Sunday, April 26, 2015

2015-03 Relative Price Trends

Consumer prices increased 1.40% year-over-year in March, whereas purchasing prices fell 5.70% over the same period.  Based on this metric, China is in its 40th month of economic contraction.
The consensus seems to be that the market is misbehaving and can only be brought back under control by the central bank.  Alternatively, the central bank is misbehaving and can only be brought back under control by the market.  Deflation is not bad, it is simply a process to correct mistakes made in the past.  A Reuters article touched upon this issue, but missed the point.
Policymakers have publicly expressed worry that the risk of deflation is rising for the world’s second-largest economy, as the drag from a property market downturn and widespread factory overcapacity is compounded by an uncertain global outlook and soft commodity prices.
No mention is made of the factors that caused an overheated property market and excessive investment in factory capacity leading up to this moment.  There is some hope for financial journalism, because at least some positive aspects of deflation were mentioned.
[W]hile lower commodity prices have punished the extraction and power production sectors, the pain is not felt across the board, as some companies have taken advantage of lower input costs to maintain profit margins.
Unfortunately, influencers within the financial industry are either unaware of or reject the theory that money is not neutral.  Two representatives of Australia and New Zealand Banking Group made this ridiculous comment:  "[O]nly permanent liquidity injection will be able to sustain the current favorable monetary conditions to head off the risk of deflation."

Sunday, April 19, 2015

2015-03 Stock Market Valuation

The Shenzhen Composite ended March at 0.26 gold ounces, up 0.05 ounces from February and up 102% from March of last year.  The index was trading at an average price-to-earnings ratio of 45.30.

March’s close, 0.26 gold ounces, was the highest price paid since September 2007.  The previous stock market bubble peaked out in August 2007.  There has now been 27 months of year-over-year positive price increases, the longest length of time for the data available.

The month-over-month increase in the gold price of the Shenzhen Composite was 23.13%, but the price to earnings ratio only increased 15.41%, meaning the impressive appreciation in stock prices was at least somewhat driven by earnings growth.  However, the last two times the stock market has hit these levels, a bull market that cut the value of the index by at least two-thirds soon followed.

Wednesday, April 15, 2015

2015-03 Book Review

Book Review: Economic Change in China, c. 1800-1950, by Philip Richardson.

How Europe, as opposed to China, came to dominate modern history is a debate that will not be settled any time soon. Professor Richardson’s book attempts to view this debate from the perspective of economic change.

In a story on economic growth, development, and change, the entrepreneur is the main character. Professor Richardson acknowledges that modern industry requires entrepreneurship to make headway (p. 62). The only other times entrepreneurs are mentioned, though, is to say that the government did not “create the context within which private entrepreneurs were able to respond effectively” (p. 84) and that “industrial modernization was considered too important to be left to private entrepreneurs” (p. 88). It is like Hamlet with scant reference to the prince.

Without a firm grasp on the causes of economic change, Professor Richardson can only tell the story of what happened, but not why it happened. These are two very different stories. The descriptions of economic trends in the book either lack vigorous analysis or contradict each other. One example of this is the typical inflationist viewpoint that falling prices are dreadful. The author cites other work showing that prices fell 40% between 1820 and 1850 (p. 22-23), drawing the conclusion that this was mostly the result of silver outflows due to trade. The author mentions the massive issue of paper currency (p. 19) and overstocking of ‘ever normal’ granaries (p. 22) before that period, but does not directly correlate these issues as possibly being the reason prices rose to an unsustainable level before 1820. This shows the author’s lack of understanding of money’s impact on the economy.

When foreign trade is mentioned, it is either considered favorable or unfavorable. All trade is favorable, the only defining feature of trade is whether it is free or unfree. Despite considerable discussion of interprovincial trade in agricultural goods, the author never draws the conclusion that trade between two provinces (i.e. domestic trade across internal borders) could be favorable or unfavorable.

None of the book’s citations are primary sources. Nor are there any citations of works in Chinese. Although Chinese scholars are cited, all of their works were written and published in English. Would a text written about early American development be taken seriously if no English language citations were used?

The book is a second-rate analysis of second-hand materials. The main body of text is only about 100 pages long, so it could pass as an introduction to issues related to economic change in China if the author had a solid understanding of entrepreneurship, monetary policy, and trade. That is not the case. Pass over this book.

Sunday, April 12, 2015

2015-03 Relative Equity Trends

In March, the consumer goods sector and the materials sector continued their trends over the last few months.  The consumer goods sector continued to decline from a year ago, but the rate of decline over the last twelve months has slowed from -13.36% in February to -5.99% in March.  The materials sector continued to expand, and the rate of increase over the last twelve months has accelerated from 12.25% in February to 15.62% in March.  This indicator would indicate that the Chinese economy continues to be in a state of expansion that started in June 2014.

The end user prices for these goods contradict the movements in equities.  Raw materials and commodities prices have been declining over this period, whereas consumer goods prices have remained above negative territory.  However, equity returns for the companies that produce commodities have out performed equity returns of consumer goods sector companies.  This is most likely driven by the fact that new credit is flowing faster into the materials sector, which is further exacerbating the oversupply in raw materials.  The equity value of these companies is being driven higher as their investment in new assets further deteriorates their future cash flows, thus facilitating an even larger correction than would originally be required.

In the news:
  • [SCMP] “Aluminum Corp of China Ltd (Chalco), the leading producer of primary aluminium and raw material alumina in the country, posted its largest-ever loss in 2014 due to huge writedowns and weak metal prices as the Chinese economy slowed.”
  • [Platts] “With concentrate prices at current low levels, most of China’s molybdenum miners still in operations are incurring losses, an official from a major miner in China said on the sidelines of the 11th China Molybdenum Annual Conference that was held over March 27-29.”
  • [Reuters] “China’s largest listed gold producer Zijin Mining Group reported net profit growth for the first time in three years in 2014 but expects gold prices to hover at low levels due to the global economy slowdown.”
  • [Bangkok Post] “In Malaysia, Great Wall Motor Co Ltd (GWM), China’s biggest maker of sport utility vehicles (SUVs) and pickup trucks, has partnered with Go Automobile Manufacturing Sdn Bhd to invest 2 billion ringgit to assemble energy-efficient vehicles in Kedah state.”
  • [Bloomberg] “China Mengniu Dairy Co. surged to a seven-month high in Hong Kong trading after China’s second-largest dairy producer posted full-year profit that beat analyst estimates.”
  • [HKS] “China’s largest diaper maker Hengan International Group (1044) saw net profit rise 5.2 percent last year to HK$3.92 billion, thanks to a quick turnaround in the second half after a slip of 4.5 percent in the first.”

Sunday, April 5, 2015

2015-02 Interest Rate Trends

In February 2015, short-term, state-sector and long-term, private sector interest rates continued to converge.  The overnight Shanghai Interbank Offer Rate (Shibor) ended February at 3.44%.  That is a considerable increase from January’s rate of 2.81%.  The trailing average for February since the start of the index is 2.46%, meaning this year’s February is 98 basis points higher than average.

The Wenzhou Comprehensive Index ended February at 19.74%.  That is one basis point lower than the ending rate for January, and 31 basis points below the trailing February average, which stood at 20.05%.

At 3.41%, the Shibor overnight rate is higher than the yield on a 12 month term deposit, which stood at 3.00% at the end of February.  Both represent loans to the same financial institutions, so credit quality is the same.  In a normal interest rate environment, the short-term yield should be lower than the long-term yield, but this not a normal interest rate environment.

The highest-yielding maturity for Shibor loans in February was the one-month rate at 5.08%.  The prime lending rate was 5.60% in February, so the minimum spread was only 52 basis points.  The yield curve significantly flattened since the same time last year.

The Chinese state-sector is experiencing higher borrowing costs, a flattening yield curve, and compressed spreads.  This will most likely lead the central bank to inject more money into the capital markets to delay the cleansing effects of a market correction.  This will lead to further downward pressures on the renminbi against major foreign currencies, especially the U.S. dollar.

Wednesday, April 1, 2015

Critique: “China is getting ahead. Can the rest of the world keep up?”

Any time an industry in China is mentioned, the phrase “China is X years behind the U.S. in this industry, but it is rapidly catching up.” usually appears somewhere in the article.  Linda Bernardi, the Chief Information Officer at IBM, recently wrote an article that appeared in the Washington Post titled “China is getting ahead.  Can the rest of the world keep up?”  China seems to have only taken 15 years to create its own tech bubble, modeled after the one the developed world experienced at the turn of the millennium.

The praise for China’s tech industry and criticism of Silicon Valley seem to be contradictory.  The author’s main criticism of Silicon Valley can be summed up by the sentence:  “I worry that American entrepreneurs feel good based on how much they’ve raised rather than what they’re actually producing.

The key, though, is that the author is actually able to list the accomplishments of American entrepreneurs:  Google, Amazon, Apple, and Facebook.  These companies changed the world.  The Chinese companies listed in the article, such as Alibaba, have only managed to import existing technologies from the outside world and then put up barriers to foreign competition.

Ironically, the only accomplishments of the Chinese technology sector that the author is able to quantify are the amount of money these companies have raised and their valuations.  The author mentions the $167.6 billion IPO made by Alibaba in 2014, which made it “the biggest IPO in U.S. history as well as the world’s most valuable online retailer.”  On the domestic side, the author mentions “a handful of Chinese companies in multiple cities have raised more than $100 million in funding and are valued in billions.”  Should we feel good about these companies based on how much they have raised, or rather what they are actually producing?

The author lists the five ingredients for success that China possess.  One of them is: “A sense of hunger, enthusiasm and confidence[.]  This is the feeling we had in Silicon Valley maybe 10 or 15 years ago.”  Yes, that sense of hunger, enthusiasm, and confidence were driven by the tech bubble.  Congratulations on getting ahead, China.