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June 19, 2015

June 19, 2015

Investment Summary

World economic optimism is rising, and as a result, demand for government bonds is receding.

Inflation is starting to be felt in some Asian countries, especially India.  We note that new jobs and higher wages are a trend in the U.S., and we expect this trend to gain strength in the next few months.  U.S. interest rates are on course to rise in September, and we may see more rises after that if the U.S. economy continues to improve.  Our view is that the Fed is not afraid to raise rates, and that they feel that they must take some action to avoid losing credibility; they have to show that they have the ability to swim in the opposite direction than the one they’ve been swimming in since 2009.

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We like China and are interested in Japan.  In our opinion, Europe is dangerous, and the U.S. is moderately attractive.  Within the U.S., it is important to be invested in the growth sectors, healthcare, banking, and technology.

          China — Bullish

MSCI, Inc. (a U.S. company that provides widely-used indices of world stock markets and sectors) announced their plan for the inclusion of Chinese A shares in global indices.  Why does it matter?

MSCI announced that they would include China in their indices because China is substantially underrepresented on the basis of China’s share of global GDP, corporate profits, and stock market valuations.  When the inclusion process is completed, Chinese stocks will have a much higher weighting in MSCI indices.  We anticipate the growth in representation will be gradual, starting within 12 months and growing steadily for several years.  This will be a huge source of demand for Chinese stocks which will last for many years.

MSCI Charts the Gradual Inclusion of Mainland China Shares in Its Indices

061815MSCI.png Source:  MSCI

In our view the best opportunities for good-to-excellent investment returns are currently outside of the U.S.  This does not mean that we are bearish on the U.S.  We are not.  We are bullish on certain sectors of the U.S. — especially banks and medical related stocks, such as generic and other pharmaceuticals, biotechs, drug retailers and wholesalers, and other health care technology companies.  We are also bullish on certain fast-growing sectors of U.S. technology: cybersecurity, big data, and other segments of the software industry.

China and Japan are the areas with the best potential for returns.  We do not know how long China’s strong stock market rally will continue, but it could go on for years.  Many have called for a major collapse of the Chinese A-share market, perhaps prompted by the tightening of margin requirements.  There have been two or three minor tightenings of margin requirements in the last few months, and the market continues to hit new highs.

China will not be included in the global investment indices in a big way this year.  However, as the country allows more foreign investment inflows, there will be a major shift in the Chinese weighting in global indices which will give the current stock market rally many more years of life.

China’s Inclusion in Global Indices: Reasons and Implications

1.  China is hugely underrepresented.  The world’s second-biggest economy, its stock market capitalization deserves about a 15 percent weighting in world economic indices, but currently sits far below that weighting.

2.  Inclusion of Chinese shares in the indices will create a huge demand from foreigners who must successfully track the performance of the indices in order to maintain demand for their ETFs, mutual funds, and managed accounts.

3.  In order to be included, China is gradually opening all of their domestic stock markets to foreign investors.  They have not done this in a big way previously, because it will diminish the government’s control of their market mechanism.  Foreign investment in Chinese stocks may also have an impact on their economy.  Their economy has been top-down controlled, but when the stocks of government companies can be traded by foreigners, it will create an element of volatility and foreign control, which will begin as small influences — but will grow more significant.

The government is allowing and encouraging foreign ownership of Chinese stocks in spite of the risks, because a major part of China’s master plan is to pursue greater global influence in economic, monetary, political, and military affairs.  Stock-market integration with the world markets is a stepping stone on the path to achieving this goal.

4.  Shares of big and liquid Chinese companies will be the first to experience demand from foreign investors, and over time, small and medium-sized Chinese companies will also be included in the indices.

5.  This process will probably encourage more sales of stakes in major state-owned enterprises (SOEs) to foreigners.  Selling portions of the government’s stakes in SOEs is part of the plan to make SOEs more efficient, less corrupt, and less dependent on favor-seeking and political power instead of good business management.  The anti-corruption campaign in China can’t work if there is no corresponding reining in of SOEs’ power.  Favoritism and corruption give them advantages in contracts, prices, orders, and other areas.  The Chinese public, because of the benefits of being well-connected, often curries favor with government.  Consequently, SOEs are poorly managed, and need to improve their return on investment, which is currently half that of the average Chinese company in spite of their major competitive advantages.  Selling stakes to foreigners will help push them to clean up their operations and improve their performance.

Japan — Bullish

Japan is aggressively inviting foreign investors into Japanese shares from all angles, and shifting some deep-seated cultural and business traditions.

According to The Wall Street Journal, the Chief Investment Officer of the Government Pension Investment Fund (GPIF), Hiromichi Mizuno, pointed out that the government and other bodies have assured shareholders that there will be more dialogue between shareholders and company management, and that government investment institutions are increasing their commitment to Japanese and foreign stocks.  There is a new optimism among Japanese investment companies about the ability of the Abe administration to conquer deflation, increase corporate profits, and create a higher GDP growth rate in Japan.

Even more surprising, aggressive statements by U.S. activist investors towards certain old-line non-communicative companies have been received with respect and responsiveness by the Japanese.  This is astounding, and a major sea-change.  Additionally, activist investors have recently been invited to meet with high Japan government officials and have been welcomed to Japan.  Both of these trends are a 180-degree reversal of Japan’s centuries-old tendencies and cultural habits.

Europe — Bearish

Europe looks like a difficult place to invest for the next few months for two reasons: Russia and Greece.

First, Greece has ignored all of the olive branches that Germany and Europe have offered it, and appears ready to risk going down the path to default and exit from the Eurozone, and perhaps the European Union (the legal implications of a Eurozone exit are unclear).  They would default on and repudiate at least 80 percent of their debt — the portion held by international institutions — and they would replace the Euro with a new Drachma, devalue their currency drastically, and endure three years of severe economic depression instead of acting to repay debt and live within the fiscal boundaries set by their creditors (the IMF and European institutions).  At this point, analysts place at least a 50 percent probability on that outcome.  Greece may also continue to drag on in a no-man’s land, neither reaching a resolution, nor cutting off the game and exiting the Euro — offering neither the relief of a solution, nor the catharsis of sharp, relatively brief pain of a crisis.

Second, Russia continues its aggression in Ukraine, and is ratcheting up tensions with the Baltic states.  The Baltic states are part of NATO, but NATO has thus far behaved like a toothless tiger, and most Europeans, according to polls, are willing to let the Baltics go down in order to avoid a war with Russia.  If either Ukraine or the Baltic states are thrown under the bus, Europe’s toothlessness will be even more evident.

Clearly, any of these events will destabilize Europe and make the stock markets very volatile to the downside.  We recommend avoiding investments in Europe for the next few months.

Gold — Neutral and Getting More Positive

Gold is still in a basing pattern with $1,245/oz. at the top of the range and $1,150/ oz. at the bottom.  If gold breaks out above $1,250, the long bear market in gold may be coming to an end.  The ongoing problems with Russia and Greece could give gold an impetus to move up, especially if they become more serious.

Inflation has been quiescent in Europe and the U.S., but a lower Euro and lower currencies in Asia are adding to inflationary pressures in both areas.  We note that inflation is rising in Asia due to drought (food inflation), the bottoming of the oil price, and the substantial devaluation of Asian currencies over the last few quarters.  Currency devaluation puts pressure on the price of imports.

In our view, Greek economic and/or currency instability, war, and inflation would be immediate catalysts for gold.

In Yesterday’s Commentary, We Also Discuss:

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