My Diary 339 --- Decoupling More Likely Now, Where To Put Money IN, China Tops The World, It Sounds Familiar

October 13, 2007

Kidnapped by the Q-end reports and meetings, I wasn’t able to have another free hand to put down my thoughts, but markets kept moving, in particular the equities, commodities and currencies. These three topics plus economy and asset allocation will be today’s focuses.

At the mean time, global credit markets continue to improve as well, albeit slowly, witnessed by the level of ABCP outstanding in the US continued to level off,  Eurbor rates made another move down, although remained elevated and the falling spread between AAA and BBB US jumbo mortgage rates (-20bp since Sept).

There are a lot to be covered, and let us get the seat belt secured. Oops, next week I will be out for a biz trip again.

Decoupling more likely now

Overnight, the markets have seen a nice rise in yields in the US, as economic data (payrolls, jobless claims, retail sales) have all indicated that the path of US economic slowdown may be slower than had been indicated in September. In reality, global markets, risk appetite and liquidity conditions are normalizing following the Aug meltdown. Some riskier asset classes even have had a tremendous recovery (carry trades and equity markets), which are testing or passed all time highs. Interestingly, Fed funds probabilities have increased the chance of a further cut in October to 68%, compared with 52% a week ago, implying that all eyes remain on the US economy and the impact or not of the deteriorating housing sector.

Talking of economy, one theme over the week is the strength of Q3 global growth, which was expanding at a pace of near 3.5%. Although this data piece is backward-looking and much has changed in the past few months, it is still important. In addition, the unexpected narrowing in the US August trade deficit suggests that trade could add as much as 1% to Q3 growth, largely offsetting the drag from housing and putting upside risk to the country’s below 3% growth estimate. More importantly, a sustained continued decline in the real trade deficit and the lower dollar are seemed to help the US economy on this front. But in the nominal term, trade deficit is likely going up in the next few months due to the oil (WTI for Nov topped $83.69/bbl today). Overall, an upside risk of global GDP growth means we may have to revise more on our emerging market’s “growth decoupling story”, notably for Asia.

Certainly, we should give some credits to the response taken by policymakers which has been positively surprised on the other front, regarding the credit tightness. But there are other latest evidences concerning the sustainability of  strong growth outlook: 1) the continuing rally of EUR will post a threat to the strength of manufacturing export of EU zone and then the economy which currently grows at +2.5%yoy; 2) although Japan’s economy clearly bounced back in Q3, the island country’s growth heavily relied on business spending and exports, whereas consumer spending remained sluggish; 3) commodities’ prices, in particular oils, have backed on the rises in the recent weeks (WTI avg +80$/bbl since August 31), which adds the inflation pressures on the global economy…At +80$/bbl, I am really thinking how many Americans are still driving their SUVs… and oil price seems to be one of the “secret tools” which help Japanese Auto makers defeat the Big 3 in the US…With a picture of growth and inflation in front of us, the next thing is to look at how we allocate our money among different asset classes so that we can maximize our return… feel hot now, really…

Where to put your money in

Up till now, nobody doubts that the main driver behind equity markets’ recent performance globally is the Fed. For emerging markets the effects have been even more pronounced, thanks to the above mentioned belief that developing economies’ cycles have now decoupled from the US. But why it is equity as an asset classes which showed stellar return since August, if excluding the commodities which were largely supported by a weaker US Dollar.

There comes the relative asset valuation argument based on three key points – valuation indicators, expectations for Fed action, and the idea of decoupling.  First of all, equities now appear to represent good value vs. bonds considering the earnings yields on equities (5.6% for S&P 500) and long-term UST (10yr=4.65%); Equities look better in terms of both yield and capital appreciation potential against that other big asset class – housing; In terms of PERs, equities look reasonable, with PEs of US indices still very low compared to the average of the past 10 years. Certainly, the Asia is somewhat different now.

Talking about the valuation, there are two ways where PE ratios can be revised --prices go up or earnings fall. And that latter factor depends on two things: revenues and costs. This brings us to another factor: expectations for Fed easing as that affects the cost side by action from central banks. Having already delivered a 50bps cut, it is understandable why some investors might expect significantly more from the Fed. Recall that the Fed cut rates from 6.5% to 1% in the last easing cycle. In addition, memories of 1998-2000, when Fed easing helped to perpetuate an unprecedented bull run in equity stocks globally, are also being revived by its easing now. The Fed certainly seems likely to ease further, but that remains against the backdrop of poor US economic fundamentals and current data are not likely to telegraph a prompt massive monetary easing.

One thing different is the bull-run this time around is not in the US, it is in emerging market (EM). As such, the logic seems to be that economic growth and thus growth in company revenues can continue to rise while the Fed, which acts as the effective central bank for many EMs, reduces company costs through monetary easing… hold on a second, let me ask what then the outlook for these markets? As I will explain in the next two segments, it is questionable whether the valuations relative to historical avg make sense fundamentally now based on the first two arguments. After all, while EM are increasingly generating their own demand, that demand is still very small compared to that of industrialized economies. And while intra-EM trade has picked up substantially, the final destination of much of it is still industrialized economies – the ADB estimate that the G3 economies still account for over 60% of Asia’s exports. It is true that other developed economies are taking up some of the slack of a slowing, but with both Europe and Japan now slowing, the degree of ‘decoupling’ would have to be very great to ensure that growth in EM is not materially affected... See, the world is linked and everything will come back to you eventually...emerging markets will be the same fate....

It sounds familiar

Market Strategy 1997 February CLSA – “The outlook for China related shares remains bullish. Even after the recent strong gains in share pricings, the China World Index still has an attractive growth /PE ratio of 1.4X Red-chip companies, having emerged as an distinct new asset class in 1996, will continued to provide a high-growth safe heaven capturing China’s economic growth. Earning-enhancing asset injections will continue to underpin their growth… going forward, the rapid pace of injections and spin-offs will continued. Asser injections have been undertaken at very attractive prices up till now, but growth potential of injected assets and synergies with existing business will re-merge as key issues? “

How familiar does the scenario sound to what the bull-side analysts or strategists’ comment today…Big Wow…if 10 years is a cycle, then from 1997 to 2007, it smells so familiar now…Have anybody read the article, “ A Modern History of Investment Booms”,  wrote by Marc Faber on Mar 8th, 2007. Let me quote some of his thoughtful opinions:

[Quote]The feature most common to previous investment booms was that a bull market in one asset class was accompanied by a bear market in another important asset class. Precious metals soared in the 1970s, but bonds collapsed. Equities and bonds rose in the 1980s, but commodities tumbled. ... In the early phases of all previous investment booms, investors failed to recognize that the “rules of the game” had changed and continued to play the asset class that had been the leader in the previous investment mania.

Similarly, in the current asset inflation, investors have continued to focus on the high-tech bull market and have largely missed out on the huge increase in price of commodities, and of Indian, Latin American, and Russian equities. At the end of each investment mania, investors believed in some sort of “excess liquidity” that would drive the object of the speculation forever higher.

Most presciently, Edwards explains that with respect to investment manias, “when markets are rallying but seem expensive, when new issues fly out of the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is often to rely on the explanation that there is lots of liquidity”. I urge our readers never to forget these words!

Another common feature of the last stage of every asset boom was high trading volume, widespread public participation, high leverage, and money inflows into all kinds of money pools (Zaitech and Tokin funds, investment clubs, mutual funds, LBO funds, venture capital, private equity, emerging market, art and collectibles, and equity, commodity and index funds). In this respect, the current asset boom is no different than previous investment manias, except that it includes all asset classes and is taking place practically everywhere in the world. (End Quote)

How does that sound to you? Well, to me it looks so much like the current China markets now.  Talking about high trading volume, our internal analyst pointed out that Hong Kong is now acting like a high risk and high return emerging market of from a trading perspective, with 50%+ market cap and 60%+ turnover by China-related stocks and China liquidity spill-over could average USD10bn+ monthly… Now, let me have a quick poll here, how many of you start to consider withdrawing money out of stock markets? …

China tops the world

Does anyone have any ideas of how many Chinese companies are now standing on the top of the world? Here comes my counts and no surprisingly, in a range of industries, including banks, insurance, telecoms and airlines, the most highly valued stocks in the world are Chinese. I have the Champion list ranked by market cap below:

·         ICBC (US$333bn) is 42% bigger than the second most valuable banking group, Citi group. In fact, three of the top six banks in the world by market cap are now Chinese (plus CCB & BOC). 

·         China Life (US$245bn) is worth more than the two largest pure US insurers (AIG &Manulife).

·         China Mobile (US$346bn) is the largest telecoms company and is worth 36% more than AT&T.

·         Air China (US$31bn) is worth more than its two largest Asian competitors (SIA&Cathay Pacific) put together.

·         Elsewhere, PetroChina is the 2^nd largest energy company after Exxon Mobil; Citic Securities is the forth biggest securities broker (behind Goldman, Morgan Stanley and Merrill Lynch, China Vanke is the No. 3 real estate developer, and Bao Steel is the 6^th largest steel producer.

If I include all the names within the top 50s, my diary will run out of paper but this is not my point today. The skyrocketing market values of these Chinese companies are actually as a consequence of the out-of-scale valuation, along with 74% rise of HSCEI and 42% up of HSI since the bottom of correction in the mid-August. And the aggregated valuation benchmarks have started to fly off the scale as the 12M forward PE for MSCI China has reached 23.1X, compared to a 10yr avg of 13X.

By historical standards, this is no doubt a tough market for investors to make conviction calls. The question is can we still look for good-quality stocks, with reasonable growth prospects and decent valuations? Or should we just drive with the flow, forget fundamentals and valuations, and ride the momentum of Chinese stocks, hoping we can get out before the bubble bursts? … I think the later one sounds like a good strategy for France Bicycle Race… so if you don’t believe your “driving skills” in this volatile market environment, then we will be better off by finding sth which can protect us when the market heads to the South and it is not very hard…

Using five forward looking measures, including 20XPE, 3XPB, 2yr positive earning growth, 10% ROE and US$1bn market cap, I can still sort out a dozen of stock who has reasonable value in the HK-Chinese shares universe --- Sinopec (386), MaAnShan (323), BOC HK (2388), BOC (3988), Sinotrans (598), Huaneng (902), Huadian (1071), SZ Investment (604) and GD Investment (270)… well this is a piece of good news to me as at least we have not run out of choices… so Cheer up, now how many ppl still want to run away after having the list?

Good night, my dear friends