I was on CNBC today giving my view on the Chinese economy and the recent market sell-offs. There is a good reason for my pessimism on China one is the massive build up of debt over the last few years. Second and more important, is that the debt build up has in large part been driven by an unprecedented amount of investment much of which has been wasted. This translates ultimately into non performing loans for the banking system which will constrain future invesmteent and with it the Chinese economy. Investment is an astonishing 47% of GDP LINK1 more than double countries like Japan 22%, so a slowdown in investment cannot but have a major impact on the economy, The video can be viewed below or via the following link LINK2 as for Chinese concrete consumption here is the LINK3

I recently did a lively 50 minute conversation with Gillian Tett (Financial Times), Tim Congdon (Lombard Street Research) and Steve King (Kingston University) on the above topic for the BBC world service Newshour programme - the link is here LINK1

Stockmarkets in recent years have benefitted from very easy monetary policies. There has been quantitative easing from the Federal Reserve (QE I, II and III), The Bank of Japan and more recently the ECB. There have for some time been concerns about the outrageous valuation of shares of certain US companies such as Facebook, Twitter, Tesla, GoPro, Netflix and Amazon. Both short and long term interest rates globally have been artificially low for record amounts of time. It has been over a decade since the Federal Reserve last raised interest rates. This unusual period of money printing and record low interest rates has boosted asset prices not just stocks but also property prices in major towns and cities around the globe.

More interestingly the current bull market up until this correction, has been extremely unusual in that it has been one of the longest ever periods recorded (48 months) without a 10% correction in the S&P 500 index. The previous longest periods were october 1990- october 1997 (84 months) and March 2003 till october 2007 (54 months).  See Chart 1 below, Green candles are up for the month red candles are down for the month:

Chart 1 Monthly Movements in the S& P 500 Index

Equities are risky assets and do not go up forever in straight lines, so corrections can be at times be fast and furious. This acts as a useful reminder to investors that stocks are risky assets. Another sign that US stocks had become overvalued was the fact that the price earnings- ratio was approaching 19 to 20 times earnings see Chart 2. Whereas using Professor Shiller’s 10 year cyclically adjusted ratio – see chart 3 - the market is even more overvalued at 24 times 10 year average earnings. Prospective 10 annual returns were likely to be in the region of just 2-3% which is too low to compensate investors to hold risky assets. The recent fall in US and other stockmarkets will help to improve future stock returns to more like the 3-5% range.

Chart 2: Price to Earnings Ratio on the S& P 500

Chart 3: 10 Year Average Price Earnings Ratio on the S& P 500

The current sell-off is probably not unrelated to events in China, there the stockmarket had clearly entered bubble territory some months ago. Chinese stocks were rising despite the economy clearly slowing and it was selling at price to earning-ratios that made no economic sense even if you believed in a 7% growth story. The Chinese economy is in much greater difficulty than Chinese policy makers have been prepared to admit to date. That is why its recent devaluations of the Renminbi have been one of the catalysts for the recent global stockmarket correction. It is an admission by the Chinese that their economy is in trouble and an attempt to boost their economy through an increase in exports at the expense of some of their competitors. The Chinese economy is the second biggest economy in the world so trouble there also spells trouble for the global economy. The attempts by the Chinese government to prop up a market trading at a ridiculous 80 time forward earnings were doomed to fail and in recent days this has become very clear.

Another reason for the stockmarket sell off is that the Federal Reserve has been getting closer to raising interest rates from their artificially low target range of 0 to 0.25% - see Chart 4. Some market participants are clearly trying to get out of the market before the rise which is now most unlikely to happen in September. The low interest rates have led to US companies taking issuing record amounts of debt not so much to finance future growth but to buy back their own shares to artificially raise their earnings per share. This can work on the short run but in the long run by raising the leverage (debt to equity ratio) of US stocks increases their riskiness and therefore their potential for volatility. This is precisely what we are now witnessing.

Chart 4: Three Month US Treasury Bill interest rates

The obvious question is what does the recent turbulence imply for investors and companies should they stay put or be worried that we are facing a similar crisis to the 2007-2008 period? The good news is that that US stocks are nowhere near as overvalued as in the 2001 and 2007 although they should be weary of some of the most obscenely overvalued stocks mentioned earlier. The Chinese stockmarket remains overvalued (still some 60 times earnings!) and the economy in deep trouble - as it has massively over invested in the last 5-6 years. Even US stocks are still highly valued using the Shiller measure. This means global stocks will remain under pressure. The turbulence we have witnessed recently is likely to continue but rallies both ways tend to be fast and furious. Interest rates are also still ridiculously low and this will act as a future drag on the market as and when they rise. Investors in property may have a lot to worry about, stockmarkets are liquid markets and respond very quickly to changes in the global economy, property prices are slow react and property is a highly illiquid asset - a period of substantial and prolonged weakness in global property markets can be expected especially in major cities such as New York, London, Beijing, Hong Kong, Vancouver and Sydney. Companies should also be concerned a slowdown in the global economy will hit their earnings and we may witness a period of weakness in the global economy for the next 6 – 9 months.

Note slightly amended versions of this post have appeared as articles in TheConversation.com and Talkmarkets.com
 

 

I am glad to see that a 14 year jail sentence has been imposed on Tom Hayes LINK1 for his role in the Libor rigging scandal. To me such a sentence is entirely appropriate and hopefully more jail time will follow for others in the scandal. Rigging interest rates is a serious crime as it affects literally millions of individuals and businesses around the globe. I am fed up seeing financial crime dealt with by just imposing heavy fines on financial organizations which ultimately hit innocent shareholders. Sacking someone for financial crime is simply not a sufficiently hard sentence to discourage others from doing it. Jail time will make traders think much harder about getting involved in financial crime just to increase their bonuses. I have long argued that financial fines should come solely from the bonus pools that financial companies set aside for their employees. This way the employees will be incentivized to report and prevent financial crime occurring in their organizations and I would imagine it would get a lot more management time spent on the issue.