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Vol. X No.16 - October 1 - October 31, 2011


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Stephen Tierney MBMG International Ltd.

 


Broken China?

In the midst of the accounting scandals that are currently affecting a significant number of Chinese companies listed overseas, Eric Rosenkranz was in typically ebullient form on Squawk Box recently, warning investors to stay wary of new initial public offerings (IPOs) of Chinese companies. He explained how many firms keep multiple sets of books, telling viewers, "I've been investing in China for the last 10 years and there's one thing I've learnt - with many Chinese companies there are usually two sets of books, and whenever there are two sets of books, there are usually three."

The first set of books minimizes taxable profits and is designed to be submitted to the tax authorities.
The second set exaggerates earnings and is designed to be shown to potential investors or to banks.
The third most closely reflects the true information on the company and is, therefore, the one that investors really need to seek before investing.
Eric went on to suggest a check list of 3 boxes that he requires to be ticked before investing in a listing:
1) Whether the company is listing on a "reputable" exchange such as the NYSE, NASDAQ or Hong Kong Stock Exchange.

2) Whether it is a new or reverse listing - dangers lurk within reverse mergers that use shell companies to list - of the 200 Chinese companies that have gone public in the U.S. over the last four years, 75 percent had done so via reverse listings.
3) Whether the company that is listing uses one of the “big four” accounting firms: KPMG, Ernst & Young, Deloitte and/or PWC.

Unless all 3 boxes are ticked, Eric would suggest steering clear but flagged the quality of the auditor as being the most crucial factor.

As an independent non-executive director of Focus Media Network (a company unrelated to Focus Media China), which listed on the Hong Kong Stock Exchange's GEM board in July 2011, he was quick to point out that Focus Media Network keeps only one set of books, had to pass the stringent regulations of the Hong Kong Exchange, and retains PricewaterhouseCoopers as its accounting firm.

Even “big four” accounting firms are not necessarily 100% reliable - Eric looked at Deloitte's role in failing to pick up sooner apparent accounting fraud at Chinese financial software firm Longtop Financial - "It's not Deloitte U.S., it's a subsidiary of theirs, which is a Chinese company and one of the issues is U.S. regulators are not allowed into China to look at the books. So the U.S. regulators from the SEC have been forbidden because of country sovereignty issues from looking at the books," he said.

Whilst this is fascinating and while China looks to be of good relative value today, we still see China exposures as being a relatively small part of portfolios. The global economic backdrop is not supportive of any equity valuations right now, China is at a different stage of the economic cycle and may be entering into the end of the fat growth inflationary stage that western economies exited over a decade ago. Also, at this stage, the understandable inability of regulators to keep pace with the huge boom in all things Chinese in recent years means that, right now, we just do not trust the reliability of any numbers coming out of China - corporate or sovereign.

As Nouriel Roubini recently observed, China will be a huge opportunity on the next growth cycle but depending on how much debt China takes on, the next bust (and, therefore, major buying opportunity) is at least two years away and possibly more. A small exposure to proven stock pickers right now at current Chinese valuations is the most that we would recommend and even then you would need to keep your finger hovering over the sell button...

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Transferring out of final-salary schemes is becoming more attractive

Should I stay or should I go has been a constant question in the minds of well-advised members of final-salary schemes for years. So the idea that some senior public servants could be better off out of their final-salary scheme than staying in can only make cashing in more attractive.

It goes without saying that the new flexible drawdown regime should prove attractive to those with big defined-benefit pensions. Many of those on course for an income-rich, cash-poor retirement will doubtless welcome the freedom to go for big capital projects soon after they stop working.

Now we have the situation reported in Money Marketing last month that some high earning doctors still accruing benefits could be better off out of their pension scheme than in. This is because the combined effects of increased employee contributions, the new ฃ50,000 annual allowance charge and next April’s reduced lifetime allowance mean that for some, admittedly only a handful, the benefits are being outweighed by the costs. The clearest cases are those very close to retirement, where staying in a scheme past April 2012 will mean falling foul of the new ฃ1.5m lifetime limit rather than benefiting from ฃ1.8m by leaving before then. On paper, the numbers I have seen show the client better off by leaving rather than staying.

For advisers, however, committing a recommendation to leave the NHS scheme to paper is a big step.

The trimming of the lifetime allowance creates a one-off problem for those close to retirement but even some high earners in their forties and fifties will be starting to wonder how much benefit they are accruing from being in schemes.

Many will already be on course to hit the new lifetime limit before they retire and some are likely to break the annual allowance at some stage.

The fact that you have to leave a scheme to get a transfer out of it has been a key impediment to public sector high earners taking advantage of the flexibility of defined-contribution pensions. But the more tax and contributions eat into what high earners get back in return, the easier that decision becomes.

Transferring out of public sector schemes sounds fanciful but several IFAs and providers I have spoken to in recent months have come across situations where the numbers are at least being looked at. How many of these will go through to completion remains to be seen but I bet some of those requesting transfer valuations now are wishing they had done so before last winter’s indexation change. For those that stay put, nagging questions over how else the government might move the goalposts will persist.

Many schemes do not let members transfer out in the year before retirement but will we start to see transfers in the year before that? Those running funded schemes will be hoping not. As for those in the private sector, the risk posed by trusting the entirety of your pension saving above the Pension Protection Fund level on fortunes of a single company remains - as the recent Silentnight scheme furor reminds us.

Of course there are many variables. Will the lifetime allowance start to go up again in future? Will annuity rates go down? When it comes to pensions, nothing is set in stone. But for some well-pensioned public servants, flexibility will be what makes their retirement dreams come true. Flexible drawdown makes transferring out of gold-plated schemes seem a whole lot more attractive.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Four Horsemen of the Apocalypse - A Happy Ending?

Earlier this year, we wrote a treatise about the impending problems facing the four fiscally-challenged ‘horsemen’ of the economic apocalypse - Japan, USA, UK and the Eurozone). Today let us look at how investors face incalculable financial risks alongside exceptional investment opportunities and not necessarily in the most obvious areas.

The skewed relationship between danger and opportunity is evident in all asset classes including currencies. Many readers have significant proportions of their income and/or expenditure and/or liabilities (and in this sense any estate plans are ultimately a form of contingent liability) in Thai Baht. However, other than their own residential property and perhaps some bank deposits, many foreign residents do not maintain significant Baht-denominated assets. Whether or not they are fully cognisant of it, the decision to live in Thailand creates at least a partial exposure to Baht on an individual’s liability and expense account. Failure to take adequate Baht exposure to offset this increases an investor’s risk. Should Baht weaken, an investor might not even be fully aware of it. However, once this moves against them, e.g. Sterling’s collapse by around 1/3 to below THB50, the impact on lifestyle, purchasing power and effective net worth suddenly becomes brutally evident.

The inevitable payback for the fiscal profligacy of all 4 horsemen will massively increase such risks. All currencies will exhibit immense volatility at different times. Any strength relative to Baht creates opportunities whereas Baht strength is a risk of loss for holders of other currencies. These risks and opportunities are even greater for higher Beta currencies such as Australian Dollar which looks highly susceptible to a fall of between 10-50% in its weighted value.

To avoid risk, investors should hold only assets denominated in or hedged to Baht (or at least currencies correlated to Thai Baht). To exploit opportunities investors need to manage tactical currency exposure to include currencies with the best immediate term prospects of strengthening (writing today that would seem to be USD, SGD and RMB but this highly changeable, fluid situation requires active tactical management).

Similarly, investors also need to be very aware of the distorted risk/reward metrics of underlying different asset classes right now, largely stemming from the reduction of the RFR (the Risk-Free Rate or US 30-day T-Bill yield) to zero in nominal terms. In real, inflation-adjusted, terms this currently equates to an annual loss of around 3.5%. As all other asset return expectations derive from the RFR, the need to take on greater risk just to maintain the real value of money, has widespread implications.

Initially investors were forced to move up the curve into longer durations but the  crowding-out effect of this has seen the nominal return on two year T-Bills fall to below 0.25% while even 10 year nominal yields have fallen to around 2%.  Even the nominal yield on 30 year T-bills has fallen to just 3.5%, which is around break-even in real terms.

However, the longer term the debt instrument, the greater the risks:

* The primary risk in any debt instrument is that the issuer will ultimately default or that the market will begin to price in default expectations at some point (leaving investors the choice between realizing a potentially significant loss or holding a riskier investment than originally intended). (Since S&P downgraded US debt, money invested inflows have actually increased, largely because markets, which already priced in S&P’s downgrade, assume Moody’s and Fitch’s, despite their negative outlooks, won’t immediately follow suit. Also the downgrade perversely caused institutions such as US pension to increase exposure, replacing lower grade debt with T-Bills. To prevent a reduction in average yields, these institutional investors have also found themselves squeezed further along the duration curve. In a hypothetical case where S&P AA is stipulated as a minimum average rating, then a permissible portfolio could have previously consisted equally of S&P A rated debt and US sovereign debt, averaging AA. However, after the downgrade the allocation needed to be adjusted to maintain the average weighting. Rather than trying to replace the downgraded US debt with other AAA debt (which is now somewhat scarce) it proved easier to replace some of the lower grade A rated debt with re-rated AA+ US T-bills.)

* The second risk is interest rate risk which increases in line with debt duration. A 30-year bond would lose substantial value between now and its maturity date if interest rates increase at any point during that timescale. For shorter term bonds or bills, this risk is far less.

So just to achieve even a break-even real return from T-Bills, investors have to take on the significant risk of committing to 30-year bonds at a historically low part of the rate cycle at a time when all three major ratings agencies have negative outlooks. One direct result of such negative real yields has been the greater interest in corporate debt and in emerging market sovereign debt instruments which both appear more attractive credit risks than indebted ‘equine’ governments. However, the increased demand for these has also driven prices higher and yields lower. Interesting opportunities remain; for example, Indonesian debt should be on Baht investors’ radars because of the correlations between the currencies. However, investors need to be aware of the risk of spread blow-outs at the onset of the next crisis.

Investors are very much victims on the horns of a dilemma - the need to chase yield pushes them to take risk, the urge to avoid risk costs them the opportunity of positive real yield. Ultimately even income or low risk investors have been forced out of fixed interest markets into equities, property and alternative assets.

While some attractive property yields are available, property investment values in many jurisdictions right now, especially where any significant leverage is used to ‘juice’ returns, are vulnerable to severe corrections and even the entire loss of the amount invested. That is not to say that all property opportunities are equally risky but rather that extreme care and discretion needs to be exercised and in general we are not seeing attractive valuations or yields yet in developed or western markets, which we fear have some way further to fall from 2008 peaks.

Equities remain extremely correlated to global economic expectations and our baseline forecast is for equity markets in general to correct in the region of 20-50% from current levels over the next couple of years. Equity valuations, even after the recent correction, seem excessive within a global economic framework that has been in recession for the most of the time since 2002 but has hidden this through reliance on extreme government stimulus. Even fundamentally attractive regions like ASEAN will contract in a severe global downturn although the payback of debt in 1997 and relatively prudential macro management since then has created an environment where recovery will come more quickly, and more strongly, than in indebted nations and the trough will provide a spectacular buying opportunity for regional stocks.

Commodities in general remain even more correlated to global economic outcomes than equities. Tactical opportunities will, however, constantly present themselves throughout the deflationary and recovery cycles but investors blindly holding baskets of long commodities should expect to face extreme losses of well over 50% at times.

Precious metals remain on an upward trajectory of late but with USD2000 per oz. now in sight, the short term outlook faces some headwinds and possibly sharp pullbacks are needed before bullion’s final attainment of a ratio approaching 1:1 with the DJIA. This could well see the Dow fall towards 1800 or gold increase to over USD10,000 but the likeliest outcome is a rapprochement somewhere in the lower/middle end of potential values. Gold mining stocks may well outperform gold at various times in this unravelling.

Alternative assets can offer reasonable opportunities at the current time although again investors need to be very selective - liquid, realizable strategies such as managed futures and long/short equity are spaces to invest whereas any mark to model schemes that rely on inflows to pay redemptions will likely collapse altogether in this environment.

At times in the past a rising tide has lifted all boats - a falling tide will create a few opportunities and a myriad of risks. Any hopes that all will be all right in the long term via buy and hold or static asset allocations or undiversified portfolios will almost certainly be dashed. Defined return illiquid assets like litigation funding, student accommodation funds, traded life settlements or any other creative accounting that relies entirely on mark to model asset pricing will no doubt come crashing down around investors’ ears with horrendous losses.

What is more, for both strategic and opportunistic investors the new environment brings unbridled possibilities where money can be made in both rising and falling markets.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]


Ships? I see no ships

As the debate rages on about whether the U.S. economy is headed for a double-dip, we believe another recession is all but guaranteed, and there is nothing that can be done to prevent it. Many American politicians have been following the Nelson tenet of above. The only difference is that good old Horatio had a solution whereas Bernanke and Obama do not - apart from sticking their heads in the sand and kissing their backsides goodbye.

The bond market, which is the most reliable indicator, has been pointing to a slowdown since at least April or May. The de-leveraging process facing the U.S. is so severe that a recession is inevitable.

If you have got a USD14.5 trillion debt burden, it is going to be a pretty severe recession. Recession is usually linked to the size of the debt a country has to clear up.

In fact, the U.S. economy has been in trouble far longer than most people appreciate and has been merely using debt to prop up growth.

The U.S. was borrowing somewhere north of USD500 billion a year to create GDP growth of a little less than USD500 million a year. The U.S. has been at stall-speed for the past ten years.

When GDP growth is less than the increase in national debt every year, it just does not make sense to go on like that. To us, that is not real growth; it is just papering over the cracks which are getting bigger all the time and may end up looking like the San Andreas Fault. It is hiding over the fact that maybe we are already in a serious recession where growth is impacted by the sheer amount of debt that is actually out there.

Here at MBMG, we have been taking advantage of the rally in the Treasury market over the past few months, but that party might end soon because a recession would hurt the government's ability to raise revenues.

Once we get into that environment, at that point, you probably do not want to be holding Treasuries anymore because there is a huge amount of pressure coming down on the credit rating, not just from the growth slowdown or the move into recession, but the move into deflation.

Instead, we are holding forty five percent in cash in some of our most defensive portfolios and we have also been moving money into the Singapore Dollar and Asian government bonds.

What we are trying to do there is not only preserve capital, but to take advantage of other opportunities with cash. For instance, the Singapore Dollar has been a theme we are interested in, and some short term emerging market bonds. If you look at some of the shorter dated Indonesian bonds, we have had a kick-up from the rupiah doing ok, but also there is some yield from those instruments. Above all, please remember my old mantra of staying liquid.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on [email protected]

 


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