Financial Market Conditions at Mid-Year

As one of the many Americans who depends on a positive business and investment environment for his prosperity, I regarded the election of Barack Obama as president with Democrat supermajorities in the House and Senate with some concern.

More than the usual number of my fellow businesspeople and investors went over to that side, contrary to their own interest as it always seemed to me. Of course many of these unlikely Obama voters were as eager for hope and change after eight years of George Bush as anyone else. But if they gave consideration to the implications of Democrats supermajorities led by Obama for the economy from which they draw life and livelihood, they allowed their desire to believe to outweigh more sober analysis.

Obama took them in with the charisma, the gaseous uplift, and the promise of racial reconciliation; they convinced themselves that the redistribtionist, high-tax, anti-business, anti-capital policies to which he rallied his party constituted red meat for the Democrat base, not a program for governing.

This misapprehension survived the election, and permitted modest financial market recovery through the end of December 2008, followed by modest declines through Inauguration Day. On Inauguration Day, President Obama delivered a speech that any fair-minded listener would have to admit was far less than a rhetorical tour de force, and far more evocative of class envy and racial struggle than everyone expected.

Financial markets tanked that day and kept tanking for weeks, pressured further by the stimulus package that offered precious little real economic stimulus, but rather a shocking grab bag of packages to traditional Democrat constituencies, with not the merest nod to the rights or concerns of the minority.

We experienced headlong collapse from Inauguration Day through first week of March. Obama Democrats in the business and investment community awoke too late to the realization that the Democrat program now encompasses nationalization of vast swathes of industry on the pretext of emergency (autos and banks) or necessity (health care); that owners' property rights are provisional and expendable; that the ideological attachment of our rulers' to the green agenda trumps their duty of care to the free-market economy; and that they mean to bleed the productive sectors of the economy to feed the non-productive to the fullest possible extent they can get away with.

So far, so bad. But then something interesting happened -- we had a dramatic bounce in stock markets from March through early May. Some of this is probably discounting the possibility of a 1929-37 depression, correctly. Some might even be what I regard as an unrealistic pricing in of a rapid economic recovery, when what we still have in prospect is a deep and long recession as in the 70s and early 80s.

But some of the bounce is almost certainly due to the business and investment interests of this country re-assessing President Obama's grand and ambitious schemes and concluding that they represent impossible over-reach. Rightly or wrongly, they came around to the view that most of this stuff will never come to pass. On this view, Obama has expressed extreme initial positions just as a negotiating tactic to get more than he could with conventional bipartisanship, but less than he asks. Republicans and responsible Democrats in Congress will push back on the crazier ideas. The American people will not go along, will resist with mute passive aggressiveness and loud argumentation, once the full implications are clear. And if it is not just a tactic, if Obama really insists on every bit of what he says, Republicans will gain enough seats in 2010 to apply the brakes, if not an outright majority. One way or another, the entire Obama agenda can and will be resisted.

This is a bull item in the market since March.

After stock price gains of over 30% from March to May, markets have stalled since then, and fallen into a few air pockets. The public policy problems for the markets at this point remain the administration's apparent readiness to overturn our carbon energy-based economy and its radical intentions toward the 15% of the economy that health care represents.

But the overarching sentiment problem comes from yet another reassessment among business people and investors: even if the entire Obama agenda can be resisted and its worst effects rolled back later, on this new view a tremendous amount of violence can still be done to the U.S. economy now. In the meantime, we are still losing jobs at a sickening pace while Obama and the Congress waste unimaginable sums of money on projects lacking any other point beside paying off their friends and allies.

In the background the Chinese, our principal creditors, are objecting more and more forcefully to American fiscal unsustainability and the debasement of the U.S. Dollar that this portends. The managers of other erstwhile basket-case economies, Russia, India, and Brazil, tut-tut their agreement and back calls for changes to the global reserve system.

At the very least, these mid-year movements call upon investors to review their portfolio allocations with care. My own view is currently defensive on U.S. Dollar assets, light in risk assets in general, and seeking for growth mainly in Chinese stocks.

Coming Soon: New Currency Order

Whatever you think of the young administration of President Barack Obama, you have to admit the man does not lack for ambition. He promised that sea levels would fall and the lame would walk, and everyone understands that will take at least a couple more months. But taking over the motor industry, well that's just the work of a couple of the President's bright sparks over the weekend. It's great knowing that I'll be able to go into my Congressman's constituent services office when I need parts for my old Dodge truck.

My sources in Washington tell me that the next thing to come out of the salvation lab is a major currency reform. The American Dollar, the Yankee Greenback, it has served us so well for so long, but now it's lame too. Better just to repudiate all claims and start over, as they are wont to do in the countries of South America that have lately emerged as models of public administration.

I hear the new buck will be called the O-buck, and this is its symbol:

Kung Pao Chinese Stocks Ding

I worked in China from 1986-88. People I trained were later instrumental in the establishment of Chinese securities markets. Some of what I did, as theoretical as it seemed then, helped lay a basis for their subsequent development. Before there were Chinese stocks, I owned Chinese bonds. When the first issue of Chinese shares was offered to foreign investors, China Southern Glass in 1991, my company bought in.

I have been involved in modern China’s financial system since before its creation, and stayed involved continuously. So let’s declare biases honestly and note that I am not impartial. I am called a China hand by my Chinese friends, and dismissed as an apologist by . . . others. I’m not a dreamy China head (though I did go through that dreamy China head phase for about three weeks in 1986). I am sharply critical of what I see as deficiencies of their system.

I have been fortunate to make money in Chinese financial markets. Sometimes it has been a simple matter of doing the diametric opposite of whatever the top Wall Street firms advise in their China strategy. But when they have gotten it right and their clients have done well, as during the latest Chinese bull markets, it has been a wonderful thing to see. I’m glad so many people have good success, because in the 90s it sometimes seemed that everyone who ever invested in China lost money and ended up sour on the experience.

Certainly there have been problems that have bedeviled the Chinese markets all these years.

As a nominally communist country, China struggled at first with the very concept of financial markets. When they began to be introduced in the late 80s, they were described as “experimental.” The designation endured for a long time. It is not much of an endorsement, is it? “Welcome Capitalist Roaders to Invest in Our Experimental Markets that We Might Shut Down if We Don’t Like the Way it Goes.”

If markets were purely experimental, the social scientists running the experiment figured they might as well do lots of trials. To that end, the Chinese markets have been finely sliced and diced like Kung Pao Chicken Ding. The authorities set up a Shanghai A share market for local people and a Shanghai B share market for foreigners. Then they replicated the pair in Shenzhen – that’s four venues in China for the trading of Chinese shares. Two classes of Chinese shares, the H shares and the Red Chips, traded in Hong Kong. There were N shares, for which the initial listing was on the NYSE – China Brilliance (CBA), Shandong Huaneng (SH), and Huaneng International (HNP). Later they lost control of the process, and various stray Chinese companies did IPOs in Singapore, Tokyo, Sydney, London, and I lose track of where all else. There has been a major boom in backdoor listings of Chinese companies on junior stock exchanges around the world.

And that’s a big problem – no one can keep track. If I want Italian shares, I pretty much know where to look. If I want Chinese shares, where do I start?

(I met a Chinese market regulator, an executive of the Chinese Securities Regulatory commission, in May 2007 during the raging bull market. He was in a self-congratulatory mood, and invited me to offer congratulations too. I demurred, and instead took the opportunity to point out that their sclerotic regulatory process had prevented too many decent Chinese issuers from doing IPOs in the Chinese markets where home-team investors would most welcome them, sending them instead to go for Rube-Goldberg RTO and SPAC listings on junior stock exchanges abroad where they would struggle to gain a following or a fair valuation.)

The B share markets in particular became bogged down in a morass of low liquidity and poor quality. There were a few corporate governance issues. Many foreign institutions believed that the Chinese securities market experiment was designed to let the Chinese government move garbage off its books into foreign portfolios. I have had big investors tell me with a straight face that they assumed the Chinese meant to hose them.

Some of the international stock offerings have had that effect, but I don’t believe it was ever intentional or malicious. The Chinese thought they would impress us by making their biggest enterprises available to us – their giant steelworks, shipyards, and petrochemical complexes. It turns out that bigger is not better. The social burdens on these cities-within-factory were hard to lift.

It can be quantitatively proven that the closer a share gets to the domestic Chinese investor the better the average quality, if such a concept can be distilled from growth rates and balance sheet items. H shares that do not also list A shares are worse than H shares that do, and A shares that do not issue any class of share to foreigners are of the best quality. I have done the work on this. I’ll report the research in this space shortly.

More than one fund manager has rejected my research finding, without offering to rework the numbers. But the alternative is to believe that they have sold us better stuff than they sold themselves. Does that make sense to you? No, it is intuitively hard to accept. It could not be, because whole attractive parts of the Chinese economy, including retail/wholesale trade and part of the telecom and media space, have been off limits to foreign investment in the past or even now. That alone would raise the quality of the average domestic Chinese share, and it has nothing to do with the Chinese government going out of its way to dump its garbage on foreigners.

If you run an international mutual fund, then the Chinese markets are just one part of your opportunity set. Given that they are sliced and diced beyond comprehension and riddled with pockets of low liquidity and poor quality, you could always make the case that it’s more bother than it’s worth.

But if you are a domestic Chinese saver, then Chinese A shares are a huge part of your opportunity set. As a Chinese investor, what alternatives do you have? Interest rates on bank deposits have been reduced from 24% to very, very small, bonds are not popular, and real estate is relatively illiquid. And some of the stocks in the opportunity set are really good after all.

For most of the time, this fact has eluded detection by the so-called experts of Wall Street, who have not generally examined domestic Chinese shares as long as they remained off-limits to their international clientele. But one feature of this latest bull market has been that some foreign investors are gaining access to the domestic Chinese opportunity set, while some Chinese investors are venturing abroad. That means Chinese investors, at least the biggest exemplars of the breed, are now clients of Wall Street, and Wall Street had to open its mind and its eyes and assign some analysts to take a look at the A shares.

Formerly, when the A share markets have gone crazy on the upside every once in a while, the foreign brokers who ostensibly “cover” Chinese markets have had nothing to say. These periodic bull moves have been totally incomprehensible to them. Don’t they just prove how stupid and gullible the Chinese individual investor is? Well, no . . . there has been another obvious conclusion, but these foreigners have not always had enough information to arrive at it. That conclusion is: some domestic shares are good, and there is a time and place to buy them, if you can.

China is complicated. More than once I have had to argue with analysts over points of fact – not opinion, fact -- arguments of the Kafkaesque “Black is white” variety. Well, the facts are sometimes obscure. So who does Wall Street send to deal with this most confusing and delicate market? Often its youngest, least experienced, least capable analysts, of course! Since China is relatively speaking a small part of the global opportunity set, why send a top gun analyst? You need that guy back in Hongkong to write the thirtieth report this week on HSBC.

So what is changing these problems? The passage of time. The action of price, making China a bigger piece of global market capitalization, bringing in more investors in the good times and lately attracting more critical scrutiny in the bad. How about regulation? The financial markets’ place in modern China is not the subject of an experiment anymore. They are clearly here to stay. With this belated acceptance the worst of the slicing and dicing should be undone. Short of allowing A and B share markets to merge, the regulators can easily allow domestic investors to gain access to B and H shares and expand foreigners’ access to A shares. My sense is that China emerges from the current global financial crisis with its relative position enhanced compared to other economic players. It has national savings, it has surpluses, it can adjust policy at short notice. Sclerosis now is a bigger problem for the developed west.

I still hope for root and branch restructuring of the regulatory system that allows these changes and many others to come more quickly. But my CSRC official as well as many other Chinese advise me not to hold my breath. Even though it is a relatively new bureaucracy, it is still a bureaucracy, and an entrenched, calcified one at that.

Trade Restrictions? Won't Help You

The administration, the managed-trade segment of the policy establishment, and the labor unions should consider the experience of the auto industry. General Motors, Ford and Chrysler strong-armed Japan’s auto industry to accept voluntary export restraints (VERs) in the mid-80s. The results of the VERs are named Lexus, Acura, and Infiniti. The Japanese motor industry drove up-market and developed an unassailable reputation for superior quality, not only in their luxury marques but across their full lines. Meanwhile the market share of U.S. motor nameplates dropped from 74% in 1985 to barely 60% in 2004 in spite of the VERs. Now it is worse, and one or more of Detroit’s former big three may not survive.

VERs made negligible difference to Detroit's rate of market share erosion. Take a look market share data from 1970 through 2004 (Sources - US Dept. of Commerce, Ward’s Automotive Yearbook, D H Smith):

Dangerous New Phase of Financial Crisis (1)

For no particularly good reason, Tim Geithner on Friday in his confirmation hearing set off after China, declaring it a currency manipulator in decidedly undiplomatic language.

China is a major trading partner and a principal creditor of the United States. At a time of financial stress maybe a little more delicacy is called for in this key relationship. Or if not, then batten down for capital flight and a dollar crisis.

FT reports China hits back in kind, says of Geithner: "This is a sign of his immaturity and his inability to do such an important job."

Not a good start. Not change I can believe in.

Just sayin'.