Wednesday, January 20, 2010 12 comments ++[ CLICK TO COMMENT ]++

Found a China bear who shares similar thoughts as me

I never heard of Richard Duncan but, after reading this article on MarketWatch, his thinking is quite similar to mine. He is quoted for bearish views on China but the reality is that the scenario is much larger than that. The problems are global in nature and everyone will be affected one way or another. I don't think many will agree with Duncan's outlook but it's worth contemplating. Before someone dismisses him do note that, at least going by what's said in the article, his 2003 "The Dollar Crisis," appears to explain many of the problems we are facing now.

I have excerpted some key points from the article. For what's its worth he is far more bearish than me. Also, no one bat 100% so many predictions will turn out to be wrong. The key is to avoid getting blown up by major mistakes.


Duncan is the former London-based head of global investment strategy at ABN Amro. In 2003 he authored "The Dollar Crisis," which warned that imbalances in global trade would lead to a meltdown of the financial system.


Duncan now believes China is caught in a jam created by excessive credit. Years of easy lending and booming investment inflows have saddled its economy with surplus industrial capacity to the point where China out-produces what it consumes.

Expectations that Beijing can spark up domestic consumption to fill the void are bound to disappoint, he said, as wages are too low to support enough meaningful demand to lift the corporate sector to profitability.


...


China is not alone in facing up to a slowdown in economic growth. Most of Asia's export-dependant economies will struggle as the global slump proves structural rather than merely cyclical, he said.


Keeping currencies weak relative to the dollar in an effort to bolster exports is no longer a viable option for economic growth, Duncan said.


My view, which is influenced by Michael Pettis and others, is that the trade surplus countries are going to get hit badly. This runs completely counter to what most people believe right now but that is what happened during the Great Depression.

The key problem, as Duncan alludes to, is that there is overcapacity with very little demand. For all the bullishness around the growing consumption from countries like China and India, the reality is that they won't matter for a long time. The income levels are way too low for those countries to matter. A lot of the numbers that are quoted are quantity figures that look good on the surface but are smaller than they appear.

For instance, a country like China may sell more mobile phones or cars or shampoo than North America or Europe, but the total dollar figure of the consumption is very low. Even if China or India, or whomever, starts selling more cars than America and Europe, the price of those cars will come nowhere near what it is in America. Economists try to adjust for the relative worth of something across nations by considering the purchasing power parity figures but most of the numbers quoted in business media give no sense of relative worth. If growth investors are making a big mistake, it is what I have just described.

In the end though, if China or some other country, manages to get through this and raise worker salaries, it is going to be an economic powerhouse. China's consumption will be so large that it will be a planet all by itself. My belief is that the spectacular consumption in America from the 1940's to the 1970's was mainly due to rising wages; the consumption boom in the 1920's was partly due to increasing debt but that was not the case in the 50's and 60's.

It is really hard for me to see the export-oriented countries with low internal consumption and low internal worker compensation recover easily.


Anyway, going back to Duncan:

The subsequent crash that wiped out most of the U.S. banking system amounts to a "New Depression," where the global economy still teeters on the edge of an abyss -- held up by the life-line of government aid.
And that government support, Duncan believes, is likely to become a permanent part of the financial landscape for years, if not decades to come.

"Japan serves as a very good example of what's likely to happen in the U.S. and China," Duncan said.

The good news is that the U.S government should be able to finance huge budget deficits without resorting to printing yet more money, he said, adding that Japan has been able to do just that since the 1990s.



I'm with Duncan on this. I don't see what the big fuss is about soverign default risk. Sure, the risky ones can easily default but I highly doubt USA is anywhere near those lowly-rated countries.



Duncan advocates an aggressive approach of trillion-dollar-plus backing for industries such as solar energy and biotechnology. The idea would be to give the U.S. an "unassailable" lead in frontier technologies. That means producing goods that the world needs and which can't be produced elsewhere at cheaper prices.


Conservative-types, as well as those are more free-market-oriented probably won't like this—too much government intervention—but I think it is a reasonable idea. If you are going to spend money, might as well pursue some pie-in-the-sky ideas. I'm not too sold on solar—it's too uneconomic and it also provides little benefit to developed countries since solar depends on manufacturing and that will likely be carried out in low cost countries—but something along this line is better than the infrastructure spending that some are calling for. I have no idea what's so good about the so-called 'shovel-ready infrastructure projects' and would rather spend the money on some wind power, biotech, nanotechnology, or something.


Beijing's combined stimulus spending and government-directed bank lending amounted to a staggering 40% of gross domestic product in 2009 -- that's just a few percentage points short of outlays by the U.S. government during the height of World War II.


Duncan said he's worried that as China tries to spend its way out of the problem, it's really just making things worse. Last year's stimulus package, he said, gave a jolt to the economy much like shot of Red Bull that will wear off over time.

"It tells you how terribly wrong things are there," Duncan said.

To maintain growth of 8% this year, banks will need to crank out another round of lending equivalent to 30% of GDP.

Chinese Finance Minister Xie Xuren said earlier this month that his country is planning something along those lines. The central government has budgeted 992.7 billion yuan ($145 billion) on public investment this year, according to reports by the state-run Xinhua news agency.

What's troubling is that the expanded spending and new loans from state-owned banks will bolster production capacity, fuelling excess, and inevitably compounding deflation.

"So now they have expanded that capacity by that much more, and they have no one to sell it to," Duncan said, adding that the mood in Beijing must be one "panic" as they assess the unfolding situation. /blockquote>

Nothing new here; the usual stuff I and others who lean towards deflation have beaten to death.

Beijing will allow the yuan to rise in an attempt to help cool growing protectionist sentiment in the U.S. and Europe, as unemployment rates remains stubbornly in double digits, Duncan said, adding that other Asian currencies are likely to appreciate alongside the yuan.


Talk of currency reform began circulating earlier this month, when a Chinese policy institute floated the idea of a one-off 10% revaluation of the yuan and an annual appreciation against a basket of currencies of up to 3%. China has held its currency stable against the U.S. dollar since mid-2008. See story on call within China for yuan appreciation.

The outlook for asset prices is less clear. Duncan believes the fortune of the world's property and stock markets will depend upon the size and timing of government stimulus packages.

The need for sustained deficits to prop up the economy means gold prices will rise about 10% a year for the "rest of our lives," he said, although fears of inflation that have led some to buy the metal are overblown.

Land is another of Duncan's recommended investment.

"Over the long run, you want to own things that the government can't debase," he said.

That advice doesn't extend to commodities, especially crude oil, where Duncan believes prices been manipulated to unwarranted levels by sophisticated traders. He expects prices to fall sharply across a broad range of commodities if efforts to regulate derivatives gather steam.



I don't share the same thinking as Richard Duncan when it comes to assets. In fact, I think he is contradicting himself and some of his picks. For instance, things like gold and land tend to perform poorly under deflation. There are always exceptions but my view is that you shouldn't own those. Yet, Duncan suggests that gold will go up 10% per year for the rest of our lives and that land is attractive. My view is that those assets will get hit badly if we get the "new depression" that Duncan was talking about earlier. To give you an idea, Japanese land prices have been falling, for the most part, during the last 20 years. Land in America, Canada or even Europe would be a dangerous bet if the earlier economic prognosis comes true.


To sum up, I pretty much agree with most of Richard Duncan's points when it comes to economics; however, I don't quite share the same views when it comes to investment suggestions.

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12 Response to Found a China bear who shares similar thoughts as me

MrParkerBohn
January 21, 2010 at 4:43 PM

I agree, China makes me nervous for a whole list of reasons.
However, I'm thinking about buying back into GXC, the China ETF I sold way back in June.

GXC has recently declined to the same price where I sold it (68 something).
Since I sold it, however, several things have changed...

1)  China has had 7 months of economic growth, making its companies more valuable.
2)  China's economy has done better than expected.
3)  Other markets have risen, making China more valuable on a relative basis.  For instance, the S&P
500 is up about 20% in the last 7 months.

4)  Most importantly, my thinking about value has become somewhat clearer.  I used to think about an investment in
terms of how much return I expected to get from it, compared to how much return investors have historically been able to get out of good investments.  IE, if I could reasonably expect to get 10% or more per year, then I considered this to be a good investment, and otherwise I would simply wait and look.

Basically, I supported Buffett's baseball analogy, where you can sit there all day and watch balls go by, until you get a fat pitch and decide to swing at it.

I now disagree with this analogy.  If someone is sitting there, with lots of assets in cash or cash-like investments, then I believe they are 'swinging at cash'.

Given the choice, I might rather swing at China, than swing at cash, or at the US market.

MrParkerBohn
January 21, 2010 at 4:46 PM

Of course, only a fool (or someone much, much, smarter than me) would take an undiversified position in any emerging market.  I'm thinking on the lines of a 5% investment.

However, this doesn't make the decision any less important, since my portfolio is made of 5% investments.

Sivaram
January 21, 2010 at 6:21 PM

MrParkerBohn: "<span>Of course, only a fool (or someone much, much, smarter than me) would take an undiversified position in any emerging market.  I'm thinking on the lines of a 5% investment. "</span>
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<span>It depends a lot on one's strategy and their portfolio size too. THe latter, portfolio size, is something that few bring up but it can be a big thing. For instance, my portfolio isn't that big and looking back a few years ago, it was very small. A dollar los is a dollar lost so one should be careful regardless of how big their portfolio is. But, nevertheless, I think someone with a small portfolio can be more concentrated simply becaue the amount of money they save each year will be large relative to the portfolio. </span><span>The real big risk is when one's portfolio ends up fairly large, and their savings relative to portfolio is small. </span>
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<span>I have a feeling that a lot of people who diversify heavily have large portfolios, and are perhaps a bit older and much closer to retirement.</span>

Sivaram
January 21, 2010 at 6:39 PM

MrParkerBohn: "I now disagree with this analogy.  If someone is sitting there, with lots of assets in cash or cash-like investments, then I believe they are 'swinging at cash'."



I don't like the sound of that. I almost get the feeling that you are becoming overconfident and, perhaps, impatient. Usually people start making big mistakes when they end up like that (a lot of people start ignoring risk when they have made a lot of money and everything has been going up, up, and up.)

I still stick wtih Buffett's analogy and I think this is what you are overlooking:

Holding is cash is definitely has a cost--an opportunity cost! However, I don't think you are swinging at a pitch if you go to cash. Going to cash is sort of like letting a ball (non-strike) go by. It doesn't really help you that much but, most importantly, it doesn't hurt you. (The only exception is if you think the currency is going to collapse or someting like that--then cash is actually a big risk.)

Going to cash is not a swing. A swing, to me, commits capital and takes on (potentially) substancial risk. Even with, what appears as, the greatest opportunity, you could suffer by swinging and taking on that position. Stocks are long-term investments so anything you buy sort of locks you into the asset. Even if you can sell it a week from now, the market may mark down the asset by 20% to reflect what is expected to happen over the next 10 years.

If you hit the ball, something happens. You either get caught or move to the next base or whatever. You really can't go back and re-swing because you didn't like that pitch. So if you invest in something, you have committed. Sure, you may be able to exit with no loss in some circumstances but you have taken on risk. With cash, that's not the case. You can still swing at a better pitch that comes in the future. This is why I say cash is not swinging.

Sivaram
January 21, 2010 at 6:39 PM

MrParkerBohn: "Given the choice, I might rather swing at China, than swing at cash, or at the US market."


The above comment is kind of what makes me think that you are becoming impatient. Dont' forget that one of the cardinal mistakes in investing is to get impatient and do something for the sake of doing something.

You have some good reasons for remaining bullish on China and if you are confident with those views then go and invest in China. But I would say that your choice isn't  limited to China, USA, or cash. Maybe you will encounter a new region--say Brazil, or Australia, or Ireland, or whatever--or your favourite company may go on sale. That's the power of cash! It still keeps you at the home plate and allows you to swing at future pitches.



Having said all that, I have done quite poorly in the last year and my high cash holdings have been a huge cost. So, this is all coming from someone who isn't doing so well.

Sivaram
January 21, 2010 at 6:56 PM

Regarding your China justifications, I think they do support your bullishness in China but do keep in mind that your strategy is very different from me.

For instance, you appear to be relying on relative valuations. For instance, the fact that the S&P 500 is up 20% or whatever while the Chinese market has underperformed is not that important to me because I don't rely so much on relative judgements.

Similarly, the fact that the economy grew in the last 7 months while the security declined or went nowhere is sort of relative call. You are judging the value based on what it was 7 months ago.

I know you did more absolute valuation estimates last year so maybe you are confident with those numbers and believe you can use that as a reference. But just make sure your reference benchmarks (economy 7 months ago, S&P 500 7 months ago, etc) are reasonable. If the market was overvalued back then or if the S&P 500 was still expensive last year, then it can lead to poor decisions.

Anonymous
January 21, 2010 at 8:44 PM

The guy thinks govt. stimulus can't hold up... but he's ignoring the effects of stimulus.  Those loans create real products, real jobs, and stimulate consumption.  How else can you spur the economy to grow?  It may not kick in after one year.  Govt. spending of 30% of GDP doesn't sound unsustainable for a Communist regime with a terrific balance sheet.  The U.S. spends trillions -- and we have to borrow every cent to do it!

 I've heard nothing but the world is ending stories since I started investing in 1997.  The world keeps growing and people need to invest.  The other thing that has happened since 1997 (since 1887) and will keep happening is: the dollar will lose value.

 Sure, hold cash if it makes you sleep at night.  But cash is a long term loser.  It's sad but true.  You are locking in losses via non-stop inflation.  So the investors of the world will seek out quality stocks... even if there are bumps in the road.  

MrParkerBohn
January 23, 2010 at 1:44 PM

You make some really good points.

From my own perspective (mid 30's, saving for retirement), I do see holding lots of cash as risky.  I think many families retire with far less money than they could have had with a higher equity allocation.

I'm still undecided about a potential China investment.  In any case, I'm not super-excited by the valuation, so I may wait for confirming data to emerge.

Sivaram
January 23, 2010 at 2:17 PM

I guess we are both of similar age. I was thinking you were a bit older but guess not; I guess you are more risk averse, or perhaps smarter, than me ;)  I don't view cash as being risky but then again, I'm assuming it is a temporary holding of sorts.


I'm curious to see what you do with China. It's 'pure' emerging market investing. Everything is murky; numbers may be unreliable; growth is volatile; but profit potential is great.

Sivaram
January 23, 2010 at 2:34 PM

GUEST: "<span>The guy thinks govt. stimulus can't hold up... but he's ignoring the effects of stimulus.  Those loans create real products, real jobs, and stimulate consumption. "</span>
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<span>It's not so simple. If increasing loans (or printing money) were the path to riches, everyone would be doing it. Credit growth can positively impact the economy. The question is whether that is what in happening in China.</span>
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<span>To see why people like me are concerned about China, think back to USA in the 1920's. During the Roaring 20's, credit growth, particularly business debt, exploded. There were all sorts of credit innovations, including the ability for the masses to buy cars and appliances on credit.</span>
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<span>Yet, a lot of it was misallocated and everything fell apart by the 1930's. </span><span>USA, you will recall, was running a current account surplus and was seeing huge inflows of gold. Yet none of that meant anything because the loans that were handed out in the 20's were bad loans. </span>
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<span>GUEST: "How else can you spur the economy to grow?"</span>
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<span>You cannot growt the economy through credit in the long run. Present-day USA is an example of that. I forget the numbers but the increase in GDP from each dollar of debt in USA has been declining for decades and it's almost at the point where credit growth won't help the US economy grow.</span>
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<span>China is nowhere near USA and debt is useful (particularly in their consumer sector.) But I'm not so sure about their recent credit expansion, which is largely state government directing state banks to lend to state businesses.</span>
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Sivaram
January 23, 2010 at 2:41 PM

<span></span> 
<span>GUEST: "</span><span>It may not kick in after one year.  Govt. spending of 30% of GDP doesn't sound unsustainable for a Communist regime with a terrific balance sheet.  The U.S. spends trillions -- and we have to borrow every cent to do it!  "
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<span>Paraphrasing Warren Buffett, what matters for the economy is earnings power; not the balance sheet per se. There are some companies out there that have negative book value but the stock market prices them in the billions. Similarly, you could have all the money in the world but if the economy is unable to grow, it's tough.</span>
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<span>The best example is the one I mentioned above: USA in the 1920's to 1930's. USA, like China now, was running current account surplus and had more money than it knew what to do with. Yet, USA was hit harder during the Great Depression than Europe, which was largely running current account deficits at that time.</span>
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<span>You may be right and China may get through this fine but it remains to be seen. It's not as obvious as you believe. Chinese banks could easily end up with more than trillion in bad loans (they actually had bad loan problems in the late 90's/early 2000's but obviously not as big as now.)</span>
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<span>Guest: "I've heard nothing but the world is ending stories since I started investing in 1997."</span>
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<span>There are always bulls and bears but do note that stocks haven't done too well since 1997. In fact, near the trough early last year, bonds had outperformed stocks. Given the rally last year, stocks are beating bonds now but not by a wide margin.</span>
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<span>I don't think the world is ending, however, I think investors aren't prepared for reality. A lot of the people who were investing in the last few decades see rosy outcomes because that's the world they grew up in.  Professional money managers literally assume 10% per year returns for stocks and many academic studies also purport to support that. I have a feeling it's going to be rough. That's why I'm maintaining my neutral-to-bearish view and sitting on large amounts of cash. I have severely underperformed the markets recently though.</span>

Sivaram
January 23, 2010 at 2:48 PM

Guest: " The other thing that has happened since 1997 (since 1887) and will keep happening is: the dollar will lose value.  "


Yep.

Modern economic theory calls for money to be printed based on factors suc as economic growth,  population growth, etc, so cash will definitely lose value (typically 3% per year.) Ignoring compounding, in 30 years, the currency will lose 90% of its value. That's kind of what has actually happened to the US$ and all other developed countries that follow modern economic theories. Thre is nothng wrong with this. In fact, it's better than the hard currency standard (gold or silver standards) of the past where currencies did not lose value irrespective of population growth/economic growth/etc.

But when people like me say to hold cash, we are not talking about the long-run. Rather, we do it as a temporary holding until better long-term investments appear.
 



Guest: " Sure, hold cash if it makes you sleep at night.  But cash is a long term loser."


I agree. I'm not saying people who hold cash as a long-term investment. Rather, it is to be kept so that you can convert that into long-term investemtns when one feels like it. I wouldn't reocmmed that anyone hold cash for the long run.

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