Back in the days before the financial crisis really kicked off, we went through a ‘bad news is good news’ phase in the US.
This was around six or seven years ago, when the notion that interest rates go up as well as down was still uncontroversial.
In any case, the Federal Reserve was gently raising rates. Wall Street wasn’t too keen on this. So when economic data disappointed, you’d see markets rise. Why? Because it meant that maybe rates wouldn’t rise so fast, or maybe even go down.
Why am I raising this now? Because as I noted yesterday, we’re back in ‘bad news is good’ mode. But now investors are focusing on China. The hope is that the worse the data gets, the bigger the stimulus package we’ll see.
They’re going to be disappointed. And that’s something you need to be prepared for as an investor. Here’s why…
The bulls’ new narrative for China
Yesterday’s trade deficit data from China was worrying for anyone hoping that the country would bail out the rest of the world. Import growth in December was the slowest in two years.
Yet markets preferred to take it as a good omen. Here’s the new narrative. China is slowing down, yes. But inflation has been conquered. And while some of the air is being let out of the property bubble, it’s a healthy, necessary correction.
So if demand is shown to be slowing down, it just means that China will stop tightening policy. Monetary policy will loosen, the latest five-year plan will shift the economic focus toward the Chinese consumer, and we’ll all be off to the races again.
Maybe it’s just me, but this grand plan doesn’t make sense.
Let’s keep this basic. How did China get rich? By importing raw materials at one end, and exporting them to Western consumers in the form of cheap consumer goods. When exports collapsed in 2008, a government-backed lending surge by banks kept the economy going by driving up infrastructure spending. (For more details on this, read James Ferguson’s MoneyWeek magazine cover story from June 2011 here: China is heading for a fall – here’s what it means for you).
Chinese citizens don’t have many options as far as saving their money goes – you can’t get an above-inflation return from your bank account, and the local stock market is a casino. So – not unlike many British and American private investors – the Chinese put their faith in good old bricks and mortar.
The trouble is, to tackle rising inflation and also prevent growing unrest over the unaffordability of housing, the government has forced banks to rein in lending. That’s already hit property prices hard.
The bulls argue that because Chinese property buyers have to put down big deposits, any property crash won’t be as painful as it was in the US, for example. However, there are a couple of problems with this.
For one, it neglects the fact that there is a very significant ‘shadow’ banking system in China. Another side effect of offering low interest rates on bank deposits is that it tempts people to find other ways to make money. And lending to companies or individuals is an attractive option in a booming economy.
As Hu Zhenhua of Wenzhou University tells the China Daily: “The whole system is based on A lending to B, and B lending to C lending to D etc. If D, however, flees the country, you get this domino effect where the whole system collapses. It is a crisis and it is probably getting worse”.
Zhenhua is referring mainly to the small business sector, but it seems likely that a similar dynamic could operate in the property market. There’s no way to be sure. But the fact is that during boom times, people find ways of getting into trouble. They might have bought homes with a large deposit. But where did the deposit come from in the first place?
However, a bigger problem is this: how do you expect to build a consumer economy on the back of a property crash? If the West has learned one thing over the years, it’s that nothing buoys the consumer economy like a nice housing boom. People feel rich, their houses ‘earn’ them more than their jobs, so they spend more. When that ‘wealth effect’ goes into reverse, so do consumers.
Avoid the luxury goods sector
The point isn’t that China is going to have a catastrophic 2008-style US subprime collapse. It may or may not. What does matter is that it’s not going to bounce back rapidly. The bubble dynamic has already been turned around. When people see that prices can fall as well as rise, their mindset changes from: “Buy now before prices rise further!” to “Let’s wait a bit until prices get even cheaper”.
What does it mean for your investments? There are many implications, which we’ve gone into already (such as being wary of commodities this year). But specifically, I’d avoid the luxury goods sector. Upmarket jeweller Tiffany saw its share price slide yesterday as both its Christmas sales and its outlook statement disappointed investors. As the Financial Times points out, while the weak sales were blamed on a slowdown in the US and Europe, the “truly unpleasant surprise” came from Asia. Sales growth “dropped precipitously, from 36% to 12%” against expectations for 20%.
Now, maybe Tiffany has gone out of fashion in Asia. Retail is fickle, these things happen. I suspect though, that it’s not specific to the chain. Wealthy Chinese people are like any other wealthy people – if their asset base is in danger of being crushed, they’re not going to be keen to spend a lot of money they may not have in the near future.
On the flipside, it could be good news for companies that would benefit from lower commodity prices. we’re back in ‘bad news is good’ mode in yesterday’s Money Morning.
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