Tale of Two Economies: U.S. a 'SubPrime Sell'; China a 'Strategic Buy'

Includes: FXE, FXI, PGJ, SDS, SH, SPY
by: Enzio von Pfeil

People got scared because of higher Chinese rates, and got relieved that the Fed may be nearing the top of the rate hike cycle. Get thinking!

China's recent rate hike scared not few punters: they feared that China is starting to"tighten." We disagree: China's markets represent a supreme "buy" for the strategic investor.

First, the extent of the rate hike was so muted that these few additional basis points cannot even injure corporate profits. Besides, China's banks are not like our capitalist ones: the government still dictates who gets money and at what price. Finally, unlike us capitalists, Chinese retail punters cannot buy on margin, so by definition their investment appetite cannot even be bruised by higher rates.

Secondly, China's Economic Time™ is just fine. In a nutshell, China's Economic Time is good because she has an:

• excess demand for goods, and an
• excess supply of money

All of which bodes well for profits: strong demand means that at least the turnover portion in the profits equation keeps improving, and ample liquidity means that people have enough spare cash with which to invest in assets - like stocks.

Finally, China is a supreme "buy" because of the political growth mandate: either Beijing creates jobs - or its (pragmatic) leaders will be out of their own jobs. The recent meetings revealed little - that is because the National Party Congress this Fall will see some leadership changes. Like ahead of any re-shuffle, people are keeping their heads low. The powerful force of greater and easier communication via the pervasive internet and via easier travel conditions means that news travels faster and more fiercel - including news of social unrest. So the only way to combat unrest is to keep people employed and happy (how do I wish that Mr. Bush would take this approach in the Muddle East!). With 10 million people entering the the labor force each year, the mantra of job creation is alive and kicking.

For these reasons, China remains a supreme strategic "buy."

Meanwhile, if people are buying America because they feel that US rates are about to start falling, they had better think again. America is a "sub-prime sell."

First, rates still have a little way to go up. Back in June 2004 we garnered chuckles when suggesting that Fed Funds would be "around 6% around 2006." Even if, in our new incarnation as fund managers, we have moved away from "precise" forecasting, there is still some upside to rates. That is because the Fed, especially under new stewardship, will want to err on the side of caution way before the Presidential elections heat up next year. Besides, as we saw during the last market convulsion, Mr. Greenspan's market power remains awesome. Thus, the Fed has to keep hewing its own credentials into the granite of the market's mindset.

Secondly, rates must rise because of looming cost push inflation. For many months we have been telling people to beware of falling productivity in the US. That, combined with rising wages, means higher unit labor costs (ULCs). Cost push inflation has to hurt corporate profits. Either corporates pass the higher ULCs on - and thus goad the Fed into even more rate hikes in order to slow the economy. Or, corporates do not pass their higher ULCs on - and thus hurt their own profits courtesy of slimmer margins.

Finally, America remains a "sub-prime sell" because of the mess in the various sub-prime mortgage markets. Weeks ago we warned that even if this loan pool accounts for "only" eight percent of America's total mortgages outstanding, it can wreak havoc. That is because multiple, interconnected derivatives instruments have been chained to that eight percent tree limb. America's Economic Time is worsening, so this heightens investor angst. And once the mayhem begins, all investors will race for the (jammed) exits - especially those bright sparks who have financed sub-prime derivatives purchases with cheap yen (shall we re-name this the yen "drop" trade).

Thus, China is a supreme, strategic buy. Meanwhile, the US (despite remaining the world's most terrific economy), is a cyclical "sub-prime sell."