Date: 2016-02-02
Investment commentary
Introduction
For survival, until the next systemic meltdown, investors are probably better off focusing on the markets where relative value assessment rules over absolute value assessment; currencies and commodities spaces deserve special attention for this reason. Thanks to the monetary easing and the rates that are flirting with negative territories, I expect to see a serious moral hazard among investors, going forward. Weakened link between the fundamentals and the asset prices is likely to further weaken. This does not mean that the markets heavily reliant to the absolute value assessment are not coming back. In fact, mean reversion to a theoretically and historically sound valuation is still the most reliable way to play the markets in general, as valuation is the only metric that consistently showed stability in the long run based on my market analysis.
The way I view the world remains the same as the previous year: lenders and borrowers (of supra national, national, corporate, or individual forms) are likely to continue to clash due to the continued divergence between the different understandings of the debt problem of the two groups: borrowers (who continue to blame predatory lending and unfair plays behind the scene) and lenders (who argue for pervasive irresponsible borrowing and poor consumption planning). Production surplus (or consumption shortage) remains as the key structural flaw and weakness of the global economy, and the only constructive way out of this is a dramatic expansion of middle class in the countries with large population bases such as India, Brazil, and most notably China.
When assessing national economies, I continue to give higher points to the system whose wealth redistribution system is well functioning. This is because I have a strong conviction on the view that the current wealth disparity is here to stay and continue to widen. Those countries who fail to effectively redistribute the existing wealth are likely to run into trouble, as all the stars are aligned for an extremely unhappy public revolt against whoever is in charge of the system: they are unhappy with the job security, wage level, and asset valuation. I view rapid transition from deflation to hyperinflation as a major risk, and subsequent political instabilities from this source are likely to be extremely destructive for the economy in general.
I continue to pay special attention to China. I expect this approach to yield a positive outcome, especially because whether the future opportunity lies in China or not particularly in the short term, the factors that make great opportunities available are likely to be most easily observed in China than in anywhere else.
China
I started writing my investment commentary for 2016 on the 1st of January, 2016. In the original piece (which was too long and too full of introspection which only has subjective significance) where this one derives from, I elaborated on (1) how confident I am with regard to Chinese policy makers’ abilities to navigate the country through the current storm and many more of them to come, and (2) how viciously strong constructive Chinese market forces are. Since then, I observed serious market correction in China majorly attributable to regulatory failure having to do with daily volatility limits and the circuit breakers, which was followed by even more serious market mismanagement by Chinese regulatory authorities: its hubris against the capital flow in the currency market. Chinese authority’s intervention in the currency market is just so wasteful and pointless that it makes me gasp. If they knew better, there has been absolutely no need for China to waste so much of its precious reserve so in vain; I seriously hope the Chinese authority to manage to come up with good excuse to reconcile with the market force and take the short term pain by letting the CNY turn volatile for a little while, before they restart intervening. Then, China will be able to afford to intervene much more boldly and effectively. While my short term confidence dwindled, I remain hopeful on Chinese authorities’ ability to learn from their own mistakes, over time. A big embarrassment seems to await for the CCP, but I remain confident on Chinese economy’s long term economic success, because Chinese economy is very likely to enter another boom phase, whether it goes through hard landing or not in the near to medium term.
I find the following pattern intriguing: I grow to realize that the strongest conviction comes in the most baseless form. Religious belief is one; true believers’ basis is their own truthful belief itself on the religion. My extremely strong confidence with regard to Chinese economy despite so many discomforting recent developments ultimately boils down to my belief in humans and the civilization. Whether China has to suffer hard landing or not seems irrelevant to the equation needed for solving the global consumption shortage problem (and of course China certainly will become the rescuer of the global economy in this regard), as what different scenarios Chinese economy goes through in next 3 to 5 years only affect the time variable of the long term development. Humans have tendency to create positive changes at their best ability in the long run when the incentive structure is right. It is incorrect to think as if my optimism is truly groundless, as it is in fact backed by history of human civilization; I used the term 'baseless' because there is no quantifiable near term data on this regard, so if I argued against someone who always sees a cup of water as half empty, the conversation would not go anywhere; this is its bit that I find similar to religions. Humans have been working for prosperity for all history I can cognize, and I have not yet found any strong enough evidence that can deem such a long and powerful trend as mere luck. The education level of Chinese population and imperfect yet efficiently functioning public sector makes me be hopeful for Chinese people to create positive changes in coming decades. China’s constructive market force in the private sector is so strong that I expect such a force to be able to overwhelm various serious policy mistakes in coming years, just as an extremely well positioned company can get by even with incompetent managements. I do not even think that the CCP is foolish. In fact, exactly the opposite is true: those who lead CCP are career politicians/ policy makers trained for a decade or two at the very least, selected via probably the most competitive screening processes especially compared to the peers from any other countries. The party is simply inexperienced, and there is an ample room for improvements. The pattern I identify among the policies the CCP has been deploying is that, the CCP is highly experimental in its policies, and is willing to discontinue the bad ones and continue the good ones. Examples of the bad ones include most of recently introduced regulations in the liquid market, while those of the good ones include corruption crackdown and punishing of those who lacked integrity in dealing in the financial market. Whether the CCP’s current insiders in the decision making body are being too lenient to themselves or not does not weaken my argument, as those who are ruled significantly outnumber those who rule, and I tend to believe that corruptions at the transaction level are more harmful than crony capitalism for an economy’s functioning.
I have a high conviction that Chinese consumers will surprise economists. Maybe it is just because I have not read enough, but I still have not yet read any analyses written on Chinese consumer economy with the parameters that I believe are accurate. Most importantly, I tend to think that headcount is a far more important factor than per capita purchasing power is, for a consumer economy. I would break down consumption in general into three different shades of gray: one for survival (the most resilient kind), another for productivity (which is similar to investment and should be viewed as a positive factor for the future), and then one for anything excess (which I view as the worst among the three and cause of many problems). In aggregate, very naturally, high proportion of Chinese consumption is and will be for survival especially at the initial stage, whereas consumption in the developed economies have no other option but to rely heavily on the consumption on anything excess. This is because it takes the same amount of food to make a billionaire or a beggar full, like what Engel’s Law argues, and the same applies for many other items at different level of purchasing powers at varing degrees. Therefore, I argue for the following view: the possibility of the situation where the proportion of Chinese consumption for anything excess vis-a-vis its consumption for survival reaching that of developed peers’ (especially of the West) before China’s per capita purchasing power substantially increases is very low. By the time China’s per capita purchasing power reaches the level that enables its reliance on consumption for anything excess to equal the Western peers, China would already be a global hegemon.
While I do not believe that I will see a systemic meltdown of the PRC in my lifetime, I still shall prepare for such a tail risk by owning gold. Because I can count on gold, and also because my long term conviction on China’s growth story stands firmly, I have no intention to eliminate my exposure to China on the long side even in the bad days. However, I shall pay attention to the liquidity management to survive long enough.
While bearish sentiment currently overwhelms the market, I find some Hong Kong listed equities that benefit from Chinese consumer attractive, as I read the timing gauge as 3, 1 being the best time to buy and 10 being the worst, given the company specific growth fundamentals (that are widely acknowledged, in fact) and attractive valuation. Even in the event of the change in the level of CNY and HKD, these equities are not likely to disappoint in the medium to long term, as the rise of purchasing power is likely to recover and continue to grow in less than a year or two at the longest, in my view.
Oil and fertilizer
I am bullish on the commodities whose organic demand growth trend is not disrupted. I would identify iron ore as the commodity whose demand growth trend is seriously disrupted, but oil and fertilizer fall into the category I find favorable. There must be many more commodities with the characteristics similar to that of oil and fertilizer; I need more research on this matter (uranium?). While I recognize the possibility of further strengthening of the USD and subsequent weakness in oil prices, the opposite would not surprise me at all. The USD dollar seems to be able to keep its safe haven status, but the USD trade is already crowded, and the existence of speculation demand for commodities in general seems to be somehow completely forgotten. All these hidden-excess liquidity within the system must eventually flow into somewhere. I am in the camp that views the adjustments in the supply side to eventually arrive. However, I am deeply concerned about the ownership structure of the oil around the world. Even the national entities are eventually forced to react against low oil price, but I find it nearly impossible to time it. This is because the reserves key national entities piled up over the preceded years enable them to stubbornly fight against the self-correcting market force and further distort the supply side scene, as they have been using more production as the remedy for low oil price to meet the budget plan. One of the key players in potash scene is also a national entity, so oil is not the only one that is difficult to time, as similar dynamics have been observed in potash industry.
Nevertheless, Chinese demand for both oil and potash grew year over year, and these commodities seem necessary for humans’ survival. Within the renewable energy scene, well to tank efficiency is especially overlooked, so the subsidies will continue to drive the market and it will take a long time before the market forces take over. With so much uncertainties and offsetting forces around, my bullish stance for the equities with high beta on the relevant commodities ultimately bases itself on the attractive valuation.
Gold and some niche markets
Because the global financial system is shaky, it makes sense to hedge while keeping some assets distanced from the core of the system. Gold stands out in this regard, and gold’s risk profile is even more attractive now than few years ago. If one is serious about capital preservation and saving, he or she must own gold. The ongoing currency war is the race to the bottom, and there should not be any surprise if even the Fed changes its course and push the rates back down even to the negative territories. For now, I refrain my wild imagination and assume that the lowest rates can go is 0 or insignificant negative rates, but in one form or another, further easing is likely to come, as there is a very strong consensus that disinflationary scenario will play out for an extended period of time. This is extremely unnerving, as the eventual transition from deflation to inflation to hyperinflation is likely to put the global economy in a seriously challenging environment.
Many people forget that only those who are intended to be exposed to gold matter for gold. I have long been observing an interesting trend in the gold market: Gold holders are gold bulls with extremely high long term convictions, while gold bears hardly have a strong long term conviction on the actual bearish price movement of gold. Also, I have only been exposed to the theorists (widely perceived as conspiracy theorists) who argue for large scale downward price manipulation of gold, and never the opposite. There are so many investors who are not holding gold mostly because of the storage cost and the regulatory tackles that make the gold purchase very troublesome. All these factors are in fact evidence of how artificially depressed gold market is, and the true market force behind the gold market is extraordinarily positive and strong. As such, I diagnose that the market fundamentals for gold is intact.
Speaking of things that are relatively well insulated to the rest of the system, some niche markets such as pharmaceuticals sector and fingerprint technologies sector deserve attention.
I identify demographics as the most compelling investment basis that exists due to two factors: the fact that the change is easy to time and the certainty of the magnitude of the change. This is ideal for investments, as this enables investors to time the market while relatively accurately anticipating the upside and downside with extremely high conviction. Pharmaceuticals stand out in this regard, and because the cash this sector draws in depend on the deepest pockets, some pharmaceutical companies that show promising sales and low valuation multiples seem extremely attractive.
Fingerprint technology sector is another fascinating sector that is relatively well insulated, mostly thanks to the cash piles tech giants have built over the recent years. Rise in the adoption rate of fingerprint technology is assuring, and I still observe supply shortage of fingerprint sensors and the modules. In the current macro environment where growth is muted in most sectors, I find this sort of sector that benefits from changing need with 3 digit year over year growth extremely attractive. OLED companies are attractive for the same reason. It is little tiring to deal with tech companies because portfolio needs to be adjusted quickly to reflect the fast paced technological advancements and the market share changes within the sector, but laziness probably should not be a good enough excuse for me to avoid the sector.
Wild imagination
Lastly, the followings are the topics I continue to contemplate upon:
In future, are developing countries going to completely lose their ground as production bases due to the excessive degree of automation in developed markets?
By the time Chinese middle class emerges as the dominant driver of the global economy, will container shipments shrink significantly? Will China be more self-sustaining than the rest?
If there is one, how will investors in Myanmar or Vietnam react to global economic meltdown?
Will Korean ship makers succeed in insourcing key parts for the marine engineering structures, over time?
How long will it take for Iran to stabilize?
How fast will ETF industry grow, and how much damage will it do to the system, eventually?