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The Guiding Light of a Secular View Print E-mail


Charles Dickens “A Christmas Carol” is a wonderful story about the meaning of the holiday season. And it is so much more than that. The redemption of Ebenezer Scrooge lifts our spirits as we witness the human capacity for change and compassion. The visit of the “Ghost of Christmas Yet to Come” shows the old curmudgeon his unpleasant future if he does not change his ways. Scrooge begs the apparition,” answer me one question. Are these the shadows of things that Will be or are they shadows of things that May be?” In the end it is up to Scrooge to choose his path and write his life’s next chapter.


My faith in America is unwavering. In spite of out stumble our potential is unlimited. We must ask the same question that helped define the redemption of Ebenezer Scrooge. The ideas contained the final commentary of 2010 reflect the ongoing trends of the Global economy. Some of these trends are unsettling and beg our immediate conscious attention. These are not the shadows of what must be. We have a struggle ahead but we too are free to write our nation’s next chapter.   


“The Guiding Light of a Secular View”



Sound money management is driven over the long term by a “secular view” that encompasses expectations for markets, economic conditions and in today’s world, geopolitical developments. A secular view may span a decade or more and help keep portfolios pointed toward safety and a satisfactory balance of safety and reward. For ICM the economic, social and political themes that combine to form what we have referred to as the “Techno-Global Revolution” have provided the structure of our secular view for more than 5 years. It is through the looking glass of this secular view that we maintain perspective while observing the shorter term cyclical machinations of the American condition and assess the structural changes that alter our lives and investment opportunities.


Our guiding light, the Techno-Global Revolution consists of 13 Basic Themes (attached). In the final quarterly commentary of 2010 we will focus on four of those themes. First, “Economic power is shifting eastward on the globe”, second, “ US economic hegemony will be challenged”, third, “Monetary policy practices and benchmarks will be transformed by the revolution” and finally The Techno-Global Revolution will prove a great leveler of global standards of living.” Our secular view beckons us to see the global economic recovery as a three part puzzle. America , the Euro Zone and Emerging Markets are heading off in very different directions as 2011 begins. No player looms larger on the world stage nor portends greater gains in influence and power in coming decades than China .    


  “Sleeping on Sticks and Tasting Gall”



We can gain some insight into a culture through its folklore and axioms. In America we promote truth, hard work, perseverance and strength. George Washington is portrayed as a man of great physical prowess and integrity who could toss a silver coin the breadth of the Potomac and could not tell a lie regarding a certain cherry tree. Honest Abe told truths, split rails, enjoyed debate, studied by candle light and conquered adversity on his way to the White House. Our heroes and their stories reveal what we strive to become.


In feudal China some 2500 years ago, a time of relative peace known as the “Spring and Autumn” period was drawing to a close. In the decades that followed battles erupted across the country for property, power and wealth. One such struggle occurred in the land surrounding modern day Shanghai which laid the foundation for a tale that influences Chinese culture and stirs debate among diplomats and scholars in 2011.


The King of Yue



Goujian, the King of Yue unsuccessfully invaded his neighbor King Fuchai of Wu. Upon his capture Goujian’s life was spared. He became the personal servant of Fuchai. Goujian’s wife was put to work in the royal stables. He bore his years in captivity with grace and in time gained the respect of his captor, Fuchai, who allowed Goujian to return to Yue (despite the protestation of his advisors.) According to lore Goujian never forgot his humiliation at the hands of his captor. Goujian worked to regain his wealth and power in Yue yet he chose to sleep on a bed of brushwood and eat as a peasant. The former king hung a gall bladder on his wall and licked it every day, tasting bile to fuel his desire for retribution.


Goujian appeared loyal to Fuchai, all the while plotting his revenge. Over the course of a few years the state of Yue presented many gifts to Fuchai that at once feigned steadfast reverence and encouraged the King of Wu to take on unmanageable debt and extravagance. Goujian knew Fuchai to be an arrogant hedonist and thus indulged his most damaging desires. Fuchai built great palaces and squandered his kingdom’s wealth causing great hardship for his subjects. Goujian distracted his enemy with beautiful women while bribing his cabinet for secrets and depleting all of Wu’s grain supplies. In the decade following his return to Yue Goujian built a powerful army and accumulated great wealth largely at the expense of the debt ridden and declining state of Wu.


When Goujian was certain of his superiority he returned to Wu with a force of 50,000 warriors, putting King Fuchai and his advisors to the sword. The king’s obsession with revenge was the driving force behind his domestic and foreign policy maneuvers. Goujian proved as brutal in victory as he was deceptive in his preparations.


This narrative, known to so few Americans has served China as a source of inspiration throughout the 20th century, a turbulent time of geopolitical trauma and colonial humiliation. The parable of Goujian has been sealed within the Chinese culture for thousands of years, rarely if ever shared with outsiders. The fact that this story continues to resonate in the modern collective mind of a rising superpower leaves many to wonder about China ’s intentions. China has quietly been gaining economic and military strength as America weakens under the weight of extravagance and debt; all the while providing corporate knowledge and technology to the patient giant.



An Alternate Interpretation



Harvard scholar, Paul Cohen asserts in his text, “Speaking To History, The Story of King Goujian in Twentieth Century China ”, that there is an alternate interpretation of this parable for many Chinese. The professor argues that the King’s story is seen by most in modern China as one of perseverance and dedication.  Goujian, by the professor’s account is a story of self improvement and dedication not of revenge.


Nerds like me are free to bend our brains around the cultural significance of the parable. It’s a fun exercise but nowhere near as important as deciphering the intentions of an increasingly assertive China . Professor Cohen’s view is certainly more comforting than others, pointing to an age of global cooperation. But what if America is seen by China as a modern day Wu, weakened by the internal rot of arrogant hedonism, debt and corruption? Following the financial crisis a growing number of economists and politicians around the world see an ascending China eclipsing an America in decline.





Trading Places?



It is unlikely that the 10% per annum growth trajectory of China can be sustained indefinitely. It is also improbable that China can avoid experiencing the growing pains (social unrest, asset bubbles, boom and bust cycles and inflation) that have plagued other ascending global powers. But it appears definite that a more unsettled America will be adjusting to the realities of more influential global neighbors, and in particular, a more ambitious China .


Power Transition Theory



Will China and the US cooperate to mutual benefit as the rising global tide lifts most boats? China has certainly reaped the rewards of international trade, capital flows and shared technologies. It holds over $2.5 trillion in foreign-exchange reserves that finance its growing industries, infrastructure, military and education system. China is in the throws of a cultural and industrial revolution that is transforming it from the backward agricultural nation of Mao immersed in class warfare and brutality to a modern, more benign nation striving to master the intricacies of global finance and international business. This process will take decades. Why upset a system that serves China ’s goals so well, particularly when the task is far from complete?


But can a rising China star generate light but not heat? Can China and the US share the global stage in an evolving relationship of equals? History would argue that navigating this path will require expert diplomacy on the part of both. Those who fear conflict believe that China ’s increased economic and military clout will cause it to become impatient and assertive. America on the other hand will be slow to relinquish hegemonic leadership.


Power Transition Theory offers valuable insight. Rising powers satisfied with progress and place at the power tables are unlikely to challenge the world order. But when emerging nations feel that the system shaped and maintained by the incumbent powers is rigged against them they will demand what they believe is rightfully theirs.


The Double Wager



David Lampton, professor of Advanced International Studies at Johns Hopkins promotes the notion of the double wager. China will fall in line with the world order “betting that the rest of the world is eager for China ’s help and its markets and would allow it to grow richer and more powerful. America would not seek to prevent this rise, betting that prosperity would eventually turn China into one of the systems supporters.” In the hopeful words of Robert Zoellick, president of the World Bank, China could become a “responsible stakeholder” in the world order.


Strategic mistrust best describes the cool but mostly cordial relationship between the superpowers today. America looks for signs that China may back away from the double wager and grow increasingly militant while China is sensitive to moves by the US and its allies designed to curb its progress and influence.


Strategic mistrust does not subvert the idea that peace makes the most sense. It also does not prevent each side from protecting and advancing its national interests. The Chinese Politburo held special sessions in late 2003 and early 2004 to study the rise and fall of nations since the 1400s. China is keenly aware of its contemporary relationship with America and its allies. America knows that a powerful China will present many challenges but a disgruntled China would make a dangerous adversary.


No less a China expert than Henry Kissinger points out the difficulties facing what he calls the “co-evolution” of China and America, in the December 4th edition of the Economist, “It is not an issue of integrating a European-style nation-state, but a full fledged continental power,” “The DNA of both America and China could generate a growing adversarial relationship…Neither Washington nor Beijing has much practice in co-operative relations with equals. Yet their leaders have no more important task than to implement the truths that neither country will ever be able to dominate the other nor that conflict between them would exhaust their societies and undermine world peace.” In a recent interview with the Wall Street Journal Kissinger spoke of the need for greater long term planning to assure the successful co-operative economic evolution of China and America . Kissinger also remarked that the key issue that will foretell success or failure may lie in how the superpowers handle the inevitable emergency that is North Korea .






Global Capital Flows and The China Effect”



So kind readers, we have taken many a crooked route to get to the meat and potatoes of our economic and market commentary over the years. As 2011 gets underway our “secular view” draws our focus to China . Economic power is shifting east on the globe. China is becoming increasingly sophisticated in its investment style as it matures into a market force. China ’s $2.5 trillion foreign exchange reserve represents significant purchasing power that can influence the path of foreign economies and policies. ICM clients know well that China has been a big buyer of American Treasury and Agency debt. In 2008 and 2009 China bought $100 billion each year of US Government Securities. The financial crisis, sagging dollar and bloated US deficits have convinced the new money on the block to broaden its investment horizons. While China has hinted at diversifying its global investments before 2010 was a year when actions spoke loudly.



Power in Numbers



In 2010 China reduced it purchases of US Government Securities from $100 billion to $55 billion.( Markets have hardly reacted as Quantitative Easing has sopped the slack demand.) China ’s investment strategy has its roots in its 5 Year Plan dated 2001 and entitled “Go Global”. Simply put China planned to develop world class brands, diversify imports, expand exports, boost competitiveness and reduce low return currency reserves. China has been diversifying away from dollar assets and into hard asset purchases.

When the financial crisis shook the world’s economy most central governments put a freeze on foreign investing. In 2008 worldwide government capital investment flows slowed by 15% and in 2009 by 43%. While the western developed nations reeled from financial shock China enjoyed the buyer’s market. In 2008 China ’s capital investments doubled. China maintained the outsized pace of foreign investment in 2009 and added to it. China ’s investment objectives are tied to a long term strategy that integrates industrial, trade and currency considerations.


China knows that investments in commodities that feed its industrial expansion (and social metamorphosis) promise a greater return of future wealth and strength than pouring funds into low yield Treasuries redeemed in depreciated dollars. China also knows that it must strike a balance between feeding industrial growth and maintaining US consumption. The giant still needs American consumers to absorb its exports while it expands domestic consumption. China and the rest of the fast emerging countries of Asia will be competing for a shrinking commodities pie. Greater investments in hard assets will leave diminishing reserves for Treasuries as investors buy companies and resources. Of the approximately $8 trillion in foreign exchange reserves more than 60% is held by 11 Asian nations. Economic power has clearly shifted east.


The Next 5 Years



Beijing ’s new 5 Year Plan has a distinctly different focus from the export minded “Go Global” theme of a decade ago. The new vision of more sustainable growth through higher consumption, higher wages, less reliance on exports and more efficient energy consumption can move China closer to a balance in domestic production and consumption. Optimistic economists anticipate that China will exceed 350 million middle class households in the next 10 years. But as the Chinese consumer class grows the giant will see a reduced trade surplus and foreign exchange reserve balance. China’s need for American consumers to finance her build out through trade imbalance will diminish and so will China ’s appetite for Treasuries. As China seeks to decouple its economic development from the west America may feel the sting of higher borrowing costs. Increasing debt service costs represent one more reason for the US to implement a credible deficit reduction plan now.



China ’s Increasing Sphere of Influence



Commodity prices are sure to rise along with the number of Asian middle class families. Global commodity supplies are finite and demand increasing. We will likely experience scarcity, inflation and increased competition among nations for access to mines, oil fields, and other strategic resources. China is expanding aggressively around the globe.


When China ’s national oil conglomerate CNOOC tried to buy a controlling interest in Unocal in 2005 and faced opposition from congress she turned to riskier parts of the globe to secure her interests. Beijing proclaimed 2006 “The Year of Africa”. US investment in Africa plunged at the end of the Cold War. China has stepped in to the void but with a different approach. In addition to direct investment China offers cheap loans, infrastructure upgrades and export credits to prime the pumps of international commodity production. “In China , there are is no concept of a failed state. The Chinese way is to stoke the pace of development,” according to Jin Linbo of the China Institute of International Studies in Beijing . “If you are a typical (western) multinational, you do a one shot deal. China will build a port, a refinery. China is investing big time in what counts for Africa,” says V. Shanker the CEO for Middle East, Africa, Europe and the Americas for Standard Charter in London . 


China has constructed pipelines across Kazakhstan and Uzbekistan and mines copper in Afghanistan . China invests in iron ore in Sierra Leone, mines in South Africa, coal and gas in Australia, oil in Brazil and Venezuela and timber from Canada . China is gaining new economic allies while securing access to the precious commodities that will propel her to a leadership position in the world. China will challenge American hegemony as her investment and influence grows around the globe.




 Fed Policy is Flawed and Inefficient



Long time readers are familiar with ICM’s take on the Fed as an accomplice to the Financial Crisis. The institution has culpability in the housing bubble, the unchecked growth of the shadow banking system, failure to monitor bank lending standards and the capricious decision to allow Lehman to die while sparing Bear Sterns and AIG.


But the Fed is a victim of mission creep. The institution was intended to provide a safety buffer for the banking system after a near collapse in 1905. Its initial mandate grew to include promoting price stability and preserving the purchasing power of the dollar. The 95th Congress expanded the mandate in 1977 to include price stability, moderate long term interest rates and full employment. The addition of an employment directive politicized the roll of the Fed and set the stage for unintended consequences arising from globalization.


It’s clear that when the Fed becomes involved in the labor markets it tools are limited and very indirect. The Fed must manipulate either the cost or supply of money (or both) to spur speculative growth in lending, consumption, production and thus hiring. This less than virtuous cycle is both risky and inefficient policy. In cases where these monetary machinations have failed to produce the desired effect and the Fed has taken short rates to zero, the next step is quantitative easing. The direct purchase of securities with dollars hot off the printing presses scares many an economist inside and outside the confines of the Fed.


 In a global economy powerful companies are multinational and seek competitive advantage in the world’s cheapest and least regulated labor markets. In our previous two quarterly commentaries we stressed the number of jobs outsourced by American companies and the new job creation taking place in emerging nations. The Fed has taken great risks with its balance sheet and America ’s future pumping billions of cheap dollars into the economies of our strengthening competitors as it has attempted to meet its full employment mandate. Millions of jobs have been created by US based multinational companies outside of the United States . Low rates, increased money supply and Quantitative Easing will not address the structural labor issues facing America no matter how many dollars the Treasury prints, no matter how many bonds the Fed buys. Monetary policy practices and benchmarks will be transformed by the Techno-Global Revolution.



The Global Economy in 2011



The international cooperation and coordinated monetary and fiscal actions that followed the financial crisis has melted away. In the Euro-zone and the UK leaders have chosen a path of austerity to return to economic health. In America we have moved in a very different direction. We are choosing to fuel the stock market and consumption with the extension of tax cuts, negative real interest rates and other incentives that will add $300 billion to the $1.2 trillion deficit and the $14 trillion in outstanding national debt. While the Euro-zone and UK puts the brake to spending they increase risks of slower economic growth and reduced tax revenues. In America we push the day of reckoning further down the road and hope our creditors oblige our tempered approach to fiscal restraint. What happens when stimulus that subsidizes consumption peters out? America hopes that we will have primed the virtuous cycle where consumption spurs production to meet demand and that domestic job growth follows.


We have spoken and written often of the public to private handoff that occurred when speculative debtors and bankers and failing auto companies threatened world-wide depression. To preserve our financial system the bad debts of some became the responsibility of all. We socialized corporate risk while allowing private gain. Ironically we now witness a private sector where corporations sit on $1 trillion in cash reserves but fail to hire, banks use $800 billion in taxpayer money to repair balance sheets but fail to lend and Wall Street returns to its speculation and extravagant pay practices while contributing precious little to the reshaping of the American economy. The Federal government sits on a budget deficit that mirrors private sector and banking slush funds and state and local governments drown in debt and budget shortfalls. It is time for those who have reaped the rewards of government bailouts to invest in America ’s future rather than pocket profits gained on the tax payer’s dime. A very limited number of American consumers benefit from share buy backs or the further consolidation of wealth and power that emanates from mergers and acquisitions. Small businesses shut out of the low interest borrowing bonanza that is the corporate bond market need loans to prosper and create jobs. Wall Street lobbies to fight reforms and plots new derivatives that bury risk and reduce capital reserve requirements. Moral hazard thrives along with “too big to fail”. As we argue about the cost and nature of reforms and stimulation the fundamental causes of the crisis remain but fade from memory. That is a choice we make to our own detriment.


Stark Warnings from the UK and Middle East



Mervin King is Ben Bernanke’s counterpart at the Bank of England. King warned his countryman that they face the most dramatic squeeze in living standards since the 1920s. The UK ’s austerity measures have cut stimulus to its economy and the near term results are beginning to roll in. In the fourth quarter of 2010 the British economy began to contract. Wages are shrinking, inflation is rising and the Value Added Tax all combined to reduce take home pay by 12% in 2010, a trend expected to continue into 2011 and beyond. King shared the following, “The squeeze on living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.” The Governor of the Bank of England is trapped between the rock of inflation and the hard place of economic weakness. The Techno-Global Revolution will prove a great leveler of global standards of living. -


In striking contrast to the dire budget concerns of the US and threats of Euro-Zone defaults the Emerging Market nations of the world are barreling ahead. What the world’s creditors and producers fear most is inflation and asset bubbles driven by the easy money policies of the west. Over the next five years look for emerging markets to garner 50% of global economic growth while carrying only 13% of the world’s debt burden. Although this appears good news for the new money players it represents a failure to address the imbalances that create instability and could well foment the next bout of economic shocks. Never the less, America and the mature powers of Europe are mired in the aftermath of the financial crisis and Emerging Nations are positioned for growth in a very uncertain global arena.


We need look no further than Tunisia or Yemen, Jordan or Egypt to see the impact of poverty and inequality enforced by decades of repressive dictators and the fragile temperament of peace. The need for more balanced growth among all nations is clear. Globalization invites contagion of financial and political turbulence. An unintended consequence of the Revolution is the social networking capabilities that empower masses to organize in the face of repression and generate the power to reshape nations.


America must answer the clarion call. If we face the future with clear eyes and united determination we can navigate the world as it will be. The words of Einstein remind us, “We cannot solve our problems with the same thinking we used to create them.” Looking forward rather than back will give us and the next generation the tools needed to alter course and prosper as the Revolution rolls on.  


The US Bond Market Outlook



ICM’s fixed income strategy seeks return in the form of interest income and capital appreciation. We also have incorporated hedges against rising interest rates.


The Federal Reserve has continued to promote the view that short term rates will “remain exceptionally low for an extended period of time” and that it will continue with quantitative easing until jobs growth accelerates. With this in mind we are purchasing fixed coupon non-callable Treasuries, Agencies and corporate securities. Our goal is to “ride the yield curve” in the year to come capturing higher income and the potential of capital gain as securities move toward maturity.


Step-up Coupon Agency securities provide a hedge against a gradual increase in market interest rates due to improved growth prospects or investor demand for higher income to compensate for budgetary largess. We have carefully shopped for structured notes that meet our forecast for a potential gradual upslope in yields.


ICM has also incorporated LIBOR floaters in client portfolios. LIBOR indexed floaters also hedge against rising borrowing costs with one added kicker. Should Euro-zone finances deteriorate further and produce a negative impact on the Euro banking sector LIBOR may rise reflecting that increased risk, carrying returns on floaters higher.


The world economy is a hodgepodge of risks and opportunity. Safety of principal and conservative portfolio management continues to dominate ICM’s investment approach. The Techno-Global Revolution will continue to be our guiding light. The final chapters have yet to be written.