Asian Monetary Sluices Opening?

Seems so.

Two events of potentially profound significance are now in train. On September 29th, China's new sovereign wealth fund, China Investment Corp., commenced operations. This fund is initially capitalized at $200 billion.
On Monday, the Japanese Post Office will be privatized. This institution constitutes the world's single largest pool of savings -- $3 trillion. This privatization will actually occur over a 10-year period, with the first stage beginning on Monday.

These two events signal the beginning of a major asset re-allocation. Heretofore, all these funds were invested in government securities, or used to finance massive public works expenditures. Going forward, an increasing portion of them will seek more lucrative homes. Likely residences: equities, real estate, participation in hedge funds, private equity, leveraged deals. While both the Chinese and Japanese authorities are hewing to the line that safety will be the primary consideration, with capital appreciation secondary, even this constitutes a notable change from the past, where there was only one objective: safety.

Our guess is that both China and Japan are looking at the performance of American university endowment funds for inspiration. Since departing from the conservative standards of the past, which mandated that endowment funds be invested in relatively "safe" investments -- high quality bonds and blue chip U.S. stocks -- many of these funds have wracked up impressive returns. Of course, these returns have been achieved by accepting risk greater, by orders of magnitude, than those deemed prudent in the past. Thus far, the gamble has paid off, though there is no assurance that this new financial mantra will not end in tears.

Institutional investors, like individual investors, tend to move toward greater risk as markets rise and as PAST RETURNS accelerate. In this regard, we do not expect sovereign funds or the Japanese Post Office to behave any differently. While paying lip-service to "safety" the practice will likely be to take on ever more risk, as greed overwhelms fear, and frustration over low returns from government bonds becomes intolerable. This is the normal progression; it ends only when there is a crash (a la the mortgage-backed collapse).

For the near-intermediate future, the decisions of China and Japan mean more liquidity for equity markets, reinforcing the bull run in U.S. equities. The attractiveness of American equities, which combine compelling valuations with low risk and high human capital, is further enhanced by the falling dollar,which allows Chinese and Japanese investors to purchase more U.S. shares with the same number of yuan or yen.

Mispricing of Emerging Markets

Our concern about what we view as the overvaluation of "emerging equity markets" -- particularly the China and Russian markets, but, to a lesser extent, Brazil and other markets -- is based upon more than a comparison of price/earnings ratios relative to those sported by markets in developed countries and historical ratios within each individual market. Certainly, the very elevated price level in China and Russia, relative to their own historical valuation ranges and relative to valuation levels in the U.S. and European markets is, in and of itself, a warning signal. However, there is more, much more.

The World Bank has completed a study of the sources of national wealth and worker productivity. Its conclusions are rather startling -- although they certainly pass the common sense test. The bank has concluded that "intangible" factors -- such as the level of trust among people in a society, an efficient judicial system, clear property rights, and effective government constitute the INTANGIBLE CAPITAL which comprises the largest share of wealth in virtually all countries. The bank concludes that only 20% of the wealth of rich countries, and 40% of the wealth of poor countries, are comprised of the sum of nonrenewable natural resources and produced capital (machinery, equipment,infrastructure, urban land). In other words, 80% of the wealth in developed countries, and 60% of the wealth of poor countries is in intangible factors which determine the levels of worker productivity and,hence, economic output.

In light of these findings, investment decisions -- whether direct investment or portfolio investment -- should place heavy weight upon the quality of the institutions which support economic activity in each country where investment is under consideration, and where true valuations -- in contradistinction to arithmetic valuations and seat of the pants ("great future growth in this country," etc. etc.)judgments about where future population sizes, natural resource endowment, and mathematically calculated growth will lead. Assessing future growth therefore depends upon assessing the current trends and likely future development of quality among institutions and practices of each country.

Considered in this context, the growth prospects, and hence investing attractiveness of some of the principal destinations of capital today seem to need serious rethinking. It is rather obvious that Russia is in bad shape. Its prospects for institutional and behavioral development along the desired lines seem poor. When these considerations are placed in appropriate perspective, Russian stock prices are OVERVALUED by orders of magnitude not implied by a simple arithmetic calculus of comparative valuation and assumptions of future growth. The same is true for China. The gap between price and real value is much wider than the substantial gap suggested by arithmetic comparisons alone.

Investors, it seems to us, would be wise to recalibrate their valuation processes by factoring in the decisively important institutional and social factors which have such profound importance for future economic productivity.