making the first Legos. Building experts outside of China have mainly panned the project calling it, “…at best a folly, and at worst, madness.” Considering China’s less than envious record of throwing up apartments and schools that fall right down again, I would be nervous living anywhere near where this monster casts its long, wicked shadow.

Broad is an interesting group and I visited them at “Broad Town” in Changsha about five years ago. They specialize in the export of large project central air conditioning units and non-electric absorption chillers and outfitted the airport in Barcelona. Broad HQ is on a leafy green campus in tropical Changsha complete with a mock Egyptian pyramid and a copy of the Louvre building. Copies of famous statues including, Venus de Milo, Napoleon and even Abraham Lincoln are sprinkled haphazardly around the grounds. After passing through this amusing setting, you are taken inside a round entertainment room to watch the corporate video. And this isn’t any corporate video. Broad’s corporate video simply rocks. It begins with the dawn of mankind. Apparently, the company hired all the local down and out Caucasian English teachers (the only kind there is and the tribe of which I was a member) to dress up in fake animal skins. These actors jump around making monkey noises even though they are plainly down and out English teachers in China and then go running through the jungle screaming as the announcer intones in a deep baritone voice, “Broad Group understands that since the beginning of time, man has looked for ways to improve his environment….” It is absolutely hysterical and highly recommended.


The street’s most enthusiastic energy analyst, Mirae’s own Gordon Kwan, has published his “Top Ten Predictions for 2013” (here) on the China energy sector. Formerly a petroleum engineer for BP which, in a cruel twist of fate, sent the boy from tropical Hong Kong straight to the icy North Slope in Alaska for seven long years, Gordon understands polar bears and the oil business. Here are his top ten predictions for next year:
1) Brent and WTI price will average $115 and $95/bbl
2) China’s E&P capex will rise 20%
3) China will implement domestic refined product pricing reform
4) Natty gas prices in China will be raised 20%
5) Windfall taxes in China will be cut
6) Oil service company Weatherford (WFT US) and oil and gas producer Chesapeake (CHK US) could become the next Nexens
7) US will approve more LNG export projects to boost employment
8) Ultra-deepwater drilling day rates will hit new highs
9) Obama will approve the Keystone XL pipeline
10) BG Group (BG LN) to sell some offshore Brazil fields to China
Gordon’s top picks in his sector for 2013 are: S-Oil (010950 KS), Honam Petrochemical (011170 KS), COSL (2883 HK), Anton Oil (3337 HK) and PetroChina (857 HK).

Time for a car joke.

Five Englishmen in an Audi Quattro arrive at the Italian border.
The Italian Customs agent stops them and says, “It’s illegal to put 5 people in a Quattro.”
“What do you mean it’s illegal?” ask the Englishmen.
“Quattro means four,” replies the Italian official.
“Quattro is just the name of the automobile,” the Englishmen retort disbelievingly. “Look at the papers: this car is designed to carry 5 persons.”
“You can’t pull that one on me,” replies the Italian customs agent. “Quattro means four. You have five people in your car and you are therefore breaking the law.”
The Englishmen replies angrily, “You idiot! Call your supervisor over—I want to speak to someone with more intelligence!”
“Sorry,” responds the Italian official, “he can’t come. He’s busy with 2 guys in a Fiat Uno.”

Latest channel checks indicate that November US sales for Hyundai Motor (005380 KS) will be good again, showing positive growth month on month and year on year. There does not seem to be any negative impact on sales momentum despite the recent mileage miscalculation issue and the company believes most owners are “happy” with the fuel reimbursement plan. Surveys show that one-third of Americans rank fuel efficiency as the number one criteria in buying a car so this issue is a key barometer of how the brand is being accepted in the US. We wrote in an earlier issue of EMI how we thought HKMC were handling the problem properly and the stock has bounced back 16% this month off the bottom.

Car sales in the US for the industry overall are strong with November projected to be the strongest month in four years. Official numbers will be released next week. Part of what is, ahem, driving the growth is the advanced age of most cars on the streets here. “The US is a rolling junkyard,” says Mazda’s President of North America, Jim O’Sullivan. The average age of US cars driving around is now at a record 11 years and industry experts claim 20% of those cars are 16 years old. Sixteen years ago petrol/gas prices were $1.20 a gallon, now they are close to $4 a gallon. (Yes, I know Europeans slam US gas prices as too cheap and that we should be taxed more. This brings to mind one of Aesop’s fables of the fox losing his tail in a trap and then trying to convince all the other foxes they should cut their tails off too because it is “better.” Whatever, to that my friends). Today it costs me about $75 to fill up the tank but if gas were still a buck twenty a gallon it would only be $22 ($32 adjusted for inflation). Credit is cheap and banks are lending on new cars. I would expect auto sales in the US to stay strong as more and more consumers are forced to take the clunker to the junker.

HMC has just debuted its new “Ultra Cool Veloster C3 Roll Top Urban Warrior,” at the Los Angeles Auto Show, according to industry website The coupe has a hidden passenger-side third door and a tailgate, which reviewers are calling “innovative.” I think it is “different” even “weird.” But the ads are nice.

Hyundai Motor continues to outperform the competition on profitability and gains in market share. The company is on the path of achieving desired global brand status much like Samsung has. HMC is a great emerging markets play as well and has plans to increase production in China by 40% in three years to 1.4 mn units. While Nissan reports China production fell 44% in October and Toyota saw production absolutely crater 61%, sales in China so far this year for Korean HMC are up 11% to around 700,000 units and the company has just produced its 4 millionth car there this week.

While HMC ranks number one globally in terms of operating margins (given its expertise in sharing product platforms) the combined market cap of Hyundai and Kia of 70 tn won puts the group number three in the auto world, behind Toyota and Volkswagen. Despite the recent bounce, the stock is ridiculously cheap, at 5X PE and trading 0.9X book with close to 20% ROE. Investors fear two things: a stronger won and domestic labor strikes. In order to blunt those headwinds, the company is expanding overseas capacity and which it forecasts to reach 60% of total production in 24 months vs. 54% now. A global secular growth story with an emerging markets base, the time to own Hyundai Motors is now.


“On the twelfth day of Christmas, my true love gave to me…12 drummers drumming…”

And 11 more annoying gifts after this.

Thanksgiving weekend in the US is the time when Christmas shopping kicks off in earnest. The day after the holiday, we have “Black Friday” (so called because traditionally it is when retailers move into the black) and recently “Cyber Monday” (online shopping). While the final numbers will be released at the end of the week, latest data indicate that a record 247 mn shoppers visited stores and websites over the four-day weekend and spent $59 bn, up 13% year on year. The population of the US is just 315 mn so that means 78% of the entire US was out shopping. There must be over 50 mn children in the country clogging up the sidewalks and they can’t shop so if you take them out of the equation you are left with only 18 mn people who didn’t shop at all. A tiny but proud minority who refuse to succumb to the soul-destroying plague that is consumerism – and I’m one of them!

In our neighborhood, everyone is busily engaged putting Christmas lights up on the house and displays on the lawn. We are about the only house that doesn’t have anything and I am currently debating my position on this issue. As my neighbor was climbing a ladder to hang even more lights on his already decorated house I asked him what I should do. He looked down at me (literally and probably figuratively) and said,
“Why don’t you get some flashing lights out front that just says, ‘BAH HUMBUG!’”

The claimed average spend per customer was $423 over the entire weekend, an increase of 6.2% over last year’s $398 amount. Does this mean the American consumer is B-A-C-K and we can fire up all the shuttered and weed-choked widget and gizmo factories in China? Or is something invisible and more insidious going on, like carbon monoxide poisoning?

Christmas This Year Will Cost You $107,300
The Christmas Price Index compiled annually since 1984 by PNC Wealth Management is a light-hearted look at “the true cost of Christmas.” Each year PNC compiles the market cost of all the items mentioned in the English (formerly French) Christmas Carol, “The Twelve Days of Christmas.”

(In case you forgot or never had to learn the song, here is what you get from your “true love” during the twelve days of Christmas: a partridge in a pear tree, two turtle doves, three French hens, four calling birds, give gold rings, six geese a-laying, seven swans a-swimming, eight maids a-milking, nine ladies dancing, ten lords a-leaping, eleven pipers piping and twelve drummers drumming).
To calculate “eight maids a-milking” and “nine ladies dancing” they use the current minimum wage. How much would you have to pay for a “real Christmas” that would give you all 78 items listed in the song this year? $107,300 – a 6.1% increase over 2011.

Half of the items on the list, including the maids, ladies and lords a-leaping, haven’t gone up in price because as you would expect, minimum wage has been flat. But live geese are up 30% and swans (white and black) are up 11%. Pear trees, French hens and gold rings have also soared in price. Yet over this period of time the official Consumer Price Index has risen just 2%. What’s happening?

The reality of living in the US is that prices continue to rise briskly. For example, in Seattle a burrito and a coke will set you back $11. A sandwich lunch for two at an average café is $30. The problem with pure economic statistics, such as the closely watched CPI, is that energy and food costs are removed. Economists will happily explain why in a patronizing tone anytime you ask but most people, aside from economists, need both to live. The CPI truly does not measure the real cost of living and therefore will be a poor predictor of consumer behavior. I think it interesting to note that this four-day weekend Christmas spend per customer increased over last year 6.1% and the Christmas Price Index is up 6.2%. More than just coincidence, this is CO poisoning and probably close to the real rise in cost of living and does not bode well for retailers this season or savers going forward. Keep the gold rings and sell the rest of the stuff in the song.

The Last Page

Ron, an elderly man in Florida, owned a large farm for several years. He had a large pond in the back.

It was properly shaped for swimming, so he fixed it up nice with picnic tables, horseshoe courts, and some orange and lime trees.

One evening the old farmer decided to go down to the pond, as he hadn’t been there for a while, and look it over.

He grabbed a five-gallon bucket to bring back some fruit. As he neared the pond, he heard voices shouting and laughing with glee.

As he came closer, he saw it was a bunch of young women skinny-dipping in his pond.

He made the women aware of his presence, and they all went to the deep end.

One of the women shouted to him, “We’re not coming out until you leave!”

Ron frowned, “I didn’t come down here to watch you ladies swim naked or make you get out of the pond naked.”

Holding the bucket up Ron said, “I’m here to feed the alligator.”

Some old men can still think fast.

Derek Hillen, CAIA
Mirae Asset Securities

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