China’s Credit Bubble to ‘Blow Up’ Commodities

EDITOR’S NOTE: Fund manager David Tice just joined the Chorus of the Bears. He predicted that the American economy is months away from a deep correction that will send stocks down by as much as 50%.

Tice is known as the wildly successful manager of the Prudent Bear Fund. He sold the fund to Federated Investors just as the 2008 financial crisis was unfolding.

Now, as CNBC reports, he’s ‘emerged from hibernation to capitalise on the potential downturn.

“The market has tended to go down about every seven years. It went down in 1987, 1994, 2001 and 2008,” Tice told CNBC. “During these periods after the declines, it rallies like crazy. But now bad things are about to happen again.”

Vern Gowdie agrees. He shows you how to bunker down and prepare for those ‘bad things’ today. And how you too can capitalise on the coming downturn once the dust settles. Find out how here.

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Markets have long speculated about China’s corporate debt bubble.

Rarely a week passes without a forecast of the bubble popping. And while the timing of this crash is up for debate, most people agree the country’s in trouble. China can’t artificially prop up its system forever.

Eventually it will fail.

We discussed part of this story on 25 January, which you can revisit here. That analysis focused mainly on China’s currency, the yuan. It also covered structural flaws in the Chinese economy. Contrary to popular opinion, in my view, China isn’t manipulating its currency lower.

The Chinese yuan has been pegged at a higher level. China has done that to protect its economy from self-destructing. Remember, China has massive issues on the corporate side. The shadow banking sector has lent trillions to the corporate sector at low interest rates. Now, corporates are finding it difficult to repay those debts. That’s why China needs a stronger currency to ensure cheap imports. That allows their industries to produce cheap products to sell and meet obligations.

Unfortunately for the Chinese, however, the yuan peg is unsustainable, and will ultimately break. That’s likely to trigger a global financial meltdown, especially in the commodities markets.

I’ll explain…

China’s dwindling reserves

The country is running out of foreign reserves. Gordon Johnson of Axiom Capital argues that reserves are now at a ‘critical level’. Based on the IMF’s formula, China is already below the minimum reserve adequacy level of US$2 trillion:


Source: Axiom Capital
[Click to enlarge]

China might not be able to support the yuan for much longer. That’s no shock. We wrote on 25 January:

I wouldn’t be surprised if the currency drops by 20–25% this year. 

China’s currency remains relatively strong for now. But it’s become a question of how long it will remain stable. If China devalues its currency by 20–25% in one swift move, you’ll see massive volatility across financial markets.

Remember, Chinese authorities are tightening domestic monetary policy in an attempt to stem capital outflows. But tighter liquidity is leading to a spike in corporate defaults.

Last year, 55 corporate Chinese defaults were recorded — more than double the number in 2015.

2017 will probably see more defaults. More than 5.5 trillion yuan (US$800 billion) in corporate bonds will mature this year — that’s 1.8 trillion yuan more than in 2016, according to China Chengxin International Credit Rating Group.

A major currency devaluation would likely trigger more defaults. That’s because the country’s competitiveness would decline — it would become more expensive to import goods.

China’s corporate debt situation is worrisome. The risk will come when the yuan peg breaks. Total credit is already at a level which has caused other financial crises. That’s why the Chinese are trying to kick the can down the road.

China’s economic meltdown imminent

The Financial Times elaborated on Monday (my emphasis added):

The authorities’ objective seems to be to rein in surging leverage in the shadow banking sector through a combination of tougher regulation and tighter liquidity provision to that sector, without causing wider systemic risks to the financial sector. They also hope to be able to squeeze the growth of credit between financial entities without restricting credit provision for legitimate economic expansion.

Unfortunately, the Chinese economy is far too overleveraged to control.

Hedge fund manager Kyle Bass, founder of Hayman Capital Management, is one of the most cynical. Bass is alarmed about the growth from Chinese wealth management products (WMPs).

WMPs have surged to US$4 trillion in assets in the last few years. That might not seem like much in today’s world. However, the cracks had also emerged prior to the failure of US investment bank Bear Stearns in March 2008; in fact, almost a year earlier. At the time, the asset/liability mismatch was 2% when compared to the total banking system. Said differently, it represented a funding gap of about 2%.

In China, with US$4 trillion in total WMPs outstanding, the asset/liability mismatch is above 10%. And the size of China’s entire banking system is roughly $34 trillion.

Chinese corporates are clearly overleveraged. The system is out of control. Capital controls won’t be able to artificially protect it from collapsing forever.

While the higher yuan has stabilised the financial system for now, we’re concerned how much longer that will last. That’s why it’s imperative to connect the dots.

China’s economic meltdown to take down commodities

When China’s debt dam bursts, we expect it to trigger a major global credit crisis. And it’s likely to be far worse than the US subprime meltdown of 2008. I’m no fan of most commodities or precious metals for that reason.

That might be strange to read from a resources analyst. But don’t forget: China consumes more than 50% of global commodities. When its credit markets unravel, demand for commodities will drop. The US dollar is also likely to move higher during times of extreme panic.

That’s a lethal combination.

Remember, the greenback tends to move inverse to commodity prices. With demand forecast to nosedive, commodities are bound for lower prices in the months ahead.

Now, if this is going to happen, why buy any resource stocks today?

The answer is simple: It depends what you buy.

Without a good reason, I wouldn’t buy any of the big producers, developers or advanced explorers today. As we’ve seen multiple times, these stocks get smashed during the tough periods. If you’re patient and wait out the coming meltdown, you’ll be able to buy some of the best resource stocks in the world at bargain-basement prices.

There are certainly tough and rewarding times ahead.

And with a bit of time yet before the proverbial ‘fire sale’, I’m recommending the best speculative stocks to Resource Speculator. These stocks could easily see you triple your investment in a small amount of time. I have multiple stocks on the buy list drilling for the mother lode now. And any…or all…of them could hit the ‘big one’. That would turn around their share prices in a big way. To find out more, click here.

Regards,

Jason Stevenson,
Editor, Markets & Money

PS: My colleague Vern Gowdie is no fan of the current stock market. With what he sees as sky high valuations fuelled almost entirely by debt, Vern’s calling for a 60–80% market crash. If Vern’s crash prediction comes true, it won’t just be resource stocks that plummet. I highly recommend reading Vern’s analysis, complete with an escape plan for your wealth, here.

Jason Stevenson

Jason Stevenson

Analyst at Markets & Money
Jason shares his extensive knowledge of Australia’s mining sector as Markets and Money’s dedicated resource analyst. Whether it’s iron ore, gold, copper or lithium, you can rely on Jason to give you in-depth analysis of the biggest and most important sector of our economy. Jason provides in-depth research to Resource Speculator, Australia’s premier resource investment advisory. If you’d like to know more about Jason’s financial world view and investing philosophy then we recommend you join him on Google+. It’s where he shares investment insight, commentary and ideas that he can’t always fit into his regular Markets and Money essays.

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