By Patrick Wolff
The consensus view after the Great Recession has been that we now live in a different world. On this view, the "new normal" is that the U.S. will grow more slowly while China and other emerging market economies will grow more quickly. In this "new normal" world, commodities will only grow dearer, the U.S. dollar will keep getting cheaper, and investors looking for fatter returns should ditch U.S. equities in favor of stock markets in places like Brazil, Hong Kong and Turkey.
Some may call this pessimistic view of America worldly wisdom. I call it the New Nonsense.
Sixteen months ago, I argued in this publication that globalization was likely to slow down or even reverse, that China’s economy looked more fragile than robust, and that the U.S. was still a fine place to invest. Financial markets to date have favored this more U.S.-centric perspective, but as always past returns may not predict future results. Do the fundamentals continue to justify favoring the U.S. over emerging markets? While I have no view on what markets will do over the short run, my answer to this question on a longer time horizon is yes. In particular, investors should understand that China’s economy could be in very big trouble, with serious potential implications for many emerging market economies if a deflating Chinese economy causes commodity prices to collapse.
The argument above proceeds in four steps. First, that China’s economy is a bubble that may soon burst. Second, that when China’s bubble economy bursts, it seems likely to take commodity prices down with it. Third, that a commodity bust could severely damage many emerging market economies. And finally, that although a China/commodity bust may cause markets to swoon and would certainly hurt some U.S. companies, many U.S.-centric companies would not be harmed – and might even be helped – in such a scenario. Let’s take each element in turn.
First up, China’s economy: Fixed asset investment, building apartments, roads, factories, etc., is an unprecedented share of China’s economy. It accounts for nearly half of both total economic activity and economic growth, much larger than peak levels for any other economy in modern history. Unlike consumption, economic activity associated with fixed asset investment requires accurately forecasting the future. If it is good investment, then it creates wealth; a bad investment, on the other hand, may generate income in the short run but waste resources and cause debt failures in the long run. Eventually, the long run arrives. Sure enough, debt has been piling up, overcapacity is rampant across myriad industries, and the economy is slowing.
To believe that China’s massive fixed asset investment is not a bubble is to believe that the investment has been well made. But history teaches that even democratic governments with capitalist economies see booms turn to bubbles and then busts. Do investors really believe that an economy based on corrupt government officials building empty cities like Ordos should grow to the sky? Believe it or not, people also used to believe the Soviet Union’s economy would one day overtake the U.S.
Bulls generally take comfort in China’s super-rapid reported GDP numbers. But thanks to WikiLeaks, we know that senior government officials don’t trust the GDP numbers, and neither should investors. It is far more likely, then, that it is a bubble after all. Over the past few years, China’s economy has required more and more debt to grow at lower and lower rates. Just last month, the world witnessed severe signs of stress among China’s banks. All bubbles burst eventually, and given recent events, this one seems ready to pop.
Now consider the potential effect on commodity prices. Of all the potential consequences of China’s bubble bursting, a commodity market bust seems easiest to predict. After all, booms and busts have been the norm in commodities for as long as there have been markets! The long "super-cycle" that began early last decade has been powered by China, which dominates the demand for such industrial commodities as iron ore and copper. Although China’s share of global oil usage is much more moderate, at a little more than 10% (second only to the U.S.), it accounts for roughly 40% of the growth in oil demand, with the Middle East OPEC nations coming second. (The developed world of the U.S., the EU and Japan, by contrast, all have declining growth for oil, and that trend looks set to continue indefinitely.) It is hard to imagine commodity prices not suffering a bust in any plausible scenario when the China bubble pops.
Who loses if commodity prices deflate? Likely it is the countries that are commodity net exporters, and these are overwhelmingly emerging market economies. Countries like Brazil, Russia, and the OPEC nations all stand to lose directly from declining commodity revenues. Furthermore, credit cycles in commodity-dominated countries tend to be pro-cyclical with regard to commodity prices: when prices come down, bad loans become apparent.
How would the U.S. fare if China’s economy collapses and commodity prices crash? As a net commodity importer, the U.S. economy should benefit from lower commodity prices. Furthermore, since China has depressed wages and muscled aside various export industries, its economic growth may actually have hurt those U.S. businesses that do not sell directly to China; hence it seems plausible that if China’s economy deflates, many U.S. businesses and wage earners would benefit.
There may be severe financial stress that might ripple through markets, and the memory of 2008 is still fresh. But recall that the U.S. was the center of the last bubble, whereas this one is a world away. If one agrees that China’s economy looks risky, one should consider putting aside the New Nonsense and look for intelligent ways to invest in America.
Patrick Wolff is the founder and managing member of Grandmaster Capital Management, a long-short equity hedge fund firm based in San Francisco.