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Research Note, Thailand – June 4, 2014

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You have possibly heard about the military coup that occurred in Thailand on May 22, 2014. In brief, the military imposed martial law and has dissolved much of the elected government. They are establishing a new economic plan, and have temporarily installed the head of the military as the prime minister. In short, democracy in one of the world’s strongest economies is now dead.

Like most news events, this is a story that requires a far deeper understanding to appreciate all of the ramifications. While an objective assessment would be prudent, I am clearly biased by my connections and friendships in the country. What I see is a logical progression that started many years ago with the dismantling of their democracy when Thaksin Shinawatra’s political party (Thai Rak Thai) was elected into power – the man whom this is all about.

A quick history of recent developments in Thai politics begins with Thaksin, a former policeman-turned business leader who was elected prime minister in 2001 through the support of the mostly rural and poor farmers of Thailand. Thaksin did some good for the country in the form of rural development programs. But the downside was corruption – he is a deeply corrupt politician who used his control of the elected bodies to neuter the country’s enforcement agencies and anti-corruption safeguards. In the end, he fled Thailand for Dubai with billions in illegal wealth, escaping a two-year prison term.

In the next act of this drama his sister, Yingluck Shinawatra, who was elected prime minister in his wake on essentially the same platform as her brother, brought further economic revival to the countryside. Her method was far cruder than her brother’s. She promised and delivered on artificial price supports for rice farmers by raising the price that the Thai government would pay per ton of rice. The effect was devastating for the government. Farmers benefitted, but the government incurred at least $4.4 billion in losses (WSJ, June 17, 2013) as the rice they bought rotted in warehouses while rice prices continued to decline due to global overproduction.

This might all have been put under the rubric of bad economic policy if it were not for her last significant move as prime minister – to propose amnesty for her brother to return to Thailand and Bangkok politics. It was this last straw that led to protests, riots, and various forms of political maneuvering, rendering the current government ineffective with no clear path for bringing in a newly elected government.

While it is still not clear what precisely triggered the military’s move at this point in the drama, it is not unexpected. Thailand has a long history of military coups, the vast majority of which are without violence or bloodshed. The military is loyal to the King and only acts when there is a significant threat to the royalist nature of the country. If things go as hoped, the military rule will eventually give way to a political body that is largely in line with the King and a pro-economic ruling party. The issues of corruption still exist, and it will be quite some time until truly elected bodies will be able to function as a democracy, but this is a positive step forward.

From an investor’s perspective, this is welcome news. The market value of our holding, an ETF based on the Thai SET 50 Index (THD), moved in a narrow range immediately following the coup and is now up 4%. The larger volatility in the related index occurred many months ago when uncertainty around the Yingluck government arose and the prospect of Thaksin’s return was real. That was when we first entered the position – after a 20% drop in the Thai index on the fears of a political upheaval.

 

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

Chart 1 – The Thai SET 50 has suffered tremendous volatility in the past year as the political situation deteriorated in the country. The Amnesty Bill, allowing Thaksin to return, was the trigger that eventually led to the current coup. The market abhorred the Amnesty Bill, yet welcomed the coup.

 

Our focus now will be on how the military stabilizes the economy and sets a path for the transition to an elected government. The real damage has already occurred – Thailand’s economy contracted last quarter due to the turmoil and poor economic policies during Yingluck’s tenure. Nicknamed the “Teflon economy,” Thailand has one of the most resilient economies in the region, capable of strong growth based in Southeast Asia’s global expansion. With the elected government’s dysfunction out of the way, the country can return to stable growth as the civil administrators, business leaders and foreign investors are again able to return to the business of doing business.

All the best for an enjoyable summer.

David B. Matias, CPA

Managing Principal

Market Update: October 2013

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From Tapering to Teetering

As has been the pattern of the past six years, the summer always brings an interesting set of challenges for the financial markets.  This summer was no exception, from continued uncertainty in the financial markets soothed over by unprecedented Fed stimulus to geopolitical developments that are still unfolding.  Unfortunately, the political dysfunction that has riddled the nation for the past fews years has reached a stage that will only continue to harm the economy and the country.

The positives, however, are fairly obvious: the US continues to pump $85 billion of newly printed money into the system on a monthly basis, with the stock market as the primary beneficiary.  While the numbers vary week to week, the S&P500 is up around 15% year-to-date.  The other bits of good news are real estate prices, which are on a remarkable recovery, a nominally growing US economy, solid corporate profits, and the recent changes in our energy dependence.

Unfortunately, each of those positives are countered by negatives:  the stock market went apoplectic when Ben Bernanke suggested tapering of the stimulus, growth from the emerging markets has faltered, US overall employment levels are the same as five years ago (mid-recession), and the economic growth in the US is significantly below the long-term average needed to insulate us from negative shocks.

The employment picture is perhaps the best place to find reasons for caution.  Although the unemployment figure we so often read about is significantly down from the high of ten percent, the employment picture is a bifurcated situation.  In the recession, we lost nearly 10 million jobs in the span of just a few quarters.  And while we have created 7 million jobs since then, our labor force has grown in those five years by roughly the same number.  So in short, the labor participation rate among Americans is at a 30-year low.  The following chart shows this fairly well.

Chart 1 Image

Chart 1: Data from the Bureau of Labor Statistics shows the percentage of people employed between the ages of 16 and 65. This chart covers 1981 to present, and shows that the labor rate has not changed since 2009. With a labor rate equivalent to the 1980s, we are creating only enough jobs to satisfy the growing population base, but not replacing those lost in the recession.


The anecdotal evidence suggests the jobs we’ve created in the past five years are of far lesser value than the jobs lost.  Most are at minimum wage, there is a tremendous underemployment problem, and the divisions among social classes continues to widen.  These issues only make the next conundrum even more challenging.

Market behavior continues to indicate that we are in a cycle of bubble markets driven by consumption economics.  The next chart shows the movement of the S&P 500 over the past 30 years, in which the market is pushed to new highs in each cycle.  The driving force behind these peaks is external stimulus leading to bubble asset valuations (dotcom in the 90s, real estate in the 00s, and Fed stimulus in the 10s).  In the collapse of the two prior bubbles, the damage to the financial condition of the broader society was extensive – far greater than the benefits from those bubbles.

Chart 2 Image

Chart 2: The US stock market over the past 20 years (S&P500) has shown a broad trend of asset inflation followed by steep drops as the economic growth falters. These asset bubbles have been extraordinarily damaging, with the potential that we have formed another one. Corporate profits will ultimately determine the breath and depth of the rise and fall.

For the current market rise to continue (as opposed to correcting by 20%-50%), we need corporate revenues to grow.  Thus far, corporate profitability has backfilled the market as price-to-earnings ratios remain at or below historical averages (16x).  This has been primarily achieved through layoffs and productivity increases with some revenue increase.  With the internal measures largely exhausted, revenue growth is going to be front and center for the next several quarters.

This picture could work but demand needs to come from a mixture of domestic and global consumers.  The global scene is dominated by Europe – still struggling to get out of a recession – and Emerging Markets.  As we have seen in China and elsewhere, the massive boom in the emerging markets over the past decade has created disruptive air pockets that make predictable growth elusive.  Hence, the need for the American consumer to find additional disposable income or a willingness to once again increase personal debt levels.  With such a stagnant US employment situation, neither are likely soon.

Chart 3 Image

Chart 3. As the US equity markets surged ahead (S&P 500 shown in red) in the first two quarters, Q3 saw the Emerging Markets (shown in green) stage a partial recovery while Europe & Japan (shown in blue) also posted stronger gains.

It is for these reasons that we at Vodia Capital maintain a diversified asset allocation strategy for our portfolios.  Relying on just equities to drive gains would subject portfolios to far too much volatility and uncertainly.  While markets have shown an ability to recover in the past, these gyrations eat away at long-term returns and ultimately underperform when compared to a diversified strategy.  In response, we continue to use fixed income, commodities and derivates to both stabilize portfolios from global uncertainty and generate predictable growth.

Geopolitical

The biggest challenge to backfilling the equity asset bubble is global conflict.  Domestic issues are important and bleak, but with enough time and some basic legislation, our current situation will ameliorate or the domestic economy will simply adapt.  But until that happens, we do not have enough consistent economic growth to withstand a shock to the system and not enter another recession.

The global issues are less predictable, although we seem to have hit a moment of pause.  Despite my wildest expectations, the situation in Syria seems to have found a multi-lateral solution with Russia participating and China consenting.  While I have my doubts on the ability for the global community to truly disarm Syria’s WMD capabilities in the long-term, it is a relief to see it handled through cooperative diplomacy and through the UN.

On a separate but related front, Iran has consistently posed the greatest threat to global stability in the past few years.  Compared to Syria, Iran’s pursuit of WMD’s is a real problem with real ramifications.  Not to overstate the situation, but by many accounts this region was on the brink war if something was not done soon.  And while I also have serious doubts as to the authenticity of Iran’s overtures, we have taken steps to open a dialogue that has been closed for decades.  That is progress.

Where we do not have progress is in our own political structure.  As of this writing, we have a partial shutdown of our government, with another looming prospect of defaulting on our debt in another three weeks.  By some estimates, a complete shutdown of a few weeks could wipe out our economic growth for the quarter and possibly the year.  And defaulting on our debt is simply a non-starter – the financial ramifications are just too vast to play with.  While cooler heads will prevail, the damage to the economy through continued uncertainty has already taken a toll on lower economic growth.

Changing Energy Dynamics

The most promising development is the changing energy dynamic in the US.  The past six years have seen a dramatic and unprecedented change in our energy dependence.  Despite the mild economic recover, our use of oil has actually decreased by 10% from a combination of better vehicle fuel economy and alternative sources.  During this same time, our oil production has doubled from technological advances.  The net impact is to decrease our reliance on oil imports by half, to less than 10% of global production.

Combined with our natural gas boom, this is an incredibly positive development for the economy.  Much of our economic growth over the past decades has depended on cheap energy, creating a political structure and international presence that went to extreme lengths to protect the dynamic.  As net exporters or natural gas and coal, along with a far lighter dependence on the global oil market, untold resources will be freed up and could generate a new form of a “peace dividend” that we experienced post-Cold War.

The medium-term impact of our energy production and consumption is still of grave concern – from global climate change to the damage we are doing to our drinking water.  The shift to alternative sources, whether they be truly green or simply move us away from oil, is of paramount importance and must continue.  But the ability to shift a focus away from deeply disruptive policies to protect a bad oil dynamic is a start.  Where we take it next will determine just how much of a global leader we can be in the coming decades as the forces of economics increasingly determine our actions as a country.

All the best for an enjoyable fall.

Regards,

David B. Matias, CPA

Managing Principal

Market Minute – April 22, 2013

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Last week was another one of those moments in the market which reminds us that we are in troubled times.  Taking a completely agnostic, statistical perspective on last Monday’s events in the gold market, we again had an event that demonstrates the unstable foundation of the market.  In this case, gold dropped by 5.8% on Friday, April 12 and then 7.7% on the following Monday, for a combined two-day drop of 13.5%.

For perspective, using the prior 1,000 days of trading data as a baseline, gold typically moves around 0.5% per day.  A 2% move is big (once every couple of weeks).  3% is rare (three times a year).  A bigger move than 3% is statistically remote.  A two-day move of 13.5%, under these conditions, has a probability of one-in-a-trillion or roughly once every four billion years.  So maybe my assumptions are wrong (that market returns are normally distributed), but then you would have to discredit an entire generation of financial theory and models.

So where does this leave us?  In the span of two days, gold prices (and a host of other commodities) moved in a way that is not supposed to happen unless we are facing the most dire of global circumstances.  In effect, something snapped in commodities.  There are a host of explanations as to why (Cyprus might sell all their gold, Goldman Sachs starting bad rumors, North Korea did it, Paulson did it…. and so on), but the result is rather simple.  We are in an investing world in which market mechanics are evolving into a dynamic that is both unpredictable and challenging to comprehend.

[To emphasize the volatility problem, yesterday someone hacked the AP twitter account and sent out a false report of an attack on the White House.  The Dow dropped 140 points in a few seconds, then recovered.  Someone made a small fortune on their put options.]

My suspicion regarding gold is that the Exchange Traded Funds (ETFs) which hold a large percentage of the World’s gold supply are causing distortions in the market and led to the market dislocation.  It is a rather nuanced explanation based on the way that ETFs are created, but the theory also helps to explain the Flash Crash of 2011.  Whatever the answer is, since 2008 we have been in a new world of investing and markets.  Gold is supposed to be a safe haven, stable asset with limited volatility.  While it still may be safe in the long term, it is now subject to the same randomness as the rest of the market.

I will later elaborate about other such events during the past three weeks, but the conclusions are the same.  Under the veneer of a bull market in US stocks, there remains tremendous unpredictability and dislocations continue to manifest.

As an investment manager, we have mitigated these risks through our asset allocation strategy and the manner in which we use specific securities.  And in all likelihood, the dislocation in gold is temporary.  But time will tell, as always.

Regards,

David B. Matias, CPA

Managing Principal