Until It Melts – McLean, VA

There’s been a lot of talk regarding global economic imbalances (e.g., current account deficits, extreme debt levels) and other potentially harmful problems the world faces and must resolve. Once this starts, the argument goes, the global markets are in for a troubling time. And I agree.

The only problem with the argument is that no one has been able to predict when the trouble will begin. Hence, investors who traded on the potential for a global economic adjustment have, during the past three years, produced unsatisfactory returns.

However, investors who realized the strength of the global economy and the development of new investment trends did well, even if they kept their portfolio volatility low–a good move in case trouble occurs.

Since timing the above macro themes is impossible–something the best macro practitioners will also tell you–I encourage you to maintain a diversified portfolio that balances growth and income and is overweight emerging markets (especially Asia) and Europe.

Many readers have asked for SRI’s take on Asia for the rest of the year: Unless global markets melt, Asia (and some other emerging markets for that matter, such as Russia) will continue to perform better than their developed counterparts. When the markets do come down hard, expect Asia to recover much faster than it did previously.

Statistics from the United Nations demonstrate that emerging markets, particularly Asia, have once again become an attractive destination for foreign direct investment (FDI); see the chart below. According to the UN, 2005 FDI into emerging markets reached $325 billion, with Asia receiving $146 billion. India, Thailand, Philippines, Indonesia and Malaysia received the most money while FDI to China was flat for the first time in five years at $60 billion.

Source: UNCTAD

These numbers are another indicator that, contrary to the prevailing view, Asia continues to grow as a whole. And although China and India remain the main engines, there’s room for everyone. This provides one more justification for SRI’s long-held view that Asia’s growth potential, although influenced by global growth, should be viewed in the context of an economic region that is developing while ensuring long-lasting structural change. In other words, Asia is counting more on itself now for its economic development than just the kindness of foreign investors, as it did before.

Although headwinds will always be present–after all, no one is immune to economic cycles and disruptions to global trade–they should be viewed as short-term slowdowns in the context of a long-term economic trend that will make Asia an equal partner and strong contributor to the world’s economic growth.

Speaking of problems, China continues to pay the price (mainly verbal lashings to date) for the growing US trade deficit, while US companies and their affiliates continue to see higher profits in China. They earned $3 billion in 2004 compared to almost nothing in 1990. General Electric had $5 billion in profits from China last year and expects that number to double during the next five years.

While Congress is up in arms, and the powerful duo of Senators Charles Schumer (D-NY) and Lindsey Graham (R-SC) visits China this week for talks with Chinese officials, US companies are proceeding with business as usual. Yet, China’s President Hu Jintao is due in Washington at the end of April, the same time the US Treasury Dept is expected to release its semi-annual report on currency manipulation, in which China may be named as a currency manipulator.

Under section 3004 of the Trade Act of 1988, the Treasury Secretary is required to analyze the exchange rate policies of foreign countries and determine whether “manipulation” of dollar-exchange rates “for the purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade” is occurring.

If the report does name China as a manipulator, it will open the door for the revival of Congressional proposals, many of which are on hold, designed to restrict China’s access to the US markets.

In this regard Schumer’s comments in Beijing a couple of days ago that “to say that there’s been no progress would be wrong#.#.#.#we would like to get an idea from our Chinese hosts what the future is going to be like,” should be viewed positively. For more on the currency situation in Asia and how it will affect economies and investors, see the 1 March 2006 issue of SRI, “The Butterfly Effect.”

The Chinese have also made sure to use sharp language. According to reports from China, Wen Jiabao, China’s premier, said in a closed business gathering in China that “it is unfair for the US to scapegoat China for the US’s own structural economic problems.”

These words echo comments made a year ago by Li Ruogu, at the time a deputy governor of the People’s Bank of China (PBC): “China’s custom is that we never blame others for our own problem. For the past 26 years, we never put pressure or problems on to the world. The US has the reverse attitude, whenever they have a problem, they blame others.”

Given that this is an election year in the US and China’s leaders can’t be seen as submitting to outside pressure, expect these kinds of statements to continue. As long as no material action is taken from either party to seriously damage the US-Sino relationship and progress gradually takes place to address both parties’ concerns, the global economy will continue to benefit–and so will investors.

However, if either side pushes the other too far, the consequences could be serious. Protectionism damaged the world economy and trade before. Tariffs placed on China-made apparel products last year did slow down China’s exports somewhat, but other countries picked up the slack–not really solving any of the problems the tariffs were supposed to solve. See the charts below.

Losing Some Exports
China's Textiles
Source: OTEXA

Picking Up The Slack
India's Textiles
Source: OTEXA

Asia continues to be a long-term story. It’s a huge region that’s urbanizing itself, leading to positive domestic demand trends, growth in construction and infrastructure, and steady increase of income. Notice that ex-Japan, Asia’s 37 percent urbanization level is well below the world’s average of 50 percent. Asia, despite the big movement of people into cities and the economic growth from that migration, remains less urbanized than Africa.

For this huge movement of population–33 million people move to emerging Asia’s cities every year–to be successful and produce the expected results on a sustainable long-term basis, there needs to be structural domestic economic changes, as well as open trade policies and high investment rates. This is why the above-mentioned trade problems must be resolved with the least possible damage.

Finally, it was brought to SRI’s attention that Japan’a Chief Cabinet Secretary Shinzo Abe, the most likely successor to Prime Minister Junichiro Koizumi when he steps down in September, continues to lead opinion polls in Japan with 43 percent. This is important because Abe advocates a tougher diplomacy with China.

In other words, the Japanese seem to be comfortable with the geopolitical developments in the region, something that makes our report on the subject (see Geopolitics & Investing Quarterly: The Dragon And The Eunuch: Wars, Spies And Profits In 21st Century Asia) even more topical. Readers are strongly advised to read the report, as it not only offers specific long-term investment recommendations, but also provides details regarding some of the world’s big changes in the coming years.

Portfolio Talk
Japan is one of our long-term bullish investing themes, based on the assessment that the economy is finally coming out of its long slump. But I expect a correction in Japan’s market before the summer, one which will provide an opportunity to add more stocks to the Portfolio. For more on this, see the 1 March 2006 issue, “The Butterfly Effect.”

Despite the need for patience, another Japanese stock is being added to the Portfolio, Nidec Corporation (NSYE: NJ).

Nidec mainly produces brushless direct current (DC) motors. Its four core products in this area are spindle motors for hard disk drives, with applications in personal computers (PCs), car navigation systems and audiovisual products; DC motors for optical disk drives, with applications in PCs, digital disc drives (DVD) and compact disc (CD) players and office equipment, such as copiers and printers; fan motors, which are used in information technology (IT) devices, home applications and automotive motors, which due to the shift to electronics from hydraulic systems, are considered to be a strong future growth category.

Source: Nidec

The company is known for its well run operations and good organic growth. The stock is trading at attractive levels after the recent decline and has recently underperformed the market. Furthermore, Nidec is expected to make some acquisitions of smaller competitors, thereby enhancing its position in this growth industry. Buy Nidec at current levels.

Source: Bloomberg

The purpose of this advisory is to help investors navigate the global markets and, in the process, make money. Here then are the rules of engagement for Silk Road Investor.

The Portfolio won’t cover US-based companies, but will include companies from all the other regions of the world. US companies benefiting from themes presented here, though, will be suggested periodically.

The Portfolio will be a long-only portfolio with no cash allocation. This is being done to make fair comparisons with world stock indexes–global indexes investment advisors like to compare themselves against include only stocks and are always long.

Hedging advice will be offered. I’ve already suggested buying bonds and shorting Brazil (through iShares MSCI Brazil Index Fund, NYSE: EWZ) and BHP Billiton (NYSE: BHP) (see the 8 March 2006 issue, “Hedge Your Bets”). Thus investors will be able to achieve positive returns, while SRI will be fair when comparing its performance to the world’s indexes. Cash–once again–isn’t an option.

The Portfolio will be compared against the Morgan Stanley Capital International All Country World Index Total Return, which includes gross dividends that measure equity market performance in developed and emerging markets. The S&P 500 will also be included as a direct comparison to the US market. For more on SRI’s philosophy see the 15 February 2006 issue, “Rules Of Engagement.”

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