I’ve received a few questions about China recently. Along the lines of ‘when will its bubble burst’?
I’ll get to that in a minute. But first, a quick update on the overnight action.
US markets were back in full bull mode. The S&P 500 jumped 1.6%, while the bull market leader, the NASDAQ, put on a hefty 2%.
As the Wall Street Journal reported:
‘Fresh data in recent days showing that global manufacturing appeared to be steadying, along with the Chinese central bank’s moves to inject liquidity into the country’s banking system this week, have allayed some of the most pressing concerns about global growth, investors said.
‘In the U.S., a widely followed gauge Monday showed that the manufacturing sector in January had returned to growth, and data Tuesday showed that new orders for manufactured goods rose in December at the fastest pace in more than a year.’
In other words, the global economy is doing fine. And even if the coronavirus gets out of hand, central banks will fix it anyway!
So buy stocks!
For shrewd investors, there is an important question to consider here. Is the market correct in its assessment that the impact from the virus won’t derail global growth? Or is this a reflection of the final stages of a bull market mentality, where reality and the market go their separate ways?
Of course, we don’t know the answer to that. But it’s something worth considering.
The way I see it, markets are nearly always right. The wisdom of the crowd gets a bad rap. But collectively, the market is smarter than nearly all of us.
It’s only at the extremes where the market gets it wrong. And extremes don’t come along all that often. Who knows, we might be building up to one now? The iron-clad faith that investors have in central banks to fix EVERYTHING is a necessary precondition to an extreme forming.
While that is clearly a crazy belief, it’s worth keeping in mind that central banks CAN do a lot when it comes to asset prices. Bubbles always start with a kernel of truth. And they continue for much longer than most rational types believe possible. They challenge that belief, until enough people give in to it.
I have no idea where we are on the spectrum. But it’s something I’ll keep a close eye on.
Speaking of bubbles and beliefs, let’s take a look at China. ‘When will its bubble burst?’, is the common refrain.
China’s bubble economy has been leaking for years
The reality is that China’s bubble economy has been slowly leaking air for years. The leak picked up pace on a few occasions over the past decade. But the central planners always managed to retain control before things got out of hand.
The thing to remember is that China is a centrally planned economy. The banking system is state owned and run. The central bank built up a huge pile of foreign exchange reserves over the past few decades. This provided plenty of firepower to create credit and inject liquidity into the banking system when needed.
The flip side of this scenario is that China’s debt pile is now huge. With each ‘mini-crisis’ faced over the years, the response has always been more credit (debt) creation.
As a result, China’s total debt-to-GDP ratio is now over 300%. That is dangerously high for an economy like China.
The question is, how much of this debt is actually productive? In my view, the debt created by a centrally planned economy is inherently less productive than that created by an economy with a more free market structure (not that the ‘free market’ exists anymore).
Not surprisingly, the chart below shows you that China’s debt binge hasn’t been productive at all. As you can see in the chart below, since 2010 (when debt growth really got underway) China’s economy has slowed markedly.
Source: Wall Street Journal
The market will see it coming from a mile off
China’s huge debt burden isn’t an existential issue for China right now. And it might not be for a few more years.
But as economic growth continues to slow, it will become a massive problem.
Because slowing economic growth means less national income. Lower income servicing a growing pile of debt is a dangerous recipe. The risk of defaults will increase sharply as the economy can no longer handle the debt load.
My guess is that a decline in economic growth to below 5% will spell trouble. Capital will flee the economy and the central bank will find it increasingly hard to control the currency.
As I said, this could still take a few years to play out. But the market will see it coming from a mile off.
That’s why the hit to commodities like iron ore, copper and oil have been so extreme this past week. The coronavirus has the potential to really knock the Chinese economy. Such a knock would expose the fragile nature of its debt-laden economic structure.
I don’t think it will evolve into a full-blown issue now. But it’s a warning shot of what is to come. When China’s economy inevitably slows into the 4% or lower range, you might finally see the day of reckoning.