GBD0411

THE GLOOM, BOOM & DOOM REPORT ISSN 1017-1371

A PUBLICATION OF MARC FABER LIMITED

NOVEMBER 10, 2004

The Bubbling of Austrian Analysis People, for the most part, stood their ground firmly. But that ground itself was about to give way. Joseph A. Schumpeter, Business Cycles (New York, 1939), Vol. II, p. 794, referring to the onset of the Great Depression

INTRODUCTION A recent headline in the Financial Times read, “The bubbling up of Austrian analysis”. The article, by John Dizard, implied that the Austrian School of Economics was becoming overly popular. Dizard quoted our friend Jim Grant and also a contemporary Austrian economist, Roger Garrison, who defines the Austrian thought as “the recognition that an extra-market force (the

central bank) can initiate an artificial, or unsustainable economic boom. The money induced boom contains the seeds of its own undoing: the upturn, by the logic of market forces set in motion, will be followed by a downturn … for Mises and Hayek, monetary expansion engenders a boom, which eventually leads to a bust.” And while I think that Garrison’s explanation of the Austrian school of thought is basically correct, the Austrian School is far more complex. In The New Palgrave Dictionary of Economics (The Macmillan Press, 1987, and highly recommended as a reference book for anyone interested in economics), there are literally hundreds of pages about Austrian economics and the great Austrian economists, but I shall spare our readers all the details. The Austrian School has different schools of thought, which complicates matters. However, I am a firm believer that in the future Austrian

economics will displace the nonsensical belief held by central bankers under the ill-fated leadership of the present members of the Federal Reserve Board in the US, which is that monetary policies can create something like an “eternal boom”. Therefore, in order to prepare our readers to hear more and more about Austrian economics in future (as the monetary policies of the central banks become increasingly discredited by market forces), I have asked Sean Corrigan, who has taken me to task in the past about some of my comments on economics and who happens to know far more than myself about Austrian economics, to briefly explain the basic tenets of this school. After having gained a significant following during the Depression years of the 1930s, when business began to recover, the Austrian School was eclipsed by the Keynesians, the Chicago Monetarists, the Rationalists, and the Marxists in the 1960s.

* * *

The Austrian School in Brief: The World in Four Pictures Sean Corrigan, E-mail: [email protected] Sean Corrigan is the Investment Strategist at Sage Capital Zürich AG (www.sagecapital.com), a Swiss-based organisation dedicated to the cause of capital preservation, and is co-adviser to the Bermuda-based Edelweiss Fund. See his www.Mises.org Articles Archive.

Philosophically, the idea is that Man is a rational actor in so far as he tries to increase his well-being, or to decrease his “unease”, through purposive Action. However, each man’s individual motivation in Acting — his pleasure/pain scale, if you will — is wholly different from that of his neighbour’s and it is an ordinal one, with little scope for quantitative measurement and certainly none for aggregation. This insight is said to be one made a priori and Austrian reasoning is thence deductive, not inductive or empirical. It is also, as the above shows, focused on the subjective elements of a man’s choice.

Politically, Austrians are classic Manchester liberals, firmly behind a policy of laissez-faire and many today thus shade into minarchism, or even what Rothbard called anarcho-capitalism. Mises single-handedly destroyed any attempts to construct a socialist rationale in the famous “calculation debate”, showing that, without private property and an unhindered price mechanism, production can never be properly co-ordinated to allocate scare resources to their best and most urgent uses. Hayek joined Mises in showing that there can be no room for compromise, that a “mixed” economy inevitably

leads to an erosion of freedom and the growth of the state to the detriment of all those not in, or patronised by, the ruling classes (of whatever caste, creed, or form). Coming more to economic matters, Austrians were in the forefront of the marginalist revolution and construct their arguments from that basis. Menger and Boehm-Bawerk et al. derived the most satisfying theory of the origins of interest — the so-called natural rate being, essentially, a measure of mortal man’s inherent impatience with any delay in the gratification of his wants and needs. This is greatly influenced by the degree of plenty and comfort in which he already exists. This means that capital-rich economies with bounteous productive capabilities tend to have higher present satisfaction and so lesser impatience, more saving and hence lower rates of interest. Low interest rates naturally arise amid abundance, therefore — an abundance based upon a wide division of labour and a capital-rich layering of specialised productive means: abundance can never be entrained through forcing money market interest rates lower by fiat. Austrians hold that there is no free lunch — Bastiat’s fable of the “broken window” is often cited as a starting point for argument. Hazlitt, developing this theme, wrote that the “One Lesson” of economics is that there is no such thing as a free lunch and that we must always look beyond the immediate results of an action to see its hidden and indirect influences before we pronounce it a success or a failure. Mises developed a comprehensive Theory of Money and Credit which irrefutably shows that inflation always leads to ill effects and, together with Rothbard, campaigned for a system based on 100% commodity reserve, free-banking — no FDIC, no Fed, no fiat, no fractional reserves! Out of this arose the Theory of the Business Cycle, which discusses in detail how an inflationary infusion distorts price signals – particularly intertemporal ones. By lowering market rates below the natural one, credit expansion severs them from that which is compatible with the availability of real capital and with the concomitant willingness to save while more “roundabout” — but potentially more productive — methods are employed. Thus, the builders of plant and the makers of equipment base their return calculations on low rates, but are blinded to the fact that these do not signal the necessary limitation of end-consumer competition for the factors of production which they, or those downstream from them, will need to secure the required return on their efforts. At some point these factors will be bid away to other, more urgent uses, more compatible with consumers’ time preferences — which may in fact have been increased (their demand for goods enhanced) by the same lower rates which entrepreneurs have implicitly taken as meaning that such an appetite has diminished. These distortions will lead to bottlenecks in skills, staff, resources, equipment. They will mean that a 2

The Gloom, Boom & Doom Report

consistent price path from high-order to consumer goods will not be possible. It will mean losses and the revelation of widespread “malinvestment” — not necessarily “overinvestment”, but misdirected and sub-marginal investment, such as Global Crossing! Credit expansion will therefore sow the seeds of its own destruction as soon as any initial slack in the system is taken up and as soon as the rate of inflation (excess monetary addition) ceases even to accelerate (a process needed to keep the producer borrowers surfing ever ahead of the breaking wave of the faulty price/preference matrix in the economy). Developed in the earlier part of the century, the standard exposition implicitly assumes that most largescale borrowing is done by producers, not consumers. The former thus got the first, most beneficial use of the inflationary influx (spending the money before prices rose) and they could bid resources away from the latter as a result of this legalised fraud. This has had to be modified slightly to take account of today’s institutional framework where the consumer is a major borrowing force also, but the principles have not been challenged by this expanded scenario. Moreover, it has to take into account the internationalisation of the economy and recognise that Asian savers can substitute for US ones, for so long as they are willing to do it. (See Figure 1 for a schematic.) Austrian theory is thus dynamic, not static; logical, not empirical; individualistic, not aggregative; libertarian, not statist; it does not confuse money with wealth; it knows that production delivers prosperity, not consumption. It recognises consumer sovereignty, places prime importance on the capital structure of the economy, apotheosises the entrepreneur, despairs of government, and utterly disdains Marxists, Keynesians, Chicagoites, and all other Historicists and pseudo-Natural Scientists. In their ignorance, these latter, naturally, return the compliment and since these schools can all be used by the state as an excuse for its ever-widening interference in our lives — whereas Austrians want the minimum possible intrusion upon private property and personal liberty, for solidly economic, as well as for ethical grounds — guess who gets all the air time?

Figure 1

The Global Cone of Production

November 2004

* * * In short, Austrian economics is based on the belief that each man’s individual motivation is different from his neighbour’s and therefore rules out quantitative measurement and aggregation, which all the economic models attempt to do. Austrian economics also postulates “that there can be no room for compromise, that a mixed economy inevitably leads to an erosion of freedom and the growth of the state to the detriment of all those not in, or patronized by, the ruling classes”. Then, Austrian economics does not confuse money with wealth; it knows that production and investments deliver prosperity, not consumption, and that there is no such thing as a free lunch, which implies that it always looks beyond the immediate results of an action to see its hidden and indirect influences before it pronounces it a success or a failure. Lastly, and I regard this as particularly important in the current context, its Theory of the Business Cycle stresses that inflationary infusion distorts price signals. Misleading price signals then bring about all kinds of waves of speculation, bottlenecks, losses, and the revelation of widespread over- or “mal-investments” in the system. (For a relatively simple but comprehensive explanation of the concept of the Austrian School of Economics, I recommend to our readers Friedrich Hayek’s Monetary Theory and the Trade Cycle, first published in 1933.) However, it was not my intention to give a lecture on Austrian economics here. What caught my attention is that a headline could read “the bubbling up of Austrian analysis” at a time when the world is in the midst of the greatest financial bubble ever. It made me wonder what the headline in the Financial Times should have read, and how large it should have been, with respect to the speculative mania we now find ourselves in, if it was in proportion to the size of the headline about the bubble in Austrian economic analysis! Surely, the Financial Times would not be able to accommodate such a title. Or take the high-tech November 2004

sector, which has suddenly become very popular again. How big a bubble do we have once more in stocks such as Research in Motion (RIMM), Google (GOOG — see Figure 2; according to CNBC it is “cheap” compared to Amazon.com, EBay, and Yahoo), Travelzoo (TZOO — see Figure 3), and Overstock, which all seem to be rising into the stratosphere? (When, on October 22 and October 25, Google soared by US$17 and US$14, respectively, to

Figure 2

US$187, Amazon.com, an investors’ favourite earlier this year, fell to a new 52-week low — see Figure 4.) Fred Hickey of the High-Tech Strategist has a wonderful piece on this latest high-tech bubble (see the October 5, 2004 issue), in which he refers to the 26th Annual San Francisco Money Show. It was held September 22–24 and had a luncheon panel covering “Technology Investing: Hot Picks for 2005 and Beyond”. The several

Google Inc. (GOOG), August–October 2004

Source: BigCharts.com

Figure 3

Travelzoo Inc. (TZOO), 2003–2004

Source: www.decisionpoint.com

The Gloom, Boom & Doom Report

3

Figure 4

Amazon.com, Inc. (AMZN), 2002–2004

Source: www.decisionpoint.com

Figure 5

Gold Prices (in) around Commodity Shocks

Source: Bridgewater Associates

panelists included George Gilder, my friend Michael Murphy, and Garrett Van Wagoner, all legendary, but for investors “very” painful, high-tech luminaries. Another prominent speaker was, according to Hickey, author Harry Dent who in his book The Roaring 2000s (published in 1998) predicted that the boom would last until 2008 and that the Dow would hit 35,000. Dent’s title for this year’s speech at the Money Show was “The Next Great Bubble Boom: 2005– 2009”, which prompted Hickey to suggest that this year’s Money Show should have been more appropriately titled, “The We’ve Learned Nothing 4

The Gloom, Boom & Doom Report

from the 2000–2002 Collapse Show”. That investors and conference organisers have learned next to nothing from the high-tech bubble of the late 1990s doesn’t surprise me. But that the members of the US Federal Reserve Board have learned so little from the consequences of totally ignoring the Austrian School of Economics is truly mindboggling. We have seen that inflationary monetary infusion obscures price signals and leads to significant distortions, which in turn manifest themselves in all kinds of bottlenecks, losses, and the revelation of widespread malinvestments. In short, as Ludwig von

Mises pointed out, inflation, irrespective of whether it manifests itself in a rise in consumer prices or in the value of assets, deranges economic calculations and, as we suggested in last month’s report, financial calculation as well. (See GBD report of October 18, 2004, entitled “We Are the Children of the Bubble!”.) In view of this condition, I made the point that it had become increasingly difficult for investors to determine the relative investment merits of different asset classes. Therefore, just about every market participant had turned into a “momentum” player. So, when the Euro strengthens, as it did recently, speculators, dynamic hedgers, and all those other financial institutions whose behaviour resembles that of hedge funds, short the dollar against the Euro and the Swiss Franc. However, in doing this, they may be overlooking the fact that other currencies, including gold and the Singapore dollar, or even other assets, might be far better value than the Euro and the Swiss Franc. In this respect, an analysis by Bridgewater Associates of recent commodity price movements, including oil, compared to past commodity shocks makes for interesting reading. So, whereas in the 1968–75 period, oil, gold, and silver rose by 200%, 150%, and 100%, respectively, the upward move since 2000 in commodities has only lifted oil by less than 100%, gold by 40%, and silver by just 25%! Moreover, whereas in real terms oil rose in the 1973 oil shock by 150% and in 1979 by 100%, recent real oil price increases have been just shy of 50%. Bridgewater Associates then compares the rise in gold prices around major commodity price shocks and, as can be seen from Figure 5, it would appear that the recent rise has been very modest in comparison to previous commodity shock conditions. So, whereas I am in full agreement that the US dollar is a doomed currency in the long term, I am less certain that the Euro, the Pound Sterling, and the Swiss Franc are far better options because, at the present exchange rate, the European November 2004

price level — especially that in Switzerland — would seem to be very high compared to the US price level. Therefore, I would rather play the demise of the US dollar through the gold and silver market, than by buying Euros, whose fundamentals are not particularly enticing. But then again, I’m not so sure about

Figure 6

Copper, 2003–2004

Source: www.futures.tradingcharts.com

Figure 7

Lumber, 2003–2004

Source: www.futures.tradingcharts.com

November 2004

much additional dollar weakness in the near future, for the reasons I shall explain below.

INVESTORS’ CONSENSUS VERSUS LIKELY OUTCOME Investors and strategists will tend to argue that the recent weakness in the

US economy represents a typical mid-cycle slowdown and that a pickup in economic activity is just around the corner. The consensus also holds that stocks will be higher in a year’s time and that the market is reasonably priced. Concerning the Chinese economy, the consensus believes that a moderation in China’s growth rate has taken place. Restrictive credit policies are expected to be relaxed shortly. Therefore, by early next year, growth will once again surprise on the upside. Based on these assumptions, the popular view is that commodity prices will — following their recent sharp break (see Figure 6) — continue their bull market. However, I see a scenario which could upset this optimistic view of the global economy and asset markets. Turning first to the US economy, several recent developments raise the possibility of a more pronounced slowdown in economic activity. As indicated in last month’s GBD report, lumber prices have collapsed by more than 30% (see Figure 7). By itself, this should be enough to signal a considerable slowdown in homebuilding activity. But when combined with recent news from several homebuilders that demand has levelled off and some price weakness has been seen in one or another market (Las Vegas), along with the recent announcements of Washington Mutual (WM) of a yearon-year 35% decline in quarterly earnings and of Countrywide Financial Corp. of a 47% decline, it certainly suggests that an abrupt reversal in fortunes has begun to unfold in the housing industry. According to Washington Mutual, third-quarter loan volume slumped to US$61.8 billion, which was less than half of the US$131.9 billion reported a year earlier! At Countrywide Financial (CFC — see Figure 8), refinancing volume plunged by 55% in the third quarter, which reduced total lending by 27%. (The decline in home-related borrowings may explain the recent weakness in monetary growth.) Now, since US housing price inflation was not driven by income The Gloom, Boom & Doom Report

5

Figure 8

Countrywide Financial Corp. (CFC), 2002–2004

Source: www.decisionpoint.com

Figure 9

US Home Prices Relative to Average Household Income (1975=100), 1975–2003

Source: Bridgewater Associates

gains but by a housing-related credit bubble, something more serious than just a temporary lull in the housing market should be expected if credit flows come off, as is now the case. I think it is fair to say that for the typical US household, real incomes have been declining over the last few years principally due to significant healthcare, transport, and education cost increases. (I may add here that for those who believe that we have not experienced much inflation in recent years, or that the decline in the purchasing power of the US dollar is a myth, tuition at Stanford 6

The Gloom, Boom & Doom Report

has risen from US$2,400 annually in 1970 to currently a tad below US$30,000 — a more than ten-fold increase.) Therefore, if total mortgage credit growth — which was up by US$1.03 trillion (or 12.0%) over the 12 months to June 30, 2004, by US$1.92 trillion over two years, and by US$4.82 trillion (or 97%) over seven years — does slow down, it could have an immediate impact on real estate asset values. The end of the housing refinancing boom, combined with the fact that home prices are at a record high compared to household incomes (see Figure 9),

should then slow down further home price increases. In fact, I would expect slower credit growth to lead to a decline in the housing market. In turn, a decline in home prices will negatively affect consumption, since it is asset inflation that has driven consumer spending since 2000 (and, to some extent, the tax cuts) and not rising personal pretax incomes. The ever-optimistic homebuilders — a trait they share with miners and high-tech executives — will, of course, tell you that the housing market is fundamentally healthy. But investors won’t have to wait long to find out about the true condition of the housing industry. In last month’s report, I explained that a breakdown of financial stocks would be a warning for the credit-driven economy and the stock market, which would have to be taken seriously. A few days later, American International Group (AIG), Marsh McLennan (MMC), and other insurance stocks broke down. Shortly thereafter, Investors Financial Services (IFIN), which provides financial administration services to asset managers, collapsed. And when I mentioned to a hedge fund manager that he should short Countrywide Financial, his response was that he had done so on various occasions in the past but that he had always been stopped out. Countrywide collapsed the very next day. I have mentioned this not because I had any particular insight into Countrywide’s financial affairs (I have been short the stock for some time, and at great pain), but because the out-performance of financial and housing stocks has lasted for so long that numerous short sellers and momentum players had abandoned these groups as bear targets. But now, with the trend likely to have reversed, short sellers may once more become active on any rebound. In fact, investors should pay close attention to the rebound in financial stocks. A failure of the group to make new highs in the near future, at a time when the bond market has been rallying strongly, would have negative implications for the entire market as well as the housing sector. November 2004

An additional confirmation of deflation in the housing market would come if homebuilding stocks that are heavily exposed to the Californian and Nevada markets, such as KB Homes (which derives 70% of its operating profits from these two markets) and Lennar (which earns 44% of its operating profits from California), were to break down (see Figure 10). On its own, weakness in the US housing sector wouldn’t overly concern me. However, if it were simultaneously accompanied by weakness in the Chinese economy, which, aside from the US, is an important driver of global growth, then I would take a dimmer view of the world. We have seen that in the US, the latest credit bubble fuelled asset inflation in the housing market and, therefore, boosted consumption. However, strong credit growth did not lead to rising net capital formation and industrial production (excluding industrial production purely related to consumption, such as oil refinery production and movements of railroad cars full of imported goods). But in China the credit bubble (inherited from the expansive US monetary policies through the fixed exchange rate) led to an unprecedented capital spending boom designed to boost manufacturing capacity in order to satisfy domestic and overseas consumer demand growth, which was expected to never end. In addition, rising commodity prices led to significant inventory accumulation. However, there are suddenly signs that not all is well in the Middle Kingdom and that the likelihood of a very hard landing has increased meaningfully. To start with, car sales, which were growing at 100% year-on-year in some months of 2003, have slowed down considerably. (Sales of passenger cars rose from 750,000 units in 2001 to 1.2 million in 2002, and almost doubled to 2.1 million units in 2003.) But whereas passenger car sales still rose by 50% in the first three months of 2004, in the first nine months of this year they rose by just 17.77% and declined by 3.64% November 2004

Figure 10 KB Home (KBH), 2002–2004

Source: www.decisionpoint.com

year-on-year in September 2004. In the meantime, profits of some automakers have declined by more than 30% (GM, China’s secondlargest car manufacturer, reported that third-quarter profits were down by 44% from a year ago), as automakers were forced to cut prices in order to maintain market share amidst disappointing sales. For the indefatigable China optimists, a decline of less than 4% in passenger car sales in September 2004 may not sound like much, but, given the market share-driven mentality of executives, production is unlikely to have been cut back much, which means that inventories have risen sharply in recent months. (Car inventories rose to 115,000 in August from 80,000 at the beginning of the year and will likely have increased further in the last two months. My friend Simon Hunt of Simon Hunt Strategic Services [[email protected]], who regularly visits corporations in China, estimates that car inventories among manufacturers and dealers could be as high as 600,000 units.) Moreover, the car manufacturers, having planned their production capacity expansions based on car sales increases of more than 80% in

2003, will likely curtail capital spending once they realise that the market isn’t expanding at nearly the rate they had expected. The poor state of the Chinese car market is also reflected by the poor stock market performance of Chinese car companies (see Figure 11). In the appliance industry the picture is not much different. Inventories of unsold appliances are also reported to have bulged, and Whirlpool recently blamed a thirdquarter loss of US$10 million from its Asian operations on slowing demand in China. In the high-tech universe, conditions seem to be even worse. Analog Devices recently lowered its outlook for the fiscal fourth quarter ending October 30, and told analysts in a conference call that August sales had been weak and that a hoped-for autumn increase in orders had not occurred. And whereas in August Analog had still predicted that sales in it fiscal fourth quarter would be similar to the third quarter, when it posted sales of US$717.8 million and EPS of 43 cents, it now expects sales of US$630 to US$640 million (down 10% to 12% from the prior quarter) and EPS of between 33 and 35 cents. (I am mentioning this to show our The Gloom, Boom & Doom Report

7

Figure 11 Brilliance China Auto Holding (CBA), 2001–2004

Source: www.decisionpoint.com

readers how volatile the high-tech business has become. In August, when the current quarter was already under way, the company overestimated its quarterly sales by more than 10%! How much earnings visibility is there under these circumstances for next year?) Analog’s CEO noted that demand was weakest in Southeast Asia and Japan. Orders were particularly low for wireless handsets, wireless infrastructure, semiconductor capital equipment, and consumer products. Pressed by an analyst to comment on the company’s business in China, Analog’s CEO responded: “We will try to update you on that, once we see the results in November. I mean, clearly our business in China was down substantially this quarter (fiscal fourth quarter ending October 30), or at least it has been so far.” But to add a positive spin on disappointing revenue and profit figures, Analog’s CEO also added that “feedback from customers in China indicates inventory levels are low and government constraints are likely to end later this year or early next year”, which could signal better growth prospects ahead. (On these comments, the stock jumped 10% in a day.) 8

The Gloom, Boom & Doom Report

However, that inventories are “low” is not what we hear from our sources who regularly travel to China and visit numerous companies. According to one independent analyst, semiconductor inventories are “bloated” and sales in the fourth quarter, which is usually the year’s strongest quarter, are likely to disappoint badly, as the recent slowdown (collapse?) in the Chinese market came as a total surprise to high-tech executives. It doesn’t take much analytical skill, therefore, to see that inventories must have increased strongly. Just consider the sales of CellStar, which Fred Hickey highlighted in his October 5 HighTech Strategist report. CellStar, a leading worldwide mobile phone distributor with US$1.8 billion in sales in 2003, reported, according to Hickey, “that third quarter revenues from its Asia-Pacific region (mostly China) would be just $76 million, down 52% from the second quarter and a stunning 72% less than the $270 million recorded in Q1 2004”. (TCL, one of China’s leading domestic cell phone manufacturers, reported that August sales fell by 39% year-on-year in August, following a 19% decline in July.) The

China optimists will call this a soft landing, but for me this is a very hard landing for the cell phone industry where production capacities, especially in China, are still increasing. (The cell phone industry is the second-largest user of semiconductors after the PC industry.) Consider this. There are at present 315 million mobile phone subscribers in China, up from 50 million in 1999. (I suppose the total mobile phone population is far larger, since many users don’t subscribe to a service but buy prepaid cards.) This year’s sales will come in at around 90 million units, which, despite the recent decline, will still be an increase of almost 50% over 2003. With these kinds of growth rates over the last few years, it is easy to see that huge production overcapacities must have been built, since manufacturers have fallen prey to the “error of optimism” in anticipation of further strong sales increases ad infinitum and failed to realise that the handheld telephone market was rapidly becoming saturated. (It is estimated that in major cities the penetration rate is around 60%.) Moreover, an involuntary inventory accumulation must have taken place, since the recent sales decline was — as is so common — totally unexpected by those high-tech executives who are supposedly endowed with great foresight. (Some analysts believe that the inventory of unsold phones in China could be as high as 60 million units.) Now, I don’t doubt that the market for cell phones in China can still grow in future, and that there is still plenty of growth potential in countries such as India, where sales this year will reach “only” around 20 million units (on a population of one billion), as well as in Indonesia, Vietnam, etc. However, the growth rate of sales is slowing down at precisely the time global capacity has been boosted very substantially. In my opinion, this will lead to further price cuts for cell phones. Moreover, semiconductor sales, which are highly dependent on the cell phone market, are unlikely to meet analysts’ expectations. November 2004

Then, there is the Chinese housing market, which has slowed down considerably. Last year’s property investments as a share of GDP were 50% higher than the previous peak in 1993, a cyclical high for the housing industry, which was subsequently followed by several years of far more moderate growth. Commercial space under construction has also begun to contract significantly (down by more than 50% since the beginning of the year). It is unlikely to pick up much in the near future in view of the rise in vacancies (see Figure 12). Here, I have to explain another misconception among foreign investors. The consensus holds that the slowdown in economic activity in China is solely caused by the government’s administrative measures implemented at the end of last year in order to cool down the “overheated” economy. Hence, it is assumed that once the economy has cooled off, the restrictive economic measures of the government will be lifted and growth will automatically rebound again. But this is not my take of China’s recent economic slowdown. I believe that, in the same way that all interventions by governments and central banks are implemented, they came at the wrong time. In the case of China, the restrictive economic policies came at precisely the time the economy was about to cool down for cyclical reasons anyway. Capital investments, which in recent years rose much faster than GDP, reached probably close to 45% of GDP in early 2004, which would have exceeded the last cyclical peak in 1993. Moreover, foreign direct investments rose by almost 50% in the first few months of 2004. In my opinion, these kinds of growth rates of capital formation and foreign direct investment are indicative of major over-investments by local entrepreneurs who have little or no experience of a market economy’s cyclical forces, and of foreign companies’ insatiable appetite to participate in the latest Eldorado (after having been badly hurt by the Asian crisis in 1997 in their other emerging market investments). November 2004

Figure 12 China: Loans to the Construction Sector, 1996– 2004

Source: The Bank Credit Analyst

Therefore, with or without the Chinese government’s measures to cool the economy, I would have expected capital spending to slow down, because of the over-capacities and bloated inventories! Moreover, it is far from certain that an economic rebound will take place at all once the government’s credit controls are lifted In fact, my view is that capital formation will decline significantly in 2005 and that foreign direct investments will decline far more than is expected, as vast production over-capacities will result in widespread losses on foreign companies’ investments. In my experience as an emerging market investor, and also from what I have read about previous capital investment rushes over the last 200 years, it would be most unusual if the recent great China investment boom ended any differently than the various canal or railroad booms of the 19th century, or the great European investment rush into Russia at the beginning of the 20th century! This is not to say that China won’t become an even more important economic and political force in future; however, in the context of the present investment markets it is a warning that a Chinese economic slowdown — or, as I would expect, some form of a cyclical hard landing — could badly backfire on investors who simply base their investment

strategies on a continuous economic boom in China.

THE INVESTMENT IMPLICATIONS OF A HARDER CHINESE ECONOMIC LANDING The always extremely informative Bank Credit Analyst of September 2004 contains a supplement entitled “A Big-Picture Guide to China”, which offers an excellent insight into how important the Chinese economy has become for global economic growth over the last 20 or so years. (I highly recommend the Bank Credit Analyst’s publications, including the highly informative China Investment Strategy published by my friend Chen Zhao. For information, contact [email protected] or Tel: 1-514499 9706.) According to the Bank Credit Analyst — and this is a fact I have maintained for some time — the Chinese economy has grown on a purchasing power parity (PPP) from less than 10% of the US economy in 1980 to around 60% at present (see Figure 13). Using market foreign exchange rates, China is only the world’s sixth-largest economy, but it is the second-largest using PPP rates. In addition, the Bank Credit Analyst estimates that between 1990 and 2004, China’s percentage contribution to world real GDP growth was 28%, compared to a The Gloom, Boom & Doom Report

9

contribution of just 19% by the US. I estimate that China directly accounted for close to 50% of the growth in global GDP in the 2000– 2004 period, as most Western countries’ economic growth slowed down while China’s accelerated. But even if my estimates concerning China’s contribution to economic growth are on the high side, it is time for investors to realise that China, with its numerous markets that exceed in physical terms comparable markets in the US or in Europe, has become an important factor in the global economy. I may add that it is unique for a country to have become so important in terms of global growth — aside from the US — and this new condition will require economists to focus far more on what is happening to the Chinese economy and its political scene. It is unique because no other country in the last 100 years has become so close in size to, or in some sectors even larger than, the US economy. The emergence of China as an economic powerhouse is probably the most important event since the Second World War, both in economic and political terms. So, on the one hand we should expect the Chinese economy to increasingly drive numerous markets, as both a supplier and user of goods and services. In particular, cyclical economic fluctuations in China will increasingly be felt in the commodity markets, where the incremental demand from China since 2000 has driven prices for industrial commodities sharply higher. On the other hand, it is clear that China, with its economic weight, will also become politically far more active. In this respect, it is interesting that China recently endorsed India’s claim to a seat in the UN Security Council, which marks a major shift from Beijing’s earlier stand and reflects the new Asian orientation in China’s foreign policy under President Hu Jintao. India should be very happy about the Chinese endorsement of its cause, since it came despite China’s close ally, Pakistan, strongly opposing India getting a permanent seat in a reformed Security Council. I might 10

The Gloom, Boom & Doom Report

Figure 13 China’s GDP as a Percentage of US on PPP Basis, 1982– 2004

Source: The Bank Credit Analyst

add that China is the fourth member out of the five permanent members of the Security Council to support India’s claim to a permanent seat in the Security Council after Russia, Britain, and France have already voiced their support. (The US has so far avoided the issue!) According to political observers, China’s endorsement of India’s claim to a seat in the Security Council should be seen in the context of the expanding presence of the US in Asia, and as a sign that China is keen to improve relations with its neighbours, including India, and to engage with them more actively. According to an Indian academic, “The coming to power of President Hu Jintao marks a major change in China. It now sees its future in nationalism and in Asia and it wants a resurgent Asia.” Moreover, what I find most interesting is that China is willing to accept India as another big Asian country, whereas it is not willing to accept Japan, which is also an aspirant for a permanent seat in the Security Council, but is obviously perceived by China as a close ally of the US. Earlier, I mentioned China’s growing importance as a driver of markets around the world. This is not to say that China has already displaced the US as the largest market for goods and services in the world, but I would like to stress that since business cycle fluctuations can be expected to be more volatile in China than in the US, periods of above-trend growth, such as we have just experienced, will have a more

pronounced impact on the demand side than when the US economy expands. Conversely, when China’s expansion falls below trend-line growth, the impact on some markets should also be felt more strongly than when US growth slows down. Needless to say, some global markets will be affected with particular violence when bouts of growth and contractions occur in China and the US simultaneously! And this is what I am driving at here. Should now, or sometime in the future, the Chinese economy cool down, and should US growth come to a standstill at the same time or be followed by a business contraction, as we expect will occur within the next 12 months, the impact on numerous markets could be very powerful. I am thinking in particular of the industrial commodity markets, which have been buoyed by the housing market and strong consumption in the US, and by very strong capital spending and industrial production increases in China. Particularly vulnerable among the major markets in a synchronised Chinese/US downturn would be the copper, aluminium, nickel, and steel markets. In the GBD report of September 14, entitled “A Tale of Two Great Islands”, I showed how soybean prices had collapsed by 50% when, last March, the Chinese suddenly stepped aside from their normal buying pattern. More recently, when it was announced that copper use in China had declined by 21% in July, metal markets came under intense pressure. Nickel fell in one day by 17%, copper November 2004

by 11% (see Figures 14 and 6). The optimists now say that this setback represents a buying opportunity, pointing out that the Chinese economy will shortly gather renewed momentum, that Comex copper inventories are near historical lows (see Figure 15), and that demand continues to exceed supply. Concerning this bullish view, we should, however, consider the following. It is true that official Comex inventories are low, but low inventories have always preceded peak prices, such as occurred in 1980, 1989, and 1995; whereas high inventories coincided with copper price bottoms, such as we had in the early 1980s, in 1994, and in 2002. It is also true that while Comex inventories are currently very low, inventories among merchants are, according to Simon Hunt, very large and could lead to some Sumitomo Metals type of losses should the market continue to decline. It is also noteworthy that Shanghai Metal Exchange’s copper and aluminium inventories have also increased rapidly since September (up 91% over the last three weeks, admittedly from very low levels). But these factors are more likely to influence prices in the near term, while the overall demand supply will determine prices in 2005. According to Simon Hunt’s forecasts, supply will exceed demand next year and lead to a copper price decline, with a probable low sometime in 2006. BHP Billiton recently also warned that copper supply could exceed demand next year, which is an unusual statement for a mining group since miners are well known for their unshakeable optimism. In fact, being a director of a mining company, I have met numerous geologists and mining executives at conferences in the course of fulfilling my duties as a board member. Miners will always tell you that supplies are tight and that only very limited additional supplies can be brought on stream. However, when I then read the annual reports of different mining companies, everywhere additional mines are being opened up, which frequently increase production by as November 2004

Figure 14 Nickel, May–October 2004

Source: Futuresource.com

Figure 15 Comex Copper Inventory Has Plunged, But Now Set to Rise? 1979–2004

Source: Comex, LME, ABN-AMRO

much as 10–15%. (Escondida, the world’s largest copper mine, just announced that its third-quarter output had increased by 19.8% and that the first nine months’ production was up 17.5%.) Therefore, given the likelihood that significant copper inventories exist among merchants and copper users, and that demand in China and the US is slowing down (the US housing industry is a large user) while supplies are increasing, suggests to me that prices could decline much further over the next six months than is generally expected (see Figure 6). The same would also apply to nickel and aluminium (see Figure 16) and, of course, would also drag down the shares of non-ferrous metal companies such as INCO (N), Phelps

Dodge (PD), BHP Billiton (BHP), Alcoa (AA), and Rio Tinto (RTP), among others. The steel industry would also be a candidate for some pain from a Chinese economic slowdown. According to J.P. Morgan, China contributed 90% of global growth in steel demand and was responsible for 60% of the growth in global demand for iron ore in 2003 and, I suppose, for a similar amount so far in 2004. In particular, steel production capacity is still growing rapidly in China, with the likely outcome that China will in time become a net exporter of steel and most likely depress prices. In fact, investors who are positive on the outlook for steel might do better by owning iron ore companies such as Brazilian CVRD (RIO), because The Gloom, Boom & Doom Report

11

Figure 16 Aluminium, 2003–2004

Source: www.futures.tradingcharts.com

Figure 17 Frontline Ltd. (FRO), 2001–2004

Source: www.decisionpoint.com

rising steel production in China, while depressing world steel prices, will nevertheless increase demand for iron ore. Still, a well-informed reader of ours with a particular knowledge of the steel industry pointed out that International Steel Group (ISG) sells at US$29, earns currently annualised 12

The Gloom, Boom & Doom Report

US$8 per share (all free cash flow), and is expected — even by bearish analysts — to earn between US$5.50 and US$6.50 per share next year. He is long the stock and also other steel companies’ shares, based on the low valuation of steel companies compared to high-tech and Internet

stocks. In short, he expects ISG to rise to above US$40 next year. (As I just finished writing these lines, a takeover offer for ISG was made at around US$40.) I can’t argue much with this view, except to point out that where stocks such as US Steel have risen from US$10 at the beginning of 2003 to over US$40 recently, profit taking could send the shares lower if my weak Chinese/US economic scenario comes to pass. (Please note that short positions in steel stocks are high and could cushion serious price declines and may even entice some funds to attempt to squeeze the shorts.) What about oil and oil shares in a weak economic environment? As in the case of other industrial commodities, it is likely that some inventory accumulation has taken place and that speculators have played a role in pushing prices higher. In the first seven months of 2004, China’s oil imports were up 39.2%, which, given its GDP growth of around 10%, does suggest some inventory building. In the long run, I suppose that China’s, and also India’s, demand for oil will grow at a maximum of about 10% per annum. So, while this incremental demand from Asia is likely to support prices at a high level and will likely drive them over time even higher, in the near term some price weakness should be expected when China suddenly announces weaker import numbers. Still, oil is the one commodity I would be reluctant to short, because if Mr. Bush is reelected, an attack on Iran’s nuclear facilities becomes much more likely — by either the US or the Israeli air force — and could trigger a massive upheaval in the Middle East. Equally, given my negative view of the global economy and of other industrial commodities, I don’t think that buying oil at US$55 per barrel is a particularly favourable risk-reward proposition. In fact, rather than shorting oil, I would consider shorting the shares of tanker companies such as Frontline (see Figure 17), because the supply of tankers is now rising rapidly and is likely to depress tanker rates in 2005. November 2004

It should also be obvious that it is far easier to increase the supply of tankers than to increase the supply of energy meaningfully. In fact, all shipping and air freight companies that benefited from rising freight rates due to the rapid trade growth of China and strong imports into the US could be vulnerable in the synchronised US/ Chinese economic slowdown that I have outlined above. Lastly, how would the Asian economies and their currently very popular stock markets perform in this negative economic scenario? Since China has been driving exports of countries such as South Korea, Japan, and Taiwan strongly higher in 2004, and these now account for a very important share of these countries’ exports (and in the case of South Korea, for a higher share of total exports than to the US), one should expect a severe fall-out from a Chinese slowdown. This observation would certainly also apply to Hong Kong and its more than fully priced property market. I must admit that in the case of a synchronised economic slowdown in the US and in China (or a contraction in the US and a severe deceleration of growth in China), there are not many assets that wouldn’t be negatively affected. A case could be made that bonds would perform relatively well, as deflationary forces would make a 4% annual return look attractive. This would be the case particularly for Eurodenominated bonds, as current Euro strength is bound to keep European inflation low. Moreover, I wouldn’t be surprised if the flight into sound money such as gold and silver continued, as the Federal Reserve Board’s reaction to economic weakness would be — as has always been the case over the last 20 years — to print money. (See also GBD report of October 18, 2004, entitled “We Are the Children of the Bubble!”.) I concede that there is always a high probability that I could be wrong and that my rather unappealing global economic scenario might not come to pass. Therefore, we should also consider the investment implications if synchronised growth in the US and November 2004

China continued for the next few years. In a strong global economic scenario, we should expect inflationary pressures to build and interest rates to rise, possibly quite sharply, in 2005. This would certainly not be positive for the US housing sector and for US financial stocks, which usually perform best in an environment of declining interest rates. In this scenario of strong global growth, bonds would also perform miserably. In the US, retail, technology, and cyclical stocks would likely rebound. Asian economies and their stock markets (including Japan) would, driven by growth in the US and in China, most likely significantly out-perform US equities. It is unlikely that commodity prices and oil would decline much and could in fact strengthen further, which would benefit countries that are resource-rich, such as Russia. I would argue that the Russian stock market is one of the best ways to play growth in China. Russia is extremely complementary to China. China needs Russian resources, whereas Russia and the other former Soviet countries offer a huge market for Chinese-made consumer goods. I have, therefore, asked two friends of

mine to update us on what is happening in the Russian capital market. Ian Hague, along with Harvey Sawikin, is a principal and founder of Firebird Management LLC, whose performance has been superb. Ian has kindly provided the satirical piece that begins on page 15. (Firebird manages almost US$800 million in five portfolio equity funds and one private equity fund, including the Firebird Fund LLC [US$65 million in assets], Firebird New Russia Fund [US$164 million], Firebird Republics Fund [US$212 million] and Firebird Avrora Fund [US$91 million], most of which are focused on the former Soviet Union and emerging Eastern Europe. Three of these are among the ten bestperforming of all hedge funds over the last five years, according to MAR.) Then on page 21, Eric Kraus ([email protected]; Tel: 7095-203 5191), who is quoted in the satirical piece by Ian Hague, and who is indeed the chief strategist for Sovlink Securities in Moscow and also a director of the Marcuard Russia Fund, has provided his take on the situation. Eric also follows the fixed interest securities market closely and likes some Russian corporate bonds

Figure 18 Russia Moscow Times Index ($MTMS), 2000–2004

Source: www.decisionpoint.com

The Gloom, Boom & Doom Report

13

issued by companies such as Gazprom, Severstal, Evraz, Sistema, and MTS, all of which yield around 9%. Personally, I think that Russia is a wonderful play on China (exports from Russia to China have trebled in the last four years) and on rising commodity prices. Moreover, with the ongoing wealth creation, Russia offers numerous investment opportunities in different asset classes, including real estate, which people like Ian Hague, Harvey Sawikin, Eric Kraus, and also Richard Deitz (rdeitz@vr-capital. com), who runs a global value fund from Moscow, should be able to take advantage of. Still, if my negative forecast about China and commodity prices should prove to be correct, the Index (see Figure 18) could come under some pressure. This would not necessarily mean that all Russian shares would tumble, but weakness in commodity prices and resource stocks around the world would likely also pressure Russian resource shares despite the fact that they are relatively inexpensive.

CONCLUSIONS Recently a market commentator suggested that the US stock market was performing as if the economy was going to be strong next year. This is certainly not my interpretation of the present stock market action. General Motors is making 12-month new lows and, as explained above, financial stocks have begun to break down, which is likely to have dire consequences for the residential real estate sector. The end of home price inflation or, possibly worse, the onset of price deflation would lead to far slower consumer spending growth or to consumption contracting altogether. And whereas insurance stocks could rebound somewhat in the period ahead and therefore boost the entire financial sector, I still

14

The Gloom, Boom & Doom Report

recommend that investors lighten up their financial stock holdings. Particularly vulnerable would seem to be the sub-prime lenders or financial companies where subprime lending has become an important part of the business. Subprime lenders will get hit either way. In a recessionary environment, bad debts will be the problem because of home prices no longer rising, and in a strong economy rising interest rates could become the problem. Shares of homebuilders are admittedly not expensive. Still, the housing market will likely disappoint in 2005, and I would use any rebound in homebuilding shares from current levels as a selling opportunity. The Chinese economy is likely to disappoint investors for the reasons outlined above. Synchronised weakness in the US and China would be very negative for most equities and also for industrial

commodities, including oil. In this negative economic scenario, gold and silver should perform relatively well compared to both industrial commodity prices and the S&P 500, but this doesn’t mean that precious metals wouldn’t decline as well if liquidation were to spread across all asset classes. And while a weak Chinese economy would certainly be negative for numerous Asian countries whose economies have benefited from China’s strong growth over the last few years, I would still expect foreign (including Asian) stock markets to outperform the US market from here on (see Figure 19). Should, contrary to my expectations, the global economy surprise in 2005 on the upside, prices of industrial commodities and, in particular, oil prices should remain firm or even rise further, which would benefit resource-rich countries and natural resource companies.

Figure 19 US Equity Market Relative Performance, 1980–2004

Source: The International Bank Credit Analyst

November 2004

Putin’s Gleichshaltung: The Press Conference Ian Hague, Firebird Management LLC 152 W. 57th Street, 24th Floor, New York, NY 10019 Tel: (1-212) 698-9260; Fax (1-212) 698-9266; Website: www.fbird.com; Contact: Michelle Hynes, E-mail: [email protected]

Immediately following the disaster at Beslan in North Ossetia in the Russian Caucasus, President Vladimir Putin took two decisions that have the potential to dramatically alter the investment climate in that country for years to come. On the Monday right after the disaster he dramatically changed the electoral system of Russia, eliminating direct elections of regional governors and the first-past-the-post form of electing members of the lower house of parliament. The next day, he announced that the government had decided to merge the state-owned Rosneft oil company into Gazprom, the giant natural gas conglomerate, thereby removing the most important obstacle to legalising foreign ownership of the company’s Ruble-denominated shares and creating what could one day become one of the world’s largest companies of any kind. As always with Kremlin decisions under Putin, the announcements were sequenced for maximum political effect. The cheers of the foreign investment community in response to the second decision were supposed to drown out to some degree the howls from what remains of the domestic liberal press, foreign governments, NGOs, and free-minded people around the world. The opinion in this camp has been that Putin’s response to Beslan has been essentially a prearranged gambit to eliminate the last aspects of federalism and pluralism within the Russian political system and thereby create what Putin and his secret policeman friends like to call a “vertikal’vlasti” or a “vertical of power”. In a televised address to the nation over the weekend, he warned Russians that terrorists and their “foreign supporters” were seeking to undermine the country’s territorial integrity, just as they had contributed to the collapse of the USSR; and that their work was being made easier by the Kremlin’s inability to ensure that its orders are satisfactorily obeyed at the level of regional administrations. We think this is pretty radical stuff. Reading the transcript of the televised address, we got to thinking — what if he were to give a press conference to explain his thinking more clearly? VP: Glad to see you here. You may ask your questions. Rudolf Gitler, Rammstein Fanclub, Newsweekly: Some people have called the changes you announced a coup or revolution. What do you think is the right word for a complete re-writing of a country’s constitution by an elected leader, without recourse to a referendum? VP: Thank you for the question, Mr. Gitler. And by the way, my daughters are big Rammstein fans.… November 2004

The word I would use to describe these actions doesn’t really exist in Russian or even Soviet political language, so I will draw on my excellent German and call it a Gleichshaltung, or “coordination”. The idea behind it is as follows: when I ascended to the presidency, the country was pretty much ungovernable under the system of checks and balances that existed, so I decided to remove them. This is what the Germans did in the 1930s and it really helped to accelerate economic growth and cut down on crime. I believe the mandate that I got in my second election earlier this year — which, I remind you, I won in a landslide — makes this act legitimate. Just to make sure, I am executing the project in the form of two pieces of legislation that will be passed by the Duma, so that there can be no question under the existing constitution that I have the legal authority. Dmity Parashka, RosBusiness Consulting: But weren’t you worried about how this would be perceived by Russia’s foreign partners — the EU, the US administration, and the foreign investment community? And how about the domestic constituencies? After all, at a time like this, such actions look like political instability.… VP: Of course I know very well that people in various groups outside of the government and the legislature might raise objections to these steps. After all, these are pretty fundamental changes to the political order here in Russia. But I think I got it all covered. The organised political opposition in Russia will not say a word about this, or at least no one will hear them. For the most part, these guys are trying to get adjunct professorships at universities in California or Arizona. They will be hiding out there until 2008 when the struggle over my succession will heat up and Anatolii Chubais will throw his hat into the ring. At that time I will have the choice to actually retire, to eliminate the term limit in the constitution, or to obey the term limit and make myself head of the pet political movement that controls the Duma. This last technique would give me another four years in power, but this time as Prime Minister. It’s the same kind of constitutional switcharoo that Kuchma tried to do in Ukraine last year. Until then, my nationalised media — electronic and print — won’t be giving much time to alternative points of view. Without access to television in a big country like Russia, you are pretty well marginalised. The opposition’s former backers in the business community — you know, the so-called oligarchs — will never lift a finger against me again. They are all busy thinking about who might be next after Khodorkovskii and what parts of their industrial The Gloom, Boom & Doom Report

15

empires might be most vulnerable to a Yukos-style attack. It is heartwarming to see how much more respectfully former kingpins like Misha Friedman, Volodya Potanin, and Oleg Deripaska comport themselves these days. As far as the effect of my changes on the economy is concerned, I think in most people’s minds across the country there is understanding of the need for these steps. For too long the country has been labouring under the delusion that anything can be accomplished here under a pluralist setup. Out in the regions, federalism is associated with undisguised feudal arrangements among local elites and the regional political leaders. When we talk of SMEs and the reasons why they still only make up 20% or so of GDP, it’s clear that the overall business environment in places like Khabarovsk, Vladivostok, and St Pete is too tightly controlled by local authorities. These new powers I have arrogated to myself have the potential to break up the logjam. When local officials serve at my pleasure, I will be able to direct them to implement the proper policies. This is very popular. As for the foreigners, here I have drawn down my political accounts a little bit, but a lot less than you think. My pal Silvio Berlusconi has an intuitive understanding of what I am doing — if I ever re-privatise the television and radio, I am sure he will make a bid. The European Parliament as an entity has spoken out strongly against the changes, but on a one-to-one basis I believe I have Schroeder, Jacques Chirac, and Tony Blair all in the bag, so, like most people, I don’t pay any attention to what the EU says. As for the Americans, the Bush administration has a whole lot going on right now what with Iraq and the President performing so miserably in the debates, so they’re not going to be a problem. They are more concerned about loose nukes and Chechen jihadists attacking US troops in Iraq, which of course is absolutely not the case. Then there are the Chinese. Well, enough said. And I have scored well with investors, too. Conoco, BP, and Total are certainly not too worried or they wouldn’t have signed up to become partners with Russian companies. The Conoco deal in particular really took the wind out of the sails of anyone who thought capitalists from Houston would protest my rightward change of course. The global energy majors will continue to eat out of my hand for a long time, so desperate are they for access to our oil reserves. Furthermore, the new look of my government has encouraged other kinds of FDI in the country. Now that Gazprom seems to be in the process of acquiring all sorts of electricity generation assets — there will be big money to be made in the next ten years developing gas-fired capacity for the domestic market — real big players in this field such as E.ON, Alstom, and GE have all shown significant interest lately. In the banking sector, Citibank is looking at building out a consumer credit and mortgage business. Eventually we hope to have the foreigners make up something like 25% of this market. As for the capital markets, debt investors (foreign and domestic) remain mesmerised by the US$100 billion in 16

The Gloom, Boom & Doom Report

foreign reserves that we have now accumulated as a result of the high oil price. This is equivalent to nine months of imports and is likely to keep on growing for some time yet. Our financial specialists deserve the world’s praise for bringing the country back from the depths in 1998. Although the balance of the country’s capital account is still a negative number (–US$12 billion) — blame concerns about Yukos and the “mini-banking crisis” that the Central Bank unleashed over the summer as part of the cleanup process — we are confident that the everimproving macro-fundamentals will eventually attract back those who we want to see return to our investment market. When that happens, all the rating agencies will be scrambling to look for ways to give us the bump to investment grade. I was also delighted by the equity market’s reception of my announcement that the state-owned Rosneft and Zarubezhneft would be folded into Gazprom in exchange for a 11% block of treasury shares. This will bring the government share in GAZP up to 51%, making it possible to liberalise foreign ownership of the Ruble-denominated local shares. All of the krutye spekulyanty in the Russian stock market believe this to be the Bolshoi Kahoona of Russian investing, even though it is still basically a ministry with much value trapped in a marasmus of corruption, stupid investment decisions, and fear of change. Nevertheless, change will come. With Europe moving away from take or pay contracts and LNG beginning to create a real spot market for gas in the Asian market, the long-term future of that company is not as a monopolist in both production and transmission. I think even Gazprom knows that. My sense is that after we have extracted various unrelated concessions from the Americans in our WTO talks — together with a series of domestic price increases between now and then — we will be positioned to promise the unbundling of the company into its two different market segments, according to a leisurely time schedule that even the people at Gazprom will not object to. In the meantime, I need to be able to use gas deliveries as a stick to beat any leader in Ukraine, Central Asia, or the Caucasus who thinks that they are sovereign when it comes to their economies. The bottom line for portfolio investors at the moment is that, love me or hate me, Russian oil companies are pretty cheap at 7–8 times earnings and anyone who has been around emerging markets has had to price in risks that are a lot scarier than the ones that I have created. The overall risk/return in the stock market is still good compared to most other places around the world, but the future is just not as guaranteed as it looked two years ago. That said, I think that there are still a number of opportunities. I am a patriot, so naturally my offshore account is full of Russian equities. In order of size I like Gazprom (GAZP), of course, but also Lukoil (LKOH — see Figure 20) and Surgutneftegaz (SNGS — see Figure 21). All of the other Russian oil stocks have some peculiar aspects to them. TNK-BP does not have any tradable shares yet. Sibneft has only an 8% free float. And Tatneft … well, November 2004

who knows what is going to happen there once my people are in charge in the region? At times like this it’s best to keep things simple. Outside of the oils, there are some very exciting things happening in telecoms. The fixed line regional phone companies have been making tremendous improvements in profitability over the years. Managements at these companies have gone from miserable to pretty good as well, and we are now seeing real improvements on traditional interregional business on both an ARPU basis and in terms of tariffs. Furthermore, some of these local fixed line operators also have interests in cellular within their regions and many of them are getting into broadband and ISP provision, which tend to be fairly profitable in Russia. In this space, I like Uralszvyazinform (URSI — see Figure 22), the dominant fixed line company in the Urals region. Investors who like to keep it simple might prefer Vimpelcom (VIP) or Mobile Telesystems (MTB — see Figure 23), the two largest cellular companies which have made investors a lot of

money over the years. With the advent of new services and overall economic growth still robust, I see more upside. For those of you who really feel that things in Russia are getting a little spooky, it is a big region and there are stocks that are of interest in Lithuania, Kazakhstan, Bulgaria, and Romania. In order, I like the Lithuanian refrigerator factory Snaige (SNAI) the best — it is controlled by some brilliant young private equity managers from the West. Then there is Lietuvos Telekomas or Lithuanian Telekomas (LI A1 reg S GDR) — one of the best-performing stocks in the region over the last few years. It’s still cheap and has a dividend yield of 3%. Next there are the Kazakh oil companies, Petrokazakhstan (PKZ) and Nelson Resources (NLRR). Kazakhstan does not impose such progressive oil export duties, so all of the profits deriving from US$50 oil flow right through to the companies. These are both traded in the US, so the corporate governance tends to be a cut above the rest of the oil companies in the region.

Figure 20 Lukoil, 2003–2004

Source: Bloomberg

Figure 21 Surgutneftegaz, 2003–2004

Source: Bloomberg

November 2004

The Gloom, Boom & Doom Report

17

Figure 22 Uralszvyazinform, April–October 2004

Source: Bloomberg

Figure 23 Mobile Telesystems, 2003–2004

Source: Bloomberg

Lastly, I like selected opportunities in Bulgaria and Romania. These two countries are now on the fast track to EU entry; they both have relatively deep stock markets with good domestic participation. I recommend the two important private banks in Romania, Banca Romana Dezvoltare (BRD) and Banca Transilvania (TLV). They are a little aggressively priced on a p/e basis (in the mid20s); but they are the premier liquidity plays in two economies that are growing the fastest in all of Europe. Really price-conscious investors should also look into buying units in the State Investment Funds (SIFS). Call Dimitris Tamvakas, the broker at Alfa Securities Bucharest. He will tell you how to participate in those. In Bulgaria, my biggest holding is Bulgartabak (BTH), the state tobacco holding company that is now being privatised, but I am getting deeper and deeper into the second tier there. Eric Kraus, Sovlink Securities: Congratulations, Mr. President, on the new power alignment and thank you for

18

The Gloom, Boom & Doom Report

the stock picks. However, these actions do raise the question of what you plan to do with all of that power. Since the people you appointed into your government following the Duma elections are by and large second-tier political personalities and third-tier administrators, does this mean that we will not see any meaningful progress on the important reform initiatives that still remain? I am thinking specifically about policies that would create an institutional basis for rule of law, property rights — especially as regards real estate and land — administrative reform, banking reform, electricity sector restructuring, etc. VP: Thanks, Eric. That’s a good question. I am afraid that as of right now, only those initiatives that are mostly technical in nature and have already been started will receive priority. These include banking reform, UES restructuring, laws on collateral and foreclosure for the mortgage market, and a few others. With incomes rising, retail markets booming, even to some extent outside of Moscow, I don’t think people are in the market for radical innovations.

November 2004

I am serious about finally privatising some important stuff next year, such as the Sukhoi Log gold mine project and a rather old but very large steel plant called Magnitogorsk. But the most attractive thing privatised next year will be the state telecoms holding, Svyazinvest. The auction won’t be open to foreigners, of course, but there will be foreign money behind many of the bids that will come in from mayor Luzhkov’s Sistema, Telecoms Minister Reiman, and one or more of Viktor Vekselberg, Len Blavatnik at Access Industries, and Misha Friedman’s Alfa Bank. We intend to make them pay real money, so foreign investors who would like to participate will probably find room. Tell your clients to bring their chequebooks. I suppose that many of you will be disappointed that I do not have more to say about corruption. Normally, one of the things that guys in my position promise when they remove the consensual basis for ruling is a crackdown on corruption. I know corruption is bad for the economy, but I had to choose a lesser evil. The people who are the ultimate guarantors of my rule — the KGBisty — want some payback and this is exactly what I intend to give them. Just to give a few examples: Boris Gryzlov, the new head of the United Russia faction in the Duma, will get a cut of the tribute collected from people looking for phaseins or special exemptions from laws normally designed to promote competition and transparency; Igor Sechin is actively burrowing into senior management at Gazprom’s new oil structure, where he will face a competition with existing Gazprom management and another friend of the organs, Sergei Bogdanchikov. The winner will enjoy a true bonanza. Lastly, Defense Minister Sergei Ivanov will be in charge of a substantially larger military budget. I know he will put it to good use in the R&D field — just look at all the technology we have produced in the last ten years? He and people around him will also be getting cut in on the foreign arms sales business now worth tens of billions. One way or another, most of my colleagues from the organs and their children (many of whom now have MBAs) will begin to play a role in many of the large stateowned businesses that remain, if only to prepare them for privatisation in a few years. We intend to make Vneshtorgbank one of Russia’s leading investment banks, and without the steady hands of Siloviki, mistakes could be made. Also, for a few years more we do not see a need to create an institutional infrastructure for the enforcement of property rights in Russia. We are very happy with the current situation in which people think they have rights for as long as they do not try to exercise them in court. Much easier this way. Later on, when my guys are sufficiently propertied themselves, then we can begin to think about stuff like that. After all, isn’t kto kogo (who destroys whom) a natural law of business too? Yevgenii Gavrilenkov, Troika Dialog: But won’t the ongoing problem with property rights depress the valuations of the Russian companies that are public or are to be listed abroad? November 2004

VP: Two answers here. First, most portfolio investors are like sheep; if the stock is going up, they don’t pay attention to the fact that management can at any time strip out assets, water the stock, or setup personally-held offshore trading companies that do all of the company’s business. Especially in the resource sectors, when a commodity is hot, people look for the cheapest exposure, notwithstanding the corporate governance. This is something we have learned from watching emerging markets over the past 20 years. I think that if the story is good, as long as there are not bombs going off in Moscow, the IPOs next year will go off at handsome multiples. Second, companies that decide for their own reasons that they would like to be fair to shareholders are certainly welcome to do so. Look at Vimpelcom (VIP) and MTS. These two wireless companies have done a good job with corporate governance. I don’t want to say that we as a government oppose that. We just don’t intend to do things any other way. Why should we bend over backwards to give justice to foreign speculators when it is in such short supply everywhere else in Russia? Arkadii Ostrovskii, The Financial Times: Mr. President, in the wake of the Beslan tragedy, what lessons have you learned about the organisational problems that remain in your security apparatus? I mean, do you think the way that situation was handled reflects well or poorly on your security policies? VP: How dare you ask such a question. Obviously Russia has the most qualified security personnel in the world! Beslan was the product of jihadists from Arabia and their financial backers in the West, like George Soros. You cannot defend yourself perfectly. As my friend George Bush says, “You have to be right 100% of the time and they only have to be right once.” Arkadii Ostrovskii: Could I ask a follow-up? VP: No. Next question. Pavel Felgengauer, Nezavisimaya Gazeta: To formulate Arkadii’s question differently — since you based some of the rationale for your constitutional improvements on the need for greater coordination between the centre and the regions on security matters, do you think the setup you have put in place will be any more successful in reducing the incidence of terrorist attacks in the future? VP: Not really. There is so much over which we have little control. Of course, I also have a sinking feeling that once my appointed guys get in there in the regions, the same pathologies will come back. If a carton of cigarettes gets you through a checkpoint to go blow up a school, the fact that my guys will be the ones smoking the Parliaments doesn’t make me feel more secure. I just don’t know what else to do. In the longer term, I know that an authentic political solution to the Chechen issue is the only way to go. I The Gloom, Boom & Doom Report

19

can’t see them ever getting the extra sovereignty they are looking for — how can I give sovereignty to them when I am taking it away from everyone else? — but when the time comes I can behave as if it might be available in some form. Basically, I really am hoping that the extra degree of control I am giving myself over the day-to-day politics of the Caucasus region will be enough to reduce the frequency of attacks, at least until my term is up. After that, le déluge. So, I am hopeful but not optimistic. Besides, if I suffer somewhat in the polls for not being able to protect my citizens, I can simply ratchet up the pressure domestically on all kinds of swarthy “foreign types” across the country. People will get the message. This is becoming an important part of my legitimation strategy as we move forward in my presidency. Every great Russian leader at one point or another appeals to the chauvinist prejudices of his countrymen. They loved my “We will rub them out in their shithouses” quip. I will come up with a new one: “Save Russia, beat a Chechen” … or an Ingush or Kalmyk or a Karbardinian or an Ethiopian exchange student. It doesn’t matter. I think that if I need it, there is a deep well of ethnic animosity that I can tap into. That’s classic leadership in my country. Guy Faulconbridge, The Moscow Times: Mr. President, altogether the Yukos affair, the new high duties on oil exports, and the government’s plan to create a state holding for 20% of the country’s oil production have created the impression that private-sector development of Russia’s natural resources and infrastructure is now not approved of. Is that your position? VP: Of course not. I don’t know where you got that impression. What we are doing in the resource sector has been endorsed by the World Bank and other multilaterals as the best way to actually get a handle on the problem of diversifying the economy. Without important government input into the decisions for large multi-year projects, we are at risk of losing control over the sector to foreigners, political schemers, and flight capitalists. These are Russian resources, and our government officials have the right to enjoy the benefits of them — ahem! [coughs] — to see that they are developed in the best interests of the country! The same goes for the pipeline infrastructure. It seems to me outrageous that a private individual should be able to control a project that has such a direct impact on the country’s national interests. We are not the United States here, after all. With that in mind, we have chosen Japan as the preferred route for our big oil export pipe, not the China project that Khodorkovskii was militating for. The Japanese will pay us good money and we are less worried

November 2004

about their long-term strategic plans. The Chinese, by contrast, will find it very difficult to get too involved in energy with us. The more we help them out, the stronger they will become internationally, and we cannot be assured that they do not have a desire to create some lebensraum for themselves in the Amur region. A captain I met from Amur River Shipping Company put it to me this way. “We cannot deepen the economic relationship with the Chinese or allow any more migration. We have all this land and they are so many.” That is one market no one would like to see clear for a while. Sergei Skaterschikov, Skate Press: Mr. President, what do you think will be the ultimate fate of Yukos? VP: Now, that’s a hard one. You see, we have had such difficulty getting the Menatep shareholders to listen to reason, we have been forced to escalate our pressure on them to the point where we are left with few options. As things stand now, there definitely will be an auction of Yugansknefetgaz, the production subsidiary that accounts for 80% of YUKOS and 1.44% of world production. No foreign company will be allowed to bid, and the starting price of US$17–18 billion that was identified by the official valuator, Dresdner Kleinwort WhatsitsStein, is far too high. The latest from my Justice Ministry is that they think US$3 billion is fair. I don’t know. I am no expert. There seem to be two competing scenarios for what happens after the auction. In the first scenario, the two auction participants are the “loyal” companies, Gazprom (Rosneft) and Surgutneftegaz. One or both of them will buy the asset at some low price and then keep it for a while until a way can be found for us to get the Menatep people (Khodorkovskii and Lebedev and their friends) out of Yukos. Once that is done, Surgut or Gazprom will sell Yugansk for US$3 billion back to the government, which then will swap its interest for 80% of the new equity in a now Menatep-free Yukos. Portfolio investors like this scenario because it holds out the hope of some kind of public company remaining after the government is done. The other scenario is much simpler. It has Yugansk being sold to Gazprom(Rosneft), maybe with the German E.ON acting as a nominee bidder at a valuation that reflects the tax debt of 2000 and 2001, or about US$8 billion. With Yugansk in hand, Yukos will be a lot less valuable to the Menatep shareholders. After a few years in prison — after I decide whether I want to remain in power after 2008 — they will agree to sell their remaining equity in Yukos for freedom and a promise to emigrate, just like Boris Berezovskii and Vladimir Gussinskii. I wish I could say which of these scenarios is most correct, but I can’t. I need to keep some secrets, don’t I?

The Gloom, Boom & Doom Report

20

Russia in Future Eric Kraus, Chief Strategist, Sovlink Securities, Moscow Tel: (7-095) 203-5191; E-mail: [email protected] Market Comment for the Marcuard Russia Fund Contact: Michael Kart, E-mail: [email protected] One of our clients, a veteran of the Russian market, warns that things in Russia are never either as good or as bad as they look — again and again, this has proved to be useful advice. For whatever reason, most of the world sees Russia through the grossly distorting lens of their own prejudices, hopes, and expectations. The analyst’s task is not to subject Russia to whatever set of expectations he carries, but rather, to seek to understand Russian development in specifically Russian terms. The advent of Vladimir Putin has led to changes no less revolutionary than those seen under Gorbachev and Yeltsin. With a reversal of the very dangerous disaggregation of the Russian state under Mr. Putin’s predecessors, Russia is currently benefiting from an extremely virtuous macroeconomic policy, slow but positive reform, and very rapid economic growth. Despite some of the recent noise, we believe that the recentralisation of power under Mr. Putin has enhanced political stability and predictability, and, most important for the sustainability of the economic model, the benefits of this growth are, at least to some extent, being shared by all strata of society. Russia is gradually developing into a middle-class country, with service industries — from mobile telephones to catering, retail, and advertising — rocketing ahead. Obviously, Russian growth has benefited greatly from the explosive rise in commodities prices, in turn driven largely by rapid Asian growth. Huge Chinese demand for virtually every commodity that Russia sells — hydrocarbons, steel, aluminium, copper, nickel, grains, pulp and paper — has pushed prices towards historic levels, leaving Russia awash in liquidity, the primary factor driving short-term movements in the Russian

exchange. Vitally, domestic Russian investors are now the primary force moving Russian equity markets. Unlike the period preceding the 1998 meltdown, the huge revenues from oil and gas export are no longer being simply squandered or stolen; rather, a large share has been captured by the state, which has allowed Russia to pay down her huge foreign debt. With only some US$95 billion in debt still outstanding, Russia has currency reserves of almost US$100 billion, plus a US$16 billion budgetary reserve fund; she is utterly unique among the emerging borrower countries in being a net creditor. Despite the very positive economic background, Russian markets pose a number of hazards to the unwary, the greedy, or the simply over-enthusiastic. The political framework is very much a work-in-progress, terrorist outrages drive volatility, and Western sentiment is once again becoming negative. Despite its meteoric rise over the past five years, due in large part to foreign misunderstandings of Russian events, the RTS remains seriously undervalued — it is currently the world’s second cheapest major equity index. While we expect the ongoing revaluation of Russia to continue, it will by no means be a linear process — sharp sell-offs can be expected as a matter of course. Financial professionals make a living by trading against misinformation, mispricings, and hysteria. Russian markets are rich in all three. The most recent example: the badly mishandled Yukos affair does not pose any real threat to the results of privatisation — it does, of course, pose a huge threat to investors in Yukos itself. The misapprehension of this simple fact has created some excellent investment opportunities, and a relative value approach is to be favoured.

THE GLOOM, BOOM & DOOM REPORT © Marc Faber, 2004 DISCLAIMER: The information, tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or other financial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financial instruments. This research report is prepared for general circulation. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should independently evaluate particular investments and consult an independent financial adviser before making any investments or entering into any transaction in relation to any securities mentioned in this report.

Research Editor & Subscription LUCIE WANG

Subscriptions and enquiries MARC FABER LTD Unit 3311–3313, 33/F Two International Finance Centre, 8 Finance Street, Central, Hong Kong Tel: (852) 2801 5410 / 2801 5411; Fax: (852) 2845 9192; E-mail: [email protected]; Website: www.gloomboomdoom.com

Copyeditor ROBYN FLEMMING E-mail: [email protected]

Design/Layout/Production POLLY YU PRODUCTION LTD Tel: (852) 2526 0206; Fax: (852) 2526 0378; E-mail: [email protected]

Author & Publisher DR MARC FABER

Source: The Wall Street Journal, October 14, 2004 Enclosure 1

Marc Faber Limited