Blog readers often travel a lot. And they certainly use WiFi. So here’s a question:
Q. Do you ever remember using a WiFi service called Gowex?
A. Lots of puzzled looks in response
Q. Not sure? You think it might be vaguely familiar, but maybe not. Well this is what the company’s website says:
“Your city is a WiFi city With loads of projects, GOWEX leads the development, creation & exploitation of WiFi Cities in the World. Learn how GOWEX takes WiFi to every corner of your city and how you can be part of the greater network of WiFi cities in the world.”
A. Now you’re looking puzzled. You’re sure you should have heard of something this big, but it really doesn’t ring any bells for you.
Gowex had a €2bn ($2.75bn) market capitalisation as recently as April. Last November, it was named one of Europe’s “Best New Listed Companies” by the Federation of European Stock Exchanges and the European Commission.
Its founder, Jenaro Garcia, won Spain’s top marketing prize in May, and a Spanish government prize for export achievement in March. He was the 39th-richest person in Spain last year as his personal wealth soared to a peak of €177m, due to investors bidding the stock up from €2 in late 2012 to a peak of €26.
But on 1 July, US investment firm Gotham City Research LLC published a report suggesting that up to 90% of its reported revenues did not exist. This week, Garcia admitted the results had been fabricated for 4 years. Gowex has since filed for bankruptcy.
So there is just one final question. Why did this happen? Why did a G20 government, a reputable financial firm such as Ernst & Young and large numbers of professional investors fail to ask the obvious questions about Gowex’s business?
And there is only one answer. Investors wanted desperately to believe that it was a solid business, that could make them money. The policies of the central banks had very deliberately forced them to take on more and more risk, for less and less reward. So anything that looked as though it might have a pulse was a possible investment, as long as it had momentum.
Everyone else was buying Gowex, just as everyone else was buying WorldCom in the dot-com bubble. Investors didn’t want to ask too many questions, for fear of finding out the truth. Nor did the Spanish government, desperate to show as its current advertising campaign states, “Its the moment of Spain”.
The Gowex bankruptcy connects, of course, to current events in Qingdao, on the opposite side of the world. That started in April with a possible $160m scandal. By last week, an alleged $15bn scandal related to gold was uncovered. Last year there was the fall of OGX in Brazil, where the one-time 8th-richest person in the world saw his company file for bankruptcy protection.
The connection as the chart shows, is the debt-fuelled fault-lines created by stimulus and quantitative easing.
The blog thus continues to fear that Gowex and Qingdao and OGX are, like Bear Stearns in 2007, just the early warning tremors of the potential earthquakes that are developing.
UPDATE 15 JULY
Gowex founder Garcia confessed to a judge yesterday that the accounts had been fraudulent since 2005. Bloomberg clearly have the same view as the blog of the whole affair:
“In the end, the most shocking part of Let’s Gowex SA (GOW)’s implosion this month wasn’t that the Wi-Fi company, worth €1.9bn ($2.6bn just 3 months ago, was a fraud. Its that it wasn’t spotted sooner. Gowex founder Jenaro Garcia fabricated clients and contracts, listed a defunct company as a holding company for his stake in Gowex, and put numbers in reports that didn’t make any sense, even as matters of basic arithmetic.”
Clearly, the only possible answer is that ‘nobody wanted to know’.
The blog’s new Research Note in the ‘Your Compass on China’ series highlights the way that China’s commodity imports have been used to finance its housing bubble. This is clearly a shock for investors, who have till now believed the imports were a sign of its superior economic policies and long-term growth prospects.
The Qingdao probe could thus become the straw that breaks the camel’s back for world markets. There are two reasons to believe this is a serious threat:
- Investors have assumed that China’s vast share of global commodity demand was due to its economic growth. Now they will slowly wake up to find it was more about supporting a housing bubble
- Similarly, they have assumed that China had become ‘middle class’ with Western living standards and incomes. Now they will be forced to realise that consumer spending has been driven by the ‘wealth effect’
The worry is that the global financial system is currently priced for perfection. and may not be resilient enough to cope with this shock. Investors, companies and individuals have been lulled into believing that central banks’ experience with the Lehman Bros collapse means they will never let markets suffer a major downturn:
- Borrowing to buy stocks in New York is at record levels
- Investors Intelligence US sentiment index at 62.2% is at danger level, above August 1987 and October 2007
- American investors so-called ‘fear index’, the VIX, is at its lowest level since 2007
The best view is always from the top of the mountain, and thus it is no surprise to see Goldman Sachs still bullish:
“If nothing unexpected upsets the stock market’s delicate balance at these lofty heights, VIX could fall to record lows.”
The Qingdao probe is exactly the type of ”unexpected” event to reveal this as simply wishful thinking. The key issue is that a large part (we don’t yet know how much), of China’s vast purchases of commodities since 2009 has not been used to build the economy. Instead, it has been used as collateral to finance a huge property bubble.
China’s new leadership clearly understand this. As the blog discussed in its February Research Note, they are now implementing a series of well-designed policies with the help of the World Bank to limit the damage from the bubble’s collapse. We can only hope they are successful.
Now, however, the rest of the world is about to discover what they already know. The blog’s fear is that this discovery will prove extremely painful, because of being so “unexpected”.
A core reason for concern is the total size of China’s corporate debt. It overtook the US in 2013 at $14.2tn, according to ratings agency S&P:
“China’s corporate issuers account for about 30% of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector. That means as much as 10% of global corporate debt, about $4tn to $5tn, is exposed to the risk of a contraction in China’s informal banking sector.”
China’s ‘collateral trade’ is at the heart of the issue. This is why the Qingdao probe is potentially so earth-shaking:
- Already some lenders are withdrawing from commodity financing in China as the risks rise
- Global market prices for copper and iron ore are declining, as informed players exit the market while they can
- The Economist notes that China’s banks are starting to become more reluctant to grant letters of credit
An investigation by the Wall Street Journal (WSJ) makes the link between the ‘collateral trade’ and housing very clear,. It appears the owner of the company at the centre of the Qingdao probe was heavily involved in real estate development:.
“In 2008, China’s government unleashed a $4 trillion stimulus package aimed at helping the economy withstand the global financial crisis. The stimulus drove a wave of credit through China’s financial system that launched a building boom in cities like Qingdao.
A real-estate company controlled by Mr. Chen currently is developing at least four projects in Qingdao, including a residential project called “Brocade City” and a large mixed-use development in the city center, according to the firm’s website.”
The WSJ adds that Mr Chen was not unique:
“Just about every trader who does collateral financing is also likely to have a real-estate development on the side, because the property sector gives higher returns,” said Jerry Chen, a metals trader at Shanghai-based Star Futures.”
It is already clear that China’s property market is entering a major slowdown, with Beijing sales down 35% so far this year. This will itself prove an enormous shock as property has been a money-making machine till now, with prices doubling every 2 to 3 years since urban property was privatised in 1998.
As property prices now fall, the ‘collateral trade’ will come to an end. In turn, investors will slowly realise that China’s economic growth has indeed been tied to a property bubble which is now beginning to burst.
There is thus a serious risk that today’s warning tremors in Qingdao will become a serious earthquake, and open fault-lines across the global financial system. Investors may now find out the hard way that central banks have instead created a debt-fuelled ‘ring of fire’, with China’s property bubble at its epicentre.
A year ago, the blog suggested that financial markets were reaching their most dangerous ‘melt-up’ stage, driven by investor complacency about the ability of central banks to protect them from any downturn. This analysis was confirmed in November, when absurdly high prices were paid for works of modern art, smashing previous records.
Gillian Tett of the Financial Times (another of the few to forecast the 2008 Crisis), also sees great danger in today’s financial market complacency. Echoing last week’s blog post on Hyman Minsky, she wrote:
“While ultra-low volatility might sound like good news in some respects (say, if you are a company trying to plan for the future), there is a stumbling block: as the economist Hyman Minsky observed, when conditions are calm, investors become complacent, assume too much leverage and create asset-price bubbles that eventually burst. Market tranquillity tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.
“That pattern played out back in 2007. There are good reasons to suspect it will recur, if this pattern continues, particularly given the scale of bubbles now emerging in some asset classes. Unless you believe that western central banks will be able to bend the markets to their will indefinitely. And that would be a dangerous bet indeed.”
Meanwhile, the latest IeC Boom/Gloom Index (above) continues to suggest the US S&P 500 Index (red line) is very exposed at its current record level. The Index (blue column) has again failed to confirm the S&P’s rise.
We are thus reaching a very dangerous stage in financial markets. Investors who do their own analysis long ago gave up trying to fight the central banks. So they invest, knowing it is all a bubble, because they have no alternative. Put simply, they cannot sit with cash in the bank when the market is rising – they will lose their jobs.
None of us can individually fight the central banks, as they have the power of the printing press to swamp financial markets. And they can keep printing – as the market expects the European Central Bank to announce before too long.
But can they print babies? People, after all, are the real source of demand, not electronic bank transfers.
So we have reached the fork in the road, just as we did in June 2008 when the blog quoted Robert Frost’s famous poem ‘The road not taken’.
Two roads diverged in a wood, and I
I took the one less travelled by,
And that has made all the difference.
The central banks chose their road a long time ago, and still believe that increasing debt levels will, in the end, restore growth to sustainable levels.
If they are wrong, then this debt can never be repaid.
Instead, as the blog discussed on Tuesday, they will find they have created an earthquake ’ring of fire’, connected by deep fault-lines running across the world.
A new article by an IMF economist makes the point that in April 2008, not a single one of the mainstream economic forecasts covered by ‘Consensus Economics’ was forecasting a recession in 2009.
The IMF itself expected growth to continue, as did the World Bank and the Organisation for Economic Co-Operation and Development. Even by September 2008, the consensus view was still for continued growth, and no recession.
As the Financial Times comments, “it is an astonishing record of complete failure“.
The blog did forecast the Crisis. But, of course, most people preferred to believe the consensus. Their caution was understandable. But sometimes it is necessary to go against the consensus. And today it is essential.
The reason is simple. Central bank policies since 2008 have clearly not solved the problems of slowing growth and too much debt. Rather, they have made them worse, much worse.
Central banks have now created a debt-fuelled ‘ring of fire’ with multiple fault-lines, as the chart above shows.
Some of these fault-lines are becoming widely acknowledged. Thus the Governor of the Bank of England has warned that the record level of London house prices poses:
“The biggest risk to financial stability, and therefore to the durability of the expansion, those risks center in the housing market and that’s why we are focused on that.”
Similarly, the new Chinese leadership has recognised their economy has moved into a New Normal, and that more stimulus would cause many more problems than it would solve.
The problem is that these realisations all come too late. Policymakers have spend $33tn, and wasted 5 years, heading in the wrong direction. We could by now have begun to emerge from the Crisis with a soundly-based platform for future growth. But instead, we are faced with dealing with the same problems as in 2008, but on a much larger scale.
Even worse is the fact that most policymakers still do not accept that demographics drive demand. They do not want to admit that the ‘Demographic Dividend’ of the Boomer-led SuperCycle growth has been replaced by a ‘Demographic Deficit’ caused by ageing global populations and falling fertility rates. Instead, most prefer to indulge in wishful thinking – arguing that adding yet more debt will somehow enable growth to return.
Thus we face a ‘ring of fire’ where the tectonic plates are shifting all the time.
This is not to say we face one big earthquake. Rather, we face a period where one medium-sized earthquake will opens up cracks elsewhere. And these cracks create the potential to create another debt-related earthquake elsewhere along the fault-line.
China is the epicentre of the first earthquake, as the blog noted in February when launching its Research Note. The first economic tremors from its new policies have already moved along the fault-line, destabilising emerging economies in a wide arc from Argentina through India and Indonesia to Turkey.
The worrying feature is that these were just an early warning of the likely impact of China’s policy shifts. We are in a world where there are multiple fault-lines with the potential to crack open when stressed by tremors from another earthquake, for example:
- US financial markets are racing higher, fuelled by levels of debt never before seen in history
- The Eurozone debt crisis remains unsolved, and the recent EU elections will make it even harder to find a solution
- Russia’s establishment of a Eurasian Economic Union highlights its intention to pressure Western Europe, which depends on its energy exports
- And, of course, there is the great debt mountain in Japan, built even higher under Abenomics
There is little that any individual or company can now do to stop these earthquakes happening. Even a complete about-turn by policymakers today would only reduce their impact, not remove the risk. But we can at least try to understand why they are likely to happen, and prepare ourselves to survive them.
This will be the aim of a new series of posts, whch the blog will intends to publish over the next few weeks. Tomorrow’s post will begin the series, updating on China’s housing and shadow banking bubble. It hopes readers will find the series helpful.
Its now nearly 2 years since the head of the European Central Bank (ECB) said he “was ready to do whatever it takes” to save the euro, and brought down interest rates in the weakest PIIGS economies (Portugal, Ireland, Italy, Greece, Spain). As the chart shows, this statement had a remarkable effect in financial markets:
- Interest rates today (green column) for the PIIGS are far lower than at their peak in 2012 (blue)
- And rates in 4 of the 5 PIIGS are lower than before the 2008 financial crisis began (red)
The reason for this remarkable turnaround is not hard to find:
- Investors believe that Germany will be happy to pick up the bills for the problems in the PIIGS
- This, of course, is wishful thinking – Germany will not, and cannot, afford the cost involved
- Thus in reality the potential break-up of the Eurozone has only been delayed by the ECB’s bluff, but not avoided
Even more worrying is that the impact of the lower rates is not not even being felt amongst businesses in the PIIGS. As the blog noted last September, lending in the PIIGS has been sharply reduced. And as the New York Times reported last week, the banks in countries such as Portugal simply don’t want to lend. As a result, interest rates for even a small €100k loan ($138k) are now at an unaffordable 10% level.
Thus although the ECB claims its policies have “worked”, they have not solved the two core problems of the European economy:
- Unemployment in the Eurozone remains at 12%, whilst almost 1 in 5 young people under 25 are unemployed
- Pension age is still around 65, even though life expectancy has now reached 80 in most countries
The end result is that economic growth is far below its potential, slipping back in Q1 to just 0.2%.
Equally disturbing is the failure of the major political parties to address these core issues in this week’s EU-wide elections. As a result, voters are disillusioned, and turning to alternative anti-EU parties in record numbers.
Greece, the initial cause of the Eurozone crisis, presents a particularly worrying example. A year ago, the blog worried that the financial crisis had led to 90% cuts in the supply of pharmaceuticals. Now the Financial Times reports that Greece’s neo-Nazi Golden Dawn party is winning votes and credibility by becoming a major provider of medical services, replacing the collapsed state system.
This is just one example of way in which Europe’s social stability is being undermined by the focus on monetary policy. It is wishful thinking to imagine that today’s lower interest rates in the PIIGS are a sign of economic recovery.
But politicians prefer to hide behind the veil of monetary policy. They refuse to show leadership as this would mean addressing the real questions about jobs, pension promises and medial services that matter to ordinary people.
The result is that fringe parties such as UKIP in the UK, the National Front in France, Golden Dawn in Greece and many others are filling the gap.
The result is that this week’s Euro elections will probably show at least 20%-25% support for the anti-EU parties. It could well be higher. And contrary to consensus opinion, these parties will not then allow ‘business as usual’ to continue in the European Parliament. Why should they, when their purpose is to destroy the EU?
It is not yet too late to change the direction of travel. Europeans are desperate for real political leadership, and for leaders who are prepared to have an honest dialogue about the hard choices that now have to be made.
Hopefully Sunday’s election results will act as a wake-up call to centre politicians. The majority of Europeans do not want to see parties such as Golden Dawn in power.
But desperate times can create desperate outcomes, as we saw in the 1930′s.
Sentiment, as measured by the IeC Boom/Gloom Index has weakened considerably over the past 3 months as the chart shows:
- It peaked at 12 in November, hitting its highest level since before the 2008 Crisis began (blue column)
- It then drifted lower in December, before rallying back to 9 in the New Year
- But now it has slipped back to 7, whilst the Boom component has dropped from 241 in June to 176 today
- Yet the S&P 500 Index of the major US shares has just made a new all-time high at 1859 (red line)
This type of divergence is often an indicator that a long-sustained market move is coming to an end. And certainly this move has been underway since 6 March 2009, so it might be considered overdue for ending.
Plus there are other signs that the great stimulus-inspired market boom is losing strength:
- The Chinese currency suddenly dropped 1.4% versus the US $ over the past 9 days
- This was its largest move since 2005, when it was unhooked from the US $
- At the same time the Japanese yen rose versus the US $, despite the government’s attempts to weaken it
- Presumably some speculators were taking profits and looking for an Asian ‘safe haven’
Nobody quite knows why this happened, but sudden moves like this are usually signs of bigger shifts underway in the tectonic plates of the global economy:
- The Wall Street Journal reports, for example, that China’s central bank decided at its February 18 meeting to curb the flows of ‘hot money’, driven by speculators who have seen riding the currency higher since 2005
- This will also help to make China’s exports more competitive, whilst leading to further economic and currency market pressure on countries who rely on exports to China
- In a sign of China’s need to boost exports, the two major monthly surveys of China’s vast manufacturing sector both reported a further slowdown
- Another factor is the US Federal Reserve’s decision to taper its stimulus programme. This is reducing the total amount of dollars available to fund global trade and market speculation
Against this background, Wall Street has begun to assume that new Fed chairman, Janet Yellen, will soon realise the economy is not as robust as had been assumed, and will quickly resume the QE stimulus programme. And they may well be right about this.
But the scale of the stimulus in China has been more than twice as large as that in the US, as discussed in the blog’s new Research Note. So changes in China’s policy will likely have a much grater impact than anything that Yellen does in the near-term.
This may be what the divergence between the Boom/Gloom sentiment index and the S&P 500 is trying to signal. As the New York Times warns: “No doubt, the International Monetary Fund would get involved, but addressing a market panic reaching from Rio de Janeiro to Beijing would be the most complex of tasks.”
Benchmark product price movements since January 2013 are below, with ICIS pricing comments:
PTA China, down 25%. “Both PTA and downstream polyester producers in China are sitting on high inventories because of slow demand”
Benzene, Europe, down 6%. “The market remains fundamentally sluggish due to limited downstream demand”
Brent crude oil, down 2%
Naphtha Europe, down 1%. “Surplus cargoes are being absorbed by the US gasoline sector”
US$: yen, up 16%
HDPE US export, up 18%. “Prices moved up slightly, based on limited availability and feedback from traders about targeted prices from producers”
S&P 500 stock market index, up 27%