Dec 31, 2011

Incredible Failures of Russian Technology - The Resource Curse Taking Its Toll

The recent technical failures of Russian technology are quite staggering. The Bulava ICBM failed numerous tests before finally successfully hitting target earlier this month, the Soyuz rocket used to launch spaceships and satellites crashed on takeoff and now a fire breaks out at the Yekaterinburg nuclear submarine. Russia has never been known as a leader in quality, but the sciences and their applications had been actively promoted during the Soviet era push for large scale industrialization.

Now the entire economy is heavily dependent on oil and gas exports which are very tightly controlled by the Kremlin. This creates corruption on massive scale and causes a deficiency of investment in education and technology. Thus the human and physical capital slowly and surely deteriorates - it is much easier to pump oil than build a spaceship after all.

Dec 30, 2011

Even Soros is Bearish on Gold

Without making this too much of a victory lap, I was delighted to read Soros Sees Gold on Brink of Bear Market on bloomberg. While he has been wrong in the past, the words of one of the most famous contemporary investors can not be ignored. At the same time, most analysts are still bullish, which is good, as usually everyone being on the same side should be a cause for worry.

Dec 29, 2011

More Downside Ahead For The S&P - Retail Investors Generally Bullish

According to the latest survey by the American Association of Individual Investors 40% of US retail investors are bullish and 30% bearish. The numbers are in line with long term averages compiled by AAII(people generally have an "optimistic" bullish bias). Judging by this, equity markets are more likely to experience a pull-back if not a real sell-off when liquidity returns at the start of January. The "Santa Rally" has probably ended.

Dec 28, 2011

Is China Calling the End of the Gold Bubble?

PBOC has announced that all Gold exchanges except for the 2 main ones in Shanghai are to discontinue operations (see the English language US edition of China Daily). It thus forcibly consolidates the market within a few large players, that are easier to monitor and control by the authorities. So far nothing new. The Chinese government has always operated this way in regards to any politically sensitive areas of the economy such as banking, insurance and most recently rare earths exports.

The timing, however, is quite interesting. Gold has been going up and investor interest in it has been building for the past 10+ years. However the regulation tightening only comes now that the market has experienced a few major hiccups (see previous WhatIf posts on Gold below, also FT article on recent sharp decreases in Gold ETF holdings). Beijing probably fears a public backlash should Gold continue to collapse, causing large losses to naive individual investors. The memory of the vocal protests before the building of the Stock Exchange after the Shanghai Composite dropped from its lofty heights in the end of 2007 must still be fresh in their minds.

Dec 27, 2011

Japan's Budget Mess

It is sometimes hard to make heads or tails of the political bickering in Japan's parliament, but matters look like they are getting serious. And seriously against prime minister Noda's intentions to raise consumption tax. A few lawmakers have already left his party (the DPJ) in protest against the tax hikes under consideration. At the same time the government's fiscal position is only getting worse, with a record 49% of next year's budget to be financed by bond issuance. Clearly raising taxes would hurt the already stagnant economy, so what can be done?

In some sense Japan has a problem that many countries wold love to have - strong currency and no inflation. A central bank can can always print more of its own currency - the constraints are only that this makes it weaker against other currencies and stokes inflation. But for Japan both of those in moderation are what it needs. So the BOJ should follow the Swiss Central Bank and weaken the yen, which should give a boost to the economy and automatically increase tax revenues.

Dec 26, 2011

Can China Micromanage the Convertibility of its Currency?

China has recently signed a series of bilateral agreements for limited direct settlement of FX transactions. First with Russia, Indonesia, Australia and more recently with Thailand and now Japan (see BBC article). All of the agreements are aimed at facilitating trade settlement without the need of using US dollars. Also they all seem to be restrictive enough to allow for careful monitoring and control by Beijing. As an example, the agreement with Thailand only allows CNY/THB settlement in the province of Yunnan (bordering Thailand) by the local branches of 4 designated banks. This approach to gradual convertibility is similar to the Special Economic Zone model that China used in the past to introduce capitalism to the country in a limited way. Despite all the media hype, the yuan is very far from challenging the dollar as a global reserve currency. But gradually allowing convertibility of the current account (currency flows based on trade in goods and services) may just work out.

Dec 24, 2011

Bearish Contrarian Signal on Gold - Popular Press Still Very Bullish

Once again the popular opinion is probably guilty of error by extrapolation. Everyone is asking not if but when Gold will reach $2000 / ounce. This is always a very worrying contrarian sign as it means nobody is even considering the opposite possibility.  "New year offers gold another shot at $2,000" on offers no specific reasons why this should happen at all, but rather explanations why it hasn't yet (the assumption being that at some point it somehow _has_ to). Even though Gold is currently tracking the equity markets, the piece claims that a European collapse should trigger a massive spike and not a selloff in the precious metal. It makes you wonder, especially given the -10.5% loss that John Paulson's Gold fund has racked up this year according to Bloomberg despite the 13% rally in bullion year-to-date. It may be that the gold miner stocks that he owns are pricing in the uncertain future demand better than the spot market.

Dec 23, 2011

Political Theatrics in Russia Continue

The relatively fair and thorough coverage (minus any mentions of Putin) of anti-Kremlin protests earlier this month by state-controlled television in Moscow did seem a bit puzzling. Now we may know why. According to BBC's website Medvedev has outlined "far-reaching" political changes to appointment of regional governors, registration of political parties and proposed the creation of independent media. Of course this is hard to take seriously, given that his term will expire very soon. But these gestures should be enough to temporarily assuage public anger until Putin is firmly back in power, or so the czar-duo is probably thinking.

Dec 22, 2011

Japan Nov Trade Deficit Worsens - Usd/Jpy to Turn the Corner Soon

The market is ignoring this fact, but Japan's trade deficit in November was a record JPY 685bn according to statistics published yesterday on Ministry of Finance website. If the trend continues, Japan will find itself in the twin-deficit predicament of the US. Just as a reminder Japan's fiscal position is among the worst in the developed world, with Debt/GDP of close to 200% (which is worse than troubled Italy). Most of the government debt is held domestically, so it is unlikely to be under pressure, but the currency should definitely start weakening. In fact the last time the Bank of Japan intervened to sell the yen when the FX rate broke 76.00 on Oct 31, contrary to popular expectations, the market did not reverse most of the move and has only briefly broken 77.00 since. I would be a buyer of Usd / Jpy around 78.00 with an initial target of 92.50

Dec 21, 2011

Property Prices in "China's Hawaii" Down Almost 30%

What is the first thing you do when you have an extra million or ten? If you are like most people you go and buy a luxury vacation home. But that would also be the first to go when you realise your business won't be going to the moon quite as fast as originally expected. The second phase of that is currently going on in China's "tropical paradise" of Hainan where prices are down 28% year-on-year (see Bloomberg article).
Vacation property is the first to go down when the market starts turning. Consider the fate of Miami in the US, Greece and Spain in Europe. Usually the rest tends to follow, especially in a market that has gone much too high by any fundamental measure. Official statistics out a few days ago showed that property prices in most Chinese cities are now also dropping. Beware the super-bubble.

Dec 20, 2011

Is the RBA Missing the Point?

Considering that China is now Australia's largest export market, I find it surprising that the RBA minutes only contain this small paragraph on the economic conditions there:
In China, most of the monthly indicators, including for industrial production and retail sales, were still consistent with solid GDP growth. However, conditions in the housing market were noticeably weaker than over the past couple of years, reflecting the effect of controls on buyers and tight credit supply for developers. Members noted that this slowing was in line with the authorities’ intentions.
RBA should be much more concerned about the situation in China - the unsustainable increase in local government debt and the political risk of the coming transition of power in 2012. The biggest challenge for the Australian government and the RBA should be finding ways to reduce its arguably overpriced currency and rebalance the economy away from reliance on the resource extraction sector. Given that "most firms ... expected wage pressures to remain contained" a more aggressive 50bps rate cut would have made more sense.

Dec 19, 2011

Has the Chinese Yuan Topped Out?

Ever since the initial 8.1 peg to the USD was scrapped in 2005, the Chinese yuan (a.k.a. RMB) has only gone up. Investors have been piling up into dim-sum bonds and US politicians keep ratcheting up the pressure on Beijing to revalue its currency. Now if the RMB is so undervalued, why did hte PBOC need to intervene to support it on Friday? (see WSJ article). In fact, it had already hit the lower limit of its officially stipulated trading band for a few days in a row.

If capital controls are lifted, the country's large current account surpluses should drive the value of the yuan higher until the resulting drop off in exports (as they get pricier) and pick-up in imports (as they get cheaper) balances out. This is according to popular wisdom and Economics 101, but completely misses the capital account part of the equation. And that one is tricky.

If investors could freely move funds across the border, would money flood into the Red economy driving the RMB higher? Or would the enormous pool of currently captive domestic savings instantly rush out to seek returns higher than the deposit rates of state-owned banks? The market is telling us the latter is more likely.

Dec 17, 2011

Rating Agencies Are Probably Overdoing It

Recently there has been a veritable onslaught on core European sovereigns by the major rating agencies, with S&P warning of a major wave of downgrades in Europe 2 weeks ago, then Moody's lowering Belgium by 2 notches on Friday and finally Fitch changing France's outlook to negative. The timing of the announcements is like a rush to the exit, with no one wanting to be left behind just in case. Rating agencies were considerably behind the curve during the 2008 financial crisis. They badly mispriced the correlation of  subprime mortgages and rated "senior" tranches of CDO's triple-A. Those same tranches ended up worth close to zero. Also they infamously rated Lehman double-A up to the moment it filed for bankruptcy. The painful experience 3 years ago and the ensuing investor and regulatory backlash has left the rating agencies quite trigger-happy with the downgrade button - possibly more than justified in some individual cases.

Dec 16, 2011

The Flip Side of Germany's European Bailouts

Among all the political noise coming out of Europe the main theme seems to be that Germany may have to bail everyone else out and is not too happy about that. While factually true, we should not forget that Germany has been the main beneficiary of the currency union. The estimates of how much stronger the Deutschemark would have been compared to the Euro if it still existed vary between 50% and 100% depending on who is running the models. Either way that would have been terrible news for Germany's economy, which is very dependent on export of capital goods - just take a look at Japan. So given that it has been enjoying all the benefits, Berlin should be more willing to spread the love. In fact it has to do that, or risk an end to its export-lead boom if Europe ever reverts to local currencies.

Dec 15, 2011

Gold Appears to have Lost its Shine

For the past 10 years Gold prices have only gone up. Many have been quick to call it a bubble, only to be proven wrong time and again, but it looks like they will finally get some redemption. For many years only professional investors cared about the price of Gold. That slowly changed and in the beginning of 2011 the mainstream news was extolling its value as a hedge against inflation, deflation, credit risk, dollar debasement and just about anything else. As Gold prices had already gone up "too much" the popular interest drove a mini-bubble in Silver, with "poor man's Gold" almost doubling between the end of Jan and end of Apr 2011.

Then the 1st Silver Shock occurred on May 2nd, driven by the CME significantly hiking margin requirements. It dropped about 33% in a few hectic sessions, but the impact on Gold was limited (-6%). Gold closed on May 9th at 1470 and in fact kept rallying to an all-time high of 1920. This level was reached in late August (and tested again in early Sep) in the aftermath of the global sell-off triggered by the S&P downgrade of the US credit rating. So far so good, but the next time around it was different.

Silver never recovered to the April high and when the 2nd Silver Shock hit on Sept 22nd, it dropped as much as 35% in 3 days. This took Gold down from 1780 to 1530 (intraday low) for a drop of 15% and while it slowly recovered to the 1800 level Gold had lost its aura of a super-hedge and became an asset like any other. Since then it has been moving in lock-step with the S&P 500. With current price at 1570 I would not go near it unless it drops to the 1000~1200 range.

China Flexes its Muscle Again

China has announced that it will levy anti-dumping duties on US-manufactured car imports (see FT link). The taxes will mostly affect luxury vehicles and as such will only have a limited economic impact. The impact is mostly political and this is the latest move in China's unwritten policy of asserting its newly acquired clout on the global political and economic stage. The emerging "superpower" has been busy escalating territorial disputes with just about all of its neighbors which pushed the US last month to increase its military commitment to the region by stationing 2500 marines in Australia (see NY Times link). This stream of international provocations also probably serves to fuel the patriotic fire at home in order to deflect attention from the increasing (and mostly unreported) instances of riots and violent protests. Keeping its grip on power will be the biggest challenge for the Communist Party into the transition of leadership in 2012.

Dec 14, 2011

Has the Euro Become Radioactive?

More and more countries are distancing themselves from the Euro. First were non-Eurozone EU members like Poland pushing off the already agreed-upon adoption. Then Greece was toying with the idea of re-introducing the drachma, and now a politician in Iceland is suggesting that they should scrap their application for joining the Euro and opt for the Canadian dollar instead (read CNBC article here).

It is more of a psychological process than a purely financial one. Eur/Usd is only down 13% from the high of just under 1.50 reached on the day before the ECB failed to raise rates again in early May (what were we thinking??). However the more the crisis drags on, the more psychological capital the common currency loses. Companies are considering contingency plans for pricing their products; central banks are dusting off the printing presses for legacy currencies; brokers and banks are conducting "war games" to make sure they can quote and settle should those currencies come back. With every passing day it appears that the Euro is unlikely to survive in its present form.

Dec 13, 2011

Corruption in China

The final verdict is out on the most infamous of the Chinese "fraudcaps", Sino-Forest Corporation. The company has officially defaulted on an interest payment of as little as $10mm (see FT article). The widespread corruption in China creates a fertile ground for fraudulent investment schemes. Transparency International  in its 2011 report ranks China at #78 in the world (the higher the number the more corruption). The same report ranks Canada as #10 and the US at #24 (interestingly Hong Kong is ranked #12).