MARKET MISCONCEPTIONS
by Marc Faber
Investors and strategists will tend to argue that the recent weakness in the U.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%.
[Mish note: I have no idea WTF he is talking about. I cashed out my lumber puts long ago thank god. Here is a current chart:
futuresource.com]
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.
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 when I mentioned to a hedge fund manager that he should short Countrywide Financial, 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.
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.
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.
Regards,
Dr. Marc Faber
for The Daily Reckoning |
