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China's Growth vs. Inflation Problems in 2008
China's booming economy has grown dramatically in the last 10 years and has been the template for the "globalization" of the world's manufacturing process. China has attempted to maintain double digit growth, as measured by GDP throughout the last decade, but 2008 is looking like a challenging year. In 2007, GDP came in at 11.2 percent, but this year it's now projected lower to around 9 percent. The catalyst for this decline is directly linked to the possibility of a U.S. recession later this year. As last year's U.S.-led credit crisis works its way into the global landscape, China's slowing growth is taking a back seat to the country's real problem this year. . . inflation!
China's #1 priority will be to tame rising inflation, while protecting top-line growth. The slowdown in the U.S. has already had a negative effect on Chinese exports, which traditionally have been the country's growth-related sweet spot. An example of this is now showing up in the overseas shipment numbers. Last month's overseas shipments rose only 6.5 percent, which was the lowest in six years and reflected the fourth quarter of '07 conditions. As Europe begins to also show signs of a slowdown this year, weak global exports will continue to be a growing problem for China. China's growth prospects in 2008 will depend primarily on its domestic economy and robust intra-Asia exports, both of which are still holding up for now.
This year's accelerated inflation picture has been mainly fueled by increased food and energy prices and is now well above the government's target of 4.8 percent. These higher consumer prices are now reflected in headline Consumer Price Index (CPI) figures, which rose last month to an 11-year high at 8.7 percent. To combat inflation, China's central bank, the People's Bank of China (PBoC), is implementing aggressive monetary policies, which includes accelerating currency appreciation, to slow-down the economy.
Foreign direct investment (FDI) continues to be strong and is fueling a positive business climate. Ironically, as the PBoC continues to raise interest rates to slow the economy, overseas investment flows (normally to fund FDI) is now ramping up into the country to chase higher yields fueled by the PBoC. The net effect of the increased incoming money flows will most likely mean future government controls limiting this activity.
As the PBoC, which is the equivalent of our Fed, tries to stabilize China's financial system, it's implementing various monetary policies to ensure economic stability, but has a reputation to change the rules as they see fit to protect their economy. As I mentioned before, the PBoC has taken on a tightening mode in 2008 to slow inflation, and accelerated currency appreciation is just one tool to accomplish that. Other monetary policies at their disposal include reserve requirement ratios for local banks (which they in fact did last Tuesday), raising official government bond lending rates, and restricting new loan activity timing and official quotas.
Looking at the currency, the managed daily float that's been in effect since July 21, 2005, has been directly related to changes in the economic climate in China. For the first 17 months of the float, the currency appreciated at a slow and steady pace of approximately 4 percent, but as global pressure mounted for China to aggressively make their currency stronger, the PBoC ramped-up the "stair-step" appreciation to nearly 7 percent last year. As inflation started to show-up in government numbers at the end of 2007, the PBoC widened the daily band to +/- 0.5 percent a day, which so far this year, has seen the renminbi appreciate nearly 3 percent. In fact, the Non-Deliverable Forward (NDF) markets are now factoring in a 12 to 15 percent appreciation by year's end. This dramatic increase is directly related to the inflation problem China faces this year.
In summary, China's growth versus inflation dilemma in 2008 may have several possible outcomes. On the growth side, a slowing global demand for goods and services is somewhat out of China's control, so maintaining internal domestic demand and consumption is probably the only way for China to maintain their traditional double-digit growth numbers. If the U.S. recession goes on for an extended period of time and if Europe heads in the same direction, 2009 will be more of a problem than this year. Another positive for the economy's growth projections will be the summer Olympics in Beijing, which will most likely show up in the second half's economic numbers. Inflation pressures though will most likely continue throughout the year, so expect more PBoC monetary actions until the official inflation rate approaches the 5 percent comfort zone for the central bank.
— Mark Noble, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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Equipment Makers Ride the Auction Wave
Analysts are predicting an uptick in spending on wireless network equipment to an annual total of $9 billion due to the recent U.S. government auction of wireless airwaves. AT&T and Verizon Wireless, the two biggest spenders at the auction, said they would use the airwaves to expand data services, most likely to build high-speed technology known as Long Term Evolution (LTE). The auctioned airwaves are being relinquished by television broadcasters as they switch to digital services. (InformationWeek)
Biotech Choosing Reverse Mergers
In this slowing IPO market, many private biotech companies are choosing reverse mergers as a more efficient and cheaper route to go public. Industry experts caution that to succeed a company needs cash on hand, a diverse portfolio, and a news flow surrounding their product set, such as proof-of concept or data showing progress. The reverse merger can open the door to new shareholders and allow the company to share its story with a broader community. (BioWorld Today)
Genetics Advance
A surge in knowledge in the genetics field is about to revolutionize medicine said scientists at last week's news conference to unveil the results of several genomic studies. One study found that lowered activity of the paraoxonase gene (PON1) may be related to adverse cardiac events. Though the findings will not have immediate clinical impact, they do provide a focus for future research. "When genes are discovered, this translates very quickly into the availability of genetics tests. Fifteen years ago there were 100 genes for which tests were available. Today, there are about 1500," said Dr. Maren T. Scheuner of the RAND Corporation. (Forbes)
Stem Cell Hopefuls
The stem cell market has grown to $87 million in less than three years, with estimated growth to $8.5 billion in the next decade, predicted analysts at the recent Stem Cell Summit in New York. Progress has been especially brisk on the adult stem cell side, outstripping embryonic stem cells because of the lower regulatory hurdles. The Bush administration has denied federal funding for embryonic stem cell research, although that restriction may fall away as the Democratic and Republican presidential candidates support funding for embryonic projects. (Chicago Tribune)
The Venture Cycle
Amid recent market turbulence, VCs are admonishing consumer Internet start-ups to focus on building strong, quality businesses and conserve cash. Kevin Efrusy of Accel partners notes that in the venture business, cycles tend to occur every 14 years. After each bubble is an "indigestion" period as the market tries to absorb the glut of new companies. A bubble is followed by a five or six down years and then five or six years of steady improvement. Although the consumer Internet space has been hot in recent years, the enterprise space may see renewed interest. (VentureWire)
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March 24, 2008
Bear(ly) Legal?
The pending acquisition of Bear Stearns by JP Morgan Chase has generated more inches of newsprint and lofty editorials in the financial press in a shorter period of time than even the Enron fiasco. We can't even settle on the proper lexicon. Is it a bailout, a rescue, or a forced sale (our preference)? The richness of a story this multifaceted just can't be ignored. We like the rumor that some of their hedge funds customers were pushing on the walls by aggressively shorting the stock. What is certain is that the Fed's series of increasingly panicked reactions to a market staggering to adjust to billions in dodgy mortgage securities has reached a new milestone. In the initial and now inoperative understanding of the deal, shareholders would have gotten $2 per share, the Fed was to guarantee $30 billion of the aforementioned dodgy paper, and JP Morgan Chase would set up a $6 billion reserve for retention payments and bad things that may happen that no one can foresee today. Why did the Bear Stearns board agree to such disastrous terms? They simply received an offer they couldn't refuse.
As an instantaneous wealth transfer, the deal was, perhaps, a landmark. Bear Stearns holders watched $3.3 billion in value vanish as JP Morgan holders cheered a windfall of $12.8 billion when their stock jumped nearly 17 percent. The $9.5 billion difference adds up almost precisely to the remaining $84 per share of book value that JP Morgan's Jamie Dimon received but wasn't going to pay for. As the Wall Street Journal op-ed had it, the Fed was desperate and "Jamie Dimon took them to school." Well, I guess, that would be us, the long suffering U.S. taxpayers that actually got schooled. The firm's namesake, John Pierpont, would have been grinning in his grave as the deal is reminiscent of the tough terms laid out (and later investigated by Congress) in his rescue of the U.S. government following the panic of 1893 and the resulting depletion of gold reserves at the U.S. Treasury. Admirers might point out that the founding of the Federal Reserve Bank in 1913 was in reaction to J.P. Morgan's death that same year. Without Morgan, there would be no one around to save the system in the future.
"JP Morgan Moves to Woo Top Bear Staff" screamed the headline in the Financial Times. Dimon is desperately trying to retain talent even suggesting that others should be prohibited from stealing his people because of his altruistic saving of the global financial system. We can almost hear the retort of the battered Bear employees, "So let me understand this. You've just taken my net worth from $20 million to pocket change and I should feel good about staying with you for the long term?" Droves of Bear brokers have already jumped ship leaving for paltry signing bonuses of $2 million each.
The egregious terms provoked a sort of prisoner's dilemma with Bear Stearns' stock, which closed at $5.96 on Thursday, almost three times the agreed sale price. A monumental battle formed between Bear creditors and trading counterparties, who pushed the deal and large Bear shareholders who wanted more money. The extreme risk posed by a bankruptcy is evident in the desire of firms to pay $6 for shares that would have been worth $2 — but which also restores par value to billions in assets that were seriously at risk. That large shareholders have been pushed to an indifference point is no surprise. When is $2 not better than nothing? For British financier Joe Lewis, $24 million must seem a number not differentiated from zero compared to the $969 million he had months earlier. This is especially true if, as part of the battle, Mr. Lewis gets to see the Fed and Jamie Dimon squirm just a bit.
Well, squirm they did. The pressure had its desired effect as this morning J.P. Morgan announced an new structure with a $10 per share price and they signed up for the first $1 billion of losses on the Fed financed mortgage paper (we would have preferred the Fed opt for 10 percent warrant coverage in JPM stock). Importantly, Bear will sell 95 million new shares to JPM giving them 39.5 percent without a shareholder vote. That leaves only 10.6 percent left to buy for control of the process. Arbitrageurs smell blood in the water. With Dimon and the Fed on the run, the stock has moved to $12 and more than 30,000 April calls at $15 were snapped up early this morning. As they say, "It ain't over till its over."
So now that we've arrived at this odd crossroad, what will be the next direction? Part of the outcome of this latest Fed invention is that primary brokers will have direct access to emergency "lender-of-last-resort" financing. We can't help but wonder what the quid pro quo ought to be. In effect, they are getting the benefits of being members of the Fed system without any of the costs and burdens. As Congress and the Fed move inexorably towards direct regulation of investment banks, they may one day discover that Goldman Sachs is nothing more than a large public hedge fund. Thus, if Goldman-as-hedge fund needs regulating, then won't all the other hedge funds require similar treatment? Maybe that is the ultimate strategic goal of the crafty Mr. Dimon. If he can force the investment banks, hedge funds, and brokers into the Fed's administrative straightjacket, then they will be much weaker competitors in the future.
The Power of the Kitchen Sink
Suddenly and oddly this expression is turning up everywhere from Hillary Clinton's operatives "throwing the kitchen sink at Obama" to the Fed and the Treasury using a "kitchen sink" strategy to fix the financial markets. It is this last one that gives us pause. We are certain that the Fed is operating within a carefully crafted and documented (albeit secret) long-term plan to re-inflate the credit markets. We also want to believe that the tactical response to each new dislocation was carefully thought out in advance as in, "suppose a major counterparty firm goes under then we will . . . or suppose a rogue trader in Europe blows $8 billion. . ." That is also how the market wants to see the world. But, in the last few months, it's increasingly difficult to defend this sanguine view. Why? Instead of evidence of stability in the money markets we are seeing even more anomalous behavior. On Friday, for example, 4-week Treasury bills closed to yield 46 basis points and the Fed funds rate close at 1 percent despite the assumed instructions by the Open Market Committee to the New York Fed on Tuesday to target a rate of 2.25 percent or 75 bps below the target rate on Monday.
Many are beginning to notice that the lower rates are not helping the housing market or even homeowners looking to refinance. While the Fed has cut rates 2 percent since December, the rate on a one-year ARM is virtually unchanged, resting above 5.5 percent. This has two components. First, many ARMs adjust with Libor which has not fallen as fast as Fed Funds. Second, the perception of credit risk is much higher, even though more traditional credit standards (like having a down payment and income) are applied. Rather than attack the problem of bad loans and liquidity directly by obliging banks to write them off and raise more capital, the Fed has served up a bottomless punch bowl of cheap credit. One critic likened recent Fed actions to buying a bottle of Four Roses for the neighborhood drunk every couple days. Although it may make him less cantankerous in the short term, the program is unlikely to lead to sobriety.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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