The developed world is de-leveraging and Europe is moving toward deflation and depression. Meanwhile, the Chinese, Southeast Asian, and Indian-led developing world is growing and experiencing inflation. We will discuss both regions in this memo.
Restructuring the massive debts of European countries will begin within a few months. Greece and, in the longer term, some other European countries will default on debt and begin to de-lever their economies on the backs of those who were kind or foolish enough to lend them money. Portugal, Spain, Ireland, and possibly Italy will have to restructure all or a part of their debt over the next few years.
How will this play out is open to question. It may be:
- Lengthening of maturities. “Your bond was to mature this year, we have decided to extend the maturity by 10 years at the same interest rate”.
- Repudiation, or sorry…‘we cannot pay you back’…Will you take 40 cents on the dollar?
- The insolvent country quits the Euro and says “We will pay you back all we owe you we are converting all debt to our new currency”. They then proceed to do quantitative easing so that they effectively print money to repay the debts with devalued currency.
- The countries show that they are able to cut costs and that they can grow their economies, thus attracting new lenders.
Europe’s de-levering of sovereign debt will likely be a bigger version of the Latin American sovereign debt restructuring/repudiation crisis of a couple of decades ago.
Right now, investors are assuming that the crisis will be deflationary, causing commodity prices to fall, world trade to diminish, and create a cascade of defaults. The past eighty years of history tells us that politicians, except for those
in Germany, have chosen to handle these types of situations in an inflation-inducing manner. In our opinion, policy makers will engage in the type of Keynesian expansionary policies which will amount to money printing, creating a period of rising inflation in the long run. This money printing or quantitative easing is what the U.S. and U.K. did in 2008 and 2009. It is what they have done in Japan and Europe (excluding Germany) for years. To fight the deflationary forces, we expect Europe (outside of perhaps Switzerland and Germany) to opt to continue the same program.
Politicians everywhere want to give things to voters, and pay lip service to balancing the budget. This will lead to higher gold prices short medium and long term and higher commodity prices long term.
CHINA, INDIA, AND STRONG ECONOMIES IN THEIR REGION ARE EXPERIENCING SOMETHING COMPLETELY DIFFERENT FROM EUROPE
China, India, and the strong economies of Southeast Asia are in a different situation. Here, the economies are strong, and no sovereign debt de-leveraging and fiscal austerity is needed. On the contrary, inflation is their problem.
As an investor, where would your rather invest when the current market volatility abates? Where governments are defaulting on debt and pension promises far exceed their ability to pay for them and the economic growth is weak (Europe), or where economic growth is strong, you have a large under-leveraged growing middle class, and no sovereign debt or unfunded public liability problems (Asia)?
WE DISAGREE WITH THE CONSENSUS ON CHINA
You have probably seen many news articles saying that China has problems and the economy will go into severe decline. For different reasons, there have been many predictions of a collapse in the Chinese economy over the past seven years.
Events have proven these prognosticators wrong time and again, but the pessimists continue to predict collapse, and new pessimists continue to join them.
The fact that China’s economy has grown faster than any major economy in the world over that period has not embarrassed them into stopping; nor has the fact that China grew rapidly during the U.S. and European banking system crisis in 2007 and 2008. Now, we have the European sovereign debt crisis and it is a serious crisis for Europe with spill-over effects for the rest of the world. We do not believe the spill-over effects in China will be enough to stop growth.
In our opinion, the negative view on China has little basis in fact. Let us examine some facts. The fear in 2007 and 2008 was that Chinese exports would collapse, bringing China to its knees. The fear was that China’s economy was solely based upon exports, we disputed this view. The fears were partially correct, China’s exports did decline while their imports rose leaving China with a very small trade surplus in Q1 2010. Apart from that, the facts differ substantially from the fears, as the first quarter of 2010 saw China’s GDP rise by 11.9%. Exports fell, and yet the economy grew at a very rapid rate.
We contend that Chinese economy is durable and broad-based; not solely driven by exports or by home purchases. When Europe’s current crisis causes China’s exports to decline further in 2010 and 2011, we do not believe that it will have a devastating effect on Chinese GDP growth.
Today’s fear is that a giant real estate bubble in China will implode and cause the economy to collapse. Let us examine the first part of the thesis that the whole of China is gripped by a real estate bubble. This thesis has a partial basis in fact, but read on to see where the fearful have missed key issues.
It is a fact is that there is a real estate bubble in some major Chinese cities, but not in the country as a whole. Small and medium sized cities (7 million people or less is considered medium-sized in China; to be big you need over 10 million people) and China’s rural areas have no real estate bubble.
It turns out that most of the wealth has been generated in the big cities. China’s wealthy have four options for investing their wealth: bank accounts with low interest rates, stocks, real estate, or gold bullion available in small quantities. There is no big bond market and no commodities market to soak up capital. To diversify their investments, the wealthy have been buying additional high-end homes for investment. Concurrently, state-owned enterprises have been developing high end real estate projects in order to show off their status and power. The confluence of these two events has caused residential property bubbles and some commercial property overcapacity in some major cities.
The national government has been proactive in implementing a number of programs including higher down payments and higher mortgage rates on second home purchases, 100% down for homes after the second home, the initiation of property taxes, disallowance of government sponsored enterprises from developing real estate, and other restrictions to cut the speculation in its four or five biggest cities. The government has required developers to build more affordable housing (of which there is a shortage) and to stop building high end housing. The effects have been as expected. In recent weeks anecdotal evidence says prices have fallen 20% in these cities. We expect prices to fall further and to return to a normal range within a year or two.
The combination of less real estate purchased and lower exports will cause China’s GDP to slow to no less than 5% in the second half of 2010. We expect GDP growth to pick up again in 2011.
CHINESE GROWTH POLICY
Our readers know that the Chinese prefer to show GDP growth between 5% and 10%, so the recent 11.9% has been uncomfortably high. They are happy to see it slow to a more manageable pace. The government has many programs up its sleeve that can be implemented to speed up and slow down growth. For example, the talk of revaluing the Yuan will be put on hold until the U.S. dollar begins to weaken. The interest rate increases that many had expected following the strong GDP in Q1 will be delayed if, as we expect, Chinese inflation moderates slightly due to lower housing and food prices. Both of these policies will stimulate GDP growth.
If we want to be pessimistic, we could project that due to the government’s program to cut real estate speculation and reign in prices in a few big cities, China’s GDP could fall to an 8% annual rate for 2010. Pessimistic projections show China posting one or two quarters of GDP growth in the 5% to 6% range. Most countries would be ecstatic with a 5% GDP growth rate. 5% to 6% is a relatively boring return for China, but many times stronger than what we expect from the developed world.
China’s Shanghai Composite
CHINA STOCK MARKET VALUATIONS AT A LOW LEVEL
Chinese stocks sell at 15 times this years anticipated earnings, while corporate profits are growing faster than any other nation in the world. When you can buy numerous companies whose earnings are growing in excess of 25% per annum for 15 times earnings, the market is getting cheap. We believe that the appeal of real estate will diminish as prices begin to fall and some of this money will rotate into stocks. We are not yet ready to buy, but we are tempted by low prices and high growth rates. Within China, we plan to focus on transportation, tourism, and domestic energy sources. The Chinese are enjoying their increased wealth and are traveling to see their country. Domestic demand for energy is strong and will continue to be strong for years.
The recent selling of Chinese shares has caused a substantial undervaluation and within a few months the investing world will awaken to this reality. Other Asian regional markets have not fallen much so while China is low enough to start buying we still expect that India, Brazil and the Asian countries which have excellent fundamental prospects to decline more as fear of the sovereign crisis spreads. If our expectations are met, within a few months we will see Singapore, Korea and some of our other favorites more attractively priced.
For the next year, we expect the demand for gold will be highly correlated with fear of sovereign debt meltdowns in over-levered fiscally irresponsible nations. Inflation will be modest and so many will draw the conclusion that inflation will not return. We disagree and suggest that readers use the current consolidation / correction in the price of gold to add to positions. Longer term, we expect gold to go to much higher levels.
In our opinion, over the next year, oil demand will grow in Asia and shrink in Europe. The sovereign debt crisis will be fundamentally negative for oil demand, while Asian growth will remain fundamentally positive, causing oil demand overall to remain slightly positive. We see the possibility that during the market volatility oil could decline to the $60 dollar range. We would view that as a long term buying opportunity.
Immense fear engendered by the European sovereign debt crisis has caused a panic rush into the U.S. dollar at the expense of the commodity currencies with good fundamentals such as the Australian, Brazilian, and Canadian as well as against the poorly managed currencies such as the Euro and British Pound.
As mentioned above fear of a global depression dominates investor thinking this week. As long as fear dominates, the rush into the U.S. dollar will continue. When emotions stabilize and facts bear out the growth thesis, the dollar will resume its decline. Longer term, we see the dollar as an overvalued currency, and predict that the well managed commodity currencies mentioned above will rise substantially versus the dollar over the next few years.
Our portfolios are largely in cash and we will spend it as bargains appear. In our opinion, investors should consider buying gold and begin looking at China’s market which is becoming attractively priced. In the case of oil, Brazil, India, Korea, and Singapore we plan to wait until the fear subsides and use the correction as an opportunity to buy into these markets.
Thanks for listening.
and Tony Danaher
Guild Investment Management, Inc., a registered investment advisor. All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.
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