21st November 2014 by The Harried House Hunter
Next week sees Thanksgiving in the US and effectively the start of ‘the holidays’, producing shorter trading weeks and lots of choppy data.
The G20 summit in Brisbane produced more positive news from China on trade, in this case with the host nation. Over the next decade, reduction in various tariffs is predicted to add $18 billion to Australian GDP. This fits in with the other big announcements on trade and infrastructure that emerged from the APEC meeting earlier this month. The Hong Kong – Shanghai ‘through train’ was also opened this week, some seeing the short delay as being a deliberate move to bundle good news together. The first day saw a flurry of excitement northbound, but little activity southbound. The instant news cycle is trying to read something into this, but we prefer to see it as a key piece of infrastructure being installed for the long term.
Other, more literal, train infrastructure is being discussed as part of the new Silk Road project, the physical infrastructure through which China intends to deliver its trade. Basically, for students of David Ricardo, trade deals are a good thing because of the law of comparative advantage (once described as the only thing in Economics that was not either obvious or trivial). Even if country A is better than country B at two different things, it is worth country A concentrating on the thing it does best (where it has a comparative advantage) and trading with country B on the other. This produces a net benefit for both countries. Specialisation and trade are a key driver to economic growth and wellbeing. Physical infrastructure building across not only China but also its trading neighbours in the Silk Road economic belt is likely to produce a significant boost to GDP. This is not merely Keynesian demand stimulus and make-work jobs, like the famous Japanese bridges to nowhere or the building of ghost cities in Western China to meet GDP targets , it is investment that generates a positive return on capital; it will drive trade and make the economy more efficient. Achieving the same or more with less, is as good a definition of economic growth as any.
This then is the new era for China, and dare we say it for investment. Capital is going to be put to work in real assets that boost productivity and growth, not chasing ever diminishing yield in the West. It is not a target culture – indeed the best thing the Chinese could do is abandon GDP targets – and it involves a steady evolution of the financial system to support it. The through train is about letting long term capital into China to support the new wave of trade infrastructure building via (rapidly evolving) capital markets. It is also about allowing Chinese households to diversify away from their own equity market and, in particular, from property. Talking this week to an analyst on Taiwan, it was interesting to see how there the notion of investing in property has already fallen heavily out of fashion. At the top of the cycle in 2010/11 investment was around 30-40% of demand, now it is near zero. The housing market itself is stuck – there is a failure to clear prices between buyers and sellers. At some point prices will clear which should be good for both consumption and other financial services. We would expect the same shift in behaviour to start to happen in mainland China too.
The stock implications for all this are for consumer goods, but also investment services and associated infrastructure. Physical infrastructure plays and railway companies are already discounting a lot of spending, but we also see for example that aluminium (for train infrastructure) is likely to be one of the few metals where demand and supply are in favour of higher prices.
Reading the Western press, one is likely to have missed a lot of these announcements in favour of the ‘historic deal on climate change’ between the US and China. This has predictably got the green lobby and their friends in the media very excited, but as we noted last week, the Chinese have not actually promised to do anything anytime soon and the deal was barely mentioned in the Chinese press. In fact, as some have pointed out this week, this was much more about US domestic politics. President Obama and the green lobby have just lost control of the Senate Environment and Public Works Committee to the Republicans and this ‘deal’ with China is designed to allow them to push through their agenda using the unelected Environmental Protection Agency (EPA.) Incoming chairman of the Environment Committee, Jim Inhofe, is a confirmed sceptic – once referring to the EPA as being like the Gestapo – and previously chairing the committee before being replaced by Californian liberal and fervent green supporter, Barbara Boxer. It was she who led the opposition to the Keystone XL Pipeline vote this week which failed by a single vote (thus sparing President Obama an awkward veto decision). This is but the opening skirmish however as the new Senate will see the bill tabled once again. As 85% of the surface area of the lower 48 states of the US moved below freezing earlier this week, they will have to remember to keep talking about climate change rather than global warming.
But the reality is that technology is already moving to solve a lot of the carbon issues, without the need for subsidies or government intervention as Tony Seba, a Stanford academic with the fabulous title of Lecturer in Entrepreneurship, Disruption and Clean Energy, explained in a fascinating presentation here in Hong Kong this week. I have discussed Tony and his work before but his latest talk updates much of the amazing stats (here is a link to a different speech in September, albeit with what looks like pretty much the same content). Talking with Tony afterwards he suggested that we think of electric vehicles, self-driving cars and solar electricity as three disruptive forces evolving simultaneously – in the way that the internet, computers and mobile phones did. Lithium ion batteries will dominate for the next few years – likely to be replaced he thinks with some nano tube related version – but that is not really the point. The real point is that the cost of electric cars will come down such that all new cars will be electric, conservatively he assumes by 2030. This of course is exactly when the Chinese are talking about peak CO2, so it is likely that they will not need any green initiatives, just wait for the market. The technology is proven (and superior), the only issue is the cost of long range electric cars versus conventional models. Currently the Tesla model S is competing at the top end. From personal experience it is in a different league to its competition in just about every aspect. As the scale of production increases, the unit cost of the battery can come down and more mid-range electric cars become price competitive, and so on. Non-price benefits in terms of maintenance, efficiency, performance and running costs are already considerable, so remove the upfront cost disincentive and the electric option becomes a no brainer.
Interestingly in a week where Toyota made a big splash about hydrogen fuel cell cars, Tony pointed out that this will not be a successful technology. Simply put, hydrogen is not a fuel, it is a storage mechanism and is actually less efficient at driving the electric motor than a lithium ion battery. Apart from the cumbersome need for a hydrogen tank in the car, the real problem is that fuel cell cars require a full replication of the multi-billion dollar gasoline infrastructure with hydrogen infrastructure. Electric cars simply require a plug in the wall. No contest.
Tony works in Silicon Valley and his answers are all largely software related. Tesla is a software company that makes cars. Google is the ultimate software company and it is making autonomous cars. The famous Google autonomous car uses a technology known as LIDAR, laser radar basically, and the most important thing is not just how well it works (check the image on the video at 21.43) but that the cost of this technology is collapsing. The roof mounted version on the Google car cost $100,000. Last year that price was down to $10,000. Next year Tony told us, there is a start-up offering the system for $1000. The implications for autonomous vehicles are similarly mind boggling, massive enhanced use of roads, a huge drop in the number of cars actually needed. Unlike cheap batteries, this technology is already here. The latest Tesla is able to collect you from your front door and shortly you will be able to tell it to park itself and charge itself. The restrictions are likely to be legal rather than technical. A fascinating experiment saw a driverless Audi RS7 go round Germany’s Hockenheimring F1 track a full five seconds faster than the human F1 driver at speeds of up to 150mph suggesting that the speed of the processing is more than enough (Tony Seba puts the amount of data from LIDAR at 1 gigabyte a second!). It will doubtless be a while before we have fully automated Uber style taxis, but autonomous electric buses and trams are an obvious development, particularly perhaps in emerging market, urban areas.
The final part of Tony’s three disruptive technologies is solar. The rate of improvement in output and fall in cost means he believes that large parts of the US will soon be self-generating electricity cheaper than it can be distributed. In other words, even if central electricity production was essentially free, it would still be cheaper to self-generate. This is not the end of the grid however, just as with social media we all create data to put back on the web, so we will all start to put electricity back on the grid. We will still require storage, but this too can be localised if the pricing structure is right, store your self-generated electricity in a local battery (even your car) and sell it onto the grid when demand is high. You could for example charge your car overnight on cheap electric, drive to work and sell the residual to the grid during the day, then fast charge at off peak hours to drive home again. Some centralised power generation will still be needed, and not everywhere can be exclusively solar, but the demand for fossil fuels will fall sharply and with it so will prices. Cheap energy, along with increased trade are two very good developments.
There is also the (not insignificant) reduction in roadside and other pollution, something much more important to Chinese policy makers than CO2. In Shanghai last weekend, it was very pleasant to see blue skies as the pre-APEC period saw factory shutdowns to ensure lower pollution. Indeed, I learned a new expression, describing something as “APEC blue” means something is really good, but only for a short period of time. A key aim of the Chinese government is going to be to try and make APEC blue mean something more permanent.
The announcement by Japan Prime Minister Abe on an early election was well flagged, but the weak GDP number that preceded the announcement was not and led the noise traders to mark down the Nikkei sharply. Some of a more cynical nature observed that the data helped Mr Abe make his case for a delay in the consumption tax hike, but if we look a little bit closer we see that the shortfall is on corporate spending not consumption and relates to an unexpected inventory build, possibly because the impact of the tax hike was under-estimated by corporates, leaving sales channels full. Inventory is a big swing factor in GDP stats – it was the key factor back in the US in 2008, for example. The reality is that Abe does not want to risk slowing demand further by hiking taxes a second time in short succession as the Ministry of Finance (MoF) is demanding. He remembers the fate of PM Hashimoto in 1997, when a nascent recovery was killed off by higher consumption taxes. So of course do the markets – which has been a key reason for scepticism in some quarters – although in 1997 the bigger cause was the Asian financial crisis. Also this time Mr Abe has a supportive central bank which gives him a better chance. The move to secure another mandate is seen as providing enough ‘capital’ to stand up to MoF on consumption taxes – although this is a delay not a cancellation – but may also be part of a wider agenda to establish a mandate to take on other entrenched, vested interests such as the farmers as part of a trade deal for example.
Over in Europe where everyone seems to be waiting on monetary policy to work its magic, it is interesting to see that a strict interpretation of the Basel rules may rule out the ability of QE to achieve anything. According to the rules, Banks should not hold more than 25% of their exposure to any one sovereign, which creates something of a problem for countries like Italy where the proportion is much higher. It also would remove/reduce the ability to play the carry on sovereigns, which has been a key trade for banks elsewhere.
Finally, and on another less positive note, we are watching the High Yield Bond ETF closely. Having tracked the equity market as a “risk asset”, the high yield bonds have failed to recover since the October wobble and look very weak. This could be a reflection of continued high issuance as corporates continue to take advantage of very low financing rates, but more likely it is sellers on any strength as investors try to get out of what is now recognised to be a very illiquid market. An orderly unwind of a crowded trade would be ideal, but we need to hope that there is not a sudden dash for the exits.