September 12, 2012

By Derek On September 12, 2012 Under September 2012

Welcome – Huan ying – Bem vindo to the first edition of “Emerging Markets Illustrated.” This is where we highlight events, ideas and research that are interesting, thought provoking or just plain stupid. But first, a quick update.

After taking the summer off to move my family from Hong Kong to Seattle, I am now talking to clients, visiting companies and am basically back in business. Having lived, worked, studied and generally been slapped around in various places in Asia since the mid-1980s, I felt it was time for a change.

The Dark Days of 1985

Table of Content

I guess it started with my first trip to China in the dark days of 1985 which ended with me almost getting deported for innocently (stupidly?) taking pictures of a secret missile base in the Gobi desert. It was then I realized it would be a good thing, a really good thing to learn Chinese.

That decision led to six years in tourist-free Taiwan where I entered this business, then several more years in Japan studying traditional martial arts (where I discovered I was very good at getting the cr@p kicked out of me by angry locals on a regular basis), to living on a boat in Malaysia, Thailand, India and Sri Lanka and then finally six years of coughing it out in Hong Kong. It was a great ride and I learned a lot.

Observations

After setting up my home office in our new house in the suburbs of Seattle (Bloomberg – at home!) and getting my daily drip feed of research from Mirae, I spent the summer studying for and passing my US brokerage exams; the dreaded Series 7 and the despised Series 63. Tearing myself away on occasion from these dry mounds of financial trivia, I noticed while the summer seemed pretty quiet on the news front, the S&P climbed 11%, Brazil was up 10%, the HSI rose 8% and Shanghai spent the time going the other way: sinking 10%. The angst felt in the market place surely wasn’t from index performance (unless you are stuck managing A-share portfolios) but rather from the complete lack of turnover. Markets quietly edged higher, almost while no one was watching and few were participating.

Perhaps the London Olympics were a major distraction. The English are gracious hosts and the Royal family did their best to help put on a good show during and even after the games.

Or maybe not. Meanwhile, more recently, net inflows to global EM equity funds were positive for six weeks in a row until slight outflows of US$1.8bn were recorded last week. My view: With many players cashed up but sitting on the sidelines and markets generally up, I think we will start to see some activity heading into Q4. Many PMs will need to chase performance. And we are here to help them do that, or at least to not get in the way.

My Mom Calls and Wants to Short Dutch Debt

Markets have steadily been discounting a European breakup and slower US growth. Draghi’s aggressive new move to buy short term Euro sovereign debt removes the biggest fear and excuse for investors who are fence-sitting. By focusing on the short end the ECB will remove the Euro break up premium attached to PIIGS sovereign debt issuance. It buys more time and for now banishes some uncertainty. The exception here is Spain, however, with Prime Minister Rajoy being a killjoy and telling markets basically now Spain doesn’t have to do anything. Apparently, there’s no “urgency” because the ECB has put Spain in a more “comfortable” position. Yes, the “mañana” culture lives on.

Wait, what’s that sound? It’s my Mom calling on my iPhone. I also think it interesting to note that the market cap of one single electronic gadget maker, Apple, exceeds that of all the equity markets of Portugal, Ireland, Italy, Greece and Spain combined. While at the same time, according to analysts at
Deutsche Bank, yields on ten-year Dutch debt are at 495 year lows! Clearly, these anomalies cannot last.

Ruminations

Buffalo

Coefficients are down….

There are healthy signs that the days of all asset classes moving in sync have also passed. From a high correlation coefficient of 0.86 among S&P 500 companies in October last year, after the August downgrade of the US credit rating by S&P, to 0.58 now, as reported by Bloomberg, the coefficient continues to decline. Stocks are beginning to react to fundamentals with a little more regularity.

Forecast accuracy is up….

While at the same time, analysts are forecasting company results with greater accuracy – and maybe confidence. Last quarter, profits beat estimates by 4.5%, vs. 6.2% the quarter before. Stock picking is coming back. Multiples are not expensive now by historical standards with the S&P trading on 14.3 times PER compared to a five-decade average of 16.4. Now that analysts are getting their groove back, what do they say about the future? Profits will be down 1.7% this quarter and will rebound 11% in Q4, jumping another 11% next year and up again about the same amount for 2014.

Corporate margins are high with interest rates low and unemployment steady at 8%. Wage growth is negligible as the shift in power away from labor will continue until unemployment halves. And inflation is dead, for now. Longer term, given all the checks being written of course, like a zombie arising from a
quiet suburban grave, inflation will return but that is a bedtime horror story for another night.

Zombies

While things are improving in the US and even Europe, China is a flock of geese and continues to head south for the winter, crapping on everyone in their path. Something doesn’t smell right there, whether it is the economic slowdown or the shadow puppet show going on in Beijing.

Like baby seals, local investors have been bludgeoned repeatedly and are selling any bounce, no matter how rare. Reported NPLs (if anyone believes that fairytale) are still around the 1% level at the big banks but increases in loans have pretty much all been at the short end as the growing dung ball of debt is rolled over and over. Banks claims on other banks (mostly loans to the shadow banking system) have risen from 25% of total loans in 2009 to 43% now, according to the WSJ. This money is then lent out to property developers, golf course builders and karaoke parlor owners. Much like China’s US treasury holdings – they ain’t getting that money back.

Bettle

Last week, the Shanghai Securities Journal reported that by year end the CBRC will require RMB 2 trillion of these interbank loans, which are currently off bank balance sheets to go ON bank B/S. That’s a big increase in B/S… The impact is naturally more bad news for these distressed distributors of dough.

Starbucks

Confidence on the Mainland is weaker than dim sum tea as evidenced by major trend reversals in the currency market. On a trip to China late last year, everyone – from the doorman to the chairman – told me that the RMB will continue to appreciate against the US dollar, 4eva. It was a one way bet and they were all on the same side. With slowing external demand and the resulting weaker local economy, locals have not been converting their f/x holdings back to RMB like they used to.

Foreign currency deposits by “non-financial companies and individuals” in China grew US$266 bn in the first half of this year – a 12- fold increase yoy, reports the SCMP. Politics in China also make us nervous from the farcical Gu Kailai trial (many Chinese believe the hefty woman pictured at the trial was not the rail thin Ms. Gu at all; who puts on weight in prison?) to Xi Jinping’s recent strange AWOL behavior. All will become clear over time but
confidence instilling this is not.

Research

Research

Chief Economist for Greater China Joy Yang, has just returned from a client trip to Beijing where they met with several higher placed officials in the NDRC, the State Council and the PBoC. Clients were surprised at “the level of complacency” among officials regarding the economic slowdown. Views on this
diverged between the NDRC and PBoC but the overall theme was the group did not find any reassurance for stronger support of the economy at the current time.

As Joy writes, “The so-called “new” Rmb 4 tn package….the projects approved by the NDRC last week were already included in the 12th 5-year plan.” Nothing new here. My view: Decisive measures are what the markets want from Beijing and that looks highly unlikely until next month’s opaque power transfer is complete. We will very likely see buying in the market, albeit at a low level, as this event approaches in anticipation of the new bosses throwing a few bones to the masses. But don’t look for any grassroots consumer buying binge to turn the macro economy around. Growth will continue to be investment-led and heavily dependent on external demand.

Anecdotally, export orders seem to be improving in Dongguan, Guangdong. Whether this is just a seasonal bump or the beginnings of a mild recovery it is too early to say. However, this is worth watching.

Henry Liu, Regional Head of Commodities Research, in his regular research piece, “The Melting Point”
writes he is still negative on the Chinese steel sector. After returning from some on the ground sniffing around in dark corners he points out that despite Chinese steel prices hitting a three year low:

Graph

they are going to keep farting the stuff out. Henry’s view is even though industry average gross margins
are now just 1% (vs. a juicy 2% last year)(gross – not net!), mills must keep producing or their credit lines will be cut. Given high (and mostly hidden) debt levels, such a move would be lethal. Industry bellwether Angang Steel (347 HK) has seen its fortunes plummet with the stock off 40% from its January high. Henry sees much greater pricing discipline upstream in the ore producers and believes that even if steel demand improves, overcapacity will keep a lid on things for some time to come.

Americana

Weather Forecast

We are mostly over the culture shock of returning to the US, I guess. Most of the shock happened in the
first month or so which I described in a note about our family road trip to Yellowstone earlier this summer. We are two months away from the Presidential election but nobody around here seems too excited about that.
The local rag, “The Seattle Times,” has been focusing coverage on area council and state elections. I think it is pretty clear that Obama is going to win. Mitt Romney has not made a compelling pitch and people, including me, just don’t trust him.

Caution

Americans love bumper stickers, no matter how obnoxious and driving around Seattle and environs I
have seen many “Obama-Biden” stickers on the back of different types of cars. Yesterday, I realized I
had just seen my first “Romney 2012” sticker.

I watched the main speeches at the two different conventions. The Republicans held theirs in Tampa, Florida, the strip club capital of America and right in the path of an oncoming hurricane. One can’t ignore the foreshadowing. The after-hours agenda must have been pretty entertaining but the main event was not. The Democrats, on the other hand, it seems, really connected with the way people here are feeling. Michelle Obama’s speech in particular was pretty damn impressive.

Markets are not too worried with another four years of an Irish White House. Despite vocal fringe opinion, as far as markets are concerned this is a non-event.

Nope

The Last Page

Opinions

Derek Hillen, CAIA
Mirae Asset Securities

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