There is a great deal of gnashing of teeth and renting of garments lately about China’s economic growth in the western press. China says that they will grow by 8% in 2009, and the more historically accurate western economists think 7%. I am in the 7% camp, and I think positive 7% is good growth. It compares with minus 3% for the U.S. and Europe.
Many people see political revolution in China as a result of layoffs of migrant workers who worked in export industries. We disagree. There will be no revolution or anything close to a revolution. In our opinion, there will be some publicized rioting, and some suffering, but in general the suffering in China will be less than that in the developed world. Although China has only a modest social safety net other than the family, the family will support most jobless people. We would be willing to bet that most of the pessimists on China have not been there in the last 5 years. China is an amazing and impressive country, and a traveler in China notices that the whole country is impressive, not just the big cities.
We believe visiting foreign countries and companies is essential in order to make an educated analysis. We try to visit China, India, and neighboring countries fairly frequently.
With 1.3 billion people, China still has a vibrant and strong rural agriculture program. The great majority of the workers laid off can return home to their rural villages, be with their families and work family plots, which now produce more food than they did five years ago.
Even though China alone will not be strong enough to pull the world out of a serious recession/depression, they will do well compared to other parts of the world.
We haven’t touched on India for several weeks. Our latest view is that after a long period of decline (about 60% from the highs), and a 20% decline in the value of the rupee versus the dollar last year, India has become more attractive. Given the chaos surrounding the Satyam fraud, the questions about the coherence of the ruling political coalition, and the upcoming election, we believe that it is best to wait and watch for an entry point later in 2009 or in 2010.
For 2009, GDP growth will be positive, although not up to historical standards. In our opinion, India is a long term investment alternative for global investors. Within India, we favor industries which benefit from India’s excellent intellectual capital, as well as consumer and medical related companies. Over time, infrastructure investment must be made for India to maintain its growth pattern.
Bombay Sensitive 30 Index (last five years)
MR. OBAMA AND FREE TRADE…
As you know, we are very concerned that free trade becomes a constant in the world, so that the world can enjoy the benefits of free and fair trade. To that end, we have included a link to an excellent, although technical, article from the Financial Times by the respected lawyer and economist Jagdish Bhagwati of Columbia University, titled Obama and Trade: an alarm sounds. http://www.ft.com/cms/s/0/f1ccbb92-ddef-11dd-87dc-000077b07658.html?nclick_check=1. In summary, he is skeptical that Mr. Obama’s appointments really understand and support the trade liberalization. We agree with him that free trade is absolutely necessary for the world to enjoy continuing growth and rising standard of living.
TECHNICAL AND FUNDAMENTAL STOCK MARKET ANALYSIS
TECHNICAL STOCK MARKET ANALYSIS
Even though we are fundamental investors, basing our decisions on our analysis of economic, social, political trends, and on fundamental analysis of economies, industries and companies, we do keep in touch with the technical view of the markets.
After many decades in the business, we have a few favorite market technicians. Most technicians whom we respect are calling for the possibility of a major rally in U.S. and foreign markets after a retest of the November 2008 lows.
IMPORTANT FUNDAMENTAL DEVELOPMENTS IN THE BANKING SYSTEM
We take the possibility of a retest seriously, and continue to work hard to analyze companies which will benefit from such a recovery. One major fundamental factor supporting the market rally thesis is that the ratio of free reserves to total reserves at U.S. Federal Reserve banks has risen to an all time high. In 1932, during the Great Depression, when the same pattern of free reserves developed, the stock market began a multi-year rally, rising by over 300 % in the next 4 plus years…during the heart of the economy’s Great Depression.
Over the short term, free reserves may be volatile as banks continue to write down their capital by writing off bad debts and toxic assets. Regardless of short term influences, it is clear that the Fed and other central banks will provide a great deal of liquidity to the banking system, for as long as is necessary. The effect of this liquidity pumping will be an increase in free reserves in the Federal Reserve System.
It has not been lost on the monetary authorities that free reserves, as a percentage of total reserves, must stay high if the banking system is to re-liquefy. Our banking industry sources tell us that the banking industry is slowly beginning to resume lending operations. If this is true, stock markets, especially in the U.S., could rise dramatically in coming months, after retesting the bottom.
BIG BANKS CANNOT LEND AS MUCH AS THEY WOULD LIKE
One of our closest friends is an expert on the mortgage finance industry in the U.S. He reports that although the U.S. federal government is pushing banks to lend more, the government banking regulators are doing the opposite. In many cases, regulators are pressuring banks to strengthen their balance sheets by raising more capital before increasing their lending. Simultaneously, the politicians in Washington are yelling that the TARP money should go to homeowners who are in danger of foreclosure.
It is obvious that one of the following two options is true.
1) Many U.S. politicians DO NOT UNDERSTAND how the U.S. fractional reserve banking system works.
2) Many U.S. politicians view politics as more important than a strong banking system.
As we have stated repeatedly in past memos, the banks need at least $1 trillion more in capital than they currently control. The Fed can provide liquidity, and they are. They can use quantitative easing, and they are. They can flood the system with cash and potentially destroy the value of the dollar, and they appear to be moving ahead on that front. The alternative is that if the banks do not have enough capital, they will not be allowed to lend under the law.
As we see it, $1 trillion more capital for banks is required now, or a much bigger infusion of capital into the banking system will be required later…after the economic recession/depression has dragged on for years.
MANY SMALL U.S. BANKS ARE IN DANGER
We have it on good authority that the U.S. financial regulators have felt for over a year that up to 3,000 small banks in the U.S. could be in trouble. A number of restructuring specialists have been hired to expedite reorganizations. There were only 25 failed banks in 2008. However, that number includes the two biggest bank failures ever, Washington Mutual and Indy Mac. In addition, the government orchestrated the forced acquisition of several banks, averting some other failures.
We expect many more regional banks to fail or be acquired at unfavorable terms for the seller in the next two years.
SUMMARY…OUR INVESTMENT OPINIONS
1. We expect market volatility for at least the next few months.
2. World stock markets will remain in a trading range until a few months before the end of the current recession/depression. Our opinion has not changed. We continue to disagree with the consensus view which now states that the U.S. economy will recover in mid 2009. We stick to our opinion that the global economy will begin to recover in early 2010 if we are lucky. More likely it will be mid 2010. Historically, world stock markets are a good buy for longer term investment four to eight months before the economy bottoms.
3. Long term investment opportunities will develop in food related investments, gold, fast growing stock markets, and foreign currencies.
4. Today, in financial circles, the talk is of deflation. Before too long, the talk will be of inflation. Many countries are growing their money supplies at very high levels. This high level of money creation will, in our opinion, eventually lead to inflation.
Thanks for listening,
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