A Contrarian Bet
When making contrarian bets, the window of opportunity is very short. Take, as an example, the strength of the South African rand over the last 12 months. After having collapsed by 50% in the second half of 2001, the rand recouped almost all of its losses in 2002. In this case, the window of opportunity is likely to have been of short duration because it’s not very likely that a secular bull market for the rand has begun.
Conversely, if you consider that investors remained very sceptical about investing in bonds, not only between 1981 and 1985, but also largely throughout the entire bull market, then one would have to say that that window of opportunity remained open for a very long time.
From a longer-term point of view, however, I am more attracted to investments in Asia. Not only are Asian economies recovering from the 1997 crisis, but they also remain extremely competitive in the manufacturing – and, increasingly, in the tradable service – sector, while their stock market valuations remain relatively low.
In particular, I should like to mention that the current US dollar weakness in no way alters the Asian economies’ competitive position, since the Chinese renminbi is pegged to the US dollar at a time when the other Asian economies are increasingly feeling the threat from the colossal Chinese export machine, which is eating into their export markets. Therefore, unless China revalues its currency (which is not very likely, for now), it is unlikely that the other Asian exporting nations would wish to have strongly appreciating currencies. So, while US economic policymakers will continue to stimulate credit growth and consumption in the United States by increasing the indebtedness of households, the wealth transfer to Asia via the US trade and current account deficit will continue and stimulate industrial production in Asia and other emerging economies.
Contrarian Investing: Designed to Impoverish the US
To an unbiased observer, it would almost seem that US economic policies are designed to impoverish the United States and to enrich Asia. In a deflationary environment, and amidst globalisation, it is inevitable that production must shift to the lowest-cost producers – which then flood the high-cost Western industrialised countries with low- cost goods.
At a recent presentation, I was told that this wealth transfer would eventually benefit the United States, since China would in the future import far more goods and services from the United States than in the past. However, this seems to be wishful thinking. Whereas Chinese exports to the United States continue to expand at a rapid clip, imports from the United States have hardly increased, while imports from Asia are soaring. In other words, China exports to the United States, Japan, and Europe, and imports its raw materials and commodities requirements largely from Southeast Asia.
Moreover, it is only a matter of time before knowledge- and science-related services will also be exported from Asia, since the cost of establishing and maintaining research labs is far lower in India and China than in Western countries. Consequently, I remain quite positive about investments in Asia.
There are, however, three caveats I must mention with respect to Asian investments. The first is that the US consumer is very likely to cave in. Lower consumption in the United States would lead to slower export growth from Asia, or even to an export contraction. And while I don’t think that this would be a devastating blow for Asian economic growth, it would nevertheless have a negative impact on foreign investors’ appetite for Asian equities. Therefore, markets may not perform particularly well under such a scenario.
The second concern I have is that, although economic growth looks superficially strong, Asian consumers are increasingly purchasing goods on credit. In the long term, this may lead to difficulties among financial institutions.
Contrarian Investing: A Golden Opportunity
Finally, there is a potential geopolitical problem. I don’t regard North Korea’s decision to restart a nuclear reactor and a plutonium reprocessing plant (which had been mothballed under a 1994 agreement with the United States) – along with its decision to withdraw from the nuclear non- proliferation treaty – to be a major problem per se. The problem lies in the question of who made the call to North Korea’s Dear Leader Kim Jong Il and suggested that he use the current US engagement and paralysis in the Middle East as a golden opportunity to restart his nuclear program.
For sure, it wasn’t one of the Western European nations, the United States, Japan, or any of the Latin American countries. But what about Iran, Iraq, China, Russia, or even South Korea? Both Iraq and Iran have an interest in creating as much geopolitical trouble for the United States as possible, and in shifting US attention away from the Middle East. The Chinese are also a likely candidate for such a call, since they may wish to use North Korea in the future in the same way the Soviet Union used Bulgaria during the Cold War to carry out dirty jobs. Russia could also be interested in North Korea as an ally, fearing the increased Chinese presence and influence in Far East Russia. Finally, the South Koreans know that unification with North Korea is only a matter of time. So why not seize the opportunity to have the North bring into the marriage nuclear weapons, given Korea’s small size and military vulnerability when compared to its powerful neighbours such as China, Russia, and Japan?
These issues aside, however, the bulk of the evidence clearly speaks in favour of Asia’s prospects. Indeed, the fact that investors around the world remain underweight in the Asian region only strengthens the case for its potential. Whereas US international mutual funds had over 4% of their assets invested in Asia between 1993 and 1997, today, these funds have less than 1% of their assets in this region. Considering that Asia is not only growing more rapidly than Western countries, but is also home to 56% of the world’s population, and that many of its markets – such as for TVs, radios, motorcycles, cellular phones, steel, etc. – are far larger than in Euroland or the United States, even a 4% exposure would seem to be extremely low. A less-than-1% asset allocation, then, seems almost irresponsible.
Therefore, it is my belief that it is only a matter of time before the world’s savings, which between 1997 and 2001 flowed largely to the United States, will be redirected towards Asia and lead to fairly strong rallies in the region.
For The Daily Reckoning
April 1, 2003
P.S. I may add that in the case of Asia, the window of opportunity for the contrarian has existed now for a number of years – to be precise, since early 1998. It is true that, over the last two years, Asian markets have outperformed the United States, but they remain extremely depressed by historical standards. In US dollar terms, many Asian markets are still down by 70% from their highs. But, unlike the Nasdaq, they have now built bases since 1998 and therefore offer lower-risk entry points than the TMT (technology, media, and telecom) sector, the S&P 500, and Western European markets – which, although down percentage- wise by a similar amount, have at this point not built any longer-term bases.
Several headlines over the weekend mention “recession”. The prospect of 360,000 US troops putting down roots in Iraqi sand troubles the economy. Or at least, it troubles economists. The economy was already troubled long before George W. Bush decided to bring freedom to the desert.
The “shock and awe” campaign seems to have impressed no one – neither the Iraqis, nor investors, nor economists. Shares are lower than they were a week ago. Gold is higher, by about $7. And gold shares? They rose about 6% last week.
The entire world economy is “dysfunctional”, says Stephen Roach. The US has been the world’s growth engine for many, many years. But now, American consumers can’t seem to get their motors started.
US Consumers continued to buy in February. But for the second month in a row, there was no growth in consumer spending – despite record amounts of new money entering the economy through mortgage refinancings.
Where’s the money going? Well, it appears to be just enough to allow householders to stay in the same place. Mortgage interest alone is running at about $265 billion annually. Property taxes, up nearly 50% since 1995, add a couple hundred billion more.
After servicing his debt and taxes, the consumer just doesn’t have enough fuel left over for his growth engine. “War…and the peace that eventually follows…changes none of this,” says Roach.
We’re not so sure. We old fuddy duddies here at the Old School Daily Reckoning remember when a billion dollars was real money. Now, people toss a few billion here, a few there, as if it were chump change. Operation Iraqi Freedom, alone, will probably end up costing about $200 – $300 billion…or about $2,500 per US household (and as Sean mentioned last week, £100 a week for their UK counterparts). Since millions of families are already at the edge of insolvency…the extra costs of the war will probably push thousands of them into bankruptcy. On the homeland front as well as the Iraqi one, there may be more casualties than expected.
Sean Corrigan in London…
– Remember, we are supposed to be on the verge of a deflation in this country. A deflation, strictly defined, is when people want to hold more money, rather than more goods. And so, in general, prices decline, the volume of credit begins to contract, and employment and output begin to fall.
– Well, we have just had some of the worst retail price hikes in well over a year – a 3.2% increase – so strike one there. As for the money side, well…in January, UK householders, far from wanting money, took out another £8.7 billion in credit. That’s around £375 pounds per household, per month – £12 a day.
– In the past year, household disposable income – i.e. that left to us after the government does its rob-Peter-to-pay- Paul bit with taxes and welfare – increased by 3.1% (just below that inflation rate, you will notice). In money terms, this meant we were left with an extra £21.5 billion in our collective pay packets, according to figures from the government statistics office. Yet unfortunately, in the same period, our borrowings leapt ahead by 13.8%, or £102 billion.
– Now, you don’t require a degree in either maths or economics to work out that someone who maintains his lifestyle by borrowing and extra £4.75 for every extra £1 he earns, clearly does NOT want money more than goods. It is also painfully obvious that this profligate is on a one- way track to Carey Street – traditional home of the Bankruptcy department of the High Court!
– Ladies and Gentlemen, that profligate is most likely the person you see in the mirror. If you ARE one of the few for whom this description is a gross calumny, I apologise…but it only means the person staring in the mirror next to you is travelling down this road to financial perdition twice as fast, in order to make up for your unusual forbearance.
– Now, as the BBC reports, private firms are having to push up wages for their staff, according to analysts Income Data Services. What no-one tells you is that this is one reason why UK businesses, struggling to make ends meet, are losing out to foreign competition.
– Ian McCafferty, the CBI’s chief economic adviser, denied there was anything to be alarmed at here, saying: “Private sector firms are showing pay restraint as economic uncertainty spreads. There is no sign of pay pressures posing any threat to underlying inflation.” No, Ian. FIRMS are not a threat – the BANK OF ENGLAND is! There the one who’s allow all this excess credit to be created.
– The worst of it is that manufacturing – theoretically our most productive business – is being crushed partly because it is being forced to pay wages above the world value of its output. This is because credit inflation (that £100 billion of extra debt) is putting money in the tills of service sector companies, who are then paying higher wages…and because government is spending money it has taxed and borrowed into existence on keeping public sector wages high also.
– For all the huff and puff from Brown about how well we are doing under his wise stewardship, and for all the nonsense from the Bank about tolerating ‘unbalanced growth’ and ‘welcoming government spending’, this is why the UK economy is rapidly rolling toward the cliff edge. – If you want further testimony as to the state of the nation’s finances – as well as the managerial competence of ‘Third Way’ interventionists – look no further than Network Rail. In its first business plan, the Guardian reported that the government-backed (but somehow off the public accounts) infrastructure company set a target of reducing its expenditure by a fifth – equivalent to £1bn a year. The company said that if it continued to go through cash at its present rate, it would spend more than £27bn in the five years to 2006 – compared with a budget of £17bn set by the rail regulator.
– Network Rail’s deputy chief executive, Iain Coucher, said that the company was likely to cut the workforce of 14,000 to 11,500 and said that 4,000 miles of track – 20% of its network – was overdue for replacement. “There has been, for whatever reason, a backlog of renewals which should have been done and which have not been,” said Mr Coucher. “The cost of maintaining an old and fragile network is very high. It’s a bit like having an old car which you should have renewed but have not. It is getting more and more expensive.”
– Mr Coucher also admitted that the company was finding it harder than expected to hammer down spending (remember that little inflation problem we discussed above?) “It’s proving difficult to get costs out of the cost base as quickly as we would like to.”
– In the markets, so far, war is proving to be somewhat less bullish that advertised…for shares, that is. War is plenty bullish for oil and gold and all the other sorts of assets that investors seek when they’re terrified of buying shares. But yesterday, European equities lost ground for the fourth session in a row: the FTSE Eurotop 300 index ended down 3.6% percent at 744. In Paris, the CAC 40 closed down 4.2%, while London’s FTSE 100 lost 2.6% to close at 3,613.
– The first 13 days of war haven’t brought much luck to American investors, either. Yesterday, the Dow tumbled another 154 points to 7,992, while the Nasdaq dropped 2% to 1,341. Meanwhile, gold and oil continued to power ahead: the safe-have metal gained $4.50 to $336.90 an ounce, while oil gushed 88 cents to $31.04 a barrel.
Back in Paris…
*** From Tim Freeborn in our London office:
I’ve been checking my history books and have found uncanny parallels between the Iraqi war and the Boer war:
1) An Imperial power, apparently at its zenith, but in fact in serious relative economic decline. 2) Huge international opposition. 3) Struggle for control of key resources: gold, oil. 4) Fairly early conventional victory followed by massively expensive guerrilla campaign lasting two years.
The London market rocketed when war was declared in 1899. Then, interest rates went up as government borrowing soared. Equities fell on early defeats…and then generally suffered with the economy. In the end, Britain did win, but its economic performance in the following decade was poor.
*** “I don’t like the way this war is going,” said Col. Aubray, after Sunday’s mass. Rare among the French, the old soldier seems sympathetic to Bush’s war. But it brings back bad memories.
“It reminds me of the Algerian War. You know, we had a huge military advantage. And we actually won the war, militarily. I remember I was stationed at a tiny village…I was the only European for miles around. And they encouraged us to bring our wives…to show that it was all very safe and ordinary. So Marie-Noëlle came with me. We had friends in the village. But we were never sure when they might try to cut our throats.
“And Algeria was not like Iraq. The French had been there for hundreds of years…it was a department of France, like a state in the US. But once the locals decided to get rid of us, we couldn’t stop them.
“And we paid a terrible price. I don’t mean just money, either. That kind of guerrilla warfare – house to house, where you can’t trust the civilians and never know who’s going to try to blow you up – degrades an army. Terrible things were done during the Algerian war…on both sides. And in the end, we had to leave. It was just too costly to stay.”