As the Eurozone Stalls, China Cuts the Red Tape

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

Forty-four percent. That’s the alarming unemployment rate for those aged 15 to 25 in Italy, where I traveled last week to meet with other global chief executives and business leaders.

The reasons for Italy’s high youth unemployment? Tortuous red tape, high taxation and thuggish unions. More so than any other EU nation, Italy is mired in unionization. This has created a restrictive jobs market that crowds out well-educated, aspirational young people, many of whom are forced to flee their homes and seek work elsewhere.

But “elsewhere” within the European Union is currently not much of an improvement. Even in Germany, the EU’s most reliable economy, train and airline unionists have gone on strike, bringing the country to a near-standstill. Incredibly, both Italy and France—where the youth unemployment rate stands at 24 percent—want the EU to foot the bill for their joblessness woes. Global investors’ patience has been stretched thin as European Central Bank (ECB) President Mario Draghi and German Chancellor Angela Merkel continue to bicker over how to resolve the region’s slowdown.

As I told CNBC Asia’s Bernie Lo, the EU’s default policy is to tax anything that moves. Led by pro-taxation economists such as France’s Thomas Piketty, Europe’s policies have become a sort of contagion resonating throughout the rest of the world. The eurozone countries have an imbalanced approach to jumpstarting their economies, relying only on monetary policy but failing to address fiscal issues such as punitive taxation and entitlement spending.

You can see how disastrous the results have been: France and Germany’s industrial production has turned down recently. Their purchasing managers’ index (PMI) numbers are below the 50-mark line, indicating contraction. This trend is especially worrisome because Europe is a bigger trading partner with China than the U.S. is.

So what’s the solution?

The EU would do well to look east, specifically to China.

China Handing over Its Economy’s Keys to Capital Markets
This week senior Chinese officials are meeting in Beijing to resolve the sorts of problems the EU can’t seem to fix, let alone acknowledge. On the chopping block are regulations—hundreds of them. According to Premier Li Keqiang, 416 lines of red tape have allegedly either been abolished or eased in order to facilitate business growth in important sectors such as transportation, logistics and telecommunications. In June, Li vowed to slash an additional 200 measures.

The Chinese government also plans to relax oversight of key areas such as utilities and natural resources, land and the pricing mechanism of money. Gone is the government’s control over shale gas, coal bed methane and imported liquefied natural gas (LNG). The mining sector’s tax code has been reformed. And for the first time, private companies have been granted the license to ship crude oil.

It appears as if China is starting to see the light. They’re introducing competition back into their capital markets instead of strangling it, as the eurozone is fond of doing. Between January and September, 10.97 million new jobs were created in China, exceeding the government’s goal of 10 million in 2014 and beating the benchmark by an entire quarter, according to China’s National Bureau of Statistics (NBS).

As you can see below, new business start-ups in China have skyrocketed.

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These red tape-cutting measures, coupled with fiscal stimulus, are needed now more than ever. As promising as Premier Li’s promises are, China still faces deflation and declining real GDP growth. The Asian country’s economy is currently headed for its slowest expansion since 1990, the main culprit of which is the struggling real estate market.

Other problems also continue to hold China back, many of them deeply-rooted and systemic. The Ease of Doing Business Index ranks China 158 out of 189 economies in the “Starting a Business” category and an almost-dead-last 185 in the “Dealing with Construction Permits” category. According to the World Economic Forum’s most recent Global Competitiveness Report, the two most problematic factors for conducting business in China are access to financing and corruption, another issue Chinese officials are addressing this week.

These issues can’t and won’t be fixed overnight. But unlike the EU, China acknowledges them and is seeking innovative solutions. One of the only benefits to having a one-party system, as China does, is that you can’t shuffle off a set of problems to another party and then lay the blame at their feet when they go unresolved. You must think long-term.

Constructive Manufacturing News
A couple of days ago we were relieved to learn that China’s flash PMI came in at 50.4. Anything over 50 indicates growth in the manufacturing sector, but as I’ve discussed on numerous occasions, what really matters is that the one-month reading crosses above the three-month moving average. Such a “cross-above” historically means that commodities and commodity stocks perform better in the coming months. Based on our research, three months following a cross-above, there’s a 73 percent chance that the S&P 500 Index will rise more than 2.4 percent and a 55 percent chance that the S&P 1500 Energy Index will rise more than 0.7 percent.

As you can see, this crossover did indeed occur, the first time it’s done so since May.

One-Month Reading for china's Flash PMI Crosses Above the Three-Month Reading
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Of course, flash PMIs are merely preliminary, and we won’t know the final results until the end of the month. But for now this is certainly positive news.

Emerging Asia Wins with Cheap Commodities
One of the reasons why Chinese manufacturing is picking up steam might be the recent collapse in commodity prices. Low commodity prices undeniably hurt certain stocks in the space, and we’ve felt the pain in some of our funds. The silver-lining, though, is that these low prices have helped non-Japan Asian companies get ahead, a tailwind for our China Region Fund (USCOX). Because labor continues to be relatively cheap in Asia, commodities tend to be the single-largest company expenditure.

Lower Energy and Food Prices Will Help Chinese Businesses
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Lower steel and aluminum costs benefit machinery, automobile and equipment manufacturers, as well as homebuilders, shipbuilders and oil and drilling equipment suppliers; falling corn and wheat prices are welcomed by food and beverage producers; cheap copper is good for construction and engineering, utilities and electrical equipment.

Then there’s oil and gas. Since June, Brent crude has corrected itself over 25 percent. Again, this is a headwind for petroleum companies and large net-oil-exporting nations such as Russia and Mexico, but cheap energy equates to huge savings for emerging Asian countries.

Asian Markets Benefit Most from Lower Oil Prices
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One final bellwether of economic growth I want to touch upon is accelerated electricity generation and usage. In the past, Chinese Premier Li Keqiang has cited this as one of the more reliable indicators of economic activity because electricity is not easily stored and the data is difficult to manipulate. This month, energy production improved 4.1 percent year-over-year —not a huge cause for celebration, but a step in the right direction nonetheless.

Increased Electricity Production in China Is a Reliable Indicator of Economic Activity
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China Is a Long-Term Story
Compared to many eurozone nations, China is relatively young. Whereas the median age in Italy is 43 years, in China it’s 35. There’s huge growth potential in this region, especially now that Premier Li has resolved to cut red tape and balance monetary and fiscal policy. In 10 years’ time, the 35-to-45 cohort, a well-educated group with good salaries and credit, will expand dramatically.

Consider this: of the 1.35 billion Chinese citizens, about 618 million, nearly half, have access to the Internet. Of those, 302 million, nearly half again, shop online. These numbers will continue to grow, and with them, greater investment opportunity. Name one Western European company that, in recent years, has achieved the sort of success Alibaba, Tencent or Baidu has. Not in a Piketty economy.

I encourage investors who are seeking growth potential to check out our China Region Fund’s composition.

And to those who prefer a “no-drama” fund, please take a look at our Near-Term Fax Free Fund (NEARX).

Index Summary

  • Major market indices finished higher this week.  The Dow Jones Industrial Average rose 2.59 percent. The S&P 500 Stock Index dropped 4.12 percent, while the Nasdaq Composite rose 5.29 percent. The Russell 2000 small capitalization index rose 3.37 percent this week.
  • The Hang Seng Composite rose 1.21 percent; Taiwan rose 1.56 percent and the KOSPI rose 1.32 percent.
  • The 10-year Treasury bond yield rose seven basis points to 2.26 percent.

Domestic Equity Market

The S&P 500 index posted a gain this week, contradicting the previous month long bearish trend.  Equity market strength came on earnings results, some near-term Ebola fears subsiding, and positive home sales numbers.  With Wednesday being the only negative closing day, the S&P 500 continues to stay above its 200-day moving average, showing strength in the bullish trend of the overall market.

S&P 500 Economic Sectors
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Strengths

  • All sectors were positive for the week, led by health care. Tractor Supply Co. was the top performer in the S&P 500, up 13.09 percent over the prior five days following a better-than-expected earnings report. Celgene Corp was another top gainer, up 16.91 percent in the period.
  • The Industrial sector continued to do well. The sector was led by airlines, which were up 11.88 percent for the week. Ingersoll-Rand and Illinois Tools Works benefited from a strong sector rebound, up 6.59 percent and 5.41 percent respectively.
  • Higher than expected new home sales provided a tail wind for equity market bulls.

Weaknesses

  • Telecom was the worst performing sector this week, mainly on weak news from AT&T, down 0.70 percent. However, the sector still closed positive for the week.
  • The consumer staples sector was the next lowest performer. Costco and Wholefoods closed down as money flowed from defensive to more risky areas of the markets.
  • IBM fell 11 percent this week and was the worst performer in the S&P 500 after missing third quarter earnings and announcing it was getting rid of its money loosing chip making business.  Another big laggard was Amazon Corp, down 5.44 percent, after missing earnings and taking a large loss for unsold inventory.

Opportunities

  • Next week, pending home sales numbers are to be released, and expected to be much higher than the previous period. If they beat expectations like new home sales this week, this could add more fuel to the fire and keep the market going up.
  • Lower crude oil prices will help lower income consumers and increase discretionary spending
  • The market continues to make new highs, and rebounded strongly after touching the 200-day moving average on Wednesday, showing strong support for the equity uptrend.

Threats

  • With this next week being one of the busiest earnings weeks, market volatility may be higher than normal.
  • With a new case of Ebola in New
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