Global Market Insights | A Fisher Investments Blog

Recommended Reading

For anyone who wants to understand China: 

Reading Hayek in Beijing

Bret Stephens, The Wall Street Journal

It’s an insightful interview with Yang Jisheng, a longtime critic—and member—of China’s Communist Party, who discusses the many problems with China’s state-directed economic growth model.

Chinese policymakers seem to understand their model has limits—most aren’t as candid as Yang, but many of their slogans and policy proposals suggest they get it. Problem is, their sweeping reform plans often yield few concrete actions, and there’s a lot of give and take between the reform-oriented leaders and those who cling to more traditional, Maoist ideals. This give-and-take is likely a key reason Chinese stocks have underperformed the world lately despite China’s fine economic growth. Markets don’t move in lockstep with economies—often, over time, they move according to investors’ expectations of companies’ future growth and profitability. China may be growing fine now, but if officials don’t open the economy and financial sector and allow private firms to grow and thrive, growth might not stay fine for long.

I think reform will happen, but very slowly and likely in fits and starts—just as it has for the past couple years. For example, last year China decided to legitimize shadow financing in one city to test full nationwide financial deregulation. Officials believed formalizing private lending would help small businesses access easier, cheaper financing, which would help the region outgrow the rest of the country. But so far, they haven’t seen many results—because officials haven’t defined legitimate private lending and differentiated it from illegal fundraising (which carries the death penalty), many firms and lenders are scared of using these new channels. In order to get better results, China needs clearer laws. Officials have said they understand and plan to address this, but as usual, their plans are nebulous.

If China had a transparent, independent judiciary—heck, if it had a credible rule of law—its longer-term development would likely be smoother. But political and judicial reform, for now, are non-starters. So China will depend on the long-term success of fitful economic reform.

But that’s an academic issue—what happens in the very long term doesn’t impact stocks in the here and now. Now, investors are likely simply looking for China to enact policies that will help businesses compete and grow tomorrow.

Currency Wars—A Losing Battle

Competitive devaluations have been a hot topic lately—countries deliberately weakening their currencies in order to make their exports cheaper and, theoretically, boost output. In recent months, as Japan’s yen has weakened and supposedly given Japanese exporters an advantage over competitors in South Korea and Taiwan, investors have grown fearful of tit-for-tat competitive devaluations throughout Asia—better known as a currency war—potentially disrupting trade and economic activity. 

Good news: That’s a pretty unlikely outcome.

Here’s why. Competitive devaluation is based on a faulty premise—that a weak currency is a net benefit. A weaker currency does help somewhat by making exports cheaper, but that doesn’t always translate into higher export volumes. For example, the value of Japan’s exports has increased as the yen has weakened, but export volumes have fallen. So it’s tough to argue a weaker yen has boosted overall output. Plus, the weak yen has a nasty side effect—more expensive imports. This is a big headwind for Japan, which imports most of its fuel—pricier energy raises production costs. Manufacturers are also squeezed by more expensive imports of component parts. And as energy costs rise, they likely have less cash to spend on these imported components. That can potentially lead to supply shortages, pushing export costs higher and offsetting much of the weak currency’s positive effects.

You can see this in Taiwan’s recent trade data—that may seem like a surprising source, but Taiwan exports several high-tech components (e.g., semiconductors and flat screen panels) to Japanese firms, so it’s a key indicator. In March, Taiwan’s exports to Japan fell 15.6% y/y by value—and given the currency moves over the past year, that means exports by volume fell significantly, too. So Japanese firms imported fewer and more expensive components from Taiwan, which likely pushes their manufacturing costs up and diminishes their output—and makes whatever goods they do produce more expensive than they otherwise would have been.

So policymakers who deliberately weaken a currency aren’t automatically giving their economy a boost. Rather, they’re picking winners and losers between the few firms that produce goods domestically start-to-finish and the many manufacturers that import raw materials and intermediate components—not to mention the consumers who benefit from cheaper imports. Japanese policymakers may not understand this at the moment, but other countries likely do and don’t see much reason to strive for a weaker currency.

 

 

Lessons From Japan

On April 11, the Post Office made a big announcement: In the near future, it will begin offering personal bank accounts, making it a full one-stop financial services provider. 

On the one hand, this may seem like a good idea on the surface. The Big Four high street banks hold almost 75% of the personal account market, so clearly competition is needed. And the Post Office, with its strong network of 11,500 branches, might have the clout to give them a run for their money.

Pick this apart further though, and it’s fraught with problems.

The Post Office is state-owned. Technically, it’s a subsidiary of Royal Mail, which should eventually be privatized under the Postal Services Act of 2011, but for now it’s 100% government-owned. Plus, the Act doesn’t include plans to privatize the Post Office—instead, there are provisions to spin it off into a separate state-owned company.

So the Post Office is and likely remains a state-owned banking/insurance/postal services firm. That sounds a lot like Japan Post, Japan’s state-owned banking/insurance/postal services firm. Or, as The Wall Street Journal once dubbed it, the bank that ate Japan.

In terms of deposits, Japan Post is the biggest bank in the world, with about £1.39 trillion. Savers love it because it offers a small but guaranteed return, which it can do because it has state backing. And it uses most of those deposits to buy Japanese government debt—essentially, it provides the government backdoor financing, which has helped the government run its debt load up to more than 220% of GDP. If it weren’t state-owned, it wouldn’t have this luxury. Like all banks, it would have to compete and fend for itself without a government guarantee, so it would probably have to diversify away from Japanese sovereign bonds, and the government would have to get its finances in order.

I’m not saying the UK’s setting itself up for this exact same scenario once the Post Office begins taking retail deposits (in addition to the ISAs it already offers), but there’s clearly potential to distort competition and public finances. With state backing and control, the UK Post Office could easily follow Japan Post’s lead and over-concentrate in gilts. It could also offer artificially high deposit rates since it wouldn’t have to worry about maximizing shareholder value. That may help increase competition in UK banking, but it wouldn’t be free and fair competition—which is how all proper competition should be.

If policymakers want to challenge the Big Four’s dominance, offering personal accounts through the Post Office isn’t the answer. Instead, they should make it as easy as possible for challenger banks (small, upstart high street banks) to launch and grow. For example, they could make it easier and cheaper to get a banking license, reduce the business tax, further reduce corporation taxes, lighten regulations and make capital requirements more flexible (as I recently wrote on MarketMinder, current plans to temporarily reduce challenger banks’ capital requirements miss the mark badly). That will allow a healthy competition—without distorting markets.

Don’t Fret the Current Account Deficit

Since ONS revealed the UK’s current account deficit spiked in 2012, I’ve seen a few jitters about the report: 

UK Trade Gap Just Gets Worse

Wider Trade Gap Highlights Continued Problems for Troubled UK Economy

Britain’s Current Account Deficit at Worst Level Since 1989

March of the Makers? Balance of Payment Figures Make Dismal Reading

The current account aggregates net trade of goods and services, foreigners’ earnings on investments in the UK, earnings on UK investments abroad, and cross-border transfers of money, goods and services. Here’s the equation:

 

In 2012, the current account deficit rose to £55 billion, or about 3.7% of GDP—the biggest it’s been since 1989. Some posit that’s a bad sign—that since foreign investment isn’t high enough to offset the current account shortfall, capital’s draining out of the UK, and crisis thus looms.

Here’s the problem with that logic: It assumes the UK economy is a fixed pie—that there’s only a limited amount of capital, and if more leaves than comes in, then the entire country will be worse off. But that’s not quite true.

Imagine I’m a country—the Sovereign Nation of Elisabeth. I have trade relationships with three nearby countries, Landlordia, Malldonia and Supermarketland, and I have a huge deficit with each. I buy lots of goods and services from them, but I don’t sell them a darned thing—and yet my country isn’t bankrupt. Why? Because I have other sources of income, like my job, which more than offsets my outflows. In essence, I create personal wealth (at least what little I can considering California’s high taxes and cost of living).  

And that’s how it is for the UK and other advanced economies with current account deficits. The UK may send more money out than it gets from abroad, but it also creates quite a bit of wealth domestically. Inventors get ideas, create products and start companies that grow into huge businesses—that creates wealth. People invest, and asset values grow—that creates wealth. The private sector’s net return on investment has ranged from 11% to 15% for over 15 years. Through year-end 2012, the FTSE 100 had returned 959% since 1981 (7.65% annualized). Private non-financials firms have accumulated about £750 billion in cash. Household wealth has steadily grown over time and is nearly £4 trillion today. All of this domestic growth is more than enough to offset the amount of capital flowing out.

Simply put: The UK has its share of risks these days, but the current account deficit likely isn’t one of them.

 

 

On Lady Thatcher

Head over to MarketMinder for my eulogy of Margaret Thatcher. 

On The Legacy of Margaret Thatcher

Cyprus and Precedent

Ever since Dutch Finance Minister and eurogroup head Jeroen Dijsselbloem suggested Cyprus’s bailout package could be the blueprint for future eurozone bailouts, investors have fretted the possibility large bank deposits in Spain, Italy or Slovenia may not be safe if those nations need a rescue. Never mind that Dijsselbloem’s spokeswoman said he didn’t mean it and Dijsselbloem himself issued a short statement calling Cyprus a “special case” and not a template. Eurozone officials aren’t exactly known for sticking to claims like this.

So, setting aside Mr. Dijsselbloem’s comments, what’s the likelihood eurozone officials go after large deposits in future bailout negotiations?

I suspect they’re lower than you might think.

I believe Cyprus was indeed a special case—not just because of the alleged money laundering, but also because of the sheer amount of foreign capital it attracted. German Finance Minister Wolfgang Schäuble suggested as much, saying Cyprus’s model of “attracting capital with low taxes and lax regulation” doesn’t work.

Hmm…that reminds me of 2011, when Mr. Schäuble told EU finance ministers Ireland’s 12.5% corporate tax rate “can’t stay like this.”

Core Europe—particularly Germany and France—has long sought to “harmonize” (a euphemism for synchronize) financial, tax and regulatory policy throughout the eurozone. They say this is to restrain “uncompetitive” behavior, conveniently ignoring that the outliers with more internationally favorable policies are actually competing. Ireland’s tax rate—one of the most competitive globally—was deemed uncompetitive, and Germany and France tried to force a raise. Officially, they argued this was necessary to raise Ireland’s tax revenues, but it soon leaked that they wanted a more equitable distribution of multinational corporations throughout Europe. Or, more simply, they thought Ireland was “hogging” all the business.

And today, I suspect they think Cyprus (and to some extent Luxembourg and Malta) is “hogging” all the foreign capital—that, by offering easy tax treatment and a light regulatory environment, Cyprus wasn’t playing fair with the rest of Europe. And it follows that, rather than make their own tax codes and regulatory schemes more attractive, they’d rather Cyprus and the eurozone’s other financial havens handicap themselves in order to spread the foreign capital around the continent. This gives officials every incentive to whack the banking sectors in these nations—and officials have made some telling comments about Luxembourg’s financial sector in recent days (Luxembourg, rightly, thumbed its nose).

The corollary of this is that officials have far less incentive to force losses on depositors in nations with smaller, less internationalized financial sectors. There’s no overarching (and misguided) desire to cut them down to size in the name of supposedly fair play. If these nations need a sovereign bailout, officials likely revert to the old bailout-for-austerity model, with taxpayers, shareholders and junior bondholders shouldering the financial burden.

The Inefficiencies of Public Investment

 As Europe continues muddling through a recession, the calls for more public investment in research and development are getting louder—high-tech fiscal stimulus, if you will. 

I can see why this sounds attractive. Typically, fiscal stimulus is associated with infrastructure spending, which only brings a temporary jobs boost. Improved infrastructure does facilitate economic activity—think how bigger high-speed broadband networks would improve commerce, or how more efficient rail systems would improve shipping times—but those improvements don’t immediately register in GDP. By contrast, spending on high-tech innovation—at least in theory—would provide longer-term job support as well as boost output.

But, there’s a catch—governments typically aren’t so great at picking which research initiatives to invest in. The money often goes to waste, as it did when the US invested $150 million in an LG Chem lithium ion battery production facility—where auditors discovered employees spent most of their time playing videogames because production never went online. Or, it’s used to create products for which there’s not much economic need. This is what’s happened in Taiwan, where the state-funded Industrial Technology Research Institute is about to release hotly anticipated … diapers.

Taiwan-Made ‘Smart’ Disposable Diapers to Hit Market This Year

By “smart” diapers, they mean diapers fitted with computer sensors registering when adult diapers are soiled and WiFi transmitters to let hospital workers know they need changing. It’s certainly one of the most innovative products I’ve ever seen, and I have to applaud the supply-side approach—there likely wasn’t huge pre-existing demand for something like this—but I question how productive these will be. The market seems limited—they’re designed for hospital, not household use. And whether hospitals will spend on the new technology or simply rely on patients to summon nurses when diapers need changing seems uncertain.

If a private investor were deciding whether to fund this project, they’d likely do a cost-benefit analysis weighing these and other factors to determine whether the initiative’s profitable. That last word is key—because private investors have more skin in the game, and because their main goal is return on investment, they’ll only invest in projects they expect to earn a competitive profit. And those projects likely end up being the most economically useful. Governments typically don’t have that profit motive, so there’s less incentive for them to be discerning about the pros and cons.

Don’t get me wrong, computerized diapers may very well improve quality of care for some Taiwanese patients. I just think money might be better spent on things that could have a greater impact—maybe improved X-ray technology, cutting-edge treatments, or new pharmaceuticals. Thankfully though, those industries have ample private funds behind them.

Will Spain Get a Break?

Spain may get some much-needed flexibility from EU taskmasters: Chief budget enforcer Olli Rehn said he might relax Spain’s 2013 deficit target “if there has been a serious deterioration in the economy.”

I’m not sure what constitutes a “serious deterioration,” considering Spain’s already in pretty bad shape. Considering the recession has worsened since Rehn loosened the 2012 target last March, a reprieve seems likely.

In an ideal world, the EU wouldn’t just grant an easier target, but it’d change its metrics. Currently, officials use the deficit-to-GDP ratio—a useful means of comparing different countries’ deficits, as it scales the overrun relative to the size of the economy, but not so useful when charting an individual country’s progress. A country’s absolute deficit could narrow from one year to the next, but if its economy contracted enough, the debt-to-GDP ratio could weaken, disguising the fiscal progress. This could force the country to enact tougher tax hikes and spending cuts in the following year to compensate, further hurting growth and trapping the country in a vicious cycle. If the EU were to set absolute deficit targets instead—merely making sure Spain overspends by less and less each year—troubled states could likely avoid some of the crippling tax hikes they’ve had to pass in recent years.

Without additional flexibility, Spain could get caught in this trap. Even with the reduced deficit-to-GDP target in 2012, Spain still had to pass one of the toughest tax hikes in its history to comply with EU budget monitors. Rising taxes have already weighed heavily on Spain’s consumers and private sector (Exhibit 1), and the 2012 hikes could further dampen these key economic components.

 

Exhibit 1: GDP, Business Investment and Consumer Spending

Source: Bank of Spain.

If the EU were to grant Spain a looser deficit target for 2013—ideally, one that stipulated the absolute deficit, not a deficit-to-GDP ratio—Spain might be able to unwind at least some of these tax hikes, giving consumers and private firms a break. That would improve Spain’s economic growth prospects, and with higher growth comes higher tax revenue, which would help Spain narrow the budget gap much more quickly—and in a manner that would make its people better off.

Showdown in Portugal

 Last year, I theorized that the EU/IMF/ECB troika’s mandated deficit targets were contributing to Portugal’s economic troubles by forcing the government to raise taxes when it should have cut them to stimulate growth. 

Now, it seems Portuguese President Anibal Cavaco Silva has the same idea:

 

Portugal Warns EU-IMF Troika to Back Off on Austerity Demands

Ambrose Evans-Pritchard, The Telegraph

One day after asking Portugal’s constitutional court to investigate the legality of the tax increases in 2013’s budget, President Silva gave a rousing speech on his “arguments” with the troika’s requirements. “Fiscal austerity is leading to declining output and lower tax revenue. We must stop this vicious circle,” he said.

He’s quite right. Below is an updated snapshot of how Portugal’s fared under the past year of austerity:

 

 

Source: October and December Statistical Bulletins, Bank of Portugal.

 

The more these numbers fall, the more Portuguese citizens hurt, and the less tax revenue the government collects—and the longer it takes to narrow the deficit. This aspect of the troika’s policy is counterproductive.

Now, some analysts say President Silva’s speech was a rebuke to Prime Minister Pedro Passos Coelho, but I don’t see it this way. Coelho had to pass another round of austerity measures last October in order for Portugal to continue receiving aid under its 2011 bailout agreement, and spending cuts alone wouldn’t have satisfied the troika. Without the threat of discontinued aid looming over him, it’s difficult to imagine Coelho—historically a champion of freer markets—pushing for Portugal’s largest tax hike in recent memory. President Silva may be using the tax hikes’ “fairness” as grounds to question their constitutionality, but in my view, this is likely just legal cover for an international political gambit. It seems pretty clear the troika, not the prime minister—and tax hikes in principle, rather than their fairness—is in his crosshairs.

Whether the troika takes heed and softens a bit, however, is another matter entirely.

 

More Trouble in Hungary

Storm clouds are gathering once again in Hungary. 

Over the summer, things appeared to be improving there. Prime Minister Viktor Orban’s government had amended prior legislative changes that would have limited the central bank’s independence and eroded some personal freedom. The need to comply with EU treaties, it seemed, would trump Orban’s ultra-nationalist aims.

Now, however, it appears optimism was premature. Orban may have adjusted the central bank legislation to comply with the EU’s requirements, but in practice, he’s still managed to strip the bank’s independence. In 2011, Orban appointed four “non-executive members” to the bank’s board, and these individuals have steamrolled monetary policy in Orban’s preferred direction, overruling bank President Andras Simor and his deputies.

Orban has been dissatisfied with Simor’s monetary policy since he took office in 2010. Simor has focused on preventing runaway inflation—a real risk in Hungary, where the currency is near all-time lows. Orban, however, wants monetary policy to be much more accommodative in order to offset the contractionary effects of his economic policy. Because he’s slapped banks, telecom and energy firms with extraordinary taxes, banks aren’t lending, businesses aren’t investing, and Hungary’s economy continues stagnating. Hence, Orban wants to slash interest rates to get capital moving again so he can keep these harmful taxes in place.

Simor would rather not play along—he understands loosening monetary policy will increase the risk of inflation and won’t fix Hungary’s underlying economic and policy issues. But rather than listen to reason, Orban seems content to continue forcing his agenda. Simor’s term expires next March, and Orban’s deputies are already eyeing a “new strategic alliance” with a central bank chief much more aligned with their interests—interests that likely include doing whatever it takes to artificially boost growth before the 2014 general election. A policy turnaround—something Hungary needs desperately—appears sadly unlikely.