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China, Bubbles, Inflation and Opportunities

Capital Comment Newsletter: June 2011

Some speak of the future
My love she speaks softly
She knows there's no success like failure
And that failure's no success at all

Bob Dylan - Love Minus Zero/No limit

Over the last couple of months we’ve been really busy setting up the new business – so my apologies for not having sent out CAPITAL COMMENT for a while.

I’ve also been working on a new interactive version of the newsletter which I hope will be ready for the next issue. In addition to my economic commentary this will provide greater insight into our current projects and opportunities in the market.

So in the meantime I thought I’d talk about the concerns over China’s expansion, how I think it might affect us here in NZ, and what we’ve been doing at TBK Capital.

China – will success bring failure?

According to international accountancy firm PricewaterhouseCoopers, China will overtake and dominate global trade by 2030. Currently China’s international trade is worth US$2.21 trillion compared with US$2.66 trillion for the U.S. and has now overtaken Japan to become the world’s second largest economy. It is the world’s largest goods producer with 19.8% of all manufactured goods.

PwC chief economist Justin Lin says if China continues to grow at an annual rate of 8% it would be twice the size of the U.S. economy in 20 years. To see the BBC News article click here.

But there are rumblings in the background. In my January newsletter last year - entitled "Global recovery, Bubbles appearing, Food’s the future" - I wrote about the concerns that China’s economy was overheating and asset bubbles and inflation pressures were building. Even though at the time - and since then - the Chinese authorities have introduced measures to tighten credit “to pre-empt rising inflation and avoid asset price bubbles” the Chinese economy continues to roar ahead and bubble and inflation fears remain. To see a recent article in The Australian headed “Asset bubble main threat to China growth”, click here.

In the review of a new book entitled “Bubbles and Busts”, appearing in The Economist, arguments are put forward as to whether demand for commodities from China will continue to drive the commodity boom – and prices – or not. The reviewer of the book concludes “I find myself in sympathy with both these arguments which seems a little paradoxical. The smooth nature of reported Chinese growth, the massive government-led investment expansion and the blithe extrapolation of these trends into the future make me very suspicious, but I have no idea when the trend will break. If it keeps going, then I think commodity-led inflation will be a problem; if it doesn't then the world will have a problem generating growth.” To read the review click here.

Of course there is no question that the China led commodities boom has been of great benefit to Australia and New Zealand. Here it’s been dairy foods, which assisted Fonterra setting a new annual export record of 2.1 million tonnes of product to international markets last August and a new record payout to farmers expected to be announced in September. This demand is driven by a new aspiring middle-class with more discretionary income and a desire for more nutritious foods. To see a recent ShareChat article on this subject click here. And this is likely to continue. Oxfam has warned that rising food prices are demanding radical reform of the global food system. This provides a great opportunity for New Zealand and our innovative approach to food production. To see the BBC News article click here.

New Zealand also looks to be a benefactor of China’s quest to diversify its international investment. There is speculation that China's sovereign wealth fund, the Chinese Investment Corporation, is investing heavily in this country, including government bonds.

Our Prime Minister John Key said he is not surprised, as China's been buying more and more New Zealand bonds. He said it makes sense, given they have a high domestic inflation rate and the returns from New Zealand are quite high, and our financial security is stable. See Interest.co.nz articles how John Key defends Chinese investment here and Bernard Hickey’s discussion on how the government’s policies push up the NZ dollar here. For a good summary of the growth of the Chinese economy and its future click here to read last weekend’s article in the Sydney Morning Herald titled “Not when but if it slows down”.

Inflation on the rise

A Sunday Star Times article early last month titled “Soaring costs hit Chinese exports” shows no country is safe from the world wide concern about the growing risk of inflation. Headline inflation in China hit 5.4% in March, but food bills and wages are rising far faster than that. Combined with higher costs for energy and raw materials, it means that the cheap price of Chinese manufactured goods is under severe pressure.

Here in New Zealand predictions of impending high inflation are starting to appear. Last week there were numerous stories about inflation expectations and the spectre of an increase in interest rates to combat it. Articles included "Inflation tipped to hit 20 year high” in which Tower CEO Sam Stubbs is quoted as saying "We are highly confident that with many countries printing so much money, that has to flow through inflation in those countries. For example, inflation in China is running close to 10 per cent, and because we import so much from China, we import their inflation." See Stuff article here. And the Reserve Bank of New Zealand’s latest inflation expectation shows annual inflation is expected to be 3% in two year’s time – see Interest.co.nz article here.

The other interesting thing about inflation is it doesn’t seem to increase in a straight line - more like an exponential curve. Accordingly world governments have a short time window to get inflation under control with light-handed policies. Traditionally this has been through gradually increasing interest rates. But right now they’re in a dilemma. Internationally a low interest rate environment is in play to stimulate economies and keep unemployment at bay.

The fear most governments must have would be that raising interest rates too soon will plunge the world back into recession, but leaving it too late will allow inflation to get out of control. There may be other ways to combat inflation without raising interest rates, but I don’t know what they are. And they’re probably politically unacceptable or will have detrimental unintended consequences.

So what does all this mean?

My view – as expressed in my January CAPITAL COMMENT - is inflation in New Zealand is on the rise again. And there are two uncomfortable aspects to it this time. First much of it is imported and second it’s hitting where it hurts - like fuel and food.

Last March ANZ Bank chief economist Cameron Bagrie said the sectors where prices were rising were mainly "incontestable" and in a flat economy this meant spending will have to come out of other areas of consumer spending. He said "If you asked the average New Zealander, over the last five years, it will feel like the average rate of inflation will have been well above where the official print has been. The reason is, the stuff we pay for every day, we notice has been going up, and we don't get out and buy a new computer very often." See the Stuff article here.

So while the fact that TVs, computers, and the like have become so much more affordable, this doesn’t really help having to live.

But there is good news appearing. For example:

  • Exports and trade surpluses are at record levels. Click here to see ShareChat article.
  • The markets are signalling the current and future outlook for the New Zealand economy is good. An article by Roger Kerr in Interest.co.nz shows how the popularity of New Zealand as an investment destination, the demand for NZ Government Bonds, and even our equity market are saying things are looking good. To read his opinion click here.
  • And most important, the OECD has rated New Zealand among the happiest of its member countries. This is an interesting read, to do so click here.

Time to move

If inflation is about to rise – and interest rates remain low - now is the time to invest in assets that offer protection against inflation.

One of the reasons we formed TBK Capital was to assist people looking for funds to structure their requirements in ways other than going to a reluctant bank manager - or to a now nonexistent finance company – to raise a loan.

The time is right for a different approach and the last three months we have had success not only in raising debt but also structuring requests for funds in a way that is attractive to investors – many of whom believe the inflation train is on its way down the track.

In the next day or so I’ll be sending you a couple of examples of the work we are doing. Both provide exciting opportunities for private equity investors in booming industries with international potential.

Cheers

JP

John Paine
TBK Capital Limited

Email: john.paine@tbkcapital.co.nz

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