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So much depends on the People's Bank of China
12/17/2010 8:30 am EST
It replaces that old Wall Street saw “Don’t fight the Fed.”
Right now what China’s central bank does on currency exchange rates, money supply, and interest rates is way more important to the global economy and to global markets than interest rates and quantitative easing from the Federal Reserve or sovereign debt purchases and bailouts engineered by the European Central Bank. The People’s Bank of China, China’s central bank, drives the world’s financial markets.
But before I ship “Don’t fight the Fed” off to the Valhalla for old slogans to drink mead with “Remember the Maine” and “Kilroy was here,” I want to extract some lessons for how to turn this new mantra into investing profits.
Just as “Don’t fight the Fed” worked very profitably most of the time, I think “Don’t fight the People’s Bank” will produce good profits most of the time. But just like the old mantra, the new one is likely to blow up on investors some of the time. All you’ve got to do to turn good profits into great profits is figure out how to avoid some of those explosions.
And that’s where “Don’t fight the Fed” can give us some important clues for when to follow “Don’t fight the People’s Bank” and when to ignore the mantra’s advice.
For example, “Don’t fight the Fed” was a winning strategy in 1997, 1998 and 1999.
The technology-dominated NASDAQ Composite climbed 22% in 1997 and then accelerated to a 40% gain in 1998. Stocks rose because the Federal Reserve rather than acting to let air out of the bubble was pumping it in. Money supply as measured by M2, rose by 8.5% from December 1997 to December 1998, according to data from the Federal Reserve.
And in 1999? The Fed still didn’t throttle back—much. Money supply grew by 6% that year, providing plenty of cash to drive stock prices even higher. The NASDAQ climbed 86% that year.
In 1998 and 1999, studiously bearish investors questioned stock market valuations and called the run up in stocks unsustainable. They argued that what was then called the “Greenspan put,” a virtual guarantee from the Fed that it would pump money into the markets if any crisis threatened the markets, was encouraging reckless investing in stocks with wildly unrealistic valuations.
They were right, of course. Eventually. But if you shorted on that wisdom in 1998 or 1999, you got killed. The bottom didn’t fall out of stocks until 2000. The NASDAQ fell 39% in 2000, another 21% in 2001, and another 32% in 2002. Investors who had been arguing that stocks were overvalued for years were totally vindicated, although many of them had pulled out of the market to lick their wounds. (As John Maynard Keynes put it, "Markets can remain irrational a lot longer than you and I can remain solvent.")
These bears had fought the Fed and the Fed won. Which illustrated aptly the mantra’s cynical view of the financial world: You can be oh, so right, and the Fed oh, so wrong, and for much of the time all your superior knowledge, wisdom, and smarts don’t matter one bit. The Fed, even if it’s dead wrong, will win because it’s got the trillions go back up its point of view.
Remember this history as we move to look at the present.
I think there’s a good chance that the People’s Bank of China is going to turn out to be disastrously wrong about how to run China’s economy.
The country’s central bank has, apparently, decided that it’s OK to let bank lending run wild, to rely on price controls to fight inflation, to keep the yuan cheap versus the dollar, and to discourage saving by keeping deposit rates well below the rate of inflation. The bank’s monetary policy risks letting inflation get so far out of control that there won’t be any way to gently step on the brake.
And that wouldn’t be a good thing. Even thinking about it as an investor makes me want to run for the hills.
But not yet, my mantra says. Yes, the People’s Bank may be wrong, but its moves will still move the markets. And it would be foolish to bet against the People’s Bank.
For a while at least.
China’s government is apparently much less worried about inflation than are overseas investors and market analysts.
On December 14, in the first official statement after the weekend meeting of the Central Economic Work Conference, Zhang Ping, head of the National Development and Reform Commission, told state television that Beijing plans to set a 4% target for consumer price inflation next year, up from 3% in 2010.
And the government doesn’t seem to be worried at all that at 5.1% in November inflation is running way above its targets for 2010 and 2011.
Reports out of Beijing—although nothing absolutely official yet—is that the government will set the 2011 quota for new bank lending at 7.5 trillion yuan ($1.1 trillion). That’s the same quota that the government set for 2010 and that banks will almost certainly exceed by the end of this month. 2010 was supposed to be the year that China reined in bank lending from the stunning doubling in new loans in 2009 from 2008 in response to the global financial crisis. Instead, once you add in off-balance sheet lending, the total for 2010 will be essentially unchanged from 2009. And the new target will just continue that pace.
The effects have been huge. The money supply has climbed by 50% in the last two years. Even for a country growing as fast as China that’s wildly inflationary.
So why is the People’s Bank not fighting inflation harder?
Three reasons I think.
First, there’s a conviction in Beijing, against very solid evidence pointing in the other direction in my opinion, that inflation will peak in mid-2011 with the new vegetable harvest. Food inflation is indeed a major contributor to the 5.1% annual consumer inflation rate in November. Food prices climbed at an 11.7% annual rate that month. Apparently enough influential voices among Beijing’s economic planners believe that a bad harvest of summer vegetables is to blame for that spike in food prices and general inflation. And that will be fixed with the next harvest so there’s no reason to clamp down on the general economy now.
Second, there’s the constant worry in China about keeping the economy growing fast enough to produce jobs for all the workers that enter the country’s work force each year. That has led to a steady national goal, in economic plan after economic plan, of 8% growth. The view among economists has long been that it takes at least 7% growth to keep up with a growing workforce. But recent trends suggest that 7% or even 8% may not be enough. China has encouraged a massive increase in college enrollment—an average 30% annual increase in each of the last ten years—without producing enough jobs for the new graduates. One-third of the 5.6 million 2008 graduates failed to find work in their first year out of school. And, according to a recent report in the Beijing Times the average college graduate is making only $44 a month more than the average migrant worker. For families that scrimped, saved, and in some cases starved to send their kids of college, this is a huge disappointment. The government in Beijing knows the history of regimes in countries such as Ethiopia and Iran that educated a young population and then didn’t produce enough jobs. Generating jobs in value-added, up-the-technology-ladder industries is one of Beijing’s most important goals. You weigh fighting inflation versus the survival of the Communist Party and see where you come out.
Third, there’s China’s election schedule. The financial markets are appropriately cynical about U.S. politics. If they have to take an economic downturn, Presidents want to do it in the first half of a term. If it’s at all possible, Presidents want to goose the economy before an election year. Well, China has its own schedule for changing leaders. Chinese premier Wen Jiabao has two years left in office. He’d certainly like to go out on an economic high note that would add to the already impressive economic credentials of his years in office. The thinking is that Wen will do whatever it takes to keep China’s economy humming. And that has led to what the financial markets are calling the “Wen Jiabao put” in an echo, not especially flattering mind you, of the “Greenspan put” that encouraged the risky behavior that contributed so much to the last two U.S. bear markets. The “Wen Jiabao put” means that, whatever the rhetoric, whatever the half-hearted measures to control inflation, investors in China and in the emerging economies and global industries that depend on growth in China can count on the People’s Bank to do whatever it takes to keep the economy growing at 8% or better.
All this argues, strongly I believe, not to fight the People’s Bank. Go with the growth story in China. Use dips (And you’ll get them as traders in Shanghai try to outguess Beijing http://jubakpicks.com/2010/12/09/shanghai-market-falls-on-speculation-that-another-interest-rate-increase-is-on-the-way-soon/ ) on fears that the bank is going to move strongly on inflation—and “strongly” means more than a rate increase of 0.25 percentage points or two—as buying opportunities. Buy more shares of companies in commodities or mining that depend on growth in China’s economy—even at current prices. Count on emerging stock markets such as Brazil, India, and Turkey to stay in favor with investors who see them as part of the larger “China” story.
“Don’t fight the People’s Bank” says that’s the right strategy now. For a while. But not forever.
Remember that the history of “Don’t fight the Fed” in 1999 and 2000 says that eventually there is a day of reckoning for central banks pursuing wrong-headed policies—and for the stock markets that have depended on them.
So the question becomes how long you go along with the People’s Bank.
I’d say “Don’t fight the People’s Bank” through the next vegetable harvest in the late summer and fall of 2011. If inflation isn’t moderating its pace by then, it will become harder for the People’s Bank to claim that the problem is just a bad harvest. By that time, we’ll also have eight or nine months of numbers on new bank loans and we’ll start to see evidence that banks are going to come in way above quota. Savers will have seen their savings fall in value—nothing like capping interest payments at 2.5% and letting inflation run at 5.1%. (For one way that the Chinese are trying to counter this effect see my post http://jubakpicks.com/2010/12/06/with-inflation-on-a-run-the-chinese-are-buying-gold-too/ ) Premier Wen will be a year closer to retirement and the new leadership will be lobbying for the outgoing regime to take the hit from introducing the unpopular moves needed to fight inflation.
Certainly investors should check in every quarter on inflation rates, real estate prices, money supply and other numbers that might indicate that the People’s Bank has lost its ability to control markets in the same way that the Fed lost control in 1999 and 2000.
But until you see signs of that loss of control—or until you see frost on the pumpkins—I think your best strategy is “Don’t fight the People’s Bank.”
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of November see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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