Wednesday, April 25, 2007

Beavering away

Macro Man has the champagne on ice, reading to pop the cork when, as seems inevitable, EUR/USD makes a new post-1999 high. Perhaps another rubbish reading on durable goods or housing will do the trick. For the time being, profit taking seems to be the order of the day, taking the other side of demand caused by Voldemort and yet another strong ifo reading in Germany.

In Japan, the trade surplus surged to a record high on an unadjusted basis in March, providing some suggestion that the yen is, indeed, undervalued. Macro Man has never disputed that the yen is undervalued; rather, he has claimed that the yen is not terribly undervalued against the US dollar. It was interesting to see that exports to the US were up only 2.4% y/y, while those to Asia and the EU rose 10% and 13.7% respectively. Yes, Virginia, exchange rates do eventually matter!
Macro Man is beavering away with a few research projects at the moment, some of which will hopefully bear fruit over the next couple of days. Yesterday's jitters feel a mile away, though tellingly the IBEX has mustered only flat performance after yesterday's shellacking, seriously lagging the rest of Europe. Whether this bodes ill for the future remains to be seen, though Macro Man can guarantee you that he was not the only person to send charts of Astroc, a company of which he had never heard until this week.

So, it's back unto the research breach, but Macro Man will sign off with a question for those readers who specialize in equities:

Why is it that of the few global equity markets that are underperforming the US, three of them (Japan, Hong Kong, and Taiwan) are in countries ostensibly well-placed to leverage Chinese growth to the hilt?


Anonymous said...

I'm no expert on equities, but the banks/financial component are quite large for all three of the indices (GWGT gives you group weights, i.e. TPX Index GWGT Go) that you mention TPX (11.7%), TWSE (14.2%), and HSI (39.4%). Given that lead in, guess what the worst performing sector YTD is in each of these markets? That's right, the banking/financial sectors.

The weakness of financials in each of these countries speaks to domestic weakness in Japan and Taiwan (not sure about Hong Kong). Taiwan especially is a darling of the global macro community, but one needs to keep a few things in mind: 1) politics are turning negative given that the leading KMT (the local pro-China party) presidential candidate has been tainted by a corruption scandal making the upcoming election somewhat of a toss up; 2) the attractive P/E is driven by the large banking component which is in need of consolidation, the only problem is that local politics make it extremely unlikely that the government will allow any transactions that will involve significant job losses; and 3) Taiwan is also a technology play at a time when memory prices are at or below the cost of production, TWSE should participate in a Nasdaq rally, but local financials will likely continue to be a drag.

So what does all of this mean? Well, long Taiwanese equities is not really a China play, but more a value play (dividend yield of 3.3%, w/ 10yr govt bond yield of 2.1%). The currency will likely remain a funding currency, much like JPY, as domestic corporates and investors continue to go offshore in search of higher yields. The more direct China plays (long metals; long AUD, NZD, and CAD; long AS51) have performed much better and are all near the highs. Things on the periphery are MYR (which has already moved quite a bit) and IDR (which hasn’t but offers attractive yield for an SE Asian ccy). Think the way to play Chinese growth in equities is through US, European, and Japanese industrials as these are the firms active in supplying the capital infrastructure for Chinese growth.

Macro Man said...

Interesting take. I hadn't realized financials were driving valuation and performance to that degree.

What makes it particularly ironic, of course, is that financials are the leading light of that other underperformer, the SPX; the street is awash with research talking about how poor earnings and P/E are ex-financials.

I'd agree with your Taiwan analysis- there's not many markets in the world where the dividend yield on stocks is 1.5 times the long term bond yield. Of course, it's been that way for a while with so sgin of the gap closing, and the carry isn't enough to make up for the execrable erpformance of the TWD.

As an aside, Taiwan is a lot like Japan in more ways than one- it is also an aging population that is gagging to send money offshore.

Of the "pure" China plays, I prefer MYR; it is one of the few Asian curencies where the CB is on record approving of currency strength, it is entering the Citi GB index in a couple months, it has the big c/a surplus, etc.

IDR is a great trade in theory but seems to have become rather pointles recently. NDF carry versus $ is fairly paltry and the CB has decided that 9100 +- is a decent level to peg the currency. I think that's one to hop on if the CB regime changes 9as it did in Malaysia in November of last year.

The commodity bloc is too rich for my blood to allocate new money at the moment; there are too many carry traders involved at present(including me.)

I quite like the idea of going long global infrastructure stocks as a China play; not only will the developing world need their products/services for years to come, but word on the street is that the new Temasek-style investment authority will be looking long and hard at thes types of companies.

Anonymous said...

Ah yes... but IDRTWD offers much more juice...

Macro Man said...

Yes, I had that one in real life for a long time. Got bored of the IDR leg for reasons described above and then took off TWD when things started looking wobbly 6-7 weeks ago.

It's tempting to whack the TWD again, but I know a lot of people already have. Now, we may be breaking out of this long term triangle in $/TWD...but I'd prefer to see it make a new high before getting sucked in.

Moreover, I observe that it's MayDay next Tuesday, and I cannot help but remember the old ditty that I ignored this time last year...

"Cassandra" said...

I might throw out the following to you, before delving into the sectoral differences or index anomalies that might crimp performance, instead focusing on just the macro.

My guess is that in addition to these markets' reasonably significant negative correlations to their currencies' USD exchange rates (this IS huge - look at the TOPIX expressed in USD over past 12mo.), the still-large family/meaningfully large shareholder interests present in each of these markets that result in potential governance conflict of interest issues, the more paternal and diverse constituencies to which the Corporations are subject to (particularly in Japan), I think that there is a meaningfully large difference in capital structures that gives north american companies, in a nutshell, more leverage, and higher ROEs EVAs & CFROIs.

In addition to American co's liberal use of leasing, outsourcing, sub-contracting, consulting, and anything else that reduces assets whether real or through smoke & mirrors, one just doesn't see companies in the highlighted countries doing what Autozone or Deluxe has done in using every dollar of available cashflow plus a as much debt as the balancesheet will bear (and occasionally more than it can bear) to continuously buy back shares, that some [apologists? OBNs] would argue is an unceasing bid to optimize their capital structure. Cynics on the other hand, might be forgiven for asking optimizing "to what?", and would argue that although American companies are admittedly more awash with cash than they've been in recent past, many companies are surfing the edge of the capital structure envelope in a bid to "meet earnings", "short-term goose the stock price upwards" and/or avoid takeover, and are apparently optimizing with little margin for error and to an environment that assumes liquidity will always be increasing, for should liquidity implode, or dry-up for whatever reason, there may be many enterprises that find it difficult to continue to generate returns that justify the premiums at which they are current valued. Not all, certainly, but a reasonable less-than -salubrious minority.

Anonymous said...

Dear Cassandra,

Interesting hypothesis, but don't European companies have many of the same corporate finance structures that Asian companies? Not so much the family ownership, but large cross-holdings, heavy reliance on banks, and less leverage than their US counterparts? European stocks have managed to beat their US counterparts for the past two years.

"Cassandra" said...

anonymous, to certain extent, yes, but a crucial difference has been the path-dependancy of prior return, or the fundamental valuations from where recent gains started. German real estate, for example, has been the worst-performing European real estate market....if one begins in 1994. If one begins in 1988, things change since there was enormous price-spike following reunification greatly in excess of other markets. So European equity markets were coming from a very low absolute and relative valuation base.

Also, like Japanese companies who've responded to strong currency and endemically high labour friction and energy costs
by capital investments, improved manufacturing methods, strategic outsourcing, their leverage is operating leverage that kicks in when marginal demand picks up. Given the industrial nature of Japan, this really kicked in 2003 when Chinese demand for machinery, steel chemicals, realted shippping, etc. really exploded. In western europe's case, it's resulted from its own liquiidty growth post monetary integration coupled with eastern european growth, & the recycling of petrodollars. The American leverage is by comparison, pure financial leverage of the zaitech type since the manufacturing has continued to be hollowed & outsourced which diminishes the changes in the marginal cost of goods once a monopsonistic like walmart has beaten the daylights out of the subcontractor.

Macro Man said...

Cassandra, how financially levered are US corporates? Most of the (top down) stuff I read talks about FCF and the great state of balance sheets and the relative reluctance to isse debt (despite the rich market valuation of such debt.)

My sense is/was that the tide is just turning and that conditions are just now falling into place for companies to start gearing up, an impression reinforced by the tightness of spreads.

But I don't own a copy of Graham and Dodd and don't pore through balance sheets on a case by case basis...

"Cassandra" said...

At once, across the universe of US listed companies (and I consider the broad scope of the equal wtd opportunity set vs. cap-weighted since its more indicative of the landscape), "liquidity" (net monetary assets as % of tot assets) has deteriorated at the same time as "structure" (ratio of adj equity to adj assets) has improved. Structure does measure how much leverage a balance sheet could bear, ceteris paribus, whereas liquidity measures the fact of what in fact of matter (retained earnings) has built-up. US Corp "liquidty" as described above sits at the mean of 17yr avg, whereas structure sits 0.5 STD above its 17 year mean, at the highest level during this period. Presumably, US liquidity has returned to mean as a result of aggressive buy-backs, activists insisting upon return of cash, pre-emptive moves to "use it or lose it" , and the fact that private equity boys pluck the low-hanging fruit, not the highly-leveraged, eventually spitting it back out to the public or trade-buyer stripped to the bone. But if in aggregate, liquidity is only "mean" even though adj equity-to-adjassets is best-ever, this perhaps says companies have been better at limiting assets - or financial engineering their way to high returns on equity through outright asset sales, outsourcing, sale-leaseback transactions. On the surface, some might say this is good (if EVA or CFROI is your bible), but let me pose the question as to whether this is really smart in a world where - as en enterprise - one still needs labour, facilities, capital equity, transportation services, etc. IF the enterprise no longer "owns" it, but liquidity is everywhere and inflation potential "rife", doesn't the liquidiation of assets, leasing, outsourcing etc. expose the enterprise to the full brunt of inflationary pressures? Earnings and cashflow thus, while presently robust and sufficient, become far more volatile, and uncertain under many circumstances - particularly those where input prices, costs are rising faster than incomes and thus difficult to pass along which doesn;t sound far off what we see at present.

Japanese and European firms by contrast tend to internalize much more, maintain more prudent overall levels of liquidity (even if suboptimal) and bloat their balance sheets with ownership of assets (buildings land cap eqt) resulting in better higher assets and higher equity. In good times this gives them lower ROEs and operating leverage (i..e a drag on returns), but also reduces risks and exposure to upside inflationary shocks. There is no ex-ante correct answer to whether its better to be conservative and prudent or "shoot the moon" because we're all buggered in a tail event. I am conservative by nature, can see the logic in trying to optimize, BUT believe that the agent/principal conflicts in the yankee model, combined with unitary nature of a single constituency [shareholders] produces sub-optimal results for society. But this is beer-chat.

Finally, one must also ask about off-balance sheet liabilities, and here US companies also rule the roost insofar as a great of the S&P500 have major-league unfunded pension liabilities that are not present in Euro and Japanese firms since these are liabilities of the State (who conveniently have already tackled the lions share of the prob with a single-payer, universal coverage model. These are by no means inconsequential (according to preliminary research pieces I've seen) as only a very enterprises are overfunded (IBM, Weyerhauser, etc) some of the new ones (young firms) have little exposure as they are all defined contrib, though the aggregate of unfunded liabilities resulting from legacy defined benefit and rising healthcare costs are monstrously negative across the equity universe, again a hit against future earnings until companies can encourage their plan benficiaries to switch to some sort of "divine coverage".

Macro Man said...

Really interesting, thanks. Couldn't one argue, though, that concerns over the mediocrity of liquidity are overatated given that the rationale for such mediocrity is a (largely) voluntary decision to buy back stock? I suppose the flip side of the argument is that liqudity could easily be improved, but at the expense of EPS, which would ultimately resut in lower stock prices.

Good point about the OBS liabilities of the smokestack DB firms. I've always had the sneaky suspicion that the endgame for GM (poster child for underfunded pension and healthcare liabilities) will be the socialization of those liabilities- i.e. Uncle Sam will assume them and spread the burden from the GM shareholder to the populace at large. That way, GM can get their clocks cleaned by Toyota exclusively through the dmerits of their crappy products, rather than via the competitive disadvantage imposed by the DB albatross...

"Cassandra" said...

re: legacy liab....I am with you there Sparky! Playing Nostradamus at the turn of the century, before my current Cameo as a Cassandra, I forecast precisely such a reordering of the US political economy, but that it would only come about following a most sensational national crisis (like the "vomit scene" in Team America). I was of course told "never in my lifetime" [by doctors and fianciers alike), but I remain convinced that the US (at GM & Ford's behest) will end up doing BOTH a Daiko Henjo on unfunded corp and possibly state defined benefit pension obs and universal single-payor health care, before my oldest daughter is in college (I've got six years left here.)

With respect to corporate liquidity, I do not think there is any concern whatsoever (making my points strongly dissonant against prevailing convention). In fact, the entire financial community believes technology, J-I-T logistics, modern capital markets etc., better govt policy (!!??!!) makes current balance sheets not only appropriate, perhaps underlevered (as IBM pointed out yesterday in announcing that they will buy back $15 billion of stock, and that they will gear-up to do so). And they are right(for the moment) as IBM has $14bn of LT borrows on $150bn market cap and $30bn of equity.

But the original question was why has the US market outperformed, and I think this type of gearing plays a part. My contrarian point is that this type of gearing increases volatility, and while there is apparently no end in sight to the new-and-improved-non-bank-
fincl-system and the liquidity and thus stability it provides, investors should make certain not to overly congratulate themselves before understanding that leverage - whether overt or covert - cuts both ways, and that zaitech-like solutions that may seem clever at the time of implementation have an uncanny way of coming unhinged as the formerly virtuous unvirtuously returns to bite one in the arse. Though I may be morally brainwashed, I recall that even in Bugs Bunny, the metaphorical turtle always beat the hare.

Macro Man said...

But isn't US equity outperformance itself something of a myth now? I realize that you are Japan-focused, so of course the US has outperformed.

But looking at the DAX as a reasonable proxy for the ROTW, I compared price (but not total return) changes with the SPX. I used the beginning of every year in the last 20 as a starting point, and the SPX has only outperformed the DAX on a price basis using three of those years as a starting point: 1990, 2000, and 2001. And even there, current trends suggests that the gap closes by year end.

As an aside, might I say that I admire your taste in poetry, and I am glad to see that I am not the only financial blogger on whom Team Amreica made a lasting impression...I must confess to singing the theme song whenever I'm long $ and the US data rocks. Naturally, it's not been heard for some time...