Large economies are like supertankers. There are no brakes to use if you want to change direction in a hurry. Instead, you have to put the engine into reverse, and hope you can slow down fast enough to avoid the rocks.
That is what happened in China last month, as the new leadership began to unwind the largest lending bubble ever seen. Short-term corporate loans, the lifeblood of small companies, fell by Rmb 236bn ($38bn).
In pre-Supercycle days this would have been called a “credit squeeze”. Suddenly, credit tightens and investors worry about ‘return of capital’ instead of ‘return on capital’. Or as the blog’s major Research Note on China in February was titled:
“China Bank Lending: from $1tn to $10tn and Back Again?”
At the same time, gold sales are tumbling, with jewelry sales collapsing 45% in Q2. Clearly China’s anti-graft campaign is hitting its targets – no official would now dare to wear a new gold watch.
Elsewhere in NEA, GDP fell 6.8% in Japan. Abenomics, as expected, is coming to an end of its life as a supposed ‘miracle cure’ for the world’s third largest economy. As former Bank of Japan Governor Shirikawa keeps reminding us:
“The main problem in the Japanese economy is not deflation, its demographics. The issue is whether monetary policy is effective in restoring economic recovery. My observation is, it is quite limited.”
Thus the Great Unwinding of the failed stimulus policies since 2008 has now begun.
Over on the other side of the world, financial markets are slowly beginning to rediscover their role of price discovery. For 6 years, central banks have supplied them with endless amounts of free money. This has forced prices upwards in what became known as the ‘correlation trade’.
But now, oil markets are starting to follow cotton and other commodities in refocusing on the fundamentals of supply and demand. And as the International Energy Agency noted in its latest monthly report:
“Oil supplies were ample, and the Atlantic market was even reported to be facing a glut”, whilst Reuters reported that ”implied oil demand in China fell 6% last month“.
In Europe, hopes that stimulus policies will finally lead to a sustained recovery are also unwinding. The Eurozone economy failed to grow in Q2: Germany’s economy declined; France showed no growth; Italy fell back into recession.
Meanwhile in the USA, retail sales were flat in July, whilst housing remains weak due to demographic factors. This is a bad omen for GDP, as consumer spending is more than two-thirds of the economy. Thus we are likely to see a repeat of the pattern described last week by the new deputy chairman of the US Federal Reserve, Stanley Fischer:
“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”
Even more alarming, as Nobel-prize winner Prof Robert Shiller warned yesterday, is that the Cyclically Adjusted Price/Earnings (CAPE) ratio for the S&P 500 – the best predictor of long-term stock market returns – is now:
“Above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.”
Of course, nothing is certain in this world apart from death and taxes. But there are clearly signs that the long-awaited Great Unwinding is now underway. The blog will look at the potential impact of this in 4 key areas next week – oil prices, exchange rates, interest rates and equity markets.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
Naphtha Europe, down 6%. “Softening upstream ICE Brent crude oil prices and slow downstream demand continue to impact, leading to lower prices again.”
Brent crude oil, down 4%
US$: yen, down 2%
PTA China, up 2%. ”Producers continue to have to sell below cost. As a result, lower plant operating rates have halted a drastic price decline in the spot markets despite stable-to-soft conditions in the downstream polyester sectors.”
Benzene Europe, up 5%. “Unclear how September will shape up in terms of pricing and demand in Europe”
S&P 500 stock market index, up 7%
HDPE US export, up 9%. “Prices were mostly steady, with material remaining in tight supply”
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.
China’s property market is the epicentre of the global debt bubble discussed yesterday. It has been red-hot since urban residents became free to buy their own home in 1998. Before then, they lived where the state told them. With interest rates held low to boost state-funded infrastructure spending, people had few options for investing their money.
The result is that prices have become totally unaffordable for new buyers. Beijing house prices average 34 times average earnings, and Shanghai sells at 29 times average earnings. Even worse is that property has provided massive opportunity for corrupt officials to feather their nest. 30% of all property is owned by just 1% of the population, and around 2.1 million households own between 40% – 50% of China’s $10.5tn real estate and financial assets.
Now these same officials are selling in a frenzy, panicked by the thought that their property holdings will soon have to be published on the internet, for anyone to see. As China Daily reports:
“Once sky-high priced houses in Hua Qing Jia Yuan, a famous residential district near a key primary school, are witnessing a decline in prices to less than 60,000 yuan per square meter. A homebuyer said properties in that district were being sold at 100,000 yuan per square meter just six months ago, but recently she was shown a 106–square-meter house priced at 6.2 million yuan.”
The downturn is also now beginning to widen, as the government’s efforts to control shadow bank lending have led house prices across China to start falling. Thus the research unit of real estate developer Soufun reported:
“Rising market supply and sharp falls in transactions have put relatively heavy pressure on property developers’ sales, leading some to beef up promotions and adjust their pricing strategy.”
And there will likely be more falls to come, as the government wins its battles with local authorities who have been keen to support prices in order to boost their income from land sales – often their major revenue source.
The size of the earthquake now underway is highlighted in private remarks by Mao Daqing, vice chairman of China’s largest developer, China Vanke. Leaked online, they apparently suggested that China’s land bubble now parallels that of Japan before its crash in 1990:
“Tokyo’s total land value in 1990, prior to the property bust there, was equal to 63% of U.S. GDP in 1990, he said. During the Hong Kong bubble in 1997, land values there reached 66% of U.S. GDP. In 2012, the total land value in Beijing was 62% of U.S. GDP, “which is a scary number”, Mr Mao said”.
An unofficial report of the speech by JL Warren Capital highlights the core problems:
“Mao singles out three major trends in the Chinese real estate sector in 2014:
- Tier 2 and Tier 3 cities: Supply exceeds demand, by a lot
- Tier 1 cities: Continue to see robust demand; however, land prices have gone up more than Actual Selling Price for projects
- Credit has tightened.
“China’s anti-corruption campaign has had a greater impact on high-end property projects than most have realized. Investigations are ongoing into owners of property priced around 40K-50K RMB/sqm, ($6.5 – $8k/sq metre) not to mention more expensive properties. The increased scrutiny surrounding the anti-corruption campaign has caused demand to fall off in the high-end property market.
“The second-hand housing market has been even more impacted by the anti-corruption campaign. New listings for sale surged to 10-12 units per day, twice as many as before.
“Many owners are trying to get rid of high-priced houses as soon as possible, even at the cost of deep discount, because many corrupted officers have illegally accumulated several or more houses through bribery or embezzlement. As a result, ordinary people who want to sell homes in the secondary market must face deep price cuts….
“Most cities have witnessed an increase in inventory-sale ratios for residential buildings. Among the 27 key cities we surveyed, more than 21 cities have Days Sale of Inventory (DSI) exceeding 12 months, among which 9 have DSI greater than 24 months….
“The second critical issue is the demographics in China. Our research shows that by 2033, the total population aged 60 and above will reach 400 million, as well as an additional 270 million people living on social welfare. That is, by the end of 2033, there will be approximately 670 million people, or 50% of the Chinese population, will be living on social welfare”.
The detail behind the remarks makes it clear this was not a ‘top of the head’ speech, but carefully considered. Mao, along with China’s leadership, seems to recognise that there comes a point where the can cannot be kicked down the road any more, as it is likely instead to end up over a cliff.
Total housing activity totalled nearly a quarter of China’s GDP last year, according to Moody’s. So as China’s Academy of Social Sciences has warned, “we’ve got to let the growth rate go down”.
The fault lines from this earthquake thus run very deep indeed.