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Friday April 16, 2010 - 15:51:02 GMT
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Does this thing come with an escape hatch?

There's an evenin' haze settlin' over town
Starlight by the edge of the creek
The buyin' power of the proletariat's gone down
Money's gettin' shallow and weak
Well, the place I love best is a sweet memory
It's a new path that we trod
They say low wages are a reality
If we want to compete abroad

My cruel weapons have been put on the shelf
Come sit down on my knee
You are dearer to me than myself
As you yourself can see
While I'm listening to the steel rails hum
Got both eyes tight shut
Just sitting here trying to keep the hunger from
Creeping it's way into my gut

—Bob Dylan, Workingman’s Blues #2

FX Trading –  Does this thing come with an escape hatch?

 Emerging-market stocks fell the most in a month after China acted to cool real-estate speculation. (Bloomberg)

Not sure if I got this correct, but one of those a-b-c-d-e triangles would be just about perfect now.  Why? Buy the rumor of China growth, and sell the news… [Chart not available in text format.]

…but of course there is more to this story…

Two points, with some interlinked sub-points, to justify the path projected in the chart above popped into my brain this morning.  Let me try and link them for you; the bottom line is the money flow at the margin thing.

Point #1: This ain’t your grandfather’s business cycle despite growing confidence about the coming V-shaped recovery.

The story starts out where most all economic stories start out—with Mr. Consumer.  

You may have noticed US jobless claims released yesterday didn’t show much improvement.  This could mean nothing, or it could suggest the rip-roaring recovery still has some convincing to do.  This economic note from Northern Trust we thought summed it up well [our emphasis]:

Total continuing claims, inclusive of special programs, which lag initial jobless claims by two weeks, moved up to 10.536 million during the week ended March 27 vs. 10.489 million in the prior week.  This tally of continuing claims is holding above 10 million since the week ended November 21 (see chart 4).  Until we see a meaningful change in the trend of total continuing claims, the labor market situation is a source of significant concern.

[Chart not available in text format.]

We realize employment is a lagging indicator, but … any time now fellas…
This, the latest from the National Federation of Independent Business, produced by Chief Economist William C. Dunkelberg, in its Small Business Economics Trend survey for March:

“…the pessimism persists.  The March reading is very low and headed in the wrong direction, very inconsistent with the notion that the economy is recovering and that job growth has strength.   The Index has posted 7 consecutive quarterly readings below 90.  There is nothing magic about 90, other than it is an historically low reading and, in comparison, there was only one quarterly reading below 90 in the 1980-1982 recession period.  Job creation and capital expenditure plans weakened, 9 of the 10 Index components fell or were unchanged from February’s not-so-great readings.  Not the picture of an ‘expansion’.”

[Chart not available in text format.]

Needless to say, the US and Eurozone economies dumped jobs with an incredible viciousness thanks to the credit crunch.  Without jobs returning, Mr. Consumer will have trouble returning to his old glory. 

Let’s look at the number of unemployed another way.  If we add up the jobs lost since the credit crunch, roughly by looking at the charts above, we can say that China has lost the full buying power of about 15-16 million Western consumers. 

You can see the initial hit to China’s exports was quite dramatic, they have since recovered, despite the fact that US and European unemployed have not.    

[Chart not available in text format.]

Maybe it doesn’t matter.  But with austerity as the new watchword for the European continent, it’s unlikely we will see a surge in consumer demand flowing from there.  And the chart on the right above, China exports to Europe, seems to confirm just that.

Key point here: China has created massive excess capacity to produce final goods for exports, yet at the margin, the consumers needed to buy those final goods haven’t yet materialized. 

Point #2:  This ain’t your father’s perfect storm of credit now that government is rooting out all the bad guys.  From the Financial Times this morning, this headline: Alert over international capital flows…

“Capital flows to emerging markets are near the levels reached before the financial crisis but concern over tighter monetary policy is restricting growth, according to the association of the world’s leading financial institutions [The Institute of International Finance].

“…In a warning to ministers and central bank governors attending next week’s International Monetary Fund meeting, the organization of leading banks and other financial companies said rules being set by the Basel Committee on Banking Supervision would ricochet around the world.

“The institute said net capital flows to the emerging world, which it estimated to have fallen by nearly $60bn in 2009, would recover to $708.6bn this year and $746.4bn in 2011.  But those forecasts, which had been revised down, would leave them well short of levels just before the global financial crisis.”

[Chart not available in text format.]

China raised reserve requirements yesterday.  Real estate spec runs rampant.  And they know it.  From Business Insider, March 31, 2010:

According to Shih, the rot is located in the so-called Local Government Financing Vehicles

(LGFVs) belonging to one of China’s many levels of local government ranging from towns and counties to cities and provinces. LGFVs are conduits, like the Special Investment Vehicles (SIVs) were for western banks, used by local government to borrow and spend on infrastructure and other projects (like real estate). 

Local governments inject land banks, SOEs and cash into a LGFV to give it assets and a capital base for borrowing.  Guarantees of LGFV debt by local governments are also common (as are guarantees of one LGFV’s debts by another).  The usefulness of the LGFV is that it allows local government to borrow and spend way in excess of its own budget, where normally tax revenues cover only about half expenditure (with the rest coming from Beijing).  Local government deficit spending is not allowed. 

There are over 8,000 LGFVs in China with only paltry information available for all but 100 of them and even for those the information is incomplete.  Local authorities have used LGFVs to divert funds borrowed for authorised projects to other ends (e.g. loans for infrastructure spending channeled into real estate speculation by local cadres) or to borrow and feed back the proceeds to local government.  LGFVs are predominantly unprofitable, with the debt service on existing debts being funded by further cash subsidies from local government and additional borrowings. And they have been financed by asset injections at inflated prices (e.g. local government land banks) to dress up their balance sheets and facilitate borrowing, despite often being insolvent.

It's these SIVs that allow for this:

[Chart not available in text format.]

In conclusion, these local entities -- which get at least half of their revenue from real estate, and not taxes -- have one solution: keep praying for a bubble (oh, and hope that the export sector never slows down).

The mother ship that now seemingly sustains all known economic life on this planet may be deprived of some much needed supplies…does this thing come with an escape hatch?

Jack Crooks
Black Swan Capital


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Tue 17 July 2018
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