It isn’t China

But you are looking in the correct part of the world! The economy in question is South Korea, which has enjoyed an astonishing rebound since it reached a recessionary bottom last winter. The economy wasn’t much affected by the US-led subprime mortgage crisis, which infected many foreign banks, but rather the Asian Tiger was pole-axed by a collapse in world trade in the first three months of this year.

The South Korean won declined by 40% against the US dollar during the 12-month-strecth that ended in February. It has since recovered about half that drop, so it remains undervalued.

The overall outlook on the stock market is even highly upbeat. From its low point in December 2008, the Korea Composite Stock Price Index (KOSPI) is up 65%. Exports have recovered, particularly on the back of surging demand from China – a trading partner that is growing a bit more slowly than Korea, but that has considerably more muscle with 27 times the population.

Korea’s current account balance once again shows a healthy surplus. Fitch Ratings Inc, which had placed Korea on ‘credit watch’ for a possible downgrade from it’s a+ rating, recently announced that the downgrade would be unnecessary and said that Korea could expect to run a budget surplus in 2011.

Its elected pro-business government, led by President Lee Myung-bak in the beginning of 2008 is doing pretty well with the global financial crisis. Since its trade agreement with the United States is on indefinite ‘hold’ in the Congress of US House Speaker Nancy Pelosi, Korea recently signed a similar pact with the European Union, which may boost exports somewhat.

In any case, Korean government spending as a percentage of GDP is one of the lowest of the world’s most affluent developed economies. That means it will be much less of a burden than on the Korean economy that will similar outlays in the higher spending Japan, United States and European Union.

One admittedly annoying reality is that most large Korean companies abolished their dividends during the credit crunch and have yet to restore the payouts. The market, however, is still below its mid-2008 level, when the overall P/E ratio was only 11.

Hedge Funds

I guess a lot people heard, but not really know who are they – hedge funds? A lot people claimed that they have a good working knowledge about this business, but in reality, not many though. Hedge funds and the managers who run them have been getting a lot of publicity lately, but not of the flattering kind.

We have massive Ponzi schemes, equally massive losses and outsized systemic risks that are enough to frighten away many people, even the hardiest of investors. Nonetheless, they are an integral part of our financial investment landscape and they often outperform the broad stock market by wide margins. And they are now more accessible to investors via a fast-growing new vehicle – funds of hedge funds.

The first hedge funds came out in 1949 – as a strategy to neutralize the effect of overall market movements on a portfolio. Then, the strategy was simply to buy stocks that were expected to rise and selling short stocks expected to fall. The concept was simple – to add balance – to produce returns that were not market-dependent and tended to hedge a portfolio’s market exposure.
Nowadays, that has changed in a very fundamental way – besides protecting a portfolio from downside risk, hedge funds often go for a maximum return by deploying large amounts of leverage and investing in several asset classes among global markets.

Hedge funds are private partnerships that are open to a limited number of investors. To be qualified, usually you need a net-worth greater than $1 million and meet a minimum income requirement.
Institutional investors are also a dominant force behind the rising popularity of hedge funds. Firstly, pension funds – US corporate and government pension funds rarely have enough money in their kitty to cover all their expected future liabilities to their members and this is a major reason why them have reached beyond traditional investment vehicles to seek outsized returns. Secondly, endowments – include colleges and universities as well as charitable institutions. The larger the institution, the higher the percentage of assets invested in hedge funds.

One should not ignore the benefits of investing in hedge funds, including true diversification across multiple asset classes, true global diversification, non-correlation with traditional investments and the concept of absolute returns. Hedge funds exist to make money in any market environment.

Commodities – Room of Opportunity?

Thus far, gold is the only major commodities that are trading at all-time high in US dollar terms. And that sets and shapes a lot expectations and opinions about the general situation of commodity market.

However, if we week at gold’s price performance against, and correlation with other types of commodities and asset classes, it may reveal some interesting observations.

Since late August, gold has strong positive correlation to silver, palladium, platinium, hogs, coffee, zinc, natural gas, corn, lead and even Baltic index and low or negative correlation with sugar, cattle, soybeans, wheat, nickel, copper, light crude, heating oil and aluminium.

In essence, soft commodities have weak relationships with gold and precious metals tend to have closely allied to gold, especially silver with a correlation of over 95%. The precious metal sector has continued to make new highs in US dollar terms, but these latest moves are at risk of some correction. Speculative activity has been far more influential than industrial buying interest and the speculative component on the futures exchanges increased sharply in all four metals in recent weeks.

Speculative interest has increased again with the net speculative long position on NMYEX rising and these patterns of trading also tend to suggest that precious commodities may have overshot itself in the near term and it has already been experiencing some profit-taking in the Far East.

The correlation gaps between gold and soft commodities, however may present a good investment opportunity. This entry point will only be logical after price adjustment on precious metals come to an end. Time for a pull-back on precious commodities can take place for quite a while for full rewind as economic numbers are still mixed and industrial demand still remains sparse.

China’s New Shopping Mall - Canada

What has these three names in common – Aluminium Corp of China (Chinalco), Jiangxi Copper Co Ltd and China Minmetals Corp, except they are Chinese owned companies? Both made acquisition in mineral related business in Peru.

The truth is that these mineral-related business that acquired by them in Peru were Canadian mining ventures. This year’s conference of the Prospectors and Developers Association of Canada in Toronto, there was one obvious thing to note i.e. the attendance of the Chinese delegation, which signaled that country’s continued interest in Canadian mining assets.

So it was no surprise to me when, in July, the state-run China Investment Corp (CIC) bought a $1.5 billion stake in Canada’s Teck Resources Ltd. CIC is one of the new breed of so-called “sovereign wealth funds” (SWF), essentially government controlled investment funds that all told control trillions in foreign reserves. CIC manages about $200 billion of China’s estimated $2.3 trillion in foreign-exchange holdings.

For Teck, the 17.2% stake taken by CIC provided a badly needed cash infusion, since the Vancouver-based producer of copper, zinc, gold, metallurgical coal, and a host of specialty metals and excess energy was saddled with debt.

Since then, China has picked up the pace.

Now PetroChina Co. Ltd. is purchasing a 60% interest in two undeveloped projects of the privately held Athabasca Oil Sands Corp of Calgary. That puts nearly 3 billion barrels of crude oil under PetroChina’s ownership, while operational control of the projects remains with Athabasca. With reserves surpassed only by those of Saudi Arabia, Canada’s oil sands are seen as a world-class asset – as well as one that’s highly strategic.

China’s large acquisitions are raising eyebrows and spooking national governments. And that’s to be expected. In 2005, when the Chinese National Offshore Oil Corp. (CNOOC) failed in its attempt to take over Unocal Corp., a U.S.-based refiner/retailer of gasoline. Unocal later merged into Chevron Corp. Several subsequent China-led takeovers of properties in North America were thwarted for apparent political reasons.

It’s that type of behaviour that makes Canadian assets so attractive. Essentially, China has become a key supplier of badly needed capital, with a focused interest in a multitude of Canadian mining-and-commodities projects. But most observers assume China is only after the big fish – advanced-stage projects, with near-term production. If you can spot the trend, you’ll see why it’s a costly mistake to focus exclusively on larger, high profile projects. China itself has now realized how much attention its bigger deal making attracts. So China’s advanced guard has cast a much wider net: It’s now studying smaller mining and commodities projects that have at least passed certain regulatory hurdles and (ideally) have proven reserves.

China & Africa

Not many people know very well about this continent. If there is any association to it, it is very unlikely to be positive. Famine, civil wars, riots, killing, clashes are among common points that we hear from CNN and magazines. Despite such a bad publicity, China, another giant at the other side of the world, is raising its bet on it.

China’s trade with Africa has increased ten-fold over the past decade, as the rising Asian power has rapidly matured into a political and economic powerhouse. And with China still in the thralls of an epic growth spurt, its designs on Africa’s resources are beginning to conflict with those of the West.

Africa is blessed with abundance with natural resources – is shaping up to be the mostly hotly contested battlefield of the 21st century. Financial Times reported that China’s state owned CNOOC Ltd is in talks with Nigeria to buy 6 billion barrels of oil – equivalent to one-sixth of the country’s total proven reserves, which is likely to cost between $30 to $50 billion. It would put China at odds with western oil groups including Exxon Mobil, Royal Dutch Shell, Chevron Corp and Total SA, which partly or wholly control and operate the 23 blocs of interest.

With government backing, Chinese firms have been able to devote billions of dollars to the development of African resources. Chinese oil companies alone have announced plans to spend at least $16 billion to gain access to the continent’s energy assets.

China’s oil consumption has doubled in the last decade, soaring to 8 million barrels per day last year from 4.2 million barrels per day in 1998, according to BP Plc Statistical Review. China imported 3.6 million barrels per day last year, equivalent to about 45% of its needs.

Sinopec Corp in June agreed to buy Swiss oil explorer Addax Petroleum Corp for $7.24 billion in a deal that will give access to China to high potential oil blocs in West Africa and Iraq. And a month later, China’s largest oil refiner CNOOC agreed to purchase a 20% stake in an oil block offshore Angola from Marathon Oil Corp for $1.3 billion.

China is also making huge investments in Africa in exchange for large supplies of iron ore, nickel, copper, cobalt, bauxite, silver and gold. China has invested in 49 African countries, Chen Jian, vice minister of commerce told the China Daily.

However, China’s friends in Africa include President Omar Bashir of Sudan, who is currently wanted by the International Criminal Court for war crimes and Zimbabwe President Robert Mugabe, who has been accused of driving his country into economic ruin and starvation and is heavily sanctioned by the United States and European Union. China is also the largest supplier of arms to Sudan, which received $7 billion of Chinese defense exports between 2003 and 2007, according to US Department of Defense.

Long on Oil

I am not an insider, but there are many insiders are telling me to lock-in oil. They say the world’s best investors are betting billions on oil. Since January this year, they have pumped an astonishing $3.8 billion into oil and gas funds – 171% increase from last year.

OPEC members are scaling back on production. Global recession has frightened OPEC member nations, who were hit hard when oil prices collapsed last fall. They have cut production by 4.2 million barrels a day and even Venezuela and Iran, who often ignore OPEC recommendations, are sticking to their quotas. Compounding the decline in production, OPEC nations are also putting new drilling projects on hold. IEA expects a 21% drop in oil and gas investment budgets in 2009. Although there are recent reports said that there is a glut of oil supply, but smart investors know that the long term outlook isn’t so fruitful. And because it takes a big increase in price to produce a small change in oil demand, prices will spike as soon as supplies tighten.

The IEA predicts global demand will rebound next year with bulk of demand coming from emerging economies. Leading the charge is China, which has been using low commodity prices to stock up on their oil reserves and they are not planning to stop anytime soon. By hoarding oil, China is doing exactly what the rest of the world’s best investors are doing – buying now before oil prices surge.

It cannot be denied that the Fed’s expansive monetary policy and the stimulus package rolled out earlier this year are doubling the money supply, which will raise some inflationary concerns. Precisely for this reason that oil is priced in US dollars, any decline in the value of the dollar makes oil relatively more expensive.

Morgan Stanley’s head of commodities research Hussien says the bet in the long term is one way and that is just up. Deutsche Bank’s chief energy economist Adam predicts oil will be at $100 in 2015 and it could happen faster if the economy recovers while Goldman Sachs raised its 2009 oil price forecast to $85 a barrel and says prices would reach $95 a barrel in 2010.

Having said that, I believe volatility will continue in short term.

Yen Intervention

It used to be a good game for carry trade when the yen is trading above 105 with almost practically zero funding cost. Now, the USD has crashed with Yen cross at below 89 and investors who had enjoyed a handsome return from borrowing cheap yen and using that to buy high yielding currencies are running for cover. They quickly found that the yen carry trade is akin to picking up pennies in front of a steamroller…. Yen has gone up 28% against the USD since June 2007 (+20% against RMB, +21% against SGD, +31% against IDR and +43% against KRW).

That in turn, makes Japanese exports significantly more expensive than their Asian competitors. That is why markets are expecting a weaker recovery for this economy. And that lead to a speculation that Japan could return to recession as soon as the fourth quarter of this year, hence will drive the authority to intervene to keep yen competitive.

Japan’s new ruling party, the Democratic Party of Japan, entered office last month and the newly appointed finance minister, Hirohisa Fujii was happily to publicly comment on exchange rates. His initial remarks that a strong yen could actually be good for the economy caught the markets by surprise and sent the yen soaring even further. Since then, the minister had done an about face, joining other major countries with verbal threats against the strength of their respective currencies.

Japan has reputation for being sensitive to movements in the currency markets and the last time Japan intervened to weaken the yen was between 2003 and 2004. Over the course of 126 days, the Ministry of Finance purchased $135 billion and sold yen in the open market and ultimately sent the yen 11% lower.

But the overall success of interventions in changing the long-term path of a currency is not great. It tends to have a higher success rate when countries act together in support of (or against) the same currency. These coordinated interventions will have a greater spillover effect on other currencies.

Last week, leaders from the G-7 met in Istanbul and the probability of a coordinated response in currencies is high. And for Japanese exporters dealing with a yen near 14-year highs against the dollar – that will spell relief.

Fed – Two Collision Courses

I got this report from DBS Bank two weeks ago. It argues that Fed policy is on two collision courses with a likely possible scenario of explosive monetary base, hence it forces the Fed to raise rates faster-than-expected once banks start to withdraw their $800 billion of reserves from the Fed. Essentially, Fed is not in the driver’s seat, banks are.

Below is the flow of its arguments, which I tend to agree.

Fed purchases of US Treasuries, especially mortgage-backed securities (MBS) comprise roughly 90% of the monetary base. But the base is being kept stable because the Fed offsets (sterilized) these purchases with sales of other assets. Now, the issue is that Fed is nearly out of assts it can use for sterilization purposes. Under current plans, Fed purchases of Treasuries and MBS will collide with the monetary base in less than 2 months. Either the Fed is finding a new way to mop up these purchases or the monetary base will expand by another $634 billion (35%) by March 2010.

Related to it, if Fed has to sterilized MBS purchase, one may ask why not just purchase fewer MBS? The answer is simply that the Fed is trying to support the housing market and financial institutions exposed to it. Traditionally, the Fed sets the risk-free rate of interest and allows the market or the Congress to pick the winners and losers via fiscal policy. Now the Fed is encroaching on Congressional territory and Congress is beginning to bite back. Two wrongs don’t make a right.

In short, Fed has already expanded the monetary base by some $800 billion since October 2008. So far, banks and other financial institutions have not lent this money out into the economy. Rather, they have kept it on deposit at the Fed. But financial institutions are taking more risk now and as the economy improves, they will withdraw those deposits from the Fed and lend these deposits where they earn a higher return. The Fed will have to match or otherwise markets will be flooded with liquidity.

Rate policy going forward will be determined more by bank willingness to take risk rather than it will be by the Fed per se. DBS argues that Fed would start to raise interest rates in 2Q10, about two quarters sooner than current market consensus, predicated on the view that this downturn was less a garden-variety recession than it was ‘shell-shock’ arising from the Lehman Brothers collapse.

Cautious Flags

It reminds me of the 1985 Plaza Accord, where James Baker committed the US to a depreciating dollar, bulldozing over the creditors and ultimately precipitating the 1987 Crash. The difference – back then the US was in position to lead the devaluation. Today, it is not. The creditors are going to bulldoze over it. The G-7 leaders meeting last weekend in Instabul, are all worried about currencies. Market fears of possible intervention to support the USD proved unfounded. For now, currencies represent one of the more troubling drags on economies.

So far, this rally has been confirmed by numerous advancing stocks with an expanding number of new highs compared to shares that are lagging. Since early August, over 90% of S&P 500 stocks have been trading above their 50-day moving averages. That is over-bough and keeps a share eye for a reversal. Watch out for market breath turning bad.

Surveys show that bullish sentiment at nearly 50%, while the number of bears in hibernation has fallen to just over 24%. That is a 2:1 ratio of bulls over bears, which is considered a negative sentiment signal from a contrarian perspective. That is because if the majority of investors are bullish, then who is left to buy? In fact, insiders at American companies are selling stocks – cashing in on the market’s big rally this summer.

Since the rally began, two market segments in particular have really taken off and have led the broad market higher – China and technology. Chinese stocks actually bottomed in November 2008, about five months ahead of the S&P 500 Index. As a result, China’s Shanghai Composite Index soared over +100% from November to August…but since then, shares suffered a decline of -23% in just four weeks. Likewise, technology has been one of the best performing US stock sectors since the rally began in March 2009. But since late July, while the S&P 500 surged +12% higher, tech stocks gained only +8%.

Should any of the indicators deteriorate further, it could be a signal that a correction could be imminent.

Biodiesel – On Empty Run

Two thirds of US biodiesel production capacity now sits unused, reports the National Biodiesel Board. Key reasons – (i) global credit crisis, (ii) a glut in capacity, (iii) lower oil prices and (iv) delayed government rules changes on fuel mixes are now threatening the viability of two of the three main biofuel sectors – biodiesel and next generation fuels derived from feedstocks other than food. Ethanol, the largest biofuel sector, is also in financial trouble.

Earlier this year, GreenHunter Energy Inc, operator of the nation’s largest biodiesel refinery stopped production and it may have to sell its Houston plant. Dozens of other new biodiesel plants, which make a diesel substitute from vegetable oils and animal fats, have stopped operating because diodiesel production is no longer economical and numerous established producers have filed for Chapter 11 bankruptcy-court protection.

Producers of next generation biofuels – those using non-food renewable materials such as grasses, cornstalks and sugarcane stalks – are finding it tough to attract investment and ramp up production to an industrial scale.

In 2007, Congress set targets for the US to blend 36 billion gallons of biofuels a year into the US fuel supply in 2022, from 11.1 billion in 2009. That would increase biofuels’ share of the liquid-fuel mix to roughly 16% from 5%, based on US Energy Information Administration fuel-demand projections. Corn ethanol, which has been supported by government blended mandates and other subsidies for years, has come under fire for driving up the price of corn and other basic foodstuffs.

The mandate to blend next-generation fuels, which kicks-in next year, is unlikely to be met because of lack of enough viable production. The EPA, which implements the congressional blending mandates, still hasn’t issue any regulations to allow biodiesel blending, though they supposed to start in January.

The business models for most biofuel companies were predicated on a much higher price of crude oil and government-guaranteed is the central to business plans. Thus far, the survival of this industry depends on the commitment and support of Mr Obama. He has supported biofuels throughout his campaign, and is working to roll out grants and loan guarantees for bio-refineries and green fuel projects.

In the meantime, carcasses are everywhere.

Bubble or Recovery?

I have heard a lot about recovery stories last couple of months. Brokers are telling me that recovery is real, but when I talked to economists, they are selling me the opposite story. So, who is telling the truth here?

So the easiest way out of this rumble is to ask what constitutes a bubble and a recovery and let the data make the final justification for it.

Bubble is a condition where prices are shooting higher and higher without strong and sustainable economic justification to it. Liquidity and shift in relative risk preference in the space of profit optimization could be the driving forces. On the other hand, economic recovery is often associated with stable growth in industrial production along with greater demand in labour. Unemployment rate usually trended downwards on sustainable basis with some signs of support for wages.

Between the lines of the writing on the Wall Street, we often led to believe the recovery is real as asset prices like commodities, metal, currencies, bonds and stock markets are leading the change – change for better, I guess. Governments are committed to support the economy and the Fed will continue to stay supportive until and unless recovery is deeply rooted. By all means, they are there and will be there to ensure that the world economy will not go to hell in a hand-basket.

In my recent meeting with some Chinese officials, I am convinced that banks in China are positioning for a bubble to burst and to take position on it. They are conserving cash, cutting lending and ready to work along with the central government to support the economy again.

Recruiters and bankers say the hiring is really yet to pick up. They told me that bubble-fueled recovery is highly unlikely to be sustainable, yet to feed into job market. Broad unemployment in the US is still rising, a normal pattern even after economies begin to emerge from recession. But economists say that any early signs of job growth are a prerequisite for a more solid-based recovery — one in which more confident consumers, and not just huge government stimulus packages, can play a role in lifting the economy.

But on the other hand, the US dollar is sliding to a new trade-weighted low as month-and quarter-end rebalancing flows moved into commodity currencies and equities, indicating some forms of acceptance of risk in the pursuit of yield. The tide could turn fast, in speed unimaginable, pretty much like art of earth-quake forecasting.

In short, this is a trading market. Never take long position because you may not have enough time to shift. Duration of bubble-feed recovery is generally far shorter and more volatile than the reverse causation.