China Perspectives: Part Two

_{by Nicole Loewensohn}

China’s famous philosopher and political theorist, Confucius, stated ‘when it is obvious that the goals cannot be reached, don’t adjust the goals, adjust the action steps’. Whilst China has pursued economic growth, there has been consistent acknowledgement that the current route to prosperity may not be viable. With this in mind, the latest five-year plan for China’s development has been released, outlining clear and sustainable goals; however the implementation of new policy may prove difficult. Recently Mr. Xi Jinping was appointed vice-chairman of China’s Central Military Commission, confirming his selection as successor to Mr. Hu, the country’s party chief and President. The change of leadership is expected to occur in 2012, yet the track-record for smooth political transition has not always been positive. Whilst political and economic reforms are currently on the agenda, political paranoia lurks at many corners.

Nevertheless, the key objectives of the five-year plan suggest that China is well and truly on its way to a sustainable future, primarily through a change in the growth pattern. Firstly, as expected, there is going to be a stronger focus on domestic consumption and the services sector, as opposed to industry and investment. This is where policymakers face a tough decision. The rising trade surplus suggests that China’s artificially low currency is preventing structural rebalancing of the economy, yet raising the value of the Yuan would cause a fall in exports, which may create unemployment and squash any rise in domestic consumption. A significant revaluation of the currency looks unlikely, but without removing price distortions and influencing wages it may be difficult to achieve growth in domestic demand and the relatively small services sector.

The other key objectives of the five-year plan are increasing the role of the private sector, urbanisation and regional development. Progress in these areas would undoubtedly help in boosting domestic consumption, but there is a long way to go. The government must be willing to allow private firms to compete with state-owned enterprises (SOEs), especially in areas such as financial services and infrastructure. This could be achieved through a reduction in red tape, giving easier access to finance for small business and reducing regulatory barriers to entry. If this eventuates, Australia could benefit significantly from strategic partnerships, considering Australia’s strong services sector and the respect China has demonstrated for Australia’s success post-GFC.

Furthermore, China’s push towards cleaner energy is also a key opportunity for Australia. China has become a world leader in renewable energy, given that it must significantly reduce carbon-intensive energy production to reverse the severe environmental degradation that has damaged quality of life and may constrain future economic growth. China is keen to expand research and development into new energy technologies, and Australia should seize the chance to develop its own alternative energy sector. Australia has had key breakthroughs in areas such as ceramic fuel cell and photovoltaic technology, yet there has been a lack of government support for their implementation. Thus China, with its seemingly endless demand for energy, could help Australia realise the full potential of such an industry. Australian natural gas reserves are also of strong interest to China. Woodside Petroleum is amongst the Australian companies who are already exporting large quantities of liquefied natural gas, whilst expanding exploration projects to keep up with rising Asian demand.

In order for progress, China must commence economic reform and early signs suggest policymakers are ready and willing to do so. Nevertheless the appointment of Mr. Xi as party successor demonstrates that open competition for government and political reform are not on the near horizon. This could have implications for, or potentially stall, economic reform, particularly if social tensions continue to rise. Censorship remains a contentious issue and even Prime Minister Wen Jiabao’s support for political reform is repressed by Chinese media sources. There has also been a significant increase in large-scale protests and outright criticism of the government via the blogosphere. Other social problems are also cause for concern. The one-child policy has created what is known as the ‘4-2-1’ problem. The law-enforced only child must now support his, or her, two parents and four grandparents, increasing reliance on pensions and other state welfare.

Ecinya has long advocated that ‘The Chinese Communist Party’ should change its name to ‘The China Central Peoples’ Party’ to reflect the obvious fact that China is a free-enterprise economy. This change would also assist to mitigate cheap shots from the West. One party rule is not a bother, and human rights reform can wait, or evolve over time. But China needs to integrate further its philosophical and geo-political actions to become a fully paid-up member of the international community. A change of name removes the ‘communist’ bogey-man from current prominence.

Whilst in the past the government has used economic growth to encourage social stability, structural economic reforms may dampen growth in the short-term. Thus in the context of a transitioning government, it is unsure how much short-term pain China will be willing to bear. In conclusion China has the potential to make significant gains despite a sluggish global economy, with a projected growth rate of around 8.7% in 2011. Australia is uniquely positioned to share in these gains and therefore it is up to us to promote a mutually beneficial relationship and ensure we take full advantage of all resulting opportunities.

CHINA PERSPECTIVES

_{by Nicole Loewensohn}

This is the first of two Insight articles specifically examining the economy of China. Whilst this week will provide a background to China’s current situation in a global context, next week’s article will focus on China’s future and the potential impacts on and opportunities for Australia.

At roughly 1.3 billion people China accounts for 19.5% of the world’s population. The one-party state is now the second largest economy in the world, behind the United States, with average GDP growth of 10% over the past three decades. These facts are nothing new; they merely serve to reinforce the immense power that China wields on a global stage. The rise of the East has been a well-documented phenomenon and whilst the flow-on benefits to developed economies have arguably sustained global growth, China is not without significant problems. Trade and geopolitical disputes, internal corruption, rising inequality and severe environmental damage are just some of the difficulties this emerging country must address, whilst being regarded as both enemy and saviour of the world’s ‘submerging’ economies.

The primary source of GDP growth in China is fixed asset investment (FAI), which reached $US2.1 trillion in the first eight months of this year. The September figure showed FAI growth of 24.5% year-on-year, with real estate development being the biggest contributor. It is thus surging property prices and the fear of a property market bubble that have led policymakers to raise interest rates and tighten controls on bank lending in an attempt to slow excessive appreciation in asset prices. However the fact that such a significant proportion of China’s GDP comes from FAI demonstrates that a slowdown in America, whilst slowing exports, will not significantly detract from Chinese growth.

Nevertheless current trade relations with the US are a concern for China. There is overwhelming support in the US House of Representatives for imposing levies on Chinese imports in reaction to the subsidy China is providing its exporters through currency manipulation. It is argued that China is undermining employment in developed countries and, as an example, 30% of Japanese firms’ manufacturing output is produced in China. In response to this, countries such as Brazil and Japan have also intervened in their currencies. The dispute has created public tension between US and Chinese officials when they recently met at the IMF in Washington, yet it is clear that America would be unable to win a trade war with China, and thus these disputes tend to highlight America’s economic woes rather than cause significant problems for China.

Trade barriers are not the only resistance emerging in the face of growing Chinese economic power. Some countries are hostile to direct investment from China and Chinese officials impose tough restrictions on outward FDI. It is illegal for an individual to invest more than 350,000 yuan (approximately $50,000) per year overseas and most of FDI coming out of China is from state-owned enterprises. In 2009 the Ministry of Commerce announced that outward FDI by Chinese enterprises grew 6.5% year-on-year to $US43.3 billion, highlighting the country’s economic magnitude, which has been key to sustaining global economic growth. Despite the jokes describing Greece as China’s first European colony, the role of China in helping to create  some form of stability following the Greek crisis cannot be overlooked, demonstrating how through direct investment China is continuing to support growth in the developed world.

The trade relationships that China has developed across the globe reflect both confidence in China’s ever-growing economic power and a tendency towards bilateral negotiations. Amidst increasing tensions concerning the South China Sea, China has showed no desire to play the gentle giant, instead taking a hard line. Located north-east of Singapore the South China sea is a major trade route on which several countries are attempting to make territorial claim, especially given the large oil and natural gas reserves that lie beneath the water. Whilst ASEAN has sought to establish Joint Development Authorities to develop areas of the sea, China negotiates bilaterally and many smaller ASEAN nations feel significantly disadvantaged. When US Secretary of State Hilary Clinton called on China to resolve the disputes, China warned America not to interfere in a strictly Asian issue. These added tensions do not throw a positive light on Chinese-US relations; however for Australia the future remains bright.

With both the US and China engaging in naval exercises as a show of force, Australia was chosen by China as the sole Western nation to participate in the war games. Furthermore this is the only time Western media has been allowed onto a Chinese navy ship during live target practice. In contrast to many other countries, Australia has also been a willing participant in bilateral negotiations concerning trade agreements. So where to from now? Australia is clearly in a position to benefit from China’s current demand for resources; however with environmental degradation becoming a severe problem, we must be ready to assist China’s inevitable shift towards cleaner, more efficient energy sources. China will also release its latest 5-Year Plan in February 2011, which is expected to focus heavily on pro-domestic consumption policies.

Finally, over the past 30 years the focus has centred on China’s growth performance in relative and aggregate terms. One should always be aware that the relative population disparity and the post-war economic dominance of America mean that the per-capita distortion is large, but reducing significantly. The trends we are currently witnessing are long-cycle trends, though commentators tend to focus on next week, next month, next year. The challenge for the one-party Chinese government is to keep growth up and social tensions down.

 

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The following excerpt comes from an interview by Barrons.com with Stephen Roach, Chairman of Morgan Stanley Asia and author of the book ‘The Next Asia’, 2/10/2010.

You met with Chinese Premier Wen Jiabao when he was in New York in late September to attend the U.N. How’s he tackling the challenge?

The Chinese premier has said before that the old structure is ‘unstable, unbalanced, uncoordinated and unsustainable.’ I think the Chinese recognize that they need to do three things to provide broad-based support for internal private consumption. They have to build a social safety net that will allow the Chinese to reduce the excesses of fear-driven—or what economists call precautionary—savings. And the safety net has to include far more aggressive funding and social security, private pensions, unemployment and medical insurance. They’ve taken very small steps, but they need to take big steps.

The second thing is to provide much more effective and aggressive support for lagging rural incomes. Some 750 million Chinese still live at impoverished levels in the countryside, and the income disparities have widened dramatically in the last dozen years between urban and rural China. They need to be more aggressive with tax policy, and in providing rebates to rural families. They need to re-think property-ownership rights of rural inhabitants and invest in information technology to boost agricultural activity.

The third thing is jobs. Ironically, while China leads Asia in GDP growth, it lags Asia in job growth. From 2000 to 2008, China’s GDP grew 10% a year, but its net employment growth was just 0.5% a year. That reflected a disproportionate emphasis on manufacturing as the growth engine. When you boost manufacturing productivity, you substitute machines for people—it’s a capital-intensive, labor-saving growth model. So what they need as an antidote is to broaden to labor-intensive services. The services’ share of the Chinese economy is minuscule at 42%, versus 58% for India and 75% in the U.S.

If China succeeds, the consumption share of GDP could go from the current rock-bottom 35% to between 42% and 45% over the next five years. That’s still low by global standards, but a huge improvement and a big shift in the momentum of China’s structural re-balancing.

One of the biggest issues in this mid-term election is the desire to pare the rate of growth in federal government spending. Economically speaking, this is spot on because the real economic cost of government is how much it spends. Bear in mind, the federal government always gets the funds it needs to pay for its expenditures – through taxation, borrowing and/or "printing." The more the federal government spends, the more productive resources it directs, leaving fewer resources at the disposal of the private sector. Because the private sector generally uses productive resources more efficiently because of competitive pressures than does the federal government, the economy’s long-run potential real economic growth rate is adversely affected by increases in federal government spending.

"The Real Economic Cost of Government Is Spending – So, What Do You Want to Cut?" Paul Kasriel, Director of Economic Research, The Northern Trust Company., 23/9/1010.

 

I think the same way planned economies ended in disaster, central banking as we know it today, will end in disaster. If there was a tribunal whose laws or criteria were sound money, Mr Greenspan would be hanged.

Mark Faber 2/1/2005.

 

The US government is a debt junkie, and if the trend continues, the doses are eventually going to become lethal………..The party out of power always blames deficits for chronic inflation, while the party in power declares that deficits have nothing to do with inflation……….Make no mistake about it, the Fed is a political institution subject to the pressures of lobbyists and constituencies of Congress and the President. Why? It’s the nature of the beast. Any man who tries to remain aloof from these pressures will lose both his influence and, eventually, his position……. As long as the government controls monetary policy there will be booms and busts. And as long as there are booms and busts, there will be an opportunity for the speculator to make money on both the upside and the downside.

Victor Sperandeo, "Trader Vic – Methods of a Wall Street Master", 1991.

 

When the US dollar begins to rise, the world will begin to normalise.

Our editor at lunch with an esteemed colleague, an Ecinya confidant, Tuesday 12/10/2010.

 

If you are playing badly blame your equipment, your playing partners, the weather, the club officials, your mother-in-law. Don’t blame yourself ! The game is too difficult to doubt your own ability.

Peter Thomson, Australian golfing icon and winner of 5 British Opens.

 

My parents were a little disconnected from me. They always had their own shows to run. Then my mother ran away with my English teacher when I was 14. They met at a parent-teacher night, and in term two my teacher disappeared and so did my mother ! My father had a bit of trouble coping after that. I don’t mean to be critical of of either of my parents – they both had their own troubles – but the result was that I was a bit self-raised as a teenager. I sometimes joke to my friends, "I never really left home, home left me."

Maybe that’s why I’ve spent most of my life celebrating the comedy and love of healthy and happy families. This is a thing a lot of writers aren’t interested in. But I understand it’s such a wonderful, valuable thing, because it’s something I didn’t have myself and found in adulthood.

I often wonder if all the people who create incredibly bleak family dystopias actually had happy, blissful childhoods, so as adult writers they are in search of the opposite.

Richard Glover’s Insight article, Sunday Life, The Sun-Herald 10/10/10.

 

We all receive our share of good luck and misfortune and neither should be boasted of nor mourned. Rather each should be approached with a positive attitude from which there is much to be learned. In this way good luck can lead to fortunes and misfortune used to advantage.

From Ron Alt, a newsagency proprietor on the central coast over several decades.

 

Quotes above: The Core Messages (note old journalistic adage – ‘90% of the message is in the head-note’)

Our quotation explanations are somewhat longer than normal. We hope the dots connect.

1. Ecinya likes Paul Kasriel because his work has a certain purity and consistency that makes it both balanced and informative. He is not captive to pet theories, dogma or ideology. Government cannot micro manage the economy in a democracy, and it is doubtful in the very long-term that an autocracy can either, but the China model suits China at this rapid development stage and probably will for about another 10 or 15 years. Don’t forget China went to sleep for about 150 years. America’s only been asleep for about 30 years with a brief period of awakening under the Clinton-Gingrich ‘Contract with America’ years.
2. Mark Faber is radical and outspoken and writes ‘The Doom and Gloom Report’. Always worth listening to and is frequently interviewed on American television. However, he gives the impression of being a ‘glass half empty’ type of commentator.
3. Victor Sperandeo’s book is our most favoured market text and we recommend it to anyone interested in reading about stock-markets and the economy. His view of Alan Greenspan was negative well ahead of the currently negative consensus and alerted Ecinya to the possibility that Mr Greenspan was something of a pretender, almost a charlatan. Our editor had a shared philosophical thread with Sperandeo emanating from reading Ayn Rand’s "The Fountainhead" and "Atlas Shrugged". Mr Greenspan and Ronald Reagan were alleged devotees of Ayn Rand but it appears that she disowned them after they used her philosophical foundations to achieve high office and then abandoned all of her principles in the pursuit of power and position. We should mention that Ms Rand never condoned the concept of fraudulent, and self-serving capitalism. Capitalism in the raw was not part of her conceptual landscape, rather capitalism and self-interest had to be enlightened, principled and rational.
4. The world need a resurgent and stable America. Our current belief is that this will emerge over the next 1-2 years. The $US turning up will be an initial sign.
5. At the moment America’s principal scapegoats are Islam and China. Rather than complain and exploit fundamental fears, America needs to restructure its economy and restore fundamental values like truth, thrift and modesty. The left needs to move to the centre and the right needs to move to the centre. The arguments at the extremes mitigate constructive introspection and progress.A crazy quilt of crony capitalism, religion, military adventurism and television has developed over the years beginning with Reagan and various myths created to perpetuate the concept of American greatness and exceptionalism. Ecinya is pro the best of America.
6. Richard Glover is the ABCs highly rated drive-time announcer and is the author of twelve books, his latest being "Why Men are Necessary". He appears to have overcome adolescent traumas and turned them into extreme positives. At the core, Ecinya believes, that good economic outcomes are shaped by good attitudes. Economic wisdom is shaped by both good and bad experiences and an excess of open discussion. Ecinya often feels that the governing parliamentary parents have left their constituent children. Additionally, as writers and commentators there is a general tendency to say what is wrong and how it can be better or improved. But generally it is couched in such critical tones that it comes across as though it is all a waste of time because things will either get worse or fail to get better.  The approach is so often cynical and sometimes invisibly self serving because it may in fact mirror our own personal circumstances, our lack of self esteem, our desire for more of everything, even embracing underlying envy.  The writings of the commentariat can be so filled with various forms and combinations of psychological baggage (dystopia we believe means ‘disorder) that we as commentators fail to achieve, or persuade, our readers that many of us have little baggage and are working through our words for the common good. Some of us indeed are a happy lot with not much to complain about.
7. Ron Alt was a big fish in a small pond for most of his life, but a great contributor to his community, and especially cognisant of the power of good intentions well executed and the need to share the credit with others of similar bent. He chose his friends wisely and while forceful in his views not given to hubris, but enjoyment of the quiet pleasures and satisfaction of a job well done.

 

 

QUANTITATIVE EASING

In a fiat money system money comes from three sources – net earnings abroad, borrowings abroad, or central bank printing. The disadvantage of excess money is that it can lead to inflation of both goods and services, and assets. This is the generally accepted principle. But now the US federal Reserve believes it is fighting deflation and needs to stimulate to achieve a desired level of inflation. Hence it is giving signals that it intends to pump money into the economy by buying existing securities for cash and the recipient institutions will lend that money to producers and consumers to achieve growth in the economy and stability in the financial system. Growth will lead to a reduction over time of America’s large unemployment problem which is officially at 9.6% and unofficially at circa 15% if you count discouraged workers and the under-employed.

Quantitative easing is said to be part of the next stage of the United States of America recovery story. Is it a good idea, or a necessary idea, or both? Europe has gone the ‘squeeze’ route preaching and practising austerity. Who is right and who is wrong? Does it matter? The answer is clearly that what is right for one economy may not be right for another. Many economists candidly admit they are unsure of what drives economies from boom to bust. Mr Greenspan was on the record as saying that ‘bubbles’ are unrecognisable at inception and in their growth phase, and only need to be addressed when they burst.

EASE OR SQUEEZE? The simple answer is you need to ease in some areas at various times and squeeze in others at various times. But ease or squeeze will not work if the STRUCTURES are not in place to get the efficient and desired outcomes and keep the narrative alive so that it becomes self-perpetuating. Sustainability comes in various descriptions – momentum, the multiplier effect etc.. Ease or squeeze will also not work if there is not an underlying narrative built around a plan. There are no silver bullets, just plain hard work and clear thinking. QE2 is not the silver bullet that the market commentariat seems to have attached exaggerated claims to. ‘Wishful thinking is the enemy of hard work’.

 

THREE MAJOR EVENTS COMING

• Friday 29 October: First cut of third quarter US GDP.
• Monday 2 November: US mid-term elections.
• Tuesday- Wednesday 3-4 November Federal Open Markets Committee meets to discuss interest rates and monetary policy generally.

The consensus number for the initial estimate of third quarter US GDP from the Wall Street Journal panel is 1.9%, having come down from 2.5% in the August survey. Of the 9 economists that we rank as most relevant the consensus is 1.6%. Paul Kasriel is at 1.5% and the lowest forecast is 0.5%, which number is not in our most relevant caculation. Should the number come in at 1.3% or below, doubts about the strength and sustainability of economic growth would come into question and the ‘double-dippers’ would again feature prominently in the ongoing debate.

The mid-term elections are effectively a vote on the presidency and current indications are that the Democrats will lose control of the lower house (House of Representatives) and suffer significant defeats in the upper house, the Senate, but possibly retaining control. There are two interpretations of this projected outcome. Firstly, that political grid-lock is exacerbated and secondly that the Democrats are forced to move from left to centre and that the Republicans are forced to move from right to centre. The latter is the bullish scenario. Much of the heat revolves around The Tea Party which appears to be mainly well-funded radical conservatives.

The Fed is expected to announce a stimulus package built around ‘quantitative easing’. Size is a problem. Will it be $200 billion or $600 billion? Should it even occur? Our guess is that monetary ease will be at the lower end, or delayed until Congressional fiscal squeeze becomes recognisable. But it is difficult for the Chairman of the Fed to openly criticise his congessional masters or the White house and private entreaties are stymied or blocked by entrenched opposition or immovable egos.

 

ECINYA PRECIS OF SOMETHING CLOSE TO OPTIMAL OUTCOMES

1. Congress has to find ways to cut government expenditures.
2. Tax reform needs to be developed with an emphasis on expansion of the aspirational middle-class and small business sector. A national sales tax and savings reform should be on the agenda as suggested by Lawrence J Kotlikoff (access link).
3. Electoral reform needs to be on the agenda including political donations.
4. The Dodd-Hagel National Infrastructure Bank Act has to be accelerated, having been first proposed in 2007.
5. Fannie Mae and Freddie Mac has to be re-structured.
6. Ways have to be found to restore Wall Street’s moral compass and monitor its behaviours in a constructive way. Excessive regulation is not the way, it requires attitudinal change. Paul Volcker is on track here.
7. Begin to raise interest rates.

Larry Summers was the Director of the National Economic Council to the White House. He has just announced his resignation. His replacement need to be announced as soon as possible and should be preferably someone with hands-on business experience, like Paul O’ Neill was before being sacked as Treasury Secretary by President Bush and Dick Cheney for having a mind of his own and refusing to engage in political spin games.

 

THE THREE ECONOMIES

Within the developed world the economy can be divided into three. Firstly, the real economy – the production of goods and services. The symbol economy – money and credit. And finally the political economy. In America there has been an inexorable shift from the real economy to the symbol and the political economy. Additionally the political economy and money and credit have formed a strong clique determined to wield influence and maintain power. The net impact is that the middle class has been squeezed and production has moved offshore – to Japan, then South Korea, then Taiwan, and now China. It would appear that restoration of the resulting imbalances can only occur initially via the Dodd-Hagel Infrastructure Bank. If the economy grows at under 2% per annum no new jobs will be created.

 

WILL AMERICA RISE FROM THE ASHES OF THE ‘MADE IN AMERICA’ GLOBAL FINANCIAL CRISIS?

If the mid terms produce some new balanced personalities that can assist and give President Obama some directional stability, the answer is ‘yes it can’. We remain hopeful and optimistic. In the meantime markets will bounce around the fundamentals of interest rates, confidence and earnings (‘ICE’). Confidence is currently the biggest and most vexatious element of ICE. It should be the aim of every Congress to see a president succeed.

 

 

 

 

1. It is unlikely that God’s plan for the universe includes making you rich. Success in the stockmarket requires effort, discipline and patience. 90% of success is having the discipline to be consistent.

2. "Research" is to contemplate the possibility that, intuitively, you may not know the answers, and worse still, you may not even know the questions. Information insightfully interpreted will help avoid being caught in a position where you can lose a lot for reasons not understood. Try to avoid making the facts fit the theory, especially in relation to timing. Speculation is not investment.
Buffetology: Can we understand the business? Does it have a sustainable competitive advantage? Do we like the people? Are we getting it at the right price?

3. Trust falling interest rates to begin a new bull market. Bull markets are driven by liquidity. It takes a lot of bad news to reverse a bull market, and a lot of good news to reverse a bear market. Calculate and analyse ‘trend’ very carefully.

4. Long range plans engender the dangerous belief that the future is under control. Try to stay flexible, open minded and sceptical. Good trading is a peculiar balance between the conviction to follow your ideas and the flexibility to recognise when you have made a mistake. In a bull market focus on price & momentum, a bear market focus on valuation. Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. BUY when others are despondently selling. SELL when others are greedily buying. When too many people are doing the same thing the market will adjust. Bull markets are driven by liquidity.

5. Markets over-react slowly; resist the temptation to buy ‘falling knives’. Momentum is essentially the market behaviour of the participants. There is a lot of ‘motion’ in ’emotion’. Do not underestimate the tendency of a trend to ultimately reach a level, either up or down, that is illogical and just plain wrong, and hence, unsustainable.

Extract from The Ecinya Investment rules

Sadness, disruption, delay, disappointment, are NOT permanent features of free enterprise. Economic and market cycles will play out again much as they have in the past. Confidence will recover, consumers will continue to save and spend, banks will continue to lend, new companies will emerge, old companies will merge. History never really repeats itself precisely, but it certainly rhymes.

From the Ecinya pages December 2002, near to the end of the last big down cycle, and before the beginning of the long 2003-2007 bull-market. The last sentence is courtesy of Mark Twain.

 

WHERE ARE WE AT?

From the March 2009 lows the All Ordinaries index (XAO) is up 49% (4636) and our global proxy the SP500 is up 69% (1141). In this market cycle the All Ordinaries peaked at 5024 on 15 April 2010, a rise of 62% and the SP500 peaked at 1217, a rise of 80%. The decline peak XAO was 4250 on 5 July 2010, a fall of 15% and the harmonic SP500 fall was to 1022 on 2 July, 18%. The current positive leg for both markets is circa +12%. Momentum and conviction are lacking.

 

WHERE DO WE CURRENTLY THINK WE ARE GOING?

We are envisaging downside targets on the SP500 of between 1030 and 1080, about 10% to 6% from last week’s closing peak of 1148. Our market quant model suggests that these SP500 numbers would give a range of circa 4300 to 4500 for the All Ordinaries.

 

WHEN?

‘When’ is the most vexatious question of them all out of Rudyard Kipling’s Six honest serving men (What, Why, When, How, Where, and Who). Our belief is that this next retracement to the SP500 and XAO will occur in October or November 2010. This month or next.

 

BULL or BEAR? Not quite the right question.

At Ecinya we do not ever admit to being a bull or a bear. We avoid such generic tags. We are either bullish or bearish, the former meaning that we think the market will go up, the latter that it will go down. If the markets are elevated we look for reasons, and later evidence, that they might go down. If down we look for reasons and evidence that they might go up. Always we try to operate against the background of our own investment rules, though we occasionally fail to heed our own advice. We consult widely, but with few selected persons of significant quality and experience.

After one more retracement we are bullish into year end. This does not necessarily mean that we will do nothing between now and then because we deal in stocks, not indices. But indices provide a directional context and given that our reference indices are weighted towards major stocks then our stock selection in a general sense will move in an harmonic way with the market, except where we have selected stocks that can outperform such as out-of-favour recovery stocks (wounded generally from the global financial crisis) or takeover targets or special situations. However, if a pervasive crisis occurs no stock is safe.

 

THE BULLISH CONTEXT

HISTORY

• History suggests that boom follows bust
• History suggests that recovery follows recession.
• History suggests that positive outcomes follow negative happenings.
• History suggests that success follows the succesful exposure and occasional prosecution of fraudulent excess.
• Economic theory and history suggests that in a fiat money world, inflation is not a problem if excess capacity exists.
• History suggests that economies perform better if politicians do not excessively impede worthwhile business endeavours by rampant and wasteful taxpayer funded expenditures (e.g bad wars such as over-time and over-budget Iraq, pink batts, building revolutions, cash for clunkers etc).

 

LOCAL FACTORS

• That the grid-locked Federal Parliament curtails the waste and extravagance of the Labor government.
• That the Reserve Bank is careful in its interest rate settings and not excessively fixated on inflation numbers at the expense of economic growth.
• That commodity prices in $US terms stay sufficiently elevated to offset the strength of the Aussie dollar.
• That China and Asia generally continue to grow and prosper.
• That tax reform stays on the agenda. Ecinya has written more than a few papers on this under ‘Insights’.
• That some useful takeovers take place.

 

EXTERNAL FACTORS

• That the US November mid-term elections come out with a result that does not enhance the standing of The Tea Party, but that the Republicans regain control of the House of Representatives and Mr Obama is forced to cheerfully shift from left to centre.
• That the new Obama economics team has some business experience rather than Wall Street or nurdish bureaucratic inclination and lineage.
• That Mr Obama comes to be regarded as a leader and not a celebrity.
• That third quarter US GDP growth is no worse than 1.3% annualised, and moves closer to 3% in the fourth quarter. First cut of Q3 GDP is published at the end of October and this might co-incide with our envisaged retracement low of circa 1030- 1080.
• That the US domestic and current account deficit undergoes what is regarded as a sustainable policy unduced capacity for improvement.
• That Europe becomes more sensible and less enamoured of welfare spending.
• That China and America do not engage in currency and trade wars.
• That the Middle East peace process show some improvement.
• That Afghanistan does not become a debacle.
• That the $US experiences an early 2011 recovery.
• That the Europeans win the Ryder Cup and the Americans show themselves to be good sports, but should they win, display an appropriate level of humility – "The game is greater than the player".

 

THE BEARISH CASE

The bearish case is simple…. none of the above take place, America becomes even more dysfunctional, Afghanistan becomes a chaotic example of failed US policy, that event risk occurs such as a terrorist attack, that Congress and Mr Bernanke simulate the American economy to oblivion and destroy the value of the $US, and no structural of attitudinal changes occur.

There are doomsayers of manifest eloquence to support the bearish case, best sellers promoting end-of-the-world-as-we-know-it scenarios, TV and radio commentators warning of economic hell with zealous rage, and ratings to match.

 

EARNINGS

Sustainable stock-market advances are dependent on EPS growth. EPS growth does not occur without good fiscal and monetary policy settings, and economic growth across the global economy. Our current belief is that the July-December 2010 period will yield subdued EPS numbers, but that confidence will be in evidence for the first half of calendar 2011. Our belief is that the stock-market will lead the economic recovery and a restoration of confidence. We are looking for the glass to be half-full in the fourth quarter, having gone from half empty, and prior to that "where is the glass?".

 

This model, not good luck, is the reason Australia has enjoyed a fifteen year expansion…. It is defined by a floating exchange rate that operates as a shock absorber, a credible medium-term inflation target that governs interest rate policy at the discretion of an independent central bank, a shift towards a more decentralised wage-fixing system, and a permanent budget surplus strategy set at about 1 to 1.5 per cent of GDP.

Paul Kelly, The Australian, May 2006.

The central issues in tax reform, therefore, are slated for the third term at the earliest. And governments are hardly famous for third-term courage. This is a cautious approach. Rudd Labor offers no road map, no broad principles, no statement of intent on future reforms. The juxtaposition between the sweeping nature of Ken Henry’s 138 recommendations and Labor’s caution is conspicuous. Second, with Australia having escaped a recession, Labor’s new focus is to target the resources sector for a revenue redistribution. This is its chief tax priority. This decision will define Rudd Labor. Its presentation is critical yet the government is unsure whether to depict its tax as an economic reform or a populist "soak the corporate rich" mantra.

Paul Kelly, The Australian, 5 May, 2010.

The time has come," the Walrus said,
"To talk of many things:
Of shoes–and ships–and sealing-wax–
Of cabbages–and kings–
And why the sea is boiling hot–
And whether pigs have wings."

"But wait a bit," the Oyster cried,
"Before we have our chat;
For some of us are out of breath,
And all of us are fat!"
"No hurry!" said the Carpenter.
They thanked him much for that.

‘The Walrus and the Carpenter’ by Lewis Carroll, 1872 from ‘Through the Looking Glass – and What Alice Found There’.

When the discussion turned to taxes, Reagan’s fist came down squarely on the table. "I don’t want to hear any more talk about taxes" he insisted. "The problem is deficit spending!" It is difficult to politely correct the President of the United States when he has blatantly contradicted himself. The $800 billion worth of deficits were the result of spending he didn’t want to cut.

David A Stockman, ‘The Triumph of Politics: Why the Reagan revolution failed’, 1986

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the King’s horses, And all the King’s men
Couldn’t put Humpty together again!

An ancient Nursery rhyme, source unknown.

 

Quotes above: The Core Messages (note old journalistic adage – ‘90% of the message is in the head-note’)

1. An excellent summary of the reasons for Australia’s record years of prosperity.
2. When politicians use the words ‘tax reform’ and ‘fairness’ in a single paragraph you know they are engaged in a giant deception that will involve you the taxpayer paying for their mistakes. No evidence that Gillard Labor has rejected Rudd Labor.
3. In public forums to ‘talk of many things’ constructively hardly ever happens because the terms of reference and the selection of the participants are designed to achieve a pre-determined, or pre-ordained, outcome.
4. Some definition of the optimum share of government in the nation’s GDP might be a useful starting point to debate tax and spending policies.
5. Now that the election is over, all of the King’s horses and all of the King’s men are silent no longer. In a crony capitalism society they have found their voice having lacked the courage generally to speak before the election, probably for fear of retribution. As Bill Hayden said: "Only the mafia bring you flowers."

 

OVERVIEW

Australia has had an ambiguous election result and the risk is policy grid-lock and inertia. The policy narrative in the election campaign from both sides was near fiasco with one side ill-prepared for leadership change and unable to talk about their economic track record over the past three years, and the other devoid of a policy narrative seemingly having forgotten the ingredients of their succesful past track-record in government. Everything is now on the table, all of the spurious election promises are null and void, and speed of productive policy delivery is of the essence. Promoting Keynesian falsehoods will lead to sub-optimal outcomes. Broadband on a blank sheet of paper, or the analysis hidden from view, will be counter-productive. Proper tax reform is essential to progress.

The election was a huge disappointment and the outcome is confusion. Briefly –

• Julia Gillard said nothing but said it well. We hope for improvement. She should stay.
• Tony Abbott lacked intellectual strength and rigour, and harped and carped. We hope for improvement. He should stay.
• Scott Morrison had a constructive narrative in and outside of his immigration portfolio responsibilities.
• Malcolm Turnbull did well in televised debates and was constructive and sensible.
• Andrew Robb was well suited to his Shadow Finance portfolio and performed very well.
• Graham Richardson showed his experience and his ability to communicate clearly and constructively.
• The Australian newspaper distinguished itself with the fairness, clarity and constructiveness of its coverage. Some others let us down.
• Joe Hockey shows no penchant for economics and finance and should be moved to a softer portfolio where his profoundly likable personality and abilities can blossom
• The Greens policies appear not to have been read by either of the major parties. Economics is not a religion, it is common sense. Labor’s alliance with the Greens is regressive paralysis.
• Tony Windsor has made a major error of judgement in his links with Rob Oakshambles. Mr Oakeshott is no doubt a decent human being but needs to have a bucket of water thrown over him in a parliamentary inner garden.
• Anyone not mentioned above, needs not to be mentioned, particularly Wayne Swan and Mr Rudd.

 

ONCE UPON A TIME

Once upon a time Ecinya was wrong to state its belief that Mr Hawke would not make a good Prime Minister but with the help of a gifted Paul Keating and a strong Peter Walsh, Mr Hawke succeeded magnificently and we were very pleased to be wrong. The Gillard government looks to be a substantial nonsense getting worse. We hope that we are wrong again, but we are concerned. Nearly all roads lead to tax reform, but real reform in an holistic way. Our Insight article on the Ken Henry tax reform package was published on 5 May 2010.

It’s conclusions were:

"ECINYA’S TAX REFORM PACKAGE

• Extend the Federal parliamentary term to a maximum of 4 years and a minimum of 3.5 years to give policy time to work (or to be modified, abandoned, or fine-tuned).
• Abolish direct donations to political parties by pooling them into a fund with a formula for distribution to retard the growth of crony capitalism and crony socialism.
• Expand the GST to food which will be a big tax, and compensate "the losers" such as pensioners and genuine welfare recipients.
• Capital gains on the sale of residential properties to be treated as ordinary income on a long-term sliding scale basis, say 7-9 years, and therafter profit on sale to be tax free.
• Abolish payroll tax collected by the states via a compensation system and many of the other taxes proposed to be abolished by Henry.
• Increase the tax free threshold and change personal and company tax rates as dramatically as is sensible.
• Have a target rate of total taxes to total GDP similar to the inflation targetting system e.g. 20% in good times.
• Introduce tax breaks on certain forms of savings particularly for younger people specifically saving to acquire a home.
• Have an exceptionally modest federal royalty tax on mining, say about 5% exceeded slightly by the mining royalties currently collected by the states.

KEN HENRY’S TAX REFORM PACKAGE

The key recommendations are set out below and we use the same numbers in our cross-reference commentary. We have ignored the 133 (non-key at this stage) recommendations not taken up by Mr Rudd and his Treasurer.

1. Impose a 40% "resources rent tax" on the mining sector.
2. Cut the company tax rate from 30% to 25%
3. Flatten personal tax rates, increase the personal tax-free threshold from $6,000 to $25,000
4. Replace state-based taxes such as payroll tax and stamp duty with broader consumption taxes including land tax on the family home.
5. Curb negative gearing.
6. Combine all family tax benefits into a single means-tested payment.
7. Taxes on interest earned from savings be slashed by 40%
8. Remove the medicare levy.
9. Restore fuel indexation.
10. Introduce traffic congestion charges.

ECINYA COMMENT

1. Emphatically disagree.
2. Agree.
3. Agree.
4. Emphatically agree, except that family home should not be subject to land tax.
5. Disagree; in fact capital gains tax on residential investment properties sold should be phased out over a holding period of say 7 to 9 years e.g. gain 100% taxable year 1, 90% year 2, 50 % taxable year 5 etc. No deduction for taxable losses (?)
6. Emphatically agree.
7. Emphatically agree.
8. Don’t know.
9. Don’t know, but do not like indexing anything….. CPI numbers are too rubbery.
10. Agree."

 

SELF INTEREST AND TAX REFORM

• Mr Kloppers wants a carbon tax. He probably also wants to export uranium and he wants his secret deal on mining taxes to go ahead. A hint of self-interest?
• Several weeks ago Mr Corbett ex Woolworths CEO and now Reserve Bank Board member expressed a ‘no changes to the GST’ view. A hint of self-interest?

There is a lot of real work to be done on tax reform and the gridlocked parliament may hinder real debate. But the real challenge is to look at tax reform in an holistic way without easy charges of self-interest able to be laid. If climate change is really about taxation (and higher electricity charges are a form of taxation) then let it be said, let it be acknowledged. If cheaper electricity is about nuclear power then let it be said. If growth is dependent on labour market flexibility then let it be said.

Keynes did not advocate wasteful spending and Mr Swan did not save Australia from the Global Financial Crisis. This needs to be said.

 

THE CAPTAINS OF INDUSTRY ARE NOW SPEAKING ( many of the King’s men are now speaking lest Humpty Dumpty Aussie might fall off the wall)

Humpty Dumpty has fallen off the fiscal and monetary wall in America and is not being put together again in a fashion or on a timetable that is universally recognised as positive. In Australia Humpty Dumpty is on the wall and many of the King’s men have arrived in today’s Australian Financial Review in a most constructive way. Pages 64 and 65 contain their messages on industrial relations, on threats to business, on a big Australia, on hiring intentions, on capital management, on Australia’s economic outlook. There is not a robust view of an unqualified economic outlook. There is an abundance of caution.

Pity that they were so silent before. But better late than never. The time has come the Walrus said to speak of many things.

 

A QUICK NOTE ON THE USA

We are fast turning to the view that the USA is far from a lost cause. The prophets of doom and gloom, in our view, are looking at America through a very narrow American-centric prism. The world needs America and we believe that once the mid-term election results are known America can make some structural adjustments alongside some constructive stimulus measures that will receive support from the surplus countries. The world may criticise America because they are the big kid on the block and over the few decades since Ronald Reagan have made some big blunders. We are hoping that the Tea Party will be seen to have failed at the mid terms and that Obama can swing to the centre and that the aspirational middle can emerge, energised and productive. Ecinya knows that "Wishful thinking is the enemy of hard work" , but it is time for America to have the express aim of being well regarded again. The world has not passed them by, the world has simply re-balanced, and for the better. Over the next few weeks Ecinya aims to write a few Insight articles on the world economy. We will start with China.

 

A QUICK NOTE ON THE MYER TAX CASE

In a former life our editor worked for Australia’s leading tax partnership. Though there are now more volumes of enacted law it is his understanding that the equity gains made by the Myer private equity partnership, on the public flotation of Myer, are taxable as ordinary income under at least two specific provisions of the Tax Act supported by well-decided legal precedents. The squeals of the partnership should be ignored and the efforts of the Australian Tax Office should be praised and endorsed.

 

 

 

 

 

 

 

 

ECINYA is an acronym for Exercise Caution In Your Affairs and is meant to remind both you, and us, that in order to get rich quickly you should endeavour to get rich slowly, as all endeavours require appropriate management of risk, and time. The stock-market from time to time appears to be an easy endeavour, but neither the economic cycle or market cycle is dead, and profits won on one adventure can disappear in the next. Folly can easily follow triumph. Those that tell you the market is easy, ‘either do not know, or do not know that they do not know’ (J K Galbraith).

Ecinya Consultants Pty Limited (ABN 22 092 041 784) is a Licensed Investment Adviser (Restricted – General Securities) License number: 197777.

George Sutton B.Ec (Syd), ACA, F Fin is an authorised representative of Ecinya Consultants Pty Limited and acts as editor of the Ecinya pages. George has been a former lecturer at The Securities Institute, a Corporate Finance Executive with two major investment banks, an analyst with BZW (which became ABN Amro and is now RBS) and then Managing Director of James Capel Australia. His major interests are the stock-market and golf – both mind games requiring technique, discipline, patience, and a sense of humour.

Ultimately, success in the stock-market comes down to you, for no matter how much we know, the future is difficult to predict, both in relation to time and dimension. No one cares as much about your money as you do and Ecinya encourages you to develop sources that can assist you to take advantage of many sources of information. In looking at source material be mindful of confirmations and divergences of opinion.

The aim of the Ecinya pages is to help you to build a set of thought processes to assist you to successfully invest, and occasionally trade. It is considered that occasional trading can enhance performance.

From ‘About ECINYA’ on the web-site

 

PROLOGUE

During the course of the week we discovered that one of our regular readers was unaware of some of the features of the web-site. Hence, the purpose of this week’s ‘Insight’ article is to provide a navigational tour of the web-site encompassed by a few introductory and concluding paragraphs.

 

HISTORY OF ECINYA

ECINYA was a weekly feature on the E*Trade web-site for the 8 year period 2000 until December 2008 when the new owners of E*Trade did not renew our contract. With the backing of an individual investor we built our own web-site which was launched on 28 July, 2009.

 

A LITTLE BIT OF BACKGROUND

A silly verse, source unknown: "As you wander through life brother, whatever be your aim, keep your eye upon the doughnut and not upon the hole." The simple message is always look at the entire doughnut, the whole doughnut.

ECINYA aims to do four main things:

• Teach you to look after your own money, in whole or part, by being aware of the dynamic world of economics and finance around you, but in an holistic way.
• Provide copy via our ‘Insight’ articles that provoke thought and provide perspectives that builds upon your own fiscal talents. Most people know more than they think they know.
• Give specific stock recommendations with entry points across a defined set of Portfolio Menus.
• By investing our own money on a regular basis we let you see our triumphs and our failures so that you learn that failure is part of the process. Sam Goldwyn said: Verbal promises aren’t worth the paper they’re written on." You also see the value of benchmarking and the nexus between strategy and tactics.

We are independent, we do not manage money for fees or brokerage except our own and a business partner, and we have no conflicts that we are aware of.

 

NAVIGATING THE WEB-SITE

There are two routes to all of the web-site content, via the tabs at the top which accesses the drop-down boxes, AND the home page.

The home page:

• Down the left hand side you can clik thru to ‘Current Headlines’ which accesses our latest ‘Insight’ article, ‘Strategic Overview’, ‘Ecinya Funds’. There is also a flash note labelled ‘Snapshots’ which is up-dated regularly, but not necessarily daily.
• Down the right hand side you can clik thru to ‘About Ecinya’, ‘Stock Recommendations’ (138 in all over 7 categories), ‘the Ecinya Market Barometer’, our Investment rules and rules from three other recognisable market gurus.
• There is also a way to contact us with a comment, a criticism, a reflection, a thought, even a compliment. Experience means that we do not embrace hubris, and we are alert to the opinions and insights of others.

The tabs at the top:

• About Ecinya – who are we, what are we doing?
• THINK – which has drop-down boxes that get you to ‘Insights’, ‘Strategy’, ‘Ecinya Market Barometer, ‘Market Wisdom’.
• ACT – drop down boxes to ‘Stock Recommendations’, and ‘ECINYA Funds’ which is known as the ‘Cactus’ Fund. Cactus encompasses a weekly report and gives you access to our detailed weekly spread-sheet. ‘Cactus’ was born on 6 January, 2009 in a market drought and caught the anticipated surge that began in March 2009. We will shortly start a new bull-market fund (again using real money) to be called ‘Daffodil’ – a flower that blooms in the spring.

Also in various places you will see words in RED and these are clik thrus to relevant and related material.

 

METHODOLOGIES

Best to access Insight Articles ‘A note for Jane’ – practical advice for a new entrant to the world of stock-markets and ‘The Bolton Response’ which details the methodologies sitting behind the published material.