Financial markets and China

Bubbles and busts

WHEN does a bull market become a bubble? And how can we rationally identify when a bubble,
by definition an irrational event, will burst? There have been many attempts to answer this
question over the years; the shadows of Charles Kindleberger and Hyman Minsky loom over any
author who attempt to tread this path.

In a new book, Boombustology: Spotting Financial Bubbles Before They Burst, Vikram
Masharamani makes a valiant attempt to add new perspective. Broadly speaking, Kindleberger
and Minsky focused on credit growth and on trigger events that allowed investors to believe a
new era was in place and thus new valuations might be justified; thus railways in the 1840s and
electrification and radio in the 1920s. Masharamani adds plenty of detail on behavioural finance,
the idea that investors' actions are guided by psychological biases, and by structural changes in
the market, such as financial innovations or new regulations. Thus, the final phase of tulipomania
may have been caused by the introduction of options, which allowed investors to make a levered
bet whilst limiting their downside.

Readers may be most interested in one of his last chapters, which applies the criteria used in the
rest of the book to China. China has seen cheap money, rapid credit growth, a property boom, a
dodgy financial system, signs of conspicuous consumption (the art market, skyscrapers), a new
paradigm (China will dominate the world) and policy distortions (lending decisions made by
central or local government). China's demand has in turn driven the commodity boom.

There is a nice table in Jeremy Grantham's latest  note at GMO which shows the proportion of
global commodities consumed in China; 53% of cement, 48% of iron ore, 47% of coal, 45% of
steel and so on. Thus if China turns out to be a bubble, commodity prices will presumably
collapse including gold. Mr Grantham's focus is more Malthusian; the combination of a rising
population and raw materials that are more scarce, or more expensive to develop, will put
upward pressure on prices.

I find myself in sympathy with both these arguments which seems a little paradoxical. The
smooth nature of reported Chinese growth, the massive government-led investment expansion
and the blithe extrapolation of these trends into the future make me very suspicious, but I have
no idea when the trend will break. If it keeps going, then I think commodity-led inflation will be
a problem; if it doesn't then the world will have a problem generating growth.

Back in the developed world, Martin Barnes of BCA Research has attempted to identify whether
equities are due for another bear market after their spectacular rally since early 2009 (the S&P
500 has doubled since its beastly low of 666). the factors he examines are monetary conditions,
valuation, the economic outlook, technical indicators and cyclical patterns (such as the
Presidential cycle). On the monetary indicators front, he pojnts out that the Fed is unlikely to
tighten any time soon and the yield curve is steeply upward-sloping, both supportive factors. He
is right, of course, but why isn't the Fed likely to tighten soon? Because of the weakness of the
financial system which made the Fed push rates down to zero, ensuring an upward-sloping yield
curve. With the system so weak, should the market have doubled?

On valuations, he points out that these are not helpful short-term indicators. He does cite the
Shiller p/e (it averages earnings over 10 years to smooth out the cycle) which is 23.3 at the
moment. However, he says the long-term average is 20, whereas Mr Shiller's website shows it as
16.4, making the market around 40% overvalued and in line with one of the 20th century peaks
in 1966. (Mr Barnes tells me that he has used the post-1950 average.)

As to the economy, well we are not very good at forecasting recessions so that's a difficult one.
Neither the ISM or the leading indicator is pointing to recession although, regarding the ISM, Mr
Barnes points out that

Bear markets often began when the index was strong and rising

The technical indicators aren't telling us much. As for the presidential cycle, we are in the third
year which is the most bullish. But that is because the Fed is supposed to ease policy and, unless
we get QE3, it is hard to see what else the US central bank can do.

If we apply the Kindleberger/Minsky model to the developed world, we have easy credit and,
arguably, a new paradigm; a commitment by the Fed to prop up asset prices. What we don't have
is wild public enthusiasm or a focus on one sector with crazy valuations, like the dotcom stocks.
So it's not quite a bubble; more the aftershock period of past bubbles. I'm inclined to agree with
Gervais Williams, the smallcap fund manager from MAM whom I met this morning, and who
believes that the overall market may be going nowhere for the next 10 years although there may
still be scope for investors to make money if (a big if) they can pick companies that will grow
their dividends.

At the front line in the battle between Chinese suppliers and their
customers
BUYERS who come back for every iteration of the historic Canton Fair, a twice-yearly trade fair
in Guangzhou, will tell you that only one thing really changes: the reasons given by suppliers for
why dirt-cheap prices have to go up. In 2008 price increases were blamed on factory relocations
required for the Olympics; in 2009 it was floods and power shortages; and in 2010 it was labour
and regulation. At this year’s spring fair, which runs from April 15th to May 5th, the battle over
pricing is being fought more keenly than ever.

To an outsider, the prices alone suggest there is nowhere to go but up. A nicely packaged
toothbrush sells for just $0.10, sunglasses for $1-3, watches for under $2 and office chairs start at
under $30 (with the proviso that in each case the order must be for hundreds of items or more).

The list of pressures on suppliers, meanwhile, runs on and on. Labour is not only expensive, it is
scarce at almost any cost. Even the most lethargic salesperson can provide a take on the impact
of commodity prices—be it petroleum, steel, cotton or wood—on products.
Smaller sellers also mention the pinch of pricier credit. Last October the one-year corporate
lending rate that serves as a widely cited benchmark was 5.31%. In April, after a series of
increases, it reached 6.31%. That increase is substantial enough—almost 20%—but the true
extent of the tightening seems to be much greater than official rates suggest.

That is because a lot of lending in China takes place in shadowy private markets. According to
Macquarie Securities, the so-called “Wenzhou rate”, based on the private-borrowing market in a
famously entrepreneurial city in south-east China, has risen to 6-8% a month, up from about
1.5% a month in late 2008 and matching levels seen in early 2008 when credit was genuinely
scarce. Pawnbrokers, Macquarie adds, are charging 4% a month for loans that are, by their very
nature, fully secured.

Access to lower rates seems, at least in part, tied to how much employment a company provides.
The bigger manufacturers—those with perhaps more than 10,000 workers—seem sanguine about
getting hold of credit (if not workers and materials). Smaller suppliers are in a tougher position,
which gives added clout to the trade buyer who can pay more upfront or the full balance fast or,
preferably, both.

As is often the case in China, new terms are being added to contracts sealed at the fair. The most
significant stipulations are tied to movements in the yuan, says Paul McLaughlin, a longtime
trade-fair customer from a British sourcing company, Libra. In the past prices offered by
suppliers were good for three months. At this year’s fair there is a broadly accepted provision
that voids any price offer if the yuan appreciates to 15.4 cents or more (it is currently worth 15.3
cents). Mr McLaughlin’s suppliers are also uncharacteristically willing to levy huge increases—
in one case, of 40%—and walk away if the terms are not met.

They are willing to do so despite the fact that returning customers like Mr McLaughlin are
thinner on the ground this year. One large manufacturer says the number of visitors is down by
more than 15% (whatever official figures might say) because Arab, Japanese and European
buyers are preoccupied by domestic problems.

The notion that disruptions like the Japanese earthquake and unrest in the Middle East could
push prices down is not much discussed at the fair, but the possibility of an abrupt price decline
is hardly inconceivable. China’s inflationary problems first surfaced in food prices, and food
prices may also herald the disinflation to come. In 2009 vegetable prices shot up; they were
strong last year as well. Good arguments were given for these price gains—among them, that
increased wealth and better nutrition lead to ever more consumption—and investment and
production ballooned. But the prices of many vegetables have since crashed, with China Daily
giving front-page treatment to a farmer in Shandong province who, faced with vast losses,
committed suicide. Suppliers may have the upper hand for now but old trade-fair hands will tell
you that arguments about price are never over.