Demographic Reality Hits
China debt bubble, Oil junk credit crunch, commodity & emerging market depression, Russian brinkmanship and terrorism are the top themes for 2016. Only an exogenous event spiking Oil prices and 2nd quarter seasonality are likely to temporarily extinguish these negative themes continuing in 2016.
Like the obesity epidemic warping our waste-lines, the primary anchor dragging the world down is gluttony. There is a glut of investment capital, manufacturing capacity and bad debt in China and a surplus of fossil fuels around the globe. The result: internal capital leaving China for safer havens, bad debt skyrocketing, capacity contracting and everything devaluing with miles to go before we sleep.
We contend that Demographics and political preservation are the underlying impetus for these escalating traumas besetting the globe. Demographic economics encompass the quantifiable financial aspects of populations and their effect on future trends. The echoes of the post World War II Baby Boom induced aging populations of the world consumption class peaked a decade ago and have begun a secular degradation of prosperity and social harmony. We are witnessing the fallout from the wealth of nations shift from a rapidly expanding workforce and rising incomes to sclerotic dependency ratios youth servicing an above normal proportion of retirees with below normal income. Borrowings for ever rising factory capacity has run into a new reality where manufacturing needs to be downsized and commodities become less valuable. The tailwind of expanding labor has turned into the storm of shrinking labor and consumption rates.
One Child Policy Conundrum
Over the next generation the US working age population will grow while China and Japan’s will shrink 20%. Similar transitions are currently underway in Russia and Europe.
It’s easier to understand the zero interest rate and massive money printing schemes (Quantitative Easing: QE) proliferating the globe when grasping these charts on aging and corresponding entitlement burdens as less productive silver haired consumers shift from producing and consuming toward more restraint and savings. Without immigration from emerging markets and and rapidly rising productivity, it will be very difficult to resurrect the halcyon boom-times of decades past until emerging markets matriculate to democratic self sustaining consumption oriented societies.
No Confidence Vote
While just 6% of Chinese investors have confidence their Government can avoid a financial meltdown, 42% assume the worst.
Cheap labor and extremely unfair trade practices fueled the Chinese manufacturing boom of the 1990’s and 2000’s. When the mortgage debt induced financial implosion swept the world into a deep recession in 2008 the final wave of outsourcing to China played its last card. With the world cutting costs and struggling to adjust to the “new normal” of slow growth, China was able to enjoy a final sharp rise in market share cornering the market on factory capacity. However, as a dictatorship lacking Shumpterian discipline, they underestimated the shifting sands beneath their production base. Wealthy western nations who had been sending currency and investment capital into China to consume and produce goods for the world have since rushed for the exits at an increasingly frenetic pace since the Oil collapse of 2014. Fitch Ratings estimates that Chinese investors have sent over $1 Trillion in capital out of the country since mid 2014. As a proxy, watch for these capital flows to mirror the trend in Oil prices.
Where’s the Floor?
Chinese factories and whole cities were built in anticipation of the flood of workers and space needed to produce a tsunami of finished products in recent decades. The first shock-wave to Chinese manufacturing supremacy was a rapid decline in capacity growth rates in 2012. This was dismissed as a hiccup due to a renewed European slowdown that could be managed. Then in late 2014 the construction boom fell to the floor.
It’s critical in a closed economy to manipulate the news. Since perception is reality, investors continued to bring capital into China with ever rising shadow banking sources supplanting local Chinese banks as financial leaders applied the brakes. Businesses began to fail in 2013 and while China has eased modestly, they continue to restrict lending and construction in a belief they can let the air out slowly for a soft landing. When bad loans piled up during the Global mortgage meltdown of 2008 China enacted their own QE by handing money to local bulge banks to write off bad debt. With junk loans back up to their late 2008 crisis levels once again, we may see State reserves utilized for carving out more non-performing loans.
China’s factory sector is in worse shape today than in 2008-2009 when the mortgage bubble burst around the world. This time there will NOT be the V shaped Chinese recovery. While affluent countries have only 10 to 15% of their economies tied to manufacturing, China has just under half and will struggle for years to achieve stability as a service oriented society. It’s estimated to take 1 to 2 more years to achieve factory equilibrium, assuming this contraction in the commodity fueled secondary industrial sector is allowed to manifest. Another year or two means more pain for emerging markets, oil and commodity prices in general. While the much larger Global Service economy should continue to grow, it will also feel medium term growth reduction from this deleveraging phase. Oil under $30 and Gold under $1000 are now realistic 2016 scenarios.
You Yuan Respect?
Currencies appreciate when their corresponding economies are stronger than their competitors. Investment flows are attracted to the best economy. Japan enjoyed such a status in the 1970’s and 1980’s and maintained a very strong currency. After almost a 40% appreciation of the Chinese Yuan during its golden years a decade ago, their currency suddenly is getting no respect with a managed 12% devaluation over the last 2 years. China is anxious to join the modern world of free floating currencies unfettered from the US Dollar peg so they can garner the respect of being a global reserve currency. With Capital moving out of China there is little choice but to shut down zombie factories and devalue the Yuan to make its exports more competitive while while they mature to a consumption culture. A cheaper Yuan means China will be exporting deflation with their shipments to reduce surpluses while they slowly right size factory capacity to more productive levels.
1st Quarter 2016 Pain
In 2008 the Global Financial Crisis (GFC) was bailed out by China’s enormous credit line to the US and the QE printing presses at global Central Banks. In hindsight, the 7 year recovery since the GFC has the look of big dead cat bounce. Papering over a Global excess of old debt with even more new debt has kicked the can down the road as leverage has surged to new heights that will take even more Herculean efforts to overcome when the next global recession arrives. With China draining its reserves in a secular slowdown and debt in excess of 200% of GDP we would not expect a lifeline of credit past The Great Wall during the next crisis. Central Bank support can only double up their tired gimmicks of printing money with far less effectiveness next time. With some eerie similarity to the 1st qtr’ 2008, we expect a painful early 2016 marketplace with more commodity deflation and struggling stock markets as we attempt to avoid a global debt and currency war panic.
Chinese Traders Heading for the Exits
China’s stock market may be a rigged game, but it does hold sway over world stock prices while falling, given the focus on all problems China these days. For years the Shanghai Composite prices proximate to the 2000 level were oddly maintained in a very dormant market. After a wild ride up and down during 2014 and 2015, prices have recently carved out a nice 5 month trading range above 2900 as local investors have begun to looking for an exit. Chinese leaders are buying the market heavily to subdue the tide, but it’s likely the tide will win. Watch for any close under 2876 to 2900 to catapult prices down to a test of 2000 once again. Such a move would coincide with US and world indices falling to new one year lows as well.
Exec Spec long term US investors are still 85% invested in Nasdaq & SP Indices and 15% in cash, while traders remain 100% in cash as short term oversold sentiment is approaching quickly.