Chinese Deflation Cancer Spreads

OK here I go. This blog has been building in my head for a long while. It will tie in with my record of forecast since I started a few years ago. The economic world is close to a catastrophic collapse. Yes, I know, I have been concerned about the world since I started. I am firmly of the belief that QE has not only just delayed the inevitable collapse of the global economy, it has made the impending scenario much worse. In fact, it has taken it from a situation that was manageable, with old fashioned crash, burn and re-build, to a situation where the fallout will make the 1930`s look like a walk in the park. The central pillar of my argument is the significant positive impact QE has had on asset prices is mirrored by the equally significant negative impact on inequality in the developed world. This is mainly due to the tsunami of cheap finance which has swept the developing world and spawned huge production potential.

Yes, bond and equity prices have risen significantly. And why shouldn’t they. With QE pumping so much money into the hands of the people who created the 2007 crash, what else would they do with it. As I have written before, lower bond yields have helped governments continue priming economies through direct state spending (debt) or policies which have encouraged significant new consumer debt. The problem is, whilst the central banks of the G7 were sleeping, China changed. It is no longer the worlds growth engine due to internal demand. It is a cancer on the supply demand curve.

Let me expand on my theory of why China will be the catalyst that sparks this almighty upheaval. BRICs have been a constant theme in the history of this blog. Iron Ore is the prime reason. They all have it. The growth in China over the last 20 years was centred around Housing, Railways and Heavy Industry. The problem is, as I explained in China and its Export Claim, the supply curve within all these aspects of growth had become overstretched. In normal developed economies, this would have sparked a flight to quality as earnings concerns came to the fore. Of course, as I have pointed out many times, return on capital is not a primary concern of state industry dominated China. Employment of the masses is the ONLY concern. I have a back of the fag packet calculation. For every 20 million Chinese workers employed, 5 million employed people in the developed world become superfluous in the current demand cycle. Now, I am not saying these people will be unemployed, just that there well paid manufacturing jobs will be replaced by low paid service jobs. That is why, over the last thirty years, inequality has been taking a hold. I explained this in Profound Inequality in America.

So how is China accelerating this process in the current environment? An example is Steel (So many blogs on the subject I cant note them all). This one vital element has been the growth engine which has sustained this process of converting rural peasant into semi-skilled townies. To produce steel, you need two primary elements, Iron Ore and Energy. In Chinas case, energy has been via Coal. Together, these three elements are all required in huge bulk, so we must include transportation into the mix

As inventory of housing has built to an unsustainable level, prices are starting to drop. Sales in the first half of 2014 are down sharply on last year. This still does not explain my theory. If China cannot consume all it produces, what can it do? Export. To this end it has done several things outside its recent state induced currency weakness. Firstly, export the raw material. Globally, these are running 30% higher than 2013.  South American countries have seen (China imports) rises of around 90%. Of course, the ire of western producers have raised the spectre of further import duties. So, this leads to the second point. Cheap exports to fellow Asian economies eg Sth. Korea, forces them to export themselves. Couple this with import restrictions on Taiwan’s exports to China and it becomes evident this is a way round tariffs from Europe and America. Thirdly, and a little more opportunistic. Export of ships, Rigs etc. Since the financial crash, shipbuilding finance from dominant European banks became scarce. This lead China to flex its mussels. It has lent, via state banks, billions of dollars to mainly Greek ship owners (I have many blogs on the subject) in exchange for the orders to be placed with Chinese yards. This has allowed China to wrestle the mantle of dominant player from Sth. Korea and Japan. The problem is, this cheap finance is creating a bubble in supply of vessels. All this at a time when the Baltic Freight Index is once aging flagging concern. Of course, the Bulk Carriers which are supplying the low cost Iron Ore from the likes of Australia and Brazil are benefiting.

Many economic forecasters are pinning their hope on China becoming a consumer society in order to create growth globally. This is a faint hope at best. For now they are flooding the world with low cost products which is leading to one main import from the developed world, Jobs. This leads me to the main crux of my argument. Demand.

I have written about a demand shortfall verses the supply boom and its resulting Deflation before. I have stated that wage growth will decline and turn negative. I am writing now as this is all becoming a reality. Wages in the UK and Australia have already registered there first ever declines. Elsewhere the downward pressure is building. Since 2008, American wages for the bottom 20% of earners has declined. The web site below gives a good view of how growth has  been distorted towards shale gas and not industrial important manufacturing:

The Geography of Employment: Mapping the Recovery [INFOGRAPHIC]

With employment in poorly paid service jobs being the illusion that has driven low unemployment in the USA and UK, income tax receipts are not dampening the budget deficits. Yes, the USA has a smaller perceived deficit but strip out income from the Federal Reserve (QE gains) and things are not so rosy. Both have adopted policies which have driven property prices to pre-recession peaks. The problem is, the China affect on wages has just made the valuation to income ratio stretched beyond affordability. Now that the boom in speculative demand is turning to net sellers, the future is not so promising.

Outcomes of my theory:

CHINA…Will try and maintain the illusion of 7.5% economic growth via internal demand acceleration. This is an illusion. Just yesterday they announced significant cuts to pay of higher paid state employees. With Iron Ore production costs double of Australia, they will probably reduce the tax disadvantage to protect this mass employer. The coal industry is losing demand and will have to make big cuts. Housing will continue to slow and eventually lead to huge bond default. Steel production will collapse and with it Iron Ore demand. Hence Coal and Oil price decline. Recent trade figures confirmed export growth and import contraction

Australia (BRICs)…The significant decline in Iron Ore price in 2014 has slowed investment but a second leg down in price (around $50-60) will put a big downer on the economy. The currency will retreat still further. Once again, housing demand will implode. High paid jobs in mining will be a big loser. Wage deflation will halt demand.

Japan…Sadly, they are likely to be the hardest hit from this China export drive. The economy will continue to struggle until eventually the currency has to give. They will have to return to nuclear power to reduce the huge energy import costs. This will slam the builders and operators of natural gas ships. Demand is going to contract still further as the Yen has its second currency decline to around Y125, the 2007 low. This will spread the deflation spores even more aggressively. I know most people take flight to the Yen during periods of uncertainty so my prediction seems odd to most. Over the last 5 years, significant moves, up and down, have been followed by stable periods of between 6-8 months before going again. Given the last significant decline bottomed in January, the next big move is just round the corner. First stop Y110 then on to 125. If you have to own equities, currency hedged Japanese are the ones.

UK…The chancellor has completely ruined the UK. I thought no one could have topped the incompetence of Gordon Braffoon. But George Osborne has done just that. Many recent posts will explain my reasoning, but put simply, he has borrowed and wasted more money than people who should know better are prepared to acknowledge. Its a bit like the Kings Clothes…George is parading naked as a Jaybird but no one has the balls to state the obvious. Let me give you a microcosm of a looming disaster. The Local Authority I have the honour to represent, has a pension shortfall of four times the income from rates. Every 0.5% move in bond yields makes a shift of around £70m. If I am right, and deflation takes hold, government bond yields could go to zero. Couple this with a decline in the underlying portfolio, which currently stands at £500m, and the shortfall could double. If you take this a fairly typical local authority, the time bomb is ticking loud and clear. Sadly, I am the only one who can hear it. I still think Sterling will test its all time dollar low of $1.08.

Sweden (Finland)…As I have stated in previous blogs, I love the Sweeds, sadly however, the writing is firmly on the wall. The primary reason is the importance of the mining sector on its industrial heritage. My scenario would see exports implode as mining companies cut still further the budget for new investment. The usual housing boom appears here and will come to an abrupt end. The currency will decline still further and the globally important companies will be snapped up by American players. Or, as I have stated in the past, a Swedish solution is forthcoming and many internal mergers take place.

USA…Here, more than any country, inequality abounds. As per my post of December last year. This will lead to significant social unrest.

EQUITIES…..I have said in the past that they cannot go down significantly at the moment as demand from Central Banks and Company buy backs is reducing supply. I have explained the role QE plays in this before. Considering the global unrest, markets during my city career of 28 years, would be significantly lower than they are now. This just highlights the influence these QE induced buyers have on prices. But what about the future? Quite frankly, I am unsure. What is clear, if prices continue to defy gravity, volume will continue to decline. Not wanting to short markets during these difficult times, because bears have been massacred since 2008, means individual stock prices will only move when poor results are released. Then the declines will be eye watering. Shrinking capital bases (due to buybacks) will make these moves more aggressive. For now, equities are an unknown beast for those of us who were brought up in a world of boom, bust, re-build economics. Not the QE induced ether they are fuelled by currently.

Bonds…I do not want to bore you all too much so that’s the end for now. Plus, my wife is giving me grief as I have chores to do. Mainly, putting a new Cedar shingle roof on our summer house…

 

 

 

 

 

 

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