In his must read piece which once again explains why the Emerging Market bubble is the greatest threat to the entire world, a theme which little by little is getting ever more traction, Grice first looks at a post-bubble economy. That of Japan.
This is why the comparison with Hong Kong could not be more shocking (and more deja vu-ish). Here is how Grice views the former British colony:I worry that Japan is a leading indicator for the rest of us. One of the things that struck us most while wandering around the place was the absence of energy. The bustle and zip I remember from my first visits to Tokyo was gone. So is the hope that things would soon turn around. There are more grey hairs than black - and people are asleep everywhere! In Starbucks, in restaurants, on the metro, on the buses and even in the shopping malls - Tokyo feels like a city which is sleepwalking.
Japan is the most rapidly aging society in the world and I believe the demographic contraction, which is only now beginning, has been the single most important factor in stretching the government balance sheet to breaking point. Is this what the future looks like? There is no panic. There is no sense of crisis. But neither is there much hope. Just resignation, apparently.
A great time for contrarians to invest? Hmmm ? I'm sure there are some good stocks around, but the Japanese market isn't cheap. The Shiller PE for the Topix currently stands at around 20x, about the same as that for the S&P500. If 20x is too rich for the S&P500 (historically you've made virtually no real long-term returns investing at such levels), its most definitely too rich for Japan, where the population is projected by the UN to shrink at an annual rate of -0.7% over the next forty years. I think someone recently argued that Japan was the unacknowledged "Tiger of Asia." Andy and I thought it looked more like a stuffed tiger.
Why are China's residents - traditionally so careful (growing up under a communist regime will do that to you) - throwing all caution to the wind? Here is one possible reason.It's been a nice change to be surrounded by such optimism! It caught us out though. Investors here have generally been disinterested in the developed market's problems. With one or two exceptions, the vast majority of people we met had little interest in the instability which might be unleashed by a more serious run on the debt of a larger Eurozone government than Ireland or Portugal, or the de-securitization of allegedly fraudulently foreclosed properties back onto US banks' balance sheets. Neither are they worried about the inflation risks that are building from the ballooning of developed market government balance sheets.
The apparent disinterest in the seriousness of developed market problems is reflected in the media, which aren't filled with stories of impending doom like they are back home. There is no talk of fiscal crisis or of painful deleveraging. There is no scapegoating of bankers' greed or politicians' incompetence - at least none for the moment because such things feature in post-bubble economies...
Instead the papers are filled with tales of another record property deal (a 400ftsq property outside the SG office in central Hong Kong just sold for HK$14m; The Economist newspaper recently ranked Hong Kong as the second most expensive property market in the world, calculating it to be 58% too expensive.
Last weekend's Sunday Morning Post reported that Sotheby's and Christies will raise more money from wine sales in Hong Kong this year than in London and New York combined. Vintage bottles are "better than stocks" according to the piece. And on the mainland, nearly four hundred years after the Tulipmania, speculation is said to be rampant in ...er... caterpillar fungus, of all things.
Here Grice once again returns to his recent meme that it is in fact China's fault for not letting its currency appreciate, and in doing so not only is it reaping the benefits of having a monetary policy that mimics that of the Fed, but an FX regime which allows it to extract far more benefits from the globalized system. The only Achiles Heel - inflation. And that is what Grice believes will bring the whole theater down.Like the other derivative plays on China and India, (e.g. Brazil, Canada, Australia) HK had a "good" crisis. So they feel confident that they can cope with whatever fate throws their way - fair enough - but having a "good crisis" can be a mixed blessing. The US had a very good EM crisis in 1997/98 only to fall victim to the tech bubble; Japan had a very good crisis in 1987 when world stock markets crashed, and was rewarded with the greatest real estate bubble in financial history a few years later; the US had a good crisis in the mid 1920s, as the UK struggled with the self-imposed deflation of a painfully overvalued exchange rate, only to be flattened by the stock market crash of 1929.
Why might having a "good" crisis prove such a poisoned chalice? Perhaps because countries pay more attention than they should to what's happening to their neighbours, keeping monetary conditions lower than the domestic climate would ordinarily merit. This was certainly true of Ben Strong's US interest rate policy in the mid-to-late 1920s when there were difficulties in Europe; it was true of the BoJ's monetary stance following the crash of 1987; it was true of the Greenspan's emergency stimulus following the EM crisis of 1997/98; it is true of EMs today, running policy which is overly calibrated to what's happening abroad.
Which of course brings up the old staple of decoupling, which ironically is most relied upon as a driving force of growth, just before it is proven to be a lie (see 2007).It feels odd defending beleaguered Ben Bernanke and his central bank brethren, but they're not the only "villains of the piece" here. EMs have more robust growth, faster productivity gains and an altogether brighter future. Their currencies should be allowed to reflect this. China has negative real interest rates and a deeply undervalued exchange rate with which the other Asian economies are trying to maintain parity. The Fed might be stoking the flames, but the EM's are doing themselves no favours by not tightening much more aggressively here.
And yet, very little happens. And here is the kicker. Grice speculates that unlike the Fed which at least pretend to be ahead of a bubble (although we know now this is only a myth), could China's regulators (PBoC et al) in fact realize that it has already lost control? If so, the repercussions are tremendous, as the entire world is now driving at 60 miles headed straight into a brick wall and nobody is even attempting to be behind the wheel.What effect will continued financial problems in the developed markets have on EM? Ironically, I think the worse developed markets get, the stronger the emerging-market narrative becomes. EM is the antithesis of DM, after all. Solvent governments, better demographics, harder working populations, etc.
So, much as I fret about the various problems in developed markets, I'm not sure those problems will be enough to puncture the emerging-market narrative, although they'll certainly set EMs back from time to time. The only thing that will remind investors there is profound risk as well as very attractive growth in EMs will be a problem within the EMs themselves, and the most obvious risk here is China. Indeed, perhaps the most surprising (and worrying) feature of our trip so far has been the almost universal conviction that China cannot hard land.
Its administrative controls work with far more precision than the one-dimensional interest-rate adjustments our central banks use, we are told: when the authorities tell investors to buy, they buy; when they tell them to stop, they stop. Today the authorities are adjusting reserve requirements and restricting multiple-home ownership as well as raising interest rates as we speak. Moreover, the regulators are terrified of a bubble and acutely alert to the danger.
The risk: a complete collapse of everything, and the biggest deflationary collapse in history, which is precisely why the Chairman's last response at D-Day will be to print an infinite amount of money to save whatever Keynesian remains are left.But, but, but ? but: regulators have rarely been a match for the folly of mobs intoxicated by the prospect of instant riches. And if the Chinese authorities exert such precise control over the behaviour of their speculative classes, why haven't they been able to cool down the credit inflation this year, which remains well above target? Why haven't they been able to eradicate the underground banks funnelling lending into ventures that are officially forbidden? And why haven't they cooled land price inflation, which remains rampant? The authorities have been telling investors to stop buying property all year, yet still they buy.
Is it possible they've (sharp intake of breath) already lost control? And if so, who's to say what will happen if the asset inflation goes into reverse? Maybe when the authorities engineer the slowdown they desire and tell investors it's safe to buy again, those investors won't want to buy. In which case a hard landing shouldn't be beyond the realms of imagination.
How much time is left?Forget US deleveraging, this represents the largest deflationary risk to the world economy. Yet it was universally dismissed by everyone we flagged it to! As far as I'm aware, no economy has managed to industrialise without hitting a few speed bumps along the way. Some Chinese bumps are overdue and to my mind the question is when, not if.
So when? As regular readers will know, I have no expertise in guessing these things (if only!) But for the very little it's worth, I think we're still a year or two away because I don't think they're tightening fast enough. History suggests the point of maximum danger to be when the authorities react too aggressively to late-cycle inflation, and I don't think we're there yet.
Markets have taken fright that the recent surge in inflation reported last week will bring about such overkill. And that's certainly possible (see the Popular Delusions of September 24th, and soon to be updated for some cheap insurance ideas on this particular "tail"), but the inflation is currently driven more by food prices. This doesn't make it any less real, but it does ensure a different response, and one that will be aimed specifically at food price controls and probably the scapegoating of merchants.
This is totally inappropriate. Not only do such measures rarely work since they exacerbate the problem by sending food prices even higher - indeed, it makes me even more bullish on agriculture, which is one of my three bubble candidates along with EMs and gold - but price controls on agriculture do nothing to address the key engine in the EM narrative today though - China's credit inflation.
Financial historians have shown that every single financial crisis since the 1870s has been preceded by rampant credit growth. So long as China's credit growth continues at its current pace, aided by the liquidity the Fed is flooding world markets with, and encouraged by artificially low interest rates, the primary risk EMs face today remains that of a bubble.
This might sound a very bullish note on which to end. It isn't. And let me be crystal clear about why: a bubble is not a bullish scenario. It's not bullish for the EM economies themselves, their citizens or for the world as a whole. The fact is all bubbles end in tears. The innocent bystanders who go to work not realising that their jobs derive from unsustainable demand suddenly find they're out of work, through no fault of their own. The investors who believe the hype - generally but not exclusively naïve retail investors - get completely wiped out, or worse find themselves in debt after leveraging into the story. Those who are sceptical, but play along thinking they'll exit before everyone else are rarely successful. And investors who refuse to participate as the bubble inflates face business risk and career risk. Go to Ireland and ask them how they feel about bubbles. They'll tell you a bubble is a curse, not a blessing.
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