What We Don't See - July 2005
John Mauldin's Outside the Box

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This week we will turn once again to a group headquartered in Hong Kong with offices in Stockholm and New York called GaveKal Research Limited. They did a long piece on What We See And What We Don't See and we have edited it down to the What We Don't See portion of the research. I really enjoy reading the guys from GaveKal, as they challenge my thinking.

(Incidentally, Louis Gave was in my office last week, coming down to watch a game [Those Yankees beat us again]. He is married to a delightful young lady from Oklahoma so comes to the area from time to time. I look forward to spending more time with him.)

They admit that it is not the obvious market observations that clients pay them to deliver, but the unobvious or what we don't see that really matters. They bring up some interesting and non mainstream views of the Euro, China and the US Dollar, which is why this was picked for Outside the Box.

- John Mauldin

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What We Don't See

Our favorite economist, Frederic Bastiat, used to say that economics was all about weighing "what one can see" against "what one can not see'. And while we realize we have used this quote repeatedly, we never get tired of it. Indeed, more than anything, it best summarizes what most investment professionals in their daily routine try to do; answer the question of "what do I know that the market does not?". We felt it might be interesting to review what we see, but we believe the market does not.

What The Market Does Not See: the Euro Carry-Trade

Every now and then, central banks fall asleep on the job and allow their currencies to achieve very overvalued levels. In turn, this slows down the underlying economy, a fact which then forces the central bank into cutting rates aggressively to counter-balance the tightening done by the FX markets. When such a turn of event occurs, financial market participants jump on it with both feet; all of a sudden, financiers are given an opportunity to borrow in a currency which a) goes down and b) whose borrowing costs keep falling. What we are describing above is not theoretical. In fact, it has happened twice in the past decade. And it is about to happen again. A fact with important investment consequences.

Between 1995 and 1998, a number of investors participated in the great "Yen carry trade". For three years, it was fantastic: whatever one bought with one's borrowed Yen, one made money. Until one did not; and then the unwinding of the Yen carry trade was both violent, and painful for those involved in it (Tiger, Sumitomo...). From 2001 to 2004, we experienced the great US$ carry trade. As we tried to show in a number of reports in the past couple of years a large number of people borrowed US$ on the premise that a) the US$ could only go down and b) borrowing US$ was nearly free (1% interest rates) and likely to stay that way for a very long time.

Needless to say, the US$ carry trade is no longer working. For a start, the US$ is no longer falling, and borrowing US$ is no longer free (the Fed just raised rates again). In turn, this raises an important question: will the unwinding of the US$ carry trade prove as painful as the unwinding of the Yen carry-trade?

As our readers know, we have argued in recent months that the unwinding of the US$ carry-trade could lead to some short-term dislocations in the financial markets. However, so far this year, the US$ on a trade-weighted basis has risen +11% in a straight line, and the impact on financial markets has been mild. So have our fears on the effects of the unwinding of the US$ carry-trade been excessive?

One explanation for the good tenure of markets in the face of the US$ rally is that most investors short the US$ (save the ones who got in the game late) are still positive on their short US$ trade. Meanwhile long-term bearishness on the US$ remains prevalent (i.e.: the belief in the "unsustainability of the US current account deficit), and so panic has not yet hit the market.

As the reality of the US$ bull market sets in, we will of course witness a change of behaviour in financial market participants. Will this change be a panic? Or will the change be a hunt for new opportunities? We use to believe it would be the former. We now believe it could be the latter. Indeed, all around the world, it is becoming increasingly obvious to investors that there is one currency which remains grotesquely overvalued, and whose interest rates can only go down: the Euro (though the AU$ also qualifies). So borrowing Euros to buy whatever else now makes a lot of sense. The US$ carry trade is in the process of being replaced by the Euro carry trade.

This means, of course, that we should expect European monetary aggregates to accelerate rapidly (as they have done). After all, if the whole world starts to borrow Euros, then there will be a lot more of them around!

The question then becomes: what will investors do with their borrowed Euros? So far, investors have been buying a lot of European government debt and a little b it of European equities. So what could trigger a change in this behavior?

Option #1: A real political crisis in Europe (i.e.: a threat by Italy to return to the Lira, or worse, by Germany to return to the DM) leads investors to shy away from EMU government bonds, or at least, to put a "risk premium" on EMU government bonds (European governments are the only governments in the OECD issuing debt in a currency that they can not print at will - a fact which should lead to some "risk premium").

Option #2: The ECB caves in and cuts interest rates aggressively. All of a sudden, European equities and real estate look far more attractive than EMU bonds.

Option #3: Returns on European assets start to lag returns on global assets because of the weak domestic growth environment. Investors then start to borrow Euros to buy assets elsewhere (i.e.: real estate in the US, Asian bonds...).

The bottom line on the Euro carry-trade: So far, the Euro carry trade has mostly benefited the European government bond market. To us, this seems unlikely to continue. And this for a simple reason: either European economic growth starts to accelerate, in which case borrowing Euros to buy European equities (especially exporters) makes sense and owning government bonds does not. Or European economic growth deteriorates, in which case questions will start to be raised on the ability of European government to meet their obligations; if of course, European governments don't decide to abandon the Euro experiment even before the market forces them to!

As we look at the situation in Europe, borrowing in Euros makes a lot of sense. Buying European equities with the borrowed Euros also makes sense (especially if one is bullish on European or global economic growth). But buying European bonds with the borrowed Euros is a risky bet on the belief that things in Europe will stay as "we see them". But can Europe stay on the edge of the abyss without either falling, or walking back?

What The Market Does Not See: Asia & US$ Leverage

We will never forget the summer of 1984. All over France and Britain, every street corner was mobbed by a hundred American tourists. Why were they there? Because one US$ was equal to one Pound, and ten French Francs! How did the US$ get to be so expensive? Because in the late 1970s and early 1980s, European banks lent US$ aggressively to borrowers in Latin America (Brazil, Mexico...), Africa (Nigeria, Zaire...) and the Middle East (Saudi Arabia, Iran, Iraq...). And the loans seemed safe enough. Weren't all these countries large commodity exporters, and, as such, steady US$ earners? And couldn't commodity prices go only way (up)? And couldn't the US$ only go another (down)? So how could lending US$ one did not have (since one was a European bank) to Brazil or Nigeria not make sense? The answer soon became clear. It would not make sense if a) commodity prices started falling (because of the excess capacity put in thanks to the new debt), b) commodity producing countries started to default and c) the US$ started to rise.

As all of the above started to happen, European banks were forced to write off the US$ loans they had made. This implied going into the market to buy back the US$ they themselves had borrowed to lend. In essence, European banks were "short-squeezed". And this US$ short-squeeze triggered the first major US consumption boom of the modern era (and coincidentally kicked off the first sirens on the frivolous US consumer, the unsustainable US trade deficit at The Economist, the Financial Times, etc...). Why are we re-hashing this? Because while History rarely repeats itself, it often rhymes. And in the past few years, we have witnessed a large increase in US$ borrowing through non US$ banks.

As our more faithful readers know, we have spent a lot of time in the past 18 months looking at the growth in the US current account deficit, the growth in Asian central bank reserves, etc... And all of our work has constantly drawn up the same conclusion: in the past couple of years, Asian central bank reserves have grown much more rapidly than domestic current account surpluses and foreign direct investments; in other words, Asian countries have managed to save more than they have earned. Last year, in China, the difference was some US$80bn... or nearly 6% of Chinese GDP.

This, of course, begs the question of where this money came from? The answer, we believe, is simple enough: the excess US$ that have shown up in central bank reserves represent borrowed US$; not earned US$. A quick example: in 2003, most of the simpletons who sit in the GaveKal HK office became convinced that the RMB was set to revalue. To cash in on this one time bonanza, a "get-rich quick" scheme was put together: the first step involved purchasing real estate on the Mainland (one of the few RMB denominated assets easy for foreigners to purchase). The second step involved securing mortgages (from HSBC, Bank of East Asia or ICBC) on the property denominated in US$. The end result was clear: a US$ liability attached to a RMB asset. Elementary my dear Watson...

So elementary in fact that, as the rumors of a RMB revaluation accelerated, everyone and their dog got in on the trade. And before we knew it, we faced a) a massive construction boom in every Chinese city (hereby depressing rental yields) and b) a growth in the PBoC's US$ reserves that had nothing to do with either trade or direct investment flows and everything to do with speculative leverage.

With an economic slowdown unfolding in China (more on that later), a revaluation becoming increasingly unlikely, a rising US$, rising US interest rates, and Chinese companies lining up to get money out of China (Haier-Maytag, TCL-Thomson, CNOOC-Unocal, Lenovo-IBM...), a number of participants (from Taiwan, HK, Singapore, Indonesia....) in the above real-estate/RMB trade might start to re-think whether the above trade is as onesided as it appeared two years ago.

If they (like us) conclude that it isn't, some will sell, turn their RMB to the PBoC and ask for the US$ back to re-pay the bank. Now obviously, the PBoC is swimming in a sea of US$. So it will have no problems meeting demands for US$. But as reserves start to sip out, Chinese money supply will shrink. Unless, of course, the PBoC allows the RMB to fall, which, given current political circumstances is highly unlikely.

The extent by which the Chinese money supply will shrink could well end up being dictated by the extent to which the PBoC has engaged in "reserve diversification". Indeed, if the PBoC has used the "borrowed US$" to buy Euros, AU$ or Yen, then as speculators come forth and ask for their US$ back, the PBoC will be in a bind. It will need to cash in the speculators demand, and sell Euros or Yen at the same time to make sure it maintains enough US$ to defend the RMB peg. The US$ will shoot up, and the currencies the PBoC diversified into will drop like rocks.

Needless to say, the operation of the PBoC are very opaque, and we have no idea the extent to which they have engaged in reserve diversification. But we know more or less what the Hong Kong Monetary Authority has been up to; our friend David Scott writes in a recent note: "the HKMA might have cut its US$ holdings to around 70% of total reserves. This is very bullish for the US$. The HKMA has a 100% US$ target for its currency. So now it faces: a) rising US interest rates relative to other currencies - so relative yields on its investment portfolio will be suffering. b) Rising HK rates relative to Euro rates (ie: the cost of its liabilities will be rising relative to the yield on its assets. c) A partial currency mismatch.

So there is a lot more to the Asian reserve diversification story than initially meets the eye. Six months ago, everyone was jumping up and down at the thought that Asian central banks would soon be diversifying their "hard-earned" US$ into other currencies (specifically the Euro). At the time, this was often cited as a "no-brainer" reason to sell the US$ and buy the Euro; you wanted to get in before the large Asian central banks. Six months later, no one is peddling that story any longer, and as we tried to show at the time for a number of good reasons, including:


1- The US$ were never "hard-earned" in the first place but were borrowed instead. With the low cost of borrowing in US$, and a confidence that local exchange rates could only go one way, Asia returned to the state of mind prevalent before the Asian crisis, when borrowing US$ made sense. In 1995-96, the US$ borrowing financed excessive consumption. In 2003-04, the US$ borrowing financed excess capital spending (especially in China).

2- The Asian Central Banks had already diversified their reserves. All across Asia, in the second half of 2004, we witnessed a game of "pass the hot potato", and which also helped explain the big increase in reserves, especially in Japanese reserves. So, in other words, the "reserve diversification" story was akin to closing the stable door once the horse had fled.

3- The Asian Central Banks' reserves are no longer growing. While Asian central bank reserves were growing by US$375bn per year this time last year, the growth is now of a meagre US$70bn, i.e.: levels not seen since the 2001 TMT bust, and, prior to that, the levels of the Asian Crisis.

Chart 1

Whatever the causes of the lack of Asian central bank reserve growth, the fact in itself has important investment consequences. Including:
  • Limited potential for Asian currencies to revalue in the coming year
  • Headwinds for Asian equity markets (less reserve growth usually means less domestic money supply growth in Asia)
  • Strong tailwinds for the US$
In our minds, the main question now is whether the "reserve diversification" done by the Asian central banks in 2004 will be unwound in 2005 or 2006 when the borrowed US$ need to be repaid. If so, the Euro, AU$, Yen, etc... have not finished falling!

Given the above, it is not a stretch to think that the unwinding of the US$ carry trade will affect Asia disproportionately; especially countries with pegged currencies (HK, Malaysia, China) which will be unable to cope with the unwinding of the US carry-trade through local currency depreciation. Countries, like Japan and Thailand, which can allow their currencies to fall (the Yen is down -9.3% and the Baht -7.7% so far this year) without incurring the wrath of the Bush administration (Thailand and Japan are both contributors in Iraq - and President Bush is a very loyal man), will, meanwhile, be able to allow for a growth of domestic monetary aggregates (should they so wish).

What The Market Does Not See: China Deflation

Returning to last Friday's Financial Times, it seems that the market is very preoccupied by the possibility of a RMB revaluation. And going around the US in recent weeks, the first question we often fielded when sitting down was: "when will China revalue?". To which we typically answered in two ways.

First Answer: Put yourself in the shoes of a Chinese policy maker. This is the situation you are facing today: Chinese equity markets are the world's worst performer and are touching 8 year lows.
  • Chinese bond markets are the world's best (Chinese 10 year yields have moved from 5.25% to 3.6% in the past twelve weeks),
  • Industrial production is rolling over (weak oil consumption, weak iron ore imports, weak Baltic, weak steel prices, weaker industrial production numbers...).
  • Real estate activity is rolling over (our friend Simon Hunt reports that an "indicator of the real slowdown in real estate is that a major supplier of chiller tubes (chiller units are the central air conditioning units for all apartment and office blocks, hotels, etc.) reports a 25% fall in 2nd quarter orders with no visibility for the 2nd half of the year. After talking with his customers, he was told that other suppliers are faring even worse...").
  • Inflation has fallen from +5.3% to 1.8% in ten months
  • M1 growth has fallen from +20% to +11% in the past year...
So nothing in China's economic data, or market performance points to the need for a RMB revaluation.

Second Answer: What purpose will a revaluation serve (apart from making you look like you are kowtowing to the Americans?) and why should western investors care? Indeed, the only economic impact of a hypothetical revaluation will be a further contraction in the (nonexistent) profit margins of Chinese companies.

Indeed, a revaluation, even a large one, would have no impact on the US current account deficit. Why? Because given the state of excess capacity in China in almost all industries, the costs of a RMB revaluation would simply be passed on to the margin of Chinese companies and not onto the US consumer. In other words, if China revalued tomorrow by 20%, Wal-Mart would tell its widget manufacturer in Guangzhou: "last week you were producing this for US$1. This week, you will continue to do the same... Or I move my production to some guy in Shanghai/Saigon/Jakarta, etc...)."

So the inflationary pressures, and the consequent meltdown in the US Treasury market, that consensus currently foresee as a direct consequence of the "inevitable revaluation" of the RMB are unlikely to happen. Worse yet, instead of exporting inflation through a RMB revaluation and higher commodity prices (as the market currently expects), China in the coming year is likely to export deflationary pressures.

On this last point, we have written so much about the coming slowdown in Chinese capital spending and the overcapacity prevalent in most industries that we feel a little reluctant of returning to the subject. So instead, we will illustrate our point through an example.

In China today, one can reportedly find over 3,000 ball-bearing manufacturers (or over 300 car manufacturers, etc...). Unfortunately, the Chinese market is probably big enough for 10 ball-bearing manufacturers. This means that 3000 ballbearing CEOs wake up every morning and wonder: "how do I get to be one of the 10?". And the answer to that question is simple enough: one gets to survive not by being the most profitable, or the most advanced technologically, or not even by being the best politically connected (though that helps). One gets to survive by being the biggest; by employing so many people that, when the down phase of the cycle occurs, the government can not afford to fire hundreds of thousands of workers. One becomes "too big to fail".

This of course means that, when capital is offered up, all three thousand ball bearing manufacturers (following their "too big to fail" business models) will grab it and spend it with both hands. Competing with each other for a) raw materials, b) labor, c) allocations on the overstretched power and transportation grids.

Unfortunately, as labor, raw material and transport costs rise, margins start to come under pressure. Especially since, given the increase in capacity, producers are incapable of passing on price increases. And given that 75% of Chinese investments are financed by retained earnings, all of a sudden, the ability to finance capital spending plans evaporates.

Unless, of course, one can get money from somewhere else. Which is where the story starts to get interesting. Indeed, in previous bust cycles, Chinese manufacturers would end up with excess capacity that no-one would buy from them at any prices (to use a technical term, the goods produced were "crap").

But this is not the situation today. After the recent Chinese capital spending boom, most Chinese manufacturers now produce goods that are competitive on the international market not only on price, but also on quality. This is a very important change whose ramifications should become obvious in the coming year: China will work through the past two years of excess capital spending by exporting aggressively. Chinese goods will attempt to gain market share by undercutting any other producer out there.

So in the coming year, US import prices will collapse. And Chinese exports will explode higher, especially in volume. The US trade deficit will widen. And the US$ will rise. Why? Because all of the profits in the trade will end up being captured on the American side of the Pacific (by US retailers, consumers, etc...).

What We Don't See: the Response to China Deflation

If, as we anticipate, Chinese capital spending slows down and a flood of cheap Chinese-made goods enter the world market (for everything from flat-screen TVs, to cars, to oil paintings...), then it is likely that the biggest winner will be the Western consumer. All of a sudden, he will be able to buy a lot more from China than he was able to just a few months before. This is especially true if, as we anticipate, commodity prices weaken in the face of the Chinese capital spending slowdown.

Unfortunately, the Western consumer's gain will also be the Western industrials loss. At the high end, Western "heavy industry" will have to deal with the fact that Chinese demand is decelerating, and at the low end, Western industry will have to deal with ever-more aggressively priced Chinese goods. In such a deflationary world, only the most efficient producers survive; i.e.: those who can still record increases in sales, not through rising prices, but through rapidly expanding volumes.

The world that we describe is not so different from the world of the post 1998 Asian Crisis. Indeed, we find a lot of the same forces at work, including:
  • A strong US$ against both Asian and European currencies
  • Weaker commodity prices (as Chinese demand slows)
  • Asian countries, (this time it is China, in 1998 it was Japan, Korea, Malaysia...) which attempt to export their way out of recent excesses
  • A growing US trade deficit (at least, ex autos)
  • Accelerating global deflationary pressures
  • A belief prevalent in the market that the US economy is about to implode
  • Low interest rates
And in the post 1998 world, only the most efficient producers thrived. We see no reason why it should be different this time. Which then leads us to the following question: how does a Western company ensure that it is efficient, and/or that it's sales increases? Here, the answers are obvious enough. It does this by:
  1. increasing capital spending, notably in technology and
  2. increasing advertising spending (to boost sales).
At least, this is what happened after 1998. Could the same thing happen again?

Like Jesuits, we will answer this question with another: will Western companies just sit around and accept the loss of market share, or will they try to fight it? And if so, do they have enough ammunition for the fight?

On the first question, we believe that it is unlikely that Western companies will accept the loss of market share without a fight. On the second question, companies definitely have the ammunition: Western companies everywhere have been publishing record earnings, are sitting on massive amounts of cash and very healthy balance sheets. Moreover, their ability to borrow, whether from banks or the markets, has been left untapped in recent years...

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And this is about to change. In the coming year, the deflationary pressures emanating from China will be met by a tech and advertising spending boom all across the OECD. Western companies will not try to beat Chinese and Asian producers on prices. They will beat them by being more efficient, through better branding, and through the offering of new, and exciting, products.

But at the end of the day, the real winner will be the OECD consumer.


I hope you enjoyed this weeks Outside the Box. You can find out more about GaveKal and their research by going to www.GaveKal.com.

Your thinking about the implications of China analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


Communications from InvestorsInsight are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors and other contributors do not necessarily reflect the opinions of InvestorsInsight, and should not be construed as an endorsement by InvestorsInsight, either expressed or implied. InvestorsInsight is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not indicative of future results.

Posted 07-25-2005 2:21 AM by John Mauldin