Investors and strategists will tend to argue that the recent weakness in theU.S. economy represents a typical mid-cycle slowdown and that a pickup in economic activity is just around the corner. The consensus also holds that stocks will be higher in a year’s time and that the market is reasonably priced. Concerning the Chinese economy, the consensus believes that a moderation in China’s growth rate has taken place. Restrictive credit policies are expected to be relaxed shortly. Therefore, by early next year, growth will once again surprise on the upside. Based on these assumptions, the popular view is that commodity prices will – following their recent sharp break-continue their bull market. However, I see a scenario that could upset this optimistic view of the global economy and asset markets.
Turning first to the U.S. economy, several recent developments raise the possibility of a more pronounced slowdown in economic activity. As indicated in last month’s GBD report, lumber prices have collapsed by more than 30%. By itself, this should be enough to signal a considerable slowdown in homebuilding activity. But when combined with recent news from several homebuilders that demand has leveled off and some price weakness has been seen in one or another market (Las Vegas), along with the recent announcements of Washington Mutual (WM) of a year on-year 35% decline in quarterly earnings and of Countrywide Financial Corp. of a 47% decline, it certainly suggests that an abrupt reversal in fortunes has begun to unfold in the housing industry.
US Housing Sector Weakness: The End of the Refinancing Boom
Now, since U.S. housing price inflation was not driven by income gains but by a housing-related credit bubble, something more serious than just a temporary lull in the housing market should be expected if credit flows come off, as is now the case. I think it is fair to say that for the typical U.S. household, real incomes have been declining over the last few years principally due to significant healthcare, transport, and education cost increases. Therefore, if total mortgage credit growth – which was up by US$1.03 trillion (or 12.0%) over the 12 months to June 30, 2004, by US$1.92 trillion over two years, and by US$4.82 trillion (or 97%) over seven years – does slow down, it could have an immediate impact on real estate asset values. The end of the housing refinancing boom, combined with the fact that home prices are at a record high compared to household incomes, should then slow down further home price increases. In fact, I would expect slower credit growth to lead to a decline in the housing market. In turn, a decline in home prices will negatively affect consumption, since it is asset inflation that has driven consumer spending since 2000 (and, to some extent, the tax cuts) and not rising personal pretax incomes.
The ever-optimistic homebuilders – a trait they share with miners and high-tech executives – will, of course, tell you that the housing market is fundamentally healthy. But investors won’t have to wait long to find out about the true condition of the housing industry. Recently, I wrote that a breakdown of financial stocks would be a warning for the credit-driven economy and the stock market, which would have to be taken seriously. A few days later, American International Group (AIG), Marsh McLennan (MMC), and other insurance stocks broke down. Shortly thereafter, Investors Financial Services (IFIN), which provides financial administration services to asset managers, collapsed. And whenI mentioned to a hedge fund manager that he should short CountrywideFinancial, his response was that he had done so on various occasions in the past but that he had always been stopped out. Countrywide collapsed the very next day. But now, with the trend likely to have reversed, short sellers may once more become active on any rebound. In fact, investors should pay close attention to the rebound in financial stocks. A failure of the group to make new highs in the near future, at a time when the bond market has been rallying strongly, would have negative implications for the entire market as well as the housing sector.
On its own, weakness in the U.S. housing sector wouldn’t overly concern me. However, if it were simultaneously accompanied by weakness in the Chinese economy, which, aside from the United States, is an important driver of global growth, then I would take a dimmer view of the world. We have seen that in the U.S., the latest credit bubble fuelled asset inflation in the housing market and, therefore, boosted consumption.
However, strong credit growth did not lead to rising net capital formation and industrial production (excluding industrial production purely related to consumption, such as oil refinery production and movements of railroad cars full of imported goods). But in China the credit bubble (inherited from the expansive U.S. monetary policies through the fixed exchange rate) led to an unprecedented capital spending boom designed to boost manufacturing capacity in order to satisfy domestic and overseas consumer demand growth, which was expected to never end. In addition, rising commodity prices led to significant inventory accumulation.
US Housing Sector Weakness: All Not Well in the Middle Kingdom
However, there are suddenly signs that not all is well in the Middle Kingdom and that the likelihood of a very hard landing has increased meaningfully. To start with, car sales, which were growing at 100% year-on-year in some months of 2003, have slowed down considerably. But whereas passenger car sales still rose by 50% in the first three months of 2004, in the first nine months of this year they rose by just 17.77% and declined by 3.64% year-on-year in September 2004. In the meantime, profits of some automakers have declined by more than 30%, as automakers were forced to cut prices in order to maintain market share amidst disappointing sales. For the indefatigable China optimists, a decline of less than 4% in passenger car sales in September 2004 may not sound like much, but, given the market share driven mentality of executives, production is unlikely to have been cut back much, which means that inventories have risen sharply in recent months.
Moreover, the car manufacturers, having planned their production capacity expansions based on car sales increases of more than 80% in 2003, will likely curtail capital spending once they realize that the market isn’t expanding at nearly the rate they had expected. The poor state of the Chinese car market is also reflected by the poor stock market performance of Chinese car companies.
Then, there is the Chinese housing market, which has slowed down considerably. Last year’s property investments as a share of GDP were 50% higher than the previous peak in 1993, a cyclical high for the housing industry, which was subsequently followed by several years of far more moderate growth. Commercial space under construction has also begun to contract significantly (down by more than 50% since the beginning of the year). It is unlikely to pick up much in the near future in view of the rise in vacancies.
Here, I have to explain another misconception among foreign investors. The consensus holds that the slowdown in economic activity in China is solely caused by the government’s administrative measures implemented at the end of last year in order to cool down the “overheated” economy. Hence, it is assumed that once the economy has cooled off, the restrictive economic measures of the government will be lifted and growth will automatically rebound again. But this is not my take of China’s recent economic slowdown. I believe that, in the same way that all interventions by governments and central banks are implemented, they came at the wrong time. In the case of China, the restrictive economic policies came at precisely the time the economy was about to cool down for cyclical reasons anyway. Capital investments, which in recent years rose much faster than GDP, reached probably close to 45% of GDP in early 2004, which would have exceeded the last cyclical peak in 1993. Moreover, foreign direct investments rose by almost 50% in the first few months of 2004.
US Housing Sector Weakness: The Latest Eldorado
In my opinion, these kinds of growth rates of capital formation and foreign direct investment are indicative of major over-investments by local entrepreneurs who have little or no experience of a market economy’s cyclical forces, and of foreign companies’ insatiable appetite to participate in the latest Eldorado (after having been badly hurt by the Asian crisis in 1997 in their other emerging market investments). Therefore, with or without the Chinese government’s measures to cool the economy, I would have expected capital spending to slow down, because of the over capacities and bloated inventories!
Moreover, it is far from certain that an economic rebound will take place at all once the government’s credit controls are lifted In fact, my view is that capital formation will decline significantly in 2005 and that foreign direct investments will decline far more than is expected, as vast production over-capacities will result in widespread losses on foreign companies’ investments. In my experience as an emerging market investor, and also from what I have read about previous capital investment rushes over the last 200 years, it would be most unusual if the recent great China investment boom ended any differently than the various canal or railroad booms of the 19th century, or the great European investment rush into Russia at the beginning of the 20th century!
This is not to say that China won’t become an even more important economic and political force in future; however, in the context of the present investment markets it is a warning that a Chinese economic slowdown – or, as I would expect, some form of a cyclical hard landing – could badly backfire on investors who simply base their investment strategies on a continuous economic boom in China.
Dr. Marc Faber
December 30, 2004
P.S. Chinese demand for natural resources is driving the commodities markets wild…and there is no end in sight. Over the past two years, commodities have done more than eight times better than traditional stocks. Just be sure you proceed with caution…
The main story in the financial world continues to be the dollar. People are thinking about it…wondering what will become of it.
James Grant writes that even drug dealers are now turning to euros. In October, a drug “mule,” making the run from Spain to Colombia, was found to have $197,000 worth of euros in his stomach. We see immediately another advantage to the euro – it is easier to swallow. The largest denomination bill for dollars is the $100 note. The European Central Bank, by contrast, puts out notes worth 500 euros. Now, you can swallow just one euro note rather than five American ones – and it will grow in value while in your stomach.
The last time the dollar fell so much for so long, the planet’s central bankers became alarmed and decided to do something about it. They gathered at the Lourve in 1987…and produced the Louvre Accords to help stabilize the buck on currency markets.
But it was a different world back in 1987. Then, U.S. debtors owed no more to the rest of the world than foreign debtors owned to its creditors. Financially at least, the ledgers balanced.
Nor did the dollar have much competition back then. Communist China was still Communist China. The word “former” had not yet appeared as a modifier for the “Soviet Union.” India was a mess. And the euro did not yet exist.
But now, the Chinese economy is growing three times as fast as the U.S. – and infinitely better. Chinese growth comes from making things, not buying them. And while Americans save nothing, the Chinese are reported to save 40% of what they earn.
Indians, too, are bustling more than ever – with a growth rate over 8%. Over most of Asia, in fact, the story is little different – people are working and saving as if they meant to get rich.
In Europe, the new currency has become a smash hit. It is estimated that between half and 75% of all American dollars are held outside the United States. Dollars were a good way to hold wealth when you couldn’t trust roubles and cruzados. Not only drug dealers, but average bakers and candlestick makers found it convenient to stuff dollars into their mattresses – just in case.
But now the euro offers an alternative. Not only can you get more purchasing power out of fewer pieces of paper … the paper also holds its value better.
Yesterday, the dollar held. Bonds held. Stocks held. The door to Hell held.
How long will they hold? We don’t know. For now. But probably not forever.
More news, from our team at The Rude Awakening:
Eric Fry, reporting from Wall Street…
“Alas, we concluded, despite a few pockets of apparent excess, no national bubble exists. But then, suddenly and serendipitously, we discovered a phenomenon we had not been seeking…a phenomenon that yielded a three-part insight…”
Bill Bonner, back in Poitou…
*** According to The Financial Times, Chinese economy’s ever-growing demand for raw materials has, of course, helped push commodity prices higher…and as a result there has been an incredible increase of pension and mutual funds flowing into commodity indices.
Our own Kevin Kerr comments on the phenomenon…
“In addition to having too many dollars in circulation, inflation can also be increased by a drop in the value of the dollar in foreign exchange markets as we have seen by the ongoing debacle in the dollar. The cause of the dollar’s recent drop is perceptions of its decreased value due to continuing national deficits and trade imbalances to say the least.
“Foreign goods, as a result, become more expensive. This makes U.S. products more attractive abroad and improves the U.S. trade balance. However, if before that happens, foreign investors are perceived as finding U.S. dollar investments less attractive, putting less money into the U.S. stock market, a liquidity problem can result in falling stock prices.
“Political turmoil and uncertainty can also cause the value of currencies to decrease and the value of hard commodities to increase. Commodity stocks do quite well in this environment, and that’s just one of the reasons why we see so much money shifting from bond funds and equities, into the resource and commodity sector shares and futures.”
[Editor’s Note: A new boom is most certainly underway in commodities and natural resources…and you can profit from it!
*** Nothing much is happening in the financial world. Without the interfering noise, we have time to think. And so much to think about. All the experts say the dollar must fall further. Alan Greenspan almost said so himself – just last month. Why then, do foreigners continue holding so many of them? On the evidence, individuals have given up on the dollar. It is only the central bankers that keep it from collapsing. As the dollar drifts lower, they lose billions. “It’s not their money,” you might say. Even so, they have reputations and jobs to worry about.
Over the last three years, the dollar has lost 30% of its value against the euro. It could easily lose another 10% or 20%. And yet, no one seems especially concerned. There must be $100 trillion worth of dollar-denominated “wealth” in the world. Even a 10% markdown would be the biggest financial shock the world has ever suffered. No one seems to care. The kind strangers overseas were nice enough to finance Americans’ overspending. Now, Americans believe they can stiff their creditors – effectively “writing off” $3 trillion worth of foreign debt – simply by letting the dollar sink. They think a lower dollar will correct the trade deficit…and make U.S. industries more profitable. From one situation that was too good to be true…they expect to go to another, also too good to be true.
There has to be a surprise here somewhere. No action of this magnitude could possibly take place without an equal and opposite reaction.
What will it be? All we can do is wait. Watch. And wonder.
*** “It was such a beautiful story…”
Our guest last evening told the story of a wild boar that had broken into her pig farm and mated with one of the sows.
“It was touching…the sow produced a big litter of piglets. They were not commercially successful, since they were thin and took a long time to grow. We gave them away to another farm…I don’t know what happened to them.
” But about a year later, the boar broke in again. There are dozens of sows in the barn…but he was such a faithful animal…that is what is so beautiful about this story…he headed for the same one.
“Alas, this time we were not far away. My husband shot him. The poor creature was a victim of his own passion. He died for love, you might say…”