Investors, listen to what China is saying

Like many people and governments, China does not like to be told what to do. If the U.S. Government wants to succeed in getting the China to up-value the Yuan, it should refrain from pressuring the Chinese Government, and certainly not resort to threats.

If you read China’s pronouncements, it is clear that the Government is sending out repeated signals that it is willing to raise the value of its currency, yet will delay doing so if the U.S. or any other major nation threatens or pressures it to take action. China, like all nations wants to keep its dignity intact, and if European and U.S. politicians have any common sense they will not aggravate China. If the outside pressure ends, the Yuan will rise by 7 to 10 percent in 2010.

As soon as China can raise the value of the Yuan without losing face and looking as if they are taking advice from Western politicians, we believe that they will do it. We hold Chinese Yuan expecting them to rise in value, and if Western politicians can keep their mouths shut, we will buy more.
World inflation and government gold purchases: Countervailing pressures in world inflation. China and India are both experiencing food price inflation, but in China non-food sectors are less inflation-prone. If China revalues the Yuan later in 2010 as we expect, we believe that inflation will be easily controlled in China. This year’s food price increase was partly due to the timing of the Chinese New Year, which fell in February as opposed to January, as it did in 2009. This caused food price inflation to rise last month, but we believe it is a temporary trend.

India is in a different situation. In India, the government controls the price of many commodities to keep them affordable to the poorer citizens. India is vulnerable to losing a great deal of money if the prices of controlled commodities rise. If India were to
abandon their Fabian socialist price control regime, the country will be better off. We expect India to be dealing with an inflation problem throughout 2010.

Inflation in the U.S., Europe, and much of the developed world should be moderate through the next few months. As economic activity gradually rebounds in coming years, inflation will become a recognized problem in the developed world. Seeing this eventuality and knowing the problems inflation that may cause some day, has given impetus to the recent government gold purchases by India, Sri Lanka and China. There are a number of reasons for recent purchases of gold by these nations, but fear of oncoming inflation is certainly one reason for their gold purchases. Technically, gold looks as if it will rise in coming months partially due to continued accumulation by sovereign buyers.

China. Recently China’s Nationals Peoples Congress session concluded. Our reading of the pronouncements from the proceedings and our observation of the historical trends, indicate that the Chinese leaders are working to build a more consumer oriented economic culture in China. The export driven model for economic growth is being outgrown and replaced by a consumer culture that may eventually rival the consumer cultures in Europe and North America.

Further, the leaders are focusing on avoiding bubbles in China. To this end they have recently been pressuring provincial governments to stop their specialty financing organizations that where started to support growth in their regions. Although these organizations are sometimes conduits for wise and well managed development, they are often conduits for corruption and unwise development. Chinese leaders have been clear that they will oppose corruption and unwise development.

Today, the Chinese economy is a three legged stool supported by exports, infrastructure development, and consumer spending. We predict that within a few years consumers will be the most important part of the economic pie. It could be a very powerful consumer led economy of over 1.3 billion people versus slightly over one billion in the consumer-driven U.S., Europe, and Japan. We should also be aware as China lessens their dependence on exports, their willingness to let foreign companies compete with home grown industries to sell products in China will also diminish. We expect China to become a less friendly venue for foreign business operations.

Many investors are reacting with fear about the probable rise of interest rates in China. We do not see the coming interest rate increase as a long-term problem. China will grow this year quite strongly even with rising interest rates. In our opinion, Chinese economic growth will be at least 8 percent in 2010. In 2011 growth could be higher.

Many of you are undoubtedly aware for the YouTube videos proclaiming the imminent demise of China. After 6 or 7 years of hearing naysayers about China it is hard to believe all of the partial truth, spin and untruth that many are spreading via YouTube and other sources. Having been to China many times over the last 20 years we hold to the obvious truths. China will add 350 million to the middle class in the next 20 years, many of them will live in the big cities.

The big cities in China will dwarf New York and London, and some already do dwarf large Continental European cities. It is not uncommon for a Chinese to tell you that they are from a small city with only about 4 or 5 million people. The growth of housing and office buildings in the big cities is to be expected.

In our opinion, China has some problems which are typical of fast growing economies. The problems are far from insurmountable, and the Chinese are dealing with these problems in a systematic manner. If serious economic problems do eventually develop in China, we expect they will not happen for at least three to five years.

Contrary to some reports in the media, we see no imminent collapse of real estate prices in China. It is true that in some major cities there are large office buildings with high vacancies. We believe that partially empty large office buildings could be filled with small business tenants, as is the case in the U.S. In the U.S., many skyscrapers buildings are filled with large numbers of smaller law firms, financial services firms, accountants, technology companies, and other entrepreneurial businesses.

Historically, most owners of Chinese office buildings have rented to large corporate tenants. Unable to find enough large renters, they are faced with partially empty buildings. Resourceful building owners are adjusting and starting to market to small and medium sized enterprises, once owners start to market to smaller enterprises these buildings will fill up.

While we do agree that there is a glut of overpriced high end apartments that will not be bought, there remains a shortage of lower-priced apartments in some cities.

U.S. stocks.We continue to be attracted to certain industries in the U.S. Among the attractive areas are exporters in technology and resources, energy companies that can grow their reserves of oil, high dividend paying companies, selected retailers, and transportation companies.

A simple solution. We have been warning about derivatives risk in these pages for 6 years or more. There is a simple way to minimize a lot of the derivatives risk and solve the problems that the proposed U.S. Consumer Protection Agency will not be able to solve…FORCE THE BANKS TO SHOW ALL DERIVATIVES on their balance sheets and make the banks cut their leverage by raising reserve requirements. For example, there could be a rule that banks must hold 8 percent capital to assets. This will limit leverage to 12 to 1.

That means that a bank must carry 8 percent equity on their balance sheet (and of course inspectors must make sure the equity is real equity not gamesman equity created through the use of financial products-derivatives). Additionally, banks should be required to put up a large margin on their derivative holdings. Doing these things will do a lot to reduce the likelihood that banks will need bailouts in the future.

Summary

China is the current engine of world economic growth, and we do not see major bubbles forming in China. We are investing in Asian markets like Thailand, Malaysia and Indonesia. We see iron ore, metallurgical coal, gold and growing energy companies as attractive. We own U.S. stocks in the before-mentioned industries and European export-related stocks (while shorting the Euro to protect ourselves from currency weakness). In the currency world we are long Australia, Canada, China, Brazil and Norway.

Guild Investment Management, Inc., a registered investment advisor. All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice. Read Guild Investment’s past periodic market and economic commentary articles by going to the Commentary Archive on their web site www.guildinvestment.com.