Global Stock Market BLOG - Mike Burnick

China Sneezes and the World Catches Cold

It used to be taken for granted that the trading day began at 9:30 AM in New York for global financial market participants; and that U.S. markets typically set the tone for the rest of the world.

But if you still had any  lingering doubts about whether or not we live today in a very tightly integrated global financial market – and that the center of gravity for this market has moved inexorably westward across the Pacific – those doubts should have been completely dispelled by Tuesday’s market action.

Tuesday February 27, 2007 began like most any other in Beijing. But the locals would have marked off their traditional Chinese calendars as the 10th day of the new year 4704 – the year of the pig – or DingHai.

But for many Chinese investors – whether hewing to tradition or not – yesterday was no doubt a memorable one in which they learned a valuable lesson about the fickle nature of financial markets.

Yesterday, Beijing started the global trading day with a bang – as Chinese domestic stock markets in Shanghai and Shenzhen sold off sharply – loosing more than 9% in a single day. Although the selling in China was the most extreme, coming I should note after triple-digit gains in 2006 – Chinese investors weren’t alone in counting their losses.

After all misery loves company!

Global investors should also take a valuable lesson from yesterday’s carnage. Globally integrated economies and markets likewise lead to highly correlated global market returns – on the downside as well as up.

Brazil lost nearly 7%, Mexico 6%, Singapore 5%, Malaysia 8%, European markets fell between 3% and 4% -- the most in three and one-half years, while U.S. markets dropped about 4% -- all in all, it was a bad day for global markets.

And Wednesday, February 28, is not shaping up to be much better. As I write this article, China has rebounded, but early returns from other markets in the Asia Pacific region show stock market losses of 3% to 4% this morning – but it’s still early …

Investing in overseas markets is typically a great way to diversify your portfolio – and it still is – most of the time.

But at times, global markets have a funny way of moving in lock-step. As, for example, when global markets have been rallying in unison without so much as a 10% correction for an extended period.

In such a condition, globally integrated trading desks, mutual fund complexes, and hedge fund managers keep a very wary eye on the exits – prepared to dash for the egress at the slightest sign of trouble.

That’s certainly what occurred yesterday, as the high correlation in financial stock market losses attests. Evidence is also found in alternative asset classes. Global bond markets rallied sharply – with the biggest gains accruing to the strongest credits – a flight to quality move that benefited U.S. Treasuries.

Also, as my colleague Jack Crooks, the Sovereign Society’s Director of Currencies, has been pointing out in his blog (China Stocks Tank – That’s Risk!), global forex markets also saw a brisk day of trade – as the famous (or perhaps infamous) yen-carry-trade apparently began to unwind.

If Jack is correct, and this is the beginning of a global liquidity rewind – then yesterday’s sell off may be just the opening act.

Whether yesterday turns out to be just a brief blip on the global radar  to clear the way for more blue-skies ahead – or the beginning of a deeper and way overdue correction – remains to be seen.

Nevertheless, investors who have perhaps grown a bit too comfortable with the global nirvana trade should take heed.

Bonds For High Yield ... and High Adventure!

Global credit spreads have dwindled to all time lows, thanks to the apparent abolition of risk in financial markets worldwide. And in this environment of stable and historically low interest rates, fixed income investors are reaching ever lower for yield these days.

But according to a recent article in Bloomberg, global credit market conditions have recently taken a turn for the surreal …

Overlooking Risks in Search of High Yields

Risk premiums on developing market bonds recently touched a record-low of less than 1.8% over supposedly “riskless” U.S. Treasuries. In fact, U.S. high yield (or junk) bonds issued by American companies actually yield more than credits in countries with shaky credit histories and dysfunctional capital markets.

What’s a fixed income investor to do in today’s world of global convergence and low risk – there’s just no place left on earth to obtain truly high yields. But how does 8.2% annually over three years sound to you? Where? Try Mongolia.

When Mongolia’s Trade & Development Bank, the nation’s biggest lender, offered $60 million worth of bonds last month the issue was met with overwhelming demand. Apparently, more than $500 million in bids from global investors poured in – making the bond issue more than 9 times oversubscribed. Of course the bank naturally responded in true western-capitalist fashion by boosting the size of the bond offering to $75 million – while lowering the coupon yield paid on the bonds to just 8.75%.

Continued brisk demand for the three-year bonds in aftermarket trading has driven yields on this Mongolian debt still lower – to a recent 8.2% -- just 3.5% more than “riskless” U.S. Treasury bonds.

Reaching for Yield in Ulaanbaatar

To be sure Mongolia is not without promise. This nation of 2.6 million – one third of which are still nomadic tribesman in the legacy of Genghis Khan – enjoys a strategic location between two up-and-coming global powerhouses: Russia and China.

And like its neighbors to the north and south, Mongolia is rich in natural resources and is eager to tap into western capital to help develop (exploit) its mineral wealth. Never mind that the country’s population lives on the equivalent of about $5 per day, similar in third-world stature with Zimbabwe and Iraq. 

Also investors shouldn’t fret about the fact that Mongolia has periodically suffered banking crises – in 1994, 1996, 1998, and again in 2000. The upside potential is enormous. As far as the rule of law and capital market transparency go, well, let’s just say Mongolia is not yet on par with western standards … but they’re working on it.

According to Mongolia’s own Trade & Development Bank, many local lenders don’t follow official regulations. And several banks would likely go bust if regulations were any more stringent. Also, according to a recent survey, nine out of ten Mongolians say corruption runs rampant in the country. In fact, 28% of Mongolians report paying bribes in the past three months.

The success enjoyed by Mongolia’s Trade & Development Bank with its first ever dollar-denominated bond issue, can no doubt by ascribed to the road-show it put on for prospective investors.  Borrowing this custom from western-style IPOs, the bank hit the road to meet with interested investors in London, Hong Kong and Singapore, according to the Bloomberg article.

These meetings gave management a chance to explain its business strategy, answer questions, and build support for the bond offering. But in this case, Trade & Development Bank officials would have been just as well served staying home.

Collateralized Livestock

One of the few queries from prospective investors was how the bank goes about securing its loans to all of those nomadic customers. After all, what would prevent them from taking the money and riding off to greener pastures?

The answer: apparently Mongols are willing to “pledge their animals as collateral.”  Most of the other questions from investors apparently related to travel and tourism … what’s the best time to visit Mongolia, weather wise ... that sort of thing.

It may be nothing, but this type of cavalier attitude about risk amid booming global financial markets certainly gives you reason to wonder just how long this kind of insanity can persist. In times like these, it’s not the return on your money you should be concerned with – it’s the return of your money!

You may find this story rather hard to believe, and I don’t blame you for having your doubts, but the truth often is stranger than fiction – especially in emerging markets. But just to make sure I’m not making this up, get the full story from the Bloomberg article by following the link below.
Bloomberg: Mongolia, Prone to Crises, Beats Ford in Bond Market

For Japan: The Sun Finally Rises

The impression that Japan has been a lost-cause for global investors should be in store for a rethink based on stronger than expected economic data out recently.

The case for investing in under-achieving  Japanese stocks can perhaps finally be made based on rebounding growth – at long last – but also based on the fact that Japan Inc. looks pretty cheap compared to its high-profile Asian neighbors.

Japan’s economy expanded at its most torrid pace in three-years, according to 4th Quarter GDP figures out last week.

Growth in the world’s second-largest economy checked in at 1.2% in the last period of 2006 – and a very fast paced 4.8% annual rate – positively stunning considering its recent past.

What makes the headline numbers sound all the more convincing is a closer look at the details.

Domestic personal consumption surged at 4.4% annual rate supported by rising wages. For Japan, which has long been forced to rely on exports to post ANY economic growth at all due to a long slumber in consumer spending, this news looks especially positive for a sustained recovery.

The Ginza Goldilocks Scenario

That’s no doubt what the ministers at the Bank of Japan (BOJ) had in mind today also, when they hiked the official policy rate (akin to the US Fed Funds rate) to a still low 0.5%. After taking this step to boost lending rates, delayed at the BOJs last meeting in January, many economists see monetary policy on hold for the remainder of the year.

Such expectations of policy stability tend to give both stock and bond markets a floor to rebound off – and Japanese stocks in particular look poised to do well in this faster growth, low inflation, stable interest rate environment – let’s call it the Ginza Goldilocks scenario.

That Japan is relatively undervalued compared to its Asian neighbors is an understatement. Last year, while Chinese mainland stocks rose to triple-digit gains and many other Asian bourses posted rich returns – Japan was the only major market in the region to under perform, rising barely 6% in 2006.

But rampant price appreciation has turned many Asia ex-Japan markets, well pricey. And a closer look at Japan Inc. reveals a healthy market that may finally see big gains ahead.

Japan Inc. is Flush With Cash

First, Japanese corporate profits are soaring, up at an annual rate of 15.5% in the third-quarter of 2006. Companies have been paying down debt, and balance sheets in the land of the rising sun are flush with cash. In fact, debt-equity ratios in the Nikkei 225 Index are now the lowest in fifty years.

Cannon, the Japanese optics and electronics giant is sitting on net cash of 1,131 billion yen (US$9.5 bil). Industrial conglomerate Matsushita has Y1,131 billion stashed in it’s vaults, while high-tech game maker Nintendo shows a balance sheet with ZERO debt, and cash of Y876 billion on hand.

All this net-cash sitting on balance sheets means these companies are obvious targets for “value enhancement strategies” – whether performed by management itself – or at the hands of a corporate raider through stepped up merger & acquisition activity.

Increased Payouts and Buyouts

One way that Japanese corporate management can unlock this hidden value in their stocks is by returning cash to shareholders, either through dividends or share buybacks. And companies are doing just that.

Big multi-nationals in Japan including Toyota, Honda, and Canon have boosted their dividend payout ratios to about 30%. Sumitomo Mitsui Financial with a 20% dividend payout target now in place, may increase it to 40%.

Another tactic growing popular in corporate boardrooms is management led buy-outs of Japanese public companies. Recognizing how cheap many of these companies are, the number of management buy outs in Japan jumped 19% to a record of 80 deals last year, worth Y687.6 billion.

Of course all of these activities should provide continued support for share prices in Japan, which explains why the land of the rising sun should see rising stock markets ahead.

Going Global By Investing Local

Global stock markets are surging to fresh record highs, once again led by emerging markets, as was the case last year. But as domestic investors scramble to catch the global market express before the train leaves the station -- they shouldn’t ignore opportunities to invest at home in stocks that offer healthy international diversification too.

Case in point, Anheuser Busch Inc (BUD). This American icon was given up for dead in recent years amid a lack of domestic consumption growth, and shifting consumer tastes toward wine and spirits. But when it comes to investing globally to secure faster growing profits, BUD has made a lot of good moves that are beginning to pay off.

When you think about Anheuser Busch today, it’s not just about Bud and Bud Light, and NASCAR race fans anymore. Anheuser Busch is a company with truly global reach that garners a growing portion of its business from international distribution deals.

To be sure, BUD still generates about two-thirds of its sales volume from the domestic market, but a growing proportion of profits is due to shrewd overseas investments the company has made.

America’s Beer Goes Global

Today, BUD is a distributor of many leading imports including Europe’s Bass Ale, Grolsch, and Becks beer. The company also distributes Japan’s Kirin, Harbin Lager and Singapore’s Tiger, one of the most popular beer beers in Southeast Asia.

BUD’s international reach also includes greater distribution of the old familiar Budweiser brands overseas too. In fact, the company just cut a deal with Heineken to distribute Bud in Central and South America.

More significantly, Anheuser Busch holds significant direct ownership stakes it some of the world’s fastest growing breweries including: a 50% stake in half of Mexico’s Grupo Modelo SA, the maker of Corona -- which has quadrupled in value since the 1990s to $9 billion today -- smart investment.

Anheuser Busch also tripled its holdings in China’s largest brewer: Tsingtao. Combined beer volume from these two overseas investments has soared more than 60% in just the past two-years alone – and now accounts for 20% of BUD’s total sales!

International Investors: This Bud’s For You …

BUD’s drive for international diversification is paying-off in its latest bottom line results. Last year, while domestic consumption of BUD brands inched ahead just 1.2% -- its international volumes surged 9.3%.

Meanwhile, beer volume for the firm’s equity partners – the aforementioned foreign brewers in which BUD holds big ownership stakes – soared nearly 20% in 2006 – mainly due to rapid sales growth from Mexico’s Modelo, and from Tsingtao in China.

The bottom line is that investors who want to go-global should also consider the merits of local companies that are already ahead of the curve when it comes to overseas diversification.

So for all you globetrotting traders out there looking to buy into the next hot Chinese IPO … instead maybe THIS BUD’s FOR YOU!

In the interests of full disclosure, this editor is both a shareholder in Anheuser Busch—and a frequent consumer of many of the firm’s many products! This article should not be considered a recommendation to purchase the stock, but please feel free to enjoy its product-line responsibly.

Water, Water Everywhere ... But Not As Much As You Think!

The United Nations’ Food and Agriculture Organization (FAO) made a “splash” in the press yesterday; with a statement it released warning of an impending global water crisis.  By 2025 the UN agency notes, some 1.8 billion people will be living in areas of the world suffering from water scarcity.

Already today, 1.1 billion people across the globe don’t have access to adequate clean water supplies to meet just the most basic of daily needs, according to the FAO’s reckoning, while 2.6 billion do not have proper sanitation,. In the last century water use grew at more than twice the rate of overall population growth.

Water’s Hard To Find In The Desert

In a brilliant piece of analysis, the FAO points out that “Water shortages are most acute in the driest areas of the world” … wow, that's quite an insight. But even discounting this shrewd bit of reasoning, the issue of global water scarcity is becoming high-profile enough, that private enterprise is spending big dollars to search for solutions.

Roughly 70% of fresh water demand comes from the global agricultural sector – and farming demand swallows closer to 90% of fresh water supplies in lesser-developed nations. Therefore, improved farming practices are a high priority to help avert water shortages going forward.

And rapid industrialization, especially in emerging nations is putting a double-edged strain on water supplies.

Globalization Strains Water Supplies

First, growing emerging economies typically experience a coincident trend toward rapid urbanization. In fact, the rural share of China’s population has already dropped to 60% today, down from about 80% in 1980.

That’s about 260 million new urban apartment dwellers in China that lack the ability to fetch their own water from the local well or river, so vast municipal water supplies must be secured to satisfy their needs. And the trend toward urbanization in China, and many other emerging nations, continues to accelerate.

------------Advertisement------------
9 Benchmark-Smashing Funds You've Never Heard Of

The world's top mutual fund gained 590% in the last five years but your broker can go to jail for telling you about it!

Find out why the U.S. government is censoring some of the world's best performing mutual funds and why, 15 minutes from now you may never get to hear about these funds again...

Click here to read Eric Roseman's special report.
-----------------------------------------

Second, pollution of fresh water lakes and rivers becomes an increasing problem in rapidly industrializing nations too. Fertilizer run-off from massive agricultural projects, chemical spills, and other contaminants threaten to foul water supplies in both the developing – and developed world.

Water is a commodity just like oil, corn, or uranium … and one that’s likewise growing scarcer by the day. And just like any other commodity – when demand exceeds supply – there’s an investment profit to be earned by someone.

Wall Street’s Water Solution

In fact, and entire sub-sector of privately funded companies are springing up to address this issue. And for investors who are thirsty for alternative investment ideas, there’s even an Exchange Traded Fund (ETF) that lets you tap into the growing profit potential in this sector: PowerShares Water Resources Portfolio (PHO – AMEX).

This innovative ETF tracks the return of the Palisades Water Index, which includes companies in the business of developing, securing and maintaining global water supplies. These firms include: pump and filter manufacturers, water utilities and irrigation equipment manufacturers, to name a few. The ETF has a 54% weighting in the industrial sector (manufacturers of water-treatment and other related gear) and 29% in water utilities.

There are 42 individual stocks held in the PHO portfolio, including several American Depository Recipts (ADRs) of foreign-based companies. The ETF has total net assets of US$1.4 billion, and PHO shares gained 23% in 2006, compared to a return of 15.8% for the S&P 500 Index.

Finally, although this ETF began trading just over one-year ago, its average daily trading volume is strong at about 470,000 shares per day over the past three months – which means that PHO is sufficiently … liquid – for investors with an interest in the water resource sector!

Much Ado About Bad Mortgage Loans

News of troubles in the sub-prime lending sector for home mortgage loans has dominated the financial press in recent days. Here’s why it may all be another case of much ado about nothing. But first the back-story …

In case you’ve just returned from the far-side of the moon, HSBC -- a leading-edge innovator in sub-prime mortgage lending -- warned last week of problems in their mortgage loan portfolios.

The troubles at HSBC stem from its purchase several years ago of the old U.S.-based Household Finance for $15 billion. Household Finance's core business of course was somewhat akin to a loan-sharking operation – only slightly more regulated.

Hubris Gets the Better of HSBC

HSBC and its Household Finance unit made a fortune during the late-great housing boom by lending money to home buyers with scant loan documentation and sketchy credit histories. Now that adjustable rates are ratcheting higher – while home prices are rolling over – it seems that an increasing number of home-owners are willing to leave their keys under the doormat and move on.

The resulting increase in defaults caused HSBC last week to increase its loan-loss reserves to $10.5 billion. But even in a worst-case scenario in which the entire amount of bad loans is written-off – HSBC may still salvage $5 billion or so in remaining equity from its $15 billion investment in Household just three years ago – so all is not lost.

Since HSBC’s troubles hit the financial press, media pundits have been falling all over themselves declaring that the housing sector is about to plunge over yet another cliff, but that remains to be seen. It seems more likely that the HSBC case is more of a company-specific problem being magnified out of proportion. In fact, it looks like a classic case of hubris getting in the way of good business sense.

Bleeding-Edge Mortgage Loan Innovator

When HSBC acquired Household Finance in 2003, as mortgage lending innovation was reaching its zenith, it was a clear-cut case of reaching for market-expanding growth at any cost. The Household business was expected to transform the stodgy reputation of HSBC and offer the company a new platform for higher-margin lending.  By combining Household’s consumer-lending prowess with HSBC’s capital base – the sky was the limit.

But in a classic case of pushing too much of a good thing, a few years post-merger HSBC decided that originating loans wasn’t enough; it would also start buying up risky mortgages from other lenders and add them to its portfolio to earn even greater profits.

Apparently the thinking at HSBC was that its own staff of cracker-jack lending experts was smarter than the competition at judging risks. HSBC of course found that they just weren’t as smart as they thought when it came to assessing default risks. Sounds eerily similar to Enron’s energy-derivative trading strategies, designed to transform the company from a stodgy old utility.

Insurers Of Last-Resort Raise Rates … After The Storm Has Passed… Sounds Familiar

As for the chicken-little act in the financial media, it seems unlikely that HSBC’s troubles are a sign of more sinister problems ahead. For the most part, the sub-prime credit market seems to be functioning normally.

It's been reported that in the derivatives market, the cost to insure sub-prime mortgage loans against default has just about doubled in the past few weeks. But that’s the nature of the beast -- a natural knee-jerk reaction to the fear-mongering headlines in the Wall Street Journal. 

Naturally the cost of insurance will go up whenever there’s a quick market disruption of this sort. Underwriters of these derivatives have pricing-power right now to command a premium in exchange for their willingness to take the other side of the trade – and guarantee companies like HSBC against even more loan defaults.

Think about the market for windstorm insurance policies immediately following a hurricane … as a homeowner in coastal South Florida, I can tell you first hand all about skyrocketing insurance costs just after the storm has passed.

Apparently, investors willing to step-up now and take the other side of this default-protection trade can earn nearly 13% per year on their money over the next decade. That’s a pretty good return in today’s low interest rate environment.

And it’s all in a day’s-work for a properly functioning credit market!

China Investment Strategy: How to Bet Your Home on the Stock Market!

I found it difficult to stop laughing long enough to type this story after reading a terrific article that appeared in the Financial Times recently. To find clear anecdotal evidence that Chinese mainland stock markets may be overheated, you need not go any further than the delicious headline: “Chinese bet the house on shares going through the roof”!

In this article, Geoff Dyer explains that China’s pawnshops are doing a land-office business these days, extending credit to Chinese homeowners who are perfectly willing to put up their dwellings as collateral for money to invest in the booming stock market.

Yes, you read that right!

You Bet Your House ...

Three years ago, state-run pawnshops in urban Chinese cities such as Shanghai began accepting houses and apartments as collateral to make consumer loans. At first, customers wanted fast access to this unconventional source of cash to fund start up business enterprises amid the booming economy. But lately, pawnshop patrons have turned to hocking their homes to raise funds for stock market speculation instead.

Retail stock market investment in China is booming, with nearly 1.4 million new brokerage accounts opened in the month of January alone. And all this red-hot trading capital must come from somewhere.

According to official China Securities Journal reports, Beijing homeowners extracted Rmb1.5 billion in 2006 by hocking their homes – and it seems that much of that cash was directed into mainland stocks – which helps explain the 130% gain in the Shanghai Index last year.

Pawnshops Prosper on the Household-Carry-Trade

Do you remember how commentators expressed worry about all the home-equity extraction that took place in U.S. housing over the last few years? Well the financial ingenuity displayed by the Chinese puts us to shame!

China’s pawnshops for their part make good money on this household-carry-trade. They charge a monthly interest rate of 2.5% to 3% -- that’s an APR of up to 36% annually, for those of you doing the math at home. But what’s 36% annual interest when the stock market jumped 130% last year!

------------Advertisement------------
9 Benchmark-Smashing Funds You've Never Heard Of

The world's top mutual fund gained 590% in the last five years but your broker can go to jail for telling you about it!

Find out why the U.S. government is censoring some of the world's best performing mutual funds and why, 15 minutes from now you may never get to hear about these funds again...

Click here to read Eric Roseman's special report.
-----------------------------------------

The reality is that the retail investment industry inside China is still a rigged game, with the house in control of almost everything. Far from freely functioning markets in the western-capitalist sense, the government runs the whole show in China. The People’s Party still hold majority stakes in most of the big banks and public companies that trade on the Shanghai and Shenzhen stock exchanges. The government also owns most of the big brokerage houses, they regulate the stock exchanges, and they even control most pawnshops.

The "House" Advantage Goes to the People's Party

As such, the state has in effect sanctioned this sort of speculation, and Chinese authorities also have a vested interest in keeping the whole game going. But they also have ultimate responsibility for keeping the game from getting out of control too. I’m not sure what your definition of “speculation” is, but watching retail investors hock their homes to bid up mainland IPO share prices more than 100% in a day? This seems to me like a textbook sign of speculative market frenzy in the making.

To help restore order, the Chinese authorities could easily raise interest rates at local banks, to make the pitiful yields available on Chinese savings accounts more attractive. This should have the desired effect of cooling speculation in stocks.

Perhaps the government is afraid to take such steps, because the resulting liquidity drain might quickly get out of control in the opposite direction and hammer the stock market as an ugly unintended consequence.

Chinese Stocks for the Long-Run

The real long-term solution is for the government to loosen its stringent capital controls on domestic financial markets, in order to level the playing field for global investors to participate. This should ultimately result in deeper, more liquid capital markets that can function without so much state-sponsored orchestration.

But for now, it’s up to China’s party bosses to try as best they can to manage the fast-growing mass of fickle individual investors throwing money into stocks -- a very difficult undertaking indeed.

Perhaps the recent 15% correction in mainland China shares has run its course after just a few weeks of profit taking, or maybe it’s the beginning of a deeper slump, only time will tell.

But one thing is clear; considering the rampant signs of speculative excess in Shanghai and Shenzhen -- investors with holdings in these markets should be fully prepared to stay invested for the long run.

Europe’s Stale Breadbasket

Agricultural commodity prices are going through the roof.

Soybeans have jumped nearly 26% in the past 12-months … Barley and Wheat have surged more than 40% since last year … and Corn prices doubled in the just the past six months …

With spot prices for such a wide variety of foodstuffs surging right now, why are the Ukrainians dumping their own Wheat harvest in the Black Sea?

Ukraine, in the heart of the former Soviet Union and known as the “breadbasket of Europe”, is a key grain supplier to the entire continent. But today, the agricultural industry in this emerging semi-capitalist state seems to be stuck in its socialist ways.

In a move taken straight out of the old Soviet-style, command economy playbook, the Ukrainian government is pursuing a policy of export restrictions on most grains, and a total ban on wheat exports.

This populist move is designed to keep domestic food prices low, earning kudos for local politicians. But budding agri-capitalists in the Ukraine are suffering big-time – as grain consumers around the world are forced to pay higher prices.

Due to these heavy-handed export restrictions, huge stockpiles of grain have built up in storage facilities at Ukraine’s ports along the Black Sea. But due to the poor condition of these aging storage silos -- many of the crops are left to rot -- and end up being dumped into the sea. Ukraine’s agricultural sector has lost “hundreds of millions of dollars”, according to one industry source. Commodity traders claim that global grain prices have been inflated by as much as $20 per ton as a result.

The World Bank has declared Ukraine’s export restrictions "unjustified", and warned of potential corruption in the government’s handling of the affair. It seems that certain small domestic grain merchants have been awarded big export quotas, while large multi-national companies with big stockpiles are able to export only small amounts of grain. According to a recent article in the Financial Times, who is wonderfully covering this story; “Suspicions are mounting that inside deals could be at play in the quota-granting process.”

Corruption? … in the former Soviet Union? … Imagine that!

War, and Rumors of War

News today from the frontlines of America’s hot war in Iraq went from bad to worse. Another U.S. military helicopter – the second in three days – was apparently shot down near Baghdad. This brings the total number of American airships brought down by enemy fire to six in less than three weeks.

Apparently the Iraqi insurgency has graduated from roadside bombs to shoulder-launched anti-aircraft missiles, probably Russian made … and almost certainly supplied by Iran. This apparent escalation on the part of the Iraqi insurgence comes as the U.S. begins to deploy thousands of additional combat troops to the country, an escalation of its own, in what’s being billed as the Baghdad push.

The ongoing civil war in Iraq (let’s stop kidding ourselves and call it what it is) was of course hastened by the 2003 U.S. led invasion of the country, a supposed beachhead in the war on terror. But now, in a striking similarity to another conflict 40 years ago and half a world away, the U.S. military finds itself caught in the middle of situation that’s still sliding from bad to worse, with no realistic solution to the conflict anywhere on the near-term horizon.

Shots Across The Bow In a Potential Trade War

Meanwhile, in another part of the globe, rumors of a simmering trade war  -- that may soon flare up -- appear to be rapidly gaining currency.

In a shot across Beijing’s bow, the U.S. last week lodged a major complaint with the World Trade Organization against China, accusing Beijing of using protectionist tax policy to unfairly subsidies its manufacturers. According to a story in the Financial Times, Chinese industrial sectors from steel to electronics have enjoyed tax-breaks to encourage exports, often at the expense of imports.

It seems that in the aftermath of the Asian financial crisis in the late 1990’s, Beijing introduced a broad range of export tax rebates to local companies, aimed at protecting Chinese exporters from rapidly depreciating currencies in other parts of Asia. Lately, China has eliminated the tax rebates in some sectors, but in spite of a now vibrant export market, many subsidies remain. And considering the record trade deficit with China of $214 billion, Washington is none too pleased with China’s protectionist tax policies.

Posturing Ahead of G-7?

I wonder where the Chinese ever came up with such ideas on free trade … maybe the vast array of agricultural price supports used to protect U.S. farmers? Or perhaps China had a glimpse at the intricate list of import tariffs designed to protect U.S. steelmakers, and other heavy industries from foreign competition? Predictably, U.S. manufacturers welcomed the WTO complaint.

Of course this retaliation for China’s free-trade affront, may amount to nothing more than some well-timed posturing ahead of the upcoming G-7 meeting. As my colleague Jack Crooks points out, six of the G-7 nations are unhappy about the recent fall in the Yen (helping Japanese exports gain a competitive advantage), which should top the list for this meeting. But expanding trade deficits, on both sides of the Atlantic, puts Chinese trade policy very high up on the agenda as well.

But in a world that has apparently become financially risk-free (or at least risk-lite) -- where credit spreads and market volatility across multiple asset classes are at or near record lows -- global financial markets can ill afford a full-blown trade war between the U.S. and China right now. That would make for a very unpleasant surprise.

About Wall Street: Corporate Profit Reports Offer Investors Little To Cheer About

Hopefully, investors who are also sports fans got their fill cheering about Sunday’s Super Bowl, because there have been precious few reasons to cheer recently while combing through the deluge of year-end financial statements issued by America’s public companies.

So far, it’s shaping up to be a pretty lackluster, if not downright disappointing, earnings reporting season. While companies in the Standard & Poor’s 500 Index are on track to grow profits about 10.5% year over year in the last quarter of 2006, it still represents a sharp slowdown from the third-quarter’s 22% growth in earnings. And most reports out so far are only slightly ahead of expectations, with very few blow-out financial performances to get investors excited.

Shrinking Surprises

Another factor that sounds a sour note this earnings season is the fact that S&P 500 companies just aren’t exceeding expectations the way they used to – which was a treat Wall Street has grown accustomed to in recent years.

According to data provided by Briefing.com, in early January and before earnings reports began pouring in; Wall Street analysts were forecasting 9.4% aggregate profit gains for S&P 500 companies. Now that most reports are in, and the index appears on track to post 10.5% earnings growth, that’s still a positive surprise, but by just a percent or so. That’s far less that the typical earnings surprise of 3% to 5% above forecasts that’s been the norm in recent years.

Also, about 60% of S&P 500 firms are exceeding expectations this earnings season, which sounds nice on the surface. But in the past few years, as many as 70% of firms reported upside surprises. And so far this season 23% of individual companies have reported disappointing results – some well below expectations – while in recent years the number falling short has been confined to just 15% to 17% of S&P 500 companies.

Not-So-Great Expectations

Going forward, expectations are also beginning to dim for the remainder of the year as well. Current quarter earnings are expected to gain about 8% over the first quarter of 2006, that’s the first single-digit profit growth period in several years. Second and third quarter results are forecast to grow just 5% to 7% -- resulting in full-year 2007 S&P 500 profit growth of just 7% to 8%. This compares to average annual earnings growth of 17% for the index over the past five years.

U.S. corporate profit growth is a key indicator that attentive investors should be watching. That’s because 40% of S&P 500 profits are generated from exports to countries around the world. As such the profitability of American blue-chip firms can serve as an early warning indicator for slowing global growth.

The jury’s still out on just how fast or how far earnings will slow among the S&P 500, but this could potentially be a negative surprise in the otherwise favorable “Goldilocks” consensus on Wall Street these days.

Irrational Exuberance: Chinese Style

To say the Chinese Communist Party still exerts psychological influence over its people and institutions would appear to be a vast understatement.

Cheng Siwei, the vice-chair of the National People’s Congress used the B-word (as in bubble) last week in public comments about the state of China’s domestic Shanghai stock market, and within 24 hours share prices on the exchange were in headlong retreat. Talk about exercising influence – this guy’s got gravitas in spades!

You can’t help but wondering what Alan Greenspan is thinking right now. The former U.S. Fed Chairman’s now famous (or is it infamous) comments about “irrational exuberance” in stocks barely caused a blip on the New York Stock Exchange when those comments were made in 1996. In fact, the bull market in U.S. stocks carried on for another four years after Greenspan’s remarks – with the very best years of the long bull-run still to come.

But where Greenspan’s warning either fell on deaf ears – or came way too early -- without being of any practical use to investors, Vice Chairman Cheng’s remarks were met with swift action on the part of investors in China.

A China Correction

Shares on the Shanghai and Shenzhen 300 Index, a widely followed benchmark for Chinese domestic shares, fell 12% over the last five trading sessions, including a one-day 6.5% plunge last Wednesday (the day after Mr. Cheng’s comments), and a 4% slide Friday. The current correction, the biggest in five years, comes after the Shanghai and Shenzhen 300 Index more than doubled in 2006.

Signs of froth in Chinese securities are certainly plain for global investors to see, should they care to look. But as Mr. Greenspan found out, it’s getting the timing right that’s the tricky part. Or as the celebrated economist and investor John Maynard Keynes once put it: “the market can remain irrational longer than you can remain solvent.”

Before the recent setback in share prices began, the domestic Shanghai and Shenzhen 300 Index was trading at a pretty lofty valuation. In fact, the Index was priced for perfection at 38 times projected profits over the next year, almost double the ratio for the Hang Seng China Enterprises Index, which is made up of Chinese companies traded in Hong Kong.

The big increase in valuation for domestic China stocks is due in large part to the fact the index soared 155% over the previous 12-months. But by way of valuation comparison, the benchmark MSCI Emerging Markets Index, sports a price-earnings multiple of just 15, indicating that Chinese domestic stocks are far removed from bargain-basement territory relative to other emerging market indexes.

Dot.com style IPO Mania on the Mainland

Another potential sign of a near-term top may be seen in the seemingly irrational amount of money that’s chasing Chinese shares; many of them newly listed stocks. Remember the dot.com IPO craze that rang the bell at the top of the U.S. market bubble?

Last year Chinese companies raised HK$342 billion on the Hong Kong stock exchange, mostly from new listings such as Industrial and Commercial Bank of China (ICBC), and analysts say there are plenty more deals in the pipeline.

But Hong Kong is relatively restrained compared to the speculative IPO fever going on in Shanghai and Shenzhen. China Life Insurance Co. stock more than doubled just since its Jan. 9th debut in Shanghai. When ICBC IPO’d last October, shares were 49 times over-subscribed. The stock has since soared about 70% in just three months.

Investors Partying With Chinese Stocks Like It’s ... Well, 1999!

China’s mainland investors pumped about 150 billion yuan into mutual funds and spent 100 billion yuan more on individual stocks in the last six weeks of 2006 alone, according to Bloomberg news, and those mutual fund flows are equal to more than one-quarter of the 580 billion yuan in assets that mainland China funds held.

Not to be outdone, Western fund managers pushed US$1.3 billion into China focused funds just during the first two weeks of 2007, that’s nearly three-times the amount for the rest of Asia excluding Japan, Bloomberg noted. And fully half of the record $22.4 billion invested in all emerging-market funds in 2006 was directed to China.

So much cheap money chasing so few shares (foreign investors face restrictions on ownership of mainland Chinese stocks) certainly explains the existence of the IPO craze.

But the truly bizarre part of this story is the fact that investors continue to irrationally throw money into mainland stocks, when the same companies can be purchased at a big discount in Hong Kong – where the shares are much more liquid to boot!

China's Mainland Shares Have Just Entered The Twilight Zone

Around this time last year about one-third of Chinese stocks that are dual listed – with shares trading in both Hong Kong and Shanghai – traded at a slight premium in Hong Kong, which is to be expected thanks to Hong Kong’s more stringent listing requirements (which adds a greater degree of transparency), and greater market liquidity.

But the rational investment world has been turned upside down. Today all of the dual-listed stocks trade at a premium in Shanghai – many of them at a substantial premium – to shares in the exact same company listed in Hong Kong.

According to a recent article in the Financial Times, there are eight Chinese companies trading at 100% premiums in Shanghai, over the share price in Hong Kong – same companies mind you, but twice the price!

Newly public shares in China Life, the company that gained 100% on its Shanghai IPO debut, are now valued about 50% higher than China Life’s H-share listing in Hong Kong! Another company, Luoyang Glass trades at a 300% markup in Shanghai over its duly-listed Hong Kong share price -- sheer madness!

It kinda reminds you of all those dot.com IPOs from 1999 (now derisively referred to as dot.gone’s), the year in which the Nasdaq Composite Index enjoyed triple-digit gains as Shanghai did last year.

Perhaps over-eager investors in the China-miracle should be reminded of an old investment axiom:

the return OF your money is more important than the return ON your money.

Capitalization … Nationalization … or Confiscation: Take Your Pick

With the first month of 2007 now in the rearview mirror, it’s worth reflecting on some of the nascent trends emerging in global investment markets. These are trends that may continue to play out over the course of the year, and thus create some interesting buying opportunities for the attentive investor.

The ongoing upside surge in global financial markets, and the apparent negative correlation in market volatility – which is moving in the opposite direction of global stock market indexes, i.e. toward record lows -- is an interesting dynamic. But much has already been written about this.

Instead, I’d like to chronicle for you an emerging market investment strategy that looks to me like a sure thing: a new trend being promoted by emerging market leaders (dictators) to capitalize on (exploit) profitable business interests, by nationalizing privately owned companies, and entire industries.

Think of it as the mirror image of the booming private equity investment trend.
In Venezuela, President Hugo Chavez is engaging in some creative asset allocation on behalf of the country by announcing plans recently to nationalize Venezuela’s telephone, energy, and electric utility sectors.

President Chavez it seems is a deep value investor at heart, since he’s determined to fetch these assets for his countrymen at a bargain-basement price – that is by saying publicly that he intends to “pay” shareholders below market prices for these assets – negotiations continue.

Chavez must certainly be commended for the broad nature of his nationalization scheme. It’s a smart idea; building a well-diversified portfolio of assets across different industries, all in one fell swoop. This should help reduce risk in the people’s portfolio. Perhaps Chavez is planning to launch his own Exchange Traded Fund.

You may ask about the market’s reaction to the new Venezuela nationalization plan? After soaring in 2006, the Caracas Stock Exchange is correcting slightly in this news; plunging about 30% in January. Apparently global investors just can’t appreciate the finer points of the Chavez investment strategy yet, but they’ll come around.

While certainly ambitious, the Chavez strategy isn’t all that original. That’s because Venezuela is simply jumping aboard an established, but still growing trend.

Bolivia’s leftist leader, President Evo Morales, announced a “hostile takeover” of the country’s energy industry last year. The President even sent the army to seize control of Bolivia’s gas fields in order to obtain “more favorable terms” from French energy giant Total, and Occidental Petroleum Corp. for development of these assets.

Shrewd negotiating tactic – Warren Buffett take note!

But these Latin American Nations can scarcely be blamed for beginning the trend toward trampling shareholder rights and setting capitalist ideals back several decades with their brazen confiscation of private assets.  After all, they’re just following the lead of their “former” socialist comrades in Russia.

You may recall just a few years ago, that the Russian government essentially nationalized its energy sector, by dismantling the nation’s largest privately held (at the time) energy company Yukos, and jailing the firm’s former CEO on (questionable) charges of corruption and tax evasion. The Yukos affair cost private investors an estimated $45 billion in lost (confiscated) market value; but the Kremlin prefers to think of it more as a socially justifiable wealth transfer.

More recently Russia threatened to cut of supplies of natural gas to Europe, unless they agree to “renegotiate” existing contract prices. And in an attempt to repeat its successful Yukos “restructuring”, Royal Dutch Shell recently received an “offer” (ultimatum) from Russian authorities to sell its controlling interest in the huge Sakhalin energy project (located in eastern Russia) to the state-run natural-gas monopoly Gazprom.

While profitable for the state (at least in the short run), this trend toward socialization, nationalization, or outright confiscation of privately held and financed assets should serve as a cautionary tale for international investors.

It would seem that developing markets, rich in natural resources, can be divided into two rather broad categories. The first, include many nations that get a taste of newfound resource-based wealth and are happy to attract more foreign investment in hopes of gaining the expertise, and the investment dollars, necessary to continue the virtuous cycle of growth and prosperity.

But there is a second group of nations, including those practicing politics that are less well-grounded in democratic principles. These nations get their first taste of resource-based riches -- and are instantly intoxicated. And all too often the response by the government is hostility and belligerence toward the very sources of private capital investment that are needed to fuel the wealth creation dynamic in the first place.

Talk about biting the hand that feeds you. As a global investor, I would much rather put my capital to work in the nations that are members of the first group, rather than the second.

China's Maratime Odyssey

According to Homer, fair Helen’s change of residence from Sparta to Troy triggered the launch of a thousand ships driving eastward across the Aegean Sea.

Today, China’s global maritime ambitions are launching a westbound shipping armada through these same waters – targeting Greece and the European Union that lies just beyond. But instead of making war, China’s interests in the Aegean appear to be purely commercial in nature.

Global exports emanating from China reached nearly US$1 trillion for the first time last year (US$969 billion to be exact), and it’s two largest trading partners, the United States and the European Union (EU), account for the lion’s share of these net imports of Chinese goods.

 

Greece, as has been the case for thousands of years, is a key gateway for imports into southeastern Europe. And on January 1, Bulgaria and Romania officially joined the EU, upping the ante for Greece, which is strategically located just to the south its new EU neighbors.

 

Greece sees itself as well positioned to capitalize on increased trade in the region, and is already in the process of expanding its port facilities at Piraeus (near Athens) in the south of Greece, and in Thessaloniki in the north. But a US$500 million makeover for the container terminal at Piraeus is already several years behind schedule.

 

So Greece is in search of investors to help finance its port expansion, which is estimated to cost upwards of US$1 billion in total.   

Enter Cosco Holdings Co., China’s state-owned container shipping conglomerate, and the fourth largest maritime shipping operation in Asia. According to the Financial Times, Cosco sees Greece as a potential hub for increased trade with the eastern Mediterranean basin, the Balkans and Europe.

 

The idea is that cargos from China shipped on huge container vessels would be offloaded in the newly refurbished Greek ports. Then smaller merchant vessels would carry these containers to smaller coastal ports in North Africa and the Black Sea.

The Chinese are reportedly considering a number of investment options including: a direct equity stake in the Piraeus Port Authority, managing certain Greek port operations under long-term contracts with the government, or even building container facilities of its own in Greece.

 

There are other potential suitors that can provide the capital Greece needs for their port expansion, including China Shipping, another state-owned firm. But Cosco is the odds-on favorite. Swinging a deal of this type should be a win-win for both Greece and for Cosco, since the two have already enjoyed a long and mutually profitable shipping relationship.

It seems that over 80% of China’s imports of oil and other raw materials, needed to fuel its boundless economic expansion, arrive on Greek owned vessels. Many of these are under long-term charter to Cosco and China Shipping by Greek shipping companies.

Meanwhile, in order to keep up with the global shipping boom, Greek shipbuilders are placing orders for a large number of new vessels. Increasingly the construction of these new ships is being outsourcing to … you guessed it -- Chinese shipyards!

This nicely brings the whole relationship around full circle, doesn’t it? Just another chapter in China’s odyssey of globalization.