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‘A butterfly flaps its wings in Athens and is heard in Beijing’

Industry investment research is often more useful in defining what assumptions are already factored into share prices than highlighting what is likely to move them going forward. Much of what passes for “analysis” in the investment industry is simply the extrapolation of current trends into perpetuity. So it should come as no surprise that market pundits, strategists and other investment operators nearly all agree that 2010 will look very similar to most of the years from the last decade: the global economy will be led by the rise of China and other emerging markets; commodity prices will continue to appreciate and the US dollar will continue to depreciate, particularly against its main rival the euro (see chart 1). Developed market equities will struggle to keep up. The future, according to this view, will look very much like the recent past. We disagree.

Chart 1: Trades of the last decade 2000-2009

It is a basic rule of investing that no asset class or industry can sustain superior risk-adjusted returns indefinitely. If it were so, investing would become easy. It is not. Flows of capital always erode supernormal returns, which is why bull markets rarely repeat. Over the last decade, capital has flowed out of the US dollar into emerging markets, commodities and the euro. The longer this trade has gone on, the more complacent investors have got about the dangers, with many even suggesting that its continued success is inevitable “forever” as if throughout history these assets have exclusively been in bull markets. Such sentiment tells you a lot about the recent past but nothing about the future. The only element of inevitability is that one day the trade will stop working with spectacular results: the question is when? The dawning of a new decade may seem a rather too convenient time for the only three successful trades of the 2000-2009 period to go into reverse, but we sense that the tectonic plates of the investment world are shifting, and that many of the macroeconomic assumptions already baked into share prices may be about to be seriously questioned or go into reverse. 2010 may be remembered not necessarily for the end of the 2009 economic recovery trade, but instead the reversal of the 10 year trade in emerging markets, commodities and the euro.

The bull market in the euro has been remarkable. From being valued at $0.85 in Q4 2000, the euro peaked at $1.60 in mid-2008 (+88%). Today the euro trades at $1.40, though theoretical purchasing power parity values it around $1.15. In addition to this fundamental cheapness, many of the structural reasons to have been bearish on the US dollar, and by implication bullish on the euro, a decade ago no longer hold true. Having fallen by an average of 31% peak to trough, US house prices are now recovering in most cities, with affordability ratios relative to earnings and particularly mortgage rates below historic averages and the supply of new homes limited by the availability of finance to house builders. The US trade deficit has shrunk from a deficit of 6% of gross domestic product (GDP) in 2006 to a deficit of 4% currently, whilst the personal savings rate as a percentage of GDP is currently running at 5% compared to 1% a few years ago. While the US government deficit of 10% and its total debt/GDP ratio of 92% is slightly higher than the eurozone as a whole, some countries within the eurozone – notably Portugal, Italy, Ireland Greece and Spain (termed the “PIIGS”) – have significantly worse public finances. There is also greater certainty of political unity in the US, a more flexible and dynamic economy and therefore almost certainly lower sovereign risk overall. It is by no means perfect but the US is an economy with a better future than its recent past would suggest.

Cyclical factors are also supportive of the US. The economic recovery in the US is proving to be considerably more “V-shaped” than the recovery in the eurozone. Our non-consensual call of two consecutive quarters of 5%+ US GDP growth now looks more certain with the news that the US economy grew by 5.7% (annualised quarter on quarter) in Q4. This should be compared with equivalent estimated Q4 growth in the eurozone of just 1.2% (annualised quarter on quarter). The labour market in the US is recovering at a rapid rate with initial jobless claims falling rapidly and is likely to see net job creation in Q1 2010 (we should see a positive non-farm payrolls number). This is normally the part of the economic cycle where interest rates begin to rise. Interest rates at 25bps in the US against 100bps in the eurozone is the last reason to still be bearish on the greenback and therefore by implication, bullish on the euro. By the end of the year, rates in the US could be higher than in the eurozone. All of this is positive for the US dollar.

When 13 European countries decided to join the euro in 1999 (notes and coins began to circulate in 2002) the incentive was most obvious for those countries that hitherto existed in the continent’s financial hinterland. By coincidence these were also on its geographical periphery. As late as 1996, the governments of the “PIIGS” were borrowing ten year money at an annual interest rate of between 9% and 13% (see chart 2). Greece did not have a 10yr bond at all until 1999. By joining the euro, they could all borrow money on the same terms as Germany, which for most of the last decade has been between 4% and 5%. Not surprisingly this vastly increased the availability of credit in the “PIIGS” resulting in rising domestic asset prices and stock market outperformance relative to “core” Europe over the last decade. It all seemed so simple.

Chart 2: European 10 year government bond yields

Rather inevitably, boom has now turned to bust. As these domestic asset bubbles deflate, the “PIIGS” are denied the option of currency devaluation or quantitative easing by membership of the euro and owing to the debts they have accumulated in euros. Owing to the high value of the euro relative to its purchasing power, the “PIIGS” economies remain uncompetitive and unattractive to international capital flows. It is a deflationary spiral likely to last many years. There are only two obvious solutions: either fiscal transfers (aka handouts) from “core” Europe or a lower value of the euro on international capital markets in order to regain competitiveness (with the latter perhaps being the easier option to sell to the electorates of the “core”).

The “Maastricht Criteria” set out the rules of membership of the currency union, with government deficits to be limited to less than 3% of GDP and total debt/GDP limited to below 60%. In 2009, only Finland and Luxembourg still met the criteria and none of the 13 member countries are forecast to stay within it in 2010. This year Greece is forecast to have a 10% deficit (down from 12.7% in 2009) and total debt/GDP of 123%. The cost to the Greek government of borrowing money for ten years is currently 7%, compared to 3.2% in Germany. With such elevated borrowing costs, and such a significant amount of total debt outstanding relative to GDP, markets will continue to view the situation in Greece as unsustainable. Either the Greek government demonstrates some credibility in bringing down public spending or its wealthier eurozone partners will have to bail it out. The alternative is that borrowing costs continue to widen until Greece defaults. None of the options are good for the euro; default would be calamitous. The Greeks and the Germans are currently dancing around their handbags preferring that the other makes the first move, but the markets may soon pull the plug and shut down the disco.

Reports that the Chinese government is in negotiations with the Greek government to help it refinance debt may not immediately arouse suspicion but it is worth highlighting how the emerging market trade has been helped by the strength of the euro. China, like many other Asian economies, pegs its currency to the dollar and its economy has benefitted significantly from the dollar depreciation against other tradable currencies. Although China has allowed the yuan to appreciate against the dollar by 20% since 2005, since 2000 by virtue of the dollar peg, the euro has appreciated against the yuan by 43% (see chart 3). Little wonder that many manufacturing industries within the eurozone over the last decade, such as the Italian textile industry, have been undercut by lower cost Asian producers. Despite (presumably insincere) protests against dollar weakness over the last few years it is difficult to argue that the dollar bear market has not suited the Chinese government’s mercantilist economic aims. Trying to keep the euro artificially high through propping up the Greek government’s liquidity might be viewed as a small price to pay in Beijing.

Chart 3: Euro/Yuan/Dollar

Much of the eurozone economy is manufacturing and export focused, so the bull market in the euro has had an obviously negative overall effect on eurozone competitiveness. For investors, however, currency and economic growth are two sides of the same coin and investors should be ambivalent to which way they generate their return. The economic progress of countries for investors should therefore be measured in the same unit of currency given that investment return is usually un-hedged. The eurozone’s anaemic growth in euros over the last decade has been well documented, as has the rapid growth of China in yuan or US dollars. What is less well known is that if economic growth is measured consistently (i.e. in the same currency) then the eurozone economy doubled in size over the last decade, with GDP increasing from just over $6,000bn to just over $12,000bn (see chart 4). The Chinese economy (including Hong Kong) trebled in size over the last decade, with GDP increasing from just over $1,500bn to $5,000bn. Conventional wisdom says it was China’s decade, yet the eurozone in aggregate added $6,000bn at the same time as the Chinese and Hong Kong economy added just a little more than $3,500bn. Yet most investors continue to hold the opinion that it is only a matter of time before China becomes the world’s biggest economy!

Chart 4: GDP of leading economies US$bn, Jan 2000 to Dec 2009

This brings us to the most dangerous assumption of all – extrapolating Chinese economic growth rates and in particular the recent exponential growth in Chinese infrastructure roll-out. We have commented before on the surprising size of the Chinese government’s 2009 fiscal stimulus package ($266bn) relative to its GDP (6.1%), and the 35% growth in loans and 30% growth in money supply in 2009 after a decade of expansion of credit in excess of GDP (see chart 5). Such stimulus has resulted in exponential growth in 2009 on transport infrastructure, residential and commercial property and even consumer expenditure on new cars. China bulls see this as confirmation of the country’s growth potential and believe that the rate of growth can be sustained at such astronomic levels. But it is more likely that given the degree of one-off stimulus in 2009, levels of growth fall significantly in 2010. This is “cash for clunkers” on a grander scale.

Chart 5: Chinese monetary conditions

Having already sustained an unprecedented decade long boom in infrastructure expenditure (gross capital formation in excess of 40% of GDP growth) it seems that relative to its lowly GDP/Capita of $3,000, Chinese infrastructure roll-out is probably already well advanced and that the multiplier effect of further infrastructure build on economic growth may be negligible. We simply do not know how many roads, airports, factories and office blocks have been built for which there is currently no use. Although anecdotal evidence suggests that the degree of infrastructure over-build could be significant, it is not likely that the Chinese government will tell us. Moreover, in order to hit headline GDP growth rates of 8-10% per annum, the Chinese economy is becoming more, rather than less dependent, on fixed asset investment-led “growth”, which contributed 45% of all GDP in 2008 (see chart 6) and, according to official statistics, more than 90% of GDP growth in the first nine months of 2009. If fixed asset expenditure in the Chinese economy (now just over 50% of the GDP compared to 18% in the US) does not grow at all in 2010 (and if the Chinese government is serious in its crack down on credit expansion then it may actually contract) then in order for the Chinese economy to sustain growth at 8% per annum, consumption and exports in total will have to expand at an unlikely 16% per annum. It is difficult to see how the stock markets of China (and indeed India where a similar process is underway) will be able to sustain their lofty valuation multiples in the face of credit tightening and lower growth.

Chart 6: Chinese GDP composition %

Moreover, if growth rates in Chinese fixed asset formation have peaked or there is no growth at all, then – in contrast to recent history – in all of the commodities for which China is the dominant consumer (copper, aluminium, cement, coal, zinc, steel, iron ore) the world is facing significant over-capacity and falling prices. All of those presentation slides showing how Chinese growth for various commodities has been exponential and how bullish this has been for those particular commodity prices can equally now be turned around to show how dependent rising prices have been on demand that will no longer be as robust. Supply would exceed demand, leading to commodity prices falling back to their marginal cost of production, eroding supernormal profit margins amongst commodity producers. Emerging economies like Brazil and Russia whose economies and stock markets are highly dependent on commodities would suffer; sovereign risk would also rise given that international investors will be fairly low down the list of priorities in the fall-out. By the time any of this becomes obvious, international investors will cut their overweight positions in emerging markets and flee back into the safety of the US dollar, further exacerbating the process. The clichéd newspaper headline of “Submerging Markets” could be seen again before too long.

The last decade has been an exceptional period for emerging market economies and stock markets and an exceptionally poor decade for developed market stock markets but not (contrary to perceived wisdom) for developed market economies. In explaining the successful trades of the last decade we would be better served focusing on those factors that have been unique to the 2000-2009 period rather than those that have always existed but have not always led to emerging market out-performance (see chart 7). This also explains why the trades have been highly correlated. The unique factor has been an abnormally low cost of capital in emerging markets and at the heart of this has been the US dollar bear market. When a butterfly flaps its wings in Athens it will be heard in Beijing.

Chart 7: The dollar, emerging markets and commodities

Barry Norris
Partner, Argonaut Capital

The opinions expresssed here represent the views of the fund manager at the time of preparation and should not be interpreted as investment advice.

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