Financial Adviser

April 2010

This month I am going to deviate from my monthly writing to present a daily letter I receive from a very respected advisory and research service.  I think it is important that client's see different viewpoints and ideas, also, as I do not see that the world has changed much in a month, I did not want to rehash any topics which I have recently covered.  Today's guest letter is from Gavekal, a financial services firm that offers institutional investors and high net worth individuals three different services: fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.  All rights are reserved.

From: Gavekal Daily April 9, 2010

The benefit of our constant interaction with clients is that it allows us to perceive where the greatest concerns reside. And in recent weeks, there have been four different questions that somehow have dominated every single client meeting we have had.

1. What is the Future of the Euro and the Eurozone? For years, we have argued that the main challenge for the Euro was not growing debt. Instead, the debt was simply a symptom of a greater problem, namely the growing productivity and competitiveness differences between the 'beer drinkers' (Germany, Austria, Scandinavia, Switzerland, etc...) and the 'red wine producers' (France, Italy, Spain, Portugal, etc...). And these differences have now come home to roost in the form of the Greek budget crisis to which there is no obvious economic solution. Instead, as we argued in What Happens Next for Europe? or The Question Europe Needs to Answer, the solution will have to be political in the shape of large and constant transfer payments from rich countries to poorer ones. But if this does not happen (and there seems to be little political appetite for it), the problems in Europe are likely to continue to fester, spreads to widen, until the cost-benefit analysis of default push some of the weaker links into restructuring their debt. Under such a scenario, the question becomes whether the looming restructuring will be 'investor friendly' (a la Uruguay in 2003) or unfriendly (a la Argentina)?

2. What is the path for long-term rates? In the US, the yield curve is now about as steep as it has ever been and with the knowledge that the Fed typically follows a) long rates, b) ISM surveys, c) economic prices and d) bank loan growth, then three out of four variables are today arguing for higher short rates. In our view, the growing signs that the US recovery is much stronger than policy-makers expected (see Will Consumers Provide the Next leg to the Market?), along with projected budget deficits for as far as the eye can see, and the knowledge that short rates are today at unnaturally low levels should lead the hawks to start making more of a splash. And with that background noise, it will be hard for long rates to compress.

3. Will inflation in Emerging Markets prove to be a bigger problem than consensus expects? Admittedly, this question rarely comes up in meetings but it is nevertheless one which is giving us pause. Indeed, we have argued since December that inflation in China could prove problematic (see Rising Inflation and a Possible Currency Surprise) and we are undeniably seeing similar worrying trends in India (see India's Cyclical vs Structural Inflation), Brazil (e.g.: yesterday's inflation number in Brazil came out at 5.17%, up from 4.83% the previous month), etc.

4. Does China face a bust? This question has clearly become the topic 'du jour' and almost every one of our recent meetings has revolved around answering that question. This sole focus on the China threat has, we must admit, been a surprise to us. Indeed, at the very time that Europe is going bust, a topic on which we have been fairly vocal over the years, we would have expected most of our clients to want to talk about that? Fortunately for us, the 'China bust' arguments are usually the same, namely a version of 'China is such a terrible capital allocator that it is bound to collapse very soon'. In our view, this very logical and thoughtful argument unfortunately fails to consider how China has been able to destroy capital for so long? As we have argued over the years, the combination of strong demographics and strong improvements in labor productivity have so far compensated for China's very weak capital productivity. Moreover, it is increasingly obvious that 'capital productivity' is the part of the Cobb-Douglas equation that China's more forward-thinking policy makers (Zhou at the PBoC, Liu at the CBRC...) are now trying to change with their plans of financial liberalization. Of course, such reforms might fail... but at this stage, it is still too early to bet on such a failure. If nothing else, China's financial liberalization means that we are still in a 'balance sheet expansion' phase.

In our view, the answer to the above four questions will be the main drivers of financial markets for the months to come and unfortunately, making a decision tree with four questions leads to at least 16 possible investment scenarios... of which only one is likely to be right!

Coridally, and until next month, your looking for answers to very hard questions advisor.

Kirk Spano