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The Smartest Man in Global Capital Markets on QE, and What to Expect Next

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In our latest interview with TSMIGCM, we take a tour around the world and review the impact of the Fed's policies.

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China

As I have written before, the real issues in China are excessive credit, volatility in policy prescriptions to deal with market dislocations, and the margin of safety between the equilibrium level of GDP growth (ELG) and the "actual" GDP growth rate. As my good friend Seth Klarmen wrote years ago, "Margin of safety in value investing is the 'key.'" This rule should also apply when analyzing sovereign credits. It is not possible to know the exact annualized GDP growth rate below which China would be unable to absorb all the new workers coming into the system each year; it is equally difficult to ascertain what China's actual GDP growth rate is in real time. What we do know is that the margin of safety (the delta between the two) is too narrow for comfort. I assume the ELG is currently 6.5% (down from 8.0% more than five years ago, primarily due to China's changing demographics) and the actual GDP rate is approximately 7.0% (not the 7.7% the PRC suggests). Thus, the margin of error here is very narrow.

It is precisely this narrowing delta that pushed policy makers to make abrupt modifications to policies and regulations. China is very fixated on being perceived as an adult on the global stage. Having to choreograph a massive spike in Shibor to "punish" speculators is inconsistent with the image they want to cultivate. As the Japanese migrate new FDI away from China to Myanmar, India, Indonesia, Thailand, Vietnam, and The Philippines, and as China slowly loses its labor cost advantages versus other key emerging markets manufacturing economies, the risks of a real China slowdown will grow over time. The impact on Latin America will be severe, most notably on Brazil where we are already seeing signs of social unrest.

I do not see China slipping below its ELG this year, but if and when this does occur, it will unleash more deflationary forces around the globe. In my last article, I argued that the Shanghai Composite (SHA:000001) would have to breach the 2,000 level, and this has now happened. It may, in fact, have to go lower in order to persuade the authorities to increase the liquidity taps once again. China is, at the end of the day, a bit of a shell game economy. The government meticulously arranges share sales between institutions (corporates, banks, etc.). I do not see this ending well. We may not get the conflagration prophesied by Jim Chanos, but it is likely to be close. It won't happen this year, though.

THE AMERICAS

Brazil

One of the benefits of massive market dislocations is that they tend to enhance transparency in terms of the true or intrinsic value of credits, asset classes, and countries. This is true of Brazil, where we are now seeing social unrest.

Brazil's President Dilma Rousseff's solution is to increase spending and social outlays; this will only be a very near-term solution, if that. The currency will remain under pressure; it may trade as low as 2.5 reais to the dollar. Some well-situated hedge fund managers have actually asked me recently to what extent I felt Brazil would have a real crisis -- for example, a run on a bank. I do not see that happening, however, current events are constructive in that they point the finger at over-regulation, excessive government at every level, and antiquated labor laws. Now that the US Fed is no longer the "bad guy," we can get sufficient introspection there that leads to substantive change. I have been very negative on Brazil versus Andean/Mexico for several years. Now, however, it would appear to me that Brazilian equities -- for the first time in several years -- are fairly priced relative to those alternative markets. Some very smart and agile equity managers are increasing Brazilian exposure purely on that basis.

Chile/Colombia/Peru

Consequently, I do see Chile, Colombia, and Peru as having gotten somewhat expensive. This will not deter the Canadian pension funds from continuing to prioritize infrastructure assets in those geographies, but it will make it more difficult to monetize the equity of locally domiciled businesses, in my view.

Mexico

Carstens has gotten his way in so far as the Fed has at least suggested that QE will not be a permanent policy. Hence, some speculative capital flows have departed Mexico, relieving pressures on the peso/dollar cross currency rate near term. To the extent that the PRI government can keep the cartels at bay and continue its commitment to deregulating the inertia inherent in the Mexican economy, I still like the investment thesis there and still see tangible evidence of increasing FDI flows that could add 1-2% to Mexican GDP estimates going forward.
No positions in stocks mentioned.
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