Climbing a Wall of Worry (25 Nov 2010)

Investors have been through a rocky 2 weeks. Ireland seemed on the verge of bankruptcy and needed to be bailed out by the IMF and the EU. But just when that appeared to be sorted out, the government was in danger of falling. Fresh elections could be held as early as in two months time. China was busy putting in new measures to curb the flood of hot money unleashed that was flooding in after America’s quantitative easing, and control inflation, and to top it off, North Korea took this time to fire artillery at South Korea, causing some property damage and casualties.

If not for the fact that I intend to rebalance my portfolio soon because the end of the year if coming up, I would happily have put in more money into equities now. All 3 concerns happening now can be considered politically driven, and one thing I have observed about most political events, their effect on the stock markets are usually quite short term. Let’s go through each of these.

First of all, Ireland. It was just this year that the Euro financial crisis hit and many European funds are still down this year in SGD terms. But there was already a huge reserve set aside to address this issue. Ireland is just one of the financially weaker that now needs to tap into this reserve. Markets got worries because the danger of the government falling meant that a new government might not accept the bailout, and if that happened, would it fracture the Euro.

However, this is a very remote possibility. No matter how much the Irish people might rail against the harsh budget cuts and belt tightening that comes with the bailout package, they have no other alternative lender. No one else is going to lend them that much money, and its not like they can hold a big asset fire sale to raise the amount either. They could do without the loan of course, but it would literally mean cutting themselves off from all international funding, and without foreign currency, they wouldn’t be able to buy any foreign goods and services. Unless they literally want to cut themselves off from the rest of the world, it is hardly an option.

So, they can take it out on their current government, bring in a new one, but even the new government would come in, take a look at the grim picture facing them and then will still end up accepting the bailout package, with all of its conditions in the end. Europe is very interesting right now. There is enough bad news that there must be some bargains there. Its just that this is going to be a long drawn out issue, and every time the next European country faces problems in the bond markets and is forced to accept a bailout, we will have these concerns surface all over again. So, investing into Europe now is going to require a lot of patience. There won’t be any quick gains, but for those who are willing to wait (and I think 3 years is going to be a minimum for Europe), then the current valuations are very cheap for Europe.

North Korea’s shelling of South Korea is another so called political event. It is almost certainly motivated politically. If a country really wanted to invade, it is not going to just shell an island. It will do far more than that. The danger is more that South Korea gets pushed beyond a certain point, such that it feels that it must take military action in the face of aggression. Has it reached that point yet? Probably not.

China’s tightening measures against the flood of money unleashed by America’s quantitative easing is the one that has the most direct economic and market impact in the longer term. Today, China has replaced the US as many of Asia’s biggest export market. China’s continued strong economic growth is one of the key drivers within Asia. If too much tightening causes China’s economy to falter, Asia would definitely feel the repercussions.

However, again from the China government’s perspective, they don’t want to see the China economy crash anymore than the rest of us. They are in the process moving two to three hundred million people from the rural areas to the cities. That is a huge number of jobs, housing, infrastructure and more that they need to create for these people. They can’t afford to have their economy crash and have millions of people jobless on the streets. And it is not like they don’t welcome foreign investment, since it was foreign investment that has resulted in such strong growth in the costal cities. However, if too much hot money flows in, inflation and over speculation in selected sectors will create problems too.

So, I personally feel that they will try all sorts of means and ways to curb too much inflow of hot money, inflation and speculation, but they will try not to touch interest rates too much. This is because raising interest rates is a very crude tool to guide economic policy, and they want to see China’s economy continue to grow strongly as well.

Thus, I am not so worried about what is currently happening. I think this year has been a big year of worry. Rarely has there been so many different things cropping up all within one year for investors to worry over, yet despite everything that has happened, most markets are on track to end the year with gains. It’s a classic case of climbing this wall of worry. There is lots of worry about, but the market will take two steps forward for every step back, and hence, over one or two years, will still move upwards. In this type of situation, the key is to remain calm, and be patient. These worries will eventually recede and when they do, we will see a significant rise in markets then.

In the meantime, the end of the year is coming up soon, so don’t forget to rebalance your portfolio! I will be doing this as well in the coming weeks.

Ireland Concerns make Germany Interesting (16 Nov 2010)

We are currently in correction mode. After the rise in markets triggered by the Fed’s QE2, China raised some of its bank reserve requirements. The move raised fears that China might be increasing interest rates, causing profit taking in markets. China’s consumer price index rose 4.4% year on year in October. It is thought that China may be willing to accept slightly lower growth to prevent too much hot money from flowing into China and this would trigger a slowdown in demand. As a result, commodities also retreated in prices. Oil was down as well (thankfully).

My view is that further tightening from Asian governments is to be expected. Asian governments know that hot money, while driving up stock markets and other assets like property, can also cause problems, precisely because they are hot money. And with Asian economies all growing strongly, there is really a concern to keep asset bubbles from developing, and to keep inflation in check.

In the medium term though, money will continue to make its way into Asia. Be it via massive funds raised in Europe and the US aimed at investing into Asia, or via corporations all looking to get a slice of the action in Asia by setting up in Asia, or direct investments from individuals and governments alike. Even currency is in Asia’s favour at the moment. The US stock market is positive year to date in US dollar terms. Convert that to SGD dollar terms and you are now looking at a loss. To investors based in the US or Europe, putting some money into Asia is almost like a no brainer. Even money invested into Asian bonds or emerging market bonds are giving them double-digit returns once converted back to Euros or USD this year.

Will this trend continue? I think it will, at least in the foreseeable future. What might cause a pull back would be if Asia suddenly chokes. But what would make Asia choke at this point? The concerns over inflation and hot money are well documented, and after the 1997/98 Asian financial crisis, all Asian governments are much more prudent now. And since they also know that allowing too rapid an appreciation in their currencies would wreck their exports, most Asian countries are all trying to keep their currencies at least at a reasonable trading level with the USD. If US thinks they can somehow deflate their currency out of their current troubles, it’s a rather unrealistic dream. Asian countries will be eventually seeing their currencies appreciate against the USD and the Euro though, whether they like it or not. Market forces are too strong in that direction.

The big inflows into Asia notwithstanding, by virtue of Asia’s increasing economic power, its countries’ currencies should appreciate. Look at Europe’s ongoing problems. Ireland has been hit in the bond market over fears that its finances were deteriorating. The interest rates on its debt has been climbing in recent weeks, with reports saying it was now as high as 8%. Investors worry that it would have to go to the EU and IMF for a bailout, though so far, the Ireland government has denied that it would do so. Fears that this would again trigger another round of crisis on the Euro currency was also one of the reasons for the current selloff. However, Ireland remains a relatively small portion of the Eurozone, so impact is still relatively limited at this point, especially since its ongoing debt problems is well known by now.

Europe is an interesting case. Especially Germany. Yes, the Euro may continue to come under pressure. They have a long road ahead of them to sort out their various problems with Greece, and other countries (the spotlight just turned back to Ireland). However, this doesn’t mean there aren’t good companies in Europe, or Germany for that matter. For example, Germany’s carmakers like BMW, Mercedes are probably doing even better in light of the lower Euro since their overseas earnings from overseas car markets are likely to see a boost due to the Euro’s fall. And a Gucci, or an LV bag isn’t going to priced any cheaper just because the Euro fell. So, I am looking to add to a Germany equity fund if these worries about Ireland cause the Euro or Europe markets to take another fall.

So, in summary, Asia’s uptrend will continue, though we can expect profit taking every now and then. At the same time, the hot money flowing in, while continuing to push up asset prices here, will not stay forever, and will add to the volatility in the region. Don’t neglect to consider other regions or countries outside of Asia. Opportunities may present themselves, even in regions which one might find difficult to consider touching right now! Don’t forget that some of the best bargains are to be had when everyone is selling.

The Fed has Turned on The Tap (8 Nov 2010)

The US Federal Reserve has turned on the taps, announcing last week that it would buy 600 billion USD worth of bonds supposedly to support the weak US economy. Personally, I think the US economy is doing fine. As our recent research report titled “US: On Track To Record-High Economic Output in 2011” shows, advance estimates show that 3Q economic growth was an annualized 2%. With the US economy expecting to grow between 2.5% to 3% in 2010 and another 2.4% in 2011, the economic output of US is now expecting to hit record levels by next year.

The main reason why there is so much hand wringing in the US, to the extent that the Fed has now turned on the taps again, is because of the unemployment rate, which is still at 9.6%. Otherwise, corporate America is actually doing great, and its companies are going to be seeing overall earnings at an all time high next year.

Nevertheless, the buying of bonds by the Federal Reserve, termed “Quantitative Easing” has unleashed a new flood of liquidity which has found its way into the market. Thus, commodity prices, emerging market bonds, emerging market equities have all seen a boost since last week’s announcement. Not all of this is simply liquidity flowing from the US into emerging markets. Emerging markets, including in particular Asia, has many other factors making it a good buy right now, including reasonable valuations, very strong earnings growth, and the entire region is basically shifting to a higher gear economically with China leading the way.

But things like strong corporate earnings, valuations and mega trends take time to happen, and some of it gradually takes place over a period of time. Asia did not suddenly wake up today and decided to become an economic powerhouse, nor did its companies suddenly overnight start to make lots of money. Now however, the Federal Reserve’s announcement has acted as the trigger, the catalyst that has unleashed the flood gates. Previously, even investors here in Asia were cautious, despite the many signs that Asia as a whole, was growing at a red hot pace.

Now, with last week’s announcement, the excess flood of money will also serve to bring about a relooking at where markets stand today, and based on fundamentals, there is much to like about Asia. This doesn’t mean just close your eyes and buy any Asian unit trust, or commodities fund, or resources fund blindly. Investors still need to be disciplined, and maintain a diversified portfolio and approach to investing. In the short term though, the flood of liquidity is going to continue to drive equity markets and commodity markets up, and after that, the strong fundamentals at least in Asian economies will help drive it Asian markets even further.

Ultimately though, will QE2 work? I don’t think so. Not in the sense that this round of QE is going to magically restore the US economy, in particular bring back jobs. But it will certainly result in a surge of liquidity that just happens to be the trigger that I believe will continue to propel Asian markets into this next phase of bull run we are seeing. In the medium term, it will also weaken the US dollar and cause commodity prices to move up even more.

Oil prices have now surged to over 88 USD per barrel as of 5 November, as a result of the Fed’s announcement and the surge of liquidity arising from it. Inflation and asset bubbles are a source of concern in Asia, and rising oil prices will heighten such concerns. It will remain to be seen if Asian governments take further steps to keep inflation in check. Also, higher oil prices will result in higher costs for Asia, which imports a lot of oil. If the US dollar continues to weaken, oil prices are likely to continue to trend higher. Certain pockets of assets, be it property, etc may also be subject to increased speculation arising from the excess liquidity, and if an asset bubble develops, then in time, it will eventually burst. Thankfully, we are not quite there yet, and based on many Asian government’s actions recently, we are trying to control the amount of hot money sloshing into Asia, so with luck, perhaps asset bubbles can be contained, or even avoided.

In the end, as with all markets, what goes up must come down. So, keep an eye out on overall stock valuations. These are the biggest indicators. We are not quite there yet, but when stocks in general all start to sell for 20 times or higher PE ratios, when all caution is being thrown aside and when everyone is queuing to jump into them, then its time to get a lot more cautious. The good news is that we are not at that stage yet, since most Asian markets are still off their all time highs. So in the meantime, enjoy the ride!