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Friday, July 28, 2006

1. Earnings 2. Reaction 3. Guidance

Barry Ritholtz wrote a very interesting and timely article on earnings season and how the market reacts to such news. With the market seeming to halt despite all the positive earnings, it makes one think as to whether the good news has already been factored in. If so, then could the flipside be true? That bad earnings have not yet been discounted and that lowered guidance will pose as a surprise? Mr. Ritholtz has gathered data supporting this in the article below. Enjoy the read but don't forget to pack your parachute....


We are about halfway through earnings season, and it looks like another quarter of double digit year-over-year earnings growth. This now makes something like 14Qs in a row. That's the good news.
To a large degree the market has already priced in these double digit year-over-year earnings gains. We see that in several data points which we discuss below.

I look for divergences, things that are different from last quarter. And on that score, there are several issues worth exploring, as they portend that something is changing in both the markets and the broader economy.

Our first chart "comes to us from Birinyi Associates Chart of the Day, and looks at the S&P500 misses versus beats on earnings: So far, we are seeing 72% of companies actually beating consensus. That ties for the best in 4 years. Misses are a mere 10% -- also the best in 4 years.

S&P500 Earnings Beats vs Misses

Courtesy of Birinyi Associates

This clearly shows the quarterly numbers are coming in better than expected.

Now is where things get interesting. Merely knowing earnings are doing well is insufficient information for investors. The key question is, how much of the good earnings are built in? How are stocks reacting after the good reports?

The chart below shows exactly that. Here are the following day returns after both upside and downside surprises:

Courtesy of Birinyi Associates

Look at the left chart in green -- that is EPS Beats. The reaction to good news is the smallest its been since 2002 (see the blue bar at bottom left), and way below the recent average if 1.2%.

That implies that most of the good news is already built into stock prices.

On the right in red, we see the EPS Misses. The next day reaction is the most severe we have seen in four years. Stocks that miss get brutally punished, and are beaten up way more than the prior four year average of 2.37% the following day.

This implies that the bad news is not yet factored in.

Finally, lets look at the last of the earnings call elements: Guidance. According to Ashwani Kaul, Reuters Fundamental Market Analyst, guidance has dramatically diverged from the past few quarters, shifting to a negative 2 to 1. Particularly warning of weaker earnings and/or revenues has been the Tech sector, and Consumer Cyclicals.

To some degree, this may be reflected in the price already. The Nasdaq has gotten slammed, and it may simply be a matter of the market anticipating a slowing (Tech is far more cyclical than most people realize).

This may also explain why the misses are getting beaten up -- the combination of a miss and guiding lower could what is the divergence from prior quarters.

Sector Rotation Update: The Picture is Clear!!!

Sorry for the late sector rotation update. Ever since our last update 2 weeks ago here's how the sectors fared:

Consumer Discretionary - Flat
Technology - Worse
Industrials - Worse
Materials - Worse
Energy - Worse
Consumer Staples - Flat
Healthcare - Better
Utilities - Better
Financials - Flat

Notice how the market's rallying but only 2 sectors are faring better? The strong performance in utilities and relatively stable positive performance of financials just confirms what we have always been saying... interest rates have peaked or are near the peak. The reason why financials are not performing better because they'll probably do bad when interest rates do come down (which is still a big "if"), and the pause in rate hikes will just be a temporary reprieve. Healthcare is the best performer in the past 2 weeks, showing the defensive nature of the market. But take note this is the laggard of all the defensive sectors due to concerns about competitoin and rising healthcare costs. Anyways, the COL fund is officially starting in August, and I'll be posting my focus list.


The Last Step - The Trickle Down

Here is something to think about over the weekend. How will corporate earnings and excess cash in balance sheets trickle down to wages? Not exactly the kind of light query that you can talk about over beer. A Marxist cloud hovering above a Capitalist empire if I may say so, begs the pop question, "Where exactly is the trickle down?"

Beggars on the streets are recipients of the trickle down just as much as your Saturday whore is. The biggest recipient of a trickle down (or trickle up?) is The Gates Foundation receiving so many billions from the master himself. Where does that leave us now?

The trickle down is the next logical step that the Fed is anticipating. Unemployment has been at an optimal rate and theories point out that any effort to even push down this rate lower will push inflation higher. Productivity and utilization rates have been highest in years. The ratio of labor to capital has also been at its record levels.

Just imagine an engineer who used to operate one machine for the factory now, with the use of technology, has increased productivity by being able to operate not one but 5 machines using his computer. But his salary does not increase. Because of willing immigrants coming into the US sucking up to lower wage rates, the engineers salary stays the same. Low cost of labor, high productivity. This must be corporate heaven!

Now the engineer is working 8 hrs a day. The factory can either add new labor or increase the engineer's pay. Here is where the crossroads lie. Should corporates increase wages or just hire low skilled workers to add production capacity?

And because of technology, hiring low skilled labor will not be much of a big problem.

But if the factory anticipates slower demand in the future, should it increase its production capacity? Is it logical to do that? What would push companies to increase capacity, increase inventory?

There must be bottle-neck somewhere.


Thursday, July 27, 2006


“I think we ought always to entertain our opinions with some measure of doubt. I shouldn't wish people dogmatically to believe any philosophy, not even mine”.

-Bertrand Russell (1872 - 1970)
British author, mathematician, & philosopher

Mild-Stagflation? Growth Recession? Real Recession? Where is the US economy headed in the next 6-12 months? This is the hot topic among investment strategists and economic forecasters today. The opinions vary, ranging from Growth Recession to Greater Depression. There is a growing number of investment gurus who believe an economic slowdown is inevitable. Some think it's already here. Even Ben Bernanke acknowledged an anticipated US economic slowdown in his recent testimony to the US Congress. Assuming the consensus is correct, the question now goes from “where do we go?” to “how LOW do we go?”. To determine where we stand, a definition of economic terms is in order:

Growth Recession:
A form of recession in which economic output continues to grow, but at a much slower pace than normal. “Normal” is meant to describe an economy growing above 2%.

A condition of slow economic growth and relatively high unemployment. It is a time of economic stagnation accompanied by rising inflation. Economic growth of less than 2% is considered stagnation.

A significant decline in economic activity spread across most sectors, lasting longer than a few months. It is visible in industrial production, employment, real income, and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by GDP.

A severe and prolonged recession characterized by inefficient economic productivity, high unemployment, and falling price levels. In times of depression, consumer's confidence and investments decrease, causing the economy to shut down.

Based on those definitions, the US economy still does not fall under any of these environments. So will the US economy suffer recession or stagflation? Truth is nobody knows yet. Only after the fact can economists accurately describe an economic event. It's that simple.

I'm not discounting any of the economic risks repeatedly outlined by the experts in their newsletters and blogs. People who trade for a living cannot afford to ignore these warnings. The bear arguments are valid and well thought-off but they are what they are – just opinions. Without more data to confirm their outlooks, no self-respecting strategist should declare with certainty that the US will suffer real recession or stagflation. So doomsayers relax. There are still too many unknown variables to accurately forecast the future. Ultimately, only when the smoke clears can we really answer the question: How low can we go?


Wednesday, July 26, 2006

Bullish Case on Bonds

Some commentary by Hoisington Investment Management, who are bullish on bonds. They feel that even if the Fed tightens a couple more times, we have seen the peak in bond yields. They feel that falling money supply growth and wage costs indicate that inflation is contained, and headline inflation numbers are actually lagging. They feel that the economy is already slowing down and at risk of recession due to the Leading Economic Index (LEI) data and due to the yield curve inversion. Their commentary supports our view that the Fed is at or close to the peak of interest rate hikes.


First Half Sell-off

Treasury yields rose across the board in the first six months of 2006. Two, five, ten and thirty year Treasuries posted results of 0.7%, -2.0%, -3.9%, and -7.6% respectively. The Federal funds rate, adjusted higher four times in 25 basis point increments during the first half of the year, was the proximate cause for the sell-off. It is our expectation that interest rates will move noticeably lower in the second half of 2006 in response to a rapidly deteriorating U.S. economic environment. The cumulative impact of a tightening Fed policy, rising interest rates, elevated energy costs and modest job growth, in concert with the structural problems of an over-leveraged consumer sector and international wage competition, has created the risk of a sharp and/or elongated slump in economic activity.

Slowdown in Progress

The question of whether an economic slowdown will occur is moot since it has arrived. Coincident indicators of economic activity, such as job growth, are decelerating rapidly. Over the past three months, private sector job gains have averaged a paltry 86,000 per month, some 44% less than the average monthly increase in 2005. Real consumer spending, which accounts for nearly 70% of total GDP, is slated to expand less than 2% in the second quarter, compared with the 3.5% gain in 2005. Construction spending (residential, commercial, industrial and public) is also on track to display no growth in the second quarter. Thus, 80% of GDP is presently expanding at only half the rate registered last year.

The sharp loss of momentum in this expansion has been well signaled by the leading economic indicators. First, the Leading Economic Index (LEI), as computed by the Conference Board, has now contracted over the past six months (Chart 1). This is a significant development since a decline of that duration has only occurred thirteen times since the end of the Korean War. Outright recessions followed nine of those episodes, and severe slowdowns were registered in the other four episodes. It is important for investors to note that short and long term interest rates fell in the aftermath of all of the previous thirteen slumps in the LEI.

An alternative leading index can be constructed by calculating the ratio of the Conference Board's composite index of coincident economic indicators divided by its composite of lagging indicators. In a late stage expansion, the rate of increase in the coincident composite should be rising less than that of the lagging composite and the ratio should be falling, exactly like the present situation.

This alternative index has the disadvantage of being far more volatile than the LEI, eliminating the ability to obtain useful knowledge from changes of a year or less. Notably, the ratio has declined over both the latest 18 and 24 month intervals. The 18 month change in the ratio has been consistently negative for a year, while that for the 24 month change has been in the red since October 2005. Since the Korean War, fourteen instances have occurred when the ratio declined a minimum of 18 months (Chart 2). Nine recessions, four severe slowdowns, and one false signal followed. Thus, the alternative leading index indicates that downside risks to the economy are large, but unlike the LEI it indicates that the evolution of the eventual outcome is at a more advanced stage.

Yield Curve Inversion

In late June, the Federal funds rate rose above the ten year Treasury note yield. This was a result of the Fed forcing the Fed funds rate higher while the ten year did not follow suit. Sometimes this is referred to as a "frontdoor" inversion. According to Expectations Theory, market investors, on average, held the view that the economy was already slowing, creating the likelihood of interest rate declines at a later date, and this fact was more important to investors than the Fed's hike in the Federal funds rate.

Over the prior 55 years, the Federal funds rate has exceeded the ten year note yield only eight times. Six of the inversions were followed by recessions. The 1966 inversion was followed by a severe slowdown, but a recession was avoided because of substantial increases in Vietnam War military spending, Lyndon Johnson's Great Society Welfare program, and a dramatic and rapid easing in Fed monetary policy under the leadership of William McChesney Martin. A 1998 inversion, unlike the earlier seven, was of the "backdoor" variety caused by a drop in ten year yields, not a rise in the Federal funds rate. If we exclude the "backdoor" inversion of 1998 since it was of a different type, recessions occurred after six of the seven previous "frontdoor" inversions.

Monetary Indicators

Today's yield curve inversion gains more significance when it is corroborated by key monetary indicators. For instance, real M2, one of the most reliable of all leading indicators, has declined from an 9% growth rate in December of 2001 to a miniscule 1.1% expansion in the twelve months ending June, 2006. Further, total reserves of the banking system have fallen over the past twelve months by .5%. Since 1945, the growth in total reserves slowed prior to all ten recessions.

Avoiding a Hard Landing

Yield curve inversions and extended declines in the leading indicators portend a recession, but they do not tell when it might occur. The historical record suggests that a recession could occur by year end, although the lead time could be longer. From the initial decline in the LEI to the start of the nine post Korean War recessions that followed, an average of 9.6 months elapsed (Table 1). The shortest lead time was four months and the longest 19 months. However, the lead time for six of the nine recessions was clustered between four and eight months. The reason that lead times vary is that the initial conditions are never the same. The initial conditions that could shorten those lags currently are the record level of household sector debt and this decade's unprecedented housing boom. But, there is an initial condition - exploding growth in China and India - that could extend the lags.
The possibilities become clearer if we examine the historical instances when the yield curve inverted and the LEI registered a six month decline.

There are only seven such instances in this half century, and recessions followed all but one. Once this double coincidence occurred, the average lead time to recession was 9.3 months (Table 2). Of the ensuing recessions, the lead times for four were clustered between five and eight months, while the other two were 14 and 16 months. It may be too late for the Fed to avoid a recession.

In the past, when the economy was under stress similar to today's, outside shocks, which could not have been anticipated, frequently occurred. In 1970 and 1974, respectively, the Penn Central Railroad and Franklin National Bank of New York failed. In the summer of 1982, Drysdale Government Securities and Lombard Wall failed, causing the U.S. government securities market to temporarily freeze. In the summer of 1990 Iraq invaded Kuwait, and 9/11/2001 is well remembered. Presently, the economy is susceptible to an outside shock that could serve as a catalyst for negative economic forces at work.

Absence of a Money/Price/Wage Spiral

Since the early 1990s, disinflation - a general decline in inflation, has characterized the United States. Presently, the sharp rise in energy costs has caused a slight, but far from serious interruption of that downward trend. In May, the year over year rise in the core Personal Consumption Expenditure (PCE) deflator was 2.1%, or slightly above the 1%-2% range that Federal Reserve Chairman Ben Bernanke has stated to be price stability. The present level is at the midpoint of the 2% and 2.2% increases in 2005 and 2004, respectively.

Although a further pass-through of energy costs is likely to push the year over year rise upward over the next several months, such a development should not be taken as a sign that inflation is moving higher. Multi-year inflations take the character of what may be termed a money/price/wage spiral. This analysis is consistent with a great deal of economic theory including Macroeconomics, Fourth Edition by Andrew Abel and Ben Bernanke. Here the authors state (page 292) that money (M2) growth is procyclical and leading, while inflation is procyclical and lags the business cycle.

To have a money/price/wage spiral develop and become entrenched in the economy, money growth must accelerate, be sustained, and lead to a speed-up of price increases across the board. Then the widespread rise in inflation must lead to faster wage increases that are validated by a further acceleration in money growth and inflation.

This happened in the 1960s and 1970s when M2 growth was the highest for any two consecutive decades. M2 growth averaged 7% in the 1960s, and then accelerated to almost 10% in the 1970s. This was the fastest acceleration for any decade other than those containing World Wars I and II. In the 1970s the core PCE deflator increased by as much as 8% per annum, more than triple the average 135 year inflation rate. Wage costs accelerated steadily in those years. The Employment Cost Index registered its all time high of nearly 11% in 1980 (Chart 3).

The current situation is extremely different. In the past two years, M2 growth has averaged just 4.2% per annum, a far cry from the pattern in the 1960s and 1970s, and well below the 6.6% average increase in M2 since 1900. The Employment Cost Index was up just 2.6% in the latest four quarters, a record low increase. Hence, money growth is decelerating and so are wage costs. This is more likely to lead eventually to a downward money/price/wage spiral rather than to an upward one.

Lower Bond Yields Ahead

Long term interest rates rose in the second quarter, following increases in the first quarter, as the Fed pushed the Federal funds rate to 5.25%. Investors may be worried that further tightening is to come, but any such actions would serve to limit money and credit growth, while increasing the negative slope in the yield curve. Any additional monetary stringency would risk a downward money/price/wage spiral.

In 1990 and 2000, the Fed failed to properly account for the lags in monetary policy and carried restraint too far. If the Fed targets inflation, a lagging indicator, with changes in the money supply, a leading indicator, they will tend to overshoot regardless of whether they are tightening or easing. Now the immediate economic risk is for overshooting on the downside. A hopeful sign is that Donald Kohn, the Fed's Vice Chairman, said that they are "aware of those risks."

With the economy already in a slowdown, recession risks rising, and inflation contained, we view the bond market setback in the first half of this year as temporary. Should a further hike in the Federal funds rate be initiated, it should not be viewed unfavorably by long term investors. This would only insure that the present economic slowdown would deteriorate into recession, causing all yields to decline precipitously.

Strong Opinions, Weakly Held

I'd like to take time out from analyzing the markets and delve into the psychology of money managers. Barry Ritholtz of the Apprenticed Investor wrote a very interesting article on the mindset of a successful trader. It tackles the fact that although one needs to be fully resolved with his/her opinions when entering the markets, one should also be open-minded and humble enough to know when one is wrong and thus act accordingly. Below is the featured column:


On Sundays, I like to post some form of general trading/investing advice. It makes for a nice respite from the week's event-driven mayhem. Yesterday, however, I did not get around to it.

To make up for that, we wax philosophical this morning on a fascinating topic -- and find that perhaps all those PHI courses in college -- after 3 years of Physics and Appl. Math -- weren't a waste after all.

I happened across an interesting phrase recently that perfectly summed up a philosophical mindset quite suitable for investors: Strong Opinions, Weakly Held.

A random click had led me to the blog of Professor Robert Sutton, who teaches Management Science and Engineering at Stanford. Sutton is the author of (I kid you not) The No Asshole Rule (Feb 2007), as well as several other management books.

Ahem -- where was I? Oh, yes, strong opinions, weakly held. That turn of a phrase really got my attention. The author was seeking to distinguish between what was "smart" and what was "wisdom." It perfectly sums up a crucial mental aspect required for the markets.

Being a successful investor often requires you to hold numerous internally conflicting concepts simultaneously -- something many the average psyche has difficulty with. One must think through the best possible analysis for your positions, and expend time and effort to thoroughly test them. You need to be able to strongly argue your postion -- bullish, bearish or cash -- but at the same time, be ready to admit error and change views.

Interestingly, the idea of strong opinions, weakly held was drawn from a different field than investing. The idea comes from Bob Johansen at the Palo Alto Institute for the Future. This independent, nonprofit research group focuses on helping companies make "better, more informed decisions about the future." That certainly sounds like something investors could profit from.

Consider the following:

"Johansen explained that – to deal with an uncertain future and still move forward – they advise people to have "strong opinions, which are weakly held." They've been giving this advice for years, and I understand that it was first developed by Instituite Director Paul Saffo. Bob explained that weak opinions are problematic because people aren't inspired to develop the best arguments possible for them, or to put forth the energy required to test them. It was just as important, however, to not be too attached to what you believe because, otherwise, it undermines your ability to "see" and "hear" evidence that clashes with your opinions . This is what psychologists sometimes call the problem of "confirmation bias." (emphasis added)

This is dead on accurate for traders, and we've discussed related concepts in Investor, Know Thyself . Its why so often Psychology trumps Economics. My favorite related book is Thomas Gilovich's How We Know What Isn't So -- and for a psychology book, its surprisingly applicable to investors.

When I think about the phrase strong opinions, weakly held, a number of market aphorisms come to mind:

-You cannot "fight the tape," but sometimes you need to "fade the trade."

-Its often said that the Trend is your friend, except for that darn bend at the end.

- I was drawn to a more technical approach due to its agnosticism of positions: Buy at support -- unless it breaks, then short.

-No matter what your overall approach, one often hears the advice that "no one is smarter than the market." Yet any contrary strategy is just that -- an attempt to outsmart the crowd.

- Don't fight the Fed is another famous cliche. However, history shows that once the Fed stops tightening, markets typically head lower.

The list goes on. The bottom line is that strong opinions, weakly held is a mindset more investors need to familiarize themselves with.

Tuesday, July 25, 2006

Trader's Balancing Act

This market is definitely going to kill all trend followers. Just imagine shorting breakdowns and buying breakouts! Don't be surprised if at the end of the day, the numbers don't add up. But don't you worry. Just continue to remember the universal break up excuse of all men (should be used once in their lifetime), "It's not you, it's me" and you will survive. There is nothing wrong with you, if ever you are losing, it is the market stupid!

The market is in a consolidation, thanks to the Fed chairman taking this plane down as smooth as he wants it to be. His balancing act will definitely result to such consolidation. In the meantime, the market is discounting a "pause" in raising rates. Expect a rally until the Fed really does it.

Here are several points to remember when the market becomes oversold and overly negative(and traders want to buy):

(1) The momentum of earnings growth is still there.
(2) Companies are buying back their shares at a rapid rate.
(3) Coporates are drowning in cash
(4) Tax rates on dividends are slashed; companies giving dividends have increased.

Be smart enough to buy companies you know that have earnings. Stay with the strong ones folks!

On the other hand, when the market gets overbought or too bullish(and traders want to short):

(1) Think of the deficit.
(2) The US will most likely slowdown next year.
(3) Think of inflation; how much do you spend at the pump.
(4) Every major central bank is raising interest rates.

As the Fed is doing its juggling act, it is of most importance that we continously remain flexible.

Watch your step!


Monday, July 24, 2006

Ben's Balancing Act

We have already proven ourselves correct in trying to decipher what Ben is trying to do... he's just keeping the sinking boat afloat, trying to keep economic growth sputtering along without inciting further inflation, keeping the financial markets in range with his flip-flopping comments. His intentions are clear in his words: "The economy should continue to expand at a solid and sustainable pace and core inflation should decline from its recent level." He's trying to avoid a faster than expected economic slowdown while just letting the slowdown handle inflation.

The question right now is will he succeed? The ramifications will be big. If he succeeds then we might have seen the market bottoms already and we will just be waiting for the consolidation to finish. If he fails (inflation runs away and he would need to hike rates more aggressively and once again face the possiblity of overshooting and a recession), who knows what depths the markets will reach.

Greenspan created the housing bubble to patch up the mess that was the stock market bubble... what solution will Ben try to conjure to patch up the holes left to him by his predecessor? The likelihood that Ben might fail lies in the fact that despite his dovish comments inflation is still there and just starting to gain momentum based on the latest June data. Annual headline inflation for the last 12 months is at 4.3%, and even more terrifying is the annual rate of 5.1% the last 3 months. Core inflation is up a scary 3.6%!!!

We still have to see wheter Ben's moves will be correct. In the meantime keep some gold ETFs like GLD in the portfolio, it wouldn't be a bad bet.


The Roof Is On Fire

When the roof is on fire, the whole house collapes. First it was the homebuilders themselves, whose sales will be hit most directly by the slowing down of the housing ATM. The walls are collapsing... who will be next?

We believe that the financial sector which delves in giving consumers abundant access to cash amid the housing boom, despite the inherent risks, will be the next to come down. The signs are ominous.

MTG (MGIC Investments), a mortgage insurance company, saw its stock drop 3.5% last Tuesday and has even fallen further despite reporting stellar Q2 results that trumped analyst estimates by $0.02, saw insurance in-force rebound from the previous quarter and inciting positive analyst comments. It seems that investors are starting to look beyond the numbers and seeing the reality that will be when the housing slowdown bites at these companies. Despite beating estimates profits at MTG are still down 14% yoy. Where's the magic?

Beyond mortgage insurers, also bound to be burned down in the financial sector are the mortgage lenders, whose stocks have still proven resilient but are showing signs of weakness as of late. Mortgage lenders have been able to escape the clutches of the housing slowdown by securitizing their risky mortages, selling them and booking gains and keeping balance sheets clean. They also have some of their mortgage exposure insured, especially the most risky ones which allow downpayments of as low as 20%.

But when the housing slowdown turns for the worse, and it will, defaults will rise, mortgage insurance premium costs will rise, and no one will be stupid enough to buy those securitized mortgages from them anymore. We'll probably see them try to securitize and sell as many mortgages as possible, but eventually it will be too late to save the industry.

Short mortgage insurers (MTG, PMI, RDN) and mortgage lenders (CFC, LEND, NEW, AHM) on breakdown or any rallies.


Overshooting in China?

Some comments by GaveKal Research this time on the recently released China Q2 GDP figures. They believe that GDP wasn't actually as high as the headline numbers, based on their proxy indicators, like electricity production and import growth. They believe no more rate hikes and reserve requirement hikes will happen for the meantime. Of course, we just got word that reserve requirement ratios have been hiked for the 2nd time in 5 weeks. Anyways, it is still useful commentary as it might also have bearing on our expected revaluation in the Rmb, which supports majority of our bullish stance on HK-listed Chinese equities.


China's growth continues to power ahead; but there is little evidence of a blow-out. The much-advertised "real" growth rate - 11.3% in Q2, a full point higher than in Q1 - is only as real as the deflator used to calculate it. And the latest deflator is decidedly dodgy. The National Bureau of Statistics (NBS) would have us believe that the GDP deflator slowed from 3.5% in Q1 to 2.9% in Q2, even though every other price index showed an accelerating trend during that period. This is most implausible.

Nominal GDP figures suggest that while growth has clearly accelerated over the past nine months, the acceleration is more modest than suggested by the "real" numbers. This interpretation is supported by growth in electricity production (one of our favored proxies) which, though somewhat volatile, is on a moving-average basis, still hovering around its 2005 average of just under 13%. Import growth (a significant indicator of domestic demand) has also clearly peaked and is now trending downwards.

Even at their current exalted levels, both nominal GDP and fixed asset investment growth remain well below their stratospheric highs of 2003-04. We suspect that the trend of headline GDP growth will be a bit hard to read for the remainder of the year, in part because there has been a change at the top of NBS. The old commissioner, Li Deshui, who appeared allergic to reporting GDP growth in excess of 10%, was axed over Chinese New Year. His successor, Qiu Xiaohua, appears more comfortable with reporting high growth rates, so the high numbers reported today and in April may in part reflect an effort by the new regime to bring physical and statistical reality into closer alignment. Nevertheless, the dodgy deflator also suggests another, more depressing interpretation: apparent growth is being maximized now, to make it easier to report a slowdown in H2, thereby vindicating government policy... Having said that, the big picture is that growth is very strong and likely to remain so for another 12 months, underpinned by strong fixed-asset investment growth, a swelling trade surplus, and a very impressive surge in industrial production.

Investment, we think, is being pumped up by local officials anxious to make a good impression before the next round of promotions in the middle of next year, leading up to the big Communist Party Congress in the fall of 2007. This type of investment is likely to begin tailing off in Q1 next year.

On this logic of a likely structural downturn next year, the government will want to be careful about the risk of overshooting on monetary tightening this year. Hence we anticipate no further hikes in interest rates or bank reserve ratios until the impact on credit growth of the most recent reserve-ratio increase - which only took effect in early July - is clear. There was some evidence of deceleration in loan growth in June and if this continues in July and August then there will be little case for additional tightening.

Aside from loan growth, the other numbers that bear watching are price indices. These all steadily declined from mid-2004 highs down to a trough in late 2005. Since then they have all picked up again, with the exception of the manufactured GDP deflator. The swiftness with which the previous trend was reversed suggests that the economy is running at very close to full capacity. If the policy stance is correct, then price indices (which are calculated on a year-on-year basis and so will continue to bulge on a low-base effect) should continue to rise moderately until about November and then crest. If, however, the authorities have underestimated the strength of demand, then we could see a severe inflationary spike in early fall which could prompt another interest rate rise.

Cautious Views on Japan

Of all the markets in the world (outside of gold), we are probably most bullish on Japan. GaveKal Research, while positive on Japan, provides some insightful words of caution. There are specifically two points of caution: 1) Did Japan shoot its own recovery in the foot again? and 2) corporates might struggle because of higher labor costs. Read on.


Did "They" Do "It" Again?

With the "they" being the Japanese policy makers and the "it" shooting any recovery in the foot. Let us explain:

As we never get bored of pointing out, structural bear markets and deflationary busts only happen when policy makers commit one, or several, of what we call the "five cardinal sins". The five sins are: 1. Protectionism, 2. Tax Increases, 3. Increases in Regulation, 4. Monetary Policy Mistake, 5. A War.

The common thread behind these five policy mistakes is that, when committed, they reduce the returns on invested capital and consequently, asset prices are pushed lower. And this puts the financial sector in trouble, etc...

Now why do we return to this long-held, and long-exposed, belief? It is not because of the failure of the Doha trade round (though that is a worry in itself). Instead, we return to the cardinal sins because they have proven to be a solid roadmap when navigating the treacherous Japanese financial markets.

Indeed, looking back at the past fifteen years, it often felt as if Japanese policy makers, if given half a chance, did their best to commit any, or all, of the above mistakes and shoot any recovery down. For example, in 1996, Japan raised taxes. In 2001, the BoJ allowed the growth rate of the Japanese monetary base to move into negative territory while the world was already experiencing a recession.

Which brings us to today and the recent announcement by a panel of LDP lawmakers of a plan to cut the maximum legal interest rates Japanese consumer finance and credit card companies are allowed to charge their customers from the current 29.2% to around 20%. This increase in regulation (which has taken the consumer finance companies completely by surprise), would likely cut off at least 9 million borrowers (out of the current 20 million) because the lower rates would make it unprofitable for consumer finance companies to take on the risk of the loans. A study by Waseda University cites that a restriction of the maximum interest rate to 23% would likely knock off 0.36% points of GDP. Needless to say, a restriction to 20% would make the economic hit even more dour.

Beyond the possible hit, there is also the threat that increases in regulation will help push more of the consumer lending underground, towards loan-sharks and Yakuza, and that the weakest consumers end up paying even more extortionate interest rates for the money they want. In other words, the LDP's good intentions could very well come to naught!

In any event, the threat of new regulations on the consumer finance industry, and thus on consumption is very real (the stocks have definitely taken it seriously). This is something that bears watching.

Labor & Profits in Japan

The recent weakness in Japanese equities (the Topix is down -10.3% so far this year) indicates that the appetite for Japanese assets is definitely falling. This is a marked change compared to the end of last year, when Japan was everyone's favorite market.

Over the past six months, we have suggested a number of possible explanations for this weakness, including the change in monetary policy (see The Importance of Japanese Liquidity Flows), the fact that Japanese companies could once again be placing market share over profitability (see Japan's Capital Spending Boom), the likely slowdown in global growth (our latest Quarterly) and even the possibility that Japan's policy makers are back to doing what they do best: nipping in the bud any recovery (see previous page). But there is yet another possible explanation for the weakness in Japanese equities: the fact that corporate profits are set to struggle because of rising labor costs.

In our past decade of following Japan, we have seen many age-old relationships break down spectacularly. One relationship that nonetheless remained solid was the one between Japanese corporate profits and Japanese over-time worked. And for a simple reason: A company facing a slowdown in sales (whether because of deflation or weak economic growth) can usually either: a) take the hit on its profit margins or b) maintain its margins and reduce its costs (i.e.: layoff some of its work-force and cut capital spending).

When Japan experienced its deflationary bust, laying off workers was simply not an option (because of institutional rigidities). Companies that faced a slowdown in sales could thus either cut capital spending (hereby jettisoning future competitiveness) or take the hit on profit margins. More often than not, the second option was chosen. Equity markets tanked and productivity sank. In turn, this meant that when the economy picked up, companies rarely hired new employees in the economic upswing (they already had all the employees from the previous cycle that they had not fired). And if demand accelerated further, companies would typically prefer to ask their workers to work overtime rather than increase payrolls (having just gone through the negative experience of excess payrolls). Thus, when we would see overtime accelerate, we could feel fairly confident that:

a) Demand in Japan was accelerating and
b) Corporate profits would pick up.

But in the past few quarters, this relationship has completely broken down. Overtime work has been re-accelerating (red line, RHS) while corporate profit growth is stuck in the low single digits and still decelerating. So why this breakdown?

The explanation might be found in Japan's increasingly tight labor market. Indeed, in the past two years, the unemployment rate in Japan has fallen from 5% to 4%. Now granted, this 4% unemployment rate seems high compared to the levels prevalent in the 1970s, 1980s or even early 1990s. But, since then, the Japanese economy has evolved from one where industry was the main driving force of growth to one where services are increasingly the new job creators. And in an economy driven by services, the minimal unemployment rate might be somewhat higher than in an economy driven by industry.

With that in mind, the Japanese labor market might be tighter than it would appear at first glance (a possibility which would help explain the BoJ's tightening). The recent rise in Japanese wages (wages had been declining for four years), also points to an increasingly tighter labor market. With a tight labor market, companies might be asking employees to work overtime not because they want to... but because they have no choice if they want to keep up with demand. Will this be good news for corporate profits? Over the long term, it should. But in the short term, disappointments might be around the corner.

What Investors Should Know About China

Sticking with the China theme on this blog, I'm posting a very interesting note from Stephen Roach. No gloom or boom scenarios, just an observation on the differences in application of economic policies between east and west. A very good to disclaimer to investing in China. Enjoy!


The more time I spend in China, the more I am struck by its inherent contradictions. I have made three visits to China in the past 12 weeks alone — breaking my own personal record. Over this period, I have spent considerable time in discussions with the Chinese leadership and its top policy officials. I have visited companies — small and large, alike. I have had a glimpse of the future, spending a weekend in Tianjin — the heart of the Binhai New Area, which could well be China’s next mega development zone. I have also traveled to the remote reaches of Hainan Island. I gave two lectures at leading Chinese universities, with ample opportunity to engage and debate a broad cross-section of students — by far, the nation’s greatest asset. I even dabbled in a now thriving contemporary Chinese art market. As I sit back and try to pull it altogether, I realize I am asking the impossible. Rich in contrasts and replete with contradictions, China defies generalization.

China's contradictions: micro vs. macro

Yet we in the West are biased toward looking at China through a very macro lens — focusing on its daunting scale and what that means for us. Ironically, that misses the basic tension that defines Chinese reform and development — a tug-of-war between the micro and the macro. Beijing is the center, the personification of the control mechanism that drives China’s macro story. Western impressions of China are formed by pilgrimages of the masses to the power centers of Beijing. These days, I often run into more of my friends in the restaurants and government agencies of Beijing than I do in New York. It is the Mecca of the China story — but it is not China. The real China exists at the provincial and local level — far removed from the Beijing-centric power network. Even after 27 years of extraordinary reforms, the real China remains very much a micro story — oftentimes at odds with the macro story that drives Western perceptions. This is one of those times.

China’s image suffers from the “1.3 billion syndrome” — the daunting math of economic development for 20% of the world’s population. As the scale of a rapidly growing Chinese economy — now the world’s fourth largest — hits a critical mass, suddenly the arithmetic takes on new meaning. The implications are all too familiar. If China stays its present course, by 2015, the size of its economy should surpass that of Japan. By the year 2030, it will pass Europe. But the real story is China’s “delta.” If the Chinese economy maintains a 12% dollar-based growth trajectory over the next 30 years, while the rich countries of the industrial world hold to 5-6% paths, then by 2035 China’s annual dollar-based growth delta will be larger than that of the US and Europe, combined (see my 13 January 2006 essay, “The Global Delta”). There’s not a multinational corporation in the world that hasn’t run numbers like this. Nor is there a politician in the developed world who hasn’t had to face the concerns of workers and voters that stem from the implications of these calculations.

China's contradictions: economic control vs. marketisation

The problem with this perspective is that it portrays China as a monolithic force, driven by the presumption of a relatively seamless transition from a centrally-planned economy to a market-based system. In my view, that is the most important contradiction of the new China. While economic control was close to absolute under the old model of the state-owned economy, that is not the case today under the increasingly marketized system. Power has been diffused away from the center, making macro control from Beijing exceedingly difficult. There’s nothing new, of course, about provincial, city, and village power bases in China. There are over 5000 years of history behind the fragmentation of governance in the Middle Kingdom. But what is new is the juxtaposition between China’s persistent fragmentation and its increasingly market-based system — a dissonance that adds considerable complexity to our understanding of recent and prospective trends in the Chinese economy.

The most visible manifestation of this fragmentation shows up in China’s runaway investment boom and the inability of the government to do much about it. The macro numbers speak for themselves. Fixed asset investment hit 45% of Chinese GDP in 2005 and should exceed the 50% threshold in 2006. There can be no denying the pro-investment requirements of Chinese economic development — namely, urbanization, industrialization, and infrastructure. But China has broken the mold in tilting its growth model toward the supply side of the macro equation. Even in their heydays, investment ratios in Japan and Korea never got much about 40%. For the second time in two years, Beijing has imposed a series of tightening measures on China’s overheated investment sector. Like the “cooling off” of 2004, three sets of actions have been taken — a modest 27 bp increase in lending rates, a 50 bp point increase in the bank reserve ratio, and a series of administrative controls targeted at China’s hottest industries. However, if these measures didn’t work a couple of years ago, I doubt they will today when dollar-based nominal GDP is 35% larger and fixed asset investment flows are over 60% greater than they were in 2004 (see my 19 June dispatch, “Scale and the Chinese Policy Challenge”).

China's contradictions: local vs. central control

This is where Chinese macro policy makers could quickly find themselves in a serious bind. Investment activity is driven very much at the local level, funded by a still highly-fragmented Chinese banking system. Fixated on social stability and job creation, local communist party officials through their influence on local bank branches often have more to say about investment project approval than company management teams or credit officers in head offices in Beijing. The impact of local banks also dwarfs the role of regulators and central bankers. The implications of this “fragmentation effect” are not lost on China’s senior policy officials. It undermines policy traction at the macro level and raises the risk of a boom-bust response of the investment sector if Chinese officials were to go too far in their tightening efforts. The relatively modest moves in the current tightening cycle reflect just such a concern, in my view. Yet the risk is that the current tightening campaign may have to go considerably further.

What I find particularly interesting is that Chinese municipalities are now taking it on themselves to issue regulations to cool off their overheated property markets; Shenzhen has taken the lead in that regard, with a 22 June announcement of ten tightening actions coming some three weeks after Beijing’s so-called administrative edicts. According to press accounts, while there was little response to the national edict, the Shenzhen residential property market has come to a virtual standstill in response to the local actions. This is an important real-time example of the tension between relatively impotent national tightening measures and the traction achieved through local actions.

In my recent meetings with a broad cross section of Chinese banks and companies, the tension between local and central control was a recurring theme. This was true not only in matters of project finance but also in the increasingly important issue of environmental policies. Motives are very different in both cases. For local officials, concerns over job creation, income support, and social stability are paramount. In conversations with local businessmen and bankers, I got the distinct impression that they viewed their mandates and objectives independently of what was going on elsewhere in China.

That was especially the case in Tianjin, whose Mayor, Dai Xiang Long, the former governor of China’s central bank, certainly knows a great deal about macro policy concerns. Now charged with running this hyper-growth area about 175 km east of Beijing, Mayor Dai suddenly sees local growth imperatives in a very different light. He characterized the Beijing view — especially the last shift toward tightening — as being very much at odds with pro-growth local objectives. But at this point in time, the bankers and businessmen I met with largely viewed the recent actions of the central government as more of an irritant rather than a major constraint. Mayor Dai, of course, wore two hats. Over dinner, he conceded that while sustainable growth for the overall Chinese economy was probably a number much closer to 7% than the current 10% pace, for Tianjin, he felt the pace was probably closer to 20%.

China's contradictions: need for resolution

The resolution of this contradiction is critical for the sustainability of Chinese economic development and reform. Fragmentation and concomitant disparities within the economy and its social structure remain salient features of the growth experience. China, as a whole, may average out to a 10% growth rate in any given year, but the dispersion across the nation is extraordinarily wide — with clusters of hyper-growth at close to 20% surrounded by rural areas where growth remains relatively stagnant.

Along with this dispersion in real economic activity comes an equally fragmented banking system, dominated by largely autonomous local branches. This seriously compromises the transmission of shifts in monetary policy to the real economy. If the central bank attempts to restrict bank lending by raising interest rates and reserve requirements — as is the case at present — under the best of circumstances, a fragmented banking system can be expected to respond very unevenly. In fact, it may well take more monetary tightening to accomplish a given policy objective in a fragmented banking system than would be the case if the system was tied more closely together. Banking reform is critical to resolving this dilemma. The public listing of state-owned banks should force a shift from locally-driven “policy loans” to commercially viable credit lines. Only then, can monetary policy levers be expected to have a meaningful impact on tempering the excesses of the investment cycle.

China still appears to be a long way away from a fully functioning macro system. As I crisscrossed this extraordinary country over the past 12 weeks, I was struck more than ever by the tension between the micro and the macro — the contrast between autonomous pockets of hyper-growth and the macro policy strategies of Beijing. This strong sense of fragmentation seriously complicates well-intended efforts of macro control. Until China can resolve this contradiction, effective policy management of its rapidly growing economy remains elusive and the risk of a boom-bust endgame cannot be ruled out.