Monthly Archives: October 2015

Two-children policy and its market implication_Part 2

Some commentators argue that the new policy is negative for Chinese housing market in the near term. The argument goes like this:

  • As some families decide to have a second child, they are going to spend more on nappies, milk, education, etc, and hence we shall see a negative impact of this policy of the savings rate in the near term. And lower savings rate results in lower housing demand.
  • Having more children means lower demographic dividend in the short term (demographic dividend is a vague statistical concept, though I assume in this context it is measured by working-age population as a share of total population), which again lowers structural demand for housing.

As mentioned in a previous post, I think the market tends to overestimate the policy effect in the short term and underestimate its effect in the long term, given the challenge of assessing the benefit of something that only takes effect gradually. However, some qualitative judgment could be made and I disagree with the commentators’ argument mentioned at the beginning of this post:

  • While it is probably true that the families that decide to have a second child would probably have to reduce their savings rate in the current year, the argument ignores the fact that some of those families may have to purchase a bigger property as their current property cannot accommodate two children. This entails a kind of structural demand that barely existed before the policy change, which lends support to the housing market with excess supply.
  • There is an important caveat about the measure of demographic dividend, i.e. working-age population as a share of total population: it fails to differentiate a very young country with a very old one. Some African countries, with a large number of population under 14, has a very similar ratio to that of Japan, with a large number of population over 65. Therefore, a more appropriate measure should be that of working-age population over population above 65, where we can clearly see the demographic vulnerability of Japan relative to that of Africa. (A even more accurate measure of demographic dividend, in my opinion, is the one that takes into account employment.) Under the improved measure, the two-children policy won’t worsen the demographic dividend of China.

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One way of differentiating value-based assets from price-based assets

I have self created two concepts that are not terribly well defined for the moment.

Value-based assets are those where price in the long run should reflect the intrinsic value of the asset, though intrinsic value could prove to be very hard to estimate. Examples include stocks (particularly of the companies with stable cash flow), corporate bond.

In contrast, price-based assets are those where the future price is heavily influenced by past price performance, as intrinsic value is to a significant extent influenced by past price performance (which really relegates the concept of intrinsic value to secondary importance). Examples include artworks, and to a less extent, gold and foreign exchange prices.

One may argue that we shouldn’t take a dichotomy/binary view and categorize assets as either value-based or price-based. Some assets may have both nature at the same time. One may argue that artworks do have intrinsic value, and hence are value-based (e.g. Old Masters pieces).

In this post, I would like to suggest one way of differentiating value-based assets from price-based assets: a contrarian style of investment/thinking may find it easier to earn excess return in value-based assets than price-based assets. Here is why.

Let’s assume the holder of an asset tends to be optimistic about its future value. However, a future buyer comes from the rest of the crowd (i.e. less optimistic for the moment). If there is media hype about the stock market and many people express their bullish views, it is likely that many people have already purchased the stocks, and – to take a contrarian way to thinking – there may not be a lot of future buyers left. In other word, prices have been bid up and there may be downward pressure for the stock price as future incremental demand is weak. In contrast, if media is very pessimistic about the stock market, which may indicate a large pool of future buyers who are looking for good price to enter. Contrarian way of investing (or value investing) has generated quite consistent track record, which indicates that most stocks are value based.

However, when it comes to the artwork prices of an artist, one tends to observe that rising prices indicate increasing number of people who collect the artworks of this artist, which entices new collectors and incremental demand. However, when prices drop, it sends a signal to the market that the existing collectors are losing confidence about this artist, or this artist becomes out of fashion, or this indicates LESS incremental demand, which is in opposite to the contrarian interpretation about the stock market. Indeed, when an artwork is bought in, i.e. the artwork fails to find a buyer during an auction, such artwork (and even other artworks of the same artist) may lose its liquidity very quickly – another evidence that a contrarian way of investing may not work in art collection.

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Two-children policy and its market implication

China finally abandons its one-child policy and allow all families to have two children. It is remarkable achievement as it partially corrected a policy decision that should have been corrected years ago, given the easily predicted decline in Chinese working-age population and the much less acute food shortage (compared to decades ago) that the country is facing.

However, for economists and market practitioners, it is very hard to estimate the impact on the economy of this policy change, let alone its market impact. Indeed, the economic benefit of such policy change takes years to take effect and the annual impact tends to be very gradual. Apparently, there are lots of factors to consider for a family to have a second child, not only the cost of raising a child, but also timing and emotional issues. I don’t think lots of families would “jump the gun” upon this policy announcement.

This creates challenge for market interpretation, as markets usually overestimates the short-term impact of an event and underestimates its long-term impact, particularly for reforms like this that have profound and yet gradual impact on a country’s growth potential. Therefore, one should be bearish on assets that are priced up today because of this news, and instead be bullish in the long term.

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How does BoJ QQE affect beyond Japan?

The way that BoJ QQE works beyond the Japanese equity market still looks like a puzzle to me.

Granted, an expansion of QQE would lower the value of yen and boost the Japanese equity market. But how to assess its impact on other countries?

  • One channel is trade. Countries that have similar export composition to Japan or those that are in the similar position of the global value chain may be hit by lower yen. However, such effect may be somewhat offset by the fact that Japanese exporters have already moved most of their manufacture bases overseas. Hence the manufacture cost is less affected by the value of yen but by the value of the currency where the factories are based, e.g. in some of the ASEAN countries.
  • The other channel is portfolio rebalance, as Japanese investors are forced to move up the risk curve. However, it is unclear to me whether the Japanese investors put extra money only in Japanese stocks or international stocks as well. It is also unclear how much the dollar purchase power of Japanese investors would increase if one compares the positive wealth effect (in yen) from QQE and the negative effect on yen. In addition, I am not sure what countries are Japanese investors’ favorite. Advanced economies where risks tend to be lower or ASEAN countries where they have large manufacture bases?

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What an inflation-targeting monetary policy may have missed…

Lots of monetary policy makers in advanced economies target price stability and aim to contain inflation (or inflation expectation) within a certain pre-determined range. More and more developing countries are refining its monetary policy framework and working towards an inflation-targeting regime.

But is there a disconnection between price stability – the goal of monetary policy – and CPI/PPI – the measure of general price level in an economy? If the answer is yes, then policy makers need to corroborate the CPI/PPI figures with other measures in order to identify the risk of price instability in the economy.

An obvious issue with CPI/PPI is lack of measure of asset price changes. One may argue that CPI does take into account rental cost. However, how about families that purchase their main living properties with mortgage? When rental yield is low relatively to history – which is the case today in many countries with low interest rate – the cost of housing for families with mortgage may be higher than those renting. One may argue that the difference shouldn’t be too large. For instance, if the housing price is too high relative to rent, then some families would delay their housing purchase and continue to rent a property. However, once a family purchases a property and live in it, it is hard to see them to switch back to renting just because rents become cheaper. Therefore, the rental yield can remain deviated from its long-term average for a sustained period of time.

I am not suggesting that we should definitely include asset inflation in CPI. Instead, I would argue that we shouldn’t include asset inflation in CPI, as the former is a function of wealth and the latter is more related to income. We’d better not mix a stock concept with a flow concept. However, I do think monetary policy should consider price stability in a broad sense, such as the risk of sharp changes in certain asset prices – which leads to all sorts of financial stability issues. In addition to financial stability issues, there are also issues around social inequality that is caused by wealth inequality. For instance, should governments provide social housing to poor people and at some time convert properties of social housing into private housing? Another example, should governments provide comprehensive coverage on medical care or instead leave it to the market?

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Structural reform: too little, too late?

Long-term productivity or growth potential is driven by human capital, fixed capital, technology development. Structural reform facilitates the combination and deployment of the three elements. As one knows, structural reform, such as labor market reform, reduction of regulatory burden and reform of financial markets, usual takes time and it takes time for the benefit of structural reform to feed into stronger growth of the economy. And most – particularly the market –  are disappointed by the progress that the countries have achieved on structural reform. Should we be correctly disappointed?

There are reasons that one should be pessimistic about the pace of structural reform in general:

  • Some policymakers are short-sighted as many of them only stay in their current positions for a couple years before getting replaced in the next election, which is too short for implementation and monitor of structural reform.
  • Many structural reforms reduce the rent that some established interest groups enjoy in the current system, hence face a lot of resistance from within the current system.
  • Bureaucracy in some international organizations – who usually promote structural reform – and their lack of influence on some sovereigns.
  • Policymakers may be complacent with status quo when things are good, and face lots of resistance when things are bad, and hence structural reform is never really implemented.

However, there are also reasons that the pace of structural reform is underestimated by data, media and market perception:

  • There aren’t many cross-country-comparable and time-consistent databases in the world that track and objectively reveal the pace of structural reform. This results in lack of information for clear assessment of reform progress.
  •  According to behavioral theories, markets tend to overestimate the impact of short-term events and underestimates the impact of long-term events. And structural reform belongs to the latter.
  • Many econometric analysis that forecasts countries’ growth potential struggle to incorporate the impact of reform in its forecasts.
  • There are lots of opportunities for developing/poor countries to gain stronger growth via reform, and some indeed have implemented it. However, this progress is under-reported by western media and ignored by financial markets.

Therefore, opportunities for investors may arise when one tries to build cross-country comparable assessment of structural reform and consistently track it, and looks at smaller markets that are ignored by established western media.

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Are DM policymakers rightly concerned about EMs?

The Fed, ECB, BoE talked about their concern about the negative impact of weak EM growth on their homeland. BIS and IMF voiced similar concern and particularly pointed on the risk associated with rising EM debt and lower liquidity in the market making of cross-border assets, particularly EM assets. Draghi, out of concern of EM growth and its effect on the EZ economy, even hinted at further easing in today’s ECB press release. And suddenly, the market seemed to wake up to the fact that EMs are paramount in today’s global economy, and DMs cannot be decoupled EMs. Only a few years ago, we were talking about decoupling, though it was the opposite direction.

Granted, due to higher growth in EMs vs in DMs, EMs are getting a big share in the global GDP and matter more for global trade and finance. However, that is not the only reason why the DM policymakers are so fixated on EM dynamics. Another reason is that DM growth potential remains weak after the Global Financial Crisis. A weak growth potential means that a country’s ability to withstand external shocks remains weak. When an external shock comes to fore, being it Chinese slowdown, Brazil downgrade or rising EM debt and liquidity crisis, the country is more likely to be tipped into recession than when it had a higher growth potential.

And it is not difficult to understand why DM growth potential remains weak. Monetary easing, being it in traditional rate cut or the innovative QE, encourages debt accumulation. It boosts short-term growth, but not really growth potential. No one expect a highly-indebted company will become persistently more productive by taking on additional debt. And the same applies to a country.

Therefore, rather than seeing DM policies mentioning about EM risks as an excuse for easing or seeing it only as a result of rising share of EM in the world, I think the weak growth potential of DMs also plays a part – and the latter keeps DM policymakers awake at night.

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