Midland Asset Management

As a partially central-planned and partially market-based economy, China’s approach to acquiring non-Chinese assets is not understandable through a CNN headline.  Through various agencies (e.g. National Development and Reform Commission), Beijing has promoted a type of “going out” policy which encourages China’s companies to invest abroad.  Those investments have included natural resources, finance, technology, consumer brands and distribution channels.  The general areas of China’s private and state-owned companies’ acquisitions are: 1) natural resources, 2) prestige deals, 3) acquisitions of foreign firms whose brand or technology can assist Chinese companies’ domestic positions, 4) bargain hunting, and 5) desperation deals for Chinese companies needing growth/distribution channels abroad because of tight margins at home (source: Dragonomics).

The big state-owned companies use the first two approaches.  Private and/or entrepreneurial local state-owned companies use the last three approaches.  The private and entrepreneurial companies have their own narrow interests.  They have raised the flag of national interests only when it assists them individually and not on the direction of Beijing.  In 2009, state-owned companies were big purchasers of resource assets, driven by Beijing wanting to control the states needs for economic growth.  As commodity prices were low, this made sense.  Australian veterans believe resource assets sold to Chinese companies were overvalued.  Time will tell.

As China transitions into a mature, industrialized country, many acquisitions will be driven based on industrial policy (driven partly by the China investment Corp).  For example, since January 2009, Beijing has released plans for 11 industries to be consolidated to smooth-out economic growth and increase domestic demand.  Domestic companies will continue to acquire international assets to protect them or to provide more leverage during this consolidation phase (e.g. they will be the acquirer not the acquiree, such as Beijing Auto making bids for Opel and Saab). 

Bottom line:  In order to make a decision regarding the investment merits of China, investors should understand the internal and external investment strategies of Chinese companies and how they are spending shareholder capital.  Their success or failure depends, in part, on internal party politics.

Always Asking, Never Assuming™

Christopher Holtby

Somebody on Wall Street came up with the politically incorrect term, P.I.I.G.S., which stands for Portugal, Ireland, Italy, Greece and Spain.  This term refers to countries with high current account deficits-to-GDP and political mismanagement of their government’s balance sheet (yes, America should be included in this list as Exhibit A).  There is a key difference between a sovereign borrower, or one that borrow in its own currency from its own people (US, UK, Japan, etc.), and one that can’t (Euro zone, Baltics, etc.).  The European Central Bank controls the currency in which member countries borrow.  The Euro zone countries are much like a state in the US, where they do not control the currency in which they borrow.

Greece is currently experiencing a debt crisis (evidenced by widening CDS country spreads and increase in government yields).  The government has three options: 1) default, 2) reduce the deficit, or 3) become an indefinite recipient of transfer payments from Euro countries that have current account surpluses.  If Greece defaults, Portugal is next, and right after that Spain, which nobody can allow or afford.   If Greece reduces its deficit (following Ireland’s example), it is questionable whether the politicians can withstand the pressure.  If Greece accepts the indefinite transfer payments, it will become similar to southern Italy and the former East Germany.  Southern Italy has been the recipient, for over 50 years, of transfer payments from the north amounting to 7-8% of Italian GDP (source: GaveKal).  This transfer payment is a form of vendor financing similar to the China/US economic relationship (that is slowly being unwound).  Countries such as the Netherlands, Finland and Germany can afford the roughly $300 billion needed in transfer payments to Greece, as these countries have current account surpluses.  The Euro zone has gone from the impossible to probable, bypassing improbable, much like the US did with the Lehman and AIG failures in the fall of 2008.

Bottom line:  Not all sovereign debt is the same, as the source for funding the debt can be very different.  Vendor financing between governments can lead to strong GDP growth (China to US) or low GDP growth (Germany to Italy).  Allocations to European investments need to take into consideration the new paradigms that are forming.       

Always Asking, Never Assuming™

Christopher Holtby

The inflation debate is raging.  Local papers, the Wall Street Journal, etc. are all talking about it.  But, nobody is talking about deflation.  In the past few months, posts have been written about how the mechanics of the money multiplier, Fed reserves, and the Fed fund rate are involved in setting the stage for inflation and how the  various scenarios of inflation, deflation and stagflation will affect investment portfolios.    

Reading communiques from global central bankers will show that the focus is on deflation.  Roughly 100% of the global economic rebound in 2009 has come from government fiscal stimulus plans (China and America lead the list, whereas Australia, Canada and the Continent are more middle-of-the-road) – (thx GS).   Yesterday, it was reported that the US consumer credit level declined $92 billion over the last 6 months to levels not seen since 1975.  The National Federation of Independent Businesses has been reporting that inventory build-ups are non-existent, there has been no organic growth of wages, and capital expenditures are down 40% from last July (small businesses are the engine of US employment).  It is very difficult to tackle deflation with interest rates at basically zero, demand falling, unemployment still growing (albeit more slowly), large output/productivity gaps and with a debt/GDP ratio approaching 100%.  

At some point, the printing of “money” and providing of fiscal non-productive stimulus (e.g. cash-for-clunkers) will lead to the erosion of the US dollar and your savings.  To what level?  When?  How fast?  Nobody knows. 

Bottom line:  Policy makers and central bankers are worried about deflation.  Investors are worried about inflation.  Unhedged exposures in various currencies (through stock or bond investments), intermediate bond portfolios that naturally “roll-down” in maturity, and the use of unlevered trading strategies are various solutions sets that each investor can consider, and they must be considered against the maturity of their liabilities and the level of wealth uncertainty that they can accept.  Find the middle road and proceed with humility.  

Always Asking, Never Assuming™

Christopher Holtby

President Obama has similar characteristics to a former President of Mexico, in that he is a great campaigner and, so far, a lousy manager.  Two weeks ago, the Wall Street Journal reported “that Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique as frustration grows over the Obama Administration’s faltering plan to overhaul U.S. financial regulation.”  Our political process generally begins with the executive branch making proposals, then Congress voting on them, and finally, the President signing the legislation.  The agency heads, SEC, FDIC, OCC, etc. have been focusing their attention on the Congress, due to the current lack of White House leadership.   

There are proposals on over-the-counter derivatives, SIPC reserve funding, transparency, loan-loss reserves, and the like.   These appear to be staggering around like a Zombie bank -  not dead, but not alive.  Looking back into legislative history, the Sarbane-Oxley Act of 2002 existed the same way until the Enron event caused a mad dash to create law.  Today, what would that event be?  Any type of systemic failure due to the failure of a Treasury bond auction, a liquidity event for some entity currently believed to be solvent, and many, many others.   There are so many systemic trigger points that NOBODY can possibly calculate a reasonable statistical likelihood of when or which one will occur.

Historically, governments and banks are myopically focused on the present, making them bad risk managers (politicians need to get re-elected and banks need steady, upward earnings-per-share growth).  With the current list of stimulus packages focused on short-term, putting-lipstick-on-a-pig solutions versus long-term structural, hard-to-swallow fixes, the bubbles are being re-created.  For example, the gains this year in stocks and bonds have primarily been in “junk” assets (e.g. high yield bonds, small cap stocks), with some exceptions.

Bottom line:  “A confident investor is a stupid investor” – Alex Pollock.  This applies to me, you, and every investment manager (traditional and alternative) or advisor.  Focus on the maturity of your liabilities, know what you own backwards and forwards as best one can, assume the government will be late to fix structural problems, and at the very least, you will have your life jacket on, and hopefully be sitting on a life raft in the middle of the Atlantic.  

Always Asking, Never Assuming™

Christopher Holtby