Wednesday, 10 February 2010

THE CHINA SYNDROME





Is this the most famous cup of coffee in movie history?


The quivering mug




In probably the greatest publicity fluke in modern cinema, Columbia Pictures released The China Syndrome twelve days before a near-catastrophic meltdown at Three Mile Island nuclear plant.  It was an accident which ended America's flirtation with nuclear energy and sent them scuttling back towards a dependence on middle-eastern oil which was, to say the least, consequential.


But I digress. 


In one of the great spine-tingling moments of '70s cinema Jack Lemmon's character, a manager at the plant, sits alone in the control room and through his coffee cup senses 'a vibration' from the nuclear core.  This sets him on the path to discovering that terrifying negligence and dumb complacency by politicians and construction companies has left the plant vulnerable to a massive meltdown of the reactor.  The film foreshadowed not only Three-Mile Island but a truly terrifying nuclear disaster at Chernobyl just a few years later.  Which brings me, in my role as Cassandra-in-Chief, to this month's theme:



Have we just felt the financial equivalent of a 'vibration'?



In my Investment Outlook over the last couple of months (free with every blog, folks, don't you skip it) I've been warning of an on-coming correction in the stock market.  It duly arrived mid-January.  The odds were that it would be modest, as it has (so far) proved, with the FTSE 100 drooping around 10% from its peak.  For now, technical indicators suggest that the immediate danger may have passed.  But the question prudent speculators and intelligent pension investors need to ask is whether it was in fact an early tremor, warning of a more violent dislocation to come.




------------------------------





In March 2007, six months before the first really big quakes from the US subprime crisis hit, the market had what was dismissed by most pundits as a 'wiggle'.



Please click to enlarge


Overnight, China had made a sudden move to clamp down on runaway share speculation, provoking a big drop in the Shanghai stock market.  Here, markets which had been sailing higher in blissfully calm waters instantly plunged 8%.  Western investors had no particular cause to fret over that Chinese move.  It was the panicky reaction itself which provided a hint that vertigo was setting in, that large investors were prepared to bail out rapidly and that, beneath the surface, greater anxieties lurked.



WHEN CHINA SNEEZES



Fast forward two years and here's a taste of the kind of headline which accompanied the start of this sharp decline:




Investors, having piled into China and the Asian economies in the belief that they've largely escaped the dead hand of the western debt crisis, have just begun to wake up to an appalling possibility: that China has been busy setting up a monumental debt crisis of its own.


One of the pre-eminent Wall St hedge fund managers, Jim Chanos, who made his name and fortune predicting and betting on Enron's destruction, has recently attracted a lot of publicity (not to mention ire from China's cheerleaders) by making a bold and controversial call. 


He believes that Chinese residential property, along with all manner of other commercial building, is in a bubble of stupendous proportions which is sure to burst.  Watch the urbane and interesting Mr Chanos explain his thinking in this video clip (to skip the preamble start around two minutes in):






Chanos isn't just flapping his mouth - he's betting big on a collapse in those industries in the region he sees as most at risk, including housing, construction, building materials etc.


If this were a parochial eastern concern, we out West might be justified in giving it not a moment's thought.  Unfortunately, China is the main - make that the only - alternative to the crippled US and European economies as an engine of world growth.  While developed nations have languished in recession, we've looked to Asia and the commodity-rich nations to haul us out. 


Indeed since the crisis began China, fuelled by a gargantuan stimulus package from Beijing's central planners, has been sucking up imports from every mine, refinery and pit across the globe, providing millions of jobs at home and abroad in its insatiable hunger for more building and new infrastructure.


But now, as Chinese property prices bubble up and a potentially major outbreak of inflation looms, the government is beginning to withdraw that easy credit.  Suddenly, China's role as chief growth driver (and therefore ours as piggyback rider) is coming into question.  So if Jim Chanos is right - and among uber analysts he is not alone - we could witness a massive crash in Chinese housing and construction in 2010. 


Some of the ghastly ramifications of this are what Donald Rumsfeld would describe as 'unknown unknowns'.  But among the 'known knowns' would be: a crash in world raw materials stocks, a collapse of global commodity prices, huge damage inflicted on businesses dependent on exports to China and the prospect of another major leg down in the world economy.


But the eastern behemoth, although the biggest, is far from being the only danger to our putative recovery. Monsters lurk far closer to home.  And last week, some of them started to bare their... well, their snouts.




----------------------------





PIGS FLY! (as the price of bacon plummets)



Portugal, Ireland (Iceland / Italy), Greece and Spain - or, as some smart-aleck analyst has monickered them, the 'PIGS' - are currently swilling around in a cesspit of debt from which escape can only be a messy business.


We've already seen the Irish housing industry flushed down the toilet and with it much of its banking sector.  But now there's a whole array of basket-case nations around Europe caked in government debt, lining up for a trip round the U-bend.  Here's a quick run down of the star names:


GREECE



  • The 100-pound gorilla in the room.  A minnow among European economies but its heavy-spending government is having to borrow 13% of its GDP this year to pay its bills which, with their tax receipts in the tank and an economy in the sewer means it is, theoretically at least, at risk of defaulting on its debt.  Such an event would drop numerous European lenders (especially German banks) who own those bonds deep in the Schei├če.  And if Greece defaults and cannot pay its debts, it cannot insure the customer deposits at its own banks.  They might then get their own 'Northern Rock'-type panic except, this time, not just at one or two institutions but at every bank.  They are currently locked in negotiations with the nervous Germans and the EU to find a solution - and most commentators believe the Germans can't afford not bail them out, which is why the default risk is theoretical - but any bailout could have the other PIGS lining up to get their snouts in too...


PORTUGAL



  • The 200-pound gorilla.  Similar story, similar-sized economy, more banks at risk.  Portugal's government last week attempted to raise $500million by issuing bonds at auction - which would normally be no problem - yet the auction failed, attracting just $300million.  Bond markets plunged, sending 10-year yields soaring towards 5%.  The government can ill-afford to pay higher interest rates but, along with an increasing number of Eurozone countries, it's out of their hands: the cost of raising cash to pay off their debts is going up whether they like it or not.


please click to enlarge



SPAIN





  • So that'll be the four-hundred pound gorilla, then.  Spain, as we cheap-flight junkies know, saw a tremendous   building boom up until 2008, especially on the Costas.  It soon became absurdly dependent on housing and construction - an incredible 60% of all domestic loans in 2007/8 were related to the real estate sector.  Banks were badly hit when many of these investments went belly up in the crash and, just like here, the government came rushing to their aid.  This has (so far) prevented a banking meltdown but Zapatero's bank bailout has put taxpayers on the hook and, with unemployment approaching 20% (yes, you read that right) investors are beginning to question Spain's ability to bridge its own debt-gap in 2010.




RIGHT, SO WHO'S THE 800-POUND GORILLA?







Germany?










America??













???




















Yes!  It's our adored ex-Iron Chancellor, the man who, lest we forget, in 2008 single-handedly saved the world economy.  Wouldn't it be delicious if, just eighteen months later, he had to go cap in hand to the IMF for a bailout? 


Friends, that is the prospect many serious analysts are now contemplating if we don't get our government spending under control, and fast.  


It's hardly surprising we're in trouble (given that Dr. Brown's prescription for solving an epic debt crisis has been to borrow a whole shed-load more), because a recent study by Kenneth Rogoff, former head of the IMF, shows that throughout history government debt crises almost always follow banking crises - precisely because governments are so keen to ride to the rescue.  The record shows that, usually, disaster strikes for these countries about two years after their banks go bust.









RING OF FIRE



After Japan, our debt burden (debt as a proportion of what we produce) is the biggest in the whole wide world.




Unfortunately the government debt figures above are already out of date -
and not in a good way




The major culprit here is the sea of debt in the financial sector, but for now let's just consider our own share of this mountain, as taxpayers.  The UK budget deficit - the annual difference between what we spend and what we earn - is estimated to reach £178billion this year.  But it could well end up being more. 


Here's the danger: the market whisper is that anything around or above £200billion is likely to provoke mass dumping of UK government bonds, as large investors become fearful of our ability to pay this ballooning debt without simply printing money and creating serious inflation; at a time when our government is showering bonds on the market like confetti in a desperate attempt to raise cash, these investors could well refuse to take that inflation risk at the current low rates of return, stage a buyers strike and sell up. 


Friends, if your pension or investments are in longer-dated (2-years plus) UK government bonds, or in any beyond the safest countries  highlighted in the chart below, your principal is at risk of taking a hit in a major sell-off






If you are in these types of bonds - and if you have a pension you may well be - you should urgently consider reallocating those into shorter-term (1-year or less) government bonds outside the 'Ring of Fire' if you possibly can.  If you cannot, you may wish to think seriously about switching now from bonds into cash.


For a cool, clear perspective listen to Bill Gross, an extremely shrewd investor and head of the world's biggest bond investment house, Pimco.  When he talks, bond traders listen.  He describes the UK government bond market as 'resting on a bed of nitro-glycerine'.  To cut to the chase, start 2½ minutes in:






Ok, so what if you're not invested in any of these flippin' bonds?  What's it got to do with you?  Well, when bonds sell off, their interest rates automatically rise.  The low mortgage rates which have supported the housing market since last year are highly correlated to long-term UK government bonds (gilts).  A spike in gilts would soon lead to a swift and substantial rise in repayments for millions of homeowners.


We'd see a rise in borrowing costs across the board, making life extremely tough for any business or individual already struggling to pay their debts.  The shock would make a double-dip recession almost inevitable, with house price falls, bankruptcies and company failures moving back centre stage and unemployment taking a sharp step higher.


But, hey, look on the bright side.  At least we're not a PIG.  We can, if worse comes to worst, print money to pay off our debts but those wretched porkers cannot since they are firmly strapped into the one-size-fits-all Euro.  They are thus caught between the whims of the bond market (rock) and the whips of the German government and European Central Bank (hard place) who are deciding if and on what terms to bail them out.


A crisis in Euroland which broke the boundaries of Greece and began to spread would then trigger the next crucial link in the chain reaction, and take it global - setting the stage for a potential economic China Syndrome. 




COMING FOR TO CARRY ME HOME







When the world's central banks opened up their monetary spigots after the crash in '08, dropping interest rates to zero and pumping money into the banking system, one consequence few of the grey suits will have considered in their panic was the rebirth of an investing phenomenon known as the 'carry trade'.


In simple terms, this olde traders' technique means you borrow in a stable or sliding currency with a low interest rate, which costs you very little, and invest in an asset (usually a higher-yielding currency) which pays a significantly better rate of return.  Having eventually sold at a tidy profit, you repay what you initially borrowed and pocket the difference. 


Given the resources they now had available, traders in the re-capitalized banks didn't just use the carry trade to invest in other currencies, they bought all manner of investments, bonds and shares worldwide, particularly in emerging-market countries where returns were juiciest.  But as the steady profits from this great global game rolled in and fed their 2009 bonuses, traders began to take for granted a continuation of the two basic requirements for its success:  extremely low interest rates in, and a gradual fall in the value of, the currency you borrow (mainly, the US dollar). 


Now both of these assumptions are, unfortunately, toast.  The implications are enormous.




The US dollar falls, then suddenly lifts off, unwinding many speculative positions.  It has mirrored the rise and fall of all risky assets and, having been used as a 'funding' currency with which to buy them, is now the beneficiary as they are sold. 


  • The major central banks are now all talking about how they will withdraw monetary stimulus measures.  These have been a major reason why interest rates have stayed so low, and when rates rise...

  • The carry trade becomes difficult if not impossible to maintain, because as rates rise your borrowing costs rise, your profits disappear and the value of the dollar itself goes up and therefore... 

  • Traders who borrowed in dollars to execute carry-trades have to dump their highly-leveraged positions as the buck rises, otherwise they get wiped out.  They sell the foreign assets and currencies they hold, forcing down the value of those currencies and assets and inflating the value of the dollar, creating more pressures to sell and leading to a vicious cycle.  Exactly this scenario was responsible for much of the damage in the crash of 2008.  

If the worldwide dollar carry-trade unwinds again as the greenback surges, US stocks bought in that trade will fall and a big share and currency sell-off can be expected, especially in emerging markets like Brazil and Hong Kong but also in the UK, Australia and the Eurozone, including those poor little PIGS.



--------------------



CONCLUSION:
THE CHINA SYNDROME



Put all these factors together and what you have is a dangerous cocktail of risks, opening up the renewed possibility of what markets fear most: contagion - that nuclear-like chain reaction of events which led us from a bunch of failed subprime mortgages all the way through to full-scale global economic meltdown.


To sum them up:


  • Withdrawal of monetary stimulus leads to interest rate rises - or increased fear of interest rate rises;
  •  

  • An inability to pay their debts or borrow in bond markets leads PIGS to the very edge of default, leads banks to take another huge loan hit and the UK to the door of the IMF

  • The US dollar surges and the carry trade unwinds, leading to a plunge in any asset prices and currencies bought in that trade

  • The Chinese government tightens stimulus taps for fear of inflation, triggering a collapse in Chinese property values, a halt in construction and a global commodity crash


While the occurence this year of a straight flush of all the above would seem a trifle...unlucky... the fact that all these are being seriously talked about, not by nutters in blogs but by major players, sends us a stark message. 


This time, contrary to all appearances, the risks to your money are not falling as the market soars - they are rising.


Fortunately, market movement almost always 'tells'; it invariably whispers a technical warning to those with an ear to hear, some time before any calamity strikes.  The crashes of 1929, 1987, 2001 and 2008 could all have been avoided.  As a chart-nerd, watching out for those tells is my job.


Yours, if you want to protect your investments, is to avoid complacency.  These risks may not materialize for some time, or indeed they may never materialize (I'm not a seer, just an investor who likes to know his risks).  So we stay in the game and continue to ride the tiger - until it starts getting hungry.  Whatever you do though, don't be spun a line.  To the uninitiated, Gordon Brown may appear to have saved our economy in 2008, but look more closely...


please click to enlarge



Isn't that a beauty?


OK, I'm all doomed-out.  You'll have to wait 'til Sunday March 7th for your next dose (unless the sky caves in before then in which case I'll post an interim blog).  Check out my February Investment Outlook, below or archived, to see some of the opportunities all this has thrown up.  It's not quite time yet to stock up on beans and ammunition but, my friend, make sure you know the way to the store.


Have a great month!