Has Globalisation Peaked?

When Margaret Thatcher gained power in May 1979, one of her first actions was to remove all foreign exchange controls, and allow British investors to make investments all over the world, almost for the first time since 1914. The subsequent deregulation of the City of London, in 1986, was followed by the US repeal of the ‘The Glass-Steagall Act’. We have had thirty years of expansion in the financial sector, and a rapid growth in global economies. With the Berlin Wall coming down in 1989, with China and India as well as Russia, and Eastern Europe all opened for trade and investment, and with a massive increase in the global labour force of nearly three billion people. We have also had a deflationary wave, thanks to low Chinese labour costs. The question, which an investor has to ask himself today, is, with the Trump phenomenon in the United States, Boris Johnson leading the ‘Brexit’ movement in the UK and, as the French president said: “If the Schengen open border scheme is at an end (because of the refugee crisis)” it means, “the end of Europe”. Are we witnessing today the beginning of the end of the globalisation trend?

This week China reported a 25% drop in exports: while we must not read too much into one month’s statistics, there is no doubt that there is a general slowdown in global trade. The deflation in raw materials such as oil, gas, iron ore and other minerals, and even soft commodities, has impacted the dollar volume of trade, especially in Asia, but also there is weak demand in Europe and developed markets, which is being transmitted to the emerging markets in Asia, Africa and Latin America. We do not believe that the short term bounce in commodities prices will last. There is a long term trend of oversupply in oil and minerals, which will continue to weigh on prices for ten years or more. Our view on China, is that it became oversold in the first two months of the year. Now that the Renminbi has stabilised, capital outflows have slowed down, and Beijing has emphasised their 6.5% growth target, we expect that this will put a floor under the Asian share markets. It is remarkable how close the correlation has been between the Renminbi and global equities, last summer and again in January.

However, we continue to believe that by 2017, there will be a more serious slump developing in property values in major Chinese cities, and especially in Hong Kong, where property transactions are already down 70% from a year ago, and prices have fallen about 10%, so far in a thinly traded market. We see neighbouring cities such as Shenzhen also being in a bubble situation, where residential prices have risen eight times in ten years, whereas average household incomes have only increased two times. The risks to the banking sector as well as to economic growth with perhaps 20% of annual output related to construction are growing. In two years – 2011/2012 – China produced more cement than the US did in the entire 20th century.

Two weeks ago, Mr Modi’s government came out with his second budget. India still looks to achieve at least 7% GDP growth and 16/18% corporate earnings growth, over the next two years. They are making a substantial investment in the power sector and pursuing further privatisation of state companies. They are addressing the non- performing loan issue of the public sector banks, and restructuring the coal industry: both road and railway building, and electrification are priorities for New Delhi today. We expect that this background will be favourable for Indian share prices, given the pro-business stance of Modi’s administration, the stable Indian rupee, and consistent monetary policies. On my visit to Mumbai earlier in the year, I saw a number of start- up internet businesses: e-commerce is growing rapidly. There is a vibrant entrepreneurial sector in the consumer space in India, and we are focused on finding the best companies. Modi has tried to include the large rural population (over 50%) in the economy’s growth by introducing over 1 billion “AADHAAR” (national identity cards) for direct benefits and “JAN DHAN” scheme with over 200 million new bank accounts.

I also visited Australia last week: surprisingly the real estate sector in Australia is now a bigger contributor to GNP than the mining sector, which has fallen by almost 70% in two years. The Australian dollar has also corrected by 30% and it appears to be bottoming out. Shipments of iron ore and coal are continuing at a steady pace to China, and other Asian trading partners. One sector which we have studied in Australia is healthcare, where there are some very fine companies with innovative products, taking advantage of the changing demographics in Asia. There will be a billion people over 65 years old, in the world within the next decade, a large number of them in China. Such companies as Ramsay Healthcare, Cochlear and Blackmores have pioneered Australian sales into this market with trusted brands and products.

Last week, I visited Nanosonics, which is a A$500 million company with a growing global footprint in sales to hospitals of their ‘Trophons’ ultrasound equipment for desanitising devices. This is another of our “10 best stock” ideas in our Bamboo portfolio, which is focused on China, India and the region with several companies under US$2 billion in size.

Although there is at last a return to stock picking rather than passive indexing, a critical factor in portfolio management is valuation, and it is clear that something of a “technology bubble” has developed in the last year in the USA as well as Asia, with the leadership of the markets being led by the “FANGs” (Facebook, Amazon, Netflix and Google) and likewise in China and India, so we are reviewing all our internet businesses in these two markets to see whether the valuations are reasonable with “a margin of safety” as Benjamin Graham recommended.

We are also becoming more cautious on bank and insurance stocks, as the impact of negative interest rates (which may reach -1% in Japan) is more apparent. The disappointing performance of many of the premier brand banks such as HSBC and Standard Chartered, is teaching investors that there is no ‘Moat’ around these long established businesses – online banking, lending, wealth management and broking services are increasingly available from local and regional players with strong roots in their communities.  The international banks have no “lock” on this business.

As I travel around the world, I see more and more retail spaces close down, or struggling to break even. It is as if the internet, was a kind of “Neutron bomb” which leaves all the buildings standing, but empty of their human traffic and commerce. This is clearly a concern for property investors, in the medium term, that space in shopping malls and retail outlets will be less valuable, and rents will fall in the years to come. We continue, therefore, to avoid the property sector on principle and see that by next year, there could be a global downturn developing in high end residential as well as commercial space. (one of my Hong Kong colleagues remarks that shopping malls in Asia have in fact, become a cultural and social experience with families camping out for the weekend at IKEA: particularly in the hot countries of South East Asia – but does this really boost sales?)


Robert Lloyd George
10 March 2016

Life Below Zero

Last week, the Bank of Japan cut its key interest rate to -0.1%, joining the ECB, Switzerland, Sweden, and Denmark in the negative interest rate club. This surprising announcement means that, from the perspective of Tokyo, the risk is of more deflation and lower growth as oil and other commodities continue “lower for longer.” It is very difficult to understand what is happening today from an historical perspective. Consulting Homer’s History of Interest Rates, I have not been able to find a single instance in the last 500 years where there was a long period of negative interest rates. Eventually, deflation will bring down property values, punish debtors, and leave standing those companies which are able to maintain prices, whether telecoms, utilities, or consumer staples. Every business depending on a key price of a commodity – oil, food, minerals, even water – is subject to unmanageable cycles, as the Chief Executive of Exxon Mobil reminded us recently. If cash at the bank yields a negative return, then investors will redouble their search for income and for dependable yield.

The only problem in this environment of competitive devaluation is what happens to the US dollar and currencies linked to the US dollar, such as the Hong Kong dollar? We have seen enormous pressures coming to bear on the Hong Kong dollar and on Hibor, so that interest rates may have to be raised in Hong Kong as they were in 1997-1998; and property values and wages will deflate sharply.

We expect now that the US Federal Reserve will probably not increase rates again in 2016; and if the economic and deflationary trend worsens, then we may eventually see negative interest rates in the US also. The dollar may have peaked. Canada and Australia have seen a 30% devaluation, which enables many of their extractive and export industries to maintain some form of profitability. Japan looks like a relatively promising market this year, especially compared to China, thanks to its cheap yen and also encouraging corporate reforms.

One of the “unknowable” figures that will greatly affect Hong Kong, and China’s market and currency, this coming year is: what is the real national debt figure in China? Estimates as high as $5 trillion of NPLs or total debt of 300% of GDP (or about $30 trillion) have been talked about. Is this, in fact, a purely domestic and internal issue (China has relatively little foreign debt, although some Chinese corporates may have borrowed heavily in US dollars) in which case, it would be similar to Japan after 1990 – a generation of deflationary debt rescheduling, especially of soured property loans – but China should have the twin advantages of real national growth and central (party) direction.

China’s government will resist market forces as long as possible in maintaining the Renminbi at a stable level, although we expect, now that they use the trade-weighted basket of currencies, that we will see a 5%-10% devaluation of the Renminbi, against the dollar by the end of 2016. This will, in turn, put more pressure on its Asian trading partners, including Korea, Taiwan, and Southeast Asia. Also, capital outflows are now running at over $100 billion a month so Forex reserves could be run down in 2 years.

India is the one major economy in the world which is not subject to the negative influences emanating from China, the US, or the EU. It has an economy growing at nearly 8%, a population now fast approaching China’s at 1.3 billion, of whom half are under 30 years old. It has a large and vibrant service sector, with very well-managed companies in fast-moving consumer goods, travel and entertainment, food and beverage, and financial services. We have found at least a half dozen midcap Indian companies under US$5 billion market cap with 20% earnings growth and excellent medium-term prospects. Although there are few bargains, we believe that investors will continue to pay a premium for the real growth that India offers. The Indian Rupee is also one of the most stable Asian currencies, well managed by RBI Governor Rajan. The current account deficit has been reduced thanks to US$150 billion of oil savings from 5% to 1% of GDP.

In 2016-2017, our major bet, therefore, is on India and its surrounding markets, including Pakistan, Bangladesh, Sri Lanka, Mauritius, and even Myanmar. Although people in the west are now taking a very gloomy view of growth, and the geopolitical situation in the Middle East and Europe remains quite bleak, there is always some region of the world where it is possible to make money. This year, we believe it will be India.

One final note on gold, which has now risen nearly $100 from $1050 to $1150 per ounce, while oil and commodities have collapsed. Historically, commodities have always returned to the level of gold. Also, during the past 200 years, there have been three notable periods of deflation (1814-1830, 1864-1897, and 1929-1933) when gold’s purchasing power has appreciated by over 40%, whereas it always loses purchasing power during inflationary eras. We may now be in the last throes of a long cycle of disinflation turning into deflation, as suggested by commodity prices, which will further support the case for gold (especially if the dollar weakens); and, in an era of “Life Below Zero” interest rates, perhaps gold has a place in investors’ portfolios, in the next 5 years of currency volatility, and falling confidence in the infallibility of central banks.

Robert Lloyd George
15 February 2016

The Best Prophet of the Future is the Past

Never has it seemed more difficult to make an intelligent forecast as an investor, about what will happen and how it will impact share prices in the next year or two. Many of the themes that we identified during 2015, (deflation in China going global, consumer and internet sectors growing well where old industrial sectors as well as energy, mining and property decline) – are continuing and even accelerating in 2016. Breakthroughs in technology may have an outsized impact, for instance, electric cars on both the auto and oil industries. Being selective in our stock picking has never seemed more important than now.

China is the key to every global economic and investment trend, it seems, but China is a large continental economy, like the United States, with many diverse regions. Some like the North East are declining because of steel, shipbuilding and coal while others like Shanghai and the Hong Kong coastal region are growing because of technology, tourism and consumer exports. One of our major themes, has been the internationalization of the Chinese financial sector, and the Renminbi (now part of the IMF basket). Chinese money flowing overseas has accelerated to US$100 billion a month, and China’s Foreign Exchange Reserves has fallen by US$600 billion in the past year. Chinese tourists and investors are benefiting from relaxed visa policies in many countries like the United Kingdom.

China is now 18.5% of global GDP and has 800 million internet users. It therefore, has an outsize impact on all global trade markets. In the Golden Week holiday last October, over 750 million domestic trips and 4 million overseas trips were booked by Chinese tourists. Cinema tickets sales have grown 50% in last year, wealth management by 30% and tourism by around 28%.

Where will all the Chinese wealth go? We believe not only into property but into equities, fixed income and most importantly into M&A, buying corporate brands and new technologies. Even if China’s headline growth slows to 5%, there will be many opportunities in the internet and tourism sectors. Xi Jinping will continue with his crackdown on corruption, which must in the long run be beneficial for foreign investors, as well as Chinese investors.

When is the right time to invest in Chinese shares? We cannot really predict the fluctuations of Shanghai, Shenzhen and Hong Kong but we are taking a consistent and contrarian view in identifying great long term businesses and buying them at depressed prices, which we have been doing for the last six months.

The other two major markets, on which we take a positive view, are Japan and India. The three key destinations for Chinese tourists are Japan, Korea and Thailand. We have just added shares in Kao Corporation, which benefits from Chinese tourism and growing demand for Japanese products in mainland China’s premium disposable diaper market. Kao’s diaper sales in China are growing at 40% annually and the company recently began selling products directly via T- mall which will result in margin expansion going forward. Earnings in Japan should continue to surprise on the upside with the Yen around 120 and improved corporate governance, and in 2016, we expect Tokyo can provide us with some winning shares, amounting to a target 20% of our portfolio. Similarly, in India, we see favourable demographics and strong consumer spending with 15% earnings growth, especially in mid-cap stocks, where our partner Val-Q has doubled the index in the past year. We are benefiting from the excellent stock selection by the Val-Q team in Mumbai.

Governor Rajan of the Reserve Bank of India, is probably the most respected central banker in the region, and we expect the Rupee to remain steady, if not strong, in the coming year. We are going to invest in our “Indian Ocean Strategy” which comprises not only around 50% in Indian mid-caps but also selected growth companies in Pakistan, Sri Lanka, Bangladesh and other smaller regional markets. This region is unaffected by a slowdown in China, North America or Europe, and benefits from cheaper commodities, especially oil. Our investment in India’s major travel agent, MakeMyTrip, has been vindicated by Ctrip’s US$200 million investment in them, further underlining the growth of intraregional growth and economic cooperation.

The oil price continues to plumb new lows and may fall below US$30 a barrel. We have been focused on the benefits of this price decline to consumers and Asian importers. However, it is important to think about the secondary consequences of the oil price decline on banks, which have large lending commitment to energy businesses, and engineering companies that depend on capex by oil majors. In addition, the Sovereign Wealth Funds such as SAMA, and ADIA are cutting back and reducing their investment portfolios. The employment opportunities for labourers from India, Philippines and elsewhere South Asia will be reduced, and so will remittances. The fall in the price of energy, is the biggest factor affecting many economies especially Russia, Saudi Arabia, Venezuela but also Indonesia, Malaysia and even smaller producers such as Brunei. The geopolitical consequences will only be felt over the next two or three years.

Although the global situation continues to be uncertain, wealth creation in Asia continues at a quiet and steady pace, especially in family run businesses. We believe that investors will pay a premium for real stable growth especially in dividends. We are trying to apply the “Dividend Aristocrat” model, pioneered in United States, to our major Asian markets. If we can find companies that have consistently and sustainably increased dividends for at least a decade, this is in our view, the clearest evidence of responsible management and good corporate governance.

The advance in free trade continued last year with the Trans-Pacific Partnership and one country which we see especially benefiting is Vietnam in which we hope to make new investments in the coming year.

We would like to wish all our investors and friends, a Happy New Year of the Monkey which begins on 8 February. We shall have to be clever, nimble and inventive in our portfolio management to outperform this year.

Robert Lloyd George
12 January 2016

The Outlook for 2016 and Beyond

Looking into our crystal ball for 2016, we believe that there could be some big changes ahead. President Trump, perhaps President Marine Le Pen in France, a British exit from the European Union, a troubled future for the Euro certainly, a declining property market and slowing growth in the Chinese economy, interest rates rising in the US (but declining in Asia) further deflation with a strong US dollar, and oil bottoming out near $30 a barrel (today it is at $37). Gold, however, might be beginning a new slow ascent towards $2,000 an ounce over the next 5 years, as the aura of invincibility around the central banks begins to dissipate, and faith in fiat “paper money,” including the dollar, starts to decline.

Some forecast a recession in the United States in 2017, which would indicate that the stock market may peak out by the autumn of 2016. Manufacturing and traditional industries are already in recession. Both in the US and in China, the economy is being supported by strong growth in the services and financial sector. The migration of sales from traditional department stores, shopping malls, and outlets to on-line sales has been dramatic and is growing very fast in both hemispheres.

We are approaching the end of the debt super cycle and perhaps the end of the so-called “Kondratieff winter” in 2016-2020. It will be a period of intense volatility in currencies, commodities, and stock markets. Beginning with China, we expect that GNP will keep slowing towards 5% as the “new normal.” There will be more deflationary pressure as a result of over- capacity in almost every sector, and the central bank (PBOC) will continue to cut rates, although the Beijing government will not allow the Renminbi to depreciate as much as the market expects. Consumers and employment will remain resilient. Strong secular themes, such as the internet, health care, and the environment will be a focus for investors. Chinese consumers still have travel as a top priority, as well as upgrading appliances and buying their first car. What has changed is that they are no longer so focused on buying property; and property investment, for the first time in 7 years, is turning negative. We think it is possible, or even probable, that real estate prices will have a significant correction in China by 2017- 2018. Hong Kong high-end real estate may correct by 50%. This deflationary trend will spread from China to other major centers, such as Sydney, Vancouver, New York, and London, where Chinese property investors have been active in the past few years. Meanwhile, the falling oil price has led India’s current account deficit to fall from 4.8% to 1.3% of GNP.

Our Bamboo portfolio continue to focus on Chinese internet stocks, travel, and consumer themes. In India, we expect that the economy will remain robust as oil and other imported product prices weaken sharply and consumption grows. While most areas in the world, including Europe, Africa, and the Americas, will feel the contraction of trade with China, this is not so true of the Indian Ocean region, which will still be growing at a healthy rate. Once again, our theme in India is services rather than manufacturing, travel and tourism, and consumer sectors, rather than oil, minerals, and property. We see a positive, democratic transition in the Philippines in March 2016 and we are looking for value there. We remain bearish on energy exporters such as Indonesia and Malaysia although we are constantly on the lookout for exceptions to rules.

What is fascinating in the world today is the geopolitical changes which are coming from the dramatic fall in the oil price and other key commodities, like iron ore. In Argentina, we have seen the Peronists thrown out in favour a pro-market movement under Macri. In Venezuela, the socialists have also been defeated. The Brazilian president is under the process of impeachment. Russia will see a GDP fall of 4% or 5%, because of oil. The same pressures are coming to bear on Iran, Iraq, and Saudi Arabia. We may, perhaps, hope that over the next decade, the shrinking of the traditional oil power symbolized by OPEC, will also cut off some of the funding for the evil fanatics of ISIS and the Jihadis.

In the meantime, however, there is a serious problem in Europe, with the arrival of so many refugees and immigrants and the difficulty for the security services of keeping up their guard against internal security threats. That is why we highlight the relative political and economic stability of Asia in the next 2 or 3 years. The terms of trade have dramatically improved for Asian consumers and countries, including Japan, Korea, China, and India. Although the yen may continue to be weak, Japanese companies are reporting record profits, and share prices are still reasonable. We are finding many good opportunities in high quality Japanese companies with “a margin of safety” for investors.

Finally, as we look forward, we must also consider the impact of technology. The Climate Change Conference in Paris has focused attention on the global desire to reduce carbon emissions and burn cleaner fuel. Apart from wind and solar, perhaps the obvious beneficiaries are natural gas and nuclear. We also see many investment opportunities in the area of clean water, which is a pressing need for all the emerging countries. The electric car has become an important theme, both in China and the US, epitomized by Tesla and such companies as BYD in China. We believe the best investment opportunities may be in the manufacturers of batteries, of which there are 2 outstanding suppliers in Korea and one in Japan. It is worthwhile, again looking into the future, of trying to discern who are the winners and who may be the losers of this technological tipping point, including oil and gas producers and large automobile groups in the US, Japan, and Europe. And, of course, a theme we have reverted to several times in the past year is the deflationary impact of the internet on prices in every sector from travel to retail to property. There is a beneficial effect of this deflation in the advance of creative inventions and discovery. And, as investment managers, we must be ahead of the curve.

Robert Lloyd George
11 December, 2015

Wishing all our readers a very Happy Christmas and Prosperous New Year!

Terms of Trade

The Trans-Pacific Partnership (TPP) has been agreed, but not yet ratified by the relevant legislatures; however, investors may be certain, that it is a significant advance in free trade arrangements, for Asia Pacific nations, which will especially benefit the lower income countries, such as Vietnam, which already see higher GDP growth because of the transfer of manufacturing from China to lower cost locations. India, Pakistan, Sri Lanka, and Bangladesh are all benefiting from this trend; and we see a common theme of rapid “catch-up” from incomes and consumer spending in these large young nations with frontier capital markets.

I have just returned from the IMF meeting in Peru, where the forecast for global growth has been lowered 5 times this year to 3.5% for 2016. In my opinion, this is an excessively pessimistic forecast in view of the benefits of lower oil prices, and the global shift in terms of trade towards Asian consumers to the detriment of oil producers in the Middle East, Russia, Nigeria, Venezuela, and other OPEC countries. China has, for example, just reported a 20% fall in imports. As usual, the western press greeted this as a bearish sign of China’s slowdown. The reality is (as the accompanying charts illustrate) that China’s imports by volume have continued to grow, but the value has dramatically fallen because of the oil price and also copper, iron ore, and other industrial metals, which have fallen by 50% in the past year. China’s exports, by contrast, grew a stronger than expected 20% with a slight recovery both in the US and European Union and some weakness in the emerging economies (again, perhaps driven by the cutback in capital and consumer spending by oil exporters).

We remain, therefore, bullish on the outlook for China and for the Asian markets as we look into 2016. We continue to avoid oil, mining, and property. We focus on travel and tourism,  on the consumer and service sector, and financial services. I gave the keynote address at the Asia Hedge Fund Conference in Shanghai in September and was struck by the extraordinary growth and sophistication of the fund management industry in Shanghai. There are thousands of hedge funds in China and many more mutual funds, both fixed income and REITS as well as equity products. The Shanghai market crash has reinforced the need for professional wealth management, ethical standards, good accounting, and investment research.

I have compared Shanghai in 2015 to Boston in 1970 with the genesis of the investment industry led by Fidelity and other major fund management houses. Apart from the US$3.5 trillion of China’s official reserves, there is another US$9 trillion in Chinese household bank deposits. In November, I expect that the IMF will certify the renminbi as one of the 5 global reserve currencies in the SDR (Special Drawing Rights). China must respond, by liberalizing its capital account over the next 12 months, and allowing its citizens to invest more overseas. Even if (a conservative estimate) 20% of the total savings in China were to be invested overseas, it will have the effect of a major wave of capital coming into global financial markets led by Hong Kong (which we see as the prime beneficiary), but followed by London, New York, and other major financial centers.

This time Chinese capital will not only target property, it will be invested in companies, in technology, in western consumer brands, and in good quality dividend paying shares in the US, Canada, UK, Australia, and elsewhere. The example of Li Ka-shing is not irrelevant. He has been criticized by commentators for taking money out of China and investing it in these Anglo- Saxon jurisdictions, in telecom, water, and power utilities. In my view, he is a very smart, canny, and far-sighted investor. (This month, our research team visited Mr Li’s flagship company, CK Hutchison and were encouraged that their Watson’s pharmacy chain is opening 365 new shops each year in China.)

I believe that the liberalization of the Chinese financial sector is the biggest thing happening in the global capital markets in the next decade. Comparisons may be drawn with Japanese capital in the 1980s, but this Chinese wave is 10 times bigger and will last a lot longer. As yields on RMB deposits are steadily reduced (and the same in Indian rupee deposits), so the thirst for yield will bring Chinese investors, as it once did Japanese investors (the famous Mrs Watanabe) into western equities. In this light, we do not believe that the US market, and other major western markets, are overvalued. There does not seem to be any evidence of an incipient recession, judging by unemployment, inflation, interest rates, the oil price, or the leading indicators. The current free cash flow of 5.2% on the S&P 500 offers better value than the long-term average of 4.9% and is already discounting a 3.8% bond yield. So even if we see (as we must) yields on US treasuries rise in the next 2 years, the stock market will still not reach a peak until the first phase of rising interest rates is over, perhaps by 2017 or 2018.

Our medium-term concern, is what happens to property values, and how this impacts the banking system in China, Hong Kong, and even other locations, such as London and New York, where real asset values are extraordinarily inflated. The first signs of this property recession are now being felt in Hong Kong, where rents on commercial property in Central are being cut by 40% as luxury brands suffer the downturn in Chinese tourism. The focus in our Bamboo Asia strategy is on a range of shares in Hong Kong, China, India, Japan, and Southeast Asia, which are generally consumer, family-owned and managed businesses, not state-owned enterprises. Among companies that we have selected in this space are: Dr. Reddy’s, a leading Indian pharmaceutical manufacturer; Yes Bank, a fast-growing private bank in Northern India; Noah, which has US$10 billion under management and is the best listed Chinese wealth management group; as well as Value Partners in Hong Kong. For the National Day holiday in China this month, more than 750 million Chinese people travelled domestically; and about 400,000 visited Japan (twice as many as last year). In our investments in companies such as China Lodging, Airports of Thailand and Kao, we are trying to harness this theme of growth in Chinese tourism.

We continue to research and to find very promising smaller companies which could double and triple in the next 5 years, and we think that many of the risks of a hard landing in China (not our expectation) have been fully discounted and offer compelling valuations at a micro level.

Robert Lloyd George
15th October, 2015

P.S. We shall be issuing invitations for our investors and readers to attend a one-day conference in Hong Kong on January 13, at which we will highlight some of the aforementioned companies by inviting their management to present to our investor audience.

I thought that the below charts, which have been produced by Capital Economics, were pertinent to my view that China’s imports have been underestimated because of the collapse in the oil price. China is the largest consumer of raw commodities and benefits tremendously from the current malaise in the commodity markets.

Source: Capital Economics

The Tide Turns

At last investor sentiment towards China and the Asian markets is beginning to improve, and the summer storm is clearing. Despite the fall of nearly 40% in the Shanghai Index, China’s economy is not collapsing. The Renminbi has remained one of the strongest currencies in the world despite a slight fall of 3% against the US dollar and is likely to be adopted by the IMF next month into the Special Drawing Rights (SDR) as one of the five global currencies; and although world growth has slowed, we believe that there are still positive consequences for global consumers in the dramatic fall in energy prices. One topic that we would like to address this month is the secondary consequences of the fall in the oil price.

China’s economy is now nearly US$11 trillion. Even if the growth rate is falling to between 5% and 6% per annum, this means that China’s impact on global demand, especially other emerging markets, is extremely important not only for commodities but also for consumer goods, automobiles, luxury goods and services. Our view is that commodities will stay flat for some years because they are in an over-supply situation, including oil; and China’s growth will be less energy intensive going forward. In fact, we believe it will become much more like a European economy with the service sector exceeding 50% of GDP in the next five years.

Foreign trade, which accounts for almost 50% of GDP in China, compared to 13% in the US, is enormously important to China. Although there will be a slowdown, China’s overwhelming presence in many product markets will not go away. They have maintained a large trade surplus, nearly US$60 billion in August alone, and have foreign exchange reserves of US$3.6 trillion – far larger than any other country. There is no reason why the Renminbi should weaken significantly if Beijing wants to support it.

Unemployment is running at about 4% nationally, and we do not foresee a major social problem ahead. China’s industrial production may slow down, but its labor force is also peaking out in this decade. Its debt situation is also manageable, with very little foreign debt and most local and municipal debt owed internally and, therefore, able to be managed by the central government. The property market in China has also reached a plateau with nearly 90% home ownership according to published figures, and growth will certainly slow, although we do not yet foresee a collapse in real estate prices.

The major focus today is on financial reform and innovation. The opening up of China’s banking and securities industry will be the most significant change, and financial liberalization also means a larger outflow of Chinese capital into global markets. Beijing has also put its full weight behind the Asian Infrastructure and Investment Bank as a new vehicle to compete with the ADB and the World Bank, in its backyard, and also the “One Belt One Road” connecting Russia, Mongolia, and Southeast Asia with infrastructure, financing, and free-trade agreements as key elements. Finally we expect China to be more innovative in technology and medicine in the next decade, and the liberalization of the Shanghai market to allow easier start-up listings, like NASDAQ, will be important in encouraging innovative entrepreneurs.

If we are right about China growing at 5% or better, this is still critical to the health of Southeast Asia and China’s trading partners. In particular, we expect that Hong Kong and Singapore will benefit from the financial liberalization and growing Chinese capital outflow. The other ASEAN economies will experience high growth as a result of China’s infrastructure program and 120 million Chinese tourists traveling overseas, as well as investment into hotels, factories, airports, and road and rail. We currently have exposure in Singapore and Thailand, but we remain cautious about currency risk in Malaysia, Indonesia, and the Philippines.

India is growing at a slightly faster pace than China, at about 7%. The Indian Rupee has remained fairly stable, and India is saving US$100 billion a year on cheaper oil imports. Prime Minister Modi’s reforms are beginning to take root, and there are improvements in tax and in administration as it affects foreign investors, particularly an attack on corruption, which (as in China), reduces business costs significantly. We are focused, with our partners Val-Q in Bombay, on the midcap sector of the Indian stock market, where we see earnings growth of around 20% in consumer-related companies with a market cap of US$5 billion or less.

As a general comment, we still see deflation as the primary trend in the world. The internet is the ultimate engine of deflation. We need less space for shopping when we buy on-line; taxi medallion prices have plunged due to Uber’s competitive pressures; and hotel room rates are feeling the heat from Airbnb.

In the next 3 months, we shall see a battle between deflation (the strong background trend) and reflation (led by central banks, and including competitive devaluation — also deflationary, unfortunately). If oil plunges to US$30 or even lower, the effects will be felt widely. Some of the world’s largest equity investors, such as Norway, ADIA, KIA, and SAMA will have to reduce their new commitments. (Saudi Arabia has already drawn down US$100 billion of reserves.)

The secondary consequences of the oil price collapse will be felt most acutely in those marginal economies with high production costs – Venezuela, Colombia, Nigeria, Angola, Iran, the North Sea, and Canadian Tar Sands. We have already seen a sharp correction in oil currencies, and we are likely to see more distress in the coming year. When the oil price plunged in 1986 to US$15, it brought about the fall of the Berlin Wall within 3 years and the collapse of the Soviet Union within 5. There may be similar geopolitical effects this time around, possibly in Saudi Arabia and the Arab world.

Robert Lloyd George
15 September, 2015

China – A Contrarian Hunting Ground

This week in Shanghai we visited 15 companies in the wealth management, tourism, recruitment, and e-commerce sectors. They are mostly listed on NASDAQ, have fallen up to 30% in the past month, and some have up to 50% of their share price in cash.

On the ground, nothing much has changed. Yes, the ‘New Normal’ for China is to grow about 5%, not 7 to 10% as in past decade but then China is now a middle class country with average income US$8,000 per capita like Europe, Japan, Korea or Taiwan. Shanghai is a world class sophisticated urban centre of 20 million comparable to New York or Tokyo in style and wealth. The economy’s theme is no longer exports, infrastructure, or heavy industry: it is domestic consumption, tourism, and financial reform.

The sudden end to the Shanghai A share ‘bubble’ market is a healthy development for China’s long term evolution, towards a ‘western’ savings and investment culture, of mutual funds, pension funds, and rational long term investing, as opposed to the ‘Casino’ gambling culture of Macao, or Shenzhen. What we observed, was the rapidly growing seeds of a fund management industry, with ‘wealth management products’ producing fixed income returns of 6 to 8% p.a., real estate trusts (a form of REITS), venture capital and PE funds, hedge funds and long only equity products.

The largest private, non-bank, wealth manager controls about US$10 billion AUM, and smaller competitors growing at 50% p.a. can be found for 10 times P.E.

One of the best managed businesses is Hua Zhu (or China Lodging), which controls about 2100 mid-level hotels in China, and will sign a deal with the French group Accor, to manage 100 higher priced hotels, with an on-line booking link, for China’s estimated 120 million outbound tourists. This company and others we interviewed, are managed by US Ivy League educated ‘returnees’ an impressive group of top notch managers – mostly women.

The online e-cmmerce business is booming while ‘offline’ retail brand name sales are in recession (one can see this in the Hong Kong shopping centres of empty shops with luxury brands). China seems more advanced, than Western nations in this respect, with Alibaba’s sales of over US$550 billion, now dwarfing Amazon, or E Bay. Tencent and Baidu and their affiliates make up the core galaxy of competition, (nearly 600 million Chinese have smart phones).

The Shanghai Stock Exchange now has US$5 trillion of listed companies, and an average US$100 billion daily trading volume (larger than New York). They will now relax listing procedures to allow internet start-ups to list on a ‘new industry board’ (akin of Nasdaq). Clearly the government intervention has had mixed results especially the many suspended listings, which backfired badly: but Chinese officials learn quickly from experience, and we expect that by the end of 2015, the market will become more open and tradable with RMB convertibility (and the IMF’s imprimatur of the Yuan as a reserve currency), and the Shenzhen-HK Connect opening.

In summary, China’s ‘miracle economy’ era is over. The ‘new normal’ is lower growth: but GDP growth and share prices are not always correlated (ie. Japan 1975-1990). We believe this summer’s sharp correction is an extraordinary opportunity to accumulate patiently long term positions, in some great businesses, at reasonable valuations. We have positioned our Bamboo Fund for a strong recovery with all engines firing – not only in China but also Japan, India and South East Asia. The ongoing correction in commodities led by oil, gold, and metals is a positive ‘tax cut’ for Asian consumers.

Deflation is beneficial, and will spur inventions and discoveries, as it always has done historically in the 1870s and the 1930s.

Robert Lloyd George
August 2015

Deflationary Bull Market (continued)

History will decide whether the agreement reached today between Iran and the Western nations contributes to peace in the Middle East over the next decade or not. One thing is certain, that if the accord is implemented, and approved by the US Congress, among other parties, the immediate effect would be an increase in oil supplies of between one and two million barrels a day. With the continuing slowdown in China, and some other developing nations, this means that the over-supply in the energy market will be exacerbated, and we may see the oil price decline further below US$50 and perhaps as low as US$30 per barrel by the end of the year. Along with the fall in other commodity prices such as iron ore, food and soft commodities, this has very positive implications for China, India, Japan, South Korea and all the Asian nations which import most of their energy and raw material needs. (Indonesia and Malaysia are negatively impacted because of their energy exports.)

We believe, therefore, that the growth background for Asian equities in 2015 continues to be positive, as it has been in the first half of the year. In addition, the continuing cuts in interest rates, which most Asian nations have seen and which will continue, especially in India (where wholesale prices are now negative) and in China recently, provides a positive backdrop for shares.

The extraordinary volatility experienced in the Shanghai A-Share market, which fell over 30% in June, is a unique and contained phenomenon, which has not had a broader impact. It will also not have a significant impact on China’s economic growth, which will be maintained at 6% to 7% GDP per annum. The Renminbi has remained extremely stable, some capital has flowed back from Hong Kong to China in the short term, because Hong Kong shares offer much better liquidity for sellers than A-Shares, almost 40% of which were suspended in the last week. (This has now begun to ease and we expect that trading will resume normally). It is, therefore, reasonable to see this as a natural sharp correction in an ongoing bull market in China, which may still be in its early stages. It is a healthy correction in the sense that margin trading will be reduced, trading controls and listing procedures will be improved, and the Shanghai and Shenzhen markets will continue to grow, but at a less hectic pace, in order to achieve a broader acceptability for international investors.

Our team is now scouring the battlefield for oversold and undervalued quality Chinese and Hong Kong businesses, including some online companies which have Nasdaq listings, and may still be privatised and repatriated to China. In the other Asian markets, we also see some emerging value, especially in sectors and areas which benefit from cheaper energy, including airlines, hotels, restaurant, transport, logistics, plastics and chemical companies.

We are increasing our exposure to Japan, especially in the domestic sectors, and in those companies which have substantial export sales to China (which have been unduly marked down). The yen is exceptionally weak and corporate governance is improving. For the time being, we remain cautious on South Korea, because of corporate governance issues, which have particularly affected the valuation of the Samsung group this year.

India looks especially attractive, with corporate earnings growth expected to be above 16% in the next two years. The Monsoon is proving better than average despite its tardy arrival, and inflation is declining for the seventh consecutive month. This will continue with the fall in oil prices in the next few months. The Indian Rupee has also shown remarkable resilience in the year to date with the improving balance of payments situation, and the rapid increase in foreign exchange reserve from US$77 billion two years ago to US$352 billion today. This has greatly reduced the Indian stock market’s vulnerability to global capital flows, which affected it in the past. Indian GDP is also growing faster than that of China, (at a 7.5% rate in the first quarter of the year) and is expected to be maintained. We see special opportunities in the private sector banks, cement, automobile and mortgage finance companies, and there is also particular interest in pharmaceutical companies which are supplying generic drugs to the US market as patents for many important drugs expire.

Although we are mainly focused on the Asian region in our Bamboo Fund, we continuously screen for value opportunities around the Emerging Markets. The major issue for Africa and Latin America today, as well as Russia, is the fall in commodity prices which is having a significant impact on those countries’ purchasing power parity, and therefore on the valuation of many of their major exporters. What we appreciate most about Asia is that the management of many of our core businesses have been through tough times, in terms of the Asian crisis, (from which they have restored their balance sheets), an oil price increase to nearly US$150 a barrel, (maintaining their profit margins), and the global financial crisis which dried up much of the credit in the South East Asian region. Many local banks have now stepped into the vacuum created by the retreat of Western banks, and are achieving good return on assets. We look particularly to the financial sector in Asia, both banking and insurance, as the leading indicator of middle class growth and savings. Our focus continues to be cash flow and dividend payments as a major component of total return to our investors.

We want to emphasise to all our clients that we have maintained a very conservative philosophy in our regional investment portfolio, avoiding the excesses of the Chinese markets, so that at the worst point our fund fell no more than 3% during the steep fall in both China and Hong Kong. It has since recovered most of these losses and we are looking to add undervalued positions in the aftermath of the correction in China.

Robert Lloyd George
18th July, 2015

Where Will Chinese Wealth Go?

Today it was announced by the Boston Consulting Group that there are now four million millionaires in China (up from three million in 2014) compared to seven million in the USA. This was mainly attributed to the rise in the Chinese stock market last year, as it only includes cash, shares, and financial investments not real estate, art or businesses. In the Asia-Pacific region as a whole, private wealth rose nearly 30% last year to US$47 trillion, out of a global total of US$164 trillion.

The question that comes to mind, as the Renminbi becomes convertible by the end of 2015, and China liberalises both its financial system and its capital account, is – where will all this wealth flow? In our view, real estate has always been the primary destination of Chinese family savings, but this hunger has already been assuaged in cities such as Beijing, Shanghai, and Hong Kong, which now has the highest values per square foot in the world (HK$32,500 per sq. ft. or US$8.3 million for a 2,000 sq. ft. flat).

The new wealth will, in our view, be directed to liquid securities, such as shares, bonds, and mutual funds. With the “Shanghai-Hong Kong Connect” being swiftly followed by a parallel Shenzhen-HK capital link, the money will be flowing mainly one way, into Hong Kong, where there are over 600 listed Chinese securities, and the average multiple is 11x compared to 25x on the Shanghai market and almost a 74x compared on Shenzhen. We expect that the greater China market will harmonise into a single capital market like Europe did after 1992, with Hong Kong being the centre as London became the financial centre of the EU. We are therefore very much focused on the liberalisation of the Chinese financial sector, banking, insurance and broking as it adapts rapidly to the imminent possibility of full convertibility for the Renminbi. We have received confirmation that the IMF will officially accept the Renminbi as an international reserve currency by September, and China may move to open its capital account by the end of 2015.

China is moving rapidly from heavy industry and infrastructure development to the service and consumer sector. It is also moving from energy intensive GNP growth to a lighter model where alternative energy sources (nuclear, solar, wind and electric vehicles) assume a much greater importance. By 2030, China has pledged to reduce its carbon emissions, which is a major undertaking considering that China depends for 70% of its energy on coal, and is now the largest importer on oil in the world at 6 million barrels a day. The pressure of public opinion on the Communist Party leaders has increased in recent months, since over 20 million people viewed the video “under the dome” about the worsening problem of pollution in Beijing and its health consequences. Nothing will be more significant to the world energy balance and to the oil price than if China reduces its use of fossil fuels (this also effects geopolitics, as China moves to build base in the South China Sea and to protect its sea lanes, especially for oil tankers coming from the Middle East.

All this rapid change in China is having consequences on other countries, especially on the emerging markets in South East Asia, Africa and Latin America. We do not expect there to be a recovery in commodity prices. If Islamic State invades Saudi Arabia, the oil price would certainly jump in the short term, but there is no visible bounce in gold or other mineral prices. The world is awash with oversupply for most of these products, which Chinese demand has driven for the last decade or more.

We are still in a deflationary world, which is beneficial for consumers especially in Asia. As retail activity moves more and more onto the internet, this is also going to effect the demand for commercial space and we see a significant downturn in property values coming over the next few years. We are currently researching all of the Chinese internet stocks to find the new winners in e-commerce and other high growth sectors.

In conclusion, although the market is expecting a summer correction, because of Greece or rising US interest rates, we are looking beyond these factors, to see that China is still moving ahead fast, and liberalising. China has learnt a valuable lesson from the USA in paper wealth creation, which is now coming from stock market more quickly than from trade and manufacturing. Over 4,000 new Chinese hedge and private equity funds have started up in the past three months and assets under management rose by US$75 billion to US$433 billion. In our view the Shanghai boom is just beginning and we will be going to Shanghai next month to try to assess the foundations, and the sustainability of this important development, of the financial sector, of the world’s largest second economy.


Robert Lloyd George
June 2015

Discontinuities

Oil has rallied 25% from the bottom and, according to Fibonacci, needs to retrace 38% of its decline to break the cycle, i.e., $67 a barrel. This is now quite probable and would imply (given the extent of monetary easing and reflation in past 6 years) that from January’s deflation scare, we are now moving towards slightly higher inflation and higher interest rates. The relatively sharp upward move in bond yields (from their 30-year low) is also signalling this change.

We do not believe that this indicates an upward move in commodities generally, (thermal coal, for example, is nearly 60% below its 2011 price). Oil is a separate and special situation, still driven by Middle East political tensions. If Iran gains control of Iraq, they control almost 50% of oil supplies in the “Persian” Gulf; if they can block Saudi oil tankers (i.e., by controlling the port of Aden), this rises to about 70%. In the words of one astute European investor aged 80, this is “the most dangerous geopolitical situation since 1939,” including Russia’s revanchism, again on display during the May 9th  Moscow commemoration of victory over the Nazis.

Another potential “discontinuity” is if the cost of solar power falls and the advance of electric battery technology proceeds rapidly enough, then the use of gasoline and diesel in the world’s vehicle population (around 1 billion cars and trucks) will rapidly decline; and the oil age will end within 20 years. Supply will, in any case, be plentiful (as the Arctic and other areas are opened for exploration), and the oil price would be nearer $20 than $100. All of this is good news for energy consumers such as China, Japan, Korea and the Philippines.

In the short term, we continue to be optimistic on stocks and, more specifically, on China/Hong Kong, Japan, and India, also South Korea. Earnings growth this year will be better than expected in the region, and there is generally political and currency stability; and average GDP growth in the Asia-Pacific region is expected to average 6.3%.

How do we reconcile our bearish view on Chinese real estate values with our bullish stance in Chinese equities? Kenneth Rogoff in his notable 2009 book, This Time is Different, noted that the peak in US real estate prices occurred in 1925; but the stock market did not peak until October 1929, four years later. Although we may have actually seen the peak of Chinese property (both residential and commercial), it is a slow-moving cycle; and the massive shift of savings from ‘hard assets’ into shares (evidenced by millions of new share trading accounts opened in Shanghai and Shenzhen) will propel the share market up for several more years. A parallel was made in the Financial Times two weeks ago between the growth in GDP in Japan from 10% from 1950 up to 1970, when it slowed down to 4% in 1970s, and at that point, the Tokyo stock market began its 20 times move up, until 1989. So far, Shanghai has only doubled and is still on a reasonable P.E. ratio of 22. We expect both Shanghai and, more especially, Hong Kong, on a P.E. of 13 and 40% discount to Shanghai, will make a much more significant move in the next 2 or 3 years.

The Bamboo Fund is currently invested 40% in Hong Kong, 10% in China, 10% in India, 10% in Japan, and the balance in Singapore, South East Asia and cash. We continue to screen vigorously our potential investee companies for valuation, management quality, and product and price sustainability as well as E.S.G. We are rigorous in our research because a public listing does not certify long-term honesty or respectability. Despite our enthusiasm for solar power, we are proud not to have invested in Hanergy, a former market darling (up 400% in seven months). We did not trust management, and when their Chairman did not turn up to a meeting, their stock fell by 47% in a morning. We earn our living by finding value-for-money companies that are managed to the highest standards. Our major themes and sectors continue to be financials (banks and insurance stocks with high consumer penetration potential, for example, HDFC in India), Internet and mobile applications (especially in China, gaming and on-line shopping), power and water utilities, and healthcare. We have recently made company

visits in Taiwan, confirming the pre-eminence of our major holding, TSMC. The Taiwan market still trades 22% below 1989 levels. In India, where we have been analyzing the durability of the IT sector as reflected in space demands (Ascendas REIT, listed in Singapore) and in Japan, where we are focused on earnings growth among hi-tech exporters (Fanuc, Omron).

In conclusion, we are convinced that we are in the early stages of a long Chinese bull market in Shanghai, Shenzhen and Hong Kong shares (like New York 1925 or Tokyo 1985). There are now more than 81 million private trading accounts in China: up 12% since the start of 2015. Many people have more than one account, so this means that despite a stampede of growth, equities ownership among 1.4 billion Chinese remains very low and with plenty of room to grow.


Source: CLSA

My vision of Asia in the next few years is that, as China’s economy matures and liberalises (especially in the financial sector and the international use of the Renminbi), a single capital market will emerge, as it did in the European Union after 1992. Hong Kong will likely perform the role of central financial hub, as London did for Europe. The Hong Kong dollar may be repegged to the RMB instead of the US dollar. This is a positive for Hong Kong, because the internationalisation of the mainland Chinese currency is good for China and what is good for China is good for Hong Kong, her shop window. Both the Hong Kong and Taipei share markets will be revalued as they continue to become more visibly linked to China.

Robert Lloyd George
May 2015