Perpetual mispricing machine - Durable misconceptions about Asia’s markets

Summary

1. China's growth, a two-decade-old story, has been rewarding on average to those allowed to tap it, but access price has been high and the disappointments painful. We face huge risk of another one now, at a time other exporters and financial investors can least afford it. When might a publicly disclosed slow-down arise? Will bank performance be the symptom or the cause? 2. Japan is clearly more linked to China's growth than other rich countries, so China's problems are Japan's. Can the accumulation of improvements in Japan make up for the weight of a continued slow-down in PRC demand? 3. If the current risk is no worse than that elsewhere, what about the long term prospects? Are they superior to those elsewhere? Are current earnings multiples justified? If not now, when?

Analysis

Perpetual motion machines

This article reviews a few significant misconceptions about investments in Asia. Some are the result of making straight-line extrapolations from recent events; others stem from superficial analysis of anecdotal data. By integrating all public information into a rigorous process of comprehensive analysis, one can avoid most of these problems. But a few more fundamental misconceptions should be cut back first.

<!--[if !vml]--><!--[endif]-->The bedrock upon which standard portfolio theory stands is the capital-asset pricing model (CAPM), more appropriately known as a crappy asset-pricing model. Those who usually deride it so claim the banner of “behavioral finance,” a way of including irrational human behavior into the standard rational-actor assumptions of traditional approaches. But even these critics miss the point, especially when it comes to Asia.

Partly, this is in the nature of high-growth markets. The number of participants and the rules of play are in constant change. Both local investors and foreigners have difficulty coming to terms with this continual shifting of forces. Institutional stability is a rare event even in the most stable-looking, slowest-growing market in Asia, Japan. This leads many participants to give up on investment horizons and resort of bare-bones trading, where low levels of market efficiency still give the appearance of leaving room for profit. Nonetheless, all the inefficiencies that stem from these traits mean that one can still make good money with long-term investment strategies in Asia’s diverse markets.

Asian miss #1 – Chinese balloons

In this issue: ·       Enduring investor mistakes: Many examples how sloppy research misses the long cycle, repeatedly. ·       Philippine promises: When will the Pearl of the Orient stop breaking them? ·       Semiconductor sector: Will consolidation pressures lead to better cooperation or will national continue to subsidize overcapacity? ·       Industrial policy interferes with the individual firm’s decision-making challenge.

<!--[if !vml]--><!--[endif]-->The world continues to be transfixed by the idea of a billion Chinese consumers rising to achieve a middle-class appetite. Yet, it is the 600 million middle-class consumers within the OECD countries that were fueling much of the high growth rates that have attracted so many investors.

exports accelerated from a level equal to 20% of GDP in 2000 to over 40% in 2007-08, just as Chinese consumers were losing heart. This foreign push helped its real-GDP growth accelerate in 2003 back into the double digit growth it had not seen for almost a decade. So, it was price-discriminating foreign consumers that provided the extra 3-5% growth, rather than the poorer Chinese consumers, who were reducing their share of growth contribution from 54% down to 35%! In spite of a housing boom from 2005 to early 2008, locals were saving. In what are foreigners investing here?

In the process China increased its exposure to global risks and forced its huge production capacity into competition with the rest of the world, a gamble for which it is now paying dearly. Japan paid a similar price in the early 1990s, as it saturated the other OECD markets with its consumer and engineering goods. Export-led growth policies of this sort – common across Asia – carry their own risks.

By providing a limited number of listed companies through which foreign investors can tap this growth (of course, not many are sound enough to be sold to the public), the authorities have a significant influence over the pricing of bonds and equities. China has used this to its advantage a few times, most recently for the IPOs of its biggest banks on the Hong Kong market and its depository receipts elsewhere. But this non-market control has contributed to the creation of pricing bubbles by raising expectations unrealistically and by rationing the supply of investable assets. It also creates a conflict of interest with investors, on whose behave it claims to be regulating the securities markets. The caveat emptor rule still applies!

More concerning should be the policy of sequestering the savings of Chinese workers on shore in the banking system. By keeping the capital account closed and building up its foreign exchange reserves, China is essentially outsourcing its capital markets to New York, Tokyo and London. It invests in low-yielding liquid bonds overseas and accepts high-yielding risk capital from abroad, losing a lot of money on that intermediation spread.

While the message that China does not trust its own banking and capital markets, yet, is clear, a result is the under-investment in infrastructure and corporate development at home. Should this attitude attract foreign investors as much as it has? China has essentially trapped itself into dependency on the US Treasury through this gambit, being forced to absorb over 21% of the UST’s March net issuance. Should one trust one’s government to allocate capital on behalf of the market this way? These questions seem to have been missed in the manic rush to buy “China growth”.

The latest run of the Shanghai market, up 54% from its 4 Nov low of 1706.7 came after a 72% fall from the high mark in October 2007, a lot of volatility. But the state’s massive push of lending and grants into the economy to replace the 2-3% of GDP consumption lost by the collapse of demand from fickle foreigners has driven this rise. This is more an example of financial PR than economic development and raises serious questions about its reliability. Will Daddy always be there to bail us out? Should we trust his judgment? If one is asking these questions in Washington and London, why not in Beijing too?

There is a wider judgment question, since the nature of fast-growing markets is constant regulatory change. Regulatory risk is one of the major obstacles investors in China face. Those happy with their investments in China Mobile a year ago were heartily disappointed to find it lose some of its monopoly benefits to two competitors. The change was better for users, but took 16% of off the value of China Mobile within a month, twice as much as the broad market, which subsequently caught fright because of rediscovering this risk. To help drive the Shanghai market up from its bottom, the CSRC put a temporary ban on new stock listings in November last year and has just hinted it might lift this in June, if market sentiment is frothy enough.

Asian miss #2 – Japan redux

Across the East China Sea lies what most of the world views as the opposite of China’s growth story, Japan’s death story. The current lament is a familiar one: ageing population unable to support growing a public debt burden. The fact that Japanese programs for retraining and part-time work are bringing more of the elderly back into the workforce is usually missed. Likewise, the steady decline of private debt that has been crowded out by public debt could rise to reverse positions with it in future. In the last six months, corporate bond issuances have risen faster than any time in the last decade. There are so many options for adjustment in the long timeframe that it will take to realize the future’s trend that it seems premature to judge future earnings prospects on that basis. More pressing problems appear to be the still excessive size of the country’s bank lending capacity – a problem it shares with China and the US – plus the amount of negative equity remaining in the housing market from the 1990s property crash. The former limits profitability in banking and the latter limits domestic consumption.

There are a number of well established myths about Japan, some believed by the Japanese themselves and others held dearly by foreigners: 1) Japanese retail investors are just herd shoppers who reliably jump in at the top of the market, 2) Swings in foreign institutional investment drive the stock & currency markets, 3) Japan is a modern, stable democracy presiding over a capitalist economy, but 4) the LDP parasites will never let Japan go; so, 5) the “hollowing out” 0f Japan’s manufacturing sector (since the early 90s) will lock in the slow growth of the last 25 years. There is plenty of anecdotal evidence to support these notions and all of them have been true at one time and for a while, but they are not enduring truths upon which one can rely. Putting these notions into perspective with the events from which they sprang shows them to be truisms of the past and myths of the future

One used to be able to time the top of a market by the surge in Japanese mutual funds entering it, but in the last four years the cumulative effect of investor education, experience and broker internationalization have changed that rule. Such funds were definitely a factor in India’s index soaring but they began entering the market in early 2005, just after the BSESN had broken through 6000. Many of them rode that wave for two more years for gains of over 150%. The massive uridashi market in foreign-currency, retail-size denominated bonds has been the main vehicle for investments misnamed as carry trades. As the TOPIX index plunged last autumn from 1200 to 700 in the space of two months, Japanese began opening retail accounts at a record pace that continued through the 1Q09. These old dogs seem to have learned new tricks.

Foreign participation in Japan has been rising since 1985 but is only around 23% now, according to the Tokyo stock exchange. It has been falling from a high of 28% in 2005 and only began to rise briefly in May, over a month after Japanese retail and institutional investors had pushed the TOPIX up 15% from its 26-year low on 10 March this year. Likewise, the Yen/Dollar rate in the last few years has a poor and inconsistent relationship with foreign investment patterns. A big factor in this is the growth of foreign assets in the household’s portfolio. The swings in domestic retail and institutional holdings dwarf those of foreigners.

While all politics is the art of the strategic bribe, Japan’s Liberal Democratic Party (LDP), a misnomer if there ever was one, has mastered that art and set untouched records. Singapore’s PAP can not match its subtlety, nor can North Korea’s Kim Jong Il match the scope of its ambition. One could probably call Japan’s political system a representative oligarchy, because twenty years of popular discontent have led it into a brief partnership, have created some election reforms and brought in a prime minister who turned out to be his party’s nemesis.

As for the capitalist claim, one might better call the country socialist with Japanese characteristics. The social compact set in the 1950s, Communist-led amidst labor riots, and reinforced during the hard years of the 1970s was a social equalization formula suited to the high-growth economy Japan was then. But it has been a straightjacket to growth as the country shifted to its mature-economy phase, ensuring slower growth. If not for the inherent innovativeness, expressed in the efficiency gains of the second-, third- and fourth-tier companies, serious economic decline would have set in a decade ago. Real innovation has arisen in its techniques for maintaining an export-led economy. This profile is usually tolerated by net importers only for developing economies, as an enlightened policy. But Japan, imitated by Germany, has mastered this game, which has helped keep its top-level companies – where little innovation occurs – intact against the forces of change. Here again, some changes take a while to be recognized. The bank-reform and capital-markets change laws of 10-15 years ago have pulled away many of the props to the unresponsive superstructure of Japanese industry and the re-emergence of an M&A culture began a few years ago.

The LDP has held onto power for over 50 years in Japan and has survived many popular assaults on its graft and money-laundering machinery. Many traders have lost money by betting on the party’s demise. But a wide range of reforms forced by popular mandate and some foreign pressure (the famous gai-astu excuse for change), plus the growing symbiosis with China’s growth have gradually whittled away the props. It is ironic that LDP dissident members should have formed the party that will eventually take power this September. The chances for the LDP to strike back and limit the magnitude of their impending loss are many. The full transition to a clear change of government (a fundamental requirement to claim the status of “democracy”) may take several more years. A reformed LDP could return to power, as India’s Congress Party did five years ago after its first break in 48 years of power. No one came claim that this parasite is leaving its host voluntarily. We fully expect it to adapt to this new challenge and return again, but as a different animal, an agent of “social fairness”. One result of this piece-meal approach to regulatory change has been third-world rules for a first-world economy, making Japan’s capital markets behave like the richest developing country in the world.

One of the biggest shifts in Japanese industrial policy began in the 1980s, in response to a rise in US protectionism, which arose in the wake of the 1981-82 recession. What the major exporting companies had begun as an experiment in the late 1970s, building factories in their prime export markets, quickly became the norm in the 80s. That shift of manufacture overseas was a big factor in the slowing of real-sector growth in Japan during the 1980s, masked entirely by the rapid financial-sector expansion that created an asset bubble. In the following decade, the shift of manufacture to other markets, especially to China and other parts of Asia, led the Japanese press to coin the phrase “the hollowing out of Japan”, as the economy apparently shifted even further from manufacturing toward the service sector. One consequence of that shift and the Japanese-bank lending that accompanied it was the asset bubble and financial crisis of the rest of Asia in 1997.

But during this shift the pressure to innovate continued to reap benefits and create jobs at home. The migration of manufacture into low-income countries continues, with a new thrust toward India, but it proceeds now at a much slower pace than during the 1980s and 90s. With that shift, Japan is realizing its path to growth in spite of a declining and aging population. In the process, it is internalizing much of emerging Asia’s growth potential, weaving its destiny even tighter to the peaceful growth of China, ASEAN and India.

Asian savings – an unpromising insurance policy

Much of Asia’s social and industrial policy is modeled on that of Japan. This includes export-led growth (aka autarkic, beggar-thy-neighbor consumption policies), supported by a thin pension program that induces a high level of uncertainty, resulting in high savings rates. Bank-centered systems to finance investment rely upon low savings-deposit rates but relatively high lending rates – clearly hostile to both savers and bond market investors. This approach has given the bank regulator direct tools to control credit creation for industry and bank competition but has left employees to fend for themselves. It worked well enough while global competition was limited – high GDP growth rates led to bouts of overheated markets and brief contractions but generally increased GDP per capita (a key welfare measure) at exceptional rates.

The key to much of this system was limited product choice and continued retirement uncertainty. This kept interest rates low – a form of consumer subsidy to industry, through the banking system rather than the tax system. Low interest rates have become a mantra of so-called pro-poor policies for much of the last century, without much thought to their social implications. Like limited product choice, this idea favors the producer and borrower at the expense of the employee and investor. The excuse for this has been that the employer-producer would take care of the poor employee. Only Japan and industrial China ever tried to deliver on this promise to labor and now both have given up because of the misallocation of resources that resulted from that approach.

But no one (except Indonesia) has given up on the silly idea of suppressed interest rates, which favor the politically connected and upper-middle class but punish the rest by restricting credit allocation. Most borrowers in Asia pose fairly high credit risks to lenders. In a low-rate environment, they are unattractive borrowers and require special relationships plus strong collateral. This approach holds back much growth potential in Asia but opens a door to those who can price SME risk effectively and refinance it.

Spectacular shorts across the waterfront?

Most of the run up in global stock markets since 9 March has been government induced, by optimistic signaling and a flood of liquidity that has been parked in liquid securities. It is essentially a con – a confidence trick to stop a vicious cycle downward. Its very volatility demonstrates the lack of fundamental confidence in the earnings basis and risk pricing of current valuations. Considering how exposed China’s banks are to abusive credit expansion in this period, it has raised a lot of questions among institutional investors about whether they should actually be short that banking sector. Oddly enough, few of them ask about whether to short the consumer sector, which the government reports to be strong. This points to the continued power of local governments to set the agenda.

Unfortunately for those who make money in arbitrage trades, the high levels of liquidity that are keeping the markets afloat will only drain out gradually. Rather than another collapse, of the sort we saw in October last year and February this year, we are more likely to see six to twelve months of frustrating downward volatility. Market timers will have to wait for the slow grind to finish its work, until EPS levels really do reach their bottom.