Global Market Insights | A Fisher Investments Blog

Turning Japanese? I Really Don’t Think So.

The other day, I read an editorial in South Korea’s Chosun Ilbo suggesting Korea’s economy might soon go the way of Japan’s:

Is Spendthrift Korea Following Japan Into a Long Slump?

The logic: Korean consumer spending trends resemble Japan’s in the late 1980s, just before its economic crash—a crash that marked the end of Japan’s economic miracle and the beginning of two decades (and counting) of deflation and low growth. Hence, Korea must be on the verge of crashing and burning in a similar fashion.

This is a flawed argument though—consumer spending habits didn’t cause Japan’s crash and aren’t responsible for the malaise that followed. Japan’s troubles result more from weak demographics, flawed economic policy, lack of domestic competition and trade protectionism.

The Korean editorial also references a piece from the US’s Foreign Policy  magazine, which takes a deeper look at some of the similarities between Korea and Japan and draws the same conclusion.

Turning Japanese

Among the similarities highlighted here are the huge conglomerates that have historically dominated both nations’ economies—keiretsu in Japan and chaebol in Korea. The piece argues Japan’s failure to break up the keiretsu and increase competition among domestic producers is one big reason Japan has stalled, and it foresees similar weakness in Korea 15-20 years from now if Korea’s government can’t crack down on the chaebol.

In my view, this is only half right. Stagnant keiretsu have contributed mightily to Japan’s woes, but a key difference between the keiretsu and chaebol mitigates the risk of the same thing happening in Korea.

Japan’s six major keiretsu are all centered around banks—the banks have cross-shareholdings in the keiretsu affiliates and subsidiaries, and these companies have partial ownership of the banks. This makes it too easy for these firms to secure corporate financing—because of the cross-shareholdings, banks have a vested interest in supporting them and, problematically, keeping struggling affiliates afloat. This is why Japan has so many so-called “zombie companies”—companies that should fail and make room for smaller firms with more growth potential.

In Korea, the chaebol are legally separated from banks—no chaebol’s holding company is allowed to own a stake, however small, in a bank. Hence, chaebols’ affiliates and subsidiaries—and sometimes even the main holding company itself—can and do fail. During the late 1990s Asian financial crisis, known in Korea as the IMF Crisis, 25 chaebol went bankrupt, including one of the top-five. In Korea, the chaebol must stay competitive and profitable in order to survive. And the chaebol at the top of Korea’s economy today are quite adept at this.

That said, the need for chaebol reform is a legitimate concern in Korea. Because of the cross-shareholdings and ruling family members’ dominance of the companies’ executive boards (chaebol are all family-run), corruption runs rampant. Cross-shareholdings also give the chaebol incentive to award contracts to their own affiliates, shutting out smaller competitors who might offer a better product or service. And trade barriers designed to protect the chaebols’ dominance of Korean markets further stifle competition, making goods more expensive for Korean citizens.

Both candidates in Korea’s upcoming presidential election are campaigning chaebol reform. The ruling Saenuri party’s candidate, Park Geun-hye, is pledging to improve corporate governance, while her opponent, the Democratic United Party’s Moon Jae-in, is pushing for limits on cross-shareholding. Their proposed measures might help increase competition within Korea, but in my view, tax reform and free trade should be top of the list. Lowering Korea’s trade barriers will accomplish two things: It will make it much easier and cheaper for smaller firms to compete internationally, and competition from foreign goods would help fragment domestic markets, providing an opening for new market participants. Making the corporate tax code more equitable—it heavily favors the chaebol—would make it even easier for small firms and entrepreneurs to profit and grow. The chaebol will continue to play a role, but Korea would get a new growth engine, and all Koreans would benefit from cheaper goods, more choices and—importantly—more employment options.

But the need for chaebol reform doesn’t make Korea the next Japan. Korea’s pretty competitive globally, and its fundamentals are plenty stronger than Japan’s. There are just key policy steps the next government could take to help take Korea to the next level.

For more on this, check out my recent column on Equities.com, “Competition, Gangnam Style.”

 

A Word on “Lost Decades”

According to one research firm, the British housing market faces a “lost decade” of falling prices. The Telegraph has the scoop:

UK Housing Market Heading for ‘Lost Decade’, Warns Collins Stewart

Graham Ruddick, The Telegraph

There’s already a rather colorful debate over the forecast, with some in the banking industry calling its claims about mortgage lending suspect. To us though, those who focus on the specifics are perhaps missing the bigger picture: Very long-term forecasts are seldom accurate and rarely mean much.

Why? Two main forces will affect British home prices over the next 10 years: supply and demand. And many drivers will influence supply and demand along the way. In the near term, the success (or potential lack thereof) of the government’s efforts to increase mortgage lending will indeed impact demand. But there’s simply no predicting what other forces materialize further out. Any number of economic developments, regulatory schemes, population changes, etc. that we can’t even fathom today could arise, impacting home prices. Any time you see a very long-term forecast for anything finance-related, whether good or bad, we suggest keeping that in mind.

 

Merlin’s Magic

The Bank of England announced the results of Project Merlin on Monday. As you may recall, this was PM Cameron and Chancellor Osborne’s scheme, introduced in 2010, to increase lending (particularly to small businesses) after corporate lending took a hit in and after the 2008 credit crisis.

Project Merlin had a healthy, sensible goal—help businesses finance expansion and hiring, theoretically boosting GDP growth and employment over time. The government sought to accomplish this through lending targets. The UK’s largest banks signed a pledge to lend £190 billion in 2011, with £76 billion going to small businesses. The results? Banks exceeded the total lending quota by nearly £25 billion but fell short of the small-to-medium business goal by £1.1 billion.

Some are saying the small-business lending shortfall rendered Project Merlin an abject failure, but we’re inclined to disagree—it’s a very small miss, and the overall lending increase is a much bigger positive. Lending more to larger outfits might not have been the goal, but despite governments’ best intentions and efforts to foster certain economic activity, sometimes markets still behave otherwise.

Why’d that happen in this case? Remember, there are two sides to every loan: lender and borrower. Banks made credit available—there was sufficient supply. Small-business demand is what fell a bit short. Neither banks nor the government can force firms to take out loans; they’ll borrow if it makes sense in light of interest rates and borrowing terms. Otherwise, they’ll probably delay financing or find alternative means. And that’s likely what was at work over the last year: A few less small firms than hoped found conditions favorable, while more large companies found the lending terms perfectly palatable. Sometimes, that’s just how capitalism works.

 

Life Imitates Monty Python…

Perhaps this isn’t a perfect analogy, but the latest spat between France and Britain brings to mind this classic scene from Monty Python and the Holy Grail:

Frenchman: You don’t frighten us, English pig-dogs! Go and boil your bottoms, sons of a silly person! I blow my nose at you, so-called Ah-thoor Keeng, you and all your silly English Knnnnnniggits!

Sir Galahad: What a strange person.

King Arthur: Now, look here, my good man—

Frenchman: I don’t want to talk to you no more, you empty-headed animal food trough wiper! I fart in your general direction! Your mother was a hamster and your father smelt of elderberries!

Sir Galahad: Is there someone else up there we can talk to?

Frenchman: No, now go away or I shall taunt you a second time!

In case you haven’t been following too closely, here’s what’s happening. The US-based credit ratings agencies (Fitch, Moody’s, and Standard & Poor’s) have put France ’s credit rating on a negative watch, suggesting a downgrade may be forthcoming. France ’s government introduced a fresh €65 billion austerity package in early November, but thus far it doesn’t seem to have quieted rumors of a pending downgrade. Now, France seems to be trying to distract the ratings agencies a bit.

It started last Thursday, when Bank of France governor Christian Noyer told a French newspaper (see The Independent for a partial translation) a downgrade “doesn’t strike me as justified based on economic fundamentals. Otherwise, they should start by downgrading the UK , which has a bigger deficit, as much debt, more inflation, weaker growth and where bank lending is collapsing.” French Prime Minister François Fillon chimed in, “Our British friends have a higher deficit and debt, but it seems the ratings agencies have not yet noticed.”

David Cameron responded diplomatically, reminding folks his cabinet has spent 18 months tackling deficit reduction. He also pointed out that low yields on British sovereign debt demonstrate the market’s faith in Britain ’s ability to service its debt. (If risk of default were higher, one would expect yields to rise accordingly. British 10-year gilts yielded a very low 2.04% as of market close on 16 December.*)

Undeterred, France’s new finance minister, François Baroin, shot back: “The economic situation in the United Kingdom is very worrying. One would rather be French than British at the moment.” A private conversation between Monsieur Fillon and UK Deputy Prime Minister Nick Clegg followed, moving the debate behind the scenes.

Heated politics aside, the real story here is the strange methodology of ratings agencies. As Mr. Noyer pointed out, ratings agencies seldom base their assessments on economic fundamentals. Fisher Investments’ editorial staff has written at length about the rather odd methodologies behind ratings agencies’ assessments, and in short, we don’t see why anyone lends them much credence.

So, with that in mind, what might the ratings agencies be looking at in this case?

Cameron’s statement perhaps offers a hint. The UK’s deficit reduction plans seem largely on track thus far, and the deficit narrowed more than forecast (thanks to higher revenues) in November. France has announced credible deficit reduction measures, but they’re not quite as far in the process. The UK also has the benefit of not using the euro—France, by contrast, is saddled with the perceived risk associated with being in the eurozone. France’s banks also have more exposure to peripheral Europe’s sovereign debt, raising the specter of state-funded bank recapitalizations (which could hinder France’s austerity efforts).

And then, there’s future growth prospects. Both countries have witnessed slow GDP growth this year. But looking longer term, Britain’s economy has some competitive advantages. The Heritage Foundation ranks Britain 16^th in the world in its 2011 Index of Economic Freedom. Business regulations are largely transparent, efficient and streamlined, according to the Heritage Foundation’s report, and labor markets are flexible. Britain also plays a major role in the global economy—London is one of the top-three global financial centers (with New York and Hong Kong), and the UK’s international trade totaled £906.5 billion in 2010.**

France’s economy, on the other hand, is somewhat less liberalized, though Sarkozy has introduced some measures to change this during his presidency. Several utilities remain state-owned, its agriculture is quite subsidized (largely by EU neighbors) and its labor market is heavily regulated. The Heritage Foundation ranks it 64^th in the world in its 2011 Index of Economic Freedom, citing the knock-on effects of a “rigid labor code.”  Certainly, as the eurozone’s second-largest economy, France is a major player and has plenty of economic prowess—its international trade in 2010 totaled £700 billion.*** But there are opportunities for further structural improvements.

So why might this factor into the ratings agencies’ assessments? Higher economic growth can make it easier for nations to service their debt over the years—higher GDP can lead to increased state revenues, which can make interest payments less expensive relative to revenues. Lower growth can make that a bit more difficult. Hence why Moody’s warned this week that slower economic growth in 2012 could impede Britain’s deficit reduction progress, though it affirmed its top credit rating is stable for now.

Again though, the takeaway here isn’t that one nation’s any stronger than the other or one side any more right, but that ratings agencies’ assessments should be taken with a healthy dose of cynicism. Both nations seem plenty capable of servicing their debt.

*Source: Bloomberg

**Source: Office for National Statistics

***Source: National Institute of Statistics and Economic Studies

 

Britain’s Industrial Evolution

The Guardian has an interesting take on David Cameron’s mission to “fight for British interests,” as he put it, at last week’s EU summit. In most of his comments on this subject, the Prime Minister has said he’s focused on preventing European officials from implementing measures that would harm the City of London’s global competitiveness (such as the financial transactions tax). The Guardian suggests he take a different approach and devote “some tender loving care to British manufacturers,” citing Britain ’s proud manufacturing history and industry’s falling share of domestic output. In short, it argues, “British industry has been hollowed out.”

This view is also common in the US , which, like Britain , has evolved from a manufacturing-driven to service-based economy over the past several decades. In both nations, the manufacturing sector comprises roughly 22% of GDP (according to the CIA World Factbook). But that doesn’t mean British industry is dying; rather, it means the UK ’s economy is evolving normally. Throughout history, economic development has followed this pattern: agrarian to industrial to service-based (perhaps, in the future, we’ll see more phases, like intergalactic-commerce-based). Britain ’s at the far end of that progression (notice the absence of voices decrying that agriculture is only around 1% of total output). France , Japan , Australia and the aggregate Eurozone also have similarly portioned economies.

By contrast, many countries whose manufacturing sectors comprise a larger share of GDP are less developed and, in many cases, less economically diverse. These nations include Russia (36.8%), China (46.9%), Thailand (44.7%) and North Korea (47.8%). No one in their right mind would argue North Korea ’s economy is anywhere near as strong as the UK ’s. Developed Norway also has a relatively larger manufacturing sector at 40% of GDP, but its entire economy is less than one-fifth the size of Britain ’s. Lesson: percentage weightings alone don’t tell the whole story.

Here’s another way to look at this: According to IMF data, Britain ’s industrial output was approximately $490 billion. That makes it the eighth-largest single-country manufacturer in the world—well ahead of Taiwan , South Korea and Indonesia , which have reputations as strong manufacturers. Britain ’s industrial output is also larger than the entire economies of Poland , Belgium , Sweden , Austria and many others (if British manufacturing were a country, it’d be the world’s 20^th-biggest, which isn’t too shabby).

With these data in mind, it seems a stretch to argue British industry is dying. Its growth rate has fluctuated in sympathy with the recent recession and economic slowness, but when you take a broader, more measured view, it seems clear manufacturing is far healthier than some presume. (And a financial transactions tax won’t make it any healthier, but that’s a discussion for another time.)

 

Stop Me if You Think You’ve Heard This One Before*

Hamish McRae at the Independent has a sound take on the recent slew of seemingly negative news about Britain ’s economy: “The best way to make sense of this constant barrage of information, most of it negative, is to keep asking what is actually new and what is a rehash of stuff we already know.”

This is always a sensible approach. By the time information is widely known, markets have typically already reacted to it. Even when old information is spun in different ways, it usually doesn’t have much power to move equities meaningfully, in either direction. Markets have already moved past it and are pricing in new information and the probabilities of different events happening. It’s a lot like driving a car: Looking only in the rear view mirror doesn’t tell you what’s on the road ahead of you.

To borrow one of Mr. McRae’s examples, consider last week’s news that Moody’s downgraded the credit ratings of 12 British banks. The downgrade, of course, was a new event. However, it was long expected and—importantly—based on things we already knew about these institutions. If smaller banks come under stress, the government will probably let them fail, while larger banks, with deeper ties to the British and global financial systems, will more likely receive some government support in order to lower the risk of their troubles spilling over. The government has been heading in this direction for a while, as demonstrated by the Independent Commission on Banking’s recent proposals for financial sector reforms. Moody’s simply took this old news and gave it new clothes, in the form of a rating downgrade. And to perhaps confirm the downgrades don’t really change anything, Moody’s vouched for the UK banking system’s overall health: “The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”

Another recently repackaged item is the UK ’s second quarter 2011 economic growth. Last week, the Office for National Statistics announced the economy grew only 0.1% from April through June, less than originally estimated. Though flattish growth isn’t great news, it’s important to put it in context: the number is now more than three months old. As highlighted in our last post, some key economic indicators suggest growth picked up in the third quarter. Mr. McRae adds, “our service industries are still expecting growth and, what is more, are still profitable.” Looking at only the second quarter’s reading doesn’t really tell us what’s happened in the three-plus months since—and, much less, what will happen from here.

It wouldn’t be surprising for negative economic news to continue. But taking a minute to distinguish well-known stories from those with new information can give us all a healthier perspective, and a better sense of how the economy is truly progressing.

*The Smiths, 1987

 

Respectfully Corrected, Mr. King

Last Thursday, Bank of England (BOE) Governor Mervyn King received widespread attention for suggesting Britain’s present economic situation “is the most serious financial crisis we’ve seen at least since the 1930s, if not ever.” This was his rationale for implementing a new round of quantitative easing: The BOE will purchase £75 billion worth of gilts over the next four months, which should in theory then be lent from banks to individuals and corporations, providing a tailwind to economic growth.

Setting aside questions of the plan’s advisability, is Britain ’s economy truly in as bad of shape as Mr. King suggested? Is today as bad as, if not worse than, the Great Depression?

There’s no doubt the British economy faces challenges, and growth has slowed lately. However, true depression requires a massively shrinking economy, as occurred during the 1930s—but which hasn’t occurred so far in 2011. In fact, the UK ’s nominal GDP is at an all-time high, having recovered from the 2008-2009 recession. Much has been made of recent news the economy grew only 0.1% in the second quarter, but it’s rather normal for economic growth rates to fluctuate in the short-term. Growth often slows temporarily a couple years into an expansion without turning negative.

Following are some other positive highlights from the Office for National Statistics’ Second Quarter 2011 Statistical Bulletin:

• Growth has remained positive in 2010 even though consumer spending has fallen
• Manufacturing output has risen for seven consecutive quarters
• Services output has risen six of the past eight quarters and has grown overall in 2010 and 2011
• Employee incomes grew 3% in 2010 and have continued growing in 2011

Other recent reports also suggest the economy is healthier than given credit for:

• British corporate profits grew in Q2 2011, in both the manufacturing and service sectors
• Productivity increased in Q2 2011
• Business investment grew robustly in Q2 2011, in manufacturing and services
• A key leading indicator showed the service sector grew faster in September
• Another leading indicator showed the manufacturing sector resumed growing in September, following a slight contraction in August.

Based on these facts, it seems premature to say the UK is in either a depression or recession. More likely, it’s experiencing the volatility typical during a growth cycle.