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Strategies & Market Trends : Booms, Busts, and Recoveries -- Ignore unavailable to you. Want to Upgrade?

To: sciAticA errAticA who wrote (33570)	5/12/2003 8:53:27 AM
From: sciAticA errAticA	Read Replies (2) \| Respond to of 74559

Asia Pacific: Money to Burn Andy Xie (Hong Kong) Morgan Stanley May 12, 2003 You are holding cash and the interest rate is zero. The bank in which you keep your money pays dividends equal to 5% of the stock value. Then your friendly private banker calls you up and confidently explains that you would be better off if you owned the bank’s stock than if you continued to deposit your cash with the bank. Aha, you saw through this one! The bank’s stock price could fall but your deposits are protected, first, by the bank’s capital, i.e., shareholders, and, second, if the stock price falls to zero, by the government that regulates the bank. We saw the same situation in the Tokyo property market. The rental yield rose above the mortgage interest rate in the 1990s. For some reason, the property value always seems to drop a bit more than the pickup in the yield for owning the property. This also happened in the Hong Kong property market. The property market was more sophisticated in Hong Kong than in Tokyo and had the affordability index to show why property was worth buying. Waves and waves of bottom-fishers braved the market. They now have no cash. However, they are proud owners of high-yield assets but at much-reduced capital values. Asset markets have been cash guzzlers in East Asia for years. The cash goes to maintaining growth in value-subtracting GDP. Hong Kong property provides the best illustration of this point, in my view. Buyers effectively subsidize an industry that faces declining prices. Their past savings subsidize the property industry, which in turn keeps up GDP. Without the massive destruction of savings, the Hong Kong economy would have shown a much greater decline. The stock market is a less obvious example. It can attract money through volatility. Even though most markets in Asia have been merely fluctuating for the past ten years, they have raised money to fund one industry after another. Investors have poured money into a series of growth industries. However, the high profitability of a growth industry generally proves to be ephemeral, I believe. As capacity expands, most ex-growth industries are plagued by excess capacity and low profitability. Too much money is at the root of the problem. It causes speculative spasms in asset markets and excessive capacity formation in production. The two conspire to generate high GDP growth and value destruction. Economic growth generates high profitability in an industry, only to be destroyed by easy capital for capacity formation. The Asian experience is spreading. The world has too much money, I believe. Money with zero maturity (MZM) has grown at 12% a year in the US since the NASDAQ peaked in March 2000, 62% faster than the average for the preceding ten years. Much of the surplus liquidity in the global monetary system will be destroyed, in my view, either through (1) deflation bubbles or (2) stagflation. The world currently seems to be on the first path. The world’s asset markets are behaving increasingly like their Asian counterparts. Stock markets experience periodic speculative spikes up with little change in fundamentals. People give more and more of their savings to governments to spend. Rising fiscal deficits coincide with falling interest rates. The relationship between markets and the economy has fundamentally changed in the current environment. Falling interest rates provide the justification for pouring more savings into low-profit activities, which keeps up GDP. Giving money to the government to spend is the ultimate expression of supporting low value-adding GDP. In a normal environment, rising profitability attracts more capital. Why is there so much money? One explanation is that deflation allows monetary authorities to expand money supply with impunity. This is, of course, deceptive. Cheapening money stimulates industries that face declining profitability. Monetary stimulus holds up GDP but destroys value, in my view. A more enduring source of surplus money is the reduction in investment and production costs. The current stock of money reflects historical investment and production costs. Globalization and technology have changed investment and production trends and accelerated cost reduction, which is another name for faster productivity gains. Isn’t this a good thing? The problem is that the current wave of improved worldwide productivity mostly means more of the same thing rather than more new things. In such a situation, demand price elasticity for the world as a whole is less than one. The current productivity shock, therefore, reduces the need for money. The current stock of money could translate into demand that causes inflation. Alternatively, it could lead to speculation in asset markets, which turns such savings into more production capacity of the same stuff. As time passes, savers become less willing to give money to asset markets that have not provided meaningful returns. More of the surplus money then goes to governments. The decline in bond yields encourages governments to increase spending. Investing in the stock market is exceptionally difficult in this environment. The usual valuation metrics can be quite deceptive. For example, book value may lose its meaning. If someone can build a factory at one third of the previous cost, the book value for all existing factories should be written down by two thirds. Of course, nobody would do that. A low price-to-book ratio wouldn’t be a good guide for investment. A high dividend yield can also be misleading. A decline in product prices is the biggest threat to the dividend yield being sustained, I believe. Using depreciating cash to pay dividends is another risk. Even regulated utilities could face declining prices. When growth is weak, public policy targets redistribution. Industries that do not require investment are good targets. Such industries often pay high dividends. Stock markets around the world could become value traps, as Asian investors have known for a long time. Sustainability of earnings would then become the biggest risk to equity investors. Even currency markets have become value-destroying, in my view. The yield chase is causing capital to pour into economies with relatively high interest rates. Australia is a good example. It has a current account deficit but is experiencing rapid currency appreciation. The capital flow keeps its property price strong, which supports a high interest rate. I believe this will deflate when the property price comes down under its own weight. The chasing of high yields in the currency market will inevitably destroy a huge amount of the capital that is currently keeping poorly performing economies afloat. Even though China is battling by SARS at this time, the most sustainable investment ideas appear to be related to its rise in the global economy. China is effectively re-pricing the investment cost for more and more industries. I believe book value in China is perhaps safer than anywhere else. The reluctance to write off book value outside China is the reason that China’s export sector can sustain its profitability, in my view. As prices are artificially supported by higher depreciation costs, China’s exports enjoy high growth and profitability at the same time. This process ends for an industry when there is no significant capacity outside China. morganstanley.com