Cumberland’s 2008 Emerging Markets Strategy

2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The benchmark we use is the broad MSCI (Morgan Stanley Capital International) Emerging Markets Index; it increased by 39.4% in 2007.

Like last year, the same basic question applies: “Will the Boom Continue?” Our response is conditionally “yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets. Market volatility has increased and country allocation among the emerging market universe is critical for portfolio performance.

The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.

While the large price advances in many of the major emerging markets this year had reduced their relative attractiveness, the market drawbacks in the last few months tempered their overheated nature. China and Hong Kong are examples.

China and Hong Kong

The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.

Cumberland takes a conservative approach to participating in Chinese economic growth. We use up to eight ETFs to craft our China exposure. We will mention just two.

These two ETFs that track the shares of major Chinese firms that are listed on the Hong Kong market and/or the US market and hence meet the higher standards of these exchanges. The iShares FTSE/Xinhua China Index Fund (ticker FXI), tracks the corresponding index. It increased by 58.7% last year. The second of these ETFs, the Powershares Golden Dragon Halter USX China Fund (ticker PGJ) is comprised of the U.S. listed securities of companies that derive the majority of their revenue from the People’s Republic of China. This ETF rose by 59% last year.

The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They persist in flocking to China’s equity markets.

That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for dollar-based investors. Another importance risk facing Chinese exporters is the US presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.

On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies tracked by the two China ETFs mentioned above are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these ETFs over the course of the year. Expecting further gains in 2008, we are maintaining an overweight position in China and Hong Kong.

The heightened risks mean that it will be important to monitor developments carefully. For some recent observations and personal travel notes on China by David Kotok, see .

Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong markets performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped the iShares Hong Kong ETF (ticker EWH) advance by 40.5% this past year. The leading Hong Kong companies in this ETF are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.


Singapore’s economy and market are the most advanced of the markets Cumberland includes in our Emerging Market Portfolio. Singapore has a history of sound market-based economic policies and political stability. With few natural resources other than its people and its strategic location, the Singapore economy has demonstrated consistent strong performance, responding flexibly to changes in global markets. For example, it is now the world’s second largest inter-modal port. The iShares Singapore ETF (ticker EWS) increased by 27.8% last year, just a little less than its average annual increase of 29.9% over the past five years.

The Singapore market tends to outperform in periods of increased volatility in global markets as investors seek more stable investment opportunities. High volatility promises to be a characteristic of the emerging markets in the coming year.


The Malaysian economy is blessed with natural resources (particularly energy) a relatively stable government and currently a stimulative monetary policy. This year’s healthy economic growth of 6% should be followed by a similar advance in 2008. Like other emerging Asian economies, a modest weakening in the demand for Malaysia’s exports in 2008 is expected to be offset by stronger domestic demand. The iShares Malaysian ETF (ticker EWM) rose by 45.5% in 2007. Despite this advance, valuations are still attractive and the market appears poised for another good year in 2008.


Korea has a new, more pro-business President. However, there are a number of economic concerns that caution us from adding to our Korean position at this time. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The iShares Korean ETF (ticker EWY) registered a strong increase of 32.1% last year but has underperformed in recent months.


The performance of Taiwanese stocks was considerably weaker than expected in 2007. The iShare Taiwan ETF (ticker EWT) increased by only 7.6% over the past 12 months. The big problem seems to be the negative sentiment of domestic Taiwanese investors towards their market. Perhaps this is due to uncertainties on the political front.

The positive factors which have encouraged us to retain our overweight for this market are the attractive valuations of Taiwanese companies and our global strategy of overweighting the technology sector which constitutes the major share of EWT. We also favor the increasingly close economic inter-relationships between Taiwan and China. Also, the upcoming elections in March may encourage Taiwanese investors to return to their domestic market.


Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil registered the strongest performance among the markets in Cumberland’s equity market universe. The iShares Brazil ETF (ticker EWZ) rose by 76.6% last year. This outperformance continued through the recent market adjustment.

Brazil’s economic prospects continue to look benign with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, we expect this market will maintain strong performance in 2008.


In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which have declined during the latter half of 2007. As a result, the iShares Mexico ETF (ticker EWW) was up by only 12.3% for the year, in sharp contrast to Brazil’s 78% increase. Mexico’s interest rates remain among the highest in our Emerging Markets Portfolio, and its equity risk premium is negative. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession. For the time being, we are maintaining our underweight position.

South Africa

South Africa faces rising inflationary pressures and an external deficit that equals almost 7% of its GDP. These conditions are forcing interest rate hikes by the South African Reserve Bank despite the growing evidence that domestic demand is faltering. We expect growth in South Africa’s economy to drop below this year’s 5% pace. An inflated housing market is at considerable risk. Adding to investors concerns is the election of Jacob Zuma as the leader of the ruling ANC party. Of greater concern than the populist economic policies he may wish to employ are the press reports that Zuma is being charged with racketeering, tax evasion, and corruption. A period of domestic political turmoil could prompt an exodus of foreign investors in the coming months. The iShares South African ETF (ticker EZA) advanced by 17.3% in 2007. We anticipate underperformance for this market in the coming year.


As I write this year-end review, there are violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. So far there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds. But the global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. This event is a reminder that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.

At Cumberland in our active management of portfolios we seek to identify developing risks and rebalance portfolios accordingly. However, as not all developments can be foreseen, diversification of risks is an essential element of prudent portfolio management. A distinguishing feature of Cumberland’s risk management is our exclusive use of Exchange Traded Funds in our equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments in entire country markets, regions, sectors and/or styles. For example, the Korean ETF, ticker EWY, holds the shares of 100 Korean companies. One of our core holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE), invests in 50 companies in eleven major emerging markets. The resulting diversification of risks together with a top-down approach to active portfolio management sums up our approach to investing in these markets.

Fannie and Freddie in dysfunctional credit markets

We expected the foreclosure, subprime mess to become the central focal point of US politics; it has now done so.

The reason is simple. A single foreclosure on a street impacts the entire population of the street not just the household that lost their home. All nearby property values are hurt. Foreclosures are an indicator of a much larger cohort of trouble.

Half the foreclosures we see are in three states: Florida, Texas and California. You cannot become president of the United States without winning at least two of these three states. Thus we see the presidential race moving to this topic as the premier issue.

Since the peak of adjustable rate mortgage resets is in May 2008, we expect the politics to intensify. Every pol will offer his or her solution as the best. They will blame others for the problem.

They are all shameful. They are reactive and have not been proactive. Now the dysfunctional American political system is trying to play catch up to the dysfunctional credit markets. Such coincidences of timing have ended badly in the past. This is how we get misguided legislative and permanent tax code changes which are launched as temporary solutions. The whole thing is a sad commentary on our system.

And, as we have written twice, the Federal Reserve is held political hostage during this period by the US Senate which will not confirm nor even hold hearings on two nominees for Fed Governor spots let alone a confirmation on a third sitting Governor who is up for reappointment.

Why am I harping on the politics and the threat to the Fed?

There is a fundamental reason. The United States has two nationally franchised mortgage agencies. Fannie Mae and Freddie Mac. They have had their share of troubles as we know. They have cut their dividends and are raising capital through preferred stock issuance into order to strengthen their weakened balance sheets. They are emasculated by the Congressional system that is also one of the main sources of this credit problem. They have a regulator who has no experience in dealing with an asset class that is falling in price. OFHEO price declines are just surfacing in the OFHEO data. What planet are they on?

Note that GSE debt and specifically Fannie and Freddie is held around the world. About $1 trillion is in foreign institutional hands. Those folks are watching our political system fail and they are insecure. The spreads of GSE debt to corresponding treasury debt by maturity have doubled.

The Greenspan Fed was highly critical of the implied guarantee of the federal government when it came to GSE debt. Yet the GSE debt is still held by many institutions and the status of the implied guarantee is unchanged. The GSEs never directly affirm they have it. The documents they issue deny it. The market has believed the guarantee is valid. Why else would Fannie have a credit line with the US Treasury? Fannie hasn’t used it. BUT it is still there.

This is the time to clarify that situation once and for all. Doing so would clear the markets and put the national housing agencies back into the business they were created to handle. Will that happen? Probably not because it requires forward looking proactive political activity. An oxymoron by definition in the United States where the morons get elected to office.

This overhang of implied guarantee vs. credit risk and credit worthiness of GSE debt is a huge issue and is symptomatic of dysfunctional markets

At Cumberland we believe that the Congress will not permit the GSE debt to default. There is no rescue coming for GSE shareholders nor for the employees of the GSEs when it comes to their stock options. But debt holders are not likely to suffer default.

We also believe that the Congress will not clarify this status even though they would serve the credit markets of the world by doing so.

We are willing to hold GSE debt because we believe we will get paid. We add that many state and local jurisdictions also hold GSE debt and use it as legally authorized cash management and portfolio tools. At current spreads, some GSE debt is becoming cheap. Clients of Cumberland will find it in their taxable fixed income accounts. We are selective about the issues and the structure of each security. That detail is very important in making a debt instrument selection.

Were the Fed not political hostage it would be able to speak clearly and with a single voice about the GSE debt status. Furthermore, it could advise on how it views this debt and how institutions can use it as collateral during this financial turmoil period. We do not expect Fed Governors or presidents to compromise their role as public servants. They are people of character and understand the seriousness of their task.

It is the Congress that could make this issue clear for the markets. If GSE is federally guaranteed, say so. If the guarantee is to be phased out, say so. Uncertainty doesn’t help in periods like this.

Northern Rock has a branch in Tallahassee

Runs on financial institutions are not always seen as lines forming in front of banks. The State of Florida has suspended withdrawals from a state operated pooled investment fund. The fund was designed to benefit Florida’s counties, cities and school districts by pooling and investing their short term funds for them. The suspension occurred just days after Florida officials said that their Local Government Investment Poll was safe.

State sponsored pooled funds are commonly used around the country. They are supervised by the states; their governing rules are usually made by the legislatures. They usually do NOT have federal government support or access to the Federal Reserve. In normal times, they provide economies of scale and convenience for municipal entities and allow for short term fund investments until they are needed for payments, payrolls, debt service, etc.

Florida’s fund has been hurt by some commercial paper of financial companies that had invested in subprime mortgages and subsequently been downgraded to default status. Thus, being one step removed did not prevent a “run” on the pooled fund. The pool had $10 billion in withdrawals in just two weeks. It is down to about $15 billion in size. This has shocked all the municipal subdivisions that invested in the fund. It is impacting payrolls in certain school districts. Many municipal entities were pulling their money out of the fund until Florida halted withdrawals. The fund was once as large as $42 billion. It appears there will be losses taken on some of the fund’s remaining investments.

In Montana, there was similar news as school districts, cities, and counties pulled out $247 million from the state’s $2.4 billion investment pool. The trigger was a revelation that one of the pool’s holdings was lowered to default status. So far we have not heard that Montana has halted withdrawals.

At Cumberland, we expect that every state and municipal pooled vehicle will now be scrutinized by the respective state officials. Furthermore, many municipal entities will simply seek immediate safety by pulling their money out of pools and return to collateralized bank deposits. We see that among our municipal consulting clients.

Some readers may not know that Cumberland has a division which consults for state and local government entities. We advise them on their $millions of investments vehicles. In that division we constantly are reviewing our client’s investments. Part of that process is the examination of the content and structure of these pools. If the pool is not fully transparent, we avoid it.

When this Florida and Montana news broke it brought to mind the debacle of Orange County, California in 1994. In that episode, Orange County, one of the wealthiest counties in the country, ended up filing for bankruptcy. It quickly lost its AA- rating. Orange County had pursued a risky strategy of investing in inverse floaters. That involved putting up bonds the county owned as collateral to buy more bonds. The county fund essentially leveraged itself by betting that the bonds they were buying would yield more than their borrowing costs. That strategy blew up in 1994 when the Fed raised short term rates and long term rates followed upward. Schools and cities in Orange County had used the fund for short term investments much like municipalities do/did in Florida. The State of California eventually restructured the fund and liabilities were eventually paid but the period was tortuous for the bond markets as well as the municipalities.

Three things become evident here.

1. Poor supervision of some state and local investment managers continues in the US. In this case it is Florida and Montana. More may be revealed. At this time, it is also unclear whether the counties and other municipalities who invested in the fund knew what the fund owned. Lawyers are going to have a field day with this one.

2. Diversification has its benefits and should be stressed in all portfolios. Florida is reported to have had 20% of its investments in this type of asset-backed commercial paper.

3. Notwithstanding all the talk of problems within municipal bond insurers, the benefits of secondary credit enhancement cannot be clearer. These are another set of eyes examining the risks in the $2 ½ trillion tax-free municipal bond market.

At Cumberland, we continue to look under the hood at bond financed projects whether they have underlying credit ratings or not. And we evaluate the credit of each bond insurer. We do NOT just rely on the rating of an agency. This doesn’t mean that one can totally avoid liquidity risk; the events of last August are indicative of that market based result. Even the highest quality bonds can experience a sloppy market. It does mean being prudent is about diversification among issuers, insurers, sectors, parts of the yield curve, and, where tax efficient, geographically.

Florida’s government and professionals are spending this weekend searching for solutions to this problem. A restructuring and some extensions of maturities can help to resolve this mess. We expect the State of Florida will have to pay the losses and make the constituent municipal entities whole.

Cumberland Advisors manages about a $½ billion of tax-free, total return, municipal bond portfolios for individual clients who reside in more than 30 states. Our internal credit standards are higher than those found in the benchmark indices. We have been doing this for nearly 35 years. In the municipal bond investing world, you do not get paid well for taking default risk. Our strategy of avoidance of payment failure has protected our clients since the days of Washington Public Power (we avoided it) and Orange County, California (we avoided it). We do not expect that any of our Florida clients will experience losses because of the Florida state pool failure.

A final irony: Orange County (FL) was an investor in the Florida pooled investment fund.

Thanksgiving in Hanoi

It is the evening of Thanksgiving Day and I am looking at the wide variety of Vietnamese dishes on offer at a charming restaurant located in the courtyard of a former Buddhist monastery in Hanoi. No turkey or apple pie tonight. I pass up the charcoal-grilled squid and opt for large barbecued shrimp, which are delicious, washed down with several bottles of local beer. This unconventional Thanksgiving dinner was occasioned by a consultant project which brought me to Vietnam for the second time in several months. Despite the ill timing, I welcomed the chance to return and observe further this young, dynamic economy that is well advanced in transforming itself from a centrally planned system to a so-called "socialist market economy"..

The process of opening the Vietnamese economy to foreign investment and undertaking market-based economic reforms began some 20 years ago with the "Doi Moi" policy of renovation and economic reforms. At that time, Vietnam was an isolated, very poor, agriculture-based economy. The Soviet model of a centrally planned economy clearly had failed. The early pace of the reforms was gradual, although there was an early move to open the doors to foreign investment. The most important advances have come in recent years with a new Investment Law that provides for equal treatment of foreign and domestic investors in most respects, a new Enterprise Law, a new Competition Law and considerable reductions in bureaucratic red tape. The most important development has been the entry of Vietnam into the World Trade Organization (WTO) in January 2007. Obtaining WTO membership required successfully negotiation of bi-lateral trade agreements with all of Vietnam’s trading partners, including the United States, and undertaking an extensive list of trade and investment liberalization commitments.

Vietnam is seeing the fruits of its market reforms. The economy is booming, sustaining growth at the remarkable average annual rate of 7% over the last 20 years. A dynamic and entrepreneurial private sector, practically non-existent in 1986, has emerged. A contributing factor is a high literacy rate (90.3% for adults). By 2006 the domestic private sector together with the foreign investment sector accounted for 60% of the total output of the economy.

Foreign investment in Vietnam is growing rapidly and is playing a critical role in the economy. Vietnam is seen by international firms as an alternative or supplement to China as a manufacturing base for supplying the global markets. Labor costs are relatively low but there are shortages of skilled labor. For example, Intel reports the firm has yet to find the workers it requires for the one billion US dollar factory it is building. Infrastructure deficiencies are another constraint holding back the full potential of foreign investment.

A walk around the French quarter of Hanoi illustrates some of the characteristics of Vietnam today. The French legacy is evident in the wide tree-lined boulevards, the parks and the French architecture of the older buildings like the Opera, modeled after the Garnier Opera in Paris. In the streets, motor cycles vastly outnumber cars – a reflection of both relatively low income levels and the high duties on imported cars. Some motor cycles carry whole families, others surprisingly large volumes of commercial or agricultural goods. The traffic flows in many directions with a remarkable avoidance of collisions. Overseeing this ballet a traffic policeman in a crisply ironed uniform stands at attention, not moving a muscle. Almost no one wears a helmet.

I am wishing I had a helmet as I stand at an intersection waiting for a gap in the flow to dash across. A smiling man tugs at my sleeve, asks if I am an American and then leads me out into the flow, raising his other hand. The traffic flows smoothly around us. That event, although somewhat embarrassing, was a good example of the friendly attitude of the Vietnamese I encountered. The population is young; many speak some English, are eager to advance themselves, participate in and enjoy the benefits of a market economy. Those that have already made it to the still small but rapidly growing middle class are evident in the up-market multi-floor shopping malls. Yet, even in the streets containing the nicer shops one sees a considerable signs of poverty. I understand the income levels in the countryside, particularly in some disadvantaged regions, are still very low. Measures of income inequality are rising. The contrasts are striking.

Raising my eyes above the traffic chaos, I suddenly notice a vivid indication of one of the most serious infrastructure problems in Vietnam, an amazing complex mass of black telephone wires hanging over the side walks and meeting at street intersections. One of my colleagues reported encountering a traffic jam caused by efforts to rescue a man who somehow became entangled and trapped in the wires above the street (perhaps as he was connecting a new phone).

Addressing Vietnam’s infrastructure needs will require substantial investments. Foreign investors are being looked to for both capital and technology. It will also require improving the ability of the domestic financial system to mobilize savings and channel funds efficiently to their most economic use. Vietnam has committed in the WTO to open up its financial sector over a period of years. The authorities are likely to find it desirable to move at a more rapid pace.

The country’s two stock exchanges in Ho Chi Minh City (former Saigon) and Hanoi have registered significant increases recently in trading volume. Like other young exchanges, price volatility (risk) has been high. For example, investors in the Ho Chi Minh market saw their investments increase by almost 60% in the first three months of this year, followed by a 30% decline over the next five months, and several more sizable swings. Market capitalization is still too small to have Vietnam play a significant role in Cumberland’s Emerging Market Equity ETF portfolio, but we will follow the development of this market.

Four Commentaries from Trip to China

Report From Beijing November 6, 2007

It’s early Tuesday morning here and 13 hours ahead of east coast time. The blackberry connection is perfect so we are current on email, telephone messages and have digested the news from Citi and Google. We’ve absorbed Federal Reserve Governor Mishkin’s speech.

The contrasts in Beijing are remarkable. We see that easily when we walk through the vastness of the Forbidden City and absorb its centuries of history of emperors and concubines. Leaving Tiananmen Square and Chairman Mao’s tomb, our eyes see construction cranes and rising buildings in every direction. This place is booming.

Sadly, we note that we cannot experience the full visual effect. The air pollution is so thick you can almost cut it with a knife. The visual side of this city is impaired by this massive, irritating, toxic cloud.

I recall flying into Sao Paolo, Brazil, like Beijing, a city of 20 million people. From the plane in Sao Paolo one sees this mass of urban, modern construction. In Beijing, one can only see it a few long blocks at a time. It’s here. It’s massive. But like the sun which is blocked by the pollution cloud, your visual experience is impaired.

“The smog is awful” said one of my colleagues. Smog is a mixture of man-made polluting smoke and naturally occurring fog; Beijing is not San Francisco. There is no fog component. All this airborne gunk which irritates your eyes and cancerfies your lungs is a by-product of China’s economic growth.

“Chinese like to do things at their own pace” said a central banker. He explained why the People’s Bank of China proceeds with gradualism when implementing changes.

It is hard to grasp an understanding of this Chinese need for gradualism when sitting behind your desk in the United States. It’s more easily understood once you are here. China is not about to be pushed by American protectionist threats impacting trade or by central banker cajolery impacting monetary policy. The sooner we accept that notion the faster we westerners will succeed in negotiations about globalization and China’s role in the new world economic order.

China has four times the population of the United States and one-sixth the number of automobiles. China is absorbing 15 million transplants from rural to urban labor force in each and every year. China’s fledgling stock exchange and evolving monetary policy must be viewed in the same way one would observe teenagers. Likewise, there is a cultural divide which also requires the westerner to be thoughtful and tolerant. One needs great patience in China.

One specific item is intriguing. The Hong Kong dollar is pegged by the Hong Kong monetary authority at a 1 to 1 ratio with the U.S. dollar. The Mainland Chinese currency, the Yuan, is managed by the government and has been gradually strengthening against the U.S. dollar which means it has also been strengthening against the Hong Kong dollar.

Everyone affirms the ongoing Hong Kong dollar peg. Every official articulates the “one country, two systems” approach to the Hong Kong versus Mainland financial structure. The bond market does not believe them. Today, the ten-year U.S. treasury yielded 4.3 percent at the same time the ten-year Hong Kong government bond yielded 3.7 percent. This pricing implies that the Hong Kong – U.S. dollar peg will break in the next few years.

The bond market is pricing that restructuring sometime after the 2008 Olympics have become history.

This Chinese boom is permanent. We need to be thinking about this emerging market economy as an awakening modern giant and not a throwback to the earlier dynasties that inhabited the Forbidden City.


The Great Wall, November 7, 2007

“They got a wall in China. It’s a thousand miles long. To keep out the foreigners, they made it strong”. Paul Simon.

Thighs burn. These are steep steps and there are so many. 60 years after reading about it in a kindergarten book, the Great Wall looms before me.

We climb onward and upward. Pause. The pulse is high. More pause. The breathe returns. Resume upward. It feels so exciting to climb this ancient and mysterious fortification. Pause again. Look at the foliage in these mountains. Strange trees with bright yellow and red leaves beckon the eyes. Resume upward. “We’ll go as far as that outcropping station and stop.”

Whew! We’re here. No morning mountain chill now. Coats are open; scarves off. Pictures must be taken quickly. We must remember to get back to the bus on time and not keep the others waiting. Now down: different than up but dangerous if you slip on the steep and well worn steps. “Careful! Hold onto the rail.”

Even here the pollution cloud partially blocks the sun. Beijing’s aerial assault on the planet carries to these mountains 50 miles from the center of the city. “How wondrous this would be if the air were clear” I thought. We leave this restored antiquity and contemplate a magnificent ancient barrier and what message can it offer us on this marvelous experiential day.

Walls don’t work.

Modern Chinese know that this great edifice didn’t protect a culture and an Emperor. Walls crumble when forces are destined to breach them. Westerners learned this lesson as children from the story of biblical Joshua. Europeans saw that in Berlin. Walls don’t work. The West and the East could both learn from their history with walls.

But we human dummies still build them. Sometimes on the Rio Grande River. Other times when we are swimming in the economic pool. Another wall exists here; this one is in trade.

Guangdong province announced today that it will officially support any Chinese toy manufacturer wishing to sue Mattel for damages from the lead paint recall. Why do this now? President Bush’s task force is announcing its findings and this distraction is designed to make the Chinese manufacturers stronger when facing US actions. China wants to draw attention away from its problems with internal governance. The US wants agencies like the Food and Drug Administration to announce recalls and warnings at will and to have US inspectors in Chinese facilities.

Beijing is using a media wall. It won’t work. Beijing wants all actions negotiated. It is not going to happen when it comes to product safety and the US. This wall will fall. The risk is backlash. That will fuel the protectionist wall that America’s political fools are building.

There is a financial wall.

“One country, two systems” is the phrase that describes the status of Hong Kong. Maybe so, but only as long as it serves Beijing’s purposes. Remember: This is all sovereign China now. Longing for British colonial status serves no useful purpose.

Beijing faces an issue of huge proportions. Millions of newly successful younger people have savings that found their way into the Mainland stock exchanges. Now these stocks are 50 or 60 times earnings and carry a negative equity risk premium. There is a bubble in progress.

Beijing knows the problem. I was able to clearly affirm that in private meetings. They do not have a solution. They believe that they may be able to find one but in reality they are floundering. They want to shove the problem behind a wall. This time it is a financial wall.

One approach was to form Qualified Domestic Institutional Investor funds (QDII) so that Mainland Chinese could direct their investment monies into vehicles which would allow them to invest outside China’s borders. Hong Kong was planned to be the first outlet. When that was announced the HK market took off like a rocket and moved up by 50% in ten weeks. Global investors poured money into HK in anticipation of Mainland funds following them and bidding up prices in HK to the same lofty levels as exist in Shanghai and Shenzhen. The HK authorities are worried about volatility so they prevailed on Beijing to postpone the transfer of investment funds. That triggered this week’s sell off in HK.

Now the QDII are sitting with billions of US dollars. They await the opportunity to move and are stymied by this delay. They are a financial force and will eventually breach this wall.

In my conversations here it becomes clear that the both the HK market and the Mainland market are now driven by more than fundamentals. These valuations defy normal methodology. They are a result of intense liquidity driven momentum. Officials know it.

The skilled economists and advisers to the government in Beijing don’t know what to do. They will listen to the arguments for opening markets and easing the pressure. They understand the need for action before it gets worse. At decision time they weaken and resort to gradualism and risk aversion when making a decision. The risk they wish to avert is the political upheaval that may occur if millions of fledgling and inexperienced investors suddenly face large losses.

That could happen once the wall with Hong Kong comes down and the arbitrage between these two markets closes to some level. No one knows where that level will be but it could result in a sell off once the issue of valuation returns to the investment decision making process.

But will Beijing act? Or will they wait and watch until the forces that will ultimately break down that wall reach the threshold where they overwhelm it? This is a Chinese puzzle.

The Emperor’s Great Walls didn’t work. Neither will the modern versions of financial walls or trade walls or political walls. This lesson is needed for Westerners and Easterners. In our globalized world, walls just don’t work.

I write this from Beijing on a borrowed computer while my Cumberland associates sleep in the US. Today’s lunch was with travel colleagues in a shopping mall nearby. It teemed with young and affluent Chinese who are enjoying the fruits of this extraordinary experiment in opening an economy. They are the new global stakeholders. Believe me. They don’t want war and they don’t want walls.

Now we must go for a much needed, jet lagged induced afternoon rest and then shower and dress for a celebratory dinner at the Beijing’s famous Peking Duck house. Tomorrow we fly to Shanghai.


From Shanghai to Yellow Mountain , November 11, 2007

China Mobile’s digital speed allows me to write this from the top of Yellow Mountain. (Google Huangshan Mountain). This is the site of filming “Crouching Tiger and Hidden Dragon.” Earth’s rotation will soon bring the mountain’s soft and fading sunlight to brighten America’s eastern shores.

There are many great gorges and peaks in the world. Metaphors like the Grand Canyon or Yosemite leap to one’s American mind. Here, the foliage adds a unique distinction. The ubiquitous Huangshan pine tree has ferreted out a piece of earth among the rocks and rooted its way into history and artistic beauty.

A cable car takes our group to the mountaintop hotel; the same place where the porters climb by foot. It’s eighty Yuan (about $11) for each of us to ride a round trip of 8 minutes each way. Wealth differential here is as large a chasm as the gorge.

Fifty Yuan is paid to the porter to climb up for 5 hours with a heavy load; three hours down when returning on the 8000 steps. This is considered a good job because a porter can earn the equivalent of about $150 a month and that is more than he can make as farmer. The government will not discount the cable car for the porters. Using the cable car would eliminate jobs and income in a country where the labor force grows by 15 million people a year.

For views of this mystical and misty spot see the movie and use the internet. I attest that what you view is true. Fortunately for us, today was sunny. There’s no pollution here; there’s only majesty and sereneness and a group of smiling Buddhist monks from Malaysia on a pilgrimage.

Now for some observations about Shanghai and markets.

China’s stock markets (including Hong Kong) have reached about 5% of total global stock market capitalization. In part that is due to the soaring markets in Shenzhen and Shanghai. Actually these markets are virtual. The trading floor of the Shanghai Stock Exchange has 1600 seats but the active pit is only about 100 persons. Like the floor of the New York Stock Exchange the digital world has replaced the bustle on the “floor.” Open outcry markets are consigned to history. Global investors who visualize China’s market as less than state-of-the-art technology are wrong.

But what about these stock prices. This market is about 50 times earnings. And many of the stocks that trade are minority portions in state owned companies. That said, the outlook for Shanghai is more likely to be up than down. My friend and an experienced China investor, Don Straszheim thinks 9000 is within reach on this index; it’s now about 5000.

When he and I met last for coffee in Philadelphia’s 30th Street Station between trains, I argued vigorously about valuations and bubble markets. I suggested that 50 P/E is a bubble. I still believe that some day it will be so. But for this moment Don is right and I admit error. This Mainland China stock market has an upside bias. There are clear reasons.

A first hand look here changes one’s view. I have now interviewed some Chinese investors and some business executives. They all own stocks. They all practice a personal allocation between their real estate, bank deposits and the Mainland “A” shares that only they can buy. They seem to have limited interest in going outside although some have put small amounts in the new Qualified Domestic Institutional Investment funds (QDII). When the government says okay, this fund will allow Chinese investors to place money outside the Mainland markets.

I asked each person about their sell discipline. The universal answer is “no.” They do not have one. They only buy. They reenter the market and add to positions on dips. I gleaned that something like a 30 to 35 P/E is believed to be attractive. At a 50 to 60 P/E they seem to hold back and wait. I could not find anyone other than day traders who were sellers. A typical allocation is about 2/3 in a bank deposit at interest and 1/3 stocks. Since these folks have a positive savings rate, the allocation to stocks is constantly growing in the current monetary construction.

Monetary policy is a fundamental reason why this booming economy will sustain what appears to be outrageous stock multiples. The reason is very low interest rates. Investors get less than the rate of inflation on their bank deposits. They are limited in the real estate they can own and they have only had the freedom to own any real estate for eight years. They use mortgages at 7% to buy household real estate that they believe will appreciate at large double-digit rates. This is all they know from personal experience.

As long as the Chinese central bank sustains this monetary stimulus, this economy will be able to grow at 10 or 11 or 12 percent per year. It will have some inflation but that is blunted by very high productivity gains achieved in conjunction with this huge and growing labor force.

Think of it this way. A 10% growth rate with 5% inflation would need to have a mid-teen rate of interest to normalize equilibrium at western standards. In China the government sponsored interest rate is less than half (7.29% on one year loans) and that is after 5 rate hikes this year.

Support for this conclusion is found in the few private lending transactions where a private consortium loan carries a rate of between 15% and 20%. Some of my economist colleagues and I debated this issue but we certainly respect that 15% is representative of an unregulated market and is likely to be close to an equilibrium rate for this economy.

Internal Chinese monetary stimulus is not the only cause of the stock market surge. Shanghai is also bulled by leakage from foreign sources. The border is porous even if the rules say no outsiders without a formal approval.

Consider that the Osaka Stock Exchange (OSE) has launched a Shanghai Index ETF. It consists of 50 stocks. The index is licensed by the Shanghai exchange to Nomura for this purpose. Nomura is a leading ETF sponsor in Japan and this ETF was designed for Japanese investors.

We have yet to find out how the index is arbitraged against the actual stock prices. The prospectus is in Japanese and the security is easily available only to Japanese investors. You need to go through a complex trust in order to buy it as an American. You can track it on Bloomberg on the OSE with number 1309. Note: in Japan they use numbers and not letters for their stock symbols.

The ETF was launched on October 23rd and rose the limit on the first day. It has attracted inflows of about 11 billion yen ($100 million) a week since it was launched. That was net new cash into Shanghai stocks or through derivatives that ended up in Shanghai stocks.

A key question we raised here is about the prospect of Japanese money flows into Chinese markets. This reallocation of assets is potentially huge. Japanese households are holding over 50% of their financial assets in bank and postal deposits. This was rational for them as long as they had deflation. Remember: the buying power of a zero interest rate deposit is rising when the price level is falling. Thus a Japanese investor added wealth by sitting in a zero interest rate cash account.

That is changing in Japan and now these investors will seek alternatives. China is a big one for them. With dollar weakness persisting they are not as attracted to the US. And they understand the nature of a rapidly growing Asian market. They had a similar experience within the last generation.

Japanese investors think there is some time before the China bubble implodes. That means they are an additional potential funding source for this rising China market. We need to watch Japan’s investment flows very carefully for guidance about how to proceed as US based investors.

More thoughts on Shanghai itself.

This 19 million people city is an extraordinary boom town. A night cruise on the Huang Pu River reveals it. Near the shoreline are the illuminated facades of last century and the colonial era. A beauty is the original 1921 building of the Hong Kong Shanghai Bank Corporation (HSBC in today’s world). Behind these edifices stand the skyline of a modern miracle. You think you are seeing a science fiction movie. There are 2900 buildings in this city over 20 stories tall. The architectural eye candy is bewildering. And construction cranes are everywhere.

The TV tower (a space odyssey) dominates a section where a refinery was once was planned. In 1993 the Chinese government wouldn’t let the refinery developers sell any of their production for domestic consumption. They required that everything be exported. Fortunately for the present city, the developers pulled out and left the undeveloped swamp. Now it is a megalopolis.

We could write for another hour but must stop now and watch the sunset colors bathe Yellow Mountain. We will be back in Shanghai tomorrow and then to Hong Kong for a client meeting and a visit with some bankers and investors. We fly 14 hours to Newark on Thursday and drag our jetlagged body to our desk on Friday.


Hong Kong and Clarence Wong, November 13, 2007

I came to this computer from the “Fish Bar” restaurant on the 7th floor terrace of Hong Kong’s JW Marriott. Dinner was amid and surrounded by Hong Kong’s tall buildings and bright lights. Manager Clarence Wong is a gracious host; tell him I sent you.

6 sweet and succulent oysters (Belons from Australia) and a glass of White Haven (New Zealand) sauvignon blanc were followed by a good old fashioned American style cheeseburger (with yummy, crisp Yankee Doodle fries) washed down by a glass of Chilean Montes Alpha syrah. The latter wine is an old friend; the former, a new one and sure to be repeated if my American wine importer can get it).

The burger was delicious following a week of chop stick cuisine. I love Chinese food but really needed this respite and this globally assembled meal.

In this wonderful interconnected world, HK leaps out at you from the moment you ride across the new bridge while transiting between airport and city center. The city boils and sizzles with life among its 7 million sardinized citizens. Proximate living didn’t dampen the spirit here.

From this vantage point Hong Kong sits in the center of the Asian whirlwind. Will this last? Will the China miracle persist? What about the weak dollar?

We don’t like what we see in some of the world’s central banks.

China is fighting food price inflation by raising bank reserve requirements. Sorry, folks. That won’t work. The Beijing bosses fear civil unrest with good reason. Last weekend a Carrefour store offered a discount on cooking oil. The lines formed starting at 4 AM. When the door opened at 8, a stampede ensued; three people were killed; 31 injured. This time the Chinese press carried the story. They are learning that the internet has suppressed censorship. It also enables mobilizers of demonstrations.

But the Peoples Bank of China will not lower food prices with higher interest rates or larger bank reserve requirements. They need citizens’ incomes to rise so that growing numbers can get into a higher than subsistence standard. You don’t do that by trying to stifle growth.

In the rest of the world the central banks are fretting about the dollar. In Europe the European Central Bank (ECB) will talk about the currency but will allow the marketplace to function.

In the US the Treasury Secretary will talk about the US strong dollar and everyone else will laugh. Fortunately the Fed has not responded by raising interest rates. It cannot and should not and must not do so. The Fed is rightfully worried about a weakening US economy and a housing crisis. It probably will cut rates again.

The Bank of England has their hands full with the run on a bank and its aftermath and inflation above limits such that they cannot cut rates easily. BOE is between a Northern Rock and a hard place.

Japan is going to resist a yen breaking through 110. Hence Japanese rate increases are now on hold for a while. As soon as markets come to terms with this elongated Japanese policy the yen carry trade positioning will resume. This source of global leverage has not ended.

Other central banks are resisting the appreciation of their currencies by doing the dumbest of things. Columbia imposed a penalty on those who brought foreign inflows into their country. They wanted to stem the rise of their currency against the dollar. Instead they socked their own stock market as trading volume declined by 27%. India suffered a loss when it imposed controls. History is replete with examples of failure when controls are used instead of allowing market adjustments.

Alan Greenspan used rate hikes in 1987 to defend the dollar and triggered the stock market crash. That is when America learned its lesson. Ben Bernanke will not repeat it. Foreigners should pay attention.

Global investors now need to be attentive to central bank and foreign government actions that impose controls and restrictions. Interest rates are not the only tool. This is an alternate to raising rates to defend a currency. The fact is that neither of these approaches will work. The loser is always the country that erects the barriers or imposes the higher costs instead of allowing the foreign exchange markets to adjust.

Monetary policy has two structures. The first is managing the tradeoff between inflation and growth. When growth is solid, the central bank fights inflation. When growth is weak, it first must address the weakness. If it persists in fighting inflation, it does so at its peril.

The other trade off is between functioning markets and moral hazard. When markets are clearing and liquid, the central bank can worry about the gambling instinct that encourages folks to ignore risks (the definition of moral hazard). When markets aren’t functioning the central bank must first get them liquid and orderly again.

In the US the Fed is dealing with only partially functioning markets. And it has a weakening economy. That is why Fed policy will remain easy regardless of the US dollar and foreign exchange rates. Other countries will be best served to leave this alone and allow their currencies to adjust.

It’s 10 o’clock in Hong Kong and time for me to get some sleep. Tomorrow we will intersperse meetings with a ferry ride to Kowloon and a trip up the tram for a peek from the peak.

A Strategy Change at Cumberland

Before we leave for Dublin in a few hours we want to report making some major strategy changes. These were done during the last two weeks. Cumberland clients will see them in their reports. Here are the bullets:

We have instituted a cash reserve in the US managed accounts. The target is 10% with a variance of 2% depending on the separate account size and special needs. This is a change from a fully invested position. We had been fully invested in the US markets for many months. Some accounts have higher cash reserves now because we are taking our time in redeploying monies into the stock market.

We have instituted a cash reserve in international accounts. The target is 5% with variance depending on account size and special needs. We still like the global mature markets and the emerging markets but wish to put some profits in the bank. The bias is toward higher cash and slow redeployment just as in the US domestic accounts.

We have taken the energy weight to market weight or a little under. This is a major change from a very heavy over weight position. We have had substantial profits from our four year over weight in energy and wish to put some of those profits in the bank. Furthermore, we believe that the oil and gasoline sector are now discounting a mountain of bad news and risks. True there could be a major event ahead (hurricane or war) but also true that the market now has a huge fear risk premium which may subside. We see a lower oil price in the fall and not a higher one.

Total return bond targets remain at market neutral or shorter duration when compared with benchmarks. We have been in this mode for a while and it has certainly helped the account’s performance.

Many reasons are behind these changes and we will be discussing them over the next month or two. We wanted to get the trading done first.

We will only address one reason now. That one is the change in interest rates.

The world’s central banks are all raising rates or are on hold. Not one of them is cutting rates. Higher rates mean the discounting mechanism for stocks is under pressure. Higher rates also mean that pressure is building on credit and banking and financials. We are coming off a period of very narrow credit spreads. They have stopped narrowing and some are widening.

We also see shorter term interest rate indicators worsening Look at the TED spread as an example for those who have done the professional work on it and understand it. Also look at the TIPS-nominal spread and note how the real interest rate is rising around the world and particularly in the US.

Higher real rates may provide a future opportunity for us to lengthen bond maturities. It is too soon to do it now. We are getting ready to do that and are building a cash reserve in bond accounts for that purpose. When risk less cash earns 5%, all other investments must compete against it on a risk adjusted return basis to warrant deploying money in them. Right now that is tough test for some of them to pass.

Ok. We are off to Dublin for the GIC conference. There are 12 seats left at this very informative meeting. Anyone who can get there on short notice or any of European readers is most welcome while there is still room. To register call 215-898-9453; the speaker’s line up are below.

While I am away, you can reach the following colleagues to discuss the strategy change and your portfolios. Use our 800-257-7013 or email to reach Peter Demirali at extension 322, Matt Forester at 313, John Mousseau at 307, Carol Mulcahy at 316, Terri Pantalione at 315 or Bill Witherell at 338.

I will have black berry for email in Ireland. The Dublin program follows:

Global Interdependence Center (GIC)

GIC Abroad in Ireland

in partnership with the Central Bank & Financial Services Authority of Ireland

and the Irish American Business Chamber and Network

11 – 12 June, 2007

CONFERENCE VENUE: Morrison Hotel, Lower Ormand Quay, Dublin 1

Monday, 11 June

08:30 – 09:00

Registration / Coffee and Tea Service

09:00 – 09:15

Conference Welcome

by David Kotok, GIC Program Chair

09:15 – 11:45 (coffee break from 10:15 – 10:30)

“Monetary Policy Perspectives”

A panel discussion moderated by

Kathleen Hays, Anchor & Journalist, Bloomberg TV

Speakers include:

John Hurley, Governor of the Central Bank & Financial Services Authority of Ireland

Sandra Pianalto, President and CEO, Federal Reserve Bank of Cleveland

Charles Goodhart, Financial Markets Group, London School of Economics Professor Emeritus; former member of Bank of England’s Monetary Policy Group

Presentations and panel discussion followed by a question and answer period

11:45 – 12:30

“How the Financial Press Decides What Makes Economic News”

Address by Constance Mitchell Ford, Economics Editor, The Wall Street Journal

Presentation followed by a question and answer period

12:30 – 13:15


13:30 – 15:00

“Global Investment Strategies – ‘Traditional’ … ”

A panel discussion moderated by J. Paul Horne, Independent International Market Economist, previously of Smith Barney/Citigroup in London

Speakers include:

Paul F. O’Brien, Executive Director, Fixed Income Portfolio Manager
“Traditional Investing – Stocks, Bonds and Allocation”

Bill Clark, Director, State of New Jersey Division of Investments
“Global Asset Allocation of a Large Institution”

Martin Barnes, Managing Editor, The Bank Credit Analyst
“Global Stock Markets, Valuation and Outlook”

Presentations and panel discussion followed by a question and answer period

15:15 – 16:45

“Global Investment Strategies – ‘Exotics’ – New Investment Options … ”

A panel discussion moderated by Robert Eisenbeis, retired Executive Vice-President and Director of Research at the Federal Reserve Bank of Atlanta. Speakers include:

Ralph Segreti, Director, Global Inflation-Linked Product Manager Barclays Capital, “Inflation as an Asset Class”
Mike Buttner, Managing Director/CEO Wachovia Bank International
“Derivatives, Notional Value Exposure, Policing Collateral and Safety Issues for Financial Systems”

Howard Simons, Strategist, Bianco Research LLC
“Yen Carry Trade and its Impact on Global Financial Markets”

Presentations and panel discussion followed by a question and answer period

16:45 – 18:15 Reception at the Morrison Hotel sponsored by

Tuesday, 12 June

09:00 – 09:15

Welcome and introduction by William J. McLaughlin, President of the Irish American Business Chamber and Network

09:15 – 12:30 (coffee break from 10:30 – 10:45)

“Ireland’s Economic Development and Convergence” A panel discussion moderated by Tom O’ Connell, Assistant Director General, Economic Policy, Central Bank of Ireland. Speakers include:

Sean Dorgan, CEO, IDA, Ireland
Patrick Honohan, Professor of International Financial Economics and Development, Trinity College, Dublin
John Moloney, Group Managing Director, Glanbia plc
Mike Ryan, CEO, Merrill Lynch International Bank Ltd.
Presentations and panel discussion followed by a question and answer period

Closing Remarks by John Hurley, Governor of the Central Bank & Financial Services Authority of Ireland

12:45 – 14:00


18:30 – 20:30

Reception hosted by US Embassy in Ireland Deputy Chief of Mission Jonathan S. Benton at 7 Mespil Road, Ballsbridge, Dublin 4

The “Bubble” in Shanghai!

The world is watching a stock market bubble in Shanghai. Here are some bubble bullets; then, we’ll comment on the risk with Chinese “A” shares.

When stock markets are rising quickly and the curve turns parabolic, emotion takes over and valuation no longer drives pricing. Using valuation techniques is irrelevant in decision making during bubbles.
No one can forecast where the bubble ends. Upside price targets are meaningless.
The outside limits of bubble pricing can be astounding. History offers the Tulip Mania centuries ago as an example. For a treatise on bubbles read “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay originally published in 1841. My edition has a valuable foreword written by Bernard Baruch in 1932.
Bubbles do not “pop” in isolation. All bubbles have some ripple effect. The outcome is not predictable prior to the “pop.”
Bubbles come in all sizes and in all asset classes, not just stocks. Remember the Florida land boom and bust early last century or the Florida condo speculation now starting to unwind. Or you may recall the silver futures bubble a few decades ago.
In the US stock markets, we’ve had a bubble in bowling alley stocks. Anyone remember American Machine and Foundry and Brunswick? And in casino stocks for those who remember Resorts and Bally’s? And of course, we had the tech stock bubble 7 and 8 years go. Note that each of these started in a sector and then spread beyond the sector to other assets classes and to the general economy. That is the nature of a bubble; it is the contagion or spreading which makes bubbles dangerous.
We are in a bubble period on the Shanghai and Shenzhen exchanges. The Shanghai index is up almost fourfold from its bottom in 2006. In China there are a 100 million new investment accounts (gamblers?) playing the stock market for the first time. This occurs in the world’s 4th largest economy and at a time when economic growth is 10% per year. The Chinese “A” share market contributes about 10% of China’s capital; bank loans make up about 90%. (Data from BCA Research)

Chart patterns show the US based NASDAQ bubble and Japan’s Nikkei bubble of the late 1980s had curves similar to the current Shanghai Index. For perspective we note that the Chinese “A” Shares’ stock market capitalization exceeds 2 trillion US dollar equivalents. It is about half the size of Japan’s market and about one-fourth the size of the euro zone 13 countries.

Would a bubble “pop” hurt in China? Yes, of course, domestic Chinese investors would suffer losses. Would it sink the Chinese economy? No, unless there were a contagion. Jim Bianco rightly notes: “non-Chinese investors cannot own A-Shares, neither short selling nor derivatives trading by domestic Chinese investors is allowed.”

If the bubble “pops”, 100 million young and inexperienced investors may express their discontent with civil unrest. These folks have risked their savings and have no reference point for what they are doing and have done. The risk of a sell off in Shanghai is not just financial. It is in the political sphere. That is why it must be taken seriously.

At Cumberland, we are watching the Mainland China market closely and daily. It is a bubble in process. We do not for one minute assume that a “pop” can be contained in isolation.

Protection from a bubble requires diversification of risk. That is the soundest of principles. One needs to do that in all asset classes and all sectors and in diverse global markets. Broad diversification of risk means you cannot lose all at once. That is how one stays insulated in a bubble period. We do that by globally using exchange-traded funds (ETF). We combine them with fixed-income strategies and asset classes outside the traditional stock markets.

A second form of protection comes from the mobility. Highly liquid markets allow selling even when the markets are falling. But liquidity may disappear quickly so one should not assume that the liquidity today will be there tomorrow. Real estate, art, coins, metal in storage—none of these are liquid. That is why one needs to achieve a higher investment return when using those asset classes. The higher return is your compensation for taking the risk that liquidity may not be available if you need it. Non-believers may obtain corroborating evidence by asking Florida condo flippers about liquidity today.

This bubble in Mainland China is clearly intense. It involves the new Chinese investor class. So far, it is geographically contained which is why the Hong Kong exchange has not moved in parallel fashion. This bubble does present a risk because contagion effects may go beyond the “A” shares and cannot be forecast with any accuracy. Cumberland’s China exposure was more fully discussed on May 29th by Bill Witherell. See: .

There are strategies for bubble periods and we are applying them. Our US stock accounts have a little cash reserve being built. We have taken some of the profit from the energy position. Our non-US stock accounts remain fully invested and globally diversified. All equity account use ETFs. We are maintaining a neutral or shorter duration on bonds. Bond credit quality remains at the highest credit ratings.

We are soon off to Dublin for the GIC conference. Much of that discussion will focus on these types of risks and approaches to global investing. We will have more to report when we get back.

France is Still France

On May 6th Nicolas Sarkozy was elected by a wide margin to be President of France, decisively trouncing the Socialist candidate, Segolene Royal.  On May 16th.Sarkozy takes over from Jacques Chirac, who has been President for the past 12 years.  The 84% turnout reflected French voter’s strong desire for change.  They seek economic reforms.  Their present socialistic system has hampered France’s ability to match the dynamic performance of neighboring Germany and Britain. I lived for 28 years in France and often listened sympathetically to officials complaining about their frustrated efforts to undertake clearly needed reforms.  I can well understand the enthusiasm and sense of a fresh start for France generated by the Sarkozy victory.  The mandate for reform is clear.  But the election also served to underline the serious social divisions in France.

During the campaign, Sarkozy spelled out a clear reform agenda. Key elements include cutting taxes and social charges on overtime worked beyond the 35 hour week (stating that the French need to work more), scrapping the inheritance tax for all but the richest, setting 50% as the top rate on all personal taxation, introducing a single job contract with progressive rights, reforming unemployment benefits by linking them to active job-seeking, requiring democratic elections for union leaders, reforming the public sector employee pension system, tightening immigration rules and tightening up sentencing of repeat youth offenders. Recognizing that many past reform efforts floundered after public transportation strikes paralyzed the cities, Sarkozy has called for a guarantee of "minimum service" during future public transportation strikes. He has also taken on the student unions with his university reform ideas.  He has called for the "moral and intellectual relativism " heritage of the student revolt of May 1968 to be "liquidated."

This is a challenging program for reform. Reading through it suggests the opposition groups that will seek to derail these reforms.  At the forefront of the opposition, cheered on by the French intellectual elite, will be the public sector trade unions (controlled by the communist party) and other insiders protected by the present system.  They will be joined, ironically, by the real outsiders, those with the lowest incomes and highest unemployment rates, particularly the large black and Muslim minorities and other unemployed youth.  It is not surprising that the election results were followed quickly by the burning of some 730 cars (apparently the now well established means of showing discontent) and clashes with riot police in Paris and several other cities. In the following week students at Sorbonne University voted to blockade their campus.  A long, hot and turbulent summer appears to have started early in France.

An essential requirement for success with his reform agenda will be for Sarkozy’s UMP party to retain a healthy majority in the upcoming parliamentary elections on June 10th and 17th. Current polls suggest he will obtain this majority. If so, Sarkozy should be able to follow through with his announced intention to advance rapidly.  He intends to call parliament into extraordinary session this summer. 

However, we should not expect a Thatcher-like revolution to France’s over-protected system.  Reforms will be moderated not only by the need to overcome in one way or another the opponents to reform but also by the deeply ingrained French belief in the central role of the "State". France is still France.  French nationalism and protectionism have not disappeared.

Even Sarkozy, who is seeking  “revolutionary” changes in the French economic and social system in a move to more market-friendly domestic policies, evidently maintains his strong Gaullist roots.  He has called for "protection" for French citizens from the outside world and from globalization and suggested subsides for "national champions".  Finance Ministers across Europe soundly refuted his disturbing questioning of the political independence of the European Central Bank.  Hopefully, his protectionist statements during the campaign will not be translated into action. They clearly go against his stated desire to see the French economy recover its international competitiveness after years of underperformance.

On the international political front, American’s have welcomed the prospect of a French leader who clearly has a more positive attitude towards working with the U.S., a more positive attitude towards Israel, and a willingness to take a tough stance vis-à-vis Russia and Iran. Europeans welcome the arrival of a more active French President, but are concerned by his protectionist statements and inflexible attitude towards Turkey. No doubt, Sarkozy will seek to have France play a more prominent and effective role in Europe and on the global scene. This should be a welcome development.

We will comment again on the French scene following the June parliamentary elections.  By that time we should have a clearer indication of whether this promising first step towards a new more dynamic French economy will be followed by meaningful reforms.  In the meantime, we are maintaining a cautious underweight position in our International ETF portfolios with respect to France in comparison to our overweight for the strongly performing economy of Germany.


“Sell in May and go away” says the old Wall St. adage.  “Should you obey?” asks Paul Lim in his New York Times column (Pg. 5, Sunday Money Section, April 22, 2007).

Paul Lim noted how the S & P 500 averaged a meager 1.6% for all the May-October periods since 1945.  And he also noted how the average for the other part of the year was an impressive 7.1%. 

The broad statistics about summer seasonal market weakness argue for selling.   The case becomes even more compelling when you add to those numbers the fact that the worst market months of September and October are included within that half year period.  On the other hand, the traditionally strong summer rally months of July and August are a mitigating factor.   So where does that leave us?

We have examined this traditional seasonal message with an added dimension.  We incorporated a review of the Federal Reserve’s policy actions.  We looked at what the Fed did and not what they said.  If they raised rates, they were tightening.  If they held them unchanged, they were neutral.  If they lowered rates, they were easing.   We examined the deeds and not the words.   

The Fed’s actions alter the old adage.  New rules should read that if the Fed is tightening, you should sell in May and run for the hills.   The weak May-October seasonal period has been particularly painful for stock investors when the Fed was raising rates.

When the Fed is easing in the summer seasonal period, you can ignore the negative seasonality.  Other factors may influence the markets in either direction but an easing Fed seems to remove any negative influence that would cause you to “sell in May.”

What about a neutral Fed.  That is what we currently seem to face?   Here the history is mixed which means there is no compelling case in either direction.  But there is one small factor to consider.

During most of the post World War Two period, the intentions of the Fed were mysterious and opaque.  Often the Fed’s policy changes were not discerned until transactions were observed by “Fed Watchers.”  The Fed did not issue guidance nor did they stress transparency.   That has become different in the Greenspan-Bernanke era. 

Also different is the development of an active Fed Funds futures market.  This element is offering a market based pricing of the market’s expectation for the Federal Funds Rate, the instrument of Federal Reserve policy.  Thus we have to alter the seasonal rules again.

We would now say to “sell in May” if the Fed Funds futures market was demonstrating an expectation that the Fed was going to hike in the future.  This is currently not the case. 

We would put some weight on the Fed’s statement but only some.  We are much more influenced by the market’s pricing mechanism, where investors are betting real money on an outcome, than we are by the words emanating from the FOMC after each meeting.

Our conclusion is that the seasonal factors are not as threatening this year as they are in other years.   Fed Funds futures are still suggesting the next Fed policy change is a cut in rates.  As long as the market expects the Fed to cut, the pressure on the stock market will be mitigated by an outlook for some relief from present interest rate policy.  If that changes, we would then consider the old adage more seriously.

Cumberland’s accounts are fully invested worldwide using exchange-traded funds (ETF).  Our bond accounts are targeted on a neutral duration to their benchmarks.  We are still over weighted the energy sector and are going into our fourth year in that mode.  It is not too late to add an energy position if you haven’t already filled your appetite.   

We are very nervous about the world’s geopolitical situation.  Recent events in Pakistan, Nigeria, Ethiopia and the Middle East only intensify that concern.  The geopolitical situation today does not suggest immediate selling but it does suggest heightened vigilance.  We are constantly on alert for any event which would cause us to raise cash and change strategy. 

Sadly we must note that there seems to be an oppressive and murderous element at work in the world.  This is true in a university here as it is in the Shia-Sunni civil war in Iraq and elsewhere.  We wonder if the 21st century has added a component that has more reverence for death than for life.  Such is the profound question of our times.  Dealing with this threat is the dominant challenge for those of us who enjoy the great freedoms of the United States and the western world.


The Elephant and the Dragon – A Tale of Two Markets

The Indian and Chinese economies have both been growing at exceptional rates in the range of 9-11 percent per annum. Their equity markets have registered huge gains. India’s SENSEX index for the Bombay market rose 48.5% last year and the iShares FTSE/Xinhua China 25 (FXI).for major Chinese companies listed on the Hong Kong Stock Exchange advanced by more than 84%. Commentators have expressed concerns about possible overheating in both countries. However, we see some significant differences between the two situations. These have led us to follow a differentiated investment strategy, underweighting India while overweighting China in our Emerging Market Portfolios. Our January 22, 2007, Commentary explained our positive strategy and approach for investing in China. Below we discuss why we are taking different approach towards India’s equity markets.

After decades of under-performance, economic reforms are resulting in India being well on its way to becoming the third largest economy in the world, overtaking Japan, if measured by purchasing power parity. This is a remarkable achievement, what the Financial Times has called India’s “long-awaited coming-out party”; but warning signs are now flashing that the economy is in risk of significantly overheating. The lead article in the February 3, 2007, issue of The Economist, “India Overheats” outlines the growing concerns.

With growth advancing at the most rapid pace in 18 years, the economy is encountering various capacity constraints and infrastructure bottlenecks. Despite the market-opening reforms undertaken since 1991, excessive government regulations, including rigid labor laws, still remain a heavy burden on the private sector. According to a recent survey, essentially all firms (99%!) consider that they are operating above optimal rates. Another indication of the excess of domestic demand over supply is India’s current account deficit. It was equal to 2.3% of GDP last year and is projected to grow to almost 4% of GDP by 2008. The contrast with China’s current account surplus of 9.1% of GDP last year is striking.

India’s infrastructure (roads, rails, ports, power) is sorely inadequate. There are serious shortcomings in basic health care and the provision of drinking water. Skilled labor is in short supply due to shortfalls in both basic and secondary education. A stunning statistic is the illiteracy rate for women of about 50% (in China the ratio is one in seven).

Boosting supply by attacking the above problems is a priority for the government but will take time. The current weak budget situation will be a constraint. The Prime Minister, Manmohan Singh, is an economic reformer, but his coalition government includes the communist parties which resist many of the needed reforms.

It is, therefore, not surprising that prices in India are now advancing at a disturbing pace. Wages and property prices are soaring. India’s wholesale price inflation jumped 6.73 per cent in the 12 months to February 3. This is more than twice China’s inflation rate which is well below 3%. India’s inflation is now running significantly above the Reserve Bank of India’s “comfort zone” of 5-5.5 per cent. The RBI has been rather timid in tapping on the brakes to cool domestic demand and now finds itself distinctly behind the curve. Credit growth at an annual pace of some 30%, twice the rate in China, is feeding this inflation.

The spectacular growth of the Indian economy is threatened by these alarming signs of overheating and emerging asset price bubbles. While India’s equity prices in 2006 advanced by “only” 48.5%, they have risen over 400% over the past 4 years. Portfolio investors, sensing that India’s markets have gotten ahead of themselves and that a correction is overdue, have become increasingly wary. The SENSEX declined 5.4% during the week of February 19, and is down 1.1% so far this year. Further moves by the government to curb inflation could be the trigger for a more substantial adjustment.

We share the concerns about the apparent current overbought situation in India’s equity markets and the overheating of the economy. We anticipate that the current decline in Indian stock prices has further to go. But we also consider the medium to long term prospects for the Indian economy to be good. The second largest and second fastest growing emerging market economy belongs in emerging markets equity portfolios. We are maintaining our underweight India position in Cumberland’s managed Emerging Market ETF Portfolio for the time being. We would view a significant downward market adjustment as a buying opportunity and would consider then moving up to a neutral or even an overweight position for India.

Investing in China via Hong Kong – Riding the Dragon with Less Risk