Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

Three Key Policies to a Successful “Make In India” Initiative

Launched by the Narendra Modi-led government last September, the “Make In India” initiative is a long-term, top-down driven policy to transform India into a global manufacturing hub. The 25 economic sectors targeted by the Indian government for export-led development were those determined to possess global trade comparative advantages or significant potential for innovation and job creation. Some of these sectors include: automobiles, aviation, biotechnology, chemicals, defense, electrical machinery, food processing, media & entertainment, pharmaceuticals, railways, renewable energy, and textiles & garments.

In my recent weekly newsletters–and in my March 4, 2015 Forbes column (“Modi’s Budget Boosts Bullish Outlook for Indian Stocks“)–I have chronicled and discussed the recent re-acceleration of India’s economic growth due to a combination of government reform efforts and the decline in oil prices, the latter of which provided an immediate 3%-3.5% boost to India’s annual GDP. Since August last year, I have asserted that India’s economic growth rate would surpass that of China; this year, I expect India’s GDP to grow at about 8%–higher than China’s expected GDP growth rate which I expect to come in at 7% or below.

Recent economic data–such as April’s industrial production year-over-year growth of 4.1% (surpassing consensus by more than 200 bps) and May’s benign CPI reading of 5.0%–suggests that my Indian economic outlook is on track. With the Reserve Bank of India’s policy repo rate still at 7.25%, there remains significant room for the Indian central bank to ease monetary policy in order to maintain the country’s high growth rates, as long as the CPI reading stays below 6.0%.

I maintain that India’s long-term growth trajectory remains intact; I expect the size of India’s economy to double by the end of 2020–to $4 trillion or more–and for the earnings of the MSCI India equity index to more than double in the same time frame. In the past, I have discussed several reform policies and trends that would act as secular tailwinds for the India economy, including: 1) a concerted crackdown of cronyism and corruption and raising foreign direct investment caps from 26% to 49% in the insurance and defense industries–both of which would heavily encourage more FDI inflows into India, 2) a renewed focus on infrastructure investments–including a nationwide 4G network–as well as much-needed land reforms to encourage further industrialization, 3) rising confidence in the leadership of the Reserve Bank of India as Governor Rajan asserted the central bank’s independence with an inflation-targeting framework that was recently codified into law, and 4) India’s uniquely young and educated workforce.

I consider the “Make in India” initiative to be a major policy focus that is essential to India’s long-term economic development. Unlike China’s “growth at all costs” policy from 1978 to 2008–i.e. a 19th century style command-and-control network of various centralized systems of production–while taking advantage of low-cost labor and lax environmental regulations, India is encouraging the production of higher value-added goods through a more decentralized approach of empowering decision-makers at the corporate level. At the same time, India’s labor laws have historically offered a high degree of protection for workers. To a major extent, India’s historical rejection of the 19th century style of command-and-control capitalism has limited the country’s industrialization and consequently, its export sector of manufactured goods. Of course, over the last 25 years, India’s exports have increased both as a share of GDP and world exports–but this was mostly driven by increases in the exports of services and primary products & resources (i.e. rice, cotton, diamonds, iron ore, etc. )–as opposed to the exports of medium- and high-tech manufactured goods.

Figure 1: India – Exports of Goods and Services, 1991-2013 (source: IMF)

Indiaexports

Since 1991, total Indian exports as a share of Indian GDP rose from around 8% to almost 25% in 2013; while Indian exports as a share of world exports tripled from around 0.5% to 1.7% during the same time frame. Of note, however, is the rapid increase in Indian service exports in just the recent decade. From 2000-2013, Indian services exports as a share of world services exports have tripled to over 3.0%.

Growth in Indian services exports has been rapid; indeed, it has surpassed that of other EM countries by a wide margin (see Figure 2 below). Indian services now make up 35% of all of the country’s exports, which is even higher than the average in advanced economies.

Figure 2: Growth in Services Exports – India and EM Countries, 2000-2012 (source: IMF)

EMserviceexports

The vast majority of fast-growing EM economies over the last several decades relied on industrialization and subsequent growth of manufacturing exports (both absolute and relative to total exports) to jump-start their economies. In 2013, for example, China’s manufacturing exports accounted for 90% of total exports, double the share during 1980-85. The share of Indian manufacturing exports as a share of total exports, however, has actually declined over the last 15 years, due to India’s over-reliance on growth driven by the services and primary goods & resources industries. Within the goods sector, the share of manufacturing has declined over the last decade as well (see Figure 3 below).

Figure 3: Composition of Goods Exports for Selected EM Countries, 2000-04 vs. 2007-11

indiangoodsexports

To jump-start the “Make In India” initiative to turn India into a global manufacturing hub, I believe the following three key policies need to be adopted–either at the public- or private-sector level.

  1. Build human capital and liberalize the Indian labor market: Consensus suggests that the Indian manufacturing sector faces an existential problem when it comes to labor: despite a young, educated labor force, there is a shortage of qualified labor for the sector, as those who are qualified do not want to work in manufacturing. One way to entice workers into the industry is to focus on medium-tech or high-tech goods requiring innovation in an effort to boost the technological capacity of India and to raise manufacturing wages. Labor law reforms, along with a policy to integrate manufacturers into the education ecosystem, are also necessary in order to boost the competitiveness of the Indian manufacturing sector in the global markets;
  2. Investing in export- and manufacturing-related infrastructure: IMF studies have shown that bottlenecks among the energy, mining, transportation, and storage sectors have inhibited India from taking advantage of the devaluation of the Indian rupee over the last several years. Land reforms is also part of the economic agenda, as regulations have historically prevented or limited the rise of industries in urban areas, where most skilled labor is located;
  3. Trade reforms to expand trade in the long-run: Historically, the Indian government has utilized trade policy as a tool to address short-term objectives such as limiting inflation or minimizing the volatility in commodity prices. Such incoherent policies included export taxes, minimum export prices, and ad hoc adjustments to import duties. The World Trade Organization noted that in its last review, minimum export prices for onions, sugar, and potato were changed in order to control the domestic supply of vegetables. Such policies increase uncertainty for both exporters and importers – major trade reforms are thus needed to provide a long-term boost to Indian manufacturing exports.

U.S. Inflationary Pressures Remain Muted

In our January 25, 2015 weekly newsletter (please email me for a copy), we pushed back our forecast for the first fed funds rate hike (25 basis points) to the September 16-17, 2015 FOMC meeting as long-term (both 5- and 10-year) inflationary expectations in the U.S. continued to decline after the official end of QE3 on October 29, 2014. 80% of all forecasters at the time expected a rate hike by the July 28-29 FOMC meeting. Just a few days later–in the midst of the January 27-28 FOMC meeting–a new CNBC Fed survey suggests that most analysts now expect the first fed funds rate hike to occur at the September 16-17, 2015 FOMC meeting. Our prediction for the first fed funds rate hike is now the consensus.

10yearbreakeveninflation

Surveying both the data and the U.S. economy, there still seems to be no rising inflationary pressures, despite a pick-up in U.S. housing activity (due to the recent decline in mortgage rates) and a noticeable improvement in the U.S. job market. In fact, the U.S. CPI–even outside of energy–has continued to trend down over the last several months. E.g. the 12-month change in the U.S. CPI (less food and energy) declined from 1.9% in July to 1.6% in December, while neither the 16% trimmed-mean CPI nor the Median CPI have shown any signs of rising to a level that would justify a new rate hike cycle.

The $64 trillion question is: When will the Fed impose its first rate hike, and what does this mean for global asset prices (or the U.S. dollar)? The picture becomes even murkier when one takes into account the recent strength in the U.S. dollar (since we penned our Traderplanet.com ‘Euro Parity” article on September 24, 2014, the dollar has rallied from 1.27 to 1.14 in just a little over four months). Any new Fed rate hike cycle will likely reinforce the recent strength in the U.S./euro exchange rate (note: we now expect the euro to stage a bounce against the U.S. dollar as we believe the Euro Zone economy will surprise on the upside), especially given the open-ended nature of the European Central Bank (ECB)’s sovereign QE policy.

I am going out on a limb and predicting either one of the following scenarios: 1) The Fed hikes by 25 basis points at the September 16-17 meeting, but states that future rate hikes will be data-dependent, i.e. a rate hike will not signal the beginning of a new rate hike cycle, or 2) The Fed pushes back its first rate hike to its October 27-28 meeting, if not later.

The Fed must understand that capitalism is inherently deflationary. Ever since the Paul Volcker-led Fed slayed the U.S. inflation dragon in the early 1980s, the U.S. economy has consistently experienced disinflationary pressures. This accelerated with the German re-unification and the fall of the ‘Iron Curtain’ 25 years ago, and of course, Chinese entry into the World Trade Organization in 2001. Moreover, with the exception of three short bull markets (World War I, the 1970s and 2001-2008), commodity prices (adjusted for the U.S. CPI) have been on a 150-year downtrend in the United States as U.S productivity growth triumphed over the disciples of Thomas Malthus.

Finally, academic studies have time and again proven that there are no consistent reliable leading indicators for U.S. inflation. Common factors cited by analysts–such as M2, capacity utilization, and the cost of housing–all scored poorly relative to a simple auto-regressive (i.e. momentum model). Others, such as U.S. industrial production activity and the 10-year treasury yield, scored better. Surprisingly, the data shows that the rise in food prices have historically been the best leading indicator of U.S. inflation, which we do not believe will apply going forward.

Our analysis and our recent trip to four different cities in India has convinced us of this: What China did to global manufacturing India will do to the global services industry. I.e. We believe India–over the next 5-10 years–will unleash a wave of deflationary pressures in service wages across the world as the country builds up its 4G infrastructure, and as its smartphone adoption grows from 110 million to over 500 million handsets over the next 5 years. Unlike other countries under the traditional Asian development model (where a country will leverage its low-cost labor to industrialize and export goods to developed countries, such as the U.S.), India has no language barrier and is well-versed with technology, computer programming, and providing global services already. This is a hugely deflationary force to reckon with and I believe the Fed must take this into account as U.S. service wages (finance, legal, and IT) will consequently continue to be compressed over the next 10-20 years (while tens of millions of educated Indians will join the global middle class for the first time since the 1700s).

Why Commodities Will Rally Hard Over the Next 2-3 Weeks

The commodities complex is hugely oversold. US$ bullishness has not been this high since the depths of the financial crisis in early 2009. With the SNB eliminating the synthetic peg to the Euro–Euro bullishness will be revived over the next couple of weeks, as the 41% intraday decline of the Euro against the Swiss franc likely resulted in the short-term capitulation of all remaining Euro bulls. My sense is that the Euro will actually rise if the ECB chooses to adopt QE on January 22nd, as QE would mean the ECB will unconditionally try to keep the European Monetary Union together, which will be bullish for euro-denominated assets, as well as for assets leveraged to the global economy, such as commodities.

We also believe the latest 25 basis point easing by the Reserve Bank of India will be first of many rate cuts this year; China will also follow. With India now the world’s third largest oil importer, any economic acceleration in India will also be felt in the commodities complex.

As such, I believe the commodities space (oil, copper, silver, etc.) will rally hard over the next 2-3 weeks at the very least.

Why Crude Oil Prices Will Recover Faster than You Think

Over the last six months, WTI crude oil prices declined from a peak of $107 to $60 a barrel, or a decline of 44%. Many analysts, including the Energy Information Administration (EIA), are forecasting even lower prices, and more glaringly, for prices to stay at these levels for at least the next 12-24 months. The EIA is forecasting WTI crude oil to average $63 a barrel in 2015 (down from its October forecast of $95 a barrel), while Andy Xie, a Chinese economist, is forecasting oil prices to stay at $60 over the next five years.

The oil market is now in a state of panic. We believe WTI crude oil prices will recover to the $75 to $85 range by the second half of 2015 as: 1) fear in the oil markets subsides, 2) shale production growth plateaus or even declines, and 3) global demand increases as a reaction to lower oil prices. Let’s examine these three reasons in more detail.

1) Oil markets are panicking and prices will bounce back after the fear subsides

At $60 a barrel, WTI is now more than two standard deviations below its 200-day moving average, its most oversold level since March 30, 2009. With the exception of the 6-month declines during: 1) late 1985/early 1986, and 2) summer 2008 to December 2008, the WTI crude oil price is now at a level which has previously marked a multi-year bottom. More importantly–from a technical standpoint–oil prices have always bounced faster than most analysts expected. E.g. After hitting $10.73 a barrel in December 1998, WTI rose by 80% to $19.28 a barrel over the next 6 months; similarly, after hitting $17.48 a barrel in November 2001, WTI rose by 68% to $29.38 over the next six months. Note that in the latter case, the rise in oil prices occurred despite the 9/11 attacks and the fact that the U.S. economy was in recession. Just like today, analysts were expecting oil prices to remain low during December 1998 and November 2001. In its December 2001 forecast, the EIA expected WTI to average $21.79 a barrel in 2002. WTI would average $26.17 in 2002, or 20% higher. We believe the current supply/demand dynamics today are even more conducive for a quick snap-back and a subsequent stabilization at higher crude oil prices.

oiltradingsystem12102014

2) Shale production growth will subside faster than expected

Our recent MarketWatch.com article discusses three reasons why the U.S. shale supply response in reaction to lower oil prices will be faster than expected. Those are: i) shale drilling is inherently capital intensive; many shale E&P firms have relied on GAAP and dubious accounting practices to mask the high, ongoing costs to sustain shale production, ii) unlike the major, multi-year projects undertaken by major, integrated oil companies, shale production growth is highly responsive to prices, and iii) shale depletion rates are much faster than those of conventional oil production.

These arguments for faster-than-expected shale production declines are stronger than ever. Firstly, shale drillers have only sustained the boom as long as there was ample financing, but this game is now about to end. The spread for high-yield energy debt has already jumped from less than 450 basis points in September to 942 basis points today. We expect financing to dry up for marginal drillers and fields; higher financing costs will also increase the costs of shale oil production, creating an overall higher hurdle for shale projects. Secondly, shale fields on average take about 6-9 months to come online, which is much faster than for most conventional projects. With such a quick response time, we expect shale production growth to slow down dramatically by April-May of 2015. Thirdly, higher efficiencies have meant faster depletion rates. Shale producers are looking for quick paybacks, and so are highly incentivized to begin and ramp up production as quickly as possible. As discussed by the EIA, the monthly decline in legacy shale oil production is about 300,000 barrels a day. We expect U.S. shale oil production to begin declining by April-May of 2015 unless prices rise back to the $75-$85 a barrel range.

3) Global oil demand to surprise on the upside

Our recent MarketWatch.com article discusses why U.S. gasoline consumption is already surprising on the upside, with the AAA estimating that Thanksgiving travel by car was up by 4.3% from last year, and the highest in the number of miles driven in seven years (versus EIA’s estimate of a 20,000 barrel decline in U.S. gasoline consumption in 2015). Higher demand is also now materializing in other parts of the world. For example, the Society of Indian Automobile Manufacturers reported a higher-than-expected 10% year-over-year rise in domestic passenger vehicle sales due to lower fuel prices. We expect Indian automobile growth to pick up even more next year as the Reserve Bank India (India’s central bank) will likely cut policy rates by early next year. This will reduce the cost of auto loan financing, thus increasing automobile affordability for the Indian middle class. In addition, Chinese car sales in November still increased by 4.7% year-over-year despite an economic slowdown and a broad government mandate to limit car ownership in major cities. We believe both Chinese and Indian oil demand growth will be resilient as both the country’s central banks have ample room to slash interest rates, thus countering any pressures of a further global economic slowdown.

Now, more than ever, we reiterate our bullish stance on oil prices. We expect WTI crude oil prices to bounce back soon and to stabilize and mostly trade in the $75-$85 range by the second half of 2015.

Why CB Capital’s Upcoming Trip to India is so Important

India is experiencing a resurgence as one of the world’s largest economies. According to the late Cambridge professor Angus Maddison, India’s share of the world’s income peaked at over 20% in 1700, about equal to all of Europe’s share at the time. By 1952, however, India’s share of the world’s income has shrunk to just 3.8%, despite its status as the world’s second most populous country. Many economic liberalization policies were implemented beginning in 1991  (most reforms were forced upon India in exchange for an IMF bailout in 1991)–beginning a period of economic growth acceleration. From 2003-2007, Indian real GDP growth averaged 9% a year–hitting double digits immediately after the 2007-2009 global financial crisis. Despite years of high growth, as well as a highly educated and young workforce, the Indian economy slowed down dramatically beginning in 2012, registering just 4.4% growth that year. Today, the size of India’s economy (in nominal terms) is only US$1.9 trillion, equivalent to 2.7% of world GDP.

Since then, Indian economic growth has regained ground. The IMF recently raised its 2015 GDP growth estimate from 6.0% to 6.4%. We expect Indian real GDP growth to hit 7% in the next several years–surpassing that of China–and for the size of the Indian economy to surpass US$5 trillion (in nominal terms) by the end of 2020. As we mentioned in two of our recent articles on MarketWatch (“Why Indian stocks are a buy right now” and “Top three Indian stocks to buy (and hold)“), much of this growth will be driven by business-friendly reforms implemented by the Modi government. These reforms include: 1) removing barriers to greater foreign investments, especially in the defense and insurance sectors, 2) a national policy to provide 150 million Indians a bank account by 2018, 3) a national plan to spend $1 trillion on infrastructure investments, 4) a more independent central banking policy with a new monetary policy framework of inflation targeting, and 5) a concerted crackdown on cronyism among the highest levels of government.

The recent 30% decline in global crude oil prices (India imports 70% of its energy needs)–as well as the just-announced deregulation in diesel prices–will also provide a significant tailwind to the Indian economy. We expect Brent crude to mostly trade within the US$75-US$95 a barrel range for the next several years, thus assisting India’s growth plans.

We believe U.S.-India cross-border financing activities and investment opportunities will grow significantly as the Indian economy generates unprecedented amounts of entrepreneurial talent and wealth over the next decade. CB Capital Partners is already engaged in U.S.-India cross-border corporate finance transactions. We will be in Mumbai, Hyderabad, Pune, and Ahmedabad to meet clients and research investment opportunities for two weeks during January 4-18, 2015. We believe there are many industries poised for substantial growth and thus represent attractive, long-term investment opportunities. Following are highlights of some industries that we like–and where our clients are actively doing business in.

Digital Media: Nearly 300 million Indians go online to listen to music, watch a film, a TV show, or cricket match through their cell phones, computers, or tablets. Today, Indian digital media garner over $4 billion in digital pay revenues annually, with digital advertisement revenues at nearly $400 million. Both are expected to grow at double digits for the foreseeable future. In February 2012, Disney paid almost $500 million for the remaining stake of UTV that it did not already own—a huge bet on the emerging Indian middle class. Within this industry, CB Capital Partners is heavily involved in providing financing in the Indian animation industry. The Indian animation industry has an 8.2% market share in Asia-Pacific, and is expected to grow by over 20% annually to $2.9 billion by 2015.

eCommerce: India is experiencing the most rapid growth of online buyers in history. Amazon recently announced that its Indian online business is on track to become the fastest country ever to reach $1 billion in sales. On July 29, Flipkart, a homegrown eCommerce company based in Bangalore, announced that it raised $1 billion from Tiger Global Management, Accel Partners, Morgan Stanley Investment Management, and Singapore’s GIC. Forrester estimates the number of Indian eCommerce customers will reach 39 million by the end of this year, and an astonishing 128 million by the end of 2018. By the end of 2020, the Indian middle class population (the target market for apparel, consumer electronics, and personal care products) will rise to over 300 million, or the equivalent to the size of the U.S. population. Amazon already announced on July 30 to invest an additional $2 billion into its Indian business.

Healthcare: CB Capital Partners has substantial financing and investment experience across the healthcare industry (30% of all our transactions have been in the healthcare industry), including pharmaceuticals, generics, biotechnology, stem cells, medical devices, medical IT, and hospitals. Another sub-industry we are tracking is the medical tourism industry in India. There will be many opportunities to invest in hospitals or hospital-related services (such as medical hotels) that specialize in this trend as the global population ages. It is estimated the Indian medical tourism industry is now worth $2 billion, with over 150,000 patients traveling to India each year for medical procedures.

Finance: The Modi government’s initiative to provide 150 million Indians a bank account by 2018 is significant, as only 60% of India’s population have access to financial services today. Financial services are essential to a modern, growing society. While many Indians had traditionally put their savings in physical assets such as gold, this option will no longer be attractive as inflation trends down (the Indian CPI declined to an all-time low of 6.4% in September). Banks in particular will also benefit from the government’s recent increase in the housing loan interest tax deduction from 150,000 to 200,000 rupees (or $2,450 to $3,300) a year as this policy will increase demand for residential mortgage loans.

CB Capital Partners is ready to assist both our U.S. and Indian clients who want to learn more or are already engaged in U.S.-Indian cross-border financing or fund-raising activities. Our strategy in India covers a full suite of traditional investment banking services such as equity & debt raises, M&A services, and fairness opinions.

Emerging Markets’ Desperate Need for Renewables

In our October 28, 2013 commentary (“An Early 21st Century Narrative: The Age of Renewables“), we asserted that–due to increasing domestic crude oil production and the ongoing adoption of renewable fuels–U.S. energy independence on a national level is a foregone conclusion. The Energy Information Administration (EIA) chronicles that last year, as much as 84% of total U.S. energy demand was fulfilled by domestic sources, the highest level in 30 years.

Exhibit 1: U.S. Energy Production at 30-year High Relative to Consumption

domesticproduction2013

Interestingly, 10% of our domestic energy production now comes from renewables (including hydro, solar, wind, biofuels, and thermal). We believe government agencies in general are too pessimistic regarding the trajectory of the increasing impact of renewables on U.S. and Developed Markets’ energy production. For example, Germany (a country not known for its sunshine) recently generated over half of its electricity from solar for the first time, while Great Britain’s installed solar capacity doubled over the last year–none of which anyone has foreseen. Because of the rapid adoption of renewables, as well as the ongoing shale revolution, we continue to believe that U.S. energy independence on the national level is a foregone conclusion.

What we are more interested in–as investors and global citizens–are two more ambitious goals: 1) energy independence at the community or household level through microgrids and a “smart,” decentralized distribution system, and 2) bringing electricity and heating to more undeveloped areas of the world. The International Energy Agency (IEA) estimates that 1.3 billion people today are still without access to electricity, while 2.6 billion people have no access to clean cooking facilities.

This is a glaring social problem not just in Sub-Saharan Africa but in other developing countries/regions, such as India, China, and Developing Asia. e.g. The IEA contends that as much as 25% of India’s population today have no access to electricity. A country where a vast segment of its population is disenfranchised is both a significant impediment for future economic growth and social harmony.

According to the IEA’s 2014 World Energy Investment Outlook, global policy makers and corporations are projected to invest $40.2 trillion into our energy production and transportation infrastructure from now till 2035. 59% of these funds will be used to maintain current production, while 41% will be for new development. Two interesting trends are expected to continue over the next 20 years:

  1. There is a decisive trend towards investing into renewables and efficiency programs in both developed and emerging market countries;
  2. The role of public policy makers in shaping global energy policy has been on the rise, and will continue to rise for the foreseeable future as governments set goals for renewables adoption (e.g. California’s 33% renewables goal by 2020) and new efficiency standards.

Within the developed world, these two trends are driven by environmental and domestic energy security concerns. Within Emerging Markets, however, these are driven by more fundamental concerns. For example, economic growth and the rising cost of energy has led to a significant deterioration of China’s and India’s trade accounts in recent years. The rising cost of energy (combined with significant gold imports) was instrumental in causing India’s financial crisis last summer.

Exhibit 2: Oil Import Bills of Net Importing Developing Countries on the Rise (source: IEA)

oilimportbillEMSince 2011 (the IEA’s last study on Emerging Markets’ energy imports), energy dependence in countries like China and India has continued to rise. In fact, China’s oil imports are projected to rise above that of the U.S. sometime this year. As such, investments in renewables in both China and India are not only necessary due to environmental concerns, but national security concerns as well.

Finally, as discussed above, there is also a dire need to empower those who currently have no access to electricity in many developing countries, including India. This is crucial to sustain high economic/productivity growth, as well as for long-term social cohesion (having electricity inherently increases access to education, knowledge, and healthier lifestyles). The IEA estimates that an additional $641 billion in investments is needed to achieve universal access to electricity by 2030, $135 billion of which is needed in India. In light of the $40.2 trillion of projected investments in the global energy sector over the next 20 years, $641 billion is achievable. However, the IEA also stresses that much of these investments would need to be made in rural areas with little or no access to any existing infrastructures (e.g. power lines or even paved roads). Since the costs of building a centralized grid (or expanding the current grid) to rural areas are prohibitively high, the only alternative is to install microgrids or roof-top solar in such undeveloped rural areas. The age of renewables will thus not only bring U.S. energy independence, but increased energy access to the rest of the world as well.

 Exhibit 3: Additional Investment Required for Universal Access to Electricity ($billion in year 2010 dollars; source: IEA)

energyaccessforpoor

Engaging with China as a Global Economic Superpower

Last Wednesday, the World Bank declared China would overtake the U.S. as the world’s biggest economy on a PPP basis by the end of this year. The practice of utilizing PPP in comparing economic output across countries has become less useful as global trade and cross-border asset flows continues to grow as a percentage of the global economy. Yes, your US$ still gets you further in China than in the U.S. on average; and the median Chinese urban household still earns less than 20% of the median U.S. (both urban & non-urban) household. But this ignores the fact China is the world’s biggest importer of commodities such as copper, iron ore and precious metals–all of which are settled at world market prices which PPP has no bearing upon. Chinese economic output measured at PPP also ignores the fact that real estate prices in Tier-1 cities such as Beijing and Shanghai are now on par with those in New York and Los Angeles. Seen in this light, a Yuan actually goes further in a major U.S. city such as Houston or Dallas than in Shanghai or Beijing. Since Americans are generally much more mobile than the Chinese (which in theory allows a U.S. family to resettle to lower cost-of-living areas), a comparison between U.S. and Chinese economic output using PPP is highly misleading.

That is not to say it isn’t a worthwhile exercise. At the very least, the World Bank study has again put the Chinese economy, leadership, and corporations in the spotlight as the “Central Kingdom” re-asserts herself, first in the global economy, and second, in global geopolitics. Work done by the late British economist Angus Maddison suggests China’s share of global GDP was over 30% as recent as 1820. At their respective peaks, total economic output of China and India together made up approximately half of global GDP during most of the last two thousand years, with the exception of the last 200 years.

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As students of Asian history, the above chart comports with our understanding of the history of the Chinese dynastic system, and its subsequent decline (note that pre-1368 A.D. data–i.e. pre-Ming Dynasty–is almost non-existent, e.g. the invasion of the Mongols and its impact on China during the early 1200s does not register in the above chart). The relative decline of China’s influence as the Ming Dynasty retreated from global trade–along with a costly war with Hideyoshi-led Japan–could be seen in the above chart. The decline in Chinese relative influence accelerated in the early 1600s as the Ming Dynasty weakened, with the dynasty eventually falling due to corruption, inept management, bad harvests, and the Manchu invasion during the early to mid-1600s.

Under the Manchu-led Qing Dynasty, however, the Middle Kingdom regained her former glory. The Qianlong Emperor (who ruled for 60 years and interestingly, would die in 1799–the same year that President George Washington died) ruled an empire unprecedented in size–encompassing both Mongolia and Tibet. By 1790, the population of the Qing Empire soared to over 300 million, or just under the U.S. population today. Chinese relative economic output would peak soon afterwards at nearly 35% of global GDP.

According to Professor Maddison and Professor Dwight Perkins of the Harvard Kennedy School, what was most impressive about China during most of her history was not its sheer population growth; nor the size of her empire. What was most impressive about the Chinese economy was her successful response to population growth–i.e. her ability to sustain per capita consumption over time even as population grew. The Chinese drove productivity growth in agriculture through increased use of fertilizers, irrigation, development of crop varieties, as well as published and distributed agricultural handbooks to spread “best practices” in farming. New crops from the Americas–which could be grown on inferior lands–were also introduced.

In other words, China has a rich history of innovation, adaptation, and engaging herself with the rest of the world. By the early 19th century, however, China’s 2,000 year-old dynastic system was no longer a suitable governing system for a fast-changing, industrializing world. As innovation and change swept the world, the Chinese ruling class hung on to outdated concepts and actively discouraged reforms–including the emphasis of science/math over the “classics” in the Imperial Examination. The rigidity of China’s ruling class and system during the 19th century made her vulnerable to foreign influence and invasion. The subsequent experimentation with Communist ideology in the early 20th century would prove disastrous. All in all, it took over 150 years for China to recover and to be recognized as a global economic power once again.

The latest World Bank study is thus timely, as both China and the rest of the world need to begin addressing the consequences of China rising to become the world’s #1 economy. Consensus suggests China will surpass the U.S. in nominal GDP by 2019 (as recent as 2003, Goldman Sachs believed China won’t surpass the U.S. until 2041). e.g. Chinese battery maker BYD experienced significant growing pains due to the company’s inexperience when it opened its North American HQ in Los Angeles. As Chinese influence continues to grow around the world, there will be inevitable clashes over business practices, cultural  misunderstandings, and increased competition (including those for real estate and college applications). As an investment bank who actively engage in U.S.-Chinese cross-border transactions, CB Capital has had first-hand experience in working with Chinese companies and cultures. We are also engaging with other U.S.-Chinese cross-border groups to cultivate closer relationships between local U.S. and Chinese/Hong Kong companies.

Sure, China is experiencing growth challenges, but this is to be expected. In particular, we are watching three issues very closely. As we have discussed, the Chinese “demographic dividend” is over. We expect Chinese real GDP growth to be in the range of 5%-8% over the next several years. China’s population growth has sunk to just 0.47%, ranking 159th in the world. By 2020, the Chinese demographic pyramid will be more inverted than that of the U.S. Another challenge is China’s unprecedented credit growth over the last five years, which was fueled by the country’s well-intended but poorly-executed US$586 billion fiscal stimulus package in 2008-09. A final challenge–which comes with the territory of being potentially the world’s #1 economy–is China’s dependence on foreign energy imports. China as we speak is making slow but steady progress on shale gas, but the country’s oil consumption growth remains unabated. In fact, the Energy Information Administration (EIA) expects Chinese oil imports to surpass those of the U.S. sometime this year. Energy security will thus become an increasing concern for China over the next several years.

Chart 2: China to Become World’s #1 Crude Oil Importer in 2014

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