China's Banks Face Hurdles

Benefiting from rip-roaring economic growth and solid loan demand, China's banks have been the envy of their peers the world over. Now that economic growth has moderated, their outsize performance will be hard to sustain.

First-half profits at the nation's top four listed banks — Bank of China, Industrial & Commercial Bank of China, Bank of Communications and China Construction Bank — grew between 38% and 81%. Net interest margins continued to widen, and bad loan levels fell.

Nonperforming loans fell to 6.1% of outstanding loans at major Chinese banks by June's end, compared with 6.7% at the close of 2007, according to the country's banking regulator. In 2002, just before Beijing's last bank bailout, nonperforming loan levels were over 20%.

Of course, that's history.

China's economic growth rate is slipping, taking corporate performance with it. Overall profit growth for 1,619 mainland-listed companies rose 16% in the first half, compared with a 49% rise in 2007, according to JPMorgan figures.

Evidence of a slowdown in the property sector has some worried. Real estate sales were down 20% on the year in July, for example.

As growth slows, the banks' outlook will depend largely on how disciplined they've been about managing credit risk. This hasn't been tested since the government's 2003 bad-loan bailout.

Loan growth since then — of more than 13% in each of the last two years — has given Chinese banks among the most unseasoned collective loan books in Asia. There's little data history for banks to stress-test their books effectively.

What can be said is there are few signs the banks have excessive exposure to deteriorating asset quality in one or another problematic sectors, whether real estate or export-focused manufacturers.

It's particularly true of the property sector. Commercial bank mortgage lending was around 11% of total loans at the end of 2007, while lending to property developers was 7% — a total exposure of 18%. In the U.S., the comparable total figure was 53%, according to Goldman Sachs.

So even if this won't be anything like the crisis conditions afflicting Western peers, declining performance is likely.

With Buybacks, Look Before You Leap

Repurchases Routinely Give Shares a Lift,
But the Effect Could Be Ephemeral

Buying high and selling low: That sounds dumb. But call it a "share repurchase program" (or stock buyback), and people get excited.

Stocks regularly jump up 3% to 6% on the announcement of a buyback, and it's easy to see why they should.

Done right, buybacks are a boon. They reduce the number of shares outstanding, spreading the company's future profits over a smaller base — thus increasing earnings per share. Over time, firms that repurchase their shares have beaten the market by about three percentage points a year. Unlike dividends, buybacks generate no tax bills for ongoing shareholders.

Above all, share repurchases prevent cash from burning a hole in management's pocket. Long ago, Benjamin Graham pointed out a paradox: The better a company's executives are at managing its businesses, the worse they are likely to be at managing its cash. Great businesses produce piles of wampum — and, to management, idle cash is the devil's workshop.

Three decades ago, with oil skyrocketing and profits gushing in, energy companies squandered billions of dollars on one bone-headed diversification after another. Mobil bought Montgomery Ward, the dying retailer. Arco acquired Anaconda Copper just before metal prices collapsed. Exxon even got the bright idea of manufacturing typewriters.

In the latest oil boom, the energy giants have favored buybacks over misbegotten empire building. So far in 2008, ConocoPhillips has spent $5 billion buying back stock; Chevron, $3.6 billion. From the end of 2004 through this June 30, says analyst Howard Silverblatt of Standard & Poor's, Exxon Mobil has soaked up an astounding $102.2 billion worth of its own shares.

Big oil is not alone. All told, the companies in the Standard & Poor's 500-stock index have bought back shares valued at more than a half-trillion dollars' worth of their shares in the past year.

Unfortunately, firms don't always buy stock back when it is cheap. In fact, you would have an easier time teaching a platypus to play the clavichord than getting a manager to admit his stock is overpriced. Every three months, Duke University economist John Graham surveys hundreds of chief financial officers. During the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was "overvalued." More recently, buybacks hit their all-time quarterly high of $171.9 billion in September 2007, just before the Dow crested at 14000.

Mistimed buybacks can be deadly. In 2006 and 2007, Washington Mutual spent $6.5 billion on buybacks. In January 2007, with the stock at 43.73 per share, chief executive Kerry Killinger called the repurchase program "a superior use of capital." Also in 2006 and 2007, Wachovia sank $5.7 billion into buybacks at an average price of more than 54. Citigroup spent $8.3 billion to repurchase stock in 2006 and 2007 at share prices of about 50. In April 2008, all three banks were so capital-starved that they had to raise cash by selling shares for a fraction of what they had recently paid for them — WaMu at 8.75, Wachovia at 24, Citi at 25.27 a share.

Another warning: Contrary to popular belief, buying back stock isn't like canceling a postage stamp. Rather than being "retired," most repurchased shares sit in the corporate treasury — and they can be yanked back out for just about any reason.

Look again at Exxon Mobil, which has repurchased 2.8 billion shares, carried on its books at their cost of $131 billion. But their current market value is $229 billion. If ExxonMobil decided to get into, say, the soap and diaper business, it could buy all of Procter & Gamble, the fifth-biggest stock in America, and have $10 billion in stock left over.

No, I don't believe Exxon Mobil is about to do anything that dumb. But less canny outfits could — and will. Buy into a company that doesn't retire shares after it repurchases them and you are playing with fire.

Back in 1999 and 2000, tech companies wildly overpaid to buy back stock, while stodgier firms like Philip Morris repurchased shares dirt cheap. A buyback probably makes sense if the stock is less than its average price/earnings ratio of the past five years.

Finally, the historical outperformance of buybacks comes from an era when not everybody was doing them. From now on, long-term returns are bound to be lower. Before you invest, ask whether the stock would look cheap even without the buyback. It's hard enough to avoid buying high and selling low on your own account. Why run the risk that someone else will do it for you?

 

 

If You Bet on the Election,
Don't Use Real Money

Theories about Picking Stocks
Based on the "Presidential Cycle"
Don't Hold Up to Scrutiny

Every four years, as the clatter of the presidential campaign reaches a crescendo, Wall Street adds its voice to the din. Financial pundits spew forth one nostrum after another, often contradictory, never documented with evidence and always tailor-made to spur investors into making more trades. If you haven't yet heard "The stock market prefers Republicans," you will soon hear "The stock market prefers Democrats" or "Gridlock is good for investors."

Now that we know it's McCain and Palin against Obama and Biden, let me tell you three things about the "presidential cycle" in stock returns. There's not much to it, most of what you hear about it is wrong and there's no reliable way to make money on it.

From 1926 through the end of August, according to data from the market researchers at Ibbotson Associates in Chicago, the Standard & Poor's 500-stock index has done distinctly better under Democratic presidents (9.2% annually after inflation) than under Republicans (4.6%). While large stocks fared well in Democratic administrations, small stocks have skyrocketed, returning 16.5% a year after inflation, versus just 2.2% annually under Republicans. On the other hand, bonds have done much better in Republican than Democratic administrations (4.8% versus negative 0.4% annually, after inflation).

Heath Hinegardner

Why do stocks do better under Democratic presidents? Robert Johnson, a former finance professor who now helps run the CFA Institute (which trains financial analysts world-wide), has studied the phenomenon and found an explanation that has nothing do with party. In years when the Fed tightens the money supply by raising interest rates, the market does poorly; when the Fed eases by cutting rates, the market does well. Rate cuts are most common in the third year of presidential administration — helping explain why stocks have a significant tendency to do roughly twice as well in Year 3 of presidential terms as in years 1, 2 or 4.

Once you account for the market impact of the Fed's actions, the apparent predictive power of the presidential cycle evaporates; if you don't know whether the Fed will have to raise or lower interest rates, it doesn't matter which party is in power.

What about the nearly universal belief that "gridlock is good"?

Some pundits base that claim on numbers dating back to 1901. Dig into the data, however, and you discover that the gains from gridlock come entirely from a single year: 1919, when Woodrow Wilson, a Democrat, had to cope with a Republican House and Senate (and his own failing health). But it's absurd to give gridlock the credit for the Dow's 30.5% rise that year. Instead, it was the end of World War I, in the final weeks of 1918, that propelled the market to one of its best years ever.

The Stock Trader's Almanac, a popular reference book on Wall Street, reports that since 1949, the Dow has gone up by an annual average of 19.5% when the White House was Democratic and Congress was Republican. But that form of gridlock has occurred in just six of those 60 years, all under Bill Clinton, and in only 10 years in the past century. Such a thin slice of history is no basis for an investing strategy.

Overall, gridlock isn't good for investors. Since 1926, the S&P 500 has gained an average of 6.3%, after inflation, whenever one party controlled the White House and the other held the majority in both houses of Congress. That's less than the 6.8% annual average for the period as a whole.

What, then, should you do? The big margin of outperformance by small stocks under Democratic administrations might be worth betting on if you think Obama will win. But I wouldn't bet big on small-caps; they've beaten large stocks by such a wide margin lately that they are hardly a steal.

This time around, the credit crisis has made banks so reluctant to lend and borrowers so shaky that the Fed's recent rate-cutting push has hit the economy with all the impact of a piece of overcooked fettuccine. If the Fed has been rendered at least temporarily ineffectual, whoever is elected president may be forced to boost government spending in order to kick-start the economy. About all we can confidently say, then, is that this is unlikely to be a good time to add a lot of bonds to your portfolio.

Sometimes the most important thing for an investor to know is what not to do. Vote with your ballot; do not vote with your portfolio.

 

Beijing’s Olympian task is to curb inflation

By Stephen Roach

Too much is being made of the economic impact of the Beijing Olympics on China and the rest of Asia. China was slowing before the onset of the XXIX Olympiad and is likely to continue to slow in the year ahead. Elsewhere in Asia, a similar outcome appears to be in the offing.

Significantly, most of the Olympics-related construction activity in Beijing – some $42bn (€29bn, £23.6bn), according to the official Chinese tally – was completed more than a year ago. That means any post-Olympics construction payback should have occurred quite some time ago rather than in the aftermath of the summer games. Yes, there were plant closings in Beijing and the neighbouring city of Tianjin for a few weeks before and during the Olympics. But these two metropolitan areas collect­ively account for less than 6 per cent of total Chinese output – hardly enough to make much of a dent in the Chinese production juggernaut.

At work, instead, are powerful repercussions of an external shock that has nothing to do with the Olympics: post-bubble adjustments bearing down on the US consumer, along with collateral damage now starting to show up in Europe and Japan. Developing Asia is the most export-intensive region of the world, with a record of more than 45 per cent of its pan-regional output now going to foreign markets. China’s export share is close to 40 per cent. As the industrial world slows, China and the rest of export-dependent developing Asia will feel the effects of a shortfall in external demand with a lag. Any gyrations traceable to the Olympics are likely to be overwhelmed by these much broader, more powerful macro forces bearing down on the region.

Policymakers in China are very much aware of the mounting downside risks to economic growth. Bank lending quotas, which have been the centrepiece of recent tightening initiatives, have now been relaxed. The pace of currency appreciation has also slowed – a sharp departure from the accelerated rate of revaluation that had been evident in late 2007 and early 2008. And policy interest rates have been left unchanged in a rising inflationary climate – keeping real short-term interest rates close to zero, a highly stimulative position for any country’s monetary policy. In short, China’s pro-growth policy bias is once again coming though loud and clear, reflecting a shift in its policy stance that seems traceable to events far bigger than the ­Olympics.

In this context, inflation remains the biggest riddle for China. The recent pro-growth policy initiatives suggest that Chinese authorities are attempting to put a floor on the gross domestic product growth shortfall of somewhere in the 8 to 9 per cent range. Perhaps the biggest macro question for China over the next year is whether such a slowing – from the torrid growth pace of nearly 12 per cent in 2006-07 – is sufficient to stem the recent build-up of inflationary pressures.

There is good reason to believe that inflation risks will remain China’s most daunting macro challenge over the next few years. Particularly worrying is a growing inclination of Chinese officialdom to dismiss the build-up of inflationary pressures as “structural” – traceable to special forces that are argued to be beyond the control of domestic monetary policy. Three such developments are cited most frequently: recent labour reforms that have boosted minimum wages, an outbreak of “imported” commodity inflation, and international price equalisation that is presumed to bring the quotes of Chinese products up to world standards.

This structural excuse for China’s inflation problem is painfully reminiscent of an equally erroneous dismissal of US inflation risks in the 1970s. Back then, three structural forces were also cited as being beyond the purview of the US Federal Reserve, namely wage indexation to CPI shocks that created a wage-price spiral, imported inflation due to the worldwide commodity boom of the early 1970s, and mandated increases in production expenses traceable to regulatory initiatives in pollution abatement and worker safety.

The most important lesson of the 1970s is that the Fed proved to be dead wrong in dismissing inflation risks as structural. While inflation eased off in the middle of the decade as the US went through a deep recession, it roared back with a vengeance as the economy recovered in the latter half of the 1970s, hitting a high of 13 per cent by the end of 1979. It took a new, courageous Fed chairman, Paul Volcker, to put the structuralist inflation argument to rest by driving up the federal funds rate to extraordinary levels and putting the economy through a wrenching hard landing.

That is an outcome that China – and an increasingly China-centric developing Asia, long fixated on social stability and poverty reduction – simply cannot risk. A hard landing could prove devastating to regional development imperatives. Yet to the extent that China and other Asian countries dismiss mounting inflation risks as structural and fail to heed the most salient lesson of the 1970s, the risk of an eventual hard landing will only grow.

That poses a serious question for the rest of Asia as well as for the broader global economy: can a build-up of inflationary pressures be contained to China? In the near term the downside of the global business cycle may limit the spread of inflation. But over the medium term that could change. The cross-border linkages of globalisation may make containment of Chinese inflation exceedingly difficult.

Temporary growth risks should not be the dominant concern in post-Olympics China. Stagflation may well be the greatest risk: an externally induced growth shortfall coupled with a significant deterioration of underlying inflation risks. Chinese officials are fixated on the growth side of the stagflationary equation, but they ignore the inflation piece of the outcome. That remains the greatest worry in the aftermath of an otherwise spectacular Olympics.