May 14, 2016

A Normal Ending After Decades Of Extending Booms

A weekend topic on the global manias, starting with this report by James J. Green. “‘The only thing that really matters in asset allocation is sidestepping some of the pain when the rare, great bubbles break,’ writes Jeremy Grantham in GMO’s latest quarterly letter to investors, recounting his investment firm’s ability to tapdance around what he calls the three greatest bubbles of the past 100 years: the Japanese equity bubble of 1989; the 2000 tech bubble, and the financial crisis of 2008-2009.”

“So where are we now? Speaking of bubbles, Grantham concludes that ‘unlikely as it may sound, in 12 to 24 months U.S. house prices – much more dangerous than inflated stock prices in my opinion – might beat the U.S. equity market in the race to cause the next financial crisis.’”

“He argues that we may have thought that the notion of another real estate bubble occurring so soon after 2008-’09 would be ‘psychologically impossible’ due to the ‘intensity of the pain we felt so recently,’ but cites the rapidly rising home prices which ‘at this rate will reach one and three-quarters-sigma this summer’ — sigma referring to the number of standard deviations from historical averages.”

“And the psychology argument? Many observers are missing the housing bubble, he says, ‘driven partly by the feeling that the substantially higher prices in 2006 (with its three-sigma bubble) somehow justify today’s merely one and one-half-sigma prices.’”

From Bloomberg. “John Burbank, the hedge fund manager who in 2015 warned of a China-led global economic slowdown, said he expects a ‘major’ Chinese currency devaluation and a U.S. recession within the next year as debt levels rise and central banks are stymied on monetary policy. ‘For both it will be a normal ending after decades of extending their booms,’ Burbank said in the letter obtained by Bloomberg. ‘We think this is a time full of peril and repositioning that heralds either the start of a new market reality, i.e. inflation and too much liquidity, or the beginning of the liquidation.’”

“‘The Fed policy response now seems to be a function of global growth concerns rather than domestic considerations,’ Burbank said. ‘This essentially brings forth a period of global monetary policy convergence rather than the anticipated divergence.’ There will be ’substantial’ opportunities to make money once the ‘massive dose of central bank anesthesia wears off financial markets,’ Burbank said, adding that the dollar will resume rising ‘once markets embrace the fundamental truth of the consequences of divergent monetary policies.’”

From CNBC. “Rampant speculation in China’s commodities markets could very well be the next ‘black swan’ event that rocks global markets and possibly the global economy. Though very little attention has been paid to this recent action, speculative excesses in China’s commodity markets have taken traders and investors on a wild ride, which may likely soon spill over to the rest of the world.”

“Trading volumes and volatility have been so extreme they make the recent swings in Shanghai and Shenzhen’s stock markets look mild by comparison. Chinese speculators have driven up, and then down, the prices of everything from iron ore to steel, and from soybeans to egg futures.”

“Prices in most of these commodities have fallen back to earth after massive, but relatively brief, spikes in prices. But, that’s not to say more damage hasn’t been done to China’s already fragile market system and economy. The recent rebound in commodity prices, here at home, and the affiliated rebound in raw materials stocks, could have been driven, at least in part, by those very speculative excesses in China.”

“The ‘fake-out breakout’ also could have suggested that supply of, and demand for, raw materials is coming back into balance in a world burdened by a commodity glut. That, too, appears to be have been a diversion. These rolling bubbles are making the Chinese economy more and more unstable and more susceptible to a much-feared ‘hard landing’ in the economy. That has implications for the Mild Mild West, where growth has been hard to come by and could be upended by another deceleration in Chinese economic activity.”

The Epoch Times. “International financial and investment analysts have been keeping a close watch on China’s debt crisis. The majority of analysts predict that, once the bubble bursts, China’s economy will sink into a decline similar to Japan’s situation in the 1990s. Actually, from a technical perspective, China should have already experienced several rounds of financial debacles. However, due to fundamental differences between China and Japan, the playing out of China’s anticipated financial crisis will look quite different.”

“The Chinese economy is also driven by real estate. But asset allocation is impacted by China’s unique economic system and government intervention. Bad debt comes from several main sources: real estate, large state-owned enterprises, and local governments. China’s banking sector is owned by the government, and state-owned enterprises are known as ‘the eldest son of the Republic’—they will naturally be bailed out. With these inseparable ties of interests, the fate of China’s banking industry is destined to be different from that of Japanese banks.”

“We could say that China’s banking sector is in worse shape than Japan’s banking industry before its economic bubble burst. However, before jumping to the conclusion that China will have a financial crisis similar to Japan’s, we need to remember that there is a fundamental difference between China and Japan: in China, financial stability is tied to the stability of the Chinese Communist Party.”

“In other words, China’s state-owned financial system ‘lives and dies’ with the regime. In Japan, even if the Japanese Cabinet were to collapse, it would have no direct impact on banks. China’s financials crisis is the result of the government meddling in the economy and the regime tying its own stability to the county’s financial stability. Accordingly, the last protective measure for China’s financial sector will be the gun. Authoritarian and totalitarian regimes will use any violence necessary to maintain their power.”

“But abuse of power not only distorts the market, it also destroys it. China’s 2015 stock market crash serves as an example. Chinese people are the victims of the debt crisis, paying for it through rampant inflation.”