Unmasking the Asian Giant

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

Chinese operas have been keeping audiences enthralled for hundreds of years with mythical characters, enchanting stories and elaborate masks that add drama and mystery. While this fantastical treatment is appreciated in the theatre, it isn’t in global markets. Investors don’t like mystery—think of how uncertainty has spooked markets in recent years.

Global investors are rarely privy to every detail about the economy; that’s why it’s necessary to rely on multiple data and research to make decisions and be cautious of extreme views that unnecessarily arouse suspicion, skepticism, and criticism. These opinions may grab headlines, but rarely do they help investors’ portfolios.

A recent article in The New York Times raised doubts about the quality in China’s macroeconomic reporting. The Times pointed to evidence from “prominent corporate executives in China and Western economists” who say that “local and provincial officials are falsifying economic statistics to disguise the true depth of the troubles.” The author alarmed many of our readers, so we immediately contacted numerous analysts—many of whom have front row seats to Chinese economic data—to get their reaction.

Some analysts preempted our request by independently sending out a rebuttal, including CLSA’s China Macro Strategist Andy Rothman, in his Sinology report titled, “Lies, Damned Lies…” Since 2006, global investors have come to rely on this company’s coverage of China because of its ability to “independently monitor mainland economic activity.” See Andy’s insightful views on China from a recent webcast.

Don Straszheim from ISI also emailed his view on the veracity of Chinese data. (We note that Don was correct on a recent call on China. When he visited our office at the beginning of June, he correctly predicted the interest rate cut, which China made two days after his visit.)

We’re all influenced by emotions, of course, and when used to our advantage, can help guide how we invest. However, we need to be aware of how outside biases can influence our judgment. In Thinking, Fast and Slow, Daniel Kahneman writes about a mechanism through which biases flow called an “availability cascade,” a term coined by Cass Sunstein and Timur Kuran. Kahneman says the availability cascade is a “self-sustaining chain of events, which may start from media reports of a relatively minor event and lead up to public panic and large-scale government action.” The vicious cycle goes like this: As people begin to worry, they seek more information and are attracted to similar news reports, which encourages additional coverage. The “availability entrepreneurs” are the ones who deliberately want to keep the negative news flowing.

This may not have been the intention of the Times—and other China bears—but its business is selling newspapers.

Kahneman focuses his discussion on how policies should take into consideration a combination of “experts’ knowledge with the public’s emotions and intuitions.” This thinking also relates to investment decisions, which is why our SWOT model is designed to help us review a variety of sources, along with emotion and intuition, and categorize the results in terms of strengths, weaknesses, opportunities and threats.

We encourage our readers to take this approach: Read the Times article and analyze it alongside what analysts are saying:

It’s not breaking news that China’s data is less-than-perfect. Analysts have been saying this for years. CEBM says simply that the Times article is “a true but not new story,” while ISI believes “the shortcomings of China data is a topic every China macro journalist writes on every year or so – with small variations and supporting anecdotes.”

Part of the reason the topic of China’s “disguise” keeps coming up stems from the fact that the country has not had a very long history of “professional independence from the political machinery in Beijing,” says ISI.  Unlike developed countries, ISI believes China’s data system continues to be opaque and primitive. The countries’ inadequacies are relatively common among emerging markets, as numerous analysts have pointed out.

This fact does not release China from its responsibility to make sure that investors have accurate information. Rather, because the country has become an economic powerhouse, it is under greater scrutiny, which means it needs to improve its checks and balances. CLSA says the central government has been aware of how local officials inflate their data and “has been taking steps to mitigate the problem.” For example, more than 700,000 companies now report their data directly to the National Bureau of Statistics, rather than the local governments. NBS data is typically used to forecast consumption of key commodities, says CLSA.

The Times discussed how electricity production and consumption is “a telltale sign of a wide variety of economic activity” and is a “gold standard” for finding out how the economy is doing. A few months ago, U.S. Global’s analyst, Xian Liang talked about how important electricity consumption was as a measure of activity—some commercial banks that lend to small companies would physically check the meters themselves.

As shown in the chart below, over the last few years, China has reported electricity consumption that was much more volatile than real GDP data. Noting the extreme at the end of 2008, it’s likely that GDP fell more than was reported, and at the end of 2009, GDP likely rose more than publicly reported, says ISI.

However, the logic of the Times article to think that local officials are “overstating” data seems misguided. According to Bank of America-Merrill Lynch, China’s local officials have little incentive to over-report the use of energy because “Beijing imposes increasingly restrictive regulations on energy use per unit of GDP on local governments.” Also, since 2011, many local officials have been trying to encourage the government to ease tightening measures, so it is not in their interest to over-report power data to mask a slowdown.

What’s needed before investing in any emerging market is an ability to decipher the mountain of data and use informed judgment.  Because “all data in China are not created equal,” ISI bases its opinion on data, giving more credibility to data that is independent and discounts data that is confusing or biased. Data including purchasing managers’ index, export and import volumes, auto and vehicle sales and production, transportation and People’s Bank of China are generally high-quality and credible, says ISI.

There’s no denying the importance of China. Take a look at McKinsey’s map showing the rapid shift in the world’s economic center of gravity. Beginning in AD 1, for nearly 2,000 years, the economic center of gravity was in Asia because population growth and migration were slow. Industrialization and urbanization in Europe and the U.S. quickly shifted the economic power west for the next century. Now, “China is urbanizing on 100 times the scale of Britain in the 18th century and at more than ten times the speed,” says McKinsey.

In fact, in the past three years, a combination of lower growth in the developed countries, combined with the fast urbanization of the emerging world, the economic power has reverted back toward the east at the “fastest rate of change” in history.

Here’s another way to visualize China’s reversion to the mean, which we showed a few days ago:

All the World’s Not a Stage

China is far from perfect: While actors can perfect their lines and use masks to captivate an audience, smart investors know better to use a wealth of information across numerous sources to guide investment decisions. Weigh the evidence and judge for yourself. As my friend, Investment Strategist Keith Fitz-Gerald recently said in an interview, “A powerful China is coming, and we have two choices. Either we're at the table, or we're on the menu.” To him this means, “Good news from China is good news for the U.S.; bad news from the Chinese economy is bad news here.”

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average rose 1.89 percent. The S&P 500 Stock Index increased 2.03 percent, while the Nasdaq Composite gained 1.47 percent.
• Barra Value outperformed Barra Growth as Barra Value rose 2.26 percent while the Barra Growth index increased 1.84 percent. The Russell 2000 closed the week with a gain of 3.01 percent.
• The Hang Seng Composite posted a gain of 1.56 percent; Taiwan rose 1.03 percent, while the KOSPI rose 0.36 percent.
• The 10-year Treasury bond yield fell 3 basis points for the week, to 1.65 percent.

 

Domestic Equity Market

 

The S&P 500 Index rose 2.03 percent this week on the back of a huge rally on Friday. Two noteworthy events this week included the Supreme Court ruling on healthcare legislation announced on Thursday, which the market negatively reacted to, and the EU Summit conclusion on Friday, which provided the market a positive surprise relative to low expectations. Key proposals of the EU Summit include the establishment of a single supervisory body for eurozone banks and the allowance for direct bailout of banks, essentially back stopping the banks and likely holding the Euro together if the details can be worked out. This was a major catalyst for the market which had become accustomed to being disappointed by European leaders.

 

Strengths

• The energy sector rocketed 4.8 percent higher this week as oil rose by 6.5 percent. Much of this week’s move came on Friday when crude oil rose by more than 9 percent. Stocks that had been beaten up the most tended to be the ones that rallied the most.
• The materials sector rose 2.8 percent with leadership from construction materials, steel and fertilizer names. 
• Homebuilders were also among the best performers for the week as Lennar reported strong quarterly results and housing data continues to be better than expected.
• The best individual stock performer this week was Constellation Brands which rose 39.7 percent as the company bought the other half of its joint venture with Grupo Modelo, giving the company sole distribution of Modelo’s brands in the U.S. including Corona.

Weaknesses

• The technology sector lagged as tech heavyweights such as Intel, Hewlett-Packard and EBay all fell for the week. 
• Retailers and related names also tended to struggle this week as disappointing earnings guidance from O’Reilly Automotive appeared to begin a negative cascade that took down several high flying stocks such as Chipotle Mexican Grill and Ross Stores.
• Managed care companies were negatively impacted by the Supreme Court ruling upholding the Affordable Care Act as Wellpoint, Coventry Health and Aetna were among this week’s worst performers.

Opportunity

• With the Fourth of July holiday in the middle of the week next week, expect muted trading activity. However, the European Central Bank is expected to cut interest rates on July 5 and unemployment data will be released next Friday.

Threat

• Europe positively surprised the market this week but the threat remains that the EU Summit proposals will be unable to be implemented in a timely fashion.

 

The Economy and Bond Market

 

Treasury yields were little changed for the week but show a downward bias. The week was volatile as the market braced for two events, the Supreme Court ruling on healthcare legislation and the EU Summit. While the healthcare ruling will likely affect us more directly the bigger news of the week for the markets was the proposals put forward at the EU Summit. Southern European countries rallied the most on the positive news with Spanish bond yields hitting the lowest level in three weeks, while German yields moved higher on the news.

Strengths

• Durable goods orders rose a better than expected 1.4 percent in May, breaking a string of declines.
• New home sales rose 7.6 percent in May, which is the largest increase since April 2010. The supply of new homes also fell to 4.7 months, which is the lowest level in nearly seven years.
• In another confirmation of strength in housing, the S&P/Case-Shiller 20-city home price index rose 1.3 percent in April.

Weaknesses

• Consumer confidence fell short of expectations and has now declined for four months in a row.
• Weekly initial jobless claims remain stuck in neutral and are indicating softness for the economy and the employment picture. 
• The Brazilian central bank lowered its growth forecast for 2012 to 2.5 percent from 3.5 percent.

Opportunity

• The Fed reaffirmed its commitment to an ultra low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis. 

 

Gold Market

 

For the week, spot gold closed at $1,597.40 up $24.95 per ounce, or 1.59 percent.  Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 0.25 percent. The U.S. Trade-Weighted Dollar Index lost 0.80 percent for the week.

 

Strengths

• Gold jumped more than $44 on Friday on the expectations that investors will boost their gold holdings as Europe moves forward with a plan that could lead to more stimulus while the healthcare tax in the U.S. is likely to drive costs higher as more people will have access to healthcare but the new law does nothing to increase the supply of doctors and other healthcare professionals.  Data shows that despite the near bear market in gold, investors added almost $2 billion to their holdings in gold-backed exchange-traded funds in June. 
• Early in the week Moody’s Investors Service cut its rating on 28 Spanish banks on the likelihood that these banks will require external support.  Italy also may need some form of support which is thought to be funded by Germany, France, Spain and Italy.  Meanwhile, France’s new president moved to increase the minimum wage.  It is as if these countries believe if they can just continue to borrow they will prove that capitalism has failed.
• Central banks continued to buy gold with net purchases recorded during the first quarter of 2012 coming in at 80.8 tonnes.  Sales of silver coins in India are reported to be soaring in response to gold prices hitting record highs.  Monsoon rains in India have also been delayed and this has hurt gold sales too.  In the first quarter of 2012, domestic demand for gold witnessed a 30 percent crash year-on-year. 

Weaknesses

• Coeur d’Alene Mines said it anticipates that an impairment charge for the assets of the Martha Mine in the Santa Cruz Province of Argentina will be recognized in the second quarter of this year.  The Martha Mine has experienced high operating costs and has a short remaining mine life.  Perhaps in response to mining companies signaling they could close up in Argentina, the country loosened its strict currency rules this week, extending the deadline for more than 100 companies to cash in export earnings on the local foreign exchange market. 
• It was reported Guatemala’s new president is seeking both legal and constitutional changes for additional mining taxes, as well as a direct stake in mining and exploration companies.  President Otto Perez Molina has introduced his proposal for reform of 55 articles of the Constitution of Guatemala including a proposal for the government to acquire up to 40 percent of companies which exploit natural resources in the country.  Guatemala’s indigenous population is increasingly at odds with the government’s approval of mining licenses for international companies and major mining projects which aboriginal peoples feel infringe upon indigenous land rights. Tahoe Resources Inc., the developer of the Escobal silver mine in Guatemala, plunged as much as 45 percent on the report that the government proposed taking stakes in mining companies operating in the country.
• TD Securities issued a report showing that since the beginning of 2011, gold producers in its coverage universe have increased annual dividends by 59 percent on average compared to a 15 percent increase in the gold price over the same timeframe.  Over the past 18 months, as payouts have increased, multiples (and share prices) have declined.  In fact, approximately 50 percent of the increase in yield has come from lower share prices and 50 percent from the higher dividend payouts.  TD believes the underperformance of equities relative to gold over the past couple of years has been driven more by company and industry specific issues such as dilutive strategic acquisitions, operating and capital cost inflation, rising political risks, and the challenge of delivering meaningful production growth at acceptable rates of return. To offer yields approaching 5 percent would likely require payout ratios of close to 50 percen t of cash flow.  The onus going forward is on management teams to demonstrate discipline by shelving low-return projects, increasing dividends and possibly buying assets on attractive metrics.

Opportunities

• Australian gold production fell for the third consecutive quarter with 62 tonnes reported for the first quarter of this year, a 5 percent drop from the fourth quarter of 2011.  Russia expanded its gold holdings by 15.5 metric tons valued at $790.7 million last month to the highest level since at least 1993 as central banks are buying more of the metal to diversify their international reserves.  Russia more than doubled its bullion holdings in the past five years to 911.36 tons. “These dips give them an opportunity to top up,” said Dan Smith, a commodities analyst at Standard Charters PLC in London.  “The momentum is pretty strong from central banks heading into gold and I don’t see anything in the near future that’s going to reverse that.  There’s a general perception that currencies are not quite as solid as they were seen.”
• Asian demand for diamonds is set to boom.  While in the short term, demand for diamonds globally is struggling, analysts say demand from China and India is set to far outpace the annual 2.8 percent supply growth.  In India alone, one analyst notes, the market for diamonds is expected to grow faster than that for gold over the next few years.
• Martin Murenbeeld in his weekly gold analysis lamented in summary that gold will benefit from everything we think needs to be done: more ECB liquidity, QE3, dollar devaluation, fiscal expansion in the U.S., etc.  Gold will not benefit from a worsening recession in Europe and a further slide in U.S. growth.  Gold will also not benefit from weak growth in India and China.  We await the policymakers’ decisions.  We agree that the headwind has been the lack of will for politicians to take the necessary actions that must be addressed.  Perhaps with the rally in gold on Friday, we are getting closer to realizing the inevitable.

Threats

• The Bank of International Settlements showed in a recent study says that the budgets of most advanced economies, excluding interest payments, would need 20 consecutive years of surpluses exceeding 2 percent of gross domestic product—starting now--just to bring the debt-to-GDP ratio back to its pre-crisis level.  Moreover, monetary policy has been bearing the brink of efforts to adjust measures that cannot go on forever and which carry their own risks as economies become dependent on ultra-low interest rates.  Politicians cannot continue to dodge the root cause of the problem, spending more than their country can afford.
• The sale of gold coins in India by banks could be curbed with the Reserve Bank of India considering banning such sales.  Partly an attempt by the Reserve Bank to help curb rising gold imports, the Bank says it also believes such sales are not relevant to core banking operations.  However, banks make very good margins on the sales of gold coins in smaller denominations which are considered apt for corporate gifting and rewards for contests or for commemorative giveaways.
• The African National Congress delegates will begin debating proposals for a mining windfall tax of 50 percent as an alternative to nationalizing mines in the world’s largest producer of platinum, chrome, and manganese.  South Africa’s President Zuma, who is seeking a second five-year term in a party election in December, is under pressure from his labor union allies and a growing number of jobless young people to do more to combat poverty and unemployment in Africa’s largest economy.  The 100-year-old ANC was pushed by its Youth League in 2010 to investigate the viability of nationalizing mines to help distribute more wealth to the black majority.  While an ANC-appointed panel ruled out nationalization as an economic “disaster,” it recommends a 50 percent tax on profits of mining companies that earn returns of more than 15 percent.  “The recessive policy choices of this gov ernment are making sure South Africa cannot be seen as a serious player in the global economy,” Claude Baissac, the Johannesburg-based founder of country-risk consultants Eunomix. 

 

 

Energy and Natural Resources Market

Strengths

• In reaction to an insurance embargo on Iranian oil vessels, effective this Sunday, South Korea will halt all oil imports from Iran. These vessels rely on insurance to protect them against any accidents they may encounter, and most companies that provide this type of insurance are based in the EU. South Korea, Iran’s fourth largest oil consumer, is currently in talks with countries such as Iraq, Kuwait, Qatar, and the United Arab Emirates to find a new route to meet their demand.     
• Strikes in Norway regarding pensions and retirement age led to the closing of three more oil fields, restricting more than 15 percent of the country’s oil supply and 7 percent of its natural gas supply. Last month, Norway produced 1.63 million barrels of oil per day, and Statoil has already reported losses of up to 250,000 barrels per day. Brent Crude Oil prices saw a slight increase as a result.  
• Vale received an environmental license to expand the biggest iron-ore mine in the world, estimating that about $1 trillion worth of reserves are to be found. They hope to double their iron-ore capacity at Carajas in Northern Brazil, and by 2017 hope to increase their output to 230,000 tons per year.
• Crude oil futures (West Texas Intermediate) gained nearly 6 percent this week with most of the gain on Friday following news that European leaders had agreed to allow struggling European banks to borrow directly from bailout funds.

Weaknesses

• Aluminum has dropped in value to $1,845 per ton, its lowest price since June 7, 2010. Because of these deteriorating prices, Rusal plans to curtail 8 percent of its smelting capacity by 2013. Furthermore,provincial governments in China have granted subsidies to smelters to increase aluminum production. This comes after the government faced a loss in tax revenue and higher unemployment from the reduction of output in Henan, a province that contributes 20 percent to China’s total aluminum capacity. After the news let out, aluminum prices dropped 3 percent on the Shanghai Futures Exchange.  
• Arch Coal, in the midst of low natural gas prices and slowing electricity consumption, temporarily suspended mining operations across the country, resulting in 750 layoffs. SouthGobi Resources also has plans to halt its coal mining operations in Mongolia because of weak demand and an unpredictable future. 

Opportunities

• Lennar Corp. is in talks and has signed a memorandum of understanding with China Development Bank Corp. regarding an approximate $1.7 billion loan. This loan would help transform two former naval bases into a $13 billion housing project and greatly benefit the timber industry. 
• Within a year, Bangladesh is planning on boosting domestic natural gas supply by 63.25 percent to meet a demand that has been increasing by about 14 percent a year since 2003. Chevron and many state-owned companies have already prepared to increase supply to the country. 
• In a slow diamond market, Botswana’s Minerals Minister believes the country can turn towards copper and silver, in addition to coal mining, to provide a more prominent source of revenue. This transition of focus may diminish the weight the diamond industry has on Botswana’s economy.

Threats

• Iraq’s oil output has reached a 20-year high, passing 3.07 million barrels per day for the month of June, as it seeks to overtake Iran in becoming OPEC’s second largest producer. Iraq plans on producing 70,000 barrels a day at Halfaya field during the first week of July and hopes to more than double its output by 2015. This increase in output will weigh heavily on global oil prices.
• Guatemala’s President, Otto Perez Molina, has proposed reforms to the constitution, essentially giving the government up to 40 percent ownership in mining and exploration companies in the area. Molina campaigned on increasing foreign investment, but there may be unintended consequences should these proposals be ratified. 

 

Emerging Markets

 

Strengths

• China may lower the bank reserve requirement ratio “soon,” China Securities Journal reports on its front page this week. It seems further reserve requirement ratio reduction is the market consensus.
• Singapore’s industrial production increased 6.6 percent year-over-year in May, rising for the first time in three months as increased production of pharmaceuticals and petroleum offset a decline in electronics.
• Korea’s industrial production rose 1.1 percent year-over-year in May, the most in four months as a weaker currency supported exports.
• The Philippines is spending more on roads and schools, though it resulted in a budget deficit of $469 million in May.

Weaknesses

• China’s benchmark power-station coal price at Qinghuangdao port declined the most in more than three years amid inventories that are almost a third higher than 12 months ago, which is probably pointing to weak power generation.
• Korean manufacturers’ confidence dropped to 84 for July, a four-month low.
• The Czech Republic’s central bank cut interest rates by 25 basis points from 0.5 percent from 0.75 percent previously, in an effort to spur the slowing economy.

Opportunities

• Indonesia has been able to attract increasing foreign direct investment (FDI) in the last decade, and the momentum may continue due to vast business opportunities in the country. The money inflow from FDI should help mitigate currency risk.

• Eurozone made a step toward genuine economic and monetary union by introducing a deposit insurance scheme for the European banks, sparking a strong positive response from the financial markets. Spanish and Italian yields contracted, while equities rallied.

Threats

• The cement sector was met with profit warning by H share listed companies due to a decrease of cement prices and a margin squeeze, indicating over capacity and weak construction demand in the first half of 2012.  For the cement price to rebound, it needs more infrastructure projects.
• Hungary is on the verge of replacing its special banking tax with a so called transaction tax, with the government sharing in banks’ income generated from fees and commissions.

 

 

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