China-US Tectonic Shift Soon to Become an Earthquake

One of the first lessons investors learn is the old adage about diversification. That is, don’t put all your eggs in one basket. Of course, many try to do exactly that. But it is a low probability game.

Taking a big punt on a hoped for outcome nearly always leads to losses. And the extent of the losses usually depends on how willing and quick you are to accept that you’re wrong.

Australia seems to have forgotten this lesson. We’ve put all our eggs in the China basket. At the peak in September 2013, iron ore exports (our most valuable export) accounted for nearly half of total goods exports. And nearly all that went to China.

Now that bet is beginning to look fragile. But we’ve not yet shown any sign of acknowledging the error. It’s business as usual.

That’s partly because the market hasn’t yet punished us for our concentrated bet. Which brings me to what I want to talk about in today’s Markets and Money. That is, is there a correlation between falling commodity prices and rising property prices in Australia?

I think there might be. It goes against all logic, but it’s a great representation of the economic law of unintended consequences. It’s simply a reflection of what happens when central banks and governments all over the world try to bend the market to their will.

Let’s back up a bit first.

As I’ve written here plenty of times before, the key distorting factor in the global economy is the fact that the US dollar acts as the world’s reserve currency. Jim Rickards wrote about it (and the resulting Triffen Dilemma) in his latest issue of Strategic Intelligence.

In a nutshell, the US dollar benefits from a sort of false demand purely because other nations have to park their surplus funds somewhere. The US treasury market is the largest market in the world, thus providing a relatively safe and liquid home for global savings.

Because of this, economic imbalances build rather than resolve themselves over a normal business cycle. A great example of this is China. In the early 2000s, China fixed its currency to the US dollar. The fix was favourable to China, and it generated massive trade surpluses.

It was also favourable to the US, as China recycled these surpluses back into the US treasury market. This kept US interest rates low and allowed the US to consume much more than it produced.

These imbalances grew and grew. By July 2011, China had amassed a record amount of US Treasury holdings — US$1.314 trillion. Rumour has it that China then stated buying through Belgium, as the treasury holdings of the tiny European country began to explode.

In May 2014 its holdings peaked at US$360 billion, which at the time was the third largest hoard of treasuries after China and Japan.

This also represented the peak of China’s total foreign exchange holdings, as you can see in the chart below:


Source: TradingEconomics

Click to enlarge


This reserve accumulation by China was a result of fixing the value of its currency, the yuan, to the US dollar. In order to stop the yuan from appreciating, China had to print yuan to offset the dollar (and other currency) inflows.

This situation was incredibly bullish for global liquidity. But not anymore. As you can see China’s total reserve holdings have begun to decline. China is now a seller of US treasuries (and other currencies) as it tries to combat growing economic problems at home.

The recent stock market bust is just the latest economic woe it’s trying to deal with.

The catalyst for China’s deepening problems is the ending of QE in the US and the baby steps taken to begin raising interest rates. This has had the effect of drawing global liquidity back to the source — US capital markets — and away from the rest of the world (particularly from emerging markets).

This process has also sparked a US dollar bull market. All the carry trades that benefited from a weak US dollar and trillions of QE are now being unwound. For example, it used to be a profitable and easy trade to sell US dollars and buy commodity futures, which drove commodity prices higher (and made the trade more profitable).

Now that’s all coming undone, which is why commodities are in such a hole. Owing to the US dollar/yuan peg, QE benefited Chinese liquidity and economic growth too, which in turn had a beneficial effect on real commodity demand.

But again, that’s all coming undone due to the prospects of higher US interest rates. Ending years of easy money won’t be easy. There will be casualties, and China looks like being a major sufferer.

The London Telegraph reports that:

…the underlying picture in China is going from bad to worse. Robin Brooks at Goldman Sachs estimates that capital outflows topped $224bn in the second quarter, a level “beyond anything seen historically”.

The Chinese central bank (PBOC) is being forced to run down the country’s foreign reserves to defend the yuan. This intervention is becoming chronic. The volume is rising. Mr Brooks calculates that the authorities sold $48bn of bonds between March and June.

Charles Dumas at Lombard Street Research says capital outflows – when will we start calling it capital flight? – have reached $800bn over the past year. These are frighteningly large sums of money.

Frightening indeed. Capital outflows represent a tightening of liquidity in China. The authorities are trying to combat it by ordering their banks to lend again. They’re also trying to avoid an ongoing stock market bust by ordering insiders to buy and outlawing selling of stocks.

It will only buy time.

While China’s woes are hurting Australia’s economy via the effect on commodities and iron ore in particular, its vast capital outflows are masking the effects.

Billions in Chinese capital is pouring into Australia’s commercial and residential property markets. I was speaking to someone last week that worked on the construction of one of Lend Lease’s apartment complexes in Melbourne. He said it sold out in 48 hours, nearly all to Chinese buyers.

It’s a funny old world, isn’t it? When the economic pain of your biggest customer becomes the anaesthetic for your own economy? Who would’ve thought it!

But that’s just how it is. By putting all our eggs in the China basket, we’re inextricably a part of the major tectonic shifts of the global economy. And there’s a very big shift going on right now.

But when does it turn into an earthquake? It’s impossible to know. Keep a look out for the smaller tremors — they’re probably the best signal you’re going to get. My guess is the recent bubble bust in China was one such tremor.


Greg Canavan+,

For Markets and Money, Australia

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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