Reforming China

There have been a couple of minor reforms in China that could prove to be the start of something bigger.

The Government has proposed restricting the amount mobile phone companies can spend on marketing, at the same time they have announced a plan to create an infrastructure company to take ownership of the cell towers.

China’s State Owned Asset Supervision and Administration Commission (SASAC) that “owns” all the State Owned Enterprises has told the three cell phone companies to reduce their marketing and subsidy costs by 20% for each of the next 3 years, shifting the focus away from attracting new customers to retaining existing one. Merrill Lynch recently issued a report where they expect the profits of the whole system to rise by 12% because of this one change.

In the early stages of mobile rollout, acquiring sufficient sites to install transmitters is a major strategic imperative; market coverage, not only by area but also reliability, is a vital marketing tool to attract and retain clients.

At some point, coverage stops being a tool to differentiate between established firms as they all cover the same area – look at the coverage of the three major Canadian cell phone companies, and you see that they all provide essentially identical service in identical places, whilst they all fail to provide coverage in the same places as each other.

Depending on the exact business model chosen, an infrastructure company can free up capital for the cell phone operators as it buys up their existing infrastructure. It can reduce total capital expenditure, as the operators are able to lease capacity, resulting in less duplication of equipment. Again, using Canada as an example, our major Celcos are each building near identical LTE/ 4G systems nationwide. Capex would be greatly reduced if they leased capacity from an infrastructure company, only adding their own capacity where lease capacity was inadequate.

Under such a model, new entrants and discount brands would also find it much easier to break into the market.

The same Merrill Lynch report estimates the value of the infrastructure changes to the three Celcos to be around $30bn.

The two announced changes amount to about $50bn in today’s money. If we assume ½ that $50bn makes its way back to the Government in higher taxes and dividends from the 3 telephone companies that is an extra $25bn in Government revenues.

We are seeing similar “small” scale initiatives in other SOEs; PetroChina is preparing to sell two large gas transport pipelines. As the old Government adage goes, with a billion here and a billion there, pretty soon you are talking real money!

If this improved capital management is sustained, and don’t forget that there are a lot of insiders who will lose out if it is sustained, not only will the GDP growth rate decline at a slower pace, but Government revenues will also see a meaningful improvement, allowing them to better tackle several of the key issues, such as the shadow banking system.

These changes are small, and are certainly not the “Big Bang” approach some people are demanding, but every journey starts with a single step.

Mea Culpa

First mea culpa, this blogging on a regular basis is a lot harder than it first appears. How Leo Kolivakis at Pension Pulse can do it every day is beyond me. As it used to say on my old school report – “Must try harder”

Second mea culpa, I also got the Ukraine situation badly wrong – the worst I foresaw was what euphemistically gets called “Collateral Damage” and we are certainly beyond that now.

Despite the situation having deteriorated farther than I anticipated, it hasn’t driven the markets down any farther. The attached chart of the Gazprom GDR shows that following the initial drop on the  invasion of Crimea it has mainly ignored recent events, although volatility has picked up. 

We have hung on to our basic positions in Russia, but more recently we have been “renting” stocks to take advantage of the volatility – buying small positions on down days they selling them out when they bounce; ideally we would be doing this as part of our option overlays, but there aren’t enough listed options on the GDRs.

Few precise details have emerged about the recent gas deal signed between Russia and China, but a couple of analysts who have run their slide-rules over what little we do know have suggested that it is at best a breakeven deal for Russia. Given that Putin was very keen to show the West that he has other choices of “friends”, it would not be surprising if China were able to drive such a hard bargain; in short, Gazprom remains a continuation of State policy by other means and as such will remain very “cheap”.

Some commentators have tried to use the deal to paint President Obama in a bad light – weak, ineffective, etc – the Realpolitik is that there is very little more he could do without Europe taking a stronger stand and there certainly doesn’t appear to be much appetite for that currently. Ironically, President Reagan warned of this kind of impasse when Western Europe first started negotiating to import Russian gas back in the 80’s

Now that Sunday’s Presidential Elections have returned the pro-European Petro Poreshenko things should calm down for a while. The forced closing of poling stations in several of the pro-Russian strongholds, such as Donetsk and Lugansk, only serve to legitimize a government that will probably be just as corrupt as the last one. It doesn’t make Russian stocks a screaming buy, but they should move slowly higher as things “normalize”

In recent weeks we have observed the Brazilian market get a bounce every time Dilma’s approval ratings drops, or word leaks out that preparations for either the World Cup or the Olympics are going badly; FIFA has said publically that the preparations for the World Cup are the worst they have ever seen, whilst the IOC has apparently informally approached the UK to see how quickly they could bring back on-line the facilities used last time around.

Congress has opened an investigation into the purchase of a refinery in Pasadena TX when Dilma was the Minister for Mines and Energy and Chairperson of Petrobras. The company was forced to acquire 100% of an operation they only wanted to acquire 50% of, paying out $1.25BN instead of their expected $360M, for an asset that was possibly only worth $42M. As a long-term follower of Petrobras, none of this surprises me.

Expectations of a first round win for Dilma have faded, although she is still currently expected to win in the second round. IF the Government is forced to introduce any kind of electricity rationing because of the poor rains, the October race will be wide open. Dilma, again in her previous role as Minister for Mines and Energy, intervened in the market to ensure that returns on investment were below those required to bring in new capital, so now the country faces a shortage of back up capacity and a $20Bn subsidy bill.

I remain confident that the World Cup will be a success, in the sense that it will happen, someone will win, and that people will have fun. Should Brazil get to lift the trophy again, they will probably deem it to be the greatest series ever.

I am happy to see the election of Narendra Modi as the new Prime minister of India. To call the Gandhi clan that has been at the core of India’s mismanagement for so long “tired and corrupt” would be an understatement. India needs someone who is not permanently trying to hold the poor back, but is actively trying to give them opportunities. Modi comes with baggage that is for sure, but he deserves the benefit of the doubt at this stage.

I used the bounce in many of the Indian names in my portfolio to cut back exposure, not because I doubt Modi’s abilities, but because I recognize that he has a herculean task ahead of him. Despite all the good wishes, we won’t know if he is actually going to be successful for quite a while as the vested interests fight to maintain their privileges.

Finally, I am surprised it took the Thai military so long to intervene in the dispute between the Government and their opponents. Given how the country has become increasingly polarized whilst the economy has slowly stagnated  - the State Planning Agency recently announced that the economy has slipped back into recession – it was only a matter of time before they stepped in. 

Unfortunately the coup isn’t likely to solve much of the underlying problem as they are too closely aligned with the “Blue Shirt” opposition of the urban elite. Perhaps they would have had more credibility if they had forced Suthep’s supporters NOT to have boycotted the Februa

Half a league, half a league

Last week was not a week to write a blog.

Although the Russian invasion of Crimea was the major event and had the expected and inevitable effect on the markets, it was so overwhelming event that it drowned out any thoughtful discussion. Best to let things settle down a bit first.

As entertaining as all the sturm und drange about the invasion has been, it is actually pretty pointless. Western Nations are not going to do anything dramatic, and token visa sanctions stopping oligarchs and friends of Putin visiting their London mansions just mean they will spend more time on their yachts.

Bloomberg has gone so far as to post “Russia’s Ukraine problem in six stark lines”. All good stuff, but Putin doesn’t care. He’s rich enough and protected enough; he measures his “success” in different ways.

The UK journalist, Jeremy Paxman, recently described how he felt modern society would never support a rerun of World War 1; we are too self obsessed and hedonistic. The days of sending in a gunboat are even the Light Brigade are long gone. That is NOT necessarily a bad thing, but it does make effective sanctions harder. I am sure Paxman is right, and no doubt President Putin feels the same.

What matters to Putin is rebuilding the image of a strong Russia and reversing the humiliations, as he sees them, of Russia since the fall of Communism. If the Western Powers are so pissed off with him that they are holding emergency meetings, discussing sanctions, or moving military hardware strategically, that means he has a result.

I cannot begin to fathom where this particular story will end, and frankly I don’t think anyone else does. Of all the talking heads out there, someone will be right, but we won’t know until the end who that it is.

Russian stocks are cheap. They were cheap before this invasion, and they will remain cheap for a very long time. I would venture to say they will remain cheap until Putin is clearly on the way out (Whether the ensuing rally will be a false dawn or not only time will tell, but it will make for a fun ride). There will still be opportunities there, although many will be “rentals” for a while. I am looking for real businesses that don’t depend on Government connections and that Putin won’t find a “strategic” need to get involved in.

In the mean time, Europe has a serious problem; it is too dependent on Russian gas.

It is particularly vulnerable to further escalation in the Ukraine, but ultimately it is vulnerable to the whims of Russia. Most people would probably say that Russia has too much to lose by cutting off supplies to Europe entirely, and I would agree, but so much can go wrong in a heavy winter; a few production problems in Siberia, a faulty valve in a pumping station, new monitoring equipment not working as planned…

So I can certainly see Germany quietly restarting its nuclear electricity program to give itself more energy choices. Realpolitik will mean that any announcement will try to avoid any linkage, but I would expect confirmation over the summer that the Government has been “running tests” as it slows down the decommissioning process.

Western Oil companies will pour into the Ukraine to exploit their shale gas, Europe’s 3^rd largest reserves. Ukraine needs the money desperately and the West needs the gas; it’s a marriage made in heaven

Chevron and Shell have both signed deals already, but with the ancien regime. I’m sure, given her history, Yulia Tymoshenko will be easily persuaded to allow such contracts to stand and will encourage the newly elected president to take the same approach. Other former Soviet Satellites, such a Lithuania and Poland, will also accelerate development of their shale reserves.

Elsewhere, the most exciting thing to happen was a bond default in China, that some people are calling China’s Bear Sterns moment. Bear Sterns was famously “saved” by JP Morgan, and markets continued to rise for several more months, thinking that the credit crisis had been averted. The bankruptcy of Lehman Brothers a year later showed the folly of that over-confidence. I think the comparison is a little misplaced myself.

As I have mentioned before, China needs bond defaults so that investors start to price risk correctly and they can start to control the runaway credit in the shadow banking system. Allowing such defaults, especially in an environment where they go against vested interests, is always painful. The trick is going to be allowing sufficient defaults to take place to allow the credit cycle to work but without so many happening that a complete credit freeze occurs leading to a complete rout.

The process becomes more complicated in China where a default can very quickly be seen as a punishment of someone who did not have the right connection, reinforcing the graft and influence peddling that the Government is trying so hard to reign in.

Although this default was widely flagged ahead of time, it has set the Rumour Mill into high gear, and the market is now awash with stories of banks calling in large numbers of private loans, steel mills being forced to shut down….

Complicating the picture are some pretty awful Chinese February export numbers, down 18.1% year on year when expectations were for a gain of 7.5%. It is highly likely that these awful numbers are a product of the usual distortions that occur around Chinese New Year, as the numbers for the first two months of the year only show a decline of 1.6%. Given that the Chinese authorities are also working very hard to squeeze out the rampant over and under invoicing that plagues Chinese trade data, that is probably an OK number.

All in all, I’m starting to get encouraged that an awful lot of very bad news is in the market. We haven’t seen one of the big blow offs that usually mark a turning point, and that makes me nervous, but several of the most vulnerable markets have actually rallied in recent weeks. Barring a plague of Frogs, it is hard to imagine what isn’t being discounted at current levels.

Show me the Money!

For a great many investors, perhaps “You had me at Emerging Markets!” would have been more appropriate, but the truth for so many is that profits and market performance have too often lagged economic growth.

As I have commented in previous posts, Governments have interfered with markets to create national champions that are spectacularly inefficient, at the same time they have often turned a blind eye to corruption that has drained profits into offshore banks, or the property markets of London, Dubai, and Miami.

I was reminded of this conundrum this week whilst talking to a potential client, who asked me about China, and the somewhat bearish views of Michael Pettis. The point he was taking from Mr. Pettis’s work was that mathematically Chinese growth has to slow down more than currently expected as the economy rebalances from an investment led model to a consumption led model. I think where I disagree with Mr. Pettis is probably only a matter of timing; I think it will take a few years longer to slow growth in investment, and that raises the spectre of more malinvestment accumulating that ultimately has to be written off.

I did, however, start to think a little harder about being wrong. What would it mean if investment did slow faster or consumption grew faster than expected? I kept coming back to the 3^rd Plenum last year.

Ironically, Mr. Pettis’s argument could imply a stronger case for investing in China, as it would mean that the reformers were gaining the upper hand and actually cutting the damage being done in and by the State Owned Enterprises. IF the big Chinese SOEs are forced to ration capital and raise the rates of return on investment that would have the perverse effect of raising profits as growth fell. Valuations could actually rise, given the increased transparency.  You might almost get a second wave in investment as FDI came in to take advantage of the new opportunities being opened up.

Sadly, as things stand today, this is just a pipe-dream.

China’s shadow banking system needs to be cleaned up properly first, and the authorities are still trying to hide the problems rather than deal with them.

Recently, a product sold through China’s biggest bank, ICBC, was restructured before it could go “bankrupt”.  The restructuring only involved taking a minimal haircut on interest, but left the principle intact. Given that the underlying company was entirely bankrupt, this is being interpreted as a Government bailout of some sort, even if one is not entirely sure which level of Government was involved. Needless to say, such a move is entirely at odds with the proposed reforms of the 3^rd Plenum, and raised the moral hazard within the Chinese banks significantly. Plus ça Change!

Elsewhere, I am hopeful about Mexico and their attempts to pass reforms. I got some great feed back from the presentation made by Pemex at a recent conference, and the very grounded nature of Senior Management. Everyone was contrasting them to Petrobras and how much more realistic Pemex seemed.

Mexico Sovereign Debt was recently upgraded to an A- rating by Moody’s because of the reforms passed last year that should “strengthen the country’s growth prospects and fiscal fundamentals”. The country was also a winner at the recent WEF meeting in Davos, getting material commitments for new investment.

One area where reforms are taking place, and where we are seeing earnings growth commensurate with economic growth is sub-Saharan Africa. It is an area that interests me greatly and I am looking to get more involved even though I have to eat platefuls of humble pie to say that.

I don’t wish to underplay the problems with these markets; they don’t even qualify as Emerging but are firmly in the pre-Emerging/ Frontier camp. They are often so inefficient that even a slight reform can have a huge difference.

My Nigerian friends swear about the poor service of MTN and the other cellphone providers, but they will follow that up by telling you how much better even that poor service is compared to what they had before, and how it has improved their lives. At the same time MTN has been able to realize, in hard currency, substantial profits, all because the Authorities let a South African company challenge a national monopoly.

It is not just in Nigeria that change is happening. Zambia has been creating a more business friendly environment since Kenneth Kaunda was replaced in 1991. The attached article from the Economist highlights one of the better-know success stories, Zambeef.

Renaissance Capital has just started its 5^th sub-Saharan investment conference in Lagos, and it looks to be a blowout. Merrill will shortly be holding their Sun City conference, which looks to be as popular as ever (it’s a great conference) but the side trips to Nigeria, Kenya etc. look like the real draw this year whereas they were not even available a few years ago.

When I was at business school, too many of my friends from these countries were desperate to get their money out. Now they are all talking about starting businesses and trying to get money in.

I would NOT recommend your average investor go out and fill their portfolio with Nigerian or Kenyan stocks, even if they were actually able to get access to them. I would, however, recommend following them in the newspapers rather than just skipping over them. If you look at say a Guinness or a Nestlé, don’t skip over any discussions of these Frontier markets, but read them carefully, because if you want to see the money, that’s where it is going to be.

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 A couple of interesting videos - I'll leave it to you to decide their relative merits

Before we were so rudely interrupted…

I didn’t intend to maintain such a long break between posts, but the cold weather here in North America caused a few unexpected problems.

Meanwhile, the world seems to have decided to go into panic mode, triggered by a fall in the Argentine Peso.

Obviously the situation really has nothing to do with Argentina and its currency mismanagement. Devaluations in Argentina are a bit like eruptions of “Old Faithful” in Yellowstone National Park; if you missed the last one; it’s never too long to wait for the next one.

In Davos this week, David Rubenstein (Carlyle Group) and Larry Fink (Blackrock) both made comments about people being too optimistic and not worried enough. I have no doubt they were including Emerging Markets in that, but EM problems have been very widely flagged since last summer, whilst the S&P has gone on to reach new highs.

From the attached Economist data table, one can see that the “Fragile Five” do indeed have week external balances. Looking at Brazil, we see a Current Account deficit of 3.7% of GDP and a Budget deficit of 2.7%, almost as bad as the UK’s numbers (3.7 and 6.7), and only slightly worse than Canada’s (3.0% and 3.0%). Most of the famous “PIIGS” have at least one measure significantly worse than the “Fragile Five”, whilst PIIGS Gross Public Debt numbers are all worse than those for the Fragile Five.

I have also attached the Economist‘s Sinodependency index, an attempt to show how dependent large US companies are on China. It would be interesting to see the concept expanded to Emerging Markets in general, and across countries other than the US; Germany’s Volkswagen is the number 1 brand in China currently. The original interactive version is available here.

I am not trying to divert attention away from the significant problems that exist in Emerging Markets; they would not be Emerging Markets if they didn’t have problems. One of the lessons, however, that should have been learned from the Global Financial Crisis was that the differences in risks between Developed Markets and Emerging are less than popularly perceived, not because Emerging risks are lower, but because Developed risks are higher, even if only because of their increased Emerging Markets exposure.

I still remain deeply skeptical of the Euro project; despite all the talk of the various PIIGS being saved, they are still massively in debt, with at least one of their major balances – usually the Budget deficit – still very ugly. The overall Euro area may be in balance but that still cleaves between an almost predatory Northern group, and the moribund Southern group; the “failure-to-launch” of the French Economy puts them firmly in the Southern group. Comments out of the UK about France being the real weak link in the Euro are probably more about British Schadenfreude for all things French, but they do serve to highlight the extent of France's problems.

The Basel III leverage requirements were recently watered down at the insistence of the German and the French Governments because it would have forced their banks to shrink their balance sheets more aggressively than is currently happening; in short, their banks still require massive regulatory forbearance because they have not been cleaned up to the extent of the US and UK banks.

The UK is expected to be the fastest growing major economies in 2014, and should be the first to raise interest rates, but that has come at the expense of a re-inflated housing bubble. It’s only a matter of time before UK TV is again dominated by shows telling everyone how easy it is to make money by flipping properties.

Shadow banking, not just in China, is going to be a major issue this year. As the FT recently reported, “Shadow banking worries extend far beyond China. Paul Tucker, a former Bank of England deputy governor, claimed on Thursday that regulators around the world were struggling to keep up with the pace of change in the “shape-shifting” non-bank sector. He warned of “faltering vigour” in official oversight of global markets.

In a paper published by the US think-tank, Brookings Institution, Mr Tucker said regulators around the world needed to display greater flexibility to cope with “endemic regulatory arbitrage and the shape-shifting dynamic of finance”, pointing to problems in both advanced and emerging market economies.’

So I have to agree with Messrs. Rubenstein and Fink, there is a lot to be worried about, but where can we look for relief?

I actually take comfort from the reduction of QE by the Fed. US house prices have clearly bottomed, and as I mentioned in a previous post, US economic growth is gaining traction. Even if that does not justify the current valuations of the S&P, a stronger US economy can only be a good thing.

Despite my fears of a UK housing bubble, their economy unquestionably has momentum, and, having used unemployment as an early indicator to raise rates, failing to follow through would undermine BoE credibility. I think even a symbolic increase of 1/8^th accompanied by the message that the Bank was actively monitoring the effects of the increase on the economy, which they would be doing anyway, would send a very positive message.

The fact the Brazil’s President, Dilma Rousseff, went to Davos on a charm offensive, rather than trying to polish her socialist credentials as in previous years, suggests she at least recognizes the magnitude of her problems. A swift readjustment to imported diesel prices to compensate for the weaker exchange rate would also suggest she is prepared to act. Unfortunately, the World Cup followed by Presidential elections in October mean we are unlikely to see anything more decisive than that. IF, however, she replaces Guido Mantega as Finance Minister in her second term that would really set the markets racing.

Chinese New Year is early this year, starting January 31^st. Given that it is always a confusing period for Western observers that is probably a good thing. We have already seen signs of seasonal disruption to Steel inventories, Iron ore shipments, and possibly even the PMI. Currently the prevailing attitude seems to be all news is bad news, so the sooner we can get past these distortions, the better we can understand the real situation, whatever that might be.

Turkey will get a pass. Unless PM Erdogan does something really stupid, he will ultimately enjoy the backing of the US, the EU, and the IMF, despite all the sturm and drange in the meantime. Turkey is too important an ally, and despite Erdogan’s increasingly authoritarian tendencies, the country is firmly on the democratic track. Even 10 years ago the army would have been on the streets by now. I have known Mehmet Simsek, Turkey’s Minister of Finance, for years and he is a VERY safe pair of hands.

Elsewhere, the $7 billion in investments that Enrique Peña Nieto of Mexico managed to secure at Davos shows the benefits of his reform program. I am under no illusions as to the enormity of the task ahead of him in actually implement his program, but he has already made more progress than either Presidents Fox or Calderon, and he seems to be able to forge alliances with the other parties to produce some kind of result.

Sub-Saharan Africa has seen a renaissance in recent years. The commodities boom may have triggered it but it has gained a momentum of its own as local firms, such as Dangote in Nigeria, as well multinationals such as Nestlé and South Africa’s Tiger Brands look to expand. Some of the initiatives, like Kenya’s Mpesa, are truly world class and will continue to drive growth forwards.

Currently I am working on the premise that the first half of 2014 is going to be highly volatile, with at least a major correction across all markets, but I see that correction as being highly cathartic. The kind of correction that would give Merrill's Michael Hartnett his major buy signal, so I am also putting in place my strategies for that spike down.