Edge and Odds

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Edge and Odds

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CHINA: A VALUE TRAP?

The Chinese market is cheap, no doubt about that as this J.P. Morgan chart demonstrates. Other than Russia, where one needs a lot more than luck, China is currently THE cheap equity market in the world.image_thumb[1]

Thumbs up Here’s the bullish case:

Go on, be bold. Buy China. If there can be a consensus contrarian bet, it is increasingly Chinese stocks. (…)

China stockpicking comes with caveats such as assuming the whole country is not about to collapse under a mountain of bad debt. But such consensus predictions of widespread utter disaster rarely work out as forecast. As in the eurozone before 2012, outsiders can underestimate political will to do what it takes to avert disaster. In China in 2014, that means buying once it is clear policy makers know what they are doing with the financial system. The country’s stocks are certainly beaten down, however. Take the Hang Seng China Enterprises Index as a proxy, since mainland investing is so restricted. It is trading on seven times forecast earnings, compared with 16 and 14 for the S&P 500 and the FTSE Eurofirst respectively. Another Asian emerging market, Jakarta, trades on 15 times. Chinese stocks in general offer their biggest discount to each in at least five years.

The 40-strong HSCEI comprises mainland-incorporated companies’ Hong Kong shares, ranging from Air China to Zijin Mining via the usual names such as the big banks and the likes of PetroChina and Great Wall Motor. Put the banks aside for now: time enough to look at them when a likely wave of preferred issuance has passed.

In bargain-hunting terms the most beaten-down stocks, as measured by the change in their forward p/e ratios, include power generators, machinery makers and infrastructure builders. Spot the slowing economy fears with a dose of worry about overcapacity.

But dig a little deeper, and power generators, for one, could be worth a look. Huaneng Power’s forward p/e has fallen a quarter to eight in a year, yet its cash flow, relative to sales, has risen more than 50 per cent. China Longyuan, its windpower rival, has a p/e of 14 and lifted its cash conversion rate 80 per cent. Cheap does not mean bargain. Huaneng’s coal-based stations face environmental issues, too. But if a more upbeat mood continues bargain-seeking could become as fashionable as China-bashing has been.

(…) The MSCI China, for instance, is trading at a price-to-book ratio of 1.4, representing a 25% discount to the 5-year historical average and a 47% discount to U.S. equities, while broader EM markets are trading 16% below their historical average.

China is making progress on much needed financial system reforms. Concerns about currency depreciation and corporate defaults have been overshadowing evidence that China is moving toward achieving necessary structural reforms and that there’s likely to be a quicker timetable for key reforms than many market watchers currently expect. In March, for instance, China announced a widening of its currency band, the range within which the local currency can float. Meanwhile, the country’s central bank recently suggested that it will relax control on a number of bank deposit and fixed-income product interest rates within the next one to two years.

The Chinese government is unlikely to abandon their growth objectives. The government’s recent pledge of more stabilizing measures almost immediately following news of disappointing growth data indicates that China will prioritize achieving stable economic growth while gradually pushing ahead with much-needed reform. Meanwhile, the slowing of the Chinese economy is at least partly intentional on the part of the Chinese authorities, who want to transition the economy to one driven more by consumption than by investment, a transition that should be good news for the market. It’s also important to view China’s growth in context: China is still growing faster than other developed and emerging economies.

The Chinese market is potentially less vulnerable to tighter U.S. monetary policy. The Chinese currency and market are better positioned to withstand a rising-rate environment than many other emerging markets, given China’s current account surplus, ample foreign exchange reserve and low external debt.

Thumbs down Here’s why you should curb your enthusiasm:

To be sure, many of investors’ concerns are justified, and there are significant short-term risks for investors in Chinese stocks. These risks include the country’s unregulated shadow banking system and the risks associated with the inevitable slowing of credit growth. While an accurate estimate of the system’s size is difficult, even conservative estimates imply that it has more than doubled in size since 2008. In addition, one consequence of the China’s excess credit accumulation since 2008 is capital misallocation, or a diminishing economic impact from easy credit.

Meanwhile, headline defaults – although small and not systemic – from wealth management products and corporate bonds are signs that China needs to rein in credit growth before a possible bubble bursts. Finally, some of the reforms I mention above may be disruptive to markets in the near term, and like any value-driven investment call, my overweight to China may take a while to work.

But despite these short-term risks, I believe that Chinese stocks are worth sticking with over the longer term. You can read more about my country views in my latest Investment Directions monthly market outlook.

Punch More contrarian views that you should read before plunging deep:

Since we published “China’s Minsky Moment?” two weeks ago, the official data flow – which shows admittedly soft but fundamentally sound production – continues to conflict with real-world indicators, which reveal some alarming declines in production, prices, and demand. For example, the official manufacturing Purchasing Manager’s Index (PMI) for March 2014 indicates that manufacturing expanded, while the more objective HSBC Markit PMI suggests an alarming contraction in manufacturing activity that is consistent with a rough landing.

With such an ambiguous picture, we cannot know for sure whether Chinese production is moving ahead or falling behind… but a Kookaburra in the regional economic coal mine is calling at the top of its lungs. The recent collapse in Australian new export orders and moderate contraction in Australian production could point toward a real man-eater lurking in the Chinese bamboo (now that’s what I call some real tall grass!).

The China bulls use history to show that when the economy gets weak enough, Beijing reacts forcefully. Hence the recent Pavlovian equity bounce. I am sceptical about the Chinese government’s ability and experience to steer this giant ship through these uncharted waters. I am not alone:

My impression here is that the government is in a catch 22: it remains committed to both reforms and 7%-7.5% growth, but it is impossible to achieve both for a substantial period of time; and yet it is not ready to give up on either of those two goals. The result? That China eases less than it needs to grow 7.5% and reforms less than it needs to eliminate the risk of a credit crisis a year down the road. Financial markets remain schizophrenically shifting between hard landing, soft landing and no landing at all.

So in the short term, as economic weakness spreads and deepens, the government will make some noises to try to stabilize the economy, I believe they will be quite small, but it will cause bears to stop pressing the short trade. Medium term I am quite skeptical about how sustainable any short term mini stimulus related economic acceleration will last. (Prince Street Capital Management)

Bowl Some Chinese may be appropriate in your current diet but don’t overuse the MSG…

THE U.S. LABOR MARKET: WHERE IS GODOT?

How tight is the U.S. labor market? Not a trivial question given current low interest rates and elevated equity multiples.

Josh Wright, Bloomberg Economist sets the debate:

imageFed Chair Janet Yellen has taken an assertive tone in the debate on labor market slack, both in her speech on March 31 and at the post-FOMC press conference two weeks ago. First, in response to a question, Yellen dismissed as “tremendously premature” arguments that recent declines in short-term unemployment could lead to inflation generating tightness in the labor market, since long-term unemployment remains elevated. Then in her speech she took an even stronger stance, pointing to low wage growth as a sign of slack.

She reiterated her hope that if growth picks up, the decline in the labor force participation rate and the rise in long-term unemployment could be reversed. For economists, the clear implication was that monetary stimulus could help draw these people back into the labor market. (…)

A growing body of evidence from researchers and comments from policymakers indicates that a structural shift is at least partly to blame for the disappointing job growth at this stage of the recovery. (…)

imageThe latest of the studies on short-term unemployment and wage pressures comes from a Princeton team led by Alan Krueger (http://goo.gl/jxIYah). As in prior studies, Krueger et al. found that short-term unemployment is a better predictor of wage pressures and inflation than total unemployment. Significantly for this camp, short-term unemployment is declining toward the point where they anticipate wage pressures might take off. One of their less celebrated findings is that the long-term unemployed are unlikely to change industries.

This is bad news for Yellen’s hopes to draw potential workers back in, given recent shifts in U.S. job creation. While the total number of jobs in the U.S. economy has recovered to close to the level seen immediately prior to the Great Recession, a disproportionate share of the new jobs has come in service sectors. Many of the jobs in goods-producing sectors have not returned, and that means there are a large number of former construction and manufacturing workers who are still waiting for jobs that may not come back just because growth picks up — or at least, not before either their motivation or skills have eroded sufficiently to take them out of the running.

At the same time, the shift toward service sector jobs may bolster Yellen’s broader view of slack and undermine the academic concerns about declining short-term unemployment. If much of that decline has been led by growth in service-sector jobs that are part-time, then that would reinforce Yellen’s view of elevated underemployment as a sign of slack. In other words, if the decline in short-term employment largely reflects workers being drawn into just another area of slack, the wage pressures aren’t likely to materialize. Such employment dynamics would give Yellen a more direct counterargument to the recent studies. While Yellen might lose ground in the battle over interpreting long-term unemployment, she may still win the war on the level of slack in the labor market.

San Francisco Fed President John Williams recently said that the slack in the labor market could be “much less than assumed,” cautioning that inflation could rise more quickly than currently anticipated. The WSJ explains:

According to economists who have analyzed Labor Department data, 6.6 million people exited the workforce from 2010 and 2013. About 61 percent of these dropouts were retirees, more than double the previous three years’ share.

People dropping out because of disability accounted for 28 percent, also up significantly from 2007-2010. Of those remaining, 7 percent were heading to school, while the other 4 percent left for other reasons [often for family responsibilities].

In contrast, between 2007 and 2010, retirees made up a quarter of the six million people who left the labor force, while 18 percent were classified as disabled. About 57 percent were either in school or otherwise on the sidelines.

These 3.4M “slack” or potential workers of 2007-2010 are now a mere 726K by the same calculation.

David Rosenberg, clearly in the “tightening market camp”, notes that in spite of the on going economic recovery, those who have left the labor force (i.e. not looking for work actively) and who want a job are down more than 10% YoY. Those who do not want a job at all are up 4%. There will also be 1.5M new retirees per year for next 15 years.

On the other side of the ledger, Rosenberg points out that job openings are at a 5 year high at 4M but that 22% of firms say they can’t fill these positions (25% at the 2007 peak) with 40% of businesses claiming that there are few or no qualified applicants for job openings (45% at 2007 peak). More specifically, the Fed beige book cites shortages in health care, tech, transportation, engineering and construction.

Baby boomers can’t be the whole story, though, since the participation rate has declined for younger workers too. This part of the drop is a function of various factors, including simple discouragement, poor work incentives created by public policies, inadequate schooling and training, and a greater propensity to seek disability insurance. Globalization and technological change have also reduced employment and wage growth for low-skilled workers—which raises questions about whether current policy is focused enough on helping workers to achieve the skills necessary to work productively and earn decent incomes. (WSJ)

Rosie goes on showing that Americans are not studying optimally: in 2010, nearly 70% of bachelor’s degrees were in social sciences, psychology, visual and performing arts and communication and journalism while less than 25% graduated in engineering (13%), computer sciences (7%) and maths (3%). Americans appear ill-prepared for a new on-going revolution in the job market spurred but the powerful combination of data, software and sensors:

To understand how automation and robotics will affect the job market, Louis-Vincent Gave presents four classifications of skill-sets, which, he says, “depending on what skill-set you’re in, determines whether you get replaced.” They are: 1) non-repetitive and non-complex, 2) non-repetitive and complex, 3) repetitive and complex, and 4) repetitive and non-complex.

The first category, he says, is actually the biggest source of job growth in the developed and emerging markets and not in danger of being replaced. Examples of these include gardener, plumber, ski instructor, etc.

The second category, non-repetitive and complex, is also not in danger of being widely replaced and sees increased wage growth. The only caveat, Gave points out, is that these typically require a much higher level of education and are much more competitive. Examples include pharmaceutical research, software coding, civil engineer, or a hedge fund manager, just to name a few.

The third and fourth categories, both containing a repetitive element, are clearly in danger of the Robolution and include, on the more complex side, airline pilots, surgeons, or equity traders. On the other hand, manufacturing jobs, low-end farming, packaging, and other less complex, repetitive occupations have almost disappeared in the western world where robots have become commonplace on factory floors.

Interestingly enough, Gave sees a major problem brewing where college debt and tuition costs continue to skyrocket for an area of the job market where employment opportunities continue to diminish due to automation. (Financial Sense)

The Economist adds (The future of jobs, The onrushing wave):

The case for a highly disruptive period of economic growth is made by Erik Brynjolfsson and Andrew McAfee, professors at MIT, in “The Second Machine Age”, a book to be published later this month. Like the first great era of industrialisation, they argue, it should deliver enormous benefits—but not without a period of disorienting and uncomfortable change. (…)

The combination of big data and smart machines will take over some occupations wholesale; in others it will allow firms to do more with fewer workers. Text-mining programs will displace professional jobs in legal services. Biopsies will be analysed more efficiently by image-processing software than lab technicians. Accountants may follow travel agents and tellers into the unemployment line as tax software improves. Machines are already turning basic sports results and financial data into good-enough news stories.

Jobs that are not easily automated may still be transformed. New data-processing technology could break “cognitive” jobs down into smaller and smaller tasks. As well as opening the way to eventual automation this could reduce the satisfaction from such work, just as the satisfaction of making things was reduced by deskilling and interchangeable parts in the 19th century. (…)

There will still be jobs. Even Mr Frey and Mr Osborne, whose research speaks of 47% of job categories being open to automation within two decades, accept that some jobs—especially those currently associated with high levels of education and high wages—will survive (see table). Tyler Cowen, an economist at George Mason University and a much-read blogger, writes in his most recent book, “Average is Over”, that rich economies seem to be bifurcating into a small group of workers with skills highly complementary with machine intelligence, for whom he has high hopes, and the rest, for whom not so much. (…)

While economists debate, things are happening in the real world.

  • Average hourly earnings have been accelerating from +1.2% YoY in October 2012 to the recent +2.2-2.5% range even though core inflation is slowing. Such divergence is rather rare and actually seems to be happening when the short-term unemployment rate is below 5.0% like during the late 1990s. That rate is currently 4.2% and falling. It troughed at 3.5% in 2003 and 3.6% in 2007, meaning that from that measure, the U.S. is near full employment.

image

These charts show YoY changes in hourly wages in some industries where labor is reportedly in tighter supply (last 6 months annualized in brackets)

CONSTRUCTION (+2.8%)                                         TRUCKING (+2.6%)

   image image

INFORMATION (+5.1%)                                              SOFTWARE (+8.5%)

 image image

  • Recent surveys from the National Federation of Independent Business, the prime job creators in America, reveal that more owners are planning to pay workers more. Forty-nine percent of the owners hired or tried to hire in the last three months and 41 percent reported few or no qualified applicants for open positions. Twenty-two percent of all owners reported job openings they could not fill in the current period, a 6-year high, and very near the normal cyclical peak when, in reality, we are nowhere near the peak in labor utilization.

imageRosenberg goes on:

Recall that last August, the WSJ noted that in a report on the status of families, “the Census Bureau said 13.6% of Americans ages 25 to 34 were living with their parents in 2012, up slightly from 13.4% in 2011. Though the trend began before the recession, it accelerated sharply during the downturn. In the early 2000s, about 10% of people in this age group lived at home.”

A Gallup 2013 poll showed that the proportion rose to 14% by the end of 2013, also revealing that nearly one adult under age 35 in three lives with his/her parents… …and that:

Employment status ranks as the second-most-important predictor of young adults’ living situation once they are beyond college age. Specifically, 67% of those living on their own are employed full time, compared with 50% of those living with their parents.

Some may debate what is the cause and what is the effect but the fact is that these unemployed young adults have found a way to go by. For how long?

Ms. Yellen says that we need more time and more data before we can really assess what is going on:

(…) most research suggests that due to demographic factors, labor force participation will be coming down …. I think there is also a cyclical component in the fact that labor force participation is depressed, and so it may be that as the economy begins to strengthen, we could see labor force participation flatten out for a time… There are different views on this, within the committee, and it’s hard to know definitively what part of labor force participation is structural versus cyclical.

“As the economy begins to strengthen”. We have not seen much inclination of that yet, have we? Long term GDGP growth is 3.3% but the 10 year average is half that and keeps declining (chart from Doug Short). image

Waiting for the economy to “begin” to strengthen on its own in order to create the workers needed to grow the economy is like waiting for Godot. Who knows? He may be disabled and living with his parents…Winking smile

Contact: edgeandodds [at] gmail.com