China PVC Nov14Believing conventional wisdom can destroy your profits.  One example is playing out in the oil market before our eyes.

Another example is the myth that China was about to become middle class.  Yet income levels always made this impossible:

  • More than 9 out of 10 Chinese earn less than $20/day
  • By comparison, the basic state pension in the UK is 25% higher, at over $9k
  • But unfortunately, companies were fooled by the property bubble into believing this would suddenly all change
  • And many are still planning expansions in the hope the myth might become reality

But now China’s lending is slowing and so property prices are falling.  Thus as the chart above shows (based on Global Trade Information Services data), China has instead become a net exporter of products such as PVC that are used in the construction industry:

  • 2 years ago, China had net imports of nearly 600kt between January – October (blue column)
  • But imports fell last year to less than 200kt, as the property bubble began to burst (green)
  • This year, China has become a major exporter, with net exports of nearly 400kt (red)
  • As a result, imports from NE Asia have fallen 25% since 2012, and by 34% from NAFTA

The issue is simple.  Just as quantitative easing destroyed price discovery in oil markets, so China’s lending bubble destroyed our ability to distinguish between income and wealth effects.  As a good friend of mine in the investment community described it this week:

The problem is that we’ve been beyond the looking glass for so long now that many participants see it as normal/sensible”

Now, of course, reality is catching up with conventional wisdom, in China as in oil markets.  PVC is just one area where China is now becoming an exporter instead of importer.  Smartphones are another, as former industry leaders such as Samsung are discovering to their cost.  As China’s main economic policy conference concluded yesterday:

“The country must understand the New Normal, adjust to the New Normal, and develop under the New Normal”.

THE CYCLE OF DEFLATION IS WELL UNDERWAY
The myth of China’s middle class potential means the world is now awash with surplus capacity in a wide variety of industries.  And the position is set to get worse, as new projects come online.

In a perfect world, companies would now adapt to reality and quickly cancel all their plans to expand production.  They would also close much of the new capacity they have just opened.  But realistically, I doubt they will.  Instead, they will ask their government to impose quotas and import tariffs, to protect their own domestic market.

I therefore fear that the currency wars now underway are just the first sign of this development.  This is why I suggested last month that prudent companies would be Budgeting for the Cycle of Deflation in 2015-17, not expansion.