France Risks Upsetting Eurozone Calm…

27th November 2013

“Throughout the country we have come to the same conclusion – of a society rife with tension, exasperation and anger. There is a sense of despondency.” French regional prefects, in an unusually alarmist report to Paris

It’s notable how many notorious and dogmatic bears have capitulated in recent weeks, from hedge fund manager Hugh Hendry of Eclectica (a prominent proponent of the China hard landing thesis) to CNBC fixture Marc Faber (of Austrian school Fed hyperinflation/gold bug fame) and at the more credible and nuanced end of the guru spectrum, Jeremy Grantham of asset manager GMO. Having largely missed the huge rally in risk assets since 2009, all have more or less recanted on the basis that you can’t fight the flood of global central bank liquidity.  Grantham for instance now sees global equities rising another 20-30% over the next year or two. So what could throw a rock in this pond of complacency? Political risk is rising globally as QE driven asset inflation exacerbates underlying inequality trends and drives social polarization from the US to Thailand. France is worth watching closely on this score; while long delayed spending cuts amounting to about €60bn are set to hit most public sector employees in coming months, we can safely assume that the overtime bill for the notorious CRS riot police will be well over budget as they attempt to suppress a growing backlash on the streets against perceived excessive immigration and deteriorating living standards.

The French are accustomed to an all-powerful and intrusive bureaucracy and almost monarchical executive, the broad structure of which hasn’t changed since Napoleonic times, but they expect their Presidents to at least project French flair and virility, not become a global laughing stock. Francois Hollande’s provincial mediocrity and innumerable political U-turns have earned him the moniker ‘Flanby,’ after a wobbly Nestle dessert brand, creating a political vacuum which the far-right National Front is seeking to fill amid growing talk of the end of the Gaullist Fifth Republic. While Italy has finally rid itself of Berlusconi and the New Dawn proto fascists have been sidelined in Greece, a febrile political mood is taking hold in France. The country has been in inexorable decline since the 1990s on just about every economic metric from productivity to government debt and trend growth has been a dire 1.2%, just above Italy’s; a tipping point may be looming in terms of investor perceptions in 2014.

The usual French ritual of noisy street protests by farmers, fishermen, teachers or some other interest group protecting their privileges until they force a government climb down simply can’t play out any longer, given the EU pressure on Paris to belatedly meet its 3% deficit target and we could well see a large portion of the lower middle classes in open revolt next year. The central bank asset reflation experiment since 2009 has exacerbated wealth inequalities globally, but it is a particularly contentious issue in a country with egalitarian pretensions as a key part of its identity, set against the backdrop of a sclerotic economy and the most centralized state administration aside from China and Russia.

Taxes have risen by about 3 percentage points of GDP in the past three years, taking the overall tax burden to 46% of national income and the spending cuts  will antagonize a volatile national mood. A recent report by the OECD said there had been “no significant improvement” in France’s diminished competitive position since the financial crisis of 2008. France has swung from a trade surplus until 2004 to a deficit of about 2% of GDP (versus Germany’s 6% plus surplus). The EU and the OECD have called on the government to take more radical steps to cut the enormous public spending bill at almost 57% of GDP. Unemployment is over 11% versus just over 5% in Germany, but youth unemployment is on a par with Spain at almost 27%. Betting on a widening spread on OATS over Bunds hasn’t paid off this year, despite another credit downgrade and the government debt ratio exceeding 95% of GDP, but is a trade worth revisiting in early 2014.

The French economy unexpectedly contracted in Q3, there is no respite in Q4; the Markit composite PMI fell two points to a five-month low of 48.5 in November. Against that economic backdrop, the National Front’s populist mixture of anti-immigration, anti-EU and anti-austerity policies is gaining traction and echoes the platform of other far right wing parties emerging from the UK (UKIP) to the Netherlands (PVV),who may form a powerful ‘rejectionist’ bloc in the next European parliament, and thus resuscitate EMU sustainability fears among global investors.


Japanese Equities Break Out, Despite No Structural Reform ‘Third Arrow’ Yet

20th November 2013

The tactical asset allocation stance since Q3 has been long USD and Japanese equities for a breakout to the 17-18k level on the Nikkei by end Q1 and a move toward my productivity adjusted 110 target on the JPY. While I’ve been on the road in Asia, those bets have been paying off, while China has surprised the skeptics by announcing a broadly coherent if as ever gradualist set of pro-market reforms to reduce some of the most glaring economic perverse incentives which have undermined productivity growth and the capital-output ratio. Japanese equities trade on a 14.5x forward PER with scope for a pick-up in ROE as well as renewed JPY weakness, but above all the much heralded domestic asset reallocation into inflation hedges. Not to mention real estate; I noted on my travels prominent ads in papers from HK to Singapore and even Bangkok for prime Tokyo condo developments, which would have been unthinkable a year ago but which the yen move and ultra-low JGB rates have turned into a compelling arbitrage versus overheated (and increasingly tightly regulated) local markets. But could domestic household formation also begin to drive real estate demand?

I got talking at an airport lounge to a very senior Japanese banker who is convinced that the Abe government will soon allow joint bank accounts, joint mortgages, and joint title to property for married couples, who for the first time would be treated as a single unit for tax purposes, all of which would boost the female workforce participation rate and potential growth. That wouldn’t be so much a ‘third arrow’ as an economic Scud missile, because the anachronistic social contract for educated women in Japan has been driving many adverse trends from a low marriage and fertility rate to the moribund real estate market. A surge in dual income, reproducing and mortgage borrowing households is one key to boosting real growth to anything like the 2% a year through 2020 forecast by the government, when underlying potential growth is estimated by the BOJ at only about 50bps.

Japan trades on a P/B of 1.3x but trailing ROE is only 7% – just a little over half the return from global equities as a whole. There has been some modest improvement in in the last few quarters, in part as the weaker yen has helped boost EPS. The consensus currently expects substantial improvement to about 9.5% over the next year. Japanese ROE is so far below other markets in part due to lower asset turn but above all because of lower margins. Structural reforms that work to improve the level of net income margins remain key to a sustained rerating of Japanese equities.

Chronic Air Pollution Drives China toward Synthetic Gas and Solar

4th November 2013

Whenever I pass through HK airport, it strikes me that those grim glass boxes in the terminal crammed with smokers getting a pre-flight fix would be a good spot to acclimatize for a trip to Beijing; PM2.5 readings of 400-500, as seen in the Chinese city of Harbin recently (and Beijing in January), are roughly equivalent to those smoking boxes and levels at which schools have to be shut and strenuous outdoor activity is dangerous. Heavy smog afflicted Beijing once again during the recent Golden Week holiday, causing emergency airport and highway shutdowns, and this winter is likely to see the worst urban pollution yet and more importantly from a political perspective, far greater public awareness of the health risks. Policymakers are grappling for a solution, but the only real ones are to replace coal with cleaner energy sources like gas, nuclear and alternatives as well as suppressing energy demand growth via market pricing/’polluter pays’ green taxes.

This summer, the Brazilian government announced that it was launching an energy plan that looks to increase the role of renewable energy sources significantly over the next seven years. Development of the bioenergy, wind, and solar sectors were key points in the plan, with the goal to generate nearly 70% of its electricity from renewable energy sources by the year 2020, up from 55% today and ultimately China will have to make a similarly radical shift, in particular away from burning some of the world’s dirtiest coal. Renewables, natural gas and nuclear are likely to double as a share of total energy output from last year’s 13% to at least 26% by 2020, with wind and solar rising to 3-4% and gas (synthetic and shale) more than doubling its share to 12%.

In September, we reached a seminal moment in energy markets as China surpassed the US as the world’s largest consumer of foreign oil, importing 6.3m barrels per day. China’s growth in import demand can largely be attributed to its domestic oil demand growth, driven by gasoline demand due to the near-exponential increase in personal auto vehicles and diesel demand related to commercial trucking as China’s economy grows. By 2020 China will be second only to the US for the number of vehicles in circulation and oil imports will by then likely exceed 9m bpd. The per capita consumption differential remains vast, with an average Chinese citizen consuming a mere 2.9 barrels of oil per year or 14% or US per capita levels, and so far very low annual mileage Chinese drivers just beginning to explore the vast network of highways built in the recent infrastructure boom, albeit many of them expensive toll roads.

The core issues with pollution in China are a very wasteful energy model (e.g. fleets of trucks carry coal to power stations, sprawling cities with poor mass transit networks) and the pricing model for both energy and the pollution externalities from its use. In the near term, interim technologies like coal blending (to optimise burn efficiency by mixing different grades) and flue gas capture are gaining traction, but a wholesale move to cleaner energy is the only long-interim solution. As far back as 2007, the World Bank concluded that air and water pollution costs amounted to almost 6% of Chinese GDP; energy use per unit of GDP is vastly higher than other Asian countries like S. Korea and more than twice US levels.