I have frequently posted as a guestblogger Yves Lamoureux. Back in 2013 he called a coming China Bull Market when everyone was bearish. Here is how it turned out:
The question now is when will it burst? It shows the parabolic characteristics of a bubble. Is China 2015 = Japan 1989?
Albert Edwards prediction: sees the Emrging Market economies collapsing,driving down US stocks and reversing the recent rise in interest rates to a sub-1% 10-yr Treasury. In his diatribe, he references Zerohedge and its wont to show analogies to 1987, like this:
I have run a number of these sorts of charts over the years, including recent 2007 comparison, and none has come to fruition. So treat this as stock market eye candy.
Edwards does not say a crash is imminent either; he thinks hte next shoe to drop will be China in Q4, and will come with a rather shocking devaluation of the RMB. That could spook markets worldwide.
Yves has made some bold calls recently. In 2007 he called the top in China stocks. Now he calls a bottom and says it is time to go long. Here is his chart, and below his commentary:
We are now very bullish on Chinese shares. We called the top here in 2007. It was a few weeks before the market hit 6,000 on the Shanghai Index. The piece was called Party Like Its 1999. It focused on similarities that bubbles have. The rate of ascent was becoming parabolic and was unsustainable.
For most of the punditry, it was the Chinese miracle. I guess people never learn. Participants have the hardest of times to shake off their biases once in a bubble.
I have been a witness to long term negative sentiment toward Chinese shares in the 2003-2004 period. I felt that the sequence had the hallmark of a final C wave. I got very excited in 2005. I felt very strong that the market was prepared to go up in a final 5th wave sequence. I was right. From a base level of around 1,000 the index proceeded to trade to 6,000 in a little bit over two years.
We did explain to our subscribers recently that there are great dislocations between the economic reality and the stock index behaviour. It is even more prevalent with the Shanghai market.
Years of impressive growth have never guaranteed a higher market. Why would it matter now?
The stocks have this uncanny ability to confuse most participants anyways.
We have held to our bearish stance since 2007 to only turn to the bull camp recently.
We are very bullish. We think that we are facing a wave 3 of 3. This large sequence could in fact propel the market back to its old highs. The market could double and even triple from here.
We remember a time where Chinese funds were the rage. They are not anymore as they have lost their popularity. Long term sentiment is very negative toward China. We believe it is consistent with the psychology of a corrective wave two.
We think Asia has the upper hand in the debate of credits versus debits. Most of our work is derived from behavioural economics. We think it better lends itself to today's environment.
Market observers are out of touch with today's world. Do yourself a favour to dig in the past as it is very revealing of our future.
Yves Lamoureux http://lamoureuxandco.com/
For the first time, a mainland Chinese company has defaulted on its bonds. Shocklingly, it is a high-flier solar panel maker that trades in the US market - Suntech Power. Its stock shot up in a classic parabolic FOMO pattern (FOMO = Fear Of Missing Out), and has now fallen like a broken windmill blade below the parabolic liftoff. The irony is that Chinese solar makers have used easy credit to scale up, and throwing the solar cell market into a huge glut, crushing Western manufacturers; and now it is coming back to bite the Dragon by its own tail.
Sure, it could be a one-off, but Chnia's corporate bond market is much larger (adjusted for GDP) than the US equivalent and is highly misallocated due to easy credit and political malinvestment. While unconnected to the Euro crisis, coming so swiftly after Cyprus, it may be another harbinger that the wheels may be slowing coming off the global credit train.
Be careful what you wish for; it may come true - Chinese curse
China made a bold currency move Wednesday, and it barely registered in the West: it is encouraging the Yuan to be a reserve currency, to be used to settle transactions in and out of China, instead of the Dollar. For all those pundits and politicians pressuring China to float their currency, they just got their wish.
This marks a shift from an export-driven mercantilist economy, to a consumer-led capitalist economy. The internal pressures from mercantilism eventually create their own contradictions:
The curse is that it removes one of the largest borrowers of Dollars, and reduces demand for Dollars for international settlement. This has led the WSJ opine that the Dollar's role as the one reserve currency is coming to an end:
Asked rhetorically, can the Fed continue infinite QE (indefinite Dollar debasement) as the foundations for Dollar strength (oil trade, international settlement, safe haven) crumble?
The Fed has become the biggest buyer of Treasuries, which has worried Bill Gross to ask the question: who buys Treasuries when the Fed exits?
His answer: Treasury rates will have to go higher to attract investors. This could scuttle an incipient recovery, especially with higher oil prices. It would, however, be good for the Dollar - but it is months off until QE2 ends, and expectations of QE3 are increasing as fast as GDP fades.
The Dollar, then, remains on edge. It has traded below the trendline of support that has held for the past three years. The longer down below, the more likely it begins to lose support and possibly crash.
When measured in the Dollar Index, as shown in the chart (with the key trendline), the so-called crash would like more like slip-sliding away; but when measured against metals or commodities, it would look like gold and silver shooting north & commodities heading up parabolically - which is how they have begun to look recently. You can scan the blogosphere and pick up all sorts of predictions on silver ($130!) for example. It is pretty clear that Dollar weakness since last summer has led to commodities strength (Dollar in green, using the UUP instead of the DX; commodities in blue):
Another leading indicator of a Dollar collapse would come from the commodity currencies - the CAD, AUD and NZD, which indeed have been showing recent strength. You can scan the blogosphere and pick up all sorts of predictions on the CAD (Fifteen reasons to love the Loonie!) as well as the AUD.
A further (but in this case misleading) indicator is oil, which is undergoing a dramatic spike - up 15% in five days. Such a spike is rare and almost always fades back quickly (the one recent exception being the invasion of Kuwait in 1990, which led to the first Gulf War). Such an event-driven spike gives little guidance on the direction of the Dollar since it is likely to be temporary; indeed it may be the primary explanation of why the Dollar Index has fallen below the support trendline and stayed below. When the immediate Libyan crisis abates, oil should fall, and the Dollar recover.
Bullishness on the Buck is below 10%, according to the STU. This is what happens around a Dollar low, so they wait for it to bounce, but add that the wave structure is unsettling. The bounce that began at the QE2 announcement has now faded more than 78.6% off its peak in November, and the wave structure is ambiguous. Normally a fade beyond 78.6% means it is going beyond 100%, but they expect the opposite. Again, the explanation for the ambiguity may be the temporary oil spike.
In the longer term, the Chinese move should be good both for China and the broader world, as China rebalances toward a more Western-style economy, which will come with opening it up more for imports. The move will put pressure on the US to get its economic house in order, also a good thing in the long term. Also, the multiplicity of reserve currencies may smooth a transition to a different form of reserve currency, one not tied to any domestic set of policies, what Keynes called the Bancor. This frees the reserve currency from the tyranny of domestic policies, and lets all currencies float against a standard.
In the near-term, with turmoil in the oil-bearing countries and a painful adjustment domestically to get off the drug of stimulus and back into a sound economic foundation, the US may have to live through the other Chinese curse: "interesting times."
Don't confuse speculation with inflation
Global food prices are soaring. Market speculation fueled by QE2 as well as one-off events like the Great Queensland Floods in Australia and US subsidies for ethanol have driven up prices from coffee beans to prime beef, from coal to corn, and just about everything else. The WSJ reports that eateries have little pricing power, so they have to scramble to avoid a big margin squeeze.
Mish takes it a step further, noting how commodity prices have increased across most industries, especially driven by oil and energy prices. Finished goods prices rose 1.1% in December, driven primarily by a 3.7% increase in energy inputs. Finished food rose 0.8% while wholesale inputs rose 23%. Mish concludes that "every step of the way, a decreasing portion of costs are passed along."
Even less gets to consumer prices. The great margins squeeze is on. And the rise in oil could scuttle the recoveryless recovery. (Picture courtesy Pierre du Plessis.)
This is NOT inflation. Inflation is a general rise of prices, whereas this is a rise among commodities but not end prices or wages.
Let me use an analogy. A while back I discussed "good" deflation vs "bad" deflation. The steady drop in HDTV or PC prices is an exemplar of good deflation - price drops due to the ruthless pursuit of productivity and efficiency. A general drop in prices is a symptom of bad deflation - the rise in the purchasing power of the currency. Good deflation can continue for years in certain factors of production - such as oil in the 1890s, autos in the 1910s, PCs in the 1990s and HDTVs in the 2000s - without in any way presaging or sparking bad deflation.
Similarly, a rise in classes of prices, such as commodities, is not the same as a general rise in prices. The commodities rise is likely to spill over into inflation gauges, such as the CPI, as energy and food prices tend to get passed through. But the core CPI - excluding food and energy - is unlikely to budge much. This commodities bubble echo (an echo of 2008) can continue for months without causing or presaging any general inflation.
When it bursts, it might paradoxically accelerate deflation. In our economy, debt creates money, and commodities speculation that uses margin piles on more debt. As the positions unwind, the margin is paid off and money disappears. If the effect is large enough, it can lead to deflationary pressure.
This is not to downplay very real inflation outside the US. China in particular is seeing the inflation monster threaten to swallow their economic miracle. Some argue this Godzilla is caused by Bernanke and QE2, and certainly the commodities bubble contributes to inflationary pressure inside of China, but the source of Chinese inflation is much more prosaic: their money supply is growing too fast, fueled by a credit bubble from Chinese banks, not the Fed. Chinese M2 is up 55% in two years, and its PPI is up 5.5% year over year. Chinese steps to quell inflation have been tentative so far, as they seek that elusive "soft landing." If inflation crests double digits, they may need to find their own Chairman Volcker to slay the inflation beast. Andy Xie, one of the best observers of Chinese financial markets, suggests that China may need to devalue the Yuan, slowing capital inflows and likely causing internal interest rates to rise.
What the Great Margin Squeeze means going forward is pressure on domestic US profits, headwinds from rising oil prices, and the possibility of a bursting Chinese credit bubble shocking world markets.
It is commonly asserted that the Fed sets interest rates. Instead, history shows the Fed follows the market - and gets the economy into trouble when it diverges too long from what the market is saying. Tony Caldaro has an excellent piece on the Fed and rates in the 'Oughts. He shows how the Fed sets the Fed Funds rate (red line) based on movement in the 1-year Treasury Bill rate (black line):
In 2003 the Fed held rates too low compared with the 1-yr, and the Greenspan Bubble of excessively easy credit was on. In 2006 the Fed held rates too high, and the Housing Bubble was burst. The signal for being too low or too high appears to be 50 bp - when the 1-yr is 50bp or more out of alignment, the Fed Funds rate needs to be changed.
Given this correlation, wouldn't it be more consistent policy if the Fed Funds rate were simply set by the market, and not the Fed? Or the Fed behaved by rule and not discretion?
Right now the Fed Funds rate and the 1-yr are very close. No short term rate increase is on the horizon. The 1-yr would need to crest 0.75% to spark a possible change. With a commodities-based inflation emerging due to QE2, this may happen sooner than investors, and the Fed, think.
Great stuff by Tony!
Bizarre story from this morning's STRAFOR newsletter, reprinted in ZeroHedge: that the chief of the bank has left the country due to a horrific $480B loss on US Treasury bonds. They have not confirmed the rumor, and suspect it was a planned leak from the opposition. The bank chief has higher ambitions, and is aligned with the current party chairman & the Shanghai Gang that took power after Tiananman Square 20 years ago. While the rumor may turn out to be false, the appearance of it suggests trouble in China at the highest levels. The most interesting speculation on the rumor is Zhou may instead be running from a corruption scandal.
UPDATE: ZH now reports an update out of China: "China may punish Zhou because China lost $430B on its Fannie and Freddie investment." While it doesn't add that much, it makes more sense to pin the tail on Fannie not Treasuries. The report adds: "The truth is that many Chinese thought China lost all its investment in Fannie and Freddie after they were delisted from NYSE. It is also wrong because China doesn't invest with their stocks." Confusion reigns! Confusion helps explain why the short term Chinese repo rate spiked:
Bond yields are approaching the historic lows of 2009 during the flight to quality. The rapid drop in the 10 yr in the absence of the 2008 banking crisis is truly historic. Since the April high in stocks all the mid-term Treasuries have raced down in yields (chart from EWTrends):
We may be approaching the end of a 30 year bond bull market, from the highs of 1980s to the potential lows of 2010. This chart from SeekingAlpha shows the trend:
The author raises the caution flag that a protectionist movement may be near. Seems a bit alarmist, but the Chinese currency, which began its float again to great fanfare, has now dropped for five straight days and is lower than it was then! Congress is now, once again, raising the spectre of retaliation.
A more prosaic explanation for the rush to bonds is a rise in fear, fear not of another banking crisis but of an economy rolling over again, this time (the fear story goes) with no weapons left to restart it.
GDP forecasts are being slashed. Goldman joins JP Morgan and Deutsche bank in lowering the coming Q2 revision to the low 1% range, and increasing double-dip odds to 25-30%. Looking forward, ZH reports that a "Philly Fed" forecaster sees Q3 dropping from expected 3.3% to 2.3%, and slower growth in 2011 and 2012. Chances of a negative Q4 are rising. Please refer to the charts in the ZH link for details.
Japan's GDP came in worse than expected, and led to a plethora of stories of how China has now overtaken it to become the world's second largest economy. Well, not quite, but perhaps by the end of the year. Europe's leading indicators have also rolled over, signaling a coming slowdown.The normally bullish Califia Beach Pundit reports that container traffic out of LA is showing signs of a slowdown even as imports are surging. (See first chart below.) While they see that import surge as positive, it may be due to elevated expectations of holiday shopping, expectations that are not being met. There have been a flurry of news stories of how retail is slowing and the dismal back-to-school sales are (they hope) merely delayed. The govt report can be downloaded here.
Another poor sign is the rolling over of semiconductor sales based on a leading indicator. Since gadgets have been doing well, this is an ominous sign.
Given the low rates, corporations are jumping into the bond market. Even junk bonds issuances are increasing as investors scramble for yield. This suggests that all is not fear. Corporations are said to sit on record cash, giving junk bonds a allure of relative safety.
The question for investors is why buy at these low rates? There is less reason for a flight to quality today than two years ago.
The wave pattern strongly points to a bottom coming in bonds, and then a bounce (in yields). The Monday STU notes that the gap up in the morning may be an exhaustion gap. Bullish sentiment towards Treasuries is now 98%, approaching the incredible 99% on Dec 16, 2008, right before the all-time high.
One play is to buy the 30-yr. The recent Fed "QN" announcement targets the 2-10 yr Treasuries, which have dropped the most. The 30-yr may follow. The argument that inflationary expectations are keeping the 30-yr high are likely missing the dynamic that the Fed's intervention is driving the mid-term rates lower. Right now being long the 10 and short the 30 is a likely arb play that may be keeping the 30 yr lower (higher yields). On the other hand, the intervention of the Fed has paradoxically made the 30 yr less sensitive to interest rate changes than the shorter term instruments. Hence the 30 yr may not move if inflation kicks in, while the 10 yr will move more if deflation kicks in.
Corporate bonds should also be looked at cautiously. The widely held belief that corporations are sitting on hoards of cash needs to be tempered by the even larger hordes of debt they hold. Just as corporate cash is at an all time high, so is corporate debt: $2.6T of cash but $7T of debt.
Wheat and other commodities have risen parabolically recently, an indication of a blow-off top in the making. Blow-offs are followed by severe drops. Is the blow-off top at hand?
David Rosenberg noticed how the Shanghai stock exchange is a four-month leading indicator of commodity prices. The logic would be a variant on the old saw that stocks predict recessions by six months: that China is such a factor in real demand for commodities, a slackening of Chinese purchases will drive prices down, and the Shanghai stock exchange is a leading indicator of a coming slackening of real demand.
SeekingAlpha revisits this correlation since we are now four-months after the latest fall in the Shanghai index. Are commodities about to follow?
Copper is the canary in the commodity coal mine - very sensitive to changes in real demand. Copper came to life in mid-June, in effect signaling that the Flash Crash was more likely a correction not a change of trend. The canary, however, is beginning to show signs of asthma - copper has reversed to down again; and instead of recovering from the Flash Crash we had several sideways months.
During the period of the recent commodities bubblet, the USD fell fairly hard. The USD has now reversed, and very sharply, in sync with the drop in stocks. It may be my Aug4 turn date marks a major turn across all markets, with commodities shortly to fall hard.
EWI has been getting smarter on investing in China, and prepared a fairly insightful report on Chinese and Japanese markets that weaves together cultural as well as economic trends. The result is a roadmap for their future. As an affiliate, I get broadsided with various EWI reports, and generally let them fly by. This one, however, I highly recommend. You can download it here.
The starting point is the huge credit bubble inside China. This has led to an ebullient social mood, as shown by the hemline indicator among other items in the report (see picture). (Short skirts = bubble mood. Short skirts in Army = govt-led bubble.) The report compares China today to Japan in the '80s, and lays out a roadmap for China that begins with the evaporation of a lot of credit-fueled illusory wealth.
Beyond the report, other indicators support their roadmap. In order to fuel the growth and keep their currency pegged at a low rate to the Dollar, the Chinese workers have been forced to save at low rates (earning less than the inflation rate), or put their earnings into real estate which has trapped massive amounts of capital. Trapped? The resell market in China is near zero, on the order of 1% annually or less. Buyers would rather jump into a newly constructed flat than look for an old one. Ken Rogoff thinks the property collapse in China is already starting. Capital is being badly malinvested, and the fault lines across the lucky and unlucky are beginning to fray. What happens to social mood when the bubble bursts?
An interesting on-the-ground observation from a Michigander's visit to China is worth pondering. He comes from Ground Zero (Detroit) of the huge collapse in US housing (values and vacancies), and he sees the same signs if not worse in Chengdu, especially the many vacant buildings:
Chengdu seemed worse [than Detroit]. I couldn’t tell what or why I found myself gawking at massive developments at 3 pm in the middle of the week without signs of construction, occupancy, or any activity. These were not mere strip malls but giant commercial, industrial, residential cities within a city. Skyscrapers, street front shops, apartments, malls, many I observed were vacant.
A recent study by NBER concludes that the recent rise in home prices in Beijing are driven by land values, and they have increased in real terms by an astounding 800% since 2003, an increase they characterize as "unprecedented". This could be bigger than the Japan bubble of 1989.
An increasingly-large portion of purchases has been by a decreasing number of buyers, specifically a handful of of huge companies backed by the central government (so-called SOEs), who overpay believing they are too big to fail. Apparently what is driving them is to hedge against the rising inflation in China - but the socioeconomic perspective of the EWI analysis says that explanation really reflects one of many rationalizations for simply acting to an ebullient social mood. As the breadth of purchasers narrows, the end is nigh, and in the end only the government will be left to keep the party going.
Econbrowser looks into this study and has a telling chart which shows the housing bubble in land prices, and discusses the differences and similarities to the recent US housing bubble:
Mish goes further and finds evidence of Ponzi Shark Loan operations that are driving this bubble: local officials, required to meet central government growth figures, give permits for real estate development in return for bribes. The loans for down payments to buy these new flats come from locals who have no good place to invest their earnings and pool it for high-interest loans to property buyers, keeping the bubble going. It may be the SOEs are bailing out the collapsed loan sharks, but more likely they have emerged to now be over half of all housing purchases to also keep the party going (see last chart, from the NBER story above) because real buyers are unable to keep up with the horrifically expensive prices, now 22 times average incomes. This is similar to our Fannie/Freddie eventually owning 90% of the final stages of our housing bubble.
There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved. - Ludwig von Mises
The Government Bubble has burst. This is the last bubble, after housing (2005), stocks (2007) and commodities (2008). The Tea Party spirit has infected concerned citizens worldwide as part of the Global Political Awakening, a term coined by Zbigniew Brzezinski to describe the effect of technology (television and the Internet) on the global community. The awakening has been a reaction to transnational elites and manifests in many ways locally. In the West it is leading to a pullback from stimulus and a return to fiscal austerity.
The recent G20 meeting was a repudiation of Obama's call for more stimulus. Before the meeting, Geithner revealed the US agenda, to encourage the rest of the world to stimulate so as to improve US exports. After the meeting, although Obama tried to spin it as a success, the G20 communique roundly rejected any further stimulus, with a target of halving deficits by 2013 and reducing debt-to-GDP levels by 2016.
We are all Greece now (see picture): austerity measures are being put in place well beyond Ireland, Greece and Spain, and now include the UK, Germany and France. The German efforts are focused on more than deficit reduction; they plan to cut spending as well as debt.
China has been tightening for a while, and the effects are beginning to be felt: slower car sales, softening manufacturing, beginnings of a collapse in property sales, and rising risk to Chinese banks. The Baltic Dry Index, which measures ocean shipping costs and is driven by Chinese activity, has continued to fall: down over 50% and falling for 31 consecutive sessions. It is now back to March 2009 levels and seems headed to the generational lows of the Lehman crisis in Sep 2008.
Even the lone holdout, the US, is having difficulty pushing the Stimulus Agenda forward. The Senate blocked Stimulus III and seems unlikely to bend. The House has tried a Stimulus Lite bill to extend unemployment through November (mid-term elections - get it?) but that too is likely to fail in the Senate.
The US may still pass the financial regulation bill (FinReg), although even that is a bit uncertain with the passing of Senator Byrd, Democrat. (And in a truly odd moment where politics make strange bedfellows, or perhaps he just has a tin ear, the first Black President, Obama, spoke at Byrd's funeral, even though Byrd was notorious for being a leader in the Ku Klux Klan and for leading a filibuster against the 1964 Civil Rights Act.) Despite characterization as a major change in regulation, so far the banks which are TBTF seem to be unconcerned. The FinReg bill has been denuded of most of the major changes (eg. derivatives, proprietary trading), turning it into vacuous soundbites without teeth.
The FinReg bill will have the perverse result of further freezing credit to consumers and small businesses. Instead of setting rules, it primarily sets up new regulatory bodies who will take several years to promulgate new rules. Community banks and business credit to consumers is expected to stay frozen during that period, exacerbating the credit crunch that is stifling the growth of American business.
There was some recent blather about an improvement in consumer credit, but this was due to a new reporting requirement, not any change in the real world. (Tea Partiers like to describe the government as incompetent; but it is also ceaselessly dishonest.) As this chart from the Fed shows, consumer credit continues to fall:
A report today on consumer credit was stunning: it fell in May by $9B, almost $7B more than expected; and that blather about a rise in April mentioned above was revised from a $1B rise in April into a $15B drop instead! The apparent flatlining seen in the chart above did not happen; instead we kept falling and the April flatline at the end of the blue line is now a huge drop. Consumer credit is back to March 2007 levels and has fallen for 18 of the past 20 months. The only holder of consumer credit which had any growth was .. (envelope please) .. the US Government. Once again all that is going on this economy is government life support, and that is no longer capable of withstanding the drop in the private sector:
Karl Denninger dissects this report into charts that show consumer spending broken into revolving (credit cards) and non-revolving (cars, etc.). The YoY drop is revolving is quite steep:
The drop in overall consumer credit of both sorts is also clear:
With Peak Debt comes the spectre of deflation. Since credit (debt) creates money, a tightening of credit and lack of lending can lead to a fall in money aggregates. The FinReg bill combined with the shrinking of debt worldwide will shrink the money supply as well as lower the velocity of money. The money supply has been growing slower, and on some measures actually shrinking; Peak Debt might send it negative on all measures. This is the formula for deflation. The Keynesian Cheerleaders such as Krugman are oh so worried about it now that we are hitting Peak Debt.
There is confusion around the Fed's emergency measures last year which created a $1T increase in bank reserves - why isn't that hyper-inflationary? The Fed has patiently explained what they did but this seems to be largely ignored in the blogosphere, and so this 'hyper-inflation!' meme keeps circulating. At the risk of grossly oversimplifying, consider that one of explosive risks during the Fall of 2008 was inter-bank lending. A lot of checks wing back and forth between banks, and rather than physically move cash reserves around, they lend to each other. With Lehman cratering, the risk of counter-party insolvency loomed large. If some banks went under, all those inter-bank loans with them would go down too. In order to keep the checks circulating, the Fed used various methods to assume the inter-bank risk, creating reserves in the Fed but not creating new money - simply assuming existing liabilities. (This is not inflationary, simply prudent central banking.) Money of Zero Maturity (MZM) jumped $1.5T, but total debt did not - instead it peaked at $53T just as the crisis hit and began declining on the Fed's moves:
A little broader explanation (than just inter-bank lending for checks) of why the new reserves created no inflationary spike is as follows:
How is this possible? It's a direct consequence of the massive intervention by the Federal Reserve: it took problem loans and structured bonds onto its own balance sheet, removing them from the likes of Lehman, AIG, Bear Stearns. In exchange, the central bank essentially "printed" money, i.e. obligations of the US federal government. Many of those bonds have since proved to be worth a lot less than the money printed in exchange, and many of them are entirely worthless.
The increase in MZM in 2008-09 was $1.5 trillion, the same as total debt. Net-net, therefore, zero. Obviously, no 10X multiplier effect came into play here, since the Fed's money went to replace debt gone bad and not as high-powered money to make fresh bank loans.
The US is about out of weapons to throw at deflation. The final play is more quantitative easing (QE) where the Fed buys up Treasuries and other financial assets, putting fresh money into bank accounts of US agencies. A target of $5T is being bandied about. Not all Fed directors are on board to set sail on QE2.
The problem with QE2 is the marginal productivity of debt makes it of limited if not negative value. I have posted versions of this chart several times, and it shows the same phenomenon: for each new $ of debt, we get less and less increase in GDP. We are now approaching a point of no return, where we get zero improvement for every $ of debt. If you ponder this for a moment, you realize we could borrow ourselves into a hole so deep only default would get us out: more debt with no increase in production to pay for it.
With the Fed's QE1 a sinking ship, how would they do QE2? Ed Harrison speculates they would Federalize the muni market to keep our Greeces afloat (Cal, Ill and NY in particular). The Fed has already tried QE with Treasuries, MBS's from Fannie and Freddie, and similar agency paper.
QE2 would also mirror what is happening in Europe. The ECB is buying sovereign debt to bolster its Greeces, and although its stated policy is to sterilize those purchases by selling Euro bonds (buying sovereign bonds puts money into the system; selling bonds sucks it back up), it has had at least two failed auctions where it couldn't sell enough to cover its QE purchases. This may be its policy, disguised to avoid spooking the bond vigilantes; or it may reflect diminished appetite for Euro bonds. The Bank of International Settlements put out a warning about QE, that trying to cushion austerity with purchases of bonds to keep rates down risks continued speculative bubbles and misallocation of capital.
Coming on the heels of weakness in Australian property markets, evidence is pouring in of a housing bust in the frozen north: Statistics Canada reports a 10.8% drop in building permits. In addition, home sales in June fell 30% in Vancouver and 42% in Calgary. These trends may be blips and reverse, but the sharpness of the drop mirrors the US experience in 2006.
The commodity countries like Canada and Australia trade on Chinese growth. With China tightening, a fall is not surprising. Home sales in China itself were down 50% in May. More predictions are coming in of this tightening popping the Chinese housing bubble. As Ambrose Evans-Pritchard reports:
Standard Chartered has told clients to prepare for a fall in property prices of up to 30pc in Beijing, Shanghai, Shenzen, and other large cities in China as the delayed effects of monetary tightening begin to bite.
The market yawned despite gushy headlines like Bloomberg's "Yuan Strengthens the Most in 20 Months." Mish wryly notes that since China held the peg since July 2008, duh! Bloomberg later redid the headline to "Since 2005", but the move was only 0.37%, which machts nichts compared to, say, the Euro, which fell peak to trough over 1% today. The conventional wisdom on the Street seems to be (from Art Cashin):
The first point, long-term bearish on Treasuries, was picked up by many morning pundits, but curiously not David Rosenberg who instead thinks it is good for Treasuries, and signals a time to load up. After all, China has been unloading Treasuries recently anyway, and a higher Yuan will have its biggest impact in lowering the US trade deficit which lessens pressure to borrow from abroad. The STU agrees, as Treasuries appear to be ending a B-wave triangle and starting a C wave to drive yields down, with the 30-year targeting a drop below 4%.
The second point, to go back into commodity currencies, depends on the third point. The AUD and NZD should pop for a bit, but if this is not bullish for commodities, they drop back. Indeed, since China needs to continue to tighten to stave off various bubbles, this move can be seen as simply another lever to tighten. That is bullish for the USD and bearish for the commodity trio of CAD/AUD/NZD.
The third point, that commodities go higher, presumes China continues to increase growth, whereas it appears this move is partly intended to quash internal inflation. CPI inflation at 3.1% is above China's target, and PPI is well above, up 7% over the past year, largely due to rising commodity prices. Hence it might be time to unload commodities, especially after they popped a bit today. Here is a video analysis from MPTrader of how commodities have not responded as expected:
The final point that stocks will be mixed, is curiously unenlightening from Art. Nic Lenior had a much more insightful reaction: Houston, We Have A Problem! Here are excerpts:
The rebound which we managed to anticipate from 1,040/1,045 in the S&P future was purely technical. ... The market caught most bears trapped as it broke above the 200-dma, but the volume and price action did not really confirm a major acceleration. ... As such we were hoping to sell the rebound should it reach 1,150 in S&P futures. Unfortunately I don't think we will have that pleasure.
Nic adds that a lot of traders have been waiting for the Sp1150 level to go short again. When a lot are on one side of a trade, Mother Market will fool. On the technical indicators, the STU notes that we hit Sp1130, the 50% retrace, and did so in a thrust (the gap up at the open) out of a fourth-wave triangle. We have been in an ABC flat correction, which means the final C wave will break as a "5", and could be considered complete after the fifth-wave thrust. They note how breadth closed negative on every index they track. If volume picks up to the downside, the top may indeed be in.
My take: we are in what I call the Big Tease, a name chosen to fool the maximum market participants before the end. Take a look at this nifty chart, recommended by a reader in a comment to the prior post. The Dow hit the 50 DMA and fell back. So far it has done two head fakes:
So why not drop a bit more, getting the bears short, and then thrust up in a final spike to Sp1150? A final bear trap. This wave 4 triangle and wave 5 thrust can be considered the end of the third wave of C, not all of C, requiring a larger fourth wave followed by the final thrust up.
Watch two things:
The Double Dip Countdown ticks down as the ECRI leading indicators have dipped even lower into negative territory, falling from -3.7 last week to -5.7. This is only the second negative reading and it will take a sustained drop to signal a recession, but the previously dismissive tone of the director of ECRI, Lakshman Achuthan, is showing heightened concern: "We're definitely rolling over." The -10 level is considered conclusive of a coming recession.
Global industrial production is up but continues to roll over. China (yellow line) is flat, Japan (red line) soared from a deep drop but is now clearly turning down, the Eurozone (dark line) still looks like it is improving, and the US (blue line) is rolling over and approaching zero to negative growth. Production is still positive, but a few more ticks and the US will be negative.
China is saying it will allow the RMB to float a bit, which might spark a stock move early this week - futures are up strongly on the announcement - but then they announced no change as of Monday. This might just be a bit of posturing before the G20 meeting, but it is interpreted as a vote of confidence in the global recovery despite the warning signs of a turn down coming. In any event, Chinese increase in exchange rates coming on top of labor unrest and higher wages further confirms my post of several weeks ago that the era of cheap labor is ending in China. The Chinese are likely to move slowly, but looking beyond any vote of confidence, this will put another damper on global production.
A good discussion of the implications of this move is here. Marginal exporters may suffer or go under - as I have discussed previously, many of them run on 2% margins, extremely tight - but a stronger RMB makes imports cheaper. Watch the AUD tomorrow - it might pop due to expectations of increased raw ,material exports to China.
Ten workers (mostly young women) have committed suicide at Foxconn factories in China - the same places that make iPhones and iPads. At least 13 have tried, and some reports are of 11 suicides out of over 20 attempts. Foxconn may not be running sweatshops as Upton Sinclair exposed in The Jungle, but the impact may be similar: the Chinese government is demanding changes.
This may signal the end of the cheap labor era. A recent strike at a Honda plant shows workers resisting exploitation. The inflationary forces surging inside China is also putting pressure for increased wages.
Honda workers on strike in China factory (LA Times photo)
The Beijing Youth Daily dissects the problem and finds conditions are a modern version of hellish: long hours, trapped at night in dull dormitories, severed from the social constructs of the farm villages, precluded from overtime pay, and regimented to minute details in the tasks they perform. They call themselves "pubic hairs", an exemplar of their low self-esteem.
Foxconn workers (Bloomberg photo)
Bloomberg adds additional color. Perhaps most striking are these factoids:
Apple is caught up in this mess and will add to the pressure put on these factories for change. Apple's initial response was to say they were not "sweatshops", but this missed the forest for the trees:
The word "factory" is something of a misnomer: It would be more accurate to describe Foxconn's facility as a manufacturing city, according to the AP. Large-scale industrial production is booming in China on a mind-boggling scale. Imagine a gated industrial complex that sprawls across five square miles and employs hundreds of thousands of people on assembly lines running 24 hours per day. The workers live there, eat there and shop there. And they make your iPhones and other electronic devices.
Steve Jobs comments at D8 conference still seem an effort in spin not resolution:
On the matter of the recent spate of suicides at Foxconn, the Chinese company that manufactures electronic devices for Apple and several other major consumer electronics brands, Jobs said the company was very concerned about the issue. “We are on top of this. We look at everything at these companies. I can tell you a few things that we know. Foxconn is not a sweatshop. It’s a factory — but my gosh, they have restaurants and movie theaters. But they’ve had some suicides and attempted suicides, and they have 400,000 people there. The rate is under what the U.S. rate is, but it’s still troubling. We’re trying to understand right now before we try to go in with a solution.”
This all may be a blessing in disguise. The US went through this at around the time of The Jungle, and greatly improved working conditions - plus found it came with improved productivity. At the time the US had two huge advantages over China: innovation (think: Edison) and efficiency (think: Carnegie in steel, Rockefeller in oil, Ford in manufacturing). When Japan went through this, they innovated in process (think: the Toyota manufacturing system). China now needs to step up their game, and move beyond cheap labor in virtual slave camps to push for innovation in products and process.
The Chinese story sounds an awful lot like the immigration story that has been replayed across the world: off the farms, into the cities, exploited ruthlessly, struggle in sweatshops, and slowly pull themselves out of the bottom and into the middle class. The Chinese government has been acting like a modern-day Midas, hoarding the gold (foreign reserves) and keeping their citizens relatively impoverished as they chase the mercantilist dream. Their citizens are now clamoring that the powers-that-be spread the wealth around, and let them in on a little bit of it. It is time.
China's Shanghai Exchange (SSEC) has decisively broken below a trading range and is dropping fast, down 5% Monday, 20% since early May and 25% so far for 2010. Just ten days ago, as China announced more tightening, Marc Faber warned of a China crash. Dr. McHugh put out a crash! call this weekend. After the big drop off 2007, it was first to rebound, starting in Nov08, and the first to peak, in Aug09. It has been in a big sideways move ever since, but has now dropped below the lower trendline (chart courtesy ContrarianAdvisor):
It is down 25% in nine months, and well below the 200 DMA, both signals for a big bear market. Earlier this month the momentum oscillator (ROC) crossed to negative, another bear confirmation. When the 50 DMA fell below the 200 DMA in late March, it was a Death Cross signal:
Now, a case can be made that this is a short term drop, not a crash, but it is getting more difficult after the fast drop of the past two weeks. Given the volatility of the SSEC, these signals may go away quickly; also, while it looks like the SSEC is foreshadowing US markets, the reality is that it is much smaller and some pundits say it has little impact on the US. Instead, it is more like the NASDAQ, driven by the retail investor, as compared with the other Chinese exchange, the ADR, driven by institutions. (For a really good dissection of the SSEC, go here.) Hence the views of Jim Trippon, who expects a bounce, and the blog trendlines, which follows China and India closely, that expects a bounce as well. Trendlines reasons that while the SSEC is in a bear market, after the current downturn, it will go back above the Aug09 levels to complete a C wave of a big ABC off the Nov08 low. So far it has only retraced 2% of the big drop off 2007, and a 50-62% is more common, as we saw with the Hope Rally:
In some respects, however, the SSEC both presages and reacts to other changes globally. It may not lead the US, but it acts as the most sensitive canary in the global coal. As I will lay out more in a post on commodities, a fall in the SSEC preceded the big bubble peak in commodities in 2008, and it may be signaling the peak of the bubble echo in commodities. The logic is straightforward: China has become a huge buyer of commodities, and in the past year has been stockpiling. A fall in the SSEC is the leading indicator of a pullback in China's economy.
Also, Euro weakness may be hitting China. Europe is a large trading partner with China, and the Euro drop may accelerate an SSEC drop, as it means less imports from China. The SSEC may not yet be responding to that, but they will.
Most likely the SSEC is falling because Chinese manufacturing growth is slowing. The tightening is having an effect. This was signaled by the turndown of the Chinese PMI in Q1:
It is interesting to read economist opinions on China's red hot 11.9% GDP growth in Q1: largely sanguine about Chinese prospects even though the Q1 jump is largely an artifact of a weak Q1 a year earlier. There have been concerns over suspicious Chinese stats. They measure GDP differently - essentially when budgeted, not as actually produced. The hot Q1 really means spending is out of control, hence the tightening, which includes some fairly dramatic nullifications of local government loan guarantees - an indication of out of control debt-fueld bubble.
Another indication was the surprising Q1 trade deficit. Those sanguine economists opined it meant China was rebalancing, meaning increasing consumer spending (imports from trading partners). On the contrary, it was due to investment-growth, not consumption. Imports surged due to stockpiling of commodities, and exports weakened due to weakness in the US and Europe:
Other than a passion for imported cars, which is driven by their version of Cash4Clunkers, China is not on a consumption spree:
Instead, China seems to be careening down the Stimulus Road, out of control, and now trying to grab the steering wheel. The WSJ has wondered what China will do to push back an incipient inflation, and believes they will have to allow the RMB to appreciate. Mish then asks this question in regards to a rise in the RMB, given tightening:
What would happen if China stopped its stimulus cold turkey, pricked its property bubbles, and allowed the RMB to float freely, and in response the Chinese stock market collapsed, social unrest picked up, and hot money poured out of China?
Well, the stock markets in China are crashing. China 2010 may be Japan 1989. The huge Chinese stimulus has caused surges that look a lot like Japan after the Plaza Accord in 1986, or the US in 1927 after the Brits went back on gold at the wrong level.
I suppose it is still theoretically possible that last Thurs is the top - the drop from which started before the "Sue Goldman" story broke, indicating it was driven by technicals not news. (I find the market in the short run almost always technical, with occasional jinks and ives from news that do not last very long - as the bounce from Sue Goldman clearly shows!)
While the break was expected, it is not expected to be more than a pullback before a higher high. It is not clear that it is over, but most likely so. The pattern to look for is whether a break is a false break, meaning goes below the lower trendline that has marked low points all the way up (as this one did) and then comes back above and stays above. MarketPulse shows the break of the trendline, and then coming above:
The Dow settled in at a 78% retrace of the recent high (the close at 11117 sits right there), although went almost all the way back intraday. The S&P closed a gap at 1203 and sits right at 78% as well, although it too went a bit higher intraday. If this were an impulse down, the first drop would be a wave 1 and the bounce back a wave 2. Waves 2 can go back 99% but seldom break 62%, and almost always when they break 78% go to new highs. Thus both major indices sit at the point where any move higher essentially de-confirms a top.
On the other hand, this whole break could be merely a correction, a wave B or minor wave 4, before a continued advance. As such, the 78% rule does not apply. Besides the obvious move to new highs, watch whether it stays above the trendline, which also de-confirms the break down.
If the top is still ahead, what could flag that it is near? One indicator is to watch junk bonds, which act like an intermediary between bonds and equities, and are sensitive to changes in underlying market conditions - specifically, a change in junk indicates a change in riskier bets. Doug Short has a nice piece today from Chris Kimble which shows how they tend to bottom or top ahead of the S&P:
Another indicator is copper, my favorite "Cunary in the coal mine". Copper has been rising in price as well as inventories, indicating real demand. In 2008 copper prices plunged and inventories rose - no surprise. As prices rose, inventories got worked off, and inventories turned back up, but prices kept rising. Usually copper rises early in a recovery, so this is a good sign; but much of it is attributed to Chinese stockpiling. As suppy/demand has rebalanced, prices have begun tailing off, an indicator that Chinese tightening is having an effect. They key to watch is a continued rise in prices, which either reflect a huge "bubble echo" in commodities (more on that in a later post), or a real recovery. (Funny, the prior link speculates about Peak Copper driving prices up even as inventories stay tight, which to me is yet another indicator that we are in a Bubble Echo in commodities - when oil prices peaked i 2008, Peak Oil was the explanation, not bubbleconomics).) If instead prices keep dropping with inventories, this indicates slackening demand, and the Cunary chirping "top ahead!"
Since much of the the Cunary is driven by China, a third indicator is the SSEC, the Shanghai composite. Emerging markets play a similar role to junk bonds in that they are a riskier place to invest and are sensitive to trend changes. Trendlines runs a series of posts on the SSEC and is worth checking out. Their current view is a drop in the SSEE to complete a triangle, then a thrust higher. We all remember how it bottomed first, in Nov2008, before our Mar2009 bottom, and led the way up. Its secondary top after the 2007 peak was back in August 2009. If it thrusts higher out of the triangle as Trendlines suggests, we might see it beat the Aug2009 high. The top after that could give a three or so month early warning of the top in the US.
ContrarianAdvisor, befitting its name, takes the opposite view: the SSEC has just broken below the 50 DMA and the lower trendline of a wedge, and is within a tenth of a percent of the lows for 2010. If we stay below the wedge, the SSEC would signal that it is now in the next leg down, and chirp a warning for US stocks. The potential fall suggested by this pattern is 30%.
While a fall by the SSEC itself this is not worth much as an indicator, look to see if it is confirmed across other emerging economies, especially the BRIC or BRICKS (BRIC plus Korea and Singapore). It may be the wedge with three tops so far is presaging a long topping action in the US, the triple top that may emerge from Jan19, Apr15 and whenever the final top comes between May and August.
More ominously is if the wedge breakdown is due to expectations of China letting the Yuan float again. The drop in the SSEC has been dramatic - yesterday was nearly a 5% fall.
With US markets closed today, the only action is with bonds, and the concern is that rates will continue to rise. The Fed likes to present an aura of omnipotence, but the bond vigilantes can force its hand. The Fed has kept short rates low, but the market drives longer rates. As the Fed has been ending its QE policy, long rates have gone up.
Pacifica Partners notes rates have moved much faster than most market participants have recognized: up 90% since the 10 year Treasury hit 2% a little over a year ago, and a spike up in December concurrent with a bottom in the Dollar (see chart):
Barron's notes that since Thanksgiving, the 10-yr yield has gone up 20%, and appears to be on the verge of a big breakout. They point to a bullish flag, which has broken to the upside.
The current tumult in the bond market (see my ObamaCare Spooked Bonds post) seems to be caused at least in part by a supply imbalance with Treasuries. US households are back to spending again, so they won't cover. European buyers are pulling back to solve their own Greek tragedy. Social Security is going into deficit, which means instead of buying Treasuries they will be a net seller. They used to cover a huge percent of our deficit (50%).
The big buyers, China and Japan, appear to be headed for the door, often by trying to hide the sales by funneling through proxy accounts. Their obfuscation makes it somewhat difficult to figure out if they have been selling, but given that China may report a trade deficit in Q1, the capital flows almost require them to be lightening up. ZH has estimated a $300-400B differential between forex holdings and Treasuries, one measurement of their selling. When rates turned in December, China began selling, visibly. ZH speculates that instead of selling, they are letting shorter-term Treasuries mature, and not buying anew. One columnist who says not to worry believes they are letting short term bills mature and then buying longer-term bonds. He also thinks the official TIC accounting may be missing some transactions, particularly if China obfuscates what it is doing. In any event, TIC measurements makes it clear that foreign flows into Treasuries have been dropping:
Normally forex holdings track trade flows. China has to hold a bunch of US assets to manage their Dollar trade, and to keep their currency pegged at a cheap level, has to hold an excess to "sterilize" the exchange of their currency inside China for Dollars. During the Great Recession, global trade dropped, and with that the need for the same high level of forex holdings of Dollars. Significantly, Dollar holdings dropped more than trade. This puts pressure on rates to rise, since due to less trade there are fewer foreign Treasury buyers.
The Keynesian cheerleaders for fiscal stimulus interpret the steep yield curve in the normal way, as signaling a recovery ahead. I discuss this in my The Logic for Bonds post. Normal steepening is due to increased demand for longer-term commercial loans, which we still do not see. Instead, we see a rush to float junk bonds. Sometimes the yield curve steepens due to inflationary fears, but the inflation-adjusted Treasuries, TIPS, still have a mild spread vs. Treasuries. Likely the steep curve is due to artificially low short rates, and long rates creeping up due to the supply imbalance.
The most interesting argument is that the private sector has pushed their own risk onto the public sector (TARP, Fed buying toxic debt, etc.), and now may turn on the chumps saviors. As Bruce Kasting puts it:
With the end of QE the cycle is now complete. The maximum amount of risk in the form of credit exposure and aggregate debt has now been passed to the public sectors around the world. As markets are wont to do, they are likely to turn on their benefactors now that they have succeeded.
"Mercantilism works" - Paul Krugman
Krugman's call for 25% tariffs on China are based on a profound misunderstanding of how the Great Recession will transform US manufacturing. The US is rapidly moving to a higher-value and sustainable position in global production from an older model of unskilled labor gaining a middle class salary on the assembly line. The greatest threat to this repositioning comes not from China but from within, from policies that hinder innovation and burden production.
I have written how the Great Recession will transform the West by accelerating a drop in core manufacturing and replacing it with high-value jobs in the layer of design, software and services that I call the IP layer (for Intellectual Property). A simple look at how value flows to Apple for the iPhone should convince you. Click on the sidebar thumbnail of a chart of value in the iPhone (courtesy GigaOm, sourced from Column Five Media). In sum:
The assembly line manufacturing component is about 1c on the $. Apple gets about 70c, and that does not include the service income from downloadable apps and music. Most the rest of the cost to build it is IP frozen into chips and software. The mobile operator subsidizes the purchase by $351 and gets about twice that in data fees, even before including voice minutes and sms fees. A similar model applies to the new iPad.
The IP and Services layer is where the value is. Traditional manufacturing of the sort Krugman wrings his hands over is no longer what "manufacturing" is all about.
You could argue that Apple is an outlier, but there are a myriad of similar companies in Silicon Valley, Redmond, San Diego, and elsewhere across the US. The web industry is largely centered in the US. The smartphone industry is almost wholly in Silicon Valley (Apple, Android, Microsoft's Danger division, Palm). The social networking winners are largely here as well. And of course the US and Europe have huge bio-tech and pharma industries.
It is passing strange indeed, then, that what passes for industrial policy in the US is to bailout car companies, enable huge profits in financial services, empower increased public sector union jobs, jawbone about green jobs - and continue to pluck the golden goose of innovation with:
Certainly China is catching up, but a look at history shows that China is still a paper dragon. When the US went through its period of remarkable growth to become the China of its day back in 1900, US companies were the world innovators in both technology (telegraph, telephone, lightbulb, electric generation and transmission) and process (ruthless efficiency in oil, steel, transportation and retail). When Japan emerged as a world power, it too showed innovation, particularly in commercialization (VCR, walkman) and process (just-in time manufacturing, quality). As China has emerged, it shows neither. Instead, it is a story of cheap labor and rapid flow of capital.
This is all too apparent looking at Chinese profitability. The Chinese exporters are hanging on by a thread,with a profit margin of less than 2%. They are at huge risk of failure if the Chinsese currency rises. As an equity analyst noted:
2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins.
If Krugman gets his way, the sort of assembly line manufacturing of China would not come back to the US. If the Chinese currency goes up 25%, or we throw on a tariff, the rise is from $6.50 on an iPhone to $8. Instead, it would go to Vietnam or other low cost areas.
The bigger threat to the US is a continuation of bad industrial policy that hinders US innovation, while China makes great strides to move beyond cheap manufacturing to the IP layer. Already we see R&D moving to China out of the US. Several Chinese companies are gaining world scale and competitiveness with Western companies, such as ZTE in cellphones, Haier in telecom infrastructure, Lenovo in computers, and Baidu in search.
An encapsulation of the problem with the path we are on is that government workers now surpass goods-producing workers in the US.
The last time a transformation of this magnitude occurred in the 1930s when workers left the farms and went to the assembly lines. Farming dropped from 40% of the workforce to a few percent, and yet farm production kept increasing. We had huge gains in productivity, and after WWII were able to absorb those new workers into manufacturing.
We have gotten to the point where the number of public employees in the Agriculture Dept is said to rival the number of core farmer workers. I don't know if this is quite accurate, but the joke is, why was the Agriculture employee crying? His farmer had died.
Yet that old saw misses a deeper and more important observation: while the number of core farmers has decreased, the workforce in the layer above farming - call it Food Processing - has grown dramatically, and adds a lot more value than farming itself. Food processing and the food service industry to deliver it to supermarkets and restaurants has proliferated an incredible assortment of food products. In many respects this is equivalent to the IP layer above the assembly line, and has its own intellectual property in genetic engineering, flavor enhancement, organic products, preservation, packaging and distribution. Sadly, it too is being starved of innovation, and hampered by fears of genetic modification of seeds, while China is moving ahead.
Similar to what happened in the '30s, as core manufacturing has declined, manufacturing output has not, and the jobs have shifted to the "manufacturing processing" layer above, the IP layer:
As with farming, we can promote innovation, or starve it. Right now the punditry seems intent on starving it. The most astounding fount of bad policy is the Economist Who Wants To Be Taken Seriously but says really dumb things - Paul Krugman. In a recent post in his NYT blog, he actually said that "mercantilism works". Adam Smith wrote Wealth of Nations to show the mercantilist fallacy, that the "beggar thy neighbor" policy lowers overall trade and hurts the mercantilists' citizens. The victory of Capitalism over Mercantilism was decisive, to say the least. The errors in Krugman's argument are dissected here and here. He wants us to become China. He says things this dumb:
A much more sophisticated discussion of the topic comes from Professor McKinnon of Stanford, who points out that as long as the Chinese currency is not accepted as a widely-tradeable reserve currency (like the Yen, Dollar or Euro), it cannot be floated without severe internal consequences to China. Simply put, it would rise without much to limit it, as the Chinese themselves would be loathe to recycle their savings by investing in Dollar assets since the rising RMB means their Dollar investments drop. It should come as no surprise then that mercantilist economies tend to force their citizens into huge savings while restricting their ability to spend outside the home market, since that spending would unwind the beggar-thy-neighbor cheap currency. All of this means that the clumsy Krugmanian solution (of the US becoming a mercantilist like China) would fail to change China and would lower global trade whole hurting the US consumer.
In spite of poor US policies, I see a tremendously exciting and lucrative future for the US in remaining the leader in the IP layer above manufacturing. We have already vastly increased the size and scope of our college-educated workforce, and the IP layer can absorb college graduates just as the assembly line absorbed unskilled labor off the farms. The speed of change and innovation in engineering, design and marketing mean that training for specific jobs is less valuable than being broadly skilled in learning, creativity and adaptation, all areas in which the US culturally excels.
We need the patience to ride out the Great Recession, the forebearance to let the transformation work its way across industry, and the wisdom to accept the Creative Destruction of Capitalism, rather than fall into the politically expedient trap of intervening to forestall the change.
Last month, China moved to reduce commercial bank lending and increase rates on some central bank bonds. Because a reduction of credit in China will ripple through to demand for Australia's raw materials, China essentially did Australia's tightening for it. ...
Economists completely missed the bank's intentions. All 20 economists surveyed by Dow Jones last Friday had forecast a rate increase.
If China tightening is bursting their housing bubble, will this now ratchet back to Oz? Mish has been on this issue, and notes that the Oz Prime Minister, Rudd, had pushed through a A$14,000 first-home buyer credit. Almost half of them are already struggling to make payments. Sydney is also rated the second least affordable major city, ranked by severity of housing. Rudd made the same serious blunder Barney Frank et al. did in the US, of spawning a govt-sponosred housing bubble, driving housing prices way too high. Recent tightening of the relaxed rules on down payments should cause a sharp decrease in home sales. This type of change drove UK prices down in 2008.
Steve Keen, one of the best economists in Australia, had forecast this drop by the end of 2009 - and lost a bet on it. Why? He hadn't anticipated how far Rudd would go to keep the party going. Mish notes that once the trend changes, the party is over for a long time (5-7 years); but attempts to prolong the fun often lead to blow-off tips. We may be at that point right now. Here is a chart of how far people are stretching to join the real estate party in Oz:
China's SSEC broke below the 200 DMA. It was the first to start up, in Nov 2008, and the first to break down, in July 2009. The Pragmatic Capitalist sees this as the classic post bubble price action:
[A] bursting bubble followed by a relief rally based on false hope which is ultimately followed by years of sideways or negative market action (think Japan circa 1995 or Nasdaq circa 2005). Without getting too technical and simply using this very basic definition the Shanghai index has now officially entered bear market territory.
The question is whether China will now lead us down. Graham Summers at SeekingAlphanotes that China's stimulus was announced in Nov, and their market took off; the US stimulus was announced in Feb, and the market took off in March. The SSEC began its recent decline in Dec when the Chinese authorities began tightening credit. The US QE is scheduled to end this March. Here is a comparison of stock indexes:
I think too much can be made of such comparisons, Something else is driving China down, and it has the potential of being a huge tsunami across global markets: the Chinese real estate bubble seems to be bursting. Home sales in Beijing fell 70% from Dec to Jan, and 50% in Shanghai. Well respected Chinese analysts agree. Here is a six-part series if you wish to explore further.
This bubble was spotted before the recent tightening of Chinese credit, for example here, here and here. The most noteworthy crash prediction came from James Chanos, and was highlighted in the NYT as well as many financial blogs, such as here and here. A critical assessment of Chanos' views agrees with them. The ever-present currency-speculator and Obama-supporter George Soros also agrees, as does Jim Rogers.
You can find some contrary views, such as here; but the anecdotes floating out of China nail this point: they clearly show speculative excess rushing in, as always happens near the end of a bubble. There is even some evidence that the some prices are higher than in Japan's bubble in 1989!
The warnings of an accelerating credit disaster in China came from Chinese observers, not just the Western financial press. These comments are worth pondering:
The high export growth era is over for three reasons.
- China's market share in global trade is twice as big as its GDP share. The odds are low that China could continue to expand its market share.
- Second, the tide won't rise as fast as before. The Greenspan era saw a credit bubble supercharge western consumption, but the bubble has burst. Odds are that future trade growth will be half or less as in the past.
- Finally, a western employment crisis will lead to protectionism targeting China. Other developing countries may gain market share at China's expense.
One possible way to prolong the bubble is to appreciate the currency, as Japan did after the Plaza Accord, to contain inflation and attract hot money. Such a strategy will not work in China. Japan's businesses were already at the cutting edge in production technologies and had pricing power during currency appreciation. They could raise export prices to partly offset currency appreciation. Chinese companies don't have such advantages but rely on low costs to compete.
After export-led growth peaks, consumption is the alternative to sustaining growth at a lower rate. This transition would require a wholesale change in the political economy. The key is to increase middle class disposable income and lower consumption costs. No East Asian economy has made this transition.
Now, he thinks the RE bubble won't burst until 2012, based on a 24 month lag between excess money growth and inflation. I agree on inflation - here is a great analysis by Goldman Sachs - but I disagree on cause and effect. Inflation should actually fuel real estate. Instead, the withdrawal of credit should burst the bubble, as it did in the US in 2005. That has started.
In addition, the excessive stimulus did to China what it always does: huge waste and malinvestment. The Chinese stimulus went quickly into infrastructure, roads to nowhere and ghost towns, with nothing in them.
The ghost towns are a modern wonder. You can see a video of them from this post. Those developments need continued investment to maintain, or they fall into ruin quickly. Where do you think they will be in ten years?
The most contrarian take on China also supports the bubble scenario, from a wholly different perspective: the Chinese currency will soon begin to appreciate. This needs to be examined. The Chinese have pegged it to the USD and it has become seriously undervalued. The Chinese had been letting it slowly appreciate until the summer of 2008, when they quietly ended that; the commodities bubble burst almost concurrently, and oil began its sharp fall. If the peg continues, as the USD appreciates, the RMB will also rise against other currencies, even with no policy change. But the call for it to appreciate is to rise more than the USD. This will put huge pressure on Chinese export industries. They rely on cheap labor, not high quality as the Japanese did, and may not be able to handle the appreciation. The Chinese will resist, but can they?
In order to contain inflation, China will have to do more than raise rates. It needs the RMB to appreciate above the USD, since otherwise it lets to much currency out as it sucks up Dollars in exchange for RMB by the export companies. (It has to do that to keep the RMB pegged.) As exports increase, they should feel more room to allow the slow appreciation again. Earnings from export can be used to continue investment, rather than cheap loans. A second reason for appreciation is the threat (and reality) of tariffs being slapped on it, as the Obama administration has begun to do. And so has China, back. The WTO has begun to look into Chinese hoarding, presumably to take action. Bad josh, as they say in Hong Kong. Who needs a trade war with the huge collapse already in global trade?
China has caught itself in the Mundell Incompatibility Triangle: a nation cannot manage all three of -
China has chosen to manage the free flow of capital by containing it inside, which leads to excessive accumulation. This leads to excess export capacity and asset bubbles - precisely the position China now finds itself in. Trying to manage this via rate hikes and jawboning banks will fail - and anecdotal stories suggest despite the tightening, many banks are finding ways to get around the new rules. As a consequence inflation should continue to accelerate, as explained by Paul Krugman. Inflation right now may be over 10%.
How to play this? The quickest way is to short oil and other commodities. Falling with Chinese real estate will be all those commodities it has been buying, hoarding, and plunking into ghost cities and roads to nowhere. Oil should fall the steepest. A second way is to get out of emerging markets. China sneezes, they catch serious colds. A third way is to short the AUD, which is way above PPP (88c today vs 68c PPP).
In rebuttal to this thesis, Thomas Friedman recently said: never short a country with $2T in reserves. Really? Twice before in modern history a nation ran up similar reserves: US in 1929 and Japan 1989. QED.
Yves sent this chart over to show how the Shanghai SEE is now the first major exchange to rollover after the Bubble Echo rally after last year's crash. China began their stimulus much sooner (and much more effectively) than the US, and the China market took off last November while US stocks rumbled and stumbled until March.
The wave pattern is textbook as I noted yesterday; the pattern suggests a fairly strong drop.
The second chart from the Asian STU concurs:
We are at the point in the wave count where the selling should intensify in the very short-term. ... We think market participants could be surprised by a fast move down to the 2620-2640 area that represents both the late August low and the lower Keltner channel on the daily chart.
After a 3% drop Friday and a flat day Monday, the SSEE was down over 2.3% Tuesday and falling fairly fast past another 2.3% down nearing the close on Wed.
Yves also passes on that Oct 1 is the 60th anniversary of communist rule in China. They may get the wrong sort of fireworks!
Yves adds that he had called the original bounce and top and the possibility of this pattern down. He writes that the first time China turned (July) he thought it bore watching but was a fringe element which would not drag down the Dow right away. This time he expects it to drag down the Dow and beyond. He will be on Bloomberg Radio Wednesday (Sep23) at 4p ET.
These are certainly "interesting times" for the Shanghai Composite. This morning it fell 4.4% and closed down 5.8%, breaking through the lower trendline - now down 18% over the past two weeks and 16% for the month. We might see an attempt at a recovery, coming back up to the trendline from below, and then if it fails to break through, "kissing it goodbye" for a continued fall. What was support is now resistance.
How low might it go? Bubbles retrace to their start, so the target for the Shanghai Composite is 1000. The parabolic rise up in the index is clear (see my prior post), and indicative of a bubble. Over market after market we see the pattern of a parabolic rise followed by a sharp drop back to the start of the mania.
Yves does not think we should extrapolate for a similar fall in the Dow, even with the Dow down today. He posted this chart and an analysis over at BlackSwan. The China Bubble Redux is from "liquidity froth" not fundamentals. The Dow may hold up as it did last year even as the Shanghai Composite fell steadily downward.
We will say later today what the leading pundits make of this. Most likely we are in the decline we have been expecting - the week-long B wave before the Final Surge to new highs to end this bear market rally. Whether we get to Dow10K by end of August seems problematic - I may lose my bet - but look for the US equities' correction to end between SP965-985. It hit the upper end of that range this morning.
We will then see over the last half of the year what this means for the Greater Recession. A lot of calls of its end, especially based on China's Bubble Redux and how it has pulled up Australia and other commodity countries, and may have caused the Euro economies to at least show signs of life this past quarter. I have written how China is not yet large enough to pull the world out of a recession, but it certainly can caused a stutter-step in the stats, as it may have done. If the Chinese are hitting the limits of their ability to use fresh credit (debt) to drive their bubble, the coming fall-off of growth in the Chinese economy may also drive the fall off the W-shaped recession after a momentary positive GDP report in Q3 or Q4.
The STU commented on the drop in the Shanghai Composite today, giving this chart and noting that it is approaching the lower trendline (the 2-4 line of wave C). If it breaks through the odds are high its bear market rally is over, and it will be the first to roll over. US indexes should follow after the reality sets in that the Chinese recovery was a mirage driven by debt, the Final Bubble so to speak.
Right now the S&P hovers above the crucial 992 level. A break of that indicates a change of trend and the now two-week's delayed week-long decline before the Final Surge. Thus the perspective remains of a higher high in the range of SP1100 and Dow 10K (+/- 300) by end of summer, after the decline. Recall that Dow9700 puts it in the heart of the prior 4th wave, a common stopping point; and Dow10334 puts it at the 50% retrace.
The USD strengthened today, and now seems poised for a dash higher from DX78 to DX90, a huge move. If so, oil should drop and the Dow will be under pressure as foreign interest will slacken (noting that the Dow/Dollar inverse relationship in part reflects a Dollar carry trade and the Dow as a hedge against Dollar weakness).
All in all, Monday should be a Chinese Curse Day ("may you live in interesting times") for both the Chinese markets as well as US equities.
Major Chinese markets down over 2% by mid-day, continuing a slide that began several days ago after a double top. Watch this today and Monday to see how this develops.
UPDATE Friday: The Shanghai Composite ended down 3%. It is down almost 10% for the week and over 12% from its last peak. This is in the realm of a market crash, and given how parabolic the index went up since last November, a sharp and deep drop is to be expected. It appears to be well underway. As put by Prieur du Plessis:
Chinese Shanghai Composite Index (3,046) has now declined by 12.2% since its peak of August 4. This morning the Index dropped to below its 50-day moving average (3,097), but is still comfortably trading above its 200-day line (2,413). The Rate-of-Change Indicator (black line in the bottom section of the chart) is also about to break below the zero line, thereby flashing a sell signal.
We have been following the dramatic bubble in China. The Shanghai Index has done a double top based on indications the horrific pace of reflation via bank credit is coming to an end. This chart courtesy of Gary Dorsch shows how the Chinese stocks have risen with the credit reflation. The second chart shows the double dip amidst pronouncements pulling back from the reflation.
We have also seen the end of the stockpiling. Baltic Dry has dropped indicating less shipping demand, and China *may* have stopped buying iron in particular from Australia. (This is wrapped up in a disturbing story around China trying to buy the Aussie mining company Rio Tinto, so momentary slowdowns may be due to those negotiations not the ongoing stockpiling of resources.)
The Chinese reflation may become a paradigmatic example of how government stimulus can put an economy on life support, and create an illusion of growth, but once withdrawn, so ends the faux recovery. We shall see when this story ends. The Chinese government may slow down their bubble-making to see the effect, and may find that the drop is much faster than they expect. This may cause a secondary reflation in Q4 before this effort by the Chinese comes to an end. Japan tried this in the 1990s and ended it in 1997. It put their economy on life support, and the patient remained sickly with a small remission during the US bubble in 2004-2007 and a recent relapse into a dreadfully desperate state. China may overtake Japan as the second largest economy n the world later this year, if this China bubble continues that long. A terrible fall for the formerly great Japanese economy.
Whereas the US is big enough to pull much of the world with it when it bubbles, China is not that great a factor. The end of its bubble may be seen in the future as the final bubble before the Greater Depression takes effect.
John Mauldin picks up on the China Bubble thread that I have been on for the past two weeks. He quickly dismisses China as being able to drive the West out of our Greater Recession Depression, since "China is just 7% of global GDP. Even if they grow at 8%, that only adds 0.5% to global growth, and it is likely that we will see global GDP shrink by 2.7% in 2009." See chart. He adds: "China is roughly as big as the other three of the BRICs (Brazil, Russia, and India) combined. Russia and Brazil are in recessions. Also, note that it will be decades before China's economy is as big as that of the US, even with growth of 5-6% a year more than that of the US."
He notes that China's stimulus is 1/3 of GDP, equivalent to a new Porkulus bill of $4.5T by the US. (This is still paltry compared with Japan's stimulus in the '90s, of $6.5T, more than their GDP; it did not work but saddled Japan with stifling levels of debt.) The Chinese stimulus is going out as bank debt. Mauldin quotes from Vitaliy Katsenelson's recent Foreign Policy magazine essay:
"This growth will result in a huge pile of bad debt -- as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much."
Simon Hunt adds that:
"Money is cheap with loans and credit freely available, so much so that China risks developing new bubbles in the stock and commodity markets and real estate. Speculation is based on the simple premise that prices must rise. Foreigners as well as domestic participants are feeding this frenzy, especially in metal markets.
"The frenzied loan and credit growth is unlikely to be cut back until the fourth quarter at the earliest. It is not this year or next which worries us, but post 2010. What will China do when the world economy gets hit with its next big leg down?"
He sees a staggering amount of copper (as one example) being stockpiled. Mauldin describes it as China engaged in hiding the Old Maid (the USD) by stockpiling and dumping their USD reserves on other countries, Australia in particular. In the card game, whoever ends up with it loses.
Great comment in StockTiming today on the Shanghai Index approaching key levels. See chart.
If the index tops and falls fairly hard, it will be an early warning signal to US markets. Also, it would be a harbinger of the nearing end of the Chinese stimulus. This will have ramifications on other investments, notably the Aussie Dollar.
Gary Dorsch gives a great explanation of how the China Bubble has propped the Aussie Dollar, which is now the sixth most traded currency. As he puts it:
The Australian dollar is increasingly popular with currency speculators, because of its volatile price swings, a relative lack of central bank intervention, and lends exposure to Asian tiger economies and the "Commodity Super Cycle." The "Aussie" dollar is currently the sixth-most-actively traded currency in the world, behind the US-dollar, the Euro, Japanese yen, British pound, and the Swiss franc, and changes hands in roughly 6% of worldwide foreign-exchange transactions.
The AUD ran up to 98c to the USD then fell to just over 60c in the past year. Now it has run back up over 80c. What gives Down Under? Gary Dorsch does a great job of explaining the mystery. As his chart shows, It has run up with the general commodities spike since early March, and has been driven by massive Chinese purchases, ahead of their 2008 pace. As Dorsch puts it:
Will this continue and drive the AUD to USD parity? Well, maybe not The NYT sees China as stockpiling. "[G} growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable." Why? "[A]ctual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak." The article goes on to note that the Baltic Dry Index of shipping prices shows expectations of weak trade through 2011. Perhaps the Chinese have found a way to recycle all their excess USD holdings - buying commodiites at low prices when shipping costs are low.
The wave count suggests the AUD is peaking.
Recent Comments