-->China Calling
The Daily Reckoning
Paris, France
Wednesday, 16 July 2003
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*** Budget deficit doubles since February...
*** As bonds fall, the housing bubble approaches a pin...
*** A green sarong and terrycloth slippers... and how to
have the best summer vacation ever...
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We are in the 32nd year of the Dollar Standard period, in
which dollars have replaced gold in the coffers of central
banks and the hearts of investors.
We are late in the period, we think.
"U.S. budget deficit put at $455 billion," says the
headline in today's Herald Tribune. Seems expenses -
notably the occupation of Iraq - have been running ahead of
income; the deficit is now 50% higher than February's
estimate, very near to our guess of $500 billion.
The cost of maintaining U.S. troops in Iraq has risen to
$4.6 billion a month, not to mention the soldiers who are
killed every day. The poor grunts have been left in a hot
and hostile place, where their only role seems to be to
help desert malcontents to improve their aim.
But that is not our subject for today. Today, we follow the
money and wonder how late in the Dollar Standard period we
really are.
When a study was made of how much the federal government is
likely to need to pay for all its promises, reduced by what
it is likely to collect in taxes, the calculation must have
sent sparks flying from the economists' computers. As it
turns out, the shortfall comes to $44 trillion... or about
half a million dollars per family.
That doesn't count the private debt in America - estimated
to be another quarter of a million per family.
There is also the trade deficit, which - at about $500
billion annually - deserves at least a dishonorable
mention. It is another animal altogether, of course, but
one which drinks from the same watering hole.
Now, imagine that you are the chief financial officer of
this enterprise... one that already has net debts and
liabilities far beyond its ability to pay. Even if the
entire world pitched in to help, debts of this magnitude
could never be honestly settled. And yet, the enterprise is
still living way above its means; every day, the federal
government spends about $1.5 billion more than it takes
in... and so do consumers!
Yet, Alan Greenspan is shown in today's paper with a smile
on his face, like a foolish poker player with a winning
hand. Mr. Greenspan knows he has an ace up his sleeve... or
rather, a printing press in the basement. He is prepared,
he told Congress, to keep rates low"as long as
necessary"... or even to cut them... in order to get the
economy moving. What else can he do? That is the only game
he knows... providing the world with trillions in dollar
credits. It is what made the players think Mr. Greenspan
wise... and themselves rich.
But it is a game that cannot go on forever. There is an
endgame to the Dollar Standard period. Bond investors
seemed to see it coming yesterday; they dumped bonds even
while Mr. Greenspan was talking. But gold investors saw
something different. They sold off gold, bringing the price
down $5.60. What did they see? Japan before Argentina? A
long period of falling prices and economic slump, before
the printing press money finally destroys itself?
Which of the players will be right? Those dumping
bonds... or those dumping gold? We can hardly wait to find
out...
Eric?
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Mr. Fry, checking in from the street of dreams...
- Stocks fell a little. Bonds fell a lot. The Dow dropped
48 points yesterday to 9,129 and the Nasdaq Composite
dipped 2 points to 1,753. Meanwhile, the bond market
crumbled. The 10-year Treasury note took a nosedive of 1
24/32 to yield 3.94 percent, while the 30-year government
bond cratered 2 25/32 to yield 4.95 percent.
- Bond investors rushed for the exits after Chairman
Greenspan remarked,"The FOMC stands ready to maintain a
highly accommodative stance of policy for as long as it
takes to achieve a return to satisfactory economic
performance." This Greenspan-speak, translated into
everyday English, means that the Fed will cut short-term
interest rates to the bone and print a limitless number of
dollars to insure that deflation does not take root in the
U.S. economy.
- Yesterday, bond investors rightfully imagined that the
Fed - while trying to combat deflation - might print one or
two dollars bills too many, thereby sowing the seeds of
inflation. And if a new inflationary trend were to sprout
from the U.S. economic soil, a 10-year bond yielding less
than 4% might not be the best asset to own.
- For the last several months, Chairman Greenspan has been
trudging through the undulating fields of interest rates,
swinging his monetary scythe back and forth across the
yield curve. He has felled interest rates of all varieties
like so many sheaves of wheat.
- In the process, investors learned to trust that low
interest rates would be a permanent feature of the monetary
landscape. They borrowed aggressively at low, short-term
rates and invested at higher, long-term rates (even when
the higher long-term rates weren't that high) because they
believed this yield-curve arbitrage to be a risk-free, Fed-
sanctioned trade.
- Default risk was the last thing on their minds. So they
conducted every form of interest-rate speculation known to
man - and to computer. But the problem with a permanent
license to print money is that it is never permanent.
- Interest rates sometimes rise and yield curves sometimes
"flatten out," such that short rates and long rates are
nearly equal. In fact, rates are rising now, which is very
bad news for the housing market, and for the stock market.
- Chairman Greenspan can crop the Fed funds rate to very
low levels, but he cannot prevent Treasury yields from
sprouting higher once again. Try as he might, interest
rates will go wherever they wish to go and, at the moment,
they wish to go higher... much, much higher. The yield on
the 10-year Treasury note has jumped nearly one full
percentage point since early June.
- We suspect, therefore, that the housing market will soon
feel the ill effects of rising interest rates. The housing
market will soon share the bond market's pain.
-"The housing bubble is drifting toward a sharp pin," says
Robert Tracy, lead analyst at Apogee Research."And that
pin is rising interest rates.
-"As for specific companies that will feel the pain of a
bursting housing bubble," Tracy continues,"the best
candidates are those who have ridden the housing bubble for
the past few years. Any company who underwrites, services,
holds or insures mortgages is vulnerable. Vulnerable
mortgage originators and those who service mortgage
include: Countrywide (CFC), Washington Mutual (WM),
Greenpoint (GPT). Mortgage insurers who will be hit hard
from a housing bust include Radian (RDN) and PMI Group
(PMI). Homebuilders like D.R. Horton Inc. (DHI), Lennar
Corp. Cl A (LEN) and Centex Corp. (CTX) will also feel the
pain of a housing bust.
-"But the carnage of a collapse will extend beyond the
obvious to companies like General Motors, which has seen
its own sizable mortgage operations. Other victims will
include all of the major investment banks, who have
generated hundreds of millions if not billions in fees
associated with securitizing mortgages. Even the giant
GSE's Fannie Mae and Freddie Mac could find themselves in
trouble as their flimsy equity balances (i.e. $17.9 billion
for FNM and $24.6 billion for FRE) may prove inadequate to
fully absorb a tidal wave of defaulted mortgages."
- Tracy could be wrong, of course. The housing market might
continue to flourish despite rising interest rates... But it
shouldn't. (More from Tracy in today's Daily Reckoning
guest essay below... )
See also:"The Economy: Place Your Bets"
http://www.dailyreckoning.com/body_headline.cfm?id=3311
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Bill Bonner, back in Paris...
*** Colleague Dan Denning told us what happened to him on
Bastille Day:"Well, you know it was terribly hot. I was in
my apartment, dressed in a t-shirt and a pair of boxer
shorts. Then, I heard the planes flying overhead, for the
celebration... so I just stepped out of my door for a second
to catch a glimpse of them. And, oh no... a gust of wind
slammed my door shut and I realized I had walked into the
kind of thing you have bad dreams about:
"I was locked out of my apartment in just a t-shirt and
undershorts... without a dime or a credit card... or
anything...
"What could I do? I knocked on some neighbors' doors... but
I don't know them... and they weren't home, anyway. I was
just hoping to borrow a pair of pants so I could walk over
to a friend's house. Then, I finally found someone
home... it was a young woman, also dressed in little more
than underwear...
"You know, my French is not very good, and there I was
standing at her door in my underwear trying to explain what
happened... But fortunately she didn't shut the door in my
face... and I eventually got my idea across. Naturally, she
didn't have any men's clothes... but she lent me a green
sarong and a pair of terry-cloth bath slippers. So I put
them on and walked across town to the office.
"You can imagine how people might giggle and stare at a man
walking down the street in a green sarong and bath
slippers... but here's the crazy thing; no one seemed to
notice. This is Paris, after all. I had to pass through the
gay section of town... and some guys even whistled.
"I didn't have a penny, but I persuaded a guy at an
internet café to let me send out a distress call... and
finally a friend of mine got the message and rescued me.
"The whole experience wasn't so bad. It was a little like
that flower-pot falling on your head: I met a very nice
neighbor... and I don't know... maybe that green sarong look
will catch on..."
*** While Europeans eagerly prepare to take vacation for
the whole month of August, Americans feel they must
apologize for every day they take off. Eric managed only a
few days at the beach. Other Americans take their holidays
furtively... sneaking off for a few days as if they were
playing hooky from school.
Now comes this email from our friends at Early to Rise,
explaining how work-obsessed Americans can still enjoy a
break:
How to Have the Best Summer Vacation Ever!
"You can get away from the office. You can travel. You can
even leave your laptop and cell phone behind. But you can't
make the work go away. It stays behind like a wretched
beast, waiting for your return, angry at your absence,
growling and whining and getting bigger and meaner and
harder to deal with each passing hour. By the time you get
back to the office, it will rip you to pieces and gobble
you up.
"Unless... you take precautions."
Here is a short list of the precautions they recommend for
enjoying a great vacation without getting behind in work:
"First and most important - treat your vacation like a
project...
"... Provide at least three weeks' advance notice to
everyone you are normally in contact with...
"... Two weeks before you leave, meet with all your key
subordinates and hand them a memo listing all their 'on-
vacation' responsibilities and important 'emergency' data.
Let them know that this is an opportunity to advance their
careers...
"... About a week before you leave, send a note to your boss
'reminding' him of your vacation and letting him know that
everything is under control, that you'll be checking in (if
you can check in), that you've left an emergency number
with someone (not with him), etc. Define 'emergency' in,
say, three degrees...
"... Between now and the day you leave, catch up on as much
important work as possible. Pay special attention to
projects with deadlines that are due while you are away...
"While you are on vacation, have your e-mail automatically
bounce back messages to senders with instructions on what
to do for 'emergencies'... And keep a notepad with you...
to write down the great ideas that will be flooding your
way while your brain gets a chance to relax..."
The editors of Early To Rise have prepared a 10-point guide
for the work-weary. If you accomplish each task on a
schedule (today if possible), they say, you will have a
stress-free summer holiday.
Sounds kind of nice, huh? For the complete list, see:
Early To Rise
http://www.earlytorise.com/sub/dailyreckoning.htm
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The Daily Reckoning PRESENTS: Another way to dial in
profits in China.
CHINA CALLING
By Robert Tracy
Did you ever meet a four-year old who would rather eat
broccoli than ice cream? Or an investor who would rather
buy a value stock than a"growth stock"? Value stocks are
the green vegetables of the investment world, and who wants
to eat those? Almost nobody wants to eat the stuff that's
"good for you"... the stuff that's bad for you is so much
more delectable.
The recent rally on Wall Street is a perfect case-in-point.
The shares of companies that are losing money are racking
up triple-digit gains, far outdistancing the blue chips.
But the short-term success of highly speculative stocks is
just that... short term. In the longer term, the tortoise-
like gains that companies of substance tend to produce are
much more rewarding for investors than the hare-like starts
and stops of speculative stocks.
Unfortunately, companies of substance are rare... and they
do not necessarily operate in the United States. China
Mobile (Hong Kong) Ltd., the world's largest mobile phone
operator (as measured by number of subscribers), is a
company that has captivated our attention lately. It is, we
believe, a company of substance with both a low valuation
and a promising growth profile.
During the company's latest quarter, it increased its
revenues, earnings and subscriber base. That's not too
shabby. The company also produced expanding EBITDA margins,
despite intensified competition in the Chinese
telecommunications market. Meanwhile, Moody's Investors
Service, citing CHL's improved business fundamentals, has
put the company's debt on review for a credit rating
upgrade.
We like China as an investment destination. Sure, the
massive Asian juggernaut struggles with various growing
pains. But at least the pains derive from a growing
economy, rather than a growing bureaucracy. China Mobile is
well-placed to benefit from the country's exciting long-
term growth profile. China Mobile's first-quarter revenues
rose 10% from a year before, reaching $4.55 billion, while
net earnings increased 9.7% to $1.08 billion. Subscriber
growth also continued its upward march. CHL has a whopping
127 million subscribers.
Over the past year, CHL's share price has been under
pressure, a trend we are at a loss to explain in light of
the company's continuing growth in earnings and free cash
flow. Furthermore, a few months ago, CHL began paying a
dividend that represents a 20% payout of earnings and a
2.2% dividend yield. The company also appears committed to
increasing the dividend payment in concert with growing
earnings. Yet, despite all the positive news, CHL shares
have not been a standout performer. At the current market
price, CHL trades for about 11 times trailing 12-month
earnings, 10 times 2003 estimated earnings and about 5
times enterprise value to EBITDA.
At least some of the recent weakness in China Mobile shares
can be attributed to worry about the economic effects of
the SARS epidemic in Asia. But what impact SARS will
eventually have on CHL's prospects is anybody's guess.
Certainly, if it turns out that SARS has substantially
reduced economic growth in China, CHL's subscriber growth
will also slow. But it is also possible that phone usage
will increase somewhat, as people seek to minimize face-to-
face meetings. Assuming the possibility of SARS becoming an
apocalyptic plague has been quelled, any near-term setbacks
will eventually be eclipsed by CHL's substantial long-term
growth prospects.
Another drag on CHL's share price, we think, may be
anecdotal reports of intensified competition in the Chinese
telecommunications market. It has long been anticipated
that competition would increase among China's main telecom
operators - China Mobile, China Unicom and China Telecom -
thereby putting the squeeze on prices. And, indeed, price
pressures have intensified over the past couple of years.
However, we think the market has overreacted to these
sporadic reports, and the apparent bottoming-out of CHL's
average-revenue-per-user (ARPU) numbers in the first
quarter confirms our suspicion that pricing pressure will
not be as brutal as some have forecast.
The slowing decline in ARPU is even more noteworthy
considering that most of CHL's subscriber growth continues
to come from low-usage/lower-revenue prepaid subscribers
rather than from higher-revenue-generating contract
subscribers. Contract subscribers, of course, pay a minimum
monthly fee while prepaid subscribers pay only for actual
usage. Because prepaid users generally use the prepaid plan
only so long as it's cheaper than a contract plan, they
tend to generate lower ARPU than contract customers do. And
since more of CHL's subscribers are choosing the prepaid
plan, a continuing decline in ARPU has been expected. As of
March 31, prepaid subscribers represented 60% of CHL's
total subscriber base, compared to 54% in March 2002 and
37% in March 2001.
China Mobile also said that average usage has increased to
209 minutes per user per month from 207 minutes in the
September 2002 quarter. Two minutes may not seem like a
substantial increase, until one realizes that CHL has over
120 million subscribers!
On April 16, Moody's Investors Service announced that it
was considering an upgrade in CHL's Baa2 senior unsecured
debt rating. Moody's pointed to CHL's proven business model
and strong performance as reasons for the review:"The
review reflects the strong progress that [China Mobile] has
achieved since the rating was assigned in 1999, both in
terms of building a strong business and maintaining a
healthy financial profile. It also reflects diminishing
forced acquisition risk."
In considering China Mobile for a ratings upgrade, Moody's
recently mentioned that China Mobile"has been able to
generate strong cash flows that have allowed it to fund its
expansion without a heavy reliance on debt funding. In
addition, the company is strategically important to the
economic development of [the People's Republic of China],
and is a significant source of tax revenue."
A"significant source" of revenue is something the Chinese
government would hate to lose, we suspect.
Accordingly, intensified competition and pricing pressure
that poses a threat to China Mobile's financial health
would probably be highly unpopular in government circles.
As such, we think investor fears that China will replay the
price wars that decimated the American and European telecom
experience are unfounded. To the contrary, China Mobile
looks well positioned to continue growing within the
rapidly growing Chinese economy.
Maybe it's time to eat your vegetables!
Sincerely,
Robert Tracy,
for The Daily Reckoning
Ed note. Robert Tracy is the lead analyst for Apogee
Research. While 37 Wall Street firms were saying"buy,"
Apogee said"sell!" The difference? A 152% gain. Who got it
right? Read on to get the whole story:
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