China’s role in market volatility – Beijing’s shifting priorities raise questions over assumptions of global growth

Commentators have confused cause with effect when analysing this month’s sudden downturn in financial markets, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog


Surprise and confusion seem to have been the main reactions to this month’s sudden downturn in western financial markets. Yet across the world in China, warning signs of a potential downturn have been building for some months, as discussed here in June.

As the chart below shows, President Xi Jinping’s decision to move away from stimulus policy will have a direct impact on the global economy, as this has been the main source of the liquidity that has boosted financial markets over the past decade.

China’s official and shadow bank lending totalled more than $20tn between 2009 and 2017. By comparison, the US Federal Reserve, Bank of Japan, European Central Bank and Bank of England added “only” $13tn between them.

The critical importance of China’s policy shift was highlighted in December by the state-owned Xinhua news service when it announced Mr Xi’s priorities for 2018 as being to fight “three tough battles” to secure China’s goal of “becoming a moderately prosperous society” by 2020.

“Financial deleveraging” was described as the first battle, and it seems the opening salvos have already been fired, given that China’s capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.

The People’s Bank of China then reinforced this priority in January with a statement emphasising that “slower M2 growth than before will become the ‘new normal’, as the country’s deleveraging process deepens and the financial sector gets back to the function of serving the economy”.

Western financial markets, however, seemed to adopt the “Road Runner approach” to this major paradigm shift in economic policy. Like the cartoon character Wile E Coyote, the new year saw them continuing to hang in mid-air before finally realising they were about to plummet into the chasm.

Even more worrying, now calm has been temporarily restored, is their failure to learn from the experience. Instead, commentators have mostly gone back to their comfort zone and are again focusing on the minutiae of policy statements from the major western central banks.

This could prove a costly mistake for investors and companies. As the FT reported in December, Mr Xi has already “made controlling debt at state-owned enterprises a top policy priority”, and it seems likely he will follow the IMF’s advice by increasing budget constraints for China’s zombie companies and allowing more corporate defaults. January’s shadow bank lending was the lowest January level since 2009 at just $25bn, and it was 90 per cent lower than in January 2017.

The recent rush of asset sales by major Chinese corporates such as HNA and Dalian Wanda is another clear sign of the new discipline being imposed. Foreign investors must hope the companies realise a good return from these disposals, given that they provided $221bn in dollar-denominated loans to Chinese borrowers last year.

Deleveraging is only one of Mr Xi’s “three battles”, however. And while his second battle on poverty reduction is unlikely to impact the global economy, his third battle, the “War on Pollution”, has a number of potentially critical implications.

It has already led to thousands of company closures and forcible relocations, and has severely disrupted major parts of China’s economy — causing China’s producer price index to peak at 6.9 per cent in the fourth quarter. In turn (as we had forecast here in November), this surge has created today’s “inflation surprise” as its impact rippled round the world.

One key component of the “surprise” was the disruption caused by the unexpected loss of production in key commodity markets. Oil prices have surged, for example, as China’s move away from coal has powered a short-term increase in oil demand. And, as always, the surge has been boosted by the inventory build typically associated with such unexpected and sudden price hikes. This can be seen in the second chart, which focuses on volume changes in the chemicals market, normally an excellent leading indicator for the global economy.

It confirms that consumers put aside their initial scepticism over Opec’s ability to support the oil market, as China’s excess demand helped prices to rise 60 per cent from June’s $44 a barrel to January’s $71 peak. Purchasers scrambled to build stock ahead of likely price rises for their own raw materials.

This time round, it even led buyers to abandon their normal tactic of reducing stock at year-end to flatter working capital data. Instead, inventories rose quite sharply all down the value chains, creating the illusion that demand was suddenly increasing in a co-ordinated fashion around the world.

The world has seen many similar increases in such “apparent demand” over the years, and these can temporarily add up to an extra month’s demand to underlying levels. This increase is, of course, only a temporary effect, as it is quickly unwound again once prices start to stabilise. The chart also shows that this was already starting to happen in January, with the normal seasonal stock-build being replaced by destocking.

In turn, of course, these developments raise a major question mark over the current assumption that the world is now seeing a synchronised global recovery. We suspect that by the summer, policymakers may well find themselves repeating the famous lament of Stanley Fischer in August 2014, when the Fed’s vice-chairman sadly noted that “year after year we have had to explain from midyear on why the global growth rate has been lower than predicted as little as two quarters back”.

Paul Hodges, Daniël de Blocq van Scheltinga and Paul Satchell publish The pH Report.

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Economy faces slowdown as oil/commodity prices slide


Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks.  The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:

  • It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
  • The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
  • On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks

The size of the rally has also been extraordinary, as I noted 2 weeks ago.  At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand.  They had bought 1.2bn barrels since June, creating the illusion of very strong demand.  But, of course, hedge funds don’t actually use oil, they only trade it.

The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits.  The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl.  By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.

Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week.  And this simple fact confirms how the speculative cash has come to dominate real-world markets.  The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:

  • Most commodity trading is done in relation to charts, as it is momentum-based
  • The 200 day exponential moving average (EMA) is used to chart the trend’s strength
  • When the oil price reached the 200-day EMA (red line), many traders got nervous
  • And as they began to sell, so others began to follow them as momentum switched

The main sellers were the legal highwaymen, otherwise known as the high-frequency traders.  Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second.  As the Financial Times warned in June:

“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”

JP Morgan even estimates that only 10% of all trading is done by “real investors”:

“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”

Probably prices will now attempt to stabilise again before resuming their downward movement.  But clearly the upward trend, which took prices up by 60% since June, has been broken.  Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:

  • Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
  • This inventory will now have to be run down as buyers destock to more normal levels again
  • This means we can expect demand to slow along all the major value chains
  • Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year

This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices.  It will also cause markets to re-examine current myths about the costs of US shale oil production:

  • As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
  • Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
  • So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong

PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations.  This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.

Smart CEOs will now start to prepare contingency plans, in case this should happen.  We can all hope the recent downturn in global financial markets is just a blip.  But hope is not a strategy.  And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.

 

FORECAST MONITORING
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.

Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.

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London house prices risk perfect storm as interest rates rise


2000 should have been the natural end of the BabyBoomer-led economic SuperCycle. The oldest Boomer (born in 1946) was about to leave the Wealth Creator 25 – 54 age group that drives consumer spending and hence economic growth.  And since 1970, Boomer women’s fertility rates had been below replacement level (2.1 babies/woman).  So relatively fewer young people were joining the Wealth Creator generation to replace the Boomers who were leaving.

But instead, central banks decided that demographics didn’t matter.  They believed instead that monetary policy could effectively “print babies” and create sustainable demand.  So instead of worrying about financial stability – their real role – they aimed to stimulate the economy by boosting financial asset prices – primarily shares and housing markets.

London’s housing market was a key target as the Bank of England’s Governor told Parliament in March 2007:

“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession… That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

But instead, when the Subprime Bubble burst, policymakers did even more stimulus via Quantitative Easing (QE).

The chart of London house prices since 1971 (in £2017) therefore shows 3 distinct phases:

  • 1971-1999.  Prices were typically Cyclical – (1) up 51%, down 31%; (2) up 37%, down 15%; (3) up 109%, down 43%.  But they averaged around 4.8x average London earnings
  • 2000-2007.  Central banks panicked after the dotcom crash and kept interest rates artificially low – creating the Subprime Bubble as prices rose in more or less a straight line, till they were up 196% from the previous trough
  • 2008-2017.  The market tried initially to return prices to reality, and they slipped 10%.  But then central banks rushed to flood it with liquidity and created the QE Bubble, causing prices to soar 46%

Now, however, the Stimulus Bubble is ending and a “perfect storm” is developing as 3 key myths are exposed:

The end of the ‘London is a global city’ myth.  The house price/earnings ratio averaged 4.8x between 1971-1999.  But it then took off into the stratosphere to reach 11x today, as the myth grew that Londoners weren’t relevant to the housing market.  Instead, it was said that London had become a “global city” where foreigners would set the price.

Chinese and Asian buyers boosted this myth as vast new apartment blocks were sold off-plan in the main Asian cities – often to buyers who never even visited their new “home”.  But the myth ended last year when China introduced severe capital controls – capital outflows collapsed from $640bn in 2016 to just $60bn in 2017.

The scale of the this retreat is overwhelming as The Guardian reported recently:

“The total number of unsold luxury new-build homes, which are rarely advertised at less than £1m, has now hit a record high of 3,000 units, as the rich overseas investors they were built for turn their backs on the UK due to Brexit uncertainty and the hike in stamp duty on second homes….

“Henry Pryor, a property buying agent, says the London luxury new-build market is “already overstuffed but we’re just building more of them.  We’re going to have loads of empty and part-built posh ghost towers. They were built as gambling chips for rich overseas investors, but they are no longer interested in the London casino and have moved on.””

The end of the buy-to-let mania.   Parents of students going away to college began this trend in the mid-1990s, as they bought properties for their children to use, rather than rent from poor quality landlords.  After the dotcom crash, many decided that “bricks and mortar” were a safer bet than shares, especially with the major tax breaks available.

Banks were delighted to lend against an asset that was supported by the Bank of England, finding it far more attractive than lending to a business that might go bust.  And so parents held on to their investments after their children left college – further reducing the amount of housing available for young people to buy.  But as The Telegraph reports:

“Buy-to-let investors now face tougher conditions. A weakening housing market, tough new legislation and the tightening of affordability checks by lenders are but a few problems causing landlords to run for the hills.  According to the National Landlords Association, 20% of landlords plan to sell one or more of their properties in the next 12 months.”

Interest rates will never rise.  Of course, the key to the Subprime and QE Bubbles was the Bank’s decision to collapse interest rates to stimulate the economy.  Monthly payments became much more affordable – and ever-rising prices meant there was no longer any need to worry about repaying the capital.

But some people still couldn’t afford to buy even on this basis, and by 2007 around 30% of mortgages were “interest-only” with no capital repayment at all.  These buyers should have been forced sellers when the Subprime Bubble burst; prices would then have returned to more normal levels.  But instead, the Bank of England stepped in again, as the Financial Times has reported:

“During and after the 2008 financial crisis Britain’s mortgage lenders took a more tolerant approach to non-payers through the use of forbearance ….at the height of the housing market troubles in 2011 Bank of England research suggested that as many as 12% of all UK residential mortgages were in some form of forbearance.  This helped prevent the downturn from developing into a 1990s-style crash, the Bank suggested.”

PRICES WOULD FALL 60% IF THE HOUSE PRICE/EARNINGS RATIO “REVERTS TO MEAN”
All “good things” come to an end, of course. And the London property bubble is probably no exception. Its 3 key drivers are now all reversing, and there seems little sign of any new factors that might help to keep the bubble inflating.

The risk is that interest rates continue to rise, forcing many owners to sell and bursting the Stimulus Bubble.  UK 10-year rates have already trebled from their 0.5% low in Q3 2016.  Most rates seem likely to go much higher now the 30-year downtrend has been broken, as I discussed last week.

Today’s high prices will also make it difficult for sellers to find local buyers, as the number of homes being bought/ sold each year has fallen 25% since the 2007 peak.  Most young people cannot afford to buy.  And if many people do decide to sell, potential buyers might panic, causing the slump to continue for many years – as happened before 2000.

Nobody knows how low prices might go, if they start to fall.  But ‘reversion to mean’ is usually the best measure.  If this happened, today’s average London home, selling at 4.8x earnings, would cost £193k – a 60% fall from 2017’s average price of £475k.  This figure also highlights the risk that policymakers’ denial of demographic realities has created.

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The global economy and the US$ – an alternative view

Every New Year starts with optimism about the global economy.  But as Stanley Fischer, then vice chair of the US Federal Reserve, noted back in August 2014:

 “Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”

Will 2018 be any different?  Once again, the IMF and other forecasters have been lining up to tell us the long-awaited “synchronised global recovery” is now underway.  But at the same, they say they are puzzled that the US$ is so weak.  As the Financial Times headline asked:

“Has the US dollar stopped making sense?”

If the global economy was really getting stronger, then the US$ would normally be rising, not falling.  So could it be that the economy is not, actually, seeing the promised recovery?

OIL/COMMODITY PRICE INVENTORY BUILD HAS FOOLED THE EXPERTS, AGAIN
It isn’t hard to discover why the experts have been fooled.  Since June, we have been seeing the usual rise in “apparent demand” that always accompanies major commodity price rises.  Oil, after all, has already risen by 60%.

Contrary to economic theory, companies down the value chains always build inventory in advance of potential price rises.  Typically, this adds about 10% to real demand, equal to an extra month in the year.  Then, when the rally ends, companies destock again and “apparent demand” weakens again.

The two charts above confirm that the rally had nothing to do with a rise in “real demand”:

Their buying has powered the rise in oil prices, based on the free cash being handed out by the central banks, particularly in Europe and Japan, as part of their stimulus programmes.

They weren’t only buying oil, of course.  Most major commodities have also rallied.  Oil was particularly dramatic, however, as the funds had held record short positions till June.  Once they began to bet on a rally instead, prices had nowhere to go but up.  1.4bn barrels represents as astonishing 15 days of global oil demand, after all.

What has this to do with the US$, you might ask?  The answer is simply that hedge funds, as the name implies, like to go long in one market whilst going short on another.  And one of their favourite trades is going long (or short) on oil and commodities, whilst doing the opposite on the US$:

  • Since June, they have been happily going long on commodities
  • And as Reuters reports, they have also been opening major short positions on the dollar

The chart highlights the result, showing how the US$’s fall began just as oil/commodity prices began to rise.

COMPANIES HAVE NO CHOICE BUT TO BUILD INVENTORY WHEN COMMODITY PRICES RISE
This pattern has been going on for a long time.  But I have met very few economists or central bankers who recognise it.  They instead argue that markets are always efficient, as one professor told me recently:

“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”

But if you were a purchasing manager in the real world, you wouldn’t be sceptical at all.  You would see prices rising for your key raw materials, and you would ask your CFO for some extra cash to build more inventory.  You would know that a rising oil, or iron, or other commodity price will soon push up the prices for your products.

And your CFO would agree, as would the CFOs of all the companies that you supply down the value chain.

So for the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford.  In turn, of course, this has made it appear that demand has suddenly begun to recover.  At last, it seems, the “synchronised global recovery” has arrived.

Except, of course, that it hasn’t.  The hedge funds didn’t buy 15 days-worth of oil to use it.  They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.

THE RISE IN COMMODITY PRICES, AND “APPARENT DEMAND”, IS LIKELY COMING TO AN END
What happens next is, of course, the critical issue.  As we suggested in this month’s pH Report:

“This phenomenon of customers buying forward in advance of oil-price rises goes back to the first Arab Oil Crisis in 1973 – 1974. And yet every time it happens, the industry persuades itself “this time is different”, and that consumers are indeed simply buying to fill real demand. With Brent prices having nearly reached our $75/bbl target, we fear reality will dawn once again when prices stop rising.”

Forecasting, as the humorist Mark Twain noted, “is difficult, particularly about the future”.  But hedge funds aren’t known for being long-term players.  And with refinery maintenance season coming up in March, when oil demand takes a seasonal dip, it would be no surprise if they start to sell off some of their 1.4bn barrels.

No doubt many will also go short again, whilst going long the US$, as they did up to June.

In turn, “apparent demand” will then go into a decline as companies destock all down the value chain, and the US$ will rally again.  By Q3, current optimism over the “synchronised global recovery” will have disappeared.  And Stanley Fischer’s insight will have been proved right, once again.

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US Treasury benchmark yield heads to 4% as 30-year downtrend ends


The US 10-year Treasury bond is the benchmark for global interest rates and stock markets.  And for the past 30 years it has been heading steadily downwards as the chart shows:

  • US inflation rates finally peaked at 13.6% in 1980 (having been just 1.3% in 1960) as the BabyBoomers began to move en masse into the Wealth Creator 25 – 54 age group
  • Instead of simply boosting demand, as during the 1960s-1970s, they began to work and create new supply
  • This meant supply/demand began to rebalance and interest rates then peaked at 16% in 1981

By 1983, the average Western Boomer (born between 1946-1970) had arrived in the Wealth Creator cohort, which dominates consumer spending, and the economy really began to hum.  There was a final inflation scare in 1984, when US inflation suddenly jumped from 3% to 5%, but after that the trend was downwards all the way.

The Boomers were the largest and wealthiest generation that the world had ever seen.  Their move to become Wealth Creators completely transformed the inflation outlook, as more and more Boomers joined the workforce.  And they transformed the economy by moving it into the NICE era of Non-Inflationary Constant Expansion.

Central bankers took credit for this move, claiming it was due to monetary policy.  But in reality, people are the key element in an economy, not monetary policy.  You can’t have an economy without people.  And sadly, the idea that the US Fed Chairman Alan Greenspan had somehow become a Maestro, blinded everyone to 2 key issues for the future:

  • Life expectancy was rising rapidly, meaning that the Boomers would not normally die just after retirement.  Instead, they would likely live for another 15 – 20 years after reaching age 65
  • From 1970, fertility rates had fallen below replacement level (2.1 babies/woman) across the Western world

This combination of a rise in life expectancy and a collapse in fertility rates was creating a timebomb for the economy.

THE RISE IN LIFE EXPECTANCY AND COLLAPSE OF FERTILITY RATES CREATED AN ECONOMIC TIMEBOMB

Western economies are based on consumer spending.  And spending declines once people reach the age of 55 – they already own most of what they need, and their incomes decline as they approach retirement, as the second chart shows:

  • There were 65m US Wealth Creator households in 2000, who spent an average of $62k ($2017)
  • There were only 36m in the 55+ cohort, who spent just $45k each
  • In 2017, there were 66m Wealth Creators (almost the same as in 2000) who spent $64k each
  • But there were now 56m in the 55+ cohort, who spent just $51k each

The rise in 55+ spending was also only temporary, as large numbers of Boomers have just reached 55+ and have not yet retired.  Spending by those aged 74+ was down by nearly 50% versus the peak spending 45-54 age group.

BELIEF IN MONETARISM LED TO THE DOTCOM AND SUBPRIME DISASTERS 
The dot-com crash in 2000 should have been a wake-up call for the failure of monetarism.  It also, after all, marked the moment when the oldest Boomers began to join the 55+ cohort.  But instead, policymakers thought monetarism could solve “the problem” and cut interest rates to boost the housing market – causing the subprime crash in 2008.

One might have thought – as we wrote in Boom, Gloom and the New Normal in 2011 – that this disaster would have destroyed the monetarism myth.  But no.  Abandoning monetarism would have led to a difficult conversation with voters about the need for everyone to retrain in their 50s, and prepare to take on new, and less physically demanding, roles.

Instead, policymakers tried to replace lost BabyBoomer demand by printing vast amounts of free money via the Quantitative Easing and Zero Interest Rate Policies.  Their aim was to avoid deflation, as inflation had fallen to just 0.6% in 2010 – although why this was a “bad thing” was never explained.  But in reality, they were running uphill, and the pace of the climb was becoming more vertical, as the average Western Boomer joined the 55+ cohort in 2013.

Of course, flooding the market with cheap money boosted asset prices, as they intended.  Stock markets and house prices soared for a second time. But it also created a major new risk.  More and more investors began to panic as they hunted through the markets, trying to obtain a decent “return on capital”.  They assumed central banks would never let markets fall, and so gave up worrying about the risk of making a dud investment.

INTEREST RATES ARE NOW HEADED HIGHER AS PEOPLE WORRY ABOUT RETURN OF CAPITAL
The end of the Bitcoin bubble has highlighted the fact that that risk and reward are normally related.  Most investments that offer potentially high rewards are also high risk – a lot has to go right, for them to make the possible return.  This process of price discovery – the balance of risk and reward – is the key role of markets.

Left to themselves, markets will price risk properly.  But they have been swamped for the past decade by central bank liquidity and their crucial role has been temporarily destroyed.  Now, the fact that the US 10-year bond has broken out of its 30-year downtrend tells us that markets they are finally starting to regain their role.

How high will interest rates now go?  We cannot yet know, and we can also be sure they will not move in a straight line as central banks will continue to intervene.  But as more and more investments, like Bitcoin, prove to be duds, so more and more investors will start to worry about return of capital when they invest.

4% therefore looks like the next level for rates, as we are now trading within the blue bars on the chart.  It may not take very long for this level to be reached, given the fact that the world now has a record $233tn of debt – 3x the size of the global economy.  After that, we shall have to wait and see.

 

FORECAST MONITORING
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.

I now plan to begin monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book.  The first forecasts relate to last week’s post on US polyethylene exports and today’s forecast for the US 10-year Treasury bond.  I will change confidence levels as and when circumstances change.

 

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Chart of the Year: Bitcoin, the logical end for stimulus policies

Last year it was the near-doubling in US 10-year interest rates.  In 2015, it was the oil price fall.  This year, there is really only one candidate for ‘Chart of the Year’ – it has to be Bitcoin:

  • It was trading at around $1000 at the start of 2017 and had reached $5000 by August
  • Then, after a brief correction, it stormed ever-higher, reaching $7000 last month
  • On Friday it was trading around $19000 – fortunes are being made and lost all the time

The beauty of the concept is that nobody really has a clue about what it is all about.  You can read the Wikipedia entry as many times as you like, and still not gain a clear picture of what Bitcoin is, and what it does.  But why would you want to know such boring details?

All anyone has to know is that its price is going higher and higher.  Plus, of course, there is the opportunity to laugh at stories of people who bought Bitcoins, but then lost the code – for an excellent example by a former editor of WIRED (with a happy ending), click here.

But there is another side to the story, as the second chart suggests.  “Mining” Bitcoins now uses more electricity than a number of real countries, like Ireland, for example:

  • On Friday, Bitcoin’s current annual consumption reached 33.73TWh – equivalent to Belarus’ 9 million people
  • Each transaction produces 117.5kg of CO2, as the network is powered by cheap coal-fired power plants in China
  • It also uses thousands of times more energy than a credit card swipe 

And, of course, interest is growing all the time as people rush to get rich.  Today sees the start of Bitcoin futures trading on the CME, a week after they began on the CBOE and CME.  Bloomberg suggests Exchange Traded Funds based on Bitcoin will be next.  In turn, these developments create more and more demand, and push prices ever-higher.

Comparisons have been made with the Dutch tulip mania in 1836-7, when prices peaked at 5200 guilders.  At that time, Rembrandt’s famous Night Watch painting was being sold for 1600 guilders, and at its peak a tulip bulb would have bought 156000lbs of bread.  Bitcoin probably won’t equal this ratio until next year, if its current price climb continues.

Of course, one key difference between tulips and Bitcoin is supposedly that there were always more tulips to buy – whilst there are just 21 million Bitcoins available to be mined.  And apparently, around 80% of these have been mined. Bitcoin enthusiasts therefore suggest Bitcoins will have increasing scarcity value.  But, of course, anyone can create a crypto-currency and many people have – such as Bitcoin Cash and Bitcoin Gold, and the Ethereum family.

Yet already, Bitcoin’s market capitalisation* is getting close to that of the “tech stocks” such as Apple, Alphabet (formerly Google), Microsoft, Amazon and Facebook as the chart from Pension Partners shows:

  • On 7 December, less than 2 weeks ago, its market cap was already higher than major US stocks such as Home Depot and Pfizer
  • On Friday, it hit $323bn, above Wal-Mart and P&G and close to ExxonMobil
  • This also made it worth more than the IMF’s Special Drawing Rights
  • And the total market cap of the 10 largest crypto-currencies has now reached $500bn, equal to Facebook

This is an amazing amount of money to be tied up in an asset which has no intrinsic value.  After all, what is Bitcoin?  It certainly isn’t real, although the media like to picture it as a gold coin:

  • Although it is called a crypto-currency, its volatility makes it unattractive as a currency – major changes in a currency’s value can easily cause businesses (and countries) to go bust, and Bitcoin’s value has moved by 1900% just this year
  • Nor is it a method of settling transactions, as its value is increasing all the time – obviously a good deal for the person who receives the Bitcoin when its price is rising, but why would any sensible person pay with a Bitcoin?
  • So essentially, therefore, Bitcoin is simply a speculative asset, where its value is based on the “greater fool theory”, which says “I know its not really worth anything, but I am clever enough to sell out before it hits the top”

The “story” behind its boom is also powerful because it is linked to the great investment theme of our time, the internet.  We have all seen the fortunes that can be made by investing in companies such as Apple.  Now, Bitcoin supposedly offers us the chance to invest in the Next Big Thing – a new currency, entirely based on the internet.

BITCOIN HAS MANY PARALLELS WITH OTHER MANIAS IN HISTORY, SUCH AS THE SOUTH SEA BUBBLE 
The Bitcoin mania has many parallels, such as with the South Sea Bubble from 1719 – 1720.  Its power was also based on “the greater fool theory”, and its linkage to the great investment theme of its time – the opening up of foreign trade.  As the chart from Marc Faber shows, one of its early investors was Sir Isaac Newton – one of the most intelligent people ever to live on the planet, who discovered Newton’s laws of motion and invented calculus.  Newton doubled his money very quickly when he first invested, but then re-invested at a higher price – and lost the lot.

Of course, all the dreams associated with Bitcoin and the other crypto-currencies may come true. That is part of their attraction.  Another part of their attraction is for criminals, who can launder money without being traced.  So most likely, prices will continue rising for some time as more and more people around the world see a chance of getting rich very quickly.  We have never seen a global mania before, so nobody can tell how long it will last.

The question for governments, however, is what would happen to the economy if the mania collapsed?  Only China has so far banned Bitcoin trading, as Pan Gongsheng, a deputy governor of the People’s Bank of China, explained:

“If we had not shut down bitcoin exchanges and cracked down on ICOs several months ago, if China still accounted for more than 80% of the world’s bitcoin trading and ICO fundraising, everyone, what would happen today? Thinking of this question makes me scared.”

Having let the mania develop this far, other governments  are in a difficult position – millions of people would complain if they closed down these currencies today.  And most governments are reluctant to intervene as, in reality, crypto-currencies are essentially the creation of central bank stimulus policies, as explained by US Federal Reserve chairman, Ben Bernanke, in November 2010:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” 

But by letting the mania continue, the potential impact from its collapse will increase.  Added together, crypto-currencies already have the same market cap as Facebook – and could soon overtake Apple to become the most valuable “stock” in the world.  Yet unlike Apple, they have no sales, no income and no assets.

Bernanke and the major central banks wanted to stimulate investors’ “animal spirits”, so that they would take on more and more risk.  Crypto-currencies are therefore the logical end result of their post-crisis strategy. The end of the Bitcoin mania, whenever it occurs, will therefore also mark the end of stimulus policies.

 

*Bitcoin’s market capitalisation is its equity valuation – the current dollar price multiplied by the number of Bitcoins in existence

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