The Silver Standard

It is sometimes forgotten that the defeat of the Kuomintang (KMT) Nationalist Government of China, under Chiang Kai-shek in 1949, by the Communists under Mao, was due as much to the hyperinflation and corruption of KMT officials, as to the military success of the Maoists.  The origins of China’s hyperinflation can be traced to the US Silver Purchase Act of 1934, which led directly to China going off the silver standard in 1935, as the price of silver rose from US$0.24 to US$1.29.

The new Communist government had learned a lesson from the previous decade of battling the Japanese, and then the Civil War, that you cannot finance a war with paper money and unsold debt issues.  One of their first priorities then, was to restore stability to the currency – now the Renminbi or Yuan — which they achieved by 1951. 

The last 70 years of Communist Party administration has been partly dominated by this historic fear of hyperinflation among the Chinese people, which was shared by the German people after the 1923 Weimar hyperinflation.  Moreover, there was austerity in the PRC government and Army ranks which contrasted with the previous KMT corruption.

In recent decades, a sudden flare up in inflation in China — notably in 1989 when it jumped 28% — has always alarmed the Chinese authorities because of this abiding memory.  It was, therefore, interesting to note that in 2020, when the US government increased its money supply by 26% in a matter of months — the fastest ever — China did the opposite.  There were few bailouts or transfer payments to the population.  The PBOC, or Central Bank, held the line.  Interest rates remained at 3% (on 10-year bonds), not zero.  And the RMB strengthened against the Dollar. 

So, back to the present day:  China remains conservative in its monetary policy and cautious in its foreign policy, though it is true to say that Xi Jinping, who has been behind the famous “One Belt One Road” policy (and has also taken a harder line on Taiwan), is also, like Vladimir Putin, effectively president for life, so the possibility of grandiose strategic errors is higher than in a “term limits” presidency.

The only 3 economies that experienced positive economic growth in 2020 were Taiwan, China and Vietnam.  Taiwan had the highest growth of 3%, with an excellent record on Covid (only 919 cases and 9 deaths) and a strong export record on semiconductors, where they have become, de facto, global leaders.

The Indian Budget was presented on February 1st and has further stimulated the share market with a focus on privatization, a higher fiscal deficit (9% of GDP) and more spending on infrastructure.  Nominal GDP growth will be over 14% in the coming year — the highest in the world, certainly for a major economy.  India is also increasing its spending on healthcare (manufacturing vaccines, especially), which is still only 1.5% of GDP.  We believe Pharma, as well as private banks and property companies, will benefit.  The apparent overvaluation of the Bombay Sensex may be undercounting the corporate profits surge, which we anticipate in 2021-22 to be over 40% year-on-year.  India may also open its bond market further to foreign investors and emulate China’s success in attracting foreign capital.  It is fair to say that nearly all major international investors are underweight India, which still has the best growth prospects in Asia in the decade ahead. 

Climate Change

In his new book, How to Avoid a Climate Disaster, Bill Gates explains that we have until 2050 (just about 28 years) to reach “net zero” carbon emissions — a difficult target.  He also mentions, in passing, that China achieved its goal of lifting most of its people out of poverty in the past 30 years by building many coal-fired plants very cheaply (75% less), which they are now exporting to Pakistan, Indonesia, Vietnam, and many African nations.  “If these countries opt for coal plants, as China did, it will be a disaster for the climate,” Gates comments. 

In fact, a direct correlation can be traced since 1980, between the industrialization of China (70% powered by coal), and the warming of the global climate, due to more CO2 emissions.  Europe and the USA have been flat in their emissions for decades:  the incremental change in pollution has been entirely due to China, and now to India and other developing nations.

To be fair, China is now making a huge effort in solar, wind, hydro, nuclear, and electric vehicles.  Some of our best investment opportunities have been found in these alternative energy sectors, with China’s competitive efficiency driving down prices in solar panels by 90%, and also in wind turbines, so much so that it is challenging to find players with profit growth.

Outlook for 2021

According to JP Morgan, we are about to have one of the strongest economic rebounds ever recorded, except for post-war periods.  The world economy will grow over 7% this year, led by India (14%), China (9%), and USA (6.5%).  The massive increase in liquidity, engineered by Western Central Banks, will lead to strong equity markets, especially in Asia and Emerging Markets. 

Stanley Druckenmiller, in a recent interview, said the difference between the USA and China, indeed Asia, is that “they haven’t borrowed from their future,” and therefore have a healthier, less indebted macro-economic and stock market outlook.

However, there is one interesting difference — the UK, Israel and the USA are leading the world in vaccinations today.  While Asia has, broadly speaking, very few Covid cases, they have been slow on vaccinations.  This may mean that places, like Hong Kong and Singapore may take a few months longer to open up their economies.

In summary, we expect that the US Dollar will remain weak, and commodities will enter a “super cycle” of strength in metals, energy, and food.  The stock market will remain in an uptrend, at least until we hit 5% inflation at the end of 2021 or early 2022, which will be a testing year for the global financial system.  Asian currencies should remain strong against the Dollar.  We must, perhaps, ask the question whether Bitcoin, and the rise of cryptocurrencies, is signaling a new world order in which the USA, and the Dollar will play a less important role.

Hong Kong

2 March 2021

RECOVERY AND REFLATION

As the Chinese New Year approaches on February 12th, we are trying to discern the trends in the year to come.  President Biden has set out important new policies in his first 2 weeks, including a US$1.9 trillion reflation package, and a continued tough line on China, both on trade and human rights.  Xi Jinping has responded at the Virtual Davos by proclaiming his belief in free trade and openness, while, at the same time, putting military pressure both on India and on Taiwan.  Meanwhile, markets continue to discount a rapid economic recovery from the Covid pandemic.  In Asia and Australasia, ironically, the travel and lockdown restrictions are far tighter than in the USA and Europe, although there have been, for example, only one case in Singapore and only one case in New Zealand in the past 6 months.  Southeast Asia will continue to lag behind the economic recovery of China as long as travel restrictions are in place. 

By contrast, India has had a strong recovery, with an 85% decline in Covid new cases and fatalities.  A massive rollout of the vaccine is underway in the 1.4 billion population of India, which has a median age of 28.  We see a strong recovery in the property market in India, and we have recently added Godrej Properties to our Indian Ocean Fund portfolio.  Interest rates are low, in real terms, in India; and the need for new housing is pressing.  This will also benefit the private sector banks, which we have long maintained as core positions – HDFC, ICICI Bank, Kotak Mahindra, as well as State Bank of India, which we have added in the past few months.  Indian housing affordability is at the lowest level for nearly 20 years.  We also see potential for recovery in both Singapore and Hong Kong property sectors, although these will also depend on a reopening to trade and travel. 

In China, the striking fact is that the technology sector has increased from 17%, a decade ago, to 66% of the MSCI China Composition today. 

This is an even more extreme ratio than in the USA, where the famous FAANGs are now about 15%, and technology is 28%, of the S&P 500.  The question is really, how long will it take for vaccines to be rolled out, whether they will be successful against the new variants of Covid, and whether life will return to normal by this summer.  If so, then the on-line businesses may suffer a slowdown as old line cyclicals – retail, hotels, restaurants, airlines, and trading businesses – recover their growth and profitability.  Our best guess is that the technology sector continues to outperform on profitability.  As Howard Marks has recently outlined in his interesting paper on growth and value investing, these are businesses with few capital costs, or tangible assets, but a high return on equity.  We have, therefore, not touched our core positions in Bilibili, Shenzen Innovance, and Wuxi Biologics, which constitute 22% of our portfolio.  In addition, we are increasing our exposure to semiconductors, or DRAMs, both through Taiwan and South Korea, where, in addition to Samsung Electronics, we are investing in SK Hynix, the second largest semiconductor manufacturer. 

The outlook, moreover, for emerging markets, relative to the US market, remains very promising, both in terms of valuations, and of earnings growth. 

Source: Goldman Sachs

The discount to US equities has now reached the lowest point since 1999, at 47%.  As we have often commented, over 70% of emerging markets are accounted for by China, South Korea, and Taiwan today, with a heavy technology component.  This year, we’ll see the rollout of 5G in China and in the USA, with 100 times the speed of 4G, which was introduced in 2010.  Many smaller technology companies will benefit, in both major markets, from this development, which is likely to last for the next 5 to 10 years, and involve US$17 trillion of investment in many areas, such as self-driving cars, the internet of things, Artificial Intelligence, and remote telehealth. 

While the opportunities for earnings growth in China and India remain very attractive, the risks in the broader US market, are also worth considering, since they will impact global markets.  There is a very high level of speculative activity, which is typified by Bitcoin, Tesla, and small cap stock activity.  The real risk is that there may be a sudden reappearance of inflation.  The new president has swiftly moved to raise the Federal minimum wage to $15.00 an hour.  Commodity prices are rising fast, particularly natural gas, and also palm oil prices in Southeast Asia.  The Baltic Dry Index has surged 63% in the past 2 months.  There may be many supply shortages after the pandemic ends, and pent-up demand for many consumer sectors and products.  We, therefore, are of the camp that believes inflation can surprise by rising to 3% or 4%, instead of the Federal Reserve’s preferred rate of 2%.  Interest rates would have to rise, by the end of this year, to respond to this development.  The other risk is a deterioration of US-China relations, particularly with regard to the Taiwan question, which has become more pressing – and Biden has followed Trump’s lead in maintaining close relations with Taipei.  

All of these are rather theoretical, and remote, risks at the present moment; but as the New Year of the Ox begins, we are conscious of the fine balance of risk and reward.  This is one of the reasons why we are focusing on a conservative fund structure, such as the Pacific Income Fund, which will comprise 50% of Japan and 50% the rest of Asia, focusing on high-yield, low price to book names, such as Mitsubishi, Sumitomo (of which Warren Buffett has bought 5%), and also CK Hutchison, Jardine Matheson, and some high-yield names in Korea, China, and Southeast Asia.  The two-tier market, between technology and the old cyclicals, will likely change this year, with a return to value and dividend yield. 

After a record return in 2020, we are cautious about how long this rate of return can last.  As one commentator put it, “Who would have predicted a US equity market return of 18% in 2020, in the face of nearly 25 million Covid infections, and over 420,000 deaths, an estimated GDP decline of 3.5%, earnings decline of 17%, and unemployment of about 11 million?”  This year, the risk may be that, once we return to normal, the market itself will correct on the arrival of good news. 

Predictions that China will overtake the USA by 2026/2030 are, perhaps, premature, given the demographics and productivity trends, which show a decline in China’s Total Future Productivity from 2.8% to 0.7% in the past decade.

Nevertheless, we are bullish in Chinese technology and healthcare companies, which have powered our performance for 2 years.

In conclusion, we remain positive about the outlook for the Asian economies and markets, and wish our investors and readers a Happy Chinese New Year. 

Hong Kong

1 February 2021

“Hedge Biden with Chinese Tech”

As US Election Day approaches, investors are anxious about increased capital gains tax, more regulations, and a weaker dollar. Looking round the world today, it is clear that economic growth is strongest in China, and its neighbors, South Korea and Taiwan. We have 72% of our funds invested in these 3 markets, mainly in the technology sector. The winners from the US/China trade war are Taiwan, South Korea, and (to a lesser extent) Vietnam, which is benefiting from a transfer of manufacturing, but is difficult to invest in and still has some high foreign premiums.

Taiwan Semiconductor and Samsung Electronics are the two big winners: and there are a dozen smaller names supplying cloud services, electric vehicle batteries, semiconductor equipment, and other key areas of on-line services and products (MediaTek, UMC, Delta Electronics in Taiwan, SK Hynix, Samsung SDI, and Samsung SDS in South Korea). Our assumption must be that the Covid 19 Pandemic will continue to paralyze world trade and tourism for up to another 12 months – and South East Asia, in particular, will suffer from this cessation of activity, although there are some promising signs this week of a more immediate “opening up” in Southeast Asia and Australia. China and India are both large domestic consumer economies, which will continue to exhibit robust consumer spending and corporate earnings growth.

President Xi Jinping made a visit 2 weeks ago to Shenzhen, echoing the famous “Southern Tour” of Deng Xiao Ping in January 1992 (the month our company, Lloyd George Management, was founded in Hong Kong) when he said “To Get Rich is Glorious!” and fired the starting gun for capitalism in China. This time, Xi was urging young Hong Kong entrepreneurs to consider Shenzhen (no political problems), which is, indeed, a technology hub (Tencent, HuaWei, etc.) with nearly 20 million inhabitants and low taxes. In addition, there is strong government support for the “Greater Bay” Area of Hong Kong, Shenzhen, Guangzhou, and Macau around the Pearl River, with its excellent infrastructure, and nearly 100 million middle-class population.

This is not, in our view, the end of Hong Kong which has, this year, seen 20 I.P.O.s totaling US $15 billion (and, in China, more than $47.5 billion); and ANT Financial will follow On November 4th, with an estimated US$34.5 billion (the largest ever I.P.O. anywhere). The Hong Kong / Shanghai and Shenzhen “connect” means that the Hong Kong Stock Exchange still performs a vital role for China in raising international capital, while maintaining a closed capital account.

It is worth highlighting that Taiwan, of all the free democracies, has not only performed best against Covid 19 (only 540 cases, 7 deaths) but also has the best performing stock market. Export growth has also begun to recover last month (9.4%). Forecasts for the tech sector in Taiwan are for nearly 30% average earnings growth, on a PE of 17 times. That is why we include Taiwan’s tech names in our call to “Hedge Biden” by investing in Chinese technology.

There is also the threat of “Trust Busting” against Facebook, Amazon, Google, and Apple. This does not apply to Alibaba, Tencent, Baidu and the Chinese tech sector. We expect these names will outperform in the coming year (revenues and profits up over 30%).

Also in India, we have been pleasantly surprised by the strong sales and earnings growth announced by Tata Consultancy Services and Infosys, the 2 leading Indian software groups (almost 20% gain in EPS) as well as HCL and smaller names. India, despite its large number of virus cases, is coming back strong. The death rate for Covid is less than half of what it has been in the UK and the USA. 95% of cases recover quickly.

The other reason to hedge a Democratic sweep in the November election is an easing of US / China trade tensions, which would, in our view, bring a strong rally in Chinese A Shares.

China’s economy registered 4.9% growth in the 3rd quarter, so the year 2020 may turn out positive at around 3% annual growth — the only major economy to have grown this year. The Yuan, or Renminbi, should be 10% higher against the US dollar, seen against these figures (but is held down by the PBOC).

There has been a remarkable growth in international capital flows into China’s capital markets, both bonds ($370 Bn.) and stocks ($230 Bn.), as China has eased restrictions on foreign ownership of brokers, fund managers, insurance companies, and banks. Most major US and European financial groups are now represented in Shanghai.

Normally, all this would lead to a much stronger Renminbi, now at 6.68 to the US dollar, compared to 7.18 a year ago. We believe the RMB is 10% undervalued and may see a further rise in 2021.
In an historical perspective, it may not matter too greatly who wins the election, since the economic and demographic future is reasonably predictable. The Covid 19 Pandemic has accelerated existing trends – the shift of economic gravity from the US to China, for example – but also the policy response of governments, especially in the US and Europe, to print massive reflationary packages of financial relief, which will mark the end of the 40-year deflationary trend, since Volcker in 1980. We, therefore, expect a dollar and debt crisis, within 2 years (whoever is in power in Washington), which will impact the current US bull market. Nevertheless, we maintain our view that in 2021, Asia — and especially the favoured technology stocks — will outperform.

Robert Lloyd George

Hong Kong

1 November 2020