Navarro's Big Economic Picture
No Panacea here

Last week, Senators Charles Schumer (D-NY) and Lindsay Graham (R-S.C.) stepped back from their pledge to force China to revalue the yuan – or face stiff tariffs. Maybe it is time to talk a little bit about why currency revaluation isn’t exactly the panacea our politicians are promising it might be.

Credible studies by institutions like the World Bank and economists like Morris Goldstein suggest that the yuan is undervalued by somewhere between 15% and 25%.

Lay people – everyone from Congressmen to the general public – immediately assume that if this undervaluation could be corrected, American exporters would improve their pricing relative to Chinese competitors by an equal amount. Not so.

For most manufactured goods, the gains from any currency revaluation would be quite modest. This is because the import content of most Chinese manufactured goods is quite high – over 50% for most products and as high as 70% to 80% for many. 

For example, to make toys, China must buy large amounts of imported plastic resin with an undervalued currency. To make air conditioners, China likewise needs materials like copper bought at world prices. To assemble computers and telecom equipment, which have some of the highest levels of import content, it must import a myriad of electronic components. Thus, in most cases, more than half of China’s perceived advantage of selling exports with a cheaper currency is offset by the need to buy imported raw materials at inflated prices.

An illustration may be helpful here: Assume a mid-range currency undervaluation of 20% and average import content of 60%. The net price advantage of an artificially low yuan falls to only 8%. While nothing to sneeze at, this is hardly enough to explain a “China Price” that is typically 40% to 50% below what American manufacturers can currently price at.

In fact, the “China Price” is a far more complex phenomenon. It is driven first and foremost by a vast “reserve army of the unemployed” numbering over 100 million workers that chronically and severely depresses wages. Only slightly less significant are China’s lavish subsidies to industry and continued violations of the WTO, huge advantages gained from lax environmental protection and workplace safety, and, most subtly, an unprecedented influx of foreign direct investment that provides China with the latest, most sophisticated, and low-cost manufacturing technologies.

This is not to say that we shouldn’t pressure China to reevalue their currency. Rather, it is to say that if the U.S. truly wants to compete with the China Price, the President, Congress, and business and labor leaders need to come up with a much more comprehensive set of strategies than a mere currency revaluation.

That said, that are two very real benefits of forcing China to fairly value its currency. These are significant reductions in both the U.S. budget and trade deficits. These “rewards”, however, are not without significant risk.

To see why, consider the dynamics of these potential twin deficit reductions. These dynamics begin with this perverse effect of the current fixed dollar-yuan peg: To keep the yuan artificially low, China must buy huge sums of U.S. government securities. That is well understood.

Less well understood is that other Asian countries that now directly compete with China – principally Japan, Korea, and Taiwan -- must also artificially hold down the value of their currencies so as to not surrender further advantage to China. Moreover, they do so just like China does -- by recycling large sums of U.S. dollars gained through trade back into the U.S. bond market. The result is a far larger Asian trade deficit than would otherwise exist in a floating exchange rate regime.

The U.S. budget deficit is likewise bigger than it would otherwise be for similar reasons. In particular, the current and massive Asian accommodation of the U.S.’s structural budget deficit helps keep long term interest rates artificially low. In doing so, it significantly reduces political and economic pressures on the President and the Congress to balance our burgeoning structural budget deficit.

Forget, then, all that Fed Speak nonsense from Alan Greenspan and Ben Bernanke and others about an “Asian savings glut” causing a “conundrum” of an inverted yield curve. Much of what is really going on in the bond market is a reverse run on the dollar, with China’s dollar-yuan peg the real culprit.

It should be immediately clear from this discussion why forcing the yuan upwards would also pose great dangers to the U.S. economy. As soon as China, Japan, Korea, and Taiwan no longer have to buy so many our treasury bonds to keep their currencies low, interest rates will rise – likely quite significantly.

Higher interest rates, in turn, will help prick the speculative housing bubble at a time when the froth is already considerable. Higher interest rates might also deal a deadly blow to domestic automakers like GM and Ford. Higher interest rates will also severely strain the heavily in-debt U.S. consumer. The result may well be a very nasty and long-lasting recession.

This may not be the worst danger longer term. A stronger yuan would also dramatically strengthen China’s hand when its comes to its acquisition of foreign assets – whether China is targeting a U.S. oil company, an African cobalt mine, or a Chilean copper reserve. That is, instead of China “benignly” buying U.S. treasury securities with its excess dollars, it might decide to go on a global shopping spree with its stronger currency. Any resultant acquisitions would only strengthen China’s manufacturing, distribution, and marketing capabilities at a time when China is already poised to soon become the biggest manufacturing Hegemon on the global block.

This Week’s Market Movers – Data Galore

The week gets off with a big supply side bang with the ISM index report on Monday. It’s been very bullish for months. However, its robustness begs the question as to whether or not firms are simply building inventories to meet real or phantom demand.

Tuesday the big market mover will be auto sales. They were weak last month and will likely be again – with all signs pointing to both housing and autos receding as big players in the next leg of growth. After Tuesday, the market is likely to cruise on lighter volume until Friday’s job report, always a market mover. Both the bond and stock bears will be looking for any further signs of a tightening labor market and attendant wage inflation. Insiders will watch for whether the labor participation rate is increasing, which would take some heat off the inflation gauge. So far, no good.

Personally, I so see a high rate of job creation as a reliable sign of a strong economy or bullish future market. Job creation and the unemployment rate are both lagging indicators. My own view is that the very smartest companies would not be hiring now given the downshifting economy, but companies that counter-cyclically manage the business cycle well are in the minority.

Portfolio Shorts and Longs – STAA and IMAX

My two significant portfolio additions last week were Staar Surgical (STAA) and IMAX Corporation (IMAX) Imax needs no introduction to the movie crowd. Staar makes medical devices for cataract and glaucoma surgery. The technicals for both companies are very strong and Staar may have a better mousetrap than competitors. Volume in Staar is a bit light for my tastes but for now, both stocks show buy signals.

I’m remain short QQQQ despite the Nasdaq’s strong performance last week. I’m not particularly worried. I’m in at $41.22 and current price ending last Friday is $41.93. Risk-reward continues to favor the downside. And by the way, even though the market is up for the year, once you get below the surface into individual stocks, it’s still an ugly market.

I added to my DVSA long, the ethanol biotech play. I’m holding AKSY, HEPH, and SVA with little enthusiasm. I remain short XLF, but my position is small so there is little pain and I still believe this one turns over. Finally, XING is behaving nicely.

Davio's Hedging Your Bets
Gone Fishing

Matt is kicking back this week. But catch his daily blog starting April 3^rd.

Vaino's Biotech Corner
Risk, Reward, and Buy What You Know

The reason I like investing in biotech is that most investors don’t know the difference between a chromosome and a chromaphore. I don’t mean this disparagingly: I don’t know the difference between a gibibyte and a gigabyte. This probably explains why I got burned on both Lucent and Nortel during the tech bubble. Indeed, I avoid so-called “high tech” stocks like the plague.

Note, however, that investing in biotech can be very risky business. But exactly how risky is it ? To better understand this, I calculated the beta coefficients,  for two biotech exchange-traded funds, IBB and BBH, as well as for PPH, which is the Big Pharma ETF. Note that  is a measure of return of an investment compared to the market as a whole. The closer  is to 1 the more like the whole market the investment behaves, and the less “market risk” is associated with the stock.

As noted in last week’s column by Matt Davio, BBH is really only three stocks. However, unlike BBH, IBB is a well-diversified biotech ETF; it is a weighted index based on biotech shares in the Nasdaq.

As for PPH, 65% of it is comprised of just five stocks -- JNJ, LLY, MRK, PFE, and WYE. By the way, this is understandable as there are fewer major pharmaceuticals companies than biotechs. The first table illustrates the results of my calculations as of March 1^st while the second table calculates the rates of return for the three instruments.

Note that IBB is the most volatile and therefore the most “risky” of the three instruments – with also the most prospects for rewards. Note also that while the S&P 500 has gained 11.45% over the last five years, PPH has actually lost 15.52% while despite its volatility, IBB had only a 6.24% return over the five years. That’s not quite the end of the story.

Dividing return by risk gives an idea where your investment is most efficient. The chart below shows return divided by risk for IBB, PPH, and the S&P ( = 1). I excluded BBH from this comparison as it’s really only three stocks.

The point of all this? This historical data illustrates, at least, that you more likely to lose more money investing in the supposed ‘Blue Chip’ big drug companies than in the mercurial biotechs. Moreover, you can miss out on a whole bunch of profit.

Bad News Bears

Invariably, when a little bit of bad clinical data gets reported investors panic, and prices drop. This can be a great time to buy. In this regard, two biotech companies I’ve been following announced bad clinical data over the past couple of weeks. Idenix Pharmaceuticals (IDIX) dropped almost 30% on March 23 after an announcement of bad results from a hepatitis B clinical trial. Similarly, Encysive Pharmaceuticals (ENCY) fell nearly 50% from March 24 to 27 on negative clinical data. My initial hope was that both of these were buying opportunities, so I looked at both companies. 

Here’s my take: IDIX has nothing on the market, and ENCY only receives a small revenue stream from sales of Argatroban. ENCY’s news, an ‘approvable letter’ from the FDA wasn’t that bad, and I think there is a decent chance the stock will rebound. Also, at less than $5 there’s not a lot of downside. However, at the moment I am holding off on buying ENCY, and I will stay clear of IDIX.

“Any trader or investor who ignores the power of macroeconomics over the world’s
financial markets will, sooner or later, lose more than they should—and if they are
trading on margin, perhaps more than they have.”
 -- If It's Raining in Brazil, Buy Starbucks

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
Email  |  Website

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.