Commentary and analysis on matters related to beta including indexing, exchange traded funds (”ETFs”), derivatives, their application in the portfolio management process and their effect on the investment industry.

The US and China: How Similar Are They?

That’s a broad title that can lead in so many directions.

The world today looks like we’re heading towards another two super-power situation.  Consider economic and political influence, voting on the UN security council, acquisition of oil, the space race, and even the medal count at the coming Olympics … there are a lot of themes that demonstrate the power of China, even relative to the US, and perhaps that’s one of several reasons why China is attracting plenty of foreign investment.

Before I get into a rant that leans in a fairly anti-US bias, I first want to preface this with the fact that I honestly believe that Zakaria’s comments on “the rise of the others” versus the decline of the US seems spot on.  The creativity and innovation of the US, and of course the developed world, will slowly have to compete with those from the emerging world.  But it will be some time coming in my opinion.  Since I focus on China in this post, I’ll give one example care of my cousin Grace who’s doing her grad work in that region.  So on her blog (runs in the family), she has a post showing this visual instruction for spectators to the upcoming Olympic games:

I should be like Jeff Matthews of famed “I Am Not Making This Up”. So Grace gives props to the BBC for sourcing this and here’s the accompanying text for the genius graphic:

Beijing Olympic chiefs are introducing an official cheer for patriotic spectators to spur on Team China at the Games, Chinese media reports.

The authoritative, four-part Olympic cheer, accompanied by detailed instructions, will be promoted on TV, in schools and with a poster campaign.

It involves clapping twice, giving the thumbs-up, clapping twice more and then punching the air with both arms.

The cheer is accompanied by chants of “Olympics”, “Let’s go” and “China”.

The Beijing Olympic Organising Committee has hired 30 cheering squads who will show spectators how it is done at Games stadia, reports Xinhua state media.

Say wha?  First, China is so NOT totalitarian since they won’t even have the masses practice before hand with drills.  Why not go full North Korean and have 25,000 people do that fully orchestrated “all in unison” song and dance that’s likely choreographed by the same person who gets 25,000 soldiers to march in unison each lifting their foot to the exact same height.  Scary in that “Brave New World” kind of way and all joking aside we can only hope some type of reform similar to what we’ve seen in China happens one day for North Korea.  Sadly there’s little to no chance they’ll do it on their own and given what’s happened to them over time (even before the Korean War) it will be a real challenge for them to move towards a world of partnership as opposed to isolated self-reliance.

But clearly, going back to the China graphic above, China still has a bit of North Korea old school in it and is still about hardcore conformity … it’s only a relative few who are taking hold of the new world and taking advantage of opportunities that result in tangible benefits for themselves.  It’s the creative/innovative class of the younger generation in the emerging world that will be the ones to watch.  Take a look at elite grad schools and note the demographics compared to ten and twenty years ago and you’ll get an idea of the growth of this new group.  Books are written about the billions in China and India and the demographic weight they impose is undeniable.  But it’s the future Gates, Jobs, Page/Brin to watch out for.

If the US is to really lose its place as the economic power, the rest of the world will have to compete in a manner where people try to copy their software, gadgets, and certain lifestyle attributes.  We’re nowhere close to a world where automakers try to copy the latest vehicles out of India.  They’re probably copying German not US auto designs but it’s still about the domination of the West.  How long will it be until China is designing the latest “iPhone of 2007″ Jesus Phone with the US leeching on with a fake?  I’m thinking not in my lifetime.  Maybe not.  Perhaps the blockbuster will be some YouTube, FaceBook, high intensity website that catches on fire like no other before it.

Well, long journeys begin with one step and clearly China is on an ambitious to its road to dominance.  They may not be the significant innovators until much later but in so many ways, they will be influential.  Of course, the trick for investors will be dealing with the bumps along the way and in today’s world the reality is that it’s all about a rather indirect manner to gain exposure into China.  For now, the easiest path is indirect investment via a closed end fund, mutual fund, ETF or hedge fund.

But I can’t help recalling one of many (MANY!) presentations on China I’ve attended in the past year where this gentleman (honestly, I can’t remember his name) was concerned about investing in the iShares FTSE/Xinhua China 25 Index ETF (FXI) since the underlying firms were controlled by a few people.  I’m paraphrasing but his point was clear and simple:  the Politburo controls virtually all the companies in this ETF.
Before the commentary, here’s a 1-year chart:

That’s about an 85% climb to nirvana over a two and a half month period last autumn.  Unfortunately, that’s about a 40% ulcer for the period thereafter that has dragged on for what must feel like years for anyone long FXI.  No wonder ProShares is having the time of their life with FXP and many of their other inverse ETFs.

So back to the Politburo which I still recall was the term used in the speech.  I’m no political scientist so I have no idea if the term applies for China as it did with the old USSR.  For now, I’ll assume that the situation described may still be true but given the latest helping hand from the Fed/Treasury Department/White House, you have to wonder.  The writers at Barron’s definitely have in this article with the sub-title “Socialism takes hold in US finance.  Get over it.”

We all know what’s happening and after Bear Stearns, this looks like chapter 2 of what could be a long story revolving around US policymakers adding band aid after band aid on a body that needs to bleed and perhaps follow up with a transfusion.  I thought I was decent in the art of metaphor but Randall Forsyth sets thing out clearly:

Even so, the descent down the slippery slope of socialization of the financial system is gathering speed.

“Capitalism without failure is like religion without sin,” Allan Meltzer, the distinguished economic theorist and historian once wrote.

Yet, like it or not, we don’t want to deal with such harsh verities, either in religion or the marketplace. Traditional churches are losing out to TV evangelists who promise material rewards now rather than later.

Forsyth concludes that we’ll see the pendulum swing back to increased regulation which shouldn’t be a surprise especially if the Democrats take over.

But the irony will be the trends taking place in both China and the US.   I seem to observe that they’re moving in opposite directions.  China is wanting to move into a dominant two-power global paradigm with the US as a capitalist powerhouse.  The US is on the defensive trying not to lose ground (influence).

It’s always funny when the US government comment on how bad the Chinese do things.  In the past, comments on the manner in which certain areas are treated or marginalized are retorted with Chinese counterarguments as to the manner native Americans or various other visible minorities are discriminated against.  It’s the same as the nitpicking both sides have with the other related to votes on the UN security council.

But today’s scenario is a juicy one for China.  The US government has often criticized the Chinese over various economic policies (currency, trade, commodity deals with foreign despots) and keeping a too-firm-hand on the wheel.  It’s almost too easy to respond with Bear Stearns, Fannie and Freddie.  It’s down right silly when Wall Street takes their show on the road to ask SWFs “Can you spare a billion?” and I wonder if they’ve come knocking on China Investment Corp?  Oh, wait a second … Morgan Stanley.  It’s so hard to keep track these days of all the SWFs and commentary regarding their dealings with Wall Street I-banks and the sense now is that the second wave of deals should be starting soon.

I leave you with this final chart showing the two most popular ETFs for the US and China since October 5, 2004 (inception date of FXI):

Quick note on FXI:  Don’t be fooled.  Of any asset category, it’s the China ETFs that differ from each other the most so selection criteria is critical in this niche area.

I state earlier that these two nations seem to be moving in opposite directions.  One is on the offensive while the other is on the defensive.  It’s a tough call to simplify things to the point of “buy FXI and short SPY” but in the longer term, how many investors are thinking about this?  From the SWFs point of view, it looks like it’s buy their buddies in the emerging markets but also buy the US … or at least financials at fire sale prices and with preferrential treatment in terms of yields.  The diversification story may be boring but owning some of both countries would make a ton of sense … the only difference among investors based on volatility and personal beliefs is what proportions.

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