THE NEW DEFLATION and THE PROBLEM WITH GM

Wednesday, April 13, 2010

China is in serious trouble. That is the conclusion of Dr. George Friedman, president of STRATFOR, a geopolitical strategy consulting firm. While it has had a great 30 year run, that performance will not extrapolate 30 years into the future, as many China (FXI) bulls believe. Of the Middle Kingdom’s 1.3 billion citizens, only 60 million earn a $20,000 middle class annual income, while 440 million make $3-$6/day and 600 million take in under $3/day. The people’s liberation army, which is manned predominantly by the under classes from the hinterlands, could move the country away from its modernizing trend at anytime, especially if a recession leads to starvation in the countryside.

The problem is that the Chinese are investing their massive reserves anywhere but in China, which they fear may lead to an overheating of the economy. Are they aware if risks invisible to foreign investors? The future direction of the country may be decided by its next election, the first open one in history.

Dr. Friedman much prefers investing in Japan (EWJ), which has the benefit of a stable society, immense industrial plant, advanced technology, and the largest military force in Asia. Demographic challenges can be met by offshoring labor intensive industries in China, which they have been doing aggressively for three decades. Japan is a classic case of a nation with strong fundamentals, but lousy management which can be solved with a simple change of government.

The largest threat to the nascent global economic recovery is a breakdown of back channel negotiations between the US and Iran, which could lead to a blocking of the Straits of Hormuz. This would cause oil to spike to $500 a barrel, trigger a global depression, lead to widespread sovereign debt defaults, and send Western governments toppling. That’s why neither the US or Israel will not bomb the rogue nation’s nuclear program, which in any case can only produce impractical, unusable weapons.

The greatest threat to US power would be the coalescing of a pan Middle Eastern super power. US policies that triggered a Sunni/Shiite civil war can be viewed as a success in that they prevent this from happening. The war’s trillion dollar price tag is a bargain as long as we can still buy gas at home for $3/gallon.

George likes Poland (EPOL), which he describes as the South Korea of Europe. It will greatly benefit from closer relations between Russia and Germany (click here for my own recent Poland piece). Turkey (TUR) is another buy, with a rising middle class, an economy that is not dependent on exports, and a robust banking system (click here for “Turkey is on the Menu” ).

Russia (RSX) is moving towards a stable economic platform built around its resource riches, moving on from the kleptocracy of the nineties. It is creating integrated energy majors which are establishing a global footprint and present a potent oil weapon. Monopolies in wood, grain, and diamonds are moving in the same direction.

Dr. Friedman started out life as a refugee from Hungary, his parents rowing him across the Danube in 1949 under glaring searchlights. He obtained his BA from the City College of New York and his PhD in government from Cornell. He then spent two decades teaching political science at Dickinson College in Pennsylvania. Dr. Friedman has recently published a New York Times best seller entitled The Next 100 Years: A Forecast for the 21st Century.

In the book Friedman claims the current Islamic assault on the West is failing, and will cease to be a factor on the international scene within the decade. Russia will take another run at becoming a superpower, which will fail by 2020, and leave the country even more diminished than it is today. When standards of living in China level off or reverse in the 2020’s, chronic resource shortages could cause the Middle Kingdom to implode and break up. China is far more fragile than we realize.

Japan may deal with stagnant economic and population growth the same way it did during the 1930’s by invading China as early as 2030. Japan may also take a bite out of indefensible Siberia when it remilitarizes. Poland, a unified Korea (click here for “The Economic Miracle that is South Korea” ) , and Turkey will develop into regional military and economic powers in their own right.

Friedman then describes a theoretical war by a coalition of Turkey and Japan against the US in 2050, resulting in an American victory, which leads to a new US golden age in the second half of the century. Scramjet engines make possible the development of unmanned hypersonic aircraft which can launch a precision attack any place on the planet in 30 minutes. Warfare will move into space and be fought from “battle stars,” which will also become major energy sources for earth. Friedman kind of lost me when he predicted that the next Pearl Harbor could come from Japan, but not from the sea going aircraft carriers of old, but from caves on the moon.

The big challenge towards the end of the 21st century will be the emergence of a Hispanic nation in the Southwest, which is culturally isolating itself by not integrating with the rest of the country. This could lead to the secession of several states, or a new war with Mexico, which by then, will develop into a major power in its own right. I think to avoid a second Civil War and offload some huge state deficits, Washington just might say “¡Adios!”

You can argue that someone making many of these predictions is looney. But if you had anticipated in 1970 that China would become America’s largest trading partner, the Soviet Union would collapse, Eastern Europe would join NATO, the US would enter a second Vietnam War in Afghanistan, and oil would hit $150 a barrel, you would have been considered equally nutty. I know because I was one of those people. It does seem that long term forecasters have terrible track records.

All in all, the book is a great armchair exercise in global realpolitics, and an entertaining contemplation of the impossible. More than once, I heard myself thinking “He’s got to be kidding.”

To listen to my interview with George Friedman on Hedge Fund Radio in full, please go to my radio archives by clicking here, and click on the “PLAY” arrow. Or you can download it to your IPod or your pc for free.

Where would Dr. Friedman focus his investments now? In the US, which with a 25% share of world GDP and the most powerful military in history is in an ideal position to dominate the global economy for another century.

I’m sorry I’m late getting my letter out today. I was racing home from San Francisco on Highway 24 when the California Highway Patrol pulled me over for doing 80 mph in a 65 mph zone.

The officer asked me where the fire was, and I told him I was rushing back to my office to get my investment newsletter out. He asked if this was like a stock market letter, and when I said yes, he informed me that in addition to speeding, I would be cited for a pink taillight.

I pointed out that several pension funds relied on my letter for direction and that the sooner they got it, the better their performance would be. The officer then asked if CALPERS, the California Public Employees Retirement System, was one of those. When I confirmed this, he told me that this was his pension fund, that it had lost a third of its value in the last two years, and tacked on a third violation for excessive smoke belching out of my tail pipe.

I upped the ante by informing him that a lot of home owners read my letter for real estate advice. The cop sighed that his own house had dropped in value by half, and hit me again for using my cell phone while driving, a $148 fine.

Then I noticed a Marine Corp. gunnery sergeant’s pin on his uniform. I casually mentioned that I had been a jarhead captain and was a combat pilot in Desert Storm. He murmured under his breath that he hated all officers, and then noticed the life sized blow up Barbie Doll sitting in my passenger seat that I used to gain access to the carpool lane.

As he handed me my fifth citation for illegal use of a commuter lane, a minimum $340 fine, I decided to keep my mouth shut. Who knew we financial types were so unpopular on Main Street? Looks like the next time I need to rush back from the city, I’ll be riding my bicycle.

Like a heroin addict who just can’t wean himself off of the good stuff, General Motors (GM) is going back into subprime lending to finance new auto sales.

Although the much diminished company is still has a large government ownership, and has made great strides at reforming its errant ways, they still do not understand their fundamental problem. My dad was a lifetime GM customer, religiously buying a new Oldsmobile every five years. Once he even flew to Detroit for a factory tour and drove his new prize all the way home to California.

Thirty years ago I told him he was doing GM no favors buying their cars, and the only way to force them to improve a tragically deteriorating product was to buy better made German and Japanese vehicles. This was right after the state of California forced auto makers to install seatbelts on new cars. Airbags and ABS brake systems were still years away.

His response, “I didn’t fight the Japanese for four years so I could buy their cars” (He was a Marine). GM’s problem is that my Dad passed away nine years ago. Of the original 17 million WWII veterans, 1,500 a day are dying, and there are less than 1 million left. All of them loved Detroit because it built great Jeeps, Sherman tanks, and half tracks that brought them home from harm’s way.

Their kids preferred German, Japanese, and Italian cars. Their grandkids buy Korean, and soon, Chinese and Indian vehicles. It is no coincidence that GM’s problems really accelerated with the passing of the “Greatest Generation.”

During the last 35 years, when Japan’s share of the US car market climbed from 1% to 40%, I begged GM to mend their ways and build a quality, price competitive product that Americans wanted to buy. They answer was always the same: “Nobody can tell GM how to build cars.” A more inbred, blinkered culture you could not imagine. Maybe someone should have told them.

Today, the company’s only real hope is that young, upwardly mobile Chinese continue to buy their low end cars in large numbers. Over the last decade, GM has boosted the number of dealerships in the Middle Kingdom’s capital city from seven to 27, while closing hundreds of rural dealerships in the US. The problem is that the next time you need a tune up for you Caddy, you may have to drive to Beijing to get it.

Dad Drove His Olds to the End

It seems that all you hear about these days is deflation. That is certainly what the bond market is telling us, with my screen blaring at me a miserable 2.93% yield for the ten year Treasury bond.

But there is a new definition for this economic malady that applies to us hapless consumers. In the new deflation, the value of our income falls, while the prices of things we need to buy are going through the roof.

It is a particularly pernicious form of deflation, as it is burning our candles at both ends at the same time. Take a look at the chart below, showing the cost of college tuition versus the consumer price index and home prices.

This hits home particularly hard, as I have just helped put three kids through college, and am reduced to riffling through the sofa cushions looking for spare change in order to meet the bills. When I graduated from the University of California in the early seventies, the tuition was $3,000 a year. Today it is $12,000, and climbing at a 30% annual rate (click here to see the chart relative to the CPI).

The saddest part of the story is that rampant wage deflation means that recent graduates have a grim choice between taking a poorly paid job, or no job at all. That leaves them woefully unable to repay the student loans they ran up to obtain their rapidly devaluing diplomas.

And if you were planning on becoming a teacher, forget it, unless you want to move to Saudi Arabia, Russia, or South Korea. After watching tens of millions of jobs get shipped to China over the last decade, did you expect anything less? Just ad this problem to the ever lengthening list of ways we are getting screwed.

“In a screwed up way it’s the best thing that could have happened to you. Stop going for the easy buck and produce something with your life. Create, instead of living off the buying and selling of others,” said Carl Fox in response to his son Bud  going to jail for insider trading in the 1987 film Classic, Wall Street.