A Question of Confidence

By LEWIS JOHNSON – Co-Chief Investment Officer  |  OCTOBER 29, 2014

“I suspect everyone and I suspect no one.” 
-Inspector Jacques Clouseau, “A Shot in the Dark” 1964

Markets have been on a wild ride the last few weeks.  Is a trend change underway or is this just “noise?”  Our view has been for many weeks that the economy is slowing down to work off excess inventories.  This trend change is enough to drive short term volatility higher until market participants come to understand this. The markets that are dominated by physical demand, such as the price of scrap steel in Turkey, show no sign of improvement and in fact continue to weaken.

Our research trip to Asia, now in its third week, has been very revealing about China’s growth prospects and of course, the Occupy Central demonstrations that have been so much in the news.  In this week’s Trends and Tail Risks we summarize some of our key takeaways from our research trip and ponder the issue of confidence.

Our recent travels have taken us to Hong Kong, Bangkok, and Beijing.  Hong Kong in particular is my favorite city in Asia. It’s amazing how much the city has grown since my first visit twenty years ago!  Hong Kong’s skyline at night now rivals that of any major city in the world. One commonality shared by all our Asian destinations is a sense of tension in the political sphere.

Bangkok is ruled by the military which seized power from its democratically elected leadership. Hong Kong has, of course, been partially paralyzed by the student-initiated “Occupy Central” movement which has set up tent cities covering many major highways (see picture below). The news media is full of stories about students seeking “democracy,” but we believe the real issue is the sky high cost of living in Hong Kong and other frustrations stemming from the economic challenges young people are confronting globally.

“Occupy Central” -Tent City
Source: Fundamental Global Investors

Beijing as well has not escaped its own sense of heightened political wariness. Chinese President Xi Jinping is driving one of the most reform minded Chinese administrations since Deng Xiaoping’s great wave of liberalization in the early 1990s. A vigorous anti-corruption campaign is a key part of his many ongoing initiatives. Many top business and political leaders have been swept up in this reform, which is leading to a heightened sense of conservatism among the highest echelons of Asian business leaders. This caution is starting to show up in the data.

We have spent the last three weeks talking to the wealthiest and most powerful executives in Asia. In all my years of coming to Asia, I have rarely sensed a more cautious and circumspect tone among these, the very savviest of long-term China watchers. It is worth stressing that those with whom we have been meeting have been an integral part of China’s growth for many decades. Among them are many long term China bulls whose persistent optimism has made them very wealthy. Why the change in tone?

Asia is still a place of wondrous dynamism and open-ended growth. I need no further proof than the changed skyline of Hong Kong over the last 20 years. But there is no denying that long term enthusiasm is tempered right now by a strong undertone of near term caution. Credit stress in China, which we first identified during our 2012 research trip, is a key driver. However, it’s my own opinion that a deeper issue is at work as well – the strong determination of the Chinese Communist Party to address executive level corruption. I had not understood until this trip how strongly committed China’s top leadership is to this goal. This makes perfect sense when viewed against a global backdrop of rising political instability.

Many political regimes around the world have found themselves confronting challenges to their legitimacy. Asian countries are no different. However, what is different is the extent to which Asia is run by businesspeople for businesspeople. Over here, democracy is not viewed as integral to economic and social freedom as it is back home in the United States. People here are too busy trying to make money and succeed in business. Political and social unrest here is much more disturbing because it undermines and challenges the power structure. This makes business people uneasy. With clarity lacking, confidence is low. Investments are being deferred. Some of the savviest business people are cautious, watching and waiting for more compelling opportunities to invest. We continue to find select undervalued special situations in which to invest right now. But still we do wonder at the meaning of these China veterans’ new-found hesitancy to invest. We will not lightly ignore their cautionary tone.

Our framework is to use fluctuations of the cycle to help us to opportunistically allocate capital – and to identify early the weak links in the credit chain that may fail and precipitate the next down cycle.  What could be that weak link? Asia has been so strong for so long that the markets have become complacent. Not as much as they were just a few days ago but perhaps still more than that which the fundamentals suggest. We expect to see more signs of credit stress, such as is now underway in Greece and Italy, as the inventory destocking cycle unfolds. Thomas Paine said that credit is “suspicion asleep.”  At this stage of the cycle we remain watchful  – suspecting everyone and suspecting no one.

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