Bill Bonner looking ahead to the next great investment mania…
"An appreciation of the Chinese currency is only a matter of time."
– Marc Faber
How do you say ‘bubble’ in Chinese?
We ask because, looking ahead, it may be a good word to know. For there is the latest…and perhaps the last…of the Dollar Standard blow-ups.
China was in the news yesterday…and again today. Hardly a day goes by without a mention of what has become one of the largest economies in the world…and one of the most interesting.
While the developed world grows at barely 1% or 2% per year, China’s economy races ahead 4 times as fast. Imports to the U.S. alone are said to be up nearly 40% this year, filling China’s pearly chests with dollars, and U.S. treasury bonds.
In 1985, only $2 billion went into China as foreign direct investment. By 2001, the figure had risen to nearly $50 billion. In 1985, total foreign trade with China was just $69 billion; in 2001 it was over $500 billion.
The U.S. has a GDP of about $11 trillion. China’s GDP is thought to be only about 1/10th as big. But in rural societies, many transactions are not measured in currency. And local prices are much lower, so that a Chinese meal consumed in Shanghai might be recorded as worth $1…while the equivalent in Manhattan would go for $20. Some economists try to resolve these problems by measuring economies on the basis of purchasing power. In these terms, the U.S. has an annual production of $9.6 trillion, but China’s economy is much larger than otherwise thought, at $4.9 trillion.
"You are so skeptical of everything else," began our friend Michel at lunch on Wednesday, "but you seem to believe every word about China. You seem to forget that the country is run by communists who lie about everything. In particular, they lie about economic statistics in order to make themselves look good. That’s what the Soviets did right up until the whole system fell apart. And Western economists believed them! And now they believe the Chinese. Even you believe them!"
We do not really believe the Chinese numbers, dear reader. Then again, we don’t believe the American numbers either. Instead, we take them all like dabs of paint on a Seurat or Pissarro painting. No number is reliable in itself, but stepping back, we’re able to get an impression of something we recognize.
And what we see developing in China is the familiar face of Richard Nixon’s Dollar Standard system: money floods into a country; a boom results…asset prices get marked up to absurd levels…factories and office buildings go up everywhere…finally, overcapacity and overpricing creates a bubble…that inevitably blows up.
But wait…we see something more: we also see – in broad strokes – the end of the whole system.
As the U.S. consumes more and more products from China, the Chinese accumulate more and more dollars. The average Chinese saves 25% of his income, so savings in local currency are building up, too – as much as 1 trillion dollars’ worth is in interest-bearing accounts already. The money is lent out by commercial banks, and has triggered a typical boom…followed by a typical, Dollar Standard era bubble.
"Bad loans looming as a big cloud over China," warns today’s International Herald Tribune. Visitors to China report that there are skyscrapers going up everywhere. Yet, 17% of the new buildings are already empty…and rents are slipping.
While the offices are empty, the factories hum with activity, day and night. The more Americans buy from the Chinese, the more the Chinese are encouraged to produce. As time goes by, more and more goods reach the U.S. at lower and lower prices. And so does the correction come into view. For as prices fall, profit margins fall, too. Soon, businesses – in the U.S. and in China – are no longer worth the money invested in them. Then, capital values drop, too.
At the same time, on the other end of the exchange, consumers cannot buy an infinite quantity of TV sets and automobiles. In America, the income of the average person rose only modestly in the last 30 years…and is presently dropping in real terms. How can these people be expected to buy more products? They have no more income; they have less.
And thus does the whole abstraction of credit, reserve currencies, debts, profits, and trade imbalances suddenly come clear. Stepping back, we see a ghastly picture.
But stepping back from the rush of everyday life, we get the impression that everything corrects sooner or later: financial trends, reputations, the wealth and power of nations. On this day in 1939, the Germans had already advanced deep into Poland (they crossed the border on September 1st, beginning WWII). Hitler must have thought that nothing could stop him…because, for a long time, nothing did. As he and Stalin subdued the Poles, the ‘phony war’ with France and Britain began. It was no war at all, because neither side wanted a fight. Later, he moved against the French and drove the English into the sea at Dunkirk. By 1942, Hitler controlled Europe. Had he stopped there, things might have gone better for him. But everything that swells up later shrinks down to about where it began. The Reich that was meant to last 1,000 years peaked out in early 1942.
It was almost as if the Fuhrer called together his generals and asked them: "How can we make a mess of this?" They soon had their answer; they found a way to do the almost- impossible…turn a nearly impregnable position in Europe into a losing situation…by sending troops to North Africa where they could be cut off by the British Navy…by picking a fight with his ally, Stalin…and by declaring war on the U.S.!
Three years later, Hitler’s reputation, his army, his country, his finances…even his life itself…were fully corrected.
And now we see the Dollar Standard correcting, too. Bill Gross describes the scene:
"Since its monthly trade surplus of $10 billion+ with the United States implies a $120 billion annual addition to its dollar reserves, there will come a time when [China’s] hundreds of billions if not a half trillion or so in holdings of U.S. notes and bonds look a tad too risky. In turn, the hundreds of billions that the Japanese and other Asian countries have been buying in order to keep their currencies competitive with the Chinese Yuan (Renminbi) and the U.S. dollar will be subject to a sanity check as well.
"The currency/bonds/stocks of a reflating economy engaged in guns and butter, Hummer and Hummvee spending of near- historical proportions are bad investments. Sooner, or perhaps later, our Asian creditors will wake up and smell the coffee. Perhaps their java will take the form of dollar or Treasury Note sales. Perhaps the aroma will resemble a revaluation of the Yuan and then the Yen. Either way we pay the price: higher import costs, a cutback in spending on cheap foreign goods, rising inflation, perhaps chaotic financial markets, a lower standard of living.
"Mark these words well for what they’re worth (not much, some will say): China holds the keys to our kingdom, and our Hummers. Their willingness to buy our bonds, their philosophy of fixing their currency to the U.S. dollar will one day be tested. And should their patience be found wanting, all of their neighboring Asian China wannabes will move in near unison. Reflation’s second round will have begun, U.S. interest rates will rise, our goods in the malls and the showrooms will be less affordable, and the process of national belt tightening and increased savings will have begun."
As we write, of course, belts are not being tightened; they’re being loosened. Investors at the Krispy Kreme franchise are still feeling fat and sassy. Exactly when their attitudes will change, we cannot say. Nor can we say when the Chinese bubble will blow up.
But while it is too late to safely profit from the U.S. bubble (prices are too high), Marc Faber believes there are still excellent opportunities in Chinese stocks. Some sell for low P/Es – as low as 2 – with high dividend yields. Even China Telecom still sells for only about 8.5 times earnings. Beijing Datang – a large power company – has a dividend yield over 4%. Shenzhen Expressway sells for less than 10 times earnings. Tiny Wing Shing Chemical, by contrast, sells for less than 2 times earnings. You could buy the whole company for only about $15 million, says Andy Mantel, writing in Faber’s newsletter.
The simplest China play, according to Mantel, may be the China Mantou Fund, with its offices in Hong Kong.
September 05, 2003 — Paris, France
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of "Financial Reckoning Day: Surviving The Soft Depression of The 21st Century" (John Wiley & Sons) due out in September
No, dear reader, we’re not changing our position. If the rest of the world doesn’t seem to be headed in the direction we forecast…it will just have to change course!
Not that we know where stocks are going this week or the next…not at all! That is asking too much from a free email service. We will give you our guess: the current rally will fizzle out sometime this fall. But what do we know?
What we know is that the Fed, the Bank of Japan, the People’s Bank of China, the European Central Bank, even the Bank of Nepal, for all we know, are desperately trying to keep The System going. You understand the system better than most people: it’s the Dollar Standard system created, by default, by the Nixon Administration.
Here’s how it works: the U.S. spends as much as it wants and settles its debts by issuing bonds or dollar credits. Foreign companies end up with trillions of U.S. dollars…which they use to build more factories; then they recycle the rest back to the U.S., boosting prices of stocks and bonds on Wall Street.
It’s win, win, win for everyone!
U.S. consumers get SUVs and toaster ovens…foreigners are kept busy producing them. And politicians and central bankers get to continue mismanaging their economies.
If The System could go on forever, we would surely want to get in on the fun along with everyone else. We could buy some Krispy Kreme stock…or maybe Cisco…or even our old friend, the great River-of-no-returns stock, Amazon.com. Or we could buy small-cap stocks, because, as James Boric suggested in yesterday’s Daily Reckoning, they always lead the way out of a bear market…or more real estate as Dr. Sjuggerud recommends, because the boom in real estate has yet to begin.
Or, maybe we should lend a little money to the great state of California. At more than 5% yield, who can resist?
But, as we pointed out yesterday…there’s the smart money, the dumb money, and the money so hopeless you feel you would be doing it a favor by smothering it with a pillow. In a better world, we would be able to tell you which was which right now. But the Creator did not set things out to make it easy for us to make money. We will have to wait until after the fact, along with everyone else.
Still, we have a hunch or two…
Our hunch is that people who lend to California will get what they deserve. The state has no way of paying them back. Unlike the Federal government, California has no printing press with which to settle its accounts. It must pony up, or go broke. Most likely, its bondholders will receive only pennies on the dollar – as the bonds collapse in value, or the dollar does.
Stock market buyers, too, will rue the day they heard the expressions – ‘buy the dips,’ or ‘investing for the long term’ – as the whole system becomes a lose, lose, lose affair for almost everyone. More below…
Over to you, Eric:
Eric Fry from lower Manhattan…
– The stock market continued rumbling along yesterday, as the Dow gained 19 points to 9,588 and the Nasdaq advanced 16 points to 1,869. The resurgent Nasdaq Composite is powering ahead like the days of old, as bellwethers of old like Cisco Systems lead the way. The Nasdaq has racked up seven straight winning sessions – a feat it had not accomplished since the glory days of February 2000.
– So it seems that all is well with the stock market…Right? And the economy is improving – more or less – according to most of the recent economic reports. Yesterday, for example, we learned that American workers are increasingly productive. The bad news is that fewer of them are producing.
– Productivity, which measures output per employee, grew at a 6.8% annual rate in the April-June period, or triple the first quarter’s rate. Unfortunately, the glowing ‘productivity’ gains in the second quarter were largely the result of falling employment, rather than rising production. American companies eliminated a net total of 170,000 workers during the second quarter…and the job losses continue. Initial jobless claims rose last week to 413,000, the highest weekly tally in more than a month.
– But Wall Street economists promise that better times are a-comin’ just around the corner. "The economy is improving," heralds the hopeful chorus, as it points to a lengthening strand of positive economic reports. Yesterday, the Institute for Supply Management announced that its services index held steady at the six-year high it reached last month. Meanwhile, factory orders increased for the third straight month, which is the longest winning streak for this manufacturing-sector indicator in nearly a decade.
– Even we must admit, therefore, that some aspects of the U.S. economy are improving in some ways…But please don’t ask us to join the frenzy for richly priced common stocks. Yesterday we observed that bond investors are hesitant to buy the bonds of ‘fiscally challenged’ municipalities like the state of California. They fear that lending money to the Golden State is a risky proposition. Bond investors, apparently, have read about California’s $38 billion budget shortfall and strongly suspect that this fact is not a good thing.
– But stock market investors – if they read anything at all – don’t seem to read the same newspapers that bond investors do. (Then again, most stock market investors don’t seem to read at all. Why should they?…CNBC runs continuously during market hours.) Stock investors do not seem troubled in the least that states and municipalities are struggling to make ends meet.
– If they were troubled about such matters, they would not be scooping up the shares of companies like Maximus Inc. that rely upon contracts with state and municipal governments. Maybe the eager buyers of Maximus shares are looking ahead to the day when municipal coffers will run over once again. Or maybe they are buying the stock, merely because it is going up. We do not know. What we do know, however, is that investors are not buying the stock because business is booming.
– "Hardly a day goes by without headline news detailing the dismal budgetary situation of state and local governments," observes Robert Tracy of Apogee Research. "So why, then, have the shares of Maximus Inc., which derives about 89% of its revenues from contracts with state and local governments more than doubled since April? The answer cannot possibly be that business is improving. It most certainly is not.
– "Maximus’ operating margin has been shrinking steadily since the boom days of the late 1990s," says Tracy. "and conditions for the company are getting worse, not better, as Maximus itself openly admits."
– Tracy is referring to a passage from the company’s first- quarter report that reads: "Financial results for the three months ended March 31, 2003 were impacted by delays in contract signings, work start delays, and some program scope reductions. These factors are primarily reflective of continued state budgetary pressures, which trend is expected to continue in the short term."
– Needless to say, Maximus’ "short term" difficulties may be somewhat longer term than expected if rising tax revenues don’t begin flowing into the nation’s statehouses.
– MBIA shares are another stock market curiosity. The stock of this municipal bond insurer has soared 60% since March. It’s true that business is booming, but that’s a mixed blessing. Business is strong, primarily because the finances of so many municipalities are weak. Many municipalities are in such terrible financial shape that they must insure their bonds against default in order to sell them to the public.
– That’s the good news for MBIA. The credit insurer reported a whopping 53% jump in second-quarter profits, thanks in large part to a 136% surge in new insurance policies written on municipal bonds. The bad news is that the company is on the hook whenever a cash-strapped municipality defaults on one of the billions of dollars worth of bond issues that MBIA has insured.
– "Examining MBIA’s insurance exposure," observes the Prudent Bear’s Doug Noland, "it is worth noting that California General Obligation (at $2.81 billion) ranked number two in its list of Largest Public Finance Units. The top eight exposures also include California Housing Finance Agency at $2.2 billion and Los Angeles Unified School District General Obligation at $1.92 billion. California jumped to 17% of net 2003 added exposure by geographical region."
– Indicative of California’s soaring indebtedness, the state must pay higher interest rates than many comparably rated issuers. Isn’t it curious that bond investors are balking at buying many of the same issues that MBIA is insuring?
– Note to stock market investors: Read the newspaper…or ask a literate friend to read it to you.
William Bonner, back in Paris…
*** Gold fell $1 yesterday. It is still up $29 in the last 4 weeks.
*** ‘Why is gold in a bull market?’ people are beginning to ask. Because the situation in the mid-East is going badly…because China is buying…because investors are losing faith in the dollar…because Indians are buying…because U.S. householders aren’t refinancing their homes they way they used to…because George W. Bush is in the White House…because Hillary Clinton might one day be in the White House…because California is courting bankruptcy…because the world is already saturated with dollars and debt…and because more and more debt is being added every day…because…because…because…because… because…
*** "Chirac and Shroeder say No to U.S.," says the headline in today’s Figaro. "You got yourself into this mess," was the gist of their message, referring to the Iraq situation, "you can get yourself out."
*** A report from the Detroit Free Press tells us that IRS Help Centers give taxpayers the wrong answer almost every second time they pick up the phone. What astonishes us is not that they are so ignorant – we expect that – but that anyone would call them in the first place. We had our last courteous correspondence with the IRS back in 1974, when we sent a note: "Please take me off your mailing list." We got no response.
*** We heard recently of a taxpayer who won a case against the IRS, arguing that no law had ever been passed requiring individuals to pay income taxes. According to the email account, the taxpayer sent a polite letter asking the agency to show her the law. She wasn’t contesting the issue, said she, she just wanted to know. She sent several letters, never got a direct answer, and concluded that she really didn’t have to pay. A jury apparently refused to convict her.
*** Well, it is the end of the week. The children are all back in school. Everyone has returned to work after the summer holidays. The dead, victims of the heat wave, have been collected and interred. The strikes begin next week. It is life as usual under a gray Paris sky.
"Jules needs to do some extra-curricular activities," said his mother yesterday.
"Why?" asked his father.
"Because he’ll need them on his resume in order to get into a good college…besides, he needs to find out what he likes to do and what he’s good at."
"Well, he stays up half the night playing the guitar, isn’t that enough?"
"He can’t put that on his resume…or, I guess he can, but it won’t impress anyone…how come he doesn’t at least do any sports?"
"I don’t like sports…I’m no good at them…" the boy interrupted.
"He’s like his father…" observed the old man.
"But you were on the basketball team," said his wife.
"I was terrible. I was only on the team because it was a small school and I was tall."
"It still must have helped your college application…on the other hand, you went to the University of New Mexico. So there. Jules, don’t pay any attention to your father…"
*** "Oh Daddy," said Jules’ older sister, breathless and practically in tears, "I’ve got to get this figured out. I’m just under so much pressure right now. I don’t have time for anything. I’ve got to get ready for my audition and I don’t know what to do. I couldn’t sleep last night worrying about it. I thought I was going to do Maggie in Tennessee Williams’ Cat on a Hot Tin Roof…but what do you think? Isn’t it a little too old for me? Isn’t it a little too…well…heavy and dramatic? Maybe I should do something much lighter and more in keeping with my own character. How about Liza Doolittle from Pygmalion? Or…Or…Oh I’m so upset about this…I wish I knew what to do."
"Why don’t you do something from Gigi…something typically Audrey Hepburnish…" suggested the père.
"Oh Daddy, that’s exactly what I should do. Oh thank you so much…I’ll do Gigi…yes, Gigi…I’m going to run out right now and get the text…great idea…I’ve got to get right on it…"
"When’s the audition…"