Mr. Hu Goes to Washington

By Yiannis G. Mostrous

MCLEAN, VA–Next week President Hu Jintao of China will visit the White House. The economic/trade friction between the US and China makes this one of the most polarized visits of a foreign leader in recent memory. The issues are well known, but the final outcome and its effect on the global economy remain unknown.

The Chinese president has bad luck, for his visit takes place just three weeks after the latest trade numbers were released in China. Its trade surplus came in well above expectations at $11.2 billion–or $120 billion annualized, up from $102 billion in 2005. See the chart below.

China's trade

This isn’t the first time China’s been under fire for its growing economy, although I expect the US to be an excellent host and avoid harsh criticisms while the Chinese president is in town.

Nevertheless, the pressure for further revaluations of the renminbi will persist. Expect the Chinese currency to appreciate for the rest of the year (see “The Butterfly Effect,” March 1, 2006).

But high rhetoric and technicalities aside, the most important point to understand is that the Sino-American relationship has become the most important one in the world, on the political as well as the economic front. The smoother the relationship, the better it is for everyone, especially investors. For more on China and the US, see “Until It Melts” (March 22, 2006) and “Right You Are (If You Think You Are)” (March 29, 2006).

Turning to the markets, although there’s still a lot of excitement among investors, there’s also a certain degree of nervousness over an imminent correction. At least this is the feeling I get while talking to investors–and not the perma-bear type–around the world.

The question I’m most often asked is which markets are the most vulnerable, besides the US. The answer has been the same for sometime now: India, Japan, Russia and Brazil.

Japan is of particular interest since I consider it to be one of the most exiting investment stories of this decade, together with India, Russia and Germany. I discussed the potential for a Japanese correction last month in Growth Engines (see “Japan II,” March 16, 2006).

For a longer-term perspective, Japan remains the place to be. Its economy is coming out of a prolonged slump in an increasingly assertive way. The main point to keep in mind regarding Japan’s stock market is the end of deflation in Japan’s economy.

The chart below depicts the core CPI (excluding fresh food) of Japan, which has turned positive after eight years.

Japan's CPI

That trend is the main reason for holding Japanese stocks in your portfolio–if you aren’t convinced inflation is returning in Japan, you shouldn’t hold Japanese stocks.

Another interesting point is that after years of high savings rates, consumers have started to spend again. The reason for this is the increasing strength of the economy and rising employment and real estate prices. Consumers are confident and positive about the future, which boosts consumption and helps the economy.

As the chart below illustrates, Japanese household propensity to consume, as measured by Japan’s Ministry of Internal Affairs, has been accelerating.

Japanese consumption

That confidence is also seen in the latest bank lending reports. Companies and consumers have been borrowing again in Japan, and total bank lending rose in March for the second month in a row; see the chart below.

Japanese loans

When it comes to sustainable economic growth, corporate investment is one of the most important factors. In Japan’s case, this has been demonstrated through strong corporate investment during the past four years.

The latest Tankan survey (see chart below), an economic business conditions survey of Japan’s businesses and issued by the Bank of Japan, showed favorable corporate conditions are still in place–a positive for employment growth going forward.

Expect Japan’s recovery to continue and increasingly spread into more sectors of the economy–but there will be bumps along the road. Any pullback in the market, especially a prolonged one, is an opportunity to increase exposure. For now, Portfolio holdings Nidec (NYSE: NJ) and Mitsubishi Heavy Industries (OTC: MHVYF) are the favored Japanese investments.


Looking around the world, corporations remain flush with cash. What this cash will be used for remains to be seen. The obvious ways include boosting dividend payments, increasing share buybacks, expanding merger and acquisition (M&A) activity and pursuing additional capital expenditure. For the time being, companies have started to borrow again (as investors are demanding more growth); expect a lot of M&A activity.

I’m looking for ways to expose the Portfolio to these trends; in markets SRI covers (i.e., not the US), corporate activity will remain more important for the rest of the year, especially in Europe.

Portfolio Talk

There are no changes to the Portfolio this week. The Portfolio remains well balanced, and it should perform well in the event of a (long overdue) market correction.

Investors should also pay attention to our permanent hedges. The initial recommendation to buy US Treasuries still stands (see “Hedge Your Bets,” March 8, 2006). Although yields can go higher, they’re attractive at current levels, so gaining exposure to bonds should prove beneficial.

For allocation purposes, put about 30 percent in US Treasuries via iShares (AMEX: IEF) and 10 percent in gold bullion (or the streetTRACKS Gold Trust, NYSE: GLD, if storage is a problem). Stocks, therefore, should represent about 50 to 60 percent of the Portfolio. The assumption is that investors will use SRI’s Portfolio for their stock allocation.

Finally, Brazil (NYSE: EWZ) remains a short for the adventurous, with a stop at 44 (see “Hedge Your Bets,” March 8, 2006), although it isn’t considered a permanent hedge.

A Note To Readers

This being a new service, I’ve received many questions about portfolio construction and stock selection. Let me take an opportunity to reiterate an explanation from last week’s issue:

The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while we also offer hedging ideas for more complete advice.

A characteristic common to the Portfolio companies is suitabilitiy for the new realities of a changing world. They will benefit the most from the changes taking place in the global economy.

That said, no one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game is by not losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.

It is, therefore, important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories might offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.

Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done easier this way. There’s always another week and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.