Shaw Capital Management: August 2011

Tuesday, August 30, 2011

Shaw Capital Management August 2010: Financial Markets

Sentiment in the financial markets has improved over the past month. There has been further evidence that

the recovery in the global economy is continuing; the sovereign debt crisis in Europe has not yet produced a major casualty; there has been a modest rally in the euro; and the Chinese authorities have announced that they intend to adopt a “more flexible” policy towards the renminbi that is expected to allow it to appreciate at a slightly faster rate.

Shaw Capital Management August 2010: Financial Markets - These developments have suggested that the gloom was overdone. The effect in the currency markets had been to slightly weaken both the dollar and the yen, as the “risk appetite” amongst investors and traders has increased, and to strengthen the commodity-linked currencies and ease the pressures on the euro. Sterling has also improved over the month, helped by the measures announced by the new coalition government in the UK, both before and during the recent budget statement, to significantly reduce the huge fiscal deficit.

Shaw Capital Management views on financial market - But overall movements in the major currencies have been fairly small, and there is still considerable optimism about prospects.

The latest evidence on the performance of the US economy has enhanced the prospects for the dollar, and this should also continue to provide some stability for the yen.

The sovereign debt problems in Greece, Spain, Portugal, and even in Italy, continue to worsen, and may well lead to defaults and put further pressure on the single currency system.

There must also be serious doubts about the latest improvement in sterling.

The new government in the UK is making credible efforts to reduce the size of the fiscal deficit; but it faces a daunting task, and will find it very difficult to maintain its tough stance.

There is therefore a serious risk of a crisis in the UK currency market, and so it is crucial that the international agencies prepare contingency measures to enable them to act quickly if the situation appears to be running out of control.

The latest available evidence on the performance of the US economy; show the recovery from recession remains on track.

Retail sales were 1.2% lower in May than in April, emphasising the cautious mood amongst consumers; non-farm payrolls increased by 431,000 in May, but 411,000 jobs were accounted for by temporary government hiring to complete the 2010 census, leaving the increase in “real” jobs well below expectations; new home starts fell sharply in May following the withdrawal of government measures to prop up the market, and existing home sales also fel.

And the M3 measure of broad money growth is also continuing to decline because of weak loan demand from reliable borrowers, and the reluctance of the banks to lend to anyone else. There are offsetting factors in the strength of the manufacturing sector; and consumer confidence figures remain reasonably strong.

The Commerce Department has recently revised its estimate of growth in the first quarter of the year down to a 3% annualised rate; but this rate may not have been maintained in the current quarter; and this has already led to a strong plea to Congress from the government to authorise additional spending programmes costing up to $50 billion “to keep the recovery on track”, it is not clear how Congress will respond.

The Fed chairman, Ben Bernanke’s recently testimony to Congress; that the pace of the recovery will not be strong enough to fix the jobs market or reduce the budget deficit without further help, also argued that, despite the size of that deficit, “to avoid sharp, disruptive shifts in spending programmes and tax

policies in the future, and to retain the confidence of the public and the markets, we should start planning now how we will meet these budgetary challenges”. This view about the economy is repeated in the statement after the latest meeting of the bank’s Open Market Committee, and so, although the bank believes

that the recovery is continuing, it is not surprising that it is quietly considering what steps it might have to take if the recovery unexpectedly falters.

There has been a modest recovery in the euro from a low-point in the early part of the past month, although it is still ending the period slightly lower.

The economic background in the euro-zone is continuing to improve, and there has been evidence of support for the euro, particularly from the Swiss National Bank, which reported an increase in its foreign currency reserves of more than $100 billion in May. But the benefits have been limited by the on-going sovereign debt problems amongst some member countries of the euro-zone, and especially by the serious deterioration in the situation in Spain, and so the improvement that has occurred remains very fragile.

Shaw Capital Management August Newsletter: Financial Markets Focusing Europe

The big fall in the euro in recent months is clearly having a significant impact on the performance of the

euro-zone economy.

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Factory output expanded at a record pace in April, helped by investment spending associated with the export effort, and overseas demand for European capital equipment, and the trend appears to be continuing. The major beneficiary has been Germany, but other northern member countries are also involved.

However the situation is much less encouraging in Greece, Spain, and Portugal, because they are less competitive in export markets, and are being forced to introduce austerity measures to reduce their fiscal deficits.

Domestic demand across the entire euro-zone remains weak, and so, despite the export performance of some member countries, it seems unlikely that the overall growth rate for the zone this year will reach 2%. The European Central Bank remains reasonably optimistic about prospects; but fortunately it has not moved towards an “exit strategy” that might involve reversing the measures that were introduced to counter the recession.

Short-term interest rates have been left unchanged and close to zero, the programme to provide unlimited three-month loans to the banking system is continuing, and the bank is also still intervening in the markets to buy the bonds of weaker member countries that had been sold heavily because of fears about debt defaults. The bank is therefore continuing to provide support for the system; but it is not really doing enough to offset the concerns about the debt crisis.

Greece remains in the eye of the storm; but there have been increasing concerns about the situation in Spain; and the situation has been made worse by the latest warning from the Fitch Ratings agency that it may take further massive asset purchases by the European Central Bank to prevent the sovereign debt crisis in the area escalating out of control.

Shaw Capital Management August 2010: Financial Markets Focusing Europe - There are fears that Spain will need to follow Greece in requesting help from other member countries and the IMF to enable it to avoid a default, and that Portugal, and perhaps even Italy, may also need to be rescued.

The pressures on the euro will therefore be intense; and whilst there may well be further support from the Swiss National Bank and others, the future of the single currency system clearly remains very uncertain. The latest modest rally in the euro must therefore be treated with great care.

Sterling has recovered from the weakness that developed in May, and is ending the month higher. The economic background in the UK has not provided any real support, and the Bank of England is clearly intending to maintain short-term interest rates at very low levels; but there has been some movement of funds out of the euro into sterling, and the new coalition government in the UK has introduced measures to reduce the massive fiscal deficit that have been well received in the markets and led to an improvement in sentiment.

There is clearly a risk that these latest measures in the Budget will depress the level of activity still further, and fail to solve the fiscal problems; but for the moment it seems that the new government is being given the benefit of the doubt.

The evidence on the performance of the economy ahead of the Budget announcement was still pointing to a very slow recovery in activity.

The manufacturing sector is reasonably buoyant, with exports expanding rapidly; and retail sales also increased more quickly than expected.

But unemployment rose again to 2.47 million, and the latest survey from the CBI indicated that the value and volume of business in the services sector fell, and that further weakness was expected in the second half of the year.

However the situation has obviously been changed significantly by the latest Budget measures, and the latest estimates from the newly-formed Office for Budget Responsibility are that growth will now only be 1.2% this year, rising to 2.3% next year, and improving slightly in succeeding years.

The Bank of England has welcomed the decision by the new government to introduce measures to address the problems created by the huge fiscal deficit. The governor, Mervyn King, argued recently that they would “eliminate some of the downside risks…and are desirable to remove the risk of an adverse market reaction.”

Financial Markets Focusing Greece and Spain - Shaw Capital Management Newsletter

The situation in Greece and in Spain has obviously caused great concern in London. But the Bank is also aware of the risks as a time when the economy is still in a very fragile state, and of the need to compensate for the fiscal retrenchment by maintaining a supportive monetary policy, and low short-term interest rates. There are therefore reasons for concern about the prospects for sterling. If the latest measures do succeed in reducing the fiscal deficit to manageable levels without aborting the economic recovery, and if the problems affecting the euro continue, or become even more serious, then sterling may well maintain current levels or even appreciate further.

But the situation is very uncertain, and the odds do seem to favour a further period of weakness until the effects of the latest government measures can be more accurately assessed.

The yen has weakened slightly over the past month as the improvement in market sentiment has increased

the “risk appetite” of investors for the equity markets, and for commodity-related currencies.

The economic background in Japan has continued to improve, helped by the export performance; but there are still doubts about whether this improvement can be sustained, and these doubts have been increased by the latest announcement by the new prime minister that the main priority of his government will be a reduction in the huge fiscal deficit, rather than the promotion of fresh measures to accelerate the growth rate.

There is also a further uncertainty created by the decision by the Chinese authorities to adopt a “more flexible” policy on the renminbi that presumably means that it will be allowed to appreciate slightly faster. It is not clear what the consequences of this move will be; but overall it seems likely that conditions elsewhere, especially those affecting the euro, and some disappointment with “risky” investments in global markets, will continue to provide some stability to the Japanese currency.

Sunday, August 21, 2011

Shaw Capital Management Korea: Postal Reform Rollback

The Japanese government has decided to revise the

proposed reforms of the postal system …

Shaw Capital Management Korea: One of the world’s largest financial institutions

The government now proposes to absorb Japan Post

Network Co. and Japan Post Service Co. into Japan Post

Holdings on October 1, 2011.

The newly consolidated holding group will continue

to have two financial units, turning the system into a

three-company structure, from the current five

companies (currently, the system consists of Japan Post

Holdings Co. and four units — a postal service, a savings

bank, a life insurance company and a retailer for the

services of the other three).

Under the new plan, the current Democratic Party of

Japan-led government (DPJ) also plans to double the

maximum amount of deposits that Japan Post’s banking

unit can accept per person from the current ¥10 million

to ¥20 million and to raise postal insurance coverage

from the current ¥13 million to ¥25 million.

The government is also likely to hold on to more than

a third of the postal group’s shares in a turnaround

from full privatization — this will enable the

government to veto any major changes in the firm.

The bill with these latest changes, is expected to be

submitted to the Diet.

“We made the bill’s outline with the aim of ensuring

that Japan Post will sufficiently offer universal services

throughout the nation”, Shizuka Kamei, Japan’s Finance

Minister, told reporters at a press conference.

The Japan Post group provides insurance services

through its 24,000 post offices across the nation

especially in rural areas where private banks have little

or no presence or have trouble gaining the trust of

locals, and holds savings accounts for about 57 million

people.

The group as a whole employs about 226,000 people

and, with assets of more than ¥300,000 billion, sits at

the heart of a system of public institutions that own

almost half of Japan’s national debt.

Moreover, it helps to keep the government’s cost of

borrowing low even as its gross debt closes in on 200%

of annual output.

Japan Post was nominally privatised in 2003; with the

reforms spearheaded by former Prime Minister

Junichiro Koizumi, the champion of structural reforms

for a more market-oriented economy.

Under the previous plan, Japan Post’s financial units

were to be fully released from government control by

2017. With these latest moves, Prime Minister Yukio

Hatoyama’s government, which took power last

September from the long-ruling Liberal Democratic

Party (LDP), is halting the sale of its shares to maintain

control over the company’s plentiful assets, long a

source of public financing.

Behind the proposal is the government need for a

growth strategy.

In the fiscal 2010 budget, general-account expenditures

stand at a record ¥92 trillion, so politicians are pushing

for postal savings to be used to finance their policies.

But these proposed changes to postal reform raise

numerous concerns.

First of all, if the massive postal group attracts even

more money with the lifting of the savings cap, it will

hamper private-sector financial businesses and spark

an outflow of funds from private banks.

Tadashi Ogawa, chairman of the Regional Banks

Association, says raising the deposit cap is “truly

regrettable” because small regional banks in particular

will be affected in times of financial crisis because

depositors may flee to Japan Post Bank.

Moreover, the two subsidiaries — the postal bank and

insurance company — are likely to be permitted

substantial operational freedom.

This would, for example, enable them to offer housing

loans or sell cancer insurance policies.

The uneven public-private playing field, however,

would no longer be just a domestic problem. The US

and Europe have already expressed concerns about

these developments.

Also, creating an even bigger public financial entity

will loosen the government’s fiscal discipline through

increased purchases of government bonds (JGBs) and

accelerate wasteful spending on public works projects.

The system of public institutions buying JGBs has been

central to the economic status quo that has kept Japan

afloat since its stock market plunged in 1990.

“The revision will be a turning point for the worse”,

says Naoko Nemoto, a banking analyst at rating agency

Standard & Poor’s in Japan.

The deep misgivings over public spending originate

from the way postal savings were used for years.

The money had long been used to fund unnecessary

public projects such as highways, bridges and airports

in the middle of nowhere via the Finance Ministry’s

fiscal investment and loan program, which was

reformed in 2001.

These expenditures were not only inefficient but also

lacked transparency because they were made through

government-affiliated organizations.

Creating an even bigger public financial entity is also

risky because it will distort the entire interest-rate

structure of financial markets, where loans with higher

risks should reflect higher returns.

If a public institution extends loans with below-market

interest rates to support certain industries, we are back

to the government ‘picking winners’ or worse just

backing losers.

In other words, this is yet another example of how the

DPJ is mis-managing the Japanese economy, pandering

to voters and reversing necessary reforms passed by

the Koizumi government.

Shaw Capital Management Korea: World Trade

The fall-out from the failure of the Doha Round of trade

liberalisation measures, and the impact of the recession,

are continuing to increase the threat of further

protectionist restrictions on world trading activities.

The US Commerce Department has recently launched

an investigation into whether certain forms of

aluminium made in China is being dumped, or sold at

less than its fair value, in the US; and the Chinese

Commerce Ministry has responded by launching its

own anti-dumping enquires into imports of

caprolactam, a widely-used synthetic polymer, from

both the US and Europe, and has finalised the ruling

on some nylon imports.

These developments are not likely to lead to early and

dramatic changes; but they do provide a further

illustration of the dangers if the global economic

recovery does not accelerate and lead to a relaxation

of the pressures in the trading system.

Shaw Capital Management Korea: Portfolio Recommendations

We have made no changes in our portfolios this month.

The latest developments in the government debt

markets have increased the uncertainties about

prospects for both the bond and financial markets.

However, although the pace of the global economic

recovery may be affected, there appears to be enough

momentum to enable it to continue.

We have therefore maintained the level of our exposure

to the equity markets; and we have left 10% of the funds

in the portfolio in cash deposits as a contingency

measure. Bond exposure is zero.

Shaw Capital Management Korea: Portfolio

Recommendations - The UK Hung Parliament

The bond markets are totally calm about the hung

Parliament, as they are about both UK and US bond

prospects, with yields still below 4%, in spite of the

huge deficits both countries are running.

What is going on?

The first point is that both countries are recovering,

and seem set for growth rates in the 2–3% range.

Such growth is not ‘V-shaped’ but a V was unlikely

given the shortage of oil and raw materials, which

continues to limit world recovery potential. It does

give a prospect of improving tax revenues and falling

benefit expenditures.

As growth goes forward it will be possible to work out

more accurately how much of the current deficit is

‘structural’ — i.e. will not disappear with returning

growth.

For the UK the current estimate is that about 8% of

GDP is structural: still requiring a huge programme of

retrenchment.

The second point is that neither the UK nor the US has

ever formally defaulted in modern times.

Indeed for the UK, they can date this from the end of

the Napoleonic Wars when public debt reached around

300% of GDP.

The third point is the new unwillingness to use higher

inflation to bring down the debt in real value. Inflation

(implying an ‘inflation tax’ on government monetary

liabilities which thereby lose their value) is now

proscribed after the poor experiences of developed

countries during the ‘great inflation’ of the 1970s.

Electorates have rejoiced at the new inflation targeting

policies that have formally ended governments’

experiments with this form of taxation.

The electorates hated the messy and unintended

redistributions of wealth this tax implied — often from

the weak such as pensioners to the wealthy and the

unionized.

In this context bond markets have treated Mr. Obama’s

delays and the UK’s election result as simply policy

deferred.

In that they are likely to be right.

Shaw Capital Management Korea: Portfolio

Recommendations - The state of the eurozone

By contrast the situation in the euro-zone looks

increasingly difficult.

The problem is that Greece and Portugal — the two

main current problem cases — joined the euro in the

expectation that low interest rates would keep their

public finances under control.

Internally these countries have difficulty in raising

taxes and curbing expenditure but joining the EU and

then the euro gave them the authority to insist on fiscal

discipline as the ‘price’ of joining.

Now the discipline is becoming harsh and yet interest

rate premia are rising, as the risk of default increases.

Germany and the other euro-zone countries are

unwilling to transfer resources to them — and even to

provide loans on terms below these market rates.

Germany’s position in particular has hardened

massively under hostile home reactions to perceived

‘bail-out’.

Germany is simply unwilling to make transfers after

the huge costs of its integration policies for East

Germany.

There will come a point where the advantages of being

in the euro are outweighed by the disadvantages for a

country like Greece.

Once interest rate premia get high enough inside the

euro, the attraction of floating the currency down

outside it and still paying similar interest rates will

become overwhelming to governments faced with

public hostility to further sacrifice.

A large devaluation is a way of allowing the economy

to recover and produce extra revenue.

Furthermore reintroducing the local currency will

allow the government to re-denominate the debt in

that new sovereign currency … so effecting a de facto

partial default.

These exits would not spell the end of the euro. But

they will remind markets that the euro is bound

together by political convenience only and not by some

deep commitment to European integration.

Up to now there has been a general belief in such a

commitment; however, Germany’s recent actions have

destroyed this belief.

It was this belief that kept interest rate premia down

on sovereign debt of euro-zone countries; rather like

the debt of UK local authorities — formally underwritten

by the UK government, it was felt that these countries’

debt was being implicitly underwritten by other eurozone

members. No longer.

But of course what can happen to Greece could happen

to any other country. If so its risk premia too would

rise and it too would face the same trade-off between

staying in or exiting with the freedom to float at similar

interest rates outside.

Hence the chances of more break-up would get larger

and the system would become gradually closer to a

system of ‘fixed but adjustable’ exchange rates like the

old European Monetary System.