JOHCM Fund: A View From Asia

Rudyard Kipling’s 'The Ballad of East and West' begins thus:

Oh, East is East, and West is West, and never the twain shall meet,

Till Earth and Sky stand presently at God’s great Judgment Sea;

I read a poignant, if somewhat macabre, article in the latest National Geographic magazine by Amanda Bennett, titled ‘Where death doesn’t mean goodbye’. Ms. Bennett, after years of writing about “the American way of death which glorifies medicine and drugs but fears death”, travelled to remote parts of Sulawesi Island to meet and witness the rituals surrounding death in the Torajan community.

“For Torajans, the death of a body isn’t an abrupt, final, severing event of the West. Instead, death is just one step in a long, gradually unfolding process. Late loved ones are tended at home for weeks, months or even years after death. Funerals are often delayed as long as necessary to gather far-flung relatives. Torajans do not reject medical treatment nor do they escape grief when loved ones die. Far from pushing death away, almost everyone there holds death at the centre of life. Torajans believe that people aren’t really dead when they die and that a profound human connection lasts well past death.”

Today, in several ageing societies, we grapple with a stark issue of elderly care. For those interested, Dr. Atul Gawande (of ‘The Checklist Manifesto’ fame) has written a brilliant book ‘Being Mortal’. Dr. Gawande, through research and personal experience with patients and family, explores how advances in medicine have improved and prolonged lives but created suffering and anxiety in old age as medicines focus on the disease but not on the patients and their well-being.

East meets West

Kipling, in musing that ‘never the twain shall meet’, clearly did not anticipate the dominant trend of the past few decades: globalisation. I see major evidence of convergence between the East and the West. The East, sometimes caricatured for its mysticism and spiritualism, has exported concepts like yoga that are modified and adopted by the West (hot yoga!) in ways that would bewilder the yogis who practised it in India several centuries ago. On a more mundane note, I am always amused by the success of the fusion Chinese takeaway and the popularity of the national dish of Britain, chicken tikka masala, a dish created for British palates (there is no such dish in Indian cuisine). Before 1980, if you went to Beijing or Shanghai, all you would see on the roads were bicycles, with cars being scarce. Today, the Dutch and the Nordics proudly cycle to work, while the Chinese prefer to promote fast locomotion.

Conversely, let’s see what the East has readily imbibed in return. Following President Nixon’s discarding of the gold standard in 1971, we have had a democratisation of credit. Simultaneously, the glorification of a debt-fuelled rise in living standards has become the mantra of every country in Asia. Elsewhere, new technology platforms have emerged and feel-good banal TV and media content has proliferated - the Chinese Government still resolutely refuses to succumb to dumbed-down culture though its citizens have - and trade agreements have led to labour convergence and, of course, gigantic capital flows. These are all trends blowing with the Westerly wind that brought the East closer to the West. If further proof was needed, even a self-proclaimed pacifist like President Obama has ‘pivoted’ East in his foreign policy.

With the ‘exorbitant privilege’ granted to the US dollar, the East has felt the pains of a slightly tighter US monetary policy. As is rightly the case, the Federal Reserve normally conducts monetary policy with a primary focus on the US economy. Yet, Ms. Yellen, after her recent visit to China, seems to have acknowledged the East, particularly China’s dire economic state, as a motivation in keeping rates on hold.

The East has not fully grasped the double-edged sword that this quantitative easing (QE) experiment in the world's reserve currency represents. Fear not. From what I observe, the East might well succeed in exporting to the West a couple of pernicious ideas which could leave an indelible impression on future generations across the western world. The concept of zombie companies and Universal Basic Income (UBI or guaranteed basic income), both have roots in the East. And they could leave a lasting legacy that tightens the convergence of East and West through an embrace of debt and deflation.

Preserving jobs – whatever the cost

Steeped in communism, the idea of an 'iron rice bowl' is a Chinese term that refers to guaranteed job security. Under Chairman Mao, most civil servants and SOE (state- owned enterprises) employees were assured of jobs for life. In the late 1990s there was some genuine restructuring of SOEs, accompanied by job losses. However, preserving jobs still remains a priority in much of old corporate China. Apart from providing employment, several SOEs are extensions of state policy – commercial banks being the epitome of this practice. Despite communism being partially replaced with state-directed capitalism, there is little doubt that even in 2016 the Government will do whatever it takes to protect SOE jobs.

You might have read about the debt-to-equity swap arrangements that Chinese banks are working on. Rumoured to be approximately US$1trillion in scale, banks will now become equity owners of several floundering companies only to protect jobs. They will keep funding businesses to ensure that employees remain in work.

In some respects, India is no different. Post-independence in 1947, Prime Minister Nehru adopted the economic middle path but leaned heavily on the USSR to encourage the state in appropriating the ‘commanding heights’ of the economy. His daughter, Indira Gandhi, went a step further and nationalised huge swathes of the economy in the 1970s. The public sector banks have managed to consistently lose money over the decades, but employees never bore the brunt of the problems. Air India, the national airline, essentially exists just for its employees, with double the staff strength per aircraft than its international peers despite making staggering losses over the years.

Sticking with the Indian angle, it wasn’t surprising to hear that the ruling Conservative party in the UK contemplated nationalising the operations of loss-making Tata Steel (BOM:500470, Financial) at Port Talbot. The spokesman for Jeremy Corbyn, the opposition Labour leader, “was extremely concerned and urged the government to protect the steel industry in Britain”. After all, 15,000 jobs were at stake.

Remember Fannie Mae (FNMA, Financial) and Freddie Mac, which US Treasury Secretary Hank Paulson put under a conservatorship run by the Federal Housing Finance Agency? With over US$5 trillion of debt there is some merit to suggest that it was the systemic importance of these institutions, not a desire to protect jobs, which motivated that decision. Yet employees of those two firms must have been pleased that while other leveraged sub-prime businesses went bust during the global financial crisis, they were saved. Some commentators are suggesting that as the ongoing potency of QE programmes run by western central banks is being called into question, these central banks will direct banks to lend so that businesses don’t fail. The People's Bank of China would be well placed to offer its expertise in this regard.

Recent developments in the West will stretch the boundaries of what it means to have a job or income. Several western countries are seriously contemplating the concept of a UBI. Finland is to implement a pilot project where citizens will receive a monthly income without any requirement to work. Switzerland will hold a referendum this year on a guaranteed basic income for all legal residents. Even Canada might do the same. Having seen the East take the lead on the 'iron rice bowl', this reeks of one-upmanship to me.

Death and zombies

That brings us back to the topic of death and zombie companies. According to accepted theory, the concept of large scale survival of zombie companies was first pioneered in Japan. After the land bubble peaked in 1990, Japanese banks supported several companies which struggled with high amount of debt. The idea was to give those firms enough incremental debt so that they could repay interest and carry on as normal. Some suggest that President Hoover set the precedent in 1932 when he set up the Reconstruction Finance Company. It made loans to distressed banks and bought stock in 6,000 banks totalling US$1.3 billion, and I believe it was probably the template used by the Bush administration for the US$ 425 billion Troubled Asset Relief Programme (TARP) in 2008. But most of the assets acquired under those programmes were divested. In Japan, however, death doesn’t mean goodbye. The most egregious case was the heavily indebted retailer Daiei, which had 96,000 employees. It was kept alive despite losing money for years, only to hinder the more profitable or sensible competitors, thereby hurting the sector’s profitability.

As I’ve opined before, China is the ‘New Old Japan’. Not to be outdone, this time around China will make sure that Japan’s experience will be eclipsed by a mile. Several sectors, such as shipbuilding, container shipping, aluminium and steel production, perhaps even automobile manufacturing, could be ripe for spawning zombies in the course of time. The Chinese Government does seem to understand the necessity to take the painful decisions to reduce capacity, but with the West now toying with UBI, I am very confident that the East is not going to prove Kipling right. Even after death, there is life – only for the employees.

RISK CONSIDERATIONS - The Fund invests in international and emerging markets. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. These risks typically are greater in emerging markets. Such risks include new and rapidly changing political and economic structures, which may cause instability; underdeveloped securities markets; and higher likelihood of high levels of inflation, deflation or currency devaluations.

Emerging Markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

The small and mid cap companies the Fund may invest in may be more vulnerable to adverse business or economic events than larger companies and may be more volatile; the price movements of the Fund's shares may reflect that volatility.

Because the portfolio may invest a substantial amount of its assets in issuers located in a single country or in a limited number of countries, it may be more volatile than a portfolio that is more geographically diversified.

The views expressed are those of the portfolio manager as of May 2016, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

Securities mentioned above but not held in the fund as of March 31, 2016 include Air India, Tata Steel and Daiei.