In finance, a paired trade is buying one asset and short selling another, with the goal of making money from a widening differential in the prices of the two assets. The hope is that the two asset prices move in opposite directions, the long up and the short down, or if they move in the same direction, the long moves up more, or down less, than the short. In life, one wants to be long smart and short stupid. In the same vein, here’s a big-theme, long-term strategy with obvious financial implications: go long Asia, short the US and Europe.
Proper financial analysis begins with the financial statements. What are the assets and liabilities of Asia versus the US and Europe, and which direction are those items heading? One generalization can be made: while both groups of governments often run deficits, on the whole, Asian country governments have far less accumulated debt, as a percentage of GDP, than the western democracies (Japan is an outlier, it has the most debt to GDP in either group). The same generalization can be made about private sector debt; debt finance and culture are more advanced in Europe and the US than Asia, especially in the consumer sector.
For policy and demographic reasons, the public sector debt to GDP gap should continue to widen. The western states are welfare states, while Asian countries offer fewer benefits to their citizens. A number of western nations are on an unsustainable trajectory, including the US, the United Kingdom, France, and southern Europe. Demographics compounds the problem. In general, Asian nations are younger than the west and have higher birthrates (the US is a western outlier on birthrates, and Japan is again an Asian outlier). They have more young people to shoulder a lighter benefits burden for fewer older people, who draw a disproportionate share of benefits. Fewer benefits and younger populations mean that more of Asian GDPs are saved and invested, rather than consumed, consequently Asia has had far higher trend growth rates than the west and that should continue.
While the US and Europe have promoted ever-expanding welfare states and regulation, the trend in Asia has been in the other direction. Communist states have given way to state-directed capitalism in China and southeast Asia, and private sector trade and development flourish in most of the rest of Asia. Even India appears to be shedding its yoke of socialism and moving towards a freer economy (no telling what 1.25 billion smart, ambitious Indians will do in even a semi-free economy). There are no laissez-faire Shangri-las anywhere, but the unmistakeable trend has been more freedom in Asia and less (with the exception of eastern European nations who have been shedding Soviet-era communism) in most of the western nations, including the US.
Welfare states also breed an entitlement mindset that appears to grow more entrenched as populations age. A lack of entitlements often breeds the opposite: an opportunistic, entrepreneurial focus, especially among the young. Poverty can be the best cure for poverty when governments get out of the way and the poor have the freedom to pursue their ambitions. Many Asians go abroad for college and graduate schools studies in science, engineering, and other technical fields, a contrast to western nations where finance, law, and government attract the greatest share of top students. Asian culture has long valued family cohesion, education, hard work, thrift, and self-sufficiency, and those may be Asia’s largest comparative advantage in the economic competition with the west. Two telling indicators: the average Asian work week is longer and the average Asian vacation is shorter than those of their western counterparts. Hundreds of millions of Asians have moved out of poverty the last few decades; it’s an exciting and underreported story. That trend will continue, providing dynamic ferment and growth in Asian economies.
It is ironic that the sick man of Asia is Japan, and much of what ails that country can be attributed to following western economic prescriptions. The US’s adversaries in World War II, Germany and Japan, were the two biggest economic success stories after the war. Both countries kept taxes and regulations tolerably low, worked hard, rebuilt infrastructure, used high domestic savings to fund investment, and emphasized manufacturing and exports. However, Japan artificially suppressed its cost of capital, which led to an unsustainable economic and financial boom that met its inevitable bust at the end of the 1980s. For over two decades the Japanese government has followed the western playbook: it has gone ever deeper into debt; funded countless public works projects, many of which have little or no economic value; increased its participation in the economy; monetized debt; and suppressed interest rates. The government has little to show for it—the highest debt to GDP ratio among developed economies, a lot of white elephant public works, serial recessions punctuated by anemic “recoveries,” and an aging population with a low birthrate.
It would be unwise, however, to count the Japanese out. Perhaps a crisis will be required, but Japan has a smart, hard-working, educated population, many world-class companies, and the Asian competitive hothouse forces it to continuously raise its game or fall by the wayside. It imports most of its raw materials so declining prices have been a substantial benefit. The Japanese stock market has rallied since 2012. Undoubtedly some of that has been fueled by central bank money creation, but the central bank has been doing that for over two decades and it did not stop their long-running bear market. For more on why the Japanese situation may not be as bad as it appears, see ”How Global Interest Rates Deceive Markets” by John Mauldin, at mauldineconomics.com.
Asia has another huge advantage over the US and Europe. Its leading industrialized nations have avoided global military intervention—sidestepping the Middle East—and by all indications will continue to do so. Although they can be quite touchy about developments in their own neighborhoods, they do not have the imperial aspirations of the US.
The US spends more on defense than the next eight nations combined, and only Russia and Saudi Arabia spend more as a percentage of their GDP. The European nations follow the US because it provides their defense shields. Although the US picks up most of the tab for Europe, its governments still run deficits funding their welfare states. Remarkable. Even more remarkable: many Americans, including Obama and his cohorts, think that Europe is the model the US should emulate. We certainly may, all the way into insolvency.
Most US defense and related intelligence and foreign aid expenditures are dead weight economic losses. The US has little to show for its $2 trillion plus, and climbing, that it has spent in the Middle East since 9/11. Its military forces are stationed in over 140 nations, mostly at US expense, and either a Republican or a Clinton ascendancy in 2016 almost guarantees that there will be no rethink of global interventionism.
China has concentrated on developing commercial and trade ties with other Asian nations and in Africa, Australia, South America, and the Middle East. A primary emphasis has been securing raw materials and trade access, and the Chinese have financed necessary infrastructure projects, which has the added benefit that the contracts often go to Chinese companies. China steers clear of military involvement. Thus, while the US government treats the matter of which band of corrupt thugs ends up on top in a backwater like Yemen as a matter of grave national importance, and spends good money trying to influence the outcome, the only Chinese involvement will probably be signing lucrative contracts with whichever band ultimately wins out.
There is one final reason for bullishness on Asia. Leaving aside geopolitical and military considerations, which SLL has discussed extensively, the US’s confrontation stance with Russia is redirecting that nation away from its traditional European orientation and towards Asia. More extensive Russian-Asian interlinkages make sense and will benefit both. Russia will acquire huge markets for its oil and other raw materials, plus access to Asian manufactured goods and technological expertise. In addition to raw materials, the Asian countries gain access to the substantial Russian consumer market, and their capital will find an outlet investing in Russian infrastructure and manufacturing capabilities. Russia has already signed a variety of commercial agreements with India and China (a high-speed rail link between Beijing and Moscow is under consideration) and there will undoubtedly be more. For all the gloating from Washington and in the US press about the damage US sanctions and crashing oil prices have wreaked on the Russian economy, its stock market is up 44 percent since its March 2014 low, recently hitting a three-and-a-half-year high. Some of that is probably due to Russia’s Asian pivot.
Since the turn of the century, the MSCI Emerging Markets Asia equity index is up over 425 percent. In the same span, the MSCI developed markets index is up 184 percent and the US S&P index is up a little over 35 percent. This long-term outperformance is not anomalous; Asia equities have done appreciably better for many decades. All the emerging markets (not just Asia’s) still make up only 13 percent of the world’s equity market capitalization, although they account for roughly 50 percent of world GDP and 80 percent of world population. These figures suggest a numerical case for long-term outperformance for those countries’ economies and equity markets.
Mr. Market has handed potential Asian investors a gift: returns have been positive but lower than many European and US indexes the last two years, and this has left many investors underinvested and many analysts unenthusiastic, often a good contrary indicator. (Drawing straight lines is the primary job skill of 90 percent of Wall Street analysts—what has happened in the past will happen in the future. A secondary job skill is explaining why they do not foresee trend shifts—those straight lines changing direction—although such changes are an inherent feature of financial markets.) Even those who don’t want to make the paired trade—long Asia, short the US and Europe—may want to consider increasing their outright portfolio exposure to Asia. There is not a region in the world that doesn’t have its problems, but the smart money bet is that Asia handles them in more constructive fashion than the west, as its billions of people seize their opportunities and propel economic and financial outperformance for decades to come.
The legal stuff: SLL is not an investment newsletter, the recommendations are thematic only and readers should consult with a qualified financial professional before making investments. Robert Gore has equity and exchange traded fund investments in South Korea, Taiwan, India, and Peru, and may increase or decrease his investments in those markets or invest in other Asian and emerging markets without notice.
THE INDUSTRIAL REVOLUTION, WHEN THE US LED THE WORLD IN INVESTMENT OPPORTUNITIES