Stock Markets Are Vulnerable To China Debt Issues

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 |  Includes: DIA, IWM, QQQ, SPY
by: Michael Blair

Summary

China's growth has been fueled by growth in borrowing faster than growth in GDP.

There is growing evidence that China's debt "bubble" is at risk of popping.

Given the scale of the debt, a default of any magnitude could have global ramifications.

It may be time for a defensive posture in the stock markets.

On CNBC today, Rick Santelli interviewed monetary expert Michael Moeb about the money supply. Moeb argues as I have in past articles that the $2.5 trillion of "excess reserves" that banks have "parked" at the Fed will have to be reversed at some point and when that happens there will be an excess of liquidity in the system that will compel the Fed to start selling its massive bond holdings to soak up the excess. Whether the Fed can do so quickly enough to prevent rapid growth in the money supply from triggering high inflation or whether it will result in a prolonged period of stagnant growth with higher interest rates is a wager investors are going to need to make. I think that choice will come sooner, not later.

What event might trigger the issue and bring the collision between overbought stock and bond markets and the unwinding of a massive Fed balance sheet into play?

The so-called stimulus of QE has been not much of a stimulus for anything except asset prices. Capital spending by United States corporations has remained well below its long term average - a fact inconsistent with the low interest rates being a "stimulus".

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Rather than increase investment in plant and equipment corporations have used the "stimulus" of QE to fund massive stock buybacks, approaching $500 billion in 2013 or about half the amount of "stimulus" QE pumped into the economy.

The benefit of QE was found more in CEO pay packets and stock options than in economic growth and employment.

The unwinding of QE is now underway and not a moment too soon. Restoring the Fed's balance sheet to a so-called normal level is an essential element of having a central bank with any ability to influence either of its often competing targets for inflation and employment. The problem I see is that the actions to reduce and reverse QE may be too little and too late.

International events may take over the driver's seat. The emerging markets issues that have erupted in Argentina, Venezuela, Turkey, South Africa and Brazil are relatively minor although disruptive for some. The real action may be in Asia.

Investors should keep a close eye on events in China. The Telegraph published a provocative article February 1, 2014 under the headline: "Currency Crisis at Chinese Banks Could trigger a Global Meltdown".

Borrowing abroad by Chinese banks is estimated to have reached $1 trillion according to the article, citing figures from the Bank for International Settlements. Problems in China and related shifts in the exchange rate of the Yuan could trigger a downward spiral quite quickly that might put pressure on quite a few Western banks.

The problems that may emerge are hard to dimension but the scale of borrowing is massive, with growth to $14 to $15 trillion in just five years.

That suggests the Chinese debt situation is solidly in "bubble" territory according to some observers. A February 14, 2014 Telegraph interview with Charlene Chu, formerly a senior bank analyst with Fitch based in Beijing and now head of Autonomous Research gives some insight into the issues but offers little by way of possible solutions.

We can spend our time slapping one another's backs over the strength of the U.S. economy; the brilliance of Ben Bernanke; and the "steady as she goes" prospects of continued stability under Janet Yellen but that domestic enthusiasm should be tempered a dose of international sobriety. The Lehman Brothers failure was not a United States problem but a world problem, and a failure of an even larger Chinese institution will not have ramifications that are confined to China.

The state of the world economy today is like a drop of mercury being balanced on a sheet of glass. With skill it can be kept in the center of the glass for a while but one slight jar and it will run off the glass in a direction hard to predict.

In her first official meeting with the press new Fed Chair Janet Yellen effectively told the world she saw rates rising in 6 months, not in so many words, and then tried to water down the gaffe. I watched the discussion on CNBC and despite her very strong credentials she came across as . It may be unfortunate if she faces a crisis before she has had time to develop more confidence in her ability to lead the central bank through troubled water.

As it stands, foreign investors are piling into China bonds attracted by the higher yield and the belief that the country's $3.6 trillion in foreign reserves offers protection from any catastrophe. For the time being they are probably right since the total exposure is relatively small and China is taking steps to introduce wider currency trading bands and a willingness to have weak firms face the risk of default.

Having said that, the risks in China's high leveraged economy remain high. The size of the Chinese real estate bubble could make the sub-prime growth in North America before 2008 look pretty tame and the cracks are beginning to show. Very high growth rates of the Chinese economy over the past decade have fueled enormous growth in debt as shown by this chart of International Monetary Fund data. The quality of those loans may be problematic.

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Source: Foreign Policy Research Institute

Larry MacDonald's article in Forbes March 18, 2014 entitled "China's debt bomb - Can they defuse it?" is a must read. His closing remark will haunt many investors who do not read it and think about it. He wrote: "Sell U.S. stocks".

That might be good advice.

I am maintaining a sizeable short book; a good deal of cash; and, keeping the bulk of my investments concentrated in out of favor oil and gas and mining stocks where the long term value is not going to be impacted by short term conditions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.