After dropping as low as 1679 on Tuesday the Chinese stock markets managed nonetheless managed to put in a decent week, with the SSE Composite closing the week at 1748, up 1.1% for the week, helped by Tuesday’s Obama-inspired global rally. A lot of people have asked me what I think the bottom of the market is likely to be, and though I have a very low level of confidence in my ability to predict these things, I think that even with a sharp expected drop in corporate profitability we are already at reasonable valuations.
I would guess that we are probably within 20% of the bottom, which would suggest, if I am right, that the SSE Composite is unlikely to go much below 1500. This would take the index close to its 2006 lows although, for what it’s worth, we did test 1000 in 2005. In relative terms it should be remembered that China has seen official annual GDP growth rates of over 10% during this period.
We will probably see the markets surge Monday because of recently released news (which I will discuss further below) about the State Council’s approval tonight of a RMB 4 trillion package of fiscal expenditures through the end of 2010. This is great news, but I don’t think the surge will last very long because there are many questions about the fiscal package and I don’t think there is a lot of fundamental good news out there. The biggest problem I think is the size of the global adjustment within which China must participate. This leads to two points I want to make in this entry.
1. The size of the US adjustment in Chinese terms.
The first is just to an attempt to get our arms around the magnitude of the global adjustment within which China must participate. Last week I met with a Japanese economist working for a major US fund manager who showed me a very interesting presentation he had prepared. He asked that his name not be mentioned, so over the next few weeks I will be plagiarizing his material without crediting him.
One of his graphs shows the US household savings rate from the 1950s to the present. From his graph it seems that until the early 1990s the US household savings rate tended to hover somewhere between 6% and 10% of GD, except for a brief period in the mid-1970s when it exceeded that level. Since then, as is well known, the US savings rate has declined, to around 2-3% of GDP.
As I see it the most recent globalization cycle began in the late 1980s and early 1990s. My model posits globalization cycles as being caused by rapid liquidity expansion, for which there have historically been many different reasons (including gold discoveries, the invention and expansion of joint stock banks, the recycling of trade deficits or surpluses, even in one case war reparations payments, etc.). The latest liquidity cycle was probably caused by the recycling of the large and growing US trade deficit, which can be seen as a machine that has converted US consumption into Asian savings – at first primarily Japanese and later primarily by Chinese. The decline in US savings beginning in the early 1990s is simply the flip side of the accumulation of Asian savings, and the numbers fit my model well.
Whatever the reason for the decline in US savings, I think most of us agree that it was related to the long rally in stock and real estate markets in the US, which were seen to obviate the need for households to save out of income (I would argue that the liquidity creation fueled the accompanying stock and real estate market rallies – long bull markets have always been a feature of globalization cycles). The banking system played a key role in the process by intermediating the capital inflows into the US (the obverse of the trade deficit) and converting them into consumption via an expansion in mortgage, credit card and consumer loans.
This process has probably stopped. Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise.
By how much? With households seeing their home and equity savings decline so dramatically I think one can easily argue that we will probably go above or at least to the higher end of the “normal” range of 6-10% of GDP, but even if we assume that households will only go back to the middle of the range, that still implies an annual adjustment of at least 5% of US GDP (around.$700 billion)
If global demand isn’t to collapse, someone else has to increase consumption by that amount. But who? The US government will probably increase its net spending, although it has already significantly increased its gross debt by recapitalizing the banks, and it will almost certainly see tax revenues fall. Corporations are more likely to be cutting spending than increasing it, so the combination of the two is not likely to be significant.
Can the rest of the world step up and replace US consumption? I am not an expert on global economies, but I think it is pretty safe to say that European, Japanese, and Latin American households and businesses are unlikely to be in a hurry to increase spending. In fact they are all likely to reduce consumption, although perhaps not as dramatically as the US. Given high debt levels in all those areas, there are also some constraints on fiscal expansion.
That leaves the net exporters, of which China is the most important. It is the largest saving nation, and the “other” nation along with the US at the center of the global balance-of-payments imbalance, and so much of that adjustment is likely to be forced onto China. As the country that has benefited most from US over-consumption, in other words, it is likely to be the one that will most have to adjust to a drastic cut in consumption.
