A Brief Look at the World—China, the US, Europe and the Lake Forest Investment Society

I am heading out to Chicago for one of the triannual meetings of the Lake Forest Investment Society.  We have been meeting three times a year (yes, triannual can mean three times a year) for many years to talk about the economy and the markets, including providing some specific stocks for a “portfolio.” The best performing security for the period between meetings gets its touter a free lunch. The portfolio, an unaudited, equally weighted hodge-podge of names is actually up  427% vs. the S&P at 130% over the 16 years this group has been meeting.  The Society originated as a group of ex-Mitchell Hutchins employees and some of their favorite clients who wanted an excuse to share some provocative ideas on stocks, the economy, the world and life, eat high cholesterol meals, and maybe play a little golf. Some of the members and their origins have changed over the years, but the dialogue continues. The following are some thoughts I expect to share at the meeting:

China’s Role

This global deficit crisis won’t really be resolved until China enters the picture. China needs an export market to provide sufficient jobs while it tries to move to a consumer economy. It cannot find itself with a slow-growth economy if it wants to avoid political disruption, particularly at a time of leadership change. The developed world, both the US and Europe, needs to be showing some growth in order to be consumers of Chinese goods. With new leadership coming in 2012 there is an opportunity for China to provide some form of quantitative easing through the purchase of longer-dated securities or other mechanisms.  This could be combined with the purchase of real assets and intellectual property as well in both the US and Europe. Until we see some movement by China, the developed world markets will face continued uncertainty, as the resources available to resolve the European crises, specifically, are just not adequate. However, I doubt China will move until both Europe and the US take stronger steps on their own to develop long-term deficit solutions and near-term stimuli.

The US’s Role

Contrary to what has been a continual reduction in GDP forecasts and increasing odds of a double dip by the pundits, I think the US could show decent growth in the second half of this year—not enough to create a lot of jobs, but decent. This does assume that the Super Committee or some variation thereof comes out with a long-term deficit reduction program combined with some near-term stimulus, and Congress actually supports this effort. I think the odds are greater than 60% that they will. This doesn’t necessarily provide a boost for the second half of the year, but it clears the air for next year and eliminates some elements of uncertainty in the minds of business and investors. My guess is we could have one more horrendous scare, probably coming out of Europe, before the world comes to its senses and responds to what could be a real crisis otherwise. What needs to happen long term is a whole ‘nother post, but one could read Friedman’ and Mandelbaum’s new book, “That Used to be Us,” to get a sense of some of what has to happen.

Europe

What a mess. It does not appear that the mechanisms exist to deal with the Greek deficits without putting the European banking system and maybe some other financial entities at grave capital risk. Whatever does come out of Europe as a solution—and I think it will take the Chinese to at least have the appearance of a solution—growth will be slow, as the European banks will not be in a position to lend for some time.  This is an opportunity for the Chinese probably to the detriment of the US, if they choose to pursue it.  China bashing in the US will likely drive China closer to Europe. China can also be more specific in its actions by dealing with individual countries and companies as opposed to the Union.

Other Topics

In spite of what most of the Republican primary candidates say—Jon Huntsman excluded–climate change is happening. We have no coherent policies in place and what was previously there is slowly being dismantled in Congress and by the Administration. Fiscally, we don’t seem to believe we have the resources to tackle this issue now, in spite of the long-term job creation possibilities.  And, the fascination with “fracking” and what that could do for energy independence is in the forefront with massive resources from the energy industry devoted to selling the story. In the meantime the failure of an over-funded science project, Solyndra, has raised issues about government involvement in clean tech.  These are their own topics, which I will deal with separately in other posts. In the meantime, back to the LFIS meeting, I will have a hard time coming up with a good stock idea. My personal portfolio is in cash and private illiquid companies. My compatriots will have some very interesting ideas, particularly at this moment in the market. I am not so sure the public market is as cheap as many opportunities in the private market today, particularly away from some of the frenzy around social media and other Internet related companies. Maybe one more crack in the public markets will get it there if it is combined with some stimulus in response.  In the meantime, real private companies are having a hard time finding funds from the traditional venture capital sources. We appear to be going back to the original sources of capital for venture companies, rich families either in the form of family offices or direct.  They can name their prices.  We are back to the old maxim that one makes the most money on a good price going in vs. the price going out.

Risk and Opportunity

Mother Nature, the Economy, Intellectual Property & Innovation, Strategic Risk and Private Equity 

The first quarter of 2011 was rather tumultuous to say the least, and we are entering the second quarter with very little of that turbulence fully calmed and the human toll and uncertainty continuing to rise. This has heightened concerns about specific Risks and, more generally, the global economy…  Continue reading the text version →

Or fast forward to the Q&A session in the video below.

China and the Economy, China and Innovation, China and Climate Change

The extra emphasis on China in the media culminates this week with the US visit by President Hu Jintao. Much has been written about the visit and much posturing has taken place to set a “proper” tone. It’s hard not to comment on some of what has been said before hitting on the important topics of Innovation and Climate Change.

Economy. Let’s start with the currency. I don’t quite get all the noise about China needing to increase the value of the Yuan relative to the dollar. Secretary Geithner says it will help them control their inflation and will be “fairer,” whatever that means. The prices of Chinese goods are already going up which is a result of wages rising and productivity, particularly in low value goods, not offsetting labor costs. A rise in the value of the Yuan would increase prices more and would also increase the buying power of the poorer segments of the Chinese population while doing just the opposite for that segment in the developed world.  It would have the effect of creating jobs outside of China—not in the US, but in Mexico, Vietnam and other countries that will have a labor cost advantage relative to China. The rate of inflation would likely fall in China, but, of course, it would rise in the developed world. The short-term effect on the relative trade balance would be negative for the US, as it would take time for US corporations to shift purchasing to other countries. Plus, commodity prices, particularly oil, would likely rise in dollar terms, increasing our trade deficit in energy. Anyone who really expects that such an action would create jobs or a significant enough cost advantage to stimulate US exports or US buying of US goods vs. creating exports for other low cost countries isn’t looking at what China exports and imports vs. what the US makes. Odds are the media and our wonderful congress will spend more time on the currency issues than anything else. I think President Hu is here to go shopping. By that I mean putting China in a position to buy US assets that will be of value to its growth plans, primarily access to technologies that can allow it to meet its objectives of being a leader in innovation over the next several decades. The tradeoff will likely be further access to Chinese companies and markets by the US.  I reach this conclusion from a thorough read of China’s Patent Policy put forth this past fall.

Innovation. China’s National Patent Development Strategy (2011-2020) is a scary read. China sets very high targets for patent filings over the next 5 years, dwarfing filings by the US and Japan (which already exceeds the US in patents in force). It establishes a budget for Patent services that could reach US$16 Billion annually at current exchange rates. It proposes to have ten model cities focused on utilizing the patent system and the incentives to create a vigorous intellectual property market. It will seek to acquire intellectual property from others. A couple of direct quotes from the Strategy are worth noting: “A large number of core patents will be acquired in some key fields of emerging industries and some key technological fields in traditional industries. …Encourage enterprises to acquire patent rights through innovation on the basis of digesting and absorbing imported patented technology. …Support and foster exports of patented technologies and increase the proportion of exported patent-intensive commodities and strengthen guidance on patent policies for enterprises in the process of overseas mergers and acquisitions.”  Implied in the budgets for patent services is a vigorous enforcement of patent rights. Once China has intellectual property rights (IPR) to defend, it will likely be one of the more aggressive enforcers of those rights. The number of patents in force today with their origin in the US and Japan are each almost 20 times those of China. When those numbers get closer to parity it may very well be the US that finds itself on the defensive for not respecting IPR.  This was last the case in the early days of the Industrial Revolution when the US was the upstart and more intellectual property resided in Europe, primarily the UK.

Climate Change.  China’s plans for Patent Development raise significant issues about where intellectual capital will ultimately reside. When it comes to capitalizing on two significant areas of expected (or should we say required) technological innovation and value over the next decades, China is explicit as to their importance:  “…Balance the relationship between the patent policies and some major public policies such as public health and climate change.” (My emphasis)  Others can hold forth on the health front. In the patent document and others, China continues to highlight Climate Change as a focus of its policies and its technological efforts. It is clear that China sees the requirement to respond to this threat as political as well as societal. We will ultimately be a buyer of what China and others produce unless we also look at what policies we can put in place to be competitive.  At the moment we have the intellectual leadership existing in a variety of our institutions. Shame on us if we let that leadership slip away.

What to Expect for the Economy and the Climate in 2011

2011 is shaping up to be an interesting year for the global and the US economies, and it could be an interesting year on the climate change front as well. In mid-December, 2010, it is the normal time for prognostications on the next calendar year by those who actually do the work and may know what they are talking about and those of us who read the work and make our less data-driven forecasts.  Indulge me while I put some of my thoughts about next year in print.  I think this is an important exercise for anyone to do.  It establishes a base line from which to look for and measure deviations from expectations. And it puts in place a discipline that I always suggested to analysts who worked with me: once one has developed a point of view, spend the time looking for disconfirming information. At the same time, one needs to step away from the data and do a little speculation, particularly when in the early stages of a change in direction and a possible change in the second derivative of an established trend. So here we go:

The Economy. I think next year could be surprisingly good in the US with the likelihood of us printing a 5% GDP quarter at some time during the year. The truth is the economy has been clicking along reasonably well in most areas excluding the construction industry. That industry, which at its peak can employ 10 million people, has always produced the amplitude on the downside and upside to our statistics on employment and overall GDP.  Without much lift there we are still starting to see employment numbers improve. The trade numbers, aided by a weaker dollar over the last year working its way into purchase decisions, will also add to GDP, even if the dollar does better than many expect over the next year. At the same time, we have just passed a very stimulative tax package, which puts money in wage earners’ pockets as well as corporate America, while quantitative easing continues. QE2 and the tax package probably represent the last of the stimulus efforts, which almost always are lagging indicators of economy. We do have some issues around several state budgets, but the responses by the new crop of governors could be surprising, maybe because they have to be.  One can almost sense a palpable shift now toward addressing the federal deficit with the Budget Commission’s recommendations producing some fundamental change. It may not all happen next year, but I suspect that before we are done, we will see some major changes in the tax law. I am looking forward to a 28% top rate on income and I will accept the other changes that get us there. Lots of details to observe along the way including what’s happening in the rest of the world, but if the US surprises, that may be enough.

The Climate. In spite of the cold December in populous areas of the Northern Hemisphere, 2010 may end up being the second or third warmest year globally since measurements began in 1880.  There are some indications that the changing weather patterns are themselves a product of long term anthropomorphic-driven climate change. Based on what took place in Copenhagen at the end of last year and what was just concluded in Cancun, there will be no concerted world-wide effort to do anything other than recognize that there is a problem requiring some movement away from a carbon-based global economy or simply adaptation to a warmer world. On the other hand I continue to be amazed at the innovation that is taking place globally to produce non-carbon or low carbon solutions to energy needs either through greater efficiency or truly new economic approaches. These include the transportation sector in most countries where mileage standards are much higher than in the US. These changes are driven by a desire for energy independence, economic innovation, or a response to the will of the people, even in China.  It is sad to see the limited response by the US which will ultimately result in much of the new technology being owned and controlled elsewhere. We should not be buying 9 million barrels of oil a day from other countries for many reasons well beyond the effect on the atmosphere.  And we don’t need to take on the cost and risk of additional carbon production domestically as a way to eliminate our trade imbalance, although natural gas is an interim step in the right direction. We do need to support the technology and innovation that can occur domestically to move us away from carbon and affect our trade balances as we export these solutions to others.

More to Come. There is much more to talk about on both the economy and the climate. Stay tuned.