Looking to China to Fire Up its Economy

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Following on the heels of renewed concern over Europe’s debt situation, China released its monthly economic data. Fixed asset investment, industrial production and retail sales all rose in April, yet growth was not as strong as analysts anticipated. “Weak” is the word to describe China’s April figures, says CLSA’s Andy Rothman in his Sinology Report.

While data were lower than expected, they weren’t disastrous, says Andy. According to CEBM Group, slower growth was the government’s intention. China wants the ability to manage a “stable decline” to “promote medium-to-long-term structural reforms” as well as avoid a hard landing, says CEBM.

Because they weren’t devastating results for the country, more fine-tuning, rather than a major stimulus plan, is likely to come from this emerging market if growth continues to stall. “The government should move forward to introduce accommodative policies stabilizing economic growth,” says CEBM.

Easing policy for China is only a matter of willingness. Unlike the developed countries of the West that have overworked their printing presses and are now strapped with a tremendous burden of debt, China is in good shape. According to BCA Research, the country’s overall gross debt is only 42 percent of GDP, significantly lower than all of the G-7 countries which have the most debt of the countries listed below. Of the E-7 countries, only Indonesia and Russia have less government debt compared to GDP.

To offset the country’s liabilities, BCA says China also has “a massive net asset position,” including owning interests in publicly listed firms, large companies and the country’s land mass. According to BCA, if you look at only state-owned enterprises, the net assets are nearly “as large as the total public (local and central combined) debt.” By these stats alone, it appears the emerging country does not have a solvency issue.

However, rather than serious stimulus, CLSA anticipates that China will make a move to ensure its two primary goals are met, which include new loan growth as well as M2-money supply growth of about 14 percent.  Andy says, to accomplish these goals, the government will likely boost its spending on infrastructure and low-income housing, ease restrictions on new home purchases by first-time buyers, and offer more credit to the private sector.

Hear Andy Rothman discuss a hard or soft landing China now

We believe government policy is a precursor to change, and when China feels the need to fire up its fiscal or monetary firepower, we believe the flow of money will send Chinese stocks—along with commodities—higher.

CEBM notes an interesting correlation between the A-Share market and economic growth, which points to a possible improvement. The research firm compares today’s economy with what we saw in late 2008. While the data is not as ominous and the government has grown comfortable with slower growth today, there is still a resemblance to the situation in 2008, where the market rebound led improved economic growth by four months. CEBM believes it may be seeing the same signs of bottoming of the market today, and if the 2008 trend holds, economic growth should now be in the bottoming process.

Fine-Tuning Your Portfolio to Potentially Benefit

As economic data is released over the next few months, China will be keeping a close eye to determine when to open the spigots. Before this happens, we believe investors should position their portfolios to potentially benefit. Here are two ways:

1. Invest in emerging markets companies and commodity equities. Emerging markets continue to offer the most potential for growth, and as you see below, over the past five years, as the Shanghai Composite Index rose, the S&P Global Natural Resources Index soon followed.

2. Get “paid to wait” with dividends. This week, investors fled any asset that was perceived as risky, including stocks of any country and commodities, including gold, in favor of “safe” government Treasuries. The 10-year note on U.S. Treasuries fell to 1.85 percent, which is lower than the dividend yield on numerous stocks. Currently, the annualized dividend rates on the S&P Global Natural Resources, MSCI Emerging Markets and the S&P 500 indices are nearly 2.9 percent, 2.8 percent, and 2.1 percent, respectively, all higher than a 10-year investment. Along with steady income provided by dividends, these stocks offer potential appreciation on your capital.

On May 14, I’ll be presenting at the Hard Assets Conference in New York, sharing more investing insights about China, commodities and how to apply Super S-Curves in a portfolio. I’ll be in good company, as Pam Aden, Adrian Day, Ian McAvity, Jay Taylor and Gregory Weldon will be presenting as well. I hope to share some of their thoughts as well as my takeaways in the coming weeks.

 

Index Summary

• The major market indices were lower this week. The Dow Jones Industrial Average fell 1.67 percent. The S&P 500 Stock Index decreased 1.15 percent, while the Nasdaq Composite posted a loss of 0.76 percent.
• Barra Growth outperformed Barra Value as Barra Value dropped 1.30 percent while the Barra Growth index declined 1.02 percent. The Russell 2000 closed the week with a loss of 0.22 percent.
• The Hang Seng Composite posted a loss of 5.70 percent; Taiwan dropped 3.89 percent, while the KOSPI fell 3.62 percent.
• The 10-year Treasury bond yield fell to 1.84 percent, falling 4 basis points for the week.

 

Domestic Equity Market

 

The S&P 500 Index declined 1.15 percent this week. Telecommunication services and utilities outperformed as investors sought safety in the economically defensive sectors.  Economically sensitive sectors such as materials and industrials underperformed.

Strengths

• AT&T and Verizon paced the telecommunication service sector for the third week in a row as investors sought the relative safety of market leading dividend yields.
• In a replay from last week, utilities also performed well as treasury yields continue to grind lower. 
• The best individual stock performers this week were two food-related names, as Dean Foods rose by more than 17 percent and Tyson Foods rose by 8.5 percent, as both companies beat earnings expectations.

Weaknesses

• The materials and industrial sectors remain weak as global growth concerns weighed on these sectors.  
• High profile index constituents that performed poorly this week include Cisco Systems, which fell by more than 13 percent on poor earnings guidance. JP Morgan fell by 11.5 percent on news that the company had an internal trading loss of $2 billion.
• It was a very rough week for Fossil, Inc., which fell by more than 39 percent as revenues fell short of guidance and cautious forward-looking comments caused the extreme volatility.

Opportunity

• For a second week in a row the homebuilders finished higher in a weak market, while other housing-related industry groups also performed well, including household appliances and home furnishings.

Threat

• The U.S. remains a bright spot in the global economy and external shocks from Europe or Asia can’t be ruled out.

 

The Economy and Bond Market

 

Treasury yields have had a slight downward bias again this week, which has become a persistent pattern over the past few weeks. With global economic data exhibiting a weak trend recently and European concerns back on the front page it is not surprising that treasuries have been rallying recently. This time last year there was considerable concern regarding rising inflation but that dynamic has completely changed. Both the import price index and the producer price index were reported this week. As the chart below shows, both are in an undeniable downtrend which validates the Federal Reserve’s policy to stay the course with easy monetary policy.

 

Strengths

• Consumer borrowing jumped $21.4 billion in March indicating that consumers feel comfortable enough to borrow again after several years of retrenchment.
• German industrial production jumped 2.8 percent in March, well ahead of expectations and indicating surprising strength.
• The National Federation of Independent Business small business optimism index hit a 14 month high in April. 

Weaknesses

• Economic data out of China this week showed continued slowdown as industrial production and retail sales disappointed.
• Brazilian consumer prices rose 0.64 percent in April, ahead of forecast and the biggest increase in a year.
• British retail sales fell 3.3 percent in April. The U.K. economy fell into an official recession recently as first-quarter GDP fell 0.2 percent after falling 0.3 percent in the fourth quarter.

Opportunity

• Bonds continue to grind higher and appear to be forecasting a benign inflation and slow growth.

Threat

• China’s economy is slowing faster than expected and government policy makers appear comfortable with this dynamic.
• Europe remains a wildcard with austerity programs under pressure, creating significant uncertainty. 

 

Gold Market

 

For the week, spot gold closed at $1,579.48 down $62.74 per ounce, or 3.82 percent.  Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 3.81 percent. The U.S. Trade-Weighted Dollar Index gained 1.0 percent for the week.

 

Strengths

• The Indian government caved to pressure from local gold retailers which had been on a 21-day strike and decided to withdraw the levy of 1 percent excise duty that it had imposed.  With this move gold is set to become cheaper for consumers in India and traders expect a revival in demand in the coming crucial months.  Particularly, June and July are the important months for weddings and also for rural India as the monsoon rolls in across the country and cash crops are harvested. Importantly, the government has also decided to raise the threshold limit for cash purchases of jewelry whereby purchases below this level do not require the buyer to cite their income tax related PAN number.
• Another very positive news story was that mainland China’s gold imports from Hong Kong surged more than six-fold in the first quarter.  Imports were 135.53 tons between January and March. Demand has climbed in the world’s second-largest economy as rising incomes and curbs on property speculation boosted purchases. The country is already the world’s top consumer of copper and biggest producer of steel.  The purchases through Hong Kong may signal that the mainland is accumulating reserves.
• China’s rapid economic development has completely changed the market for gold over the years.  Consumption was 203.1 tons in 2001 and, by 2011 the figure had more than tripled to 769.8 tons according to the World Gold Council.  Rising incomes in China have boosted purchasing power and citizens are turning to the precious metal as an investment and a store of value, especially given the weakness of the country’s real estate sector.  There is also a strong sentiment for China to increase its official holdings in gold: A senior official was recently quoted by local newspapers as saying that China should further diversify its foreign exchange portfolio and make more gold purchases when the price slips.

Weaknesses

• On Osisko Mining, Mike Curran, gold mining analyst at RBC, noted in his summary of quarterly results that investors were waiting for the Malartic Mine to ramp up, not heat up.  It was a tough day for Osisko as the overnight fire at their mill will likely curtail the processing of ore for the next three weeks and the company’s operating results were weak.  Osisko missed its guidance on both gold production and anticipated ore grades to be put through the mill. 
• Calculating the all in costs to produce an ounce of gold by taking net income minus the revenue and dividing by the number of ounces produced showed Osisko’s all in cost to produce an ounce of gold was $1,399 and this number was even higher than the average costs in 2011 of $1,366.   The company ended the quarter with $144 million of cash and equivalents but one analyst, Daniel Earle of TD Securities, noted the balance sheets looks tight. Given the obvious risks the analyst expects the company’s cash balance to decline to $47 million in the third quarter with $245 million in long-term debt.
• Gold Resource Corporation released earnings and held its conference call on Friday.  Unfortunately, investors were only allowed to email in their questions to the company and management was able to pick and choose what questions they were willing to address. 

Opportunities

• A couple weeks back we mentioned that Bob Hoye of Institutional Advisors published a report noting that gold’s consolidation was approaching an end and that the price performance of gold mining shares relative to the price of gold was at extremes only seen five times in the past 100 years.  On Wednesday, May 9, we had a strong divergence in the price of gold, down 1 percent, while the mining shares were up close to 2 percent on good volume setting up a bullish divergence.  This rally may have been the first wave of short covering by some faster money players.  As TD Securities noted at the start of the week, May is historically the second strongest month of the year for gold equities with an average return of 4.6 percent and the probability of a positive return is 75 percent.  Institutional Advisor reported on Friday that the last three bullish divergences occurred in July 2010, January 2011, and June 2011 and that within the next f our months gold had rallied greater than 20 percent with silver putting in even stronger gains.
• The Shanghai Futures Exchange started trading silver futures this week.  Liberalization of precious metal trading in China has been a big driver of gold over the last decade and China has been a net importer of silver for investment and fabrication demand.  Given that silver is a much smaller market than gold any pick up in demand could prove to have quite a substantial price impact. China is a country which has a long association with the metal, having had a silver-related currency standard up until the 1930s.
• With the contraction of gold equities valuations back down to 2009 levels, they are essentially reflecting gold price closer to $950, yet the price of gold is close to 70 percent higher.  Central bank buying in March was very strong and China’s demand for gold is showing signs of continued strength in its import numbers.  However, U.S. investors are fearful that if financial markets swoon such as in 2008 they will see a sell off in commodities.  Don Coxe, a well known financial historian, reminded investors on Friday that unlike today, in 2008 when Lehman went bankrupt it had a portfolio of $65 billion in commodities that J.P. Morgan aggressively liquidated.

Threats

• In the broader markets, companies that are hitting earnings expectations are getting pummeled if there is any hint of a weaker outlook.  Investors are obviously concerned with the pending increase in tax rates and scripted cuts in spending that are set to take place in 2013. Some estimate the changes could trim 4 percent off GDP.
• Europe is still a mess, socially, politically, economically, and fiscally.  Its long-term refinancing operations (LTRO) program bought banks some time but also locked the banks’ balance sheets to the performance of the government bonds they were encouraged to buy.  The public is not happy with austerity and in less than two years, eight or so European leaders or ruling parties have been forced out of office.  Youth unemployment is big problem in Europe and even college graduates in the U.S. are having difficulty getting full time jobs a year after graduation.
• Globally, since the start of the recession which took hold in 2008, the total value of government debt backed with AAA-ratings has declined from over a 50 percent share of total outstanding sovereign credit to less than 10 percent.

 

Energy and Natural Resources Market

 

Strengths

• The S&P 500 Utilities Index posted a gain of 4.6 percent this week, the second-best performing sector, as investors sought lower volatility and higher dividend yields.
• Saudi Arabia is producing approximately 10 million barrels per day and storing 80 million barrels of crude oil to meet any sudden disruption in supplies, the Oil Minister said.
• Coal shipments from the Richards Bay Coal Terminal in South Africa, the world’s single largest export coal terminal, increased 7.6 percent year-over-year to 5.2 million tons in April.
• OPEC said its crude oil production rose to 31.62 million barrels per day in April and the world will consume 88.7 million barrels per day of crude in 2012.

Weaknesses

• Industrial metal stocks fell nearly 6 percent this week on growing concern over European debt issues and weakening economic data out of China.
• Thermal coal demand at Chinese power utilities was down 1.3 percent year-over-year in April and inventories rose to 25 days, representing the highest level in the last 2.5 years.
• Chinese refined copper output was down 3.7 percent month-over-month in April, to 491 thousand tons.

Opportunities

• Refined copper demand in China is forecast to grow at 5.2 percent annually through 2015, while that of aluminum is expected to grow at 8.6 percent annually, according to China Minmetals Nonferrous Metals Holding Corp.
• India’s Ministry of Coal has proposed to set up a sovereign fund to acquire coal assets outside India, as the government is under pressure to boost energy supplies to meet the targeted 76 gigawatt additional capacity over the next five years.

Threats

• The Australian Bureau of Meteorology expects El Niño conditions to returns later this year. El Niño events tend to bring flooding across the Americas and droughts across Asia.
• Peru’s federation of mining unions said on Monday it is planning to start a two-day nationwide strike on May 14, but individual unions have not yet confirmed their participation. Peru is the world’s second-largest copper producer.
• According to the World Steel Association, global steel consumption is expected to fall by 3.6 percent in 2012.

 

Emerging Markets

 

Strengths

• China’s April Consumer Price Index (CPI) was 3.4 percent, 0.2 percent lower than March but equal to market consensus. This is below the government target of 5 percent, leaving room for further monetary easing if needed.
• Passenger vehicle sales in April were up 13 percent to 1.28 million units, the China Association of Automobile Manufacturers said Wednesday. Sales were forecast to increase 11.3 percent.
• Indonesia’s real GPD rose 6.3 percent for the first quarter, in-line with market expectations. In spite of a slowdown from the previous quarter’s GDP growth of 6.5 percent, the market was satisfied with the outcome considering the headwinds faced by the economies elsewhere.
• Standard & Poor’s stable outlook on Turkey’s long term rating is supported by the agency’s view of the country’s generally effective policymaking and institutions, its moderate and declining public debt burden, and its monetary policy flexibility, said S&P analyst Eileen Zhang.
• Separately, Sam Zell spoke at the annual CFA conference in Chicago.  He mentioned that one of his key theses in emerging markets is to invest in a country 3 to 4 years before it attains investment grade, because the process keeps policy makers honest in the run up to the upgrade.

Weaknesses

• Russian electricity distribution companies were denied transition to Regulated Asset Base (RAB) pricing by the Federal Tariff Service, throwing utility sector reform into disarray.  The Eastern European Fund has no exposure to Russian utilities.
• Taiwan exports disappointed again in April, falling at a faster pace of 6.4 percent vs. 3.2 percent in March, partly due to holidays in China. China’s April trade number was also weak. China’s exports were up 4.9 percent vs. the estimate of 8.5 percent, while imports were up 0.3 percent vs. the estimate of 10.9 percent.
• China just released April economic data. April industrial production was up 9.3 percent year-over-year, vs. the estimate of 12.2 percent; retail sales were up 14.1 percent, vs. the estimated 15.1 percent; new loans were RMB681.8 billion, vs. the estimate of 780 billion; M2 money supply grew 12.8 percent vs. the estimate of 13.3 percent; and fixed asset investment was up 20.2 percent year-to-date, vs. the estimated 20.5 percent. Due to the weak economic numbers, the market speculation this morning was that the People’s Bank of China (PBOC) will cut the bank reserve ratio tonight.
• The bank of Korea maintained its benchmark rate at 3.25 percent for the 11th successive month as expected, while Indonesia also kept its benchmark rate at 5.75 percent, but raised the central bank rate and term deposits to absorb excessive liquidity.
• Elsewhere in Asia, Malaysia’s industrial production gained only 0.6 percent in March, vs. the estimated 3.3 percent; Philippine export unexpectedly dropped 1.2 percent in March.
• China’s home sales transaction value fell 16 percent in April from the previous month as the government reiterated it will keep curbs on the property market.

Opportunities

• A significant portion of global equity returns comes from the local market currencies effect.  The chart below from BCA Research plots country equity valuation along the horizontal axis and proprietary “currency valuation” along the vertical axis.  From that perspective, China, Taiwan, and Emerging Europe markets look undervalued, while Indonesia, South Korea, and Latin America look overvalued.

• In April, China’s power production growth was less than 1 percent, one of the lowest monthly numbers. If the past is any guidance, the Chinese equity market will rally following a dismal monthly power generation.   

Threats

• One of Russian President Vladimir Putin’s first acts in his new/old job was to sign a directive for the government to implement affordable and comfortable housing. Among the tasks set to be achieved by 2018, the government must bring down the spread between average mortgage rates and inflation to a maximum of 2.2 percent.  If implemented as such, net interest margins at the banks would come under pressure.
• Weaker-than-expected April economic numbers strongly suggest the People’s Bank of China needs to cut rates or bank reserve ratio to provide liquidity to the economy. 

 

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