John Burbank’s Passport Capital was up 4.2 percent (net) in the second quarter, making the year to date return for the hedge fund 10.1 percent (net) according to a letter obtained by ValueWalk. Hedge fund assets now total $1.2 billion and firm assets total AUM is $3.0 billion. This is a particularly interesting letter from John Burbank, we will have more coverage on specific holdings and EM views, but we wanted to post an interesting segment on the biggest EM country which Burbank discusses, China.
For further reading on Passport’s Q2 performance and positioning, see John Burbank Bullish On Chinese Tech; Closes Yen Short
John Burbank on China
Slower growth in China: China is in the process of transitioning to a consumption- and service-based economy from the fixed asset investment (FAI) focus that drove a decade-long, double-digit GDP expansion and allowed the global commodity complex to benefit for much of the last ten years. According to the World Bank, in 2011, China household final consumption was only 34% of GDP whereas U.S. consumption represented 72% of GDP. Massive changes have to take place just to get China to 50% of GDP; this will likely take some time.
In the fourth quarter of 2012, China’s new administration was handed power. We believe their mandate is to lead China through this transition over many years. Over the prior decade, China benefitted from labor arbitrage and export growth, which grew reserves and funded massive infrastructure build out. We believe that era is largely over, at least in terms of intensity. And we think the huge spending that followed the global financial crisis in an effort to get the world economy back on track is unlikely to be repeated by China.
Lower fixed asset investment in China will likely keep commodity prices depressed, as the marginal buyers’ demand is lower and supply goes fallow. Moreover, China has recognized that aggregate credit growth has been too rapid and is presently attempting to rein in credit; any deceleration in credit growth is negative for Chinese purchases of bulk industrial commodities such as copper, coal, and iron ore.
Social stability—not GDP growth—is in our view China’s primary goal, and is a function of inflation and unemployment. For the time being, we think inflation pressures are not at dangerous levels. Unemployment is currently benefitting from the one-child policy, as the number of working-age Chinese added to the population is significantly lower than even three years ago. Longer term, of course, an aging demographic reduces long-run GDP potential and poses more problems than it solves.
Constraining of credit to emerging markets: We believe that there are a few reasons for this: a) overinvestment (in emerging market credit, flows have recently turned negative) and b) lending constraints on European banks, traditionally the principal lenders to emerging markets.
Strengthening dollar: The relative strengthening of the U.S. economy, along with eventual Fed tapering, could lead to higher rates and a stronger dollar. Emerging market and basic material companies have lived off cheap, dollar-denominated debt, which many will find inaccessible or prohibitively expensive when it comes time to renew. A stronger dollar equates to higher commodity prices in local currency terms for the rest of the world, which essentially is deflationary for emerging markets. Today for example, Brent crude is at or near all-time highs in local currency terms in Brazil, Russia, India, South Africa, and Turkey.
Emerging market wage headwinds: Emerging markets benefited from rapid wage increases over the past decade. While wages continue to climb, growth is decelerating. China’s wage growth was in the high teens during the 2000s and is expected to be in the low teens this decade. The wage arbitrage trade is no longer a no-brainer for companies. It is becoming a harder decision to outsource labor to China, particularly for companies with valuable intellectual property (IP) at risk.
Technological advances, while signs of progress, also export deflation and create global headwinds for wages. Robotics, cloud computing, and e-commerce all serve to reduce the need for labor. In some sense, the best and highest value-added companies are deflating the rest of the world by maintaining pricing power. Companies from Silicon Valley are the primary examples.