China’s Pyramid of Power

 

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

China celebrates another achievement this week, as Mo Yan became the first Chinese citizen to win a Nobel Prize for literature. The selection of Mo was praised by a Chinese nationalist tabloid as a sign that mainstream China could “no longer be refused by the West for long.”

Mo grew up in Shandong province in northeastern China, and during the Cultural Revolution, he left school to work in the fields, finishing his education in the army, according to The Guardian. The author draws upon his rural upbringing in his novels, mixing historical perspective with mythical elements. His real name is Guan Moye, but he chose “Mo Yan” as a pen name meaning “don’t speak,” to reflect the culture in which he grew up.

The new Nobel laureate is of the same generation as the new leaders set to take over the Politburo Standing Committee next month after the convening of the 18th National Congress of the Communist Party of China. This group of men (and one female contender) are “old enough to remember the suffering of the Cultural Revolution, but also young enough to fully experience how China has grown through Deng [Xiaoping]’s opening of the economy to market forces,” says CLSA China Strategy research.

They’ve seen vast political reforms take place, transforming China “from a country ruled by the contradictory personal whims of Mao to one ruled through institutions and rules,” says William H. Overholt in The Washington Quarterly. During these decades, “freedoms blossomed, affecting everything from clothing to haircuts to job or marital choices to social and political speech,” says Overholt.

As a result of these policies, they’ve been able to witness China’s incredible growth, with GDP averaging 10 percent per year and more than 500 million people moving out of poverty over the past 30 years.

Now after three decades of tremendous expansion, this new generation of leaders will have to carefully maneuver the country into the next decade, towing the line between maintaining the stability created during the previous Hu-Wen administration and continuing the political and economic reform necessary to adjust to the country’s slowing growth.

China’s pyramid of power is headed by the Politburo Standing Committee (PSC), which will likely have seven to nine new members led by Vice President Xi Jinping and Vice Premier Li Keqiang, selected by a vote of the Central Committee.

Unlike prior committee members who were mostly engineers, the new PSC members have varying liberal arts backgrounds, including history, law and economics, which may help to “address social concerns after decades of focusing mostly on growth,” according to CLSA.

These leaders tend to be more globally aware than their predecessors. They are better traveled, and many have family members, relatives or friends who have gone to school overseas and have foreign residency. “The rapid proliferation of mobile phones, broadband, internet has made unbiased information much easier to access,” says CLSA.

Incoming President Xi Jinping is a princeling who was born into privilege as the son of Xi Zhongxun, who was among the first generation of Chinese leadership and “one of the most liberal leaders under Deng.” His father’s claim to fame was in creating a special economic zone in Shenzhen, which transformed the area from a small village to one of the fastest-growing cities in the world and one of the busiest container ports in China.

Premier Li Keqiang comes from a more common background, as his father, Li Fengsan, was an official of the local government. After the Cultural Revolution, Li was one of the “Class of ’77” when only 273,000 people won admission to universities out of a total of 5.7 million candidates. (By comparison, 58 percent of nine million people in 2007 won admission to universities, according to a 2008 article in The New York Times.) He spent 16 years at the Central Communist Youth League, and then 10 more years in the Henan and Liaoning Provinces before becoming a member of the standing committee.

Underneath the PSC is the Politburo with 25 members, then the Central Committee with 371 members, who then dictate to more than 80 million Communist party members.

So what direction will the next generation of leaders take? This remains a “great enigma,” says Overholt. Xi has been “extremely cautious” about stating his opinions, however, “he has the confidence that comes from being a princeling and from having some military background.” In addition, the other members of the PSC have agendas that are “ambitious and outspoken.” The tensions and inconsistencies that exist within the committee members could be “creatively dynamic or immobilizing,” says Overholt.

CLSA believes that the new leadership will likely push for reform since they will be “forced to adapt to China’s slowing growth.” The research firm says that historically, large reforms successfully occurred after a crisis, including Tiananmen Square and the Asian Financial Crisis.

A nearly 500-page document by the World Bank and China’s Development Research Center of the State Council may give “promising insight into China’s future policy,” says CLSA. The comprehensive report called China 2030 identifies a long-term strategy for Chinese policymakers. The report says that “after more than 30 years of rapid growth, China has reached another turning point in its development path when a second strategic, and no less fundamental, shift is called for.”

It irons out six areas that need to be addressed:

 

1. Structural reforms to strengthen the foundation for a market-based economy need to be implemented
2. Innovations need to be accelerated
3. The country should pursue “green” opportunities
4. All citizens need opportunities and social security
5. The fiscal system needs to be strengthened
6. China needs to seek mutually beneficial relations with the world

 

The report concludes by saying that “a successful outcome will require strong leadership and commitment, steady implementation with a determined will, coordination across ministries and agencies, and sensitive yet effective management of a consultation process”  that encourages the support of the public. The potential for China to be a “modern, harmonious, and creative high-income society” is there, however, “achieving this objective will not be easy,” says the report.

This November, the U.S. will be focused on its own political situation as Americans head to the polls. While staying active and involved in national politics is important, I believe it’s just as vital to pay close attention to how the leadership change will unfold in the second-largest economy in the world.

 

Index Summary

• The major market indices fell this week. The Dow Jones Industrial Average declined 2.07 percent. The S&P 500 Stock Index fell 2.21 percent, while the Nasdaq Composite dropped 2.94 percent. The Russell 2000 small capitalization index closed the week with a loss of 2.35 percent.
• The Hang Seng Composite Index rose 0.67 percent; Taiwan fell 3.30 percent, while the KOSPI declined 3.10 percent.
• The 10-year Treasury bond yield fell 9 basis points for the week, to 1.65 percent.

 

Domestic Equity Market

 

The S&P 500 Index fell 2.21 percent this week and posted the worst week since early June. The market fell on renewed European concerns as Spain’s bailout is on hold and various European officials made conflicting comments. The boost from the Federal Reserve’s recent quantitative easing announcement appears to have faded and investors are focused on third-quarter results which began to trickle out this week but were not generally well received. All sectors were lower for the week in a broad-based sell off.

Strengths

• The utility sector was the best performer this week falling 0.73 percent. In a “risk off” week the traditionally defensive sector outperformed.
• The energy sector registered the second-best performance this week, still falling by 1.57 percent. Coal, energy service and drillers outperformed as natural gas prices rose by nearly 6 percent this week.
• Peabody Energy Corp. was the best-performing stock in the S&P 500 this week as the company rose by nearly 15 percent. CONSOL Energy Inc., another coal producer, was the second-best performer as coal stocks rallied on strong natural gas prices. 

Weaknesses

• The telecommunication services sector was the worst performer, falling 4.53 percent. The sell off was largely related to reports that SoftBank (a Japanese company) was in talks to buy Sprint Nextel, which could potentially pressure AT&T and Verizon.
• The consumer discretionary sector also underperformed as Dollar Tree gave disappointing guidance, which dragged down the entire discount store group. While the discounters were part of the story, the group experienced a broad-based sell off.
• Edwards Lifesciences Corp. was the worst performer this week in the S&P 500, falling by more than 19 percent as the company preannounced a third quarter revenue shortfall due to disappointing sales of a key device in Europe. 

Opportunity

• While debasing the value of their paper currencies in the long term, renewed money printing in the developed world may have the ability to send asset prices higher in the near term.

Threat

• The market will now shift to earnings announcements and the upcoming elections, which could cause some volatility.

 

The Economy and Bond Market

 

Treasury bond yields fell this week on increased uncertainty out of Europe. The Spanish bailout is currently on hold and mixed messages from numerous European officials just added a little more uncertainty to the situation this week.

The chart below shows a surprising uptick in the University of Michigan Consumer Confidence Index which is at the highest level since September 2007. The increasing confidence is being attributed to rising house and stock prices, giving investors a wealth effect.

Strengths

• The University of Michigan Consumer Confidence Index unexpectedly hit the highest level in five years, confirming other recent confidence indicators exhibiting strength.
• Global central bank easing continues with Brazil and South Korea both cutting interest rates by 25 basis points this week.
• U.S. foreclosure filings fell to the lowest level since July 2007; California reported a large drop in foreclosures.

Weaknesses

• Inflation measures reported a sharp jump in September as both the Producer Price Index and the Import Price Index rose 1.1 percent. On a year-over-year basis the readings remain muted but a trend worth watching.
• The World Bank and International Monetary Fund cut their growth estimates for China this week, while not totally surprising, the negative assessment remains.

Opportunity

• There remains considerable speculation about the prospects for near-term government policy action in China that would support the economy or stock market.
• Interest rates are likely to remain very low for the foreseeable future, both here in the U.S. and globally.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.

 

Gold Market

 

For the week, spot gold closed at $1,754.50 down $26.10 per ounce, or 1.47 percent.  Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 3.80 percent. The U.S. Trade-Weighted Dollar Index gained 0.41 percent for the week.

Strengths

• In the gold space the only area of strength this week was in the South African gold stocks, which rose modestly following a more aggressive fall in the prior week due to labor issues.
• The repeal of a 7 percent tax on investment-grade gold and other precious metals brought into Singapore became effective October 1.  Singapore is hoping to expand its trade in bullion, convince trading houses to store bullion with them and perhaps lure precious metals refineries to their country.  This is all part of bigger push within Asia to store wealth in assets that have maintained their purchasing power over time.
• Billionaire Carlos Slim’s third-largest holding, Frisco, announced it will acquire the Ocampo Mine for a total cash consideration of $750 million. Ocampo has underperformed analysts’ expectations due to underlying labor problems which have hurt its productivity.

Weaknesses

• Members of South Africa’s biggest union rejected a proposal by gold producers to raise wages in a bid to end a wave of strikes.  About 41 percent of South Africa’s gold output is idled, including all of AngloGold’s mines.  Two Gold Fields sites were halted after workers walked out without heeding resolution procedures set out by labor laws.   
• President Jacob Zuma said the mining strikes are having a “significant” impact on an economy already struggling to cope with Europe’s debt crisis.   The National Treasury estimates that total production lost in platinum and gold mining as of the middle of September was about $518 million.
• Disruptions at South African gold mines, which collectively represent the world’s fourth-largest gold producer, have probably cut world gold supply by 2.5 percent according to Deutsche Bank.

Opportunities

• Insider buying in resource stocks is showing a positive trend.  The latest insider stock trade reports compiled by Ink Research show that corporate executives and directors are buying 2.7 times as many stocks as they are selling in the basic materials sector, ranking it among the most undervalued sectors on the TSX.   According to Ink Research, such readings tend to support increasing prices within a sector and may bode well for further gains this year. 
• Bill Gross stated that a number of recent studies have concluded that “The U.S. balance sheet , its deficit and its ‘fiscal gap’ is in flames and that its fire department is apparently asleep at the station house.”  In a white paper titled “Gold-The Simple Facts” posted on Pimco’s website, Pimco analysts Nicholas J. Johnson and Mihir P. Worah also said some interesting things, including,  “Our bottom line:  given current valuations and central bank policies, we see gold as a compelling inflation hedge and store of value that is potentially superior to fiat currencies.”
• RBC’s precious metals team noted they are seeing evidence that suggests we may have reached a turning point where capital spending is curtailed and as a result we are seeing signs that inflation is easing in the mining space. Capital estimates in 2012 are up 23 percent over 2011 and 40 percent over 2010 levels and now stand at $200 per ounce of gold-equivalent production over the life-of-mine. RBC believes two thirds of proposed projects require a gold price of $1,500 per ounce to generate an after-tax IRR of 20 percent in the current cost environment.  They recommend investors focus on gold companies with quality assets and the ability to grow through manageable, fully funded capital programs such as Dundee Precious Metals, among others.

Threats

• October is normally one of the weaker months for gold prices.  Most of the momentum in gold prices has waned for the last three weeks after the open-ended QE3 announcement.
• Fred Hickey, who publishes the “The High-Tech Strategist,” recently noted that The Hubert Gold Newsletter Sentiment Index, which had been wallowing in negative territory recently, soared to levels that would be consistent with past corrections in prices.
• In addition, we have noted that a number of analysts on the street are now starting to raise their gold price targets after the upward move in gold to new all-time highs.

 

Energy and Natural Resources Market

Strengths

• Natural gas futures reached an 11-month high price of $3.60 per million Btu this week on a bullish weekly storage data point from the Department of Energy. 
• Coal stocks climbed over 12 percent this week as the stocks rebounded from multi-year lows reached this summer fueled by rising natural gas prices, which could reverse some of the coal-to-gas switching that occurred earlier this year with U.S. power generators. 
• Corn prices rebounded this week to more than $7.54 per bushel after the USDA, in its monthly World Agricultural Supply and Demand Estimates report, reduced estimates for global corn ending stocks by 5 percent which was below expectations with global corn stocks-to-use now estimated at a historically tight 12.4 percent.

Weaknesses

• Demand for thermal coal by Chinese power generators in the last 30 days has fallen by 12.7 percent on a year-over-year basis, as overall power demand growth is weak (2.6 percent in August) and high hydroelectric production reduces the need to burn coal for power.
• U.S. steel capacity utilization fell to 71.1 percent, the lowest reading since January 2011, as domestic demand continues to be sluggish and prices have trended lower.

Opportunities

• Refining stocks, which have far outperformed the S&P 500 this year, may have another leg up this winter.  The latest set of U.S. inventory data revealed further draws in gasoline and notably distillate stocks, exacerbating an already tight picture for refined products. U.S. distillate stocks fell by 3.2 million barrels, three times greater than expected, and October-to-date inventories are 13 percent below year-ago levels on an end-month basis. Adding further bullishness to the distillate picture is the official U.S. government forecaster (the National Oceanic and Atmospheric Administration) calling for a normal winter ahead, which would make it 20-27 percent colder than last winter, signaling robust heating fuels demand ahead according the Deutsche Bank.  
• Indonesia, the world’s biggest palm oil producer and second largest for rubber, should make agriculture more attractive for investors to improve food security, said the Organization for Economic Cooperation and Development. Restrictions on foreign ownership, complicated land rights, the need for many permits and licenses, and inadequate transport and irrigation systems are among factors discouraging investors, it said in a review of agricultural policies.
• Wood Mackenzie released a report on Monday looking at global mining capital spending which suggested $521 billion will be invested over the next four years, representing a 22 percent increase over the 2009-2012 period. Overall peak investment is forecasted in 2014, with coal and nickel capex peaking in 2012, iron ore in 2014 and copper in 2015.

Threats

• China is facing an oversupply of coal in 2012, as coal production is maintaining a high growth rate even though growth in consumption has declined and inventories are high, a top energy official said Thursday. Increasing output, weakening demand, high stocks and falling prices are major problems for the country's coal industry, said Wu Yin, deputy head of the National Energy Administration.
• The World Steel Association released its October Short Range Outlook, in which it lowered its steel demand growth expectations from its April outlook. Global steel use is expected to increase 2.1 percent in 2012 (versus previous expectations of 3.6 percent) and 3.2 percent in 2013 to 1.455 million tons (versus previous expectations of 4.5 percent growth). Chinese consumption growth estimates for 2012 and 2013, of 2.5 percent and 3.1 percent, were revised down from 4 percent and 4 percent, respectively

 

Emerging Markets

 

Strengths

• Korea cut its benchmark interest rate by 25 basis points to 2.75 percent this week to boost a weak economy affected by weak global demand and deteriorating domestic consumption.
• China’s Ministry of Railway raised its 2012 railway infrastructure investment target by 4 percent to Rmb 516 billion, or up 12 percent from 2011. The 2011-2015 railway infrastructure fixed-asset investment target is now officially set at Rmb 2.3 trillion, down from the previous Rmb 2.8 trillion target, normalizing to a better level than the market expected.
• China Huijin, a state asset management entity, is buying bank shares to help stock prices, and China State Council canceled the administrative approval process needed for stated-owned companies to buy back shares.
• Thailand’s loan growth expanded 2.8 percent in August, bringing year-to-date loan growth to 11 percent. Thailand continued to see business and individual loans grow steadily, driven by manufacture capacity expansion and consumption growth in mortgages and automobiles. Deposits grew 3.6 percent month-over-month, allowing for further loan growth.
• Bank Indonesia (BI), the central bank, kept the benchmark rate unchanged at 5.75 percent. BI highlighted that it will continue to focus on managing the external balance as well as providing support for domestic growth.
• Singapore’s third-quarter GDP grew 1.3 percent, higher than the estimated 1.1 percent, in spite of contraction in exports and industrial productivities. 

Weaknesses

• China’s bank lending was Rmb 623 billion in September; lower than Rmb 704 billion in August and the market expectation for Rmb 700 billion, showing tightness in liquidity. On the People’s Bank of China (PBOC) side, Rmb 650 billion worth of reverse repos will mature this month, bringing liquidity pressure to the market, which may force the PBOC to cut its bank reserve ratio to release liquidity into the economy.
• Philippine loan growth eased to 14 percent in August from 16 percent in July, negatively impacted by contraction in mining and farm loan demand. Real estate loans still grew 24.7 percent on a year-over-year basis.
• Bank of Korea, the central bank, cut 2012 GDP growth to 2.4 percent from 3 percent previously forecasted in July.

Opportunities

• The graph above shows the bank reserve ratio requirement among the Asian central banks. With 18 percent reserve ratio, and consequently lower loan-to-deposit ratio in the Philippines, the potential easing in monetary policy, such as further reserve ratio reduction, can help bank loan growth, which should bode well for both banking and housing markets.
• Any slowdown in China’s trend growth and capex accumulation should lower the prices of commodities and capital equipment globally, giving a boon to India.
• The seasonal pattern of monetary liquidity increases in Russia has been skewed toward the last months of the year—when balance of the budget funds are appropriated – thus setting a stage for a New Year equity rally.

Threats

• The Shanghai Composite Index responded to the two interest cuts since early June by falling 6.37 percent, and is still down 1.84 percent year-to-date. The retail accounts in China, historically accounting for more than 75 percent of the trading volume, dropped to 56 million, just a little more than half of the number in the stock market peak in early 2008. With retail investors leaving, the market liquidity has dropped sharply. Nevertheless, the retail investors’ market enthusiasm probably is a reliable contrarian indicator, which might imply a market rebound in Shanghai soon.
• October 14 is the date of the local governor elections in Russia.  One of the key demands of the protesters last year was to return to Yeltsin-era local elections. (To consolidate his power, Putin appointed local governors directly in 2004.)  Some of these local elections could generate more negative headlines.
• Improvement in Turkey’s trade balance resulted from a contraction in import demand. Imports of consumer goods led the decline, showing that domestic consumers are hitting the brakes.

 

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