 | | The Daily Reckoning | Tuesday, September 6, 2011 |
- Default...and other necessary components of economic vitality,
- Is “buying what China needs to buy” still a valid investment thesis?
- Plus, Bill Bonner on gold, real estate and the trail to Tokyo...
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|  | | | When PIIGS Fall | | Making Way for the Era of Sovereign Default | |  | | Eric Fry |
Reporting from Laguna Beach, California...
American investors returned from their Labor Day holiday to face another laborious trading day on Wall Street. As your California editor pecks away at his keyboard this afternoon, the Dow Jones Industrial Average is down more than 200 points to within spitting distance of 11,000.
For the first three trading days of September 2011, the Dow has tumbled more than 600 points — or about 5% — the worst three-day start for the month of September in the history of the US stock market. (Thanks to CNBC for this utterly meaningless statistic).
As it happens, the Dow is also down about 5% for the year-to-date, and down about 5% from its record high of October 2007. “Down 5” is not exactly the new “up,” but it feels like it. Over in the Old World, the best-performing stock market in the European Union is down 20% for the year. That’s the best one.
If you jump outside the euro zone, into the countries that opted not to latch the euro albatross around their necks, you find a couple of star performers like the British and Swiss stock markets — both down only 13% for the year.
The main problem, both here and there, is credit — or rather, credit contraction. Lots and lots of people, along with lots and lots of governments, are facing debts they simply cannot pay. However, instead of allowing the inevitable defaults to occur and to run their course, governments and central banks throughout the Western World are tirelessly cobbling together ad hoc bailouts, guarantees, rescue packages, emergency lending facilities and debt “workout” schemes — all designed to reverse the force of economic gravity.
But overly indebted entities will default, just as inevitably as flying pigs will hit the pavement.
The glide path of Greece’s financial condition is obvious. This pig is heading for the pavement, as are all the other PIIGS nations, which is why the European Union is so busy stacking up pillows and mattresses on the ground below.
The EU says its bailouts will enable Greece, Portugal, Ireland, Italy and Spain to enact the “austerity measures” that will restore solvency and keep their governmental finances airborne. Unfortunately, the effort to keep these struggling nations afloat threatens to sink the entire European Union.
Why not let the PIIGS fall to the pavement? Why not let overly indebted entities fail; let capitalism do its dirty work, so that the next generation of capitalists can step in and finance the next generation of successful enterprise.
The longer — and more strenuously — the central banks and governments of the West attempt to forestall inevitable defaults, the longer — and more painfully — the stock and bond markets of the West will abuse investors.
And let the record show that merely asserting a truth does not make it true. Central bankers and politicians can assert as often as they wish they their rescue efforts are effective, but that does not make it true. In fact, increasingly, the folks with capital at risk are “calling B.S.” on that assertion.
After more than 18 months of efforts and hundreds of billions of dollars of bailout funds pouring into Athens, Greek finances are still as sick as Dionysus after a long night of drinking. To wit: Greece’s borrowing costs hit a new record high today. To borrow money for two years, the Greek government would have to pay a whopping 52.3% per year. The US Treasury, by contrast, pays a minuscule 0.20% on its two-year debt.
You don’t have to be a professional investor to see that Greece is in trouble. But apparently, you do have to be a professional politician or central banker to believe that itisn’t. And as the dismal performance of the European stock markets testifies, the Greek problem is already a Europe problem. The chart below emphasizes the point.
The squiggles on this chart track the pricing of two different types of credit default swaps (CDS). Don’t let your eyes glaze over just yet. This is fascinating stuff. And even if it isn’t fascinating, it is instructive. CDS, to refresh, are an insurance policy against default by a specific borrower. Therefore, the greater the perceived risk of default, the higher the price of the insurance, i.e., the CDS.
The blue line on the chart tracks the average price of 5-year CDS on debt issued by 125 different European corporate borrowers. The red line tracks the price of 5-year CDS on debt issued by the French government. During the depths of the credit crisis of 2008-9, the price of CDS on European corporate debt was more than double the price of CDS on French government debt. In other words, investors were much more worried about defaults by European corporations than they were about a default by the French government.
As of this week, however, the price disparity between European corporate CDS and French Government CDS has disappeared completely. In fact, it has inverted. Investors now consider a default by the French government to be more likely than a default by the average European corporation.
This price trend does not suggest that a default by the French government is probable. In fact, such an eventuality seems highly unlikely. But the price trend of French CDS relative to corporate CDS, does suggest that a new phase of the credit crisis is underway.
The Era of the Sovereign Default is underway. Greece will be the first, but it won’t be the last.
As this sovereign default cycle unfolds, government bond yields are likely to climb, economic activity is likely to slow and paper currencies are likely to depreciate relative to gold and other hard assets. That’s the bad news.
The good news is that post-default nations will emerge leaner and meaner and ready to initiate a new era of economic growth.
That’s how the world works...or at least how it should work. It is probably no accident that this year’s very, very short list of winning stock markets features countries that suffered a painful sovereign default and/or currency crisis within the last 20 years.
The stock markets of Indonesia, Thailand, Vietnam, Philippines, Iceland, Ghana, and Venezuela are atop the leader board for 2011 with positive performances.
Default is painful, but it is also a necessary component of the economic life-cycle.
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| | The Daily Reckoning Presents | | China Forecast: Cloudy With a Chance of Rain | |  | | Chris Mayer |
Remember the phrase “Buy what China needs to buy”? It was a good thesis for us for years. I dipped the ladle into this idea bowl often. And the stocks of producers of potash, oil, iron ore and other stuff from the earth did well. But the tides of fortune ebb and flow. Will these commodities be good investments from here?
First, let me state again what every investor in commodities everywhere should know by now: China is your biggest buyer. Take a look at the nearby chart, which shows you China’s consumption of a given commodity as a percentage of world consumption.
So to answer the question I posed up top means you have to think about China’s growth rate. China slows, bad for commodities. China grows, good for commodities. Makes sense, right? In case you missed it, China’s manufacturing activity fell for the third straight month in June. The official purchasing managers index stood at 50.9, down from 52 in May. Any number over 50 means expansion and below that means contraction. Unofficially, things are probably worse, because officials have a way of dressing up doggy numbers.
What’s happened to commodity prices in those three months? Let’s look at the Dow Jones-UBS Commodity Index, which contains 19 commodities — everything from aluminum to zinc. Most of these 19 commodities have been falling for the last few months.
Keep in mind that China is still growing, just at a slower rate. Now imagine what happens if China actually contracts?
It’s one of those things that will seem extremely obvious in retrospect. But if you are worried about a slowdown in China — as I am — then you should shy away from commodities near the top of its buy list. This is the exact opposite of what I’ve said to do in the last several years.
This means you should particularly avoid cement, iron ore, coal, pigs and steel. You ought to feel better about food, wheat and chickens, which are not as sensitive to China’s buying. Oil, somewhat surprisingly, is far down the list, too, and is something of an exception. While the price of oil was down in the second quarter, China’s imports were near record highs. It doesn’t mean oil prices won’t go down if China slows or contracts, but oil seems less susceptible than other commodities at this point.
The other giant exception is precious metals. While China’s imports of copper, coal and iron ore are all down from a year ago, China still buys a lot of precious metals. There are no official data, but estimates put Chinese imports of gold at 200 tonnes through June. That compares to 250 tonnes for all of last year, which was a fourfold increase from 2009. China’s bought all of this gold despite being the world’s largest gold producer.
This kind of analysis extends further. Certain countries, too, have been riding the coattails of China’s buying binge. Brazil, for one, is a big supplier of China’s raw material needs. No surprise it has been among the worst-performing markets in the second quarter, down more than 5%. So goes China, so goes Brazil. The same might be said of Canada (also down 5%) and Australia. Russia, another big commodity market, was down 7% in the quarter.
This analysis is unsettling, I admit. But it is worth thinking about what happens if China slows further or even contracts. Every economy contracts at some point, if only for a time. China’s economy hasn’t shrunk since 1976. That’s 35 years, a long time between economic bowel movements.
On the other hand, people have been calling for China’s demise for a long time. Most recently, Jim Chanos, the famous short seller and forever known as “The Man Who Called Enron,” has found many trouble spots in China’s boom.
He points out that fixed asset investment in China is 50% of the economy. This figure easily exceeds figures from past bubbles in other markets. All that investment created “ghost cities with no people, high-speed rail lines to nowhere and empty apartments.” He also flags excessive debt engaged in real estate speculation. “The whole country of China has become a nation of real estate speculators on leverage,” he says. Real estate as a percentage of the economy has reached levels associated with pre-bubble Ireland. Inflation is also getting out of hand — hence the Chinese buying of precious metals to protect their wealth — and food and basics now eat up 50% of the average Chinese budget.
All of this too, is worrisome. What’s more unsettling is that few people want to face the ugly possibility that perhaps it is time to lighten up on commodities. “We do not think this is the time to be lightening up on commodities,” Barclays’ analysts declared emphatically in a recent note: “quite the opposite.”
That is the consensus opinion. And it is the easy opinion, because so far it has been so right. According to Barry Bannister at Stifel Financial, “Commodity prices have reached the highest 10-year rolling return in 200 years.” And in the last 10 years, the best- performing stocks have been those involved in commodity extraction. The chart below shows the FactSet industry categories and highlights the top and bottom five.
To date, “buy the dips” has been the right play in commodities. Perhaps the consensus will be right again. In fact, I hope it is. It is an easier world to invest in when you can count on China — the world’s second-largest economy — bringing its best to the table.
But I put up the caution flag here.
Regards,
Chris Mayer,
for The Daily Reckoning
P.S. I’ll be keeping a close eye on the China situation over the coming months...and a closer eye on how her economic movements might impact our relevant investment opportunities. Given China’s preeminence in today’s global economic landscape, it’s a story we simply can’t afford to ignore. Readers of my Capital & Crisis research letter will be kept abreast of what I discover with regular Friday alerts. My next one is due out in a few days. If you’re interested in getting on board, here’s a link with all the necessary information.
| | | | | | | Bill Bonner | | A View of the Long-Term Trends in the Housing Market | |  | | Bill Bonner |
Reckoning from New York, New York...
“And they shall grind the face of the poor...” — Isaiah
The markets were closed yesterday. Which was a good thing. The lights were out in Congress. Economists went to barbecues. Central bankers stayed home with their families. And investors didn’t bother to check their blackberries to find the latest prices.
In other words, it was a good day. We didn’t hear anything stupid or see anything idiotic. At least, not in the world of money. Or, that part of it within the 50 states. Besides, we were too busy to pay any attention anyway.
We went to a wedding in Manhattan. One of the people we met was a professional real estate investor:
“Everybody wants to get into real estate,” he began. “I don’t mean homeowners. Nobody wants to buy a house to live in. But people keep asking me to place money for them. They want to get into real estate.
“It makes sense. Prices have come back down to a reasonable level. You can just look at the long-term trend, over the last 40 years. Prices today are right on the trend-line, after coming down about 30%. In Florida, where I work, they’re down 50% for a lot of properties.
“So, you can put money in real estate again. And you can get a fair deal.
“And you can be pretty sure that your money won’t disappear. That’s why I’m getting so much interest from investors. What else can you buy? Some guys want to buy real estate because they’re afraid of inflation. Other guys want to buy it because they’re afraid of deflation. Some think the stock market is going crash. Others think the bond market is ready for a beating. Some think their investments are going to be hammered by depression. Others don’t know what the Hell to think.
“Even gold investors are scared. I mean, it’s been a long time since you could buy gold without worrying. I read your Daily Reckoning years ago. I bought gold too...when the price was about $800. I figured I couldn’t go too far wrong. But now the price is up at $1,900 and I’m not so sure.
“Yeah, the logic of it is simple enough. The economy has too much debt. It goes into a spell of debt-deleveraging. The authorities react by printing money because they can’t do anything else. So, the price of gold goes up.
“Sounds simple. But what we’re seeing is that it doesn’t work like that. At least, not quite that easily.
“As you say, the economy turns a little Japanese. So bonds go up. The dollar goes up. And other investments get killed. And as long as bonds and the dollar are going up...as long as we’re on the trail to Tokyo...gold doesn’t really have much ooomph behind it either. It could go down to $1,500...or even $1,000...and stay there for years.
“I don’t know any more than you do. But you have to admit that there’s now some risk, say, over the next two to five years, in buying gold. Maybe it will go up in the long run. But the long run could be a long time coming. And I’m going to retire in a couple years...so I don’t want to see my portfolio down a third or cut in half just before I retire.
“And I’m sure as hell not going to get locked into US bonds either. Maybe they will go up some more. But that’s a big risk too. Because Ben Bernanke could turn on those helicopters at any minute.
“So what are the alternatives? Stocks? Uh uh. Too risky. Bonds? Same thing. Gold? Normally, that would be a good choice. But it could be down a lot just when I need it. I can’t tell my wife that ‘it will be good for the long run’ when we might need the money sooner than that. Besides, you don’t get any dividends or interest — none — from gold.
“That leaves real estate. That’s why people want to put money in real estate. It’s priced at fair value — statistically. So, you can buy it without worrying too much about it going down. And it’s not like gold. You can get income from it. Everybody is looking for rental properties with a decent stream of income.
“And you can get such good financing. I’m seeing mortgage rates the lowest I’ve ever seen them. Of course, they’re for single family, owner-occupied housing. But people are mortgaging their own houses at under 4%. The money is practically free because the real inflation rate has got to be over 3%. Nobody knows what it really is, but I figure prices are going up around 4% or 5% so I figure the money is interest-free. Plus, sometime between now and when the mortgage loan finally gets paid off, inflation rates are bound to go up...and then not only will they be getting the loan interest-free, they’ll also be able to pay it off with much cheaper money. So, the capital value of the loan will depreciate...in fact, it could disappear.
“The smart money is taking this cheap mortgage money and using it to buy rental units. If they can get a net rental yield of 10%, they’re way ahead of the game. And that’s do-able.
“But there are two problems.
“First, it’s hard to find good deals. A friend of mine just got a 20-unit property down in Pompano Beach. It looked good on paper. But he’s getting eaten up in maintenance and repairs.
“There are a lot of deals coming through...but not many good ones. And there are a lot of people looking for good deals. You’ll hear about the good deals — because people talk about them. But you won’t be able to get one, because too many people are competing for them.
“The second problem goes back to that trend-line. Real estate went way over fair value in the last decade. Now, it’s back to fair value. You know, normally, real estate just tracks inflation, nothing more. Yeah, you get a little extra by being in the right place — like South Florida. But, overall, it just keeps up with inflation.
“But there’s no law that says that real estate has to stick to its trend-line. Or more specifically, that it just goes back to the trend-line and stops there. If it can go way over trend, it can also go way under trend. And that’s what I think we’re going to see.
“The guys who are buying real estate now, they’re going to be a little shocked and disappointed when the see that prices just keep going down.
“I know this is one of your themes too. Prices in Japan didn’t go back to trend. They went down and just kept going down. They ended up 80% below the peak. And they actually bent the trend-line down. Maybe it will go back to the trend. But I don’t think so. The population of Japan is going down. And they don’t get married. And they don’t have children. So they don’t need starter houses...or family houses...or any kind of houses. Just apartments for old people. That’s not a way to get higher real estate prices.
“The US is not in that position. Not exactly. But a lot of the demand at the starter house level was coming from Hispanic immigrants. And the numbers show that the Hispanics aren’t coming the way they used to. In fact, they’re now going the other way...they’re going home.
“Not only that, but we’re seeing more grown children move back in with parents...and more parents moving in with children. This will mean less demand for separate housing units.
“So, we’ll probably first have some over-shoot to the low side of the long-term trend-line, which will take prices down another 20% to 40%. And then, we might have a permanent bend in the trend-line, as the number of new households actually begins to go down.
“You think the middle class is having trouble now...just wait until their main asset is down 80%.
“I still think real estate is one of the safest places for money. But just don’t expect to make a lot of profit...and don’t expect it to be easy to find a good property. Remember, the profit is made when you buy. It’s hard to buy well. I spend all my time looking; but the good deals are hard to find.”
And more thoughts...
According to the Judeo-Christian religion, God gave man the days of the week and the weeks of the year.
But he held back something — holidays. He kept the seventh day for Himself, for example.
And now man has gotten into the act too. He’s created holidays of his own. Yesterday was one, intended to celebrate ‘labor,’ but really just a way of throwing a bone to the trade unions.
Still we respect it...just as we do all holidays. Which is to say, we were happy for a change of pace. But, there is always reckoning to be done anyway.
Friday, stock markets were walloped...after investors realized that they have a Great Correction on their hands, not a recovery.
The Dow was down more than 250 points. Gold shot up $47.
So, from our point of view...one went in the direction we expected. The other did not. Gold should not be going up...unless there is something we don’t understand, which is very likely.
Regards,
Bill Bonner,
for The Daily Reckoning |
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