Chinese Property and Tech Demand

Lets begin with what we know: China’s appetite for high tech gadgets is exerting a mighty influence on global demand. The recent results from Samsung Electronics, Asia’s leading technology company, give one reason why. The South Korean giant estimates that China’s flat screen TV market is now as large as America’s, and is doubling. 

Industry wide smartphone shipments were up 50% in the first quarter and as Apple’s astonishing first quarter results demonstrate, China is making its weight felt. iPhone sales in China were up 900%.  China is also having an impact on the PC market. It is likely that close to 350 m PCs will be shipped this year, a 17% gain on 2009. As the recent results from Microsoft and Intel illustrate, consumer demand in both China and other emerging markets has more pull than Western corporate buyers. Yet it will serve investors well to remember an old stock market adage: news follows share prices.

China’s stock markets have been among the worst performing indices this year. On queue over the last few weeks concern has risen about the nation’s property market and slower economic growth during the second half of the year. Some analysts are citing a drop of 40% in property transactions during the second quarter, in some of the largest cities. There is also the realisation that the shockwaves spreading out from Greece might hit China. 

A quarter of China’s exports go to Europe. Yet the Euro has been sliding against the dollar, as the markets worry that growth might falter.  China pegs its currency to the dollar, which has been rising against the Euro and so making its goods more expensive.  

China’s Property Market

Late last year Jim Chanos, one of the world’s leading short sellers, began voicing concern that China’s property market was in a bubble. You do not have to look very far to see that he has a point: last year, according to Morgan Stanley, sales of residential property were up 87%.  There can be no surprise then that residential construction has also taken off, rising some 20% according to CLSA. It is still expected that growth will be of the same level this year. 

With low interest rates and limited opportunities for alternative investments, property speculation is a popular way to make money. Particularly, as buyers of second homes were offered mortgage discounts. Chinese state enterprises have also been encouraged to join the property market. In a report earlier this year CLSA estimated that nearly a fifth of recent properties bought were kept vacant.

However, China’s many bulls will point out that the picture may not be quite as dire as critics, such as Chanos, make out. The four leading cities, Beijing, Shanghai, Guangzhou and Shenzen only represent 9% of the urban population and 8% of property sales by floor space. There are a 150 other cities with  populations of at least a million. When it comes to floor space, China’s second tier cities represented 33% of residential sales last year. Prices in these cities are 60% below the tier one cities. In the third tier of cities prices are 74% below places like Beijing and Shanghai.

Another encouraging feature of the Chinese property market is the high proportion of cash transactions. The ratio of consumer debt to GDP in the country is just 17% compared to 95% in the US. Mortgage loans as a per centage of GDP are also low when compared to that of the Anglo Saxon economies. In China the figure is 14% compared to the US, where it is just below 80%. All the same, the cost of servicing a mortgage for the average family is 43% of income, according to Morgan Stanley estimates. 

A Bear in the China Shop

China’s bulls have many convincing arguments, but so far this year, Chanos’ view has been the more accurate. He pointed out that investors ought to focus their attention on international stocks that were exposed to China’s infrastructure and building markets. In other words, steel and cement. In the month to 7 May, the SLX steel ETF had shed 18%, and Cemex, one of the world’s leading cement companies, lost almost 14% last week.

Falls like these, in combination with the growing nervousness shown by some of the analysts and strategists who follow China, give us reason to be nervous. Yet, for the time being, most of the evidence from the tech sector has been very upbeat. However, if the Chinese property market is weakening as some say, there is still time for the shock waves  to be felt in Silicon Valley. 

Over the medium and longer term China will  become  the biggest consumer of PCs, smart-phones and the like. What worries me is the following few quarters, we need to pay close attention to what is happening to tech demand in China.

Interesting Links

Here are some interesting links that cover some of the investment themes we have talked about in the last year.

China US relations

Cool, sensible talk on US and Chinese relations, given by an expert at the Carnegie Institute. Likely rise in value of RMB ahead of April is discussed, and there are some useful comments on the Google dispute and the need for the US to upgrade its internet infrastructure.

Intel vs ARM

Useful New York Times article on the battle by chip companies to dominant the smart phone market.

Pellegrini Fund

Paolo Pellegrini was the right hand for John Paulson, he now runs his own fund, PSQR. This link will take you through to his latest letter to the investors. Lots of meat and some interesting comments on what could happen to US corporate tax rates.

Oled

This one is for Geeks. A technical comparison of the Oled screen used in the Nexus Android handset and the LCD screen in the Apple iPhone. The older, cheaper, LED screen wins the contest hands down.

Charlie Munger speaks

When I was in Washington, just before Christmas a well known billionaire, speaking at a conference I attended, said that the biggest investment theme out there was working out how to profit from the coming collapse in US government finances. The billionaire said we had three years before the shoe dropped. Here is Charlie Munger saying a similar thing and on a similar time scale. He thinks the ship goes down in 2012.

Smart Medicine

Here is another brilliant Ted lecture, this time on how smart-phones and other wireless devices are leading to a revolution in medical monitoring and diagnostic technology. Today, when stuck in a meeting, we check our emails; now you can check your heart rate and glucose levels instead. You see, with technology there are endless things to worry about.

Japan, past the pint of no return.

This link will take you through to a presentation about Japan from the really rather good, Contrarian Investing website.  Not surprisingly, Japanese economic growth stalled around the time that the aging workforce started to shrink. Japan could be our future, it certainly looks as though it could soon be South Korea, which of all the Asian countries most resembles it in terms of culture and demographic profile. Lots of good data here.

US corporate taxes to rise?

The enclosed link will take you to the latest fund letter from Paolo Pellegrini's new fund. Pellegrini was John Paulson's right hand man when he did his greatest ever trade. http://www.marketfolly.com/ . There is lots of good meet in this letter. In particular, it makes a logical case for US corporate taxes rising. US corporate is the only sector of the economy that is increasing its cash holding, yet capex and employment continue to be light. Therefore hitting this sector with higher taxes could play to the larger electorate and helps plug a fiscal whole. As Hewlett Packard's results made clear, corporates are not spending a lot on new computers, growth is still coming from consumers and emerging markets. A rise in taxes has not been factored into US equity valuations yet.

I thought the following paragraph, which argues for a one off Yuan revaluation, was also interesting:



We all know a revaluation of the RMB is likely and there is at least one New York listed ETF I know of that gives exposure to this trade. The interesting thing is then what happens? Commodities will rise, that's a given because of the impact on the dollar. However, a  revaluation surely signifies a more concerted move to tilt the Chinese economy away from exports and fixed asset investment to consumer. As this sinks in will commodities continue to be strong?

Another -though unlikely thing to look out for - is that if the revaluation was much more than 5% it could hit other Asian exporters. China adds little value, it is essentially an assembly point for parts and subsystems supplied by the rest of Asia. A sharp revaluation of the RMB therefore runs the risk of hitting Asian exporters .

When it comes to Google and China it pays to be paranoid

There is a real risk that the clash between Google and the Chinese authorities mutates into a trade war. Secretary of State Hilary Clinton's statement yesterday has cranked up the temperature. It is difficult to police the internet successfully, but it is an easy task compared to  threats that come from microchips and communications systems that may have been tampered with.

In 1982, a three-kiloton explosion blew apart a natural gas pipeline in Siberia. The explosion was visible from outer space. Two decades later a leading US journalist, quoting senior secret service sources, revealed that what had taken place was a cunning plan that had been perpetrated by American security forces. The Man From Uncle had sprinkled  faulty chips and software throughout the Soviet supply chain. At a designated time they blew apart and destroyed a large part of the Soviet Union’s gas supply.  Nice work.

In September 2007,  Israel launched a successful bombing raid against  a suspected nuclear facility in Syria. Israeli planes were able to cross Syria’s borders and attack because agents had already planted a ‘kill switch’ that remotely turned off surveillance software. News of this attack was first reported in IEEE Spectrum, the respected trade magazine for electronics engineers. Over the last few days, India reported that just before Christmas it detected the first cyber attack on government computers originating from China. Last July 4th, US and South Korean government computers were put out of action following cyber attacks that again originated in China. 

As both the Israeli and Russian examples show that lethal attacks not only come from the internet, or faulty software. The real danger might come from imported chips and electronic systems. If we are looking for the cause of the next trade trade war, high tech is likely to be at the heart of it. 

Trojan Horses

Today’s integrated circuits can have 1 billion transistors, a number that will double every 18 months. To put this in context, at the rate of one transistor a second it would take 75 years for a person to check a pair of chips.  A typical cell phone has several hundred million transistors, making them difficult to check for faults. Last year about 200m smart-phones, such as the iPhone and Blackberry, were shipped. This year the number will approach 300m.  

These devices are powerful computers, but with the added twist that they are linked to the mobile phone network. Even at today’s level of sophistication it is difficult to check these devices for Trojan Horse circuits. Within  a couple of years it will be common for smartphones to have a billion or more transistors. Any foreign power hacking into the phone network has the opportunity to gain information about the time and place of individuals. It would also be possible to gain information about who that individual met and communicated with. As such, smart phones take the opportunity for information gathering and for causing havoc to a new level.

According to an essay penned by General Wesley K. Clark and Peter L. Levin, in the respected Foreign Affairs Magazine, in January 2008  the FBI reported  that 3,600 counterfeit Cisco network components were discovered inside US defence and power systems. The authors claim that as many as five per cent of chips are counterfeit.  Now ask yourself, where are most of these devices made? Those that are not made in China are often made in Taiwan. Now, imagine the potential problems we would have if Taiwan became part of the PRC. 

America says it wants to build a Smart Grid. Such a grid would be built using internet standards and use advanced IT systems. Sounds great in theory, but I hope they are able to check all parts and software because if not, the country is leaving itself wide open to attack. It's time to apply Andy Grove's dictum to politics and international affairs: only the paranoid survive.

A review of Stephen Roach's new book on China

In the first nine months of this year $126 bn of speculative money flowed into China, inflating the stock market and other asset prices. This sum is the excess in the nation’s reserves, after you deduct $327 bn in trade surplus and $64 bn in direct foreign investment. The market is voting with its wallet, it might like China’s economy but it loves the prospects of its currency even more.

The market’s view of the dollar and the renminbi gets to the heart of the issue, China and America are mirror images of each other. One saves while the other spends, one likes to invest in the future whereas the other doesn’t. The manner in which both countries’ are trying to stimulate their two economies in the wake of the financial crisis is a case in point. In the US, 15% of the funds are being spent developing carbon neutral technologies, whereas in China the figure is 85%. China is having a good financial crisis, as its stock market suggests. By contrast underperformance has become a long term trend in America. Despite the current rise, American stocks have had a miserable decade.

Tragedies always end in a death while comedies end in a marriage. When reading Stephen Roach’s recently published collection of essays, The Next Asia, there is a suspicion that one is witnessing that uniquely modern amalgam of the two, a tragicomedy in which China and America are the co-leads.

The most disturbing essay in the book relates to Roach’s appearance before the House of Representatives. In his written testimony, Morgan Stanley’s chief economist, and now the chairman of its Asian operations, attempts to explain why protectionism would be a disaster for America’s interests. Cheap goods from China and assertions that the currency is undervalued are not the key to the problem, Roach tells Congress. Placing tariffs on imports from China would be like squeezing a balloon, the problem would simply manifest itself somewhere else. Furthermore, in the wake of the financial crisis America is even more dependent on China’s investment in American bonds, so why antagonize your banker?

In his introduction Roach mentions the three mega-trends that animate our world: globalization, the IT revolution and the fact that an ageing population will require pensions. The last of these is a problem that the first two ought to have helped solve. Both globalization and the IT revolution have led to disinflation and increases in productivity. However, both these prizes have been squandered.

For twenty five years, US consumption represented 67% of GDP but, come this decade, that number surged to 72% at the peak. This rise in consumption had little to do with increasing salaries and as we now know, more to do with rising stock and house prices. Roach estimates that over the course of the last expansion, which lasted 69 months, private sector compensation, which he describes as the broadest measure of earned labor income in the US, increased by just 17% in inflation adjusted terms. This meant that it fell $480bn short of the 28% increase that occurred over the previous four business cycles. The US Bureau of Labor statistics estimates that median, inflation adjusted wages, have risen by a cumulative total of 0.9% over the seven years ending in 2007. As Roach points out, this meagre rise seems at odds with economic theory. With rather less hyperbole than John Ralston Saul, in The Collapse of Globalism, Roach has come to the same conclusion: the world’s largest submerging economy, America, is becoming just as polarized as emerging economies like China. Globalization is not working for the average American.

The imbalance will be magnified if America reverts to tariffs - the American consumer, that $10 trillion locomotive that has always pulled the World out of previous slumps, will be derailed if the protectionists on Capitol Hill have their way.

No one could be that stupid though, could they? They can in a tragicomedy. In an essay written in 2007 he estimated that the probability of America becoming more formally protectionist was 60%. He then warned that there was a disconnect between the financial markets, which seem oblivious to the risks and the direction of debate both in the Senate and Congress.

Yet while Roach is critical of his own country he hasn’t been dazzled by China. The hot money might be flowing into Shanghai property, or the Chinese stock market, but Roach fears he might be watching another slow motion train wreck. Tallyrand said of Napoleon that it was the qualities that made him great that finally caused of his downfall, you suspect the same might be true of China. The country’s response to the financial crisis is to do what it always does - invest in infrastructure. China loves fixed assets and exports, they represent more than 80% of GDP. About half the exports go to the developed countries, where consumption is fragile and the returns on fixed asset investment are falling.Between 2000 and 2008 $1.50 of credit resulted in a $1 gain in GDP, but by the first half of this year $7 of credit was required to add $1 to GDP. As China’s Premier, Wen Jiabao said in 2007, China’s economy was increasingly: “unbalanced, unstable, uncoordinated and unsustainable.” China needs less bricks and more credit cards, it needs soft infrastructure.

Warnings like these do not seem to impress investors much, which brings us to the most poignant lesson in Roach’s book. Economics does a decent job identifying the problems, where it fails miserably, is in the timing of the outcome. This tragicomedy, therefore, probably has a good more time to run.