Dangers Are Increasing

As our readers know, our baseline scenario for this year is fairly flat market, with increasing volatility and narrowing breadth. Although the economic improvement in U.S. is very weak, and equity prices have increased substantially driven on the wave of liquidity, which is unsustainable over the long term, we feel that downside is limited due to still fairly easy monetary conditions, raising profits, and the fact that Obama/Bernanke duo would easy monetary conditions further and/or enact another stimulus package if S&P 500 falls below 950. However, in the recent weeks, several factors are threatening our baseline scenario:

• Chinese economy is booming at unsustainably rapid pace and policy makers started withdrawing stimulus. New policy tightening measures are announced on almost weekly basis. While we see these pre-emptive measures as good for long-term growth, they pose threat for both equity and commodity prices.
• The Fed is scheduled to stop purchasing mortgage-backed securities at the end of March, while the U.S. housing is still extremely weak and inventory is at very high levels. Relapse in U.S. real estate prices is not out of the question.
• Euro area policy is overly restrictive for most European periphery countries. Greece is on verge of debt default, and both bailout and non-bailout scenarios could sow the seed of euro meltdown or at least significant weakening. A weaker euro essentially tightens monetary conditions in the U.S. and Japan.
• The Fed moved to hike the discount rate from 0.5% to 0.75%. The effects of the discount rate hike are basically non-existent as discount window borrowing is at a mere $14.9 billion (compared with the pre-crisis levels of $110 billion) and commercial banks are sitting on a $1 trillion cash hoard, however this might signal a change of policy and more tightening measures might follow sooner than we anticipated.
• Sentiment against big government spending has increased significantly, with Tea Party movement gaining more ground (although from very low levels), support for Obama’s policies waning, and Democrats loosing super-majority in the Senate. This could pose significant headwinds for any further stimulus packages.

Nonetheless, these sources of uncertainty will likely be resolved in the coming months, but until such time, investors should be alert and more nimble than usually.

Capitalism In North Korea
It recently came to our attention that Premier Kim Jong-il sacked his top monetary official, Pak Nam-gi for hyperinflation in food prices, caused by failed currency reform at end of last year. Marcus Noland, of Peterson Institute for International Economics, explains what happened:

In principle, currency reforms are not a bad thing. […] The North Korean case is significantly different from the conventional case in that the move was sprung on the populace without warning, and most critically, enormous limits were placed on the ability to convert cash holdings, in effect wiping out considerable household savings and the working capital of many private entrepreneurs. Citizens were instructed that they had one week to convert a limited amount of their old currency to the new currency at a rate of 100:1 (i.e., one new won would be worth 100 old won). The limit would not finance much more than a 50 kilo sack of rice at prevailing retail prices. 

The announcement set off panic buying as people rushed to dump soon-to-be-worthless currency, buying foreign exchange or any physical good that could preserve value. As the value of the North Korean won collapsed on the black market, the government issued further edicts banning the use of foreign currency, establishing official prices for goods, and limiting the hours of markets and products that could be legally traded. 

As social opposition to these moves began to manifest itself, the government was forced to backtrack, offering compensatory wage increases, sometimes paying workers at the old wage rates in the new currency, amounting to a 100-fold increase in money income. The result has been a literal disintegration of the market, as traders, intimidated by the changing rules of the game, withheld supply, reportedly forcing some citizens to resort to barter.

Food shortages, civil disobedience, protests and fighting in the streets intensified. As governments saw situation getting out of its hands, scapegoats were chosen, market regulations were lifted, use of foreign currency was once again allowed, Premier Kim Jong-il issued an unprecedented public apology, arrested money changers and illegal traders were freed, and jangmadangs (open-air markets) are once again returning to normal.

I’m in no way suggesting that North Korea is becoming next haven of free-market capitalism, as that might be years or decades away (readers should remember that attempts of freeing economy were already made in mid-1990s only to be reversed in 2004). I merely wish to highlight that no matter how many times governments around the world and through the history attempt to over-regulate and over-control the economy, starvation and bad living standards will always force the population to turn to black markets, both in currency and in goods. In fact, the existence of black markets in some sector of economy is the best indicator of unsustainable government regulations (gold during the Great Depression, alcohol during the Prohibition, various currencies through the history, and drugs at the present time).

While waiting for North Korea to open up, we encourage our readers to get some exposure to Vietnam, which recently started opening up and is now where China was a couple decades ago, and to stay alert for ways to invest in Sri Lanka, which recently won the civil war against Tamil Tigers. It is often most profitable to start investing in country immediately after a major civil war or after it starts opening up its economy – economies of Peru after winning against Shining Path and of China after opening up are great examples of this. Although the journey might be bumpy and there are bound to be problems, in the long run, the economies of such countries often offer great investment opportunities.

Investment Considerations
As we mentioned above, next few months will be critical. Current correction could still have some room to run, and it is too early to bottom-fish. While we would not recommend shorting the market or getting out of strategic positions yet, readers should still “sell the strength” rather than “buy the weakness”. We continue to like some countries and specific sectors that we mentioned in the past (i.e. U.S. refiners, Japan and Japanese banks, Thailand and its tourism-related shares, Canadian energy companies) and select commodities (primarily in precious metal and agriculture sectors), we would not add to these positions at this time or would at least scale in very slowly.

Transitioning From Liquidity To Growth

Commodity strategy for the rest of the 2010 will need to take into account that global economy is shifting from liquidity to growth phrase and from expectations to reality. In 2009, we had a broad rally in commodities due to oversold conditions, ample liquidity, and expectations of strong demand from China. However, none of these three conditions hold any more – the rally in 2009 removed oversold conditions (except perhaps in some softs), liquidity is slowly withdrawing or at least increasing more slowly, and strong demand from China has been fully priced in. On the other hand, we expect to start seeing strong growth in economic economy, especially in emerging markets, increased bearishness regarding non-commodity currencies, and continuation of industrialization in China, which are all bullish for commodities. These forces will not take effect immediately, and we wouldn’t be surprised to see consolidation and increased volatility in first half of the year, as we transition from liquidity driven rally to rally based on fundamentals. Breadth will almost certainly deteriorate, and picking the right commodity sectors will be critical. We favor precious metals over base metals, tactical plays in energy sector, and non-grain softs.

Base Metals
The LMEX Metals Index doubled last year due to ample liquidity, dollar weakness, rising global leading economic indicators and Chinese stockpiling. However, LME metal inventories are at a cyclical high and exports from Asia are just starting to recover. This suggests that a major chunk of economic recovery has already been discounted and base metals should lag precious metals.

It is important to note that at this stage of the cycle, growth-sensitive sectors such as base metals should take leadership from liquidity/defensive sectors such as precious metals which should start to underperform. But it seems that this time might be different, as base metals have anticipated the growth rebound, and both price and inventory levels increased dramatically during the liquidity stage in 2009.

From absolute return point of view, we are neutral on base metals in the first half of the year. While net speculative positions as share of open interest have almost reached complacent levels last seen in 2008, the bullish sentiment and the level of open interest are still far below the 2008 highs. The biggest risk is Chinese tightening, which could cause hard landing for Chinese economy and base metals. However, Chinese policy shift is occurring at a time when price inflation is tame and when exports are expected to surge. It is more likely that Chinese policy tightening will cause problems in real estate sector in eastern provinces, but will not cause a hard landing for the overall economy. In the second half of the year, strong growth, relatively generous monetary policy, and secular bull market in metals should push base metals higher.

Copper, lead, and mining stocks remain our favorite plays in this sector, but there might be a better entry point in next few months. We are long-term bullish on Zinc and aluminum, but they are extremely energy-sensitive (energy accounts for 43% of zinc production cost and 41% of aluminum production cost) and their price might be “pegged” to coal until bullish secular trends start taking over.

Precious Metals
Low interest rates, escalating problems with government debt around the world, availability of gold ETFs, and emerging market jewelry demand, and tight supply continue to provide tailwinds to gold on strategic horizon. Desire of Asian central banks to diversify out of the dollar (central banks have turned to net buyers for the first time since mid-1970s) also provide support to gold prices. On shorter time horizon, interest rate expectations and raising dollar due to trouble in Europe could keep gold in $1000-1050/ounce range. However, the Fed will not start withdrawing liquidity in next couple of years, and we expect gold to continue its uptrend within next couple months.

Strategic positions should be held, but we have liquidated high-beta plays such as gold miner shares in mid December and re-entry into these positions might be premature. Net speculative long positions relative to open interest have fallen below their highs, but not yet to a level which would eliminate “stale longs” and coincide with intermediate-term bottom. We would also like to note that gold has fallen below its support of $1075 in first week of February, which should have triggered a lot of sell stops; however, it immediately bounced back which might indicate that “smart money” is buying and might indicate that intermediate-term bottom has been reached. This bullish reversal poses a threat to our base scenario (of continuation of correction) and it might be prudent to start slowly scaling back into high-beta plays.

Energy
In the long term, oil and energy prices (except perhaps natural gas) are certain to increase significantly, due to extremely easy monetary policies and declining oil production. However, in the intermediate term, we have very little conviction on the direction of energy prices and prefer to stay on the side in this sector.

We do however, still like being long distillate cracks through refinery stocks. We expect to see increased U.S. import volumes, which will in turn increase trucking activity. In fact, the Trucking Tonnage Index is already firmly off its 2009 bottom (this is the key indicator of distillate fuel use).

Softs
Prices of all agriculture commodities have become extremely depressed in beginning of 2009, and they have underperformed other commodities since. We are especially bullish on non-grain softs (coffee, cotton, livestock, and sugar) where fundamentals are extremely strong:

• Cotton stock-to-use ratio will be at 15-year low by July 2010; in addition, we are seeing strong demand recovery from China, India, and Pakistan (which account for approximately 70% of world cotton consumption)
• After two consecutive years of crop disappointment in India and problems with crop in Brazil, sugar stock-to-use ratio is at 50-year low. We are also seeing raising demand from other consuming countries which might push sugar significantly higher. The main question remains whether we will have enough sugar to get to the next season or not. While we are holding our strategic positions in sugar, we believe that risk/reward of adding to positions at current levels is not high enough.
• Coffee stock-to-use ratio will fall to the lowest level or record in the next few months. At the same time, Great Recession has limited impact to coffee demand, due to strong consumption growth in emerging markets.
• Calf production this year will be the smallest since 1994 and cattle inventories will be the smallest since 1975. In addition, we should be seeing increased demand due to economic recovery.

Unlike fundamentals for coffee, cotton, livestock and sugar, fundamentals for grains are relatively bearish. Inventory levels are ample, and supply in 2010 will increase. On the other hand, grain prices remain extremely depressed by historic standards and any unexpected weather or increased demand from livestock producers (due to increased demand from expanding middle-class in emerging markets) could push them up significantly. Overall, we are slightly bullish, but would keep our sell stops extremely tight.

China Real Estate – What Bubble?

Inflows of foreign capital, low interest rates and a loose monetary policy have undeniably fueled the breathtaking real estate price increases in China over the last several months, however, as we argued in the past “while prices might be frothy in some Tier 1 cities, there is no systemic risk”. Nonetheless, concerns about the “bubble” in China's real-estate have continued increasing so we feel it is necessary to explain our thinking in more detail.

A “Bubble” That Everyone Knows Of
An asset bubble is an asset price that is supported by expectations of further price inflation and is not justified by fundamentals. A bubble usually forms due to a shift in the fundamentals which causes overconfidence to grow to extreme levels. During formation stage of the bubble, bearish voices are rare, and are overwhelmed by broad sense of euphoria. Explanations of tectonic shift in the fundamentals which have caused the asset price to reach a “permanently high plateau” start to emerge and full-fledged mania is created.

In the case of the Chinese real estate “bubble”, despite a significant price increase, there has been no sense of euphoria within investor, analyst, or policymaker community. Number of articles about the real estate bubble in China started to increase in the 2007 (from under 50 articles) and reached close to 150 articles in the 2009. Chinese authorities have a long standing policy of pre-empting price excesses in the real estate sector and various restrictive policies have been adopted in previous few years. There is a strong sense of price manipulation by developers and of unsustainably high prices within the investor community and in the household sector (however, although the desire of households to buy homes has been steadily decreasing since the 2004, the number of transactions has been steadily increasing, which might signal that structural forces have created demand inelasticity; more on this below). In other words, manic forces and herd mentality, which are critical elements leading to asset bubbles, are not present in the the Chinese real estate market.

A “Bubble” Without Lending Frenzy
Another important feature of asset bubbles is that they are typically accompanied with lending frenzies. As investors experience price appreciation, they typically lever up to increase returns and thus further massively inflate the bubble. As the mania eventually turns into a panic, deleveraging forces the speculators to liquidate which causes a total collapse in prices. Savings-driven bubbles are also possible, however, a collapse of savings driven bubble poses only minimal systemic risk as the price downside is much less dramatic, the increase in NPLs is not large, and the lack of deleveraging means that other asset classes are not significantly affected.

In the case of the Chinese real estate market, debt’s role is much less significant. Banks’ exposure to property developers stands at only 6% of the total outstanding bank lending and exposure to both developers and mortgage borrowers combined is currently at only 17% (compare that to 56% in the USA). Policymakers’ long-term worries of real estate excesses have made them impose very stringent rules on bank lending to the housing sector. Furthermore, banks' mortgage lending policies continue to be very inflexible; for example, mandatory down payment ratios are between 20% and 40%. The combination of these factors has caused total mortgage loans to be at mare 17% of the household deposits. In conclusion, the huge price increases in the Chinese real estate market over the last 10 years have primarily been fueled by the massive household savings and the retained earnings of developers. 

Supply And Demand Fundamentals
It is undeniable that the Chinese property prices have gone up tenfold over the past 20 years, but it is important to consider this data point in the context of greatly improved standards of living in China over the same period. Over the past 20 years, the disposable household income in China has been surging and the price-to-income ratio, a much better indicator of a bubble, has almost halved.

There also exists an increasing pent-up housing demand in China – although the per capita living space in China has increased almost fourth-fold in the last 30 years, the per capita real income increased sixth-fold over the same period. As the households get richer, they have been becoming increasingly dissatisfied with their living conditions (see http://www.gallup.com/poll/15082/Homeownership-Soars-China.aspx). Also, as we mentioned above, although the percentage of people that plan to buy a house in next three months has been in clear downtrend over the last 6 years, the actual floor space sold over the same period has been constantly increasing. All this indicates almost inelastic demand for housing due to the incredible growth China has been experiencing since opening up its economy.

The fundamentals on the supply side are almost equally bullish. Although the floor space in vacant residential buildings is at the all time high, the inventory-to-sales ratio is hovering at the all time low of around 2 months (compared to 8 months in the 1997, around 6 months before the 2005 in the the US, or above 10 months currently in the US).

It is also important to note that China is still in the early stages of urbanization and more than half of the population is still living in rural regions. Due to a huge income gap between the urban and the rural population, a huge number of rural dwellers are moving to the cities every year. Combine this with the mortgage borrowing policies which are slowly becoming more liberal (mortgage lending in China began only ten years ago), and you have a very tight supply-demand situation.

Investment Considerations
In summary, while the real-estate price gains over the last several months have been rampant and could become a cause of concern if they continue, we do not find classic features of an asset bubble in the Chinese real estate sector. In fact, for investors interested in finding a real estate bubble, we suggest taking a closer look at Hong Kong real estate, which is not in a bubble yet, but has all the necessary preconditions to become a huge bubble over the next few years (investors can easily gain exposure through REITs focused on the Hong Kong residential sector).

In other news, global equity markets bounced back in early February due to being technically oversold. However, we doubt that the current correction has run its course, and investors should avoid bottom-fishing at these levels. Staying in defensive sectors and countries, avoiding shorting government debt and dollars, and being overweight the US against the emerging markets is still advised.