A Reuters in an article entitled, " Wall Street rallies as global fears ebb, Google up late", voiced the theory that Basic Materials commodities and stocks had rallied Thursday on rumors of a much stronger GDP growth figure than expected from China. The average estimate for Chinese Q1 2012 GDP was +8.3% growth. The rumored figure was +9.0%. It is easy to see why this would cause a rally in basic materials and in the yuan versus the USD. When the USD Index fell considerably Thursday, overall U.S. equities rallied, not just the basic materials stocks. Many people were thinking this would be the start of another rally for the overall market.
If the Chinese Q1 GDP was indeed the reason for the rally, the Chinese have just thrown cold water on the party. They have reported a Q1 GDP of +8.1%. This is far less than the rumored +9.0%, and it is even less than the average estimate of +8.3%. In reality the situation may be even worse than it at first appears. The following table lists comparable GDP growth rates for China. It tries to show the Q4 to Q1 changes in case there is a seasonal effect.
Year | Q1 GDP Growth | Q4 GDP Growth | Change in GDP Growth Q4 to Q1 |
2007 | +11.2% | ||
2008 | +10.6% | +6.8% | -0.6% |
2009 | +6.1% | +10.7% | -0.7% |
2010 | +11.9% | +9.8% | +1.2% |
2011 | +9.7% | +8.9% | -0.1% |
2012 | +8.1% | -0.7% |
There does not appear to be a huge seasonal effect in these limited data. However, there are a couple of salient points of information in the table. First the normal yearly fluctuation seems to be in the 0% to 2% range. However, in the recent recession the growth rate fell from +11.2% in Q4 2007 to +6.1% in Q1 2009. This is -5.1% growth rate drop in a 5 quarter period (a little more than one year). With the EU recession starting, it seems likely that China will see another rapid drop in GDP growth rate soon. If the U.S. follows the EU into recession, such a drop (or worse) seems even more likely.
For those of us with good memories, the commodities and commodity stocks fell dramatically as the Chinese GDP growth rate fell. For instance WTI oil fell from $147/barrel in July of 2008 to $33/barrel in January of 2009. Other commodities and commodity stocks exhibited similar behavior. I am not saying we will see the same thing this time. Some rules have been instituted or changes to limit the carnage. However, it may be helpful to compare where we are now to where we were then.
In January of 2008, after a Chinese Q4 GDP growth of 11.2%, most analysts had acknowledged the U.S. would soon be going into recession. In the fall of 2008, the recession was officially declared. Plus Lehman Brothers went bankrupt. The U.S. credit markets seized up, and the U.S. equities markets fell until early March of 2009. Not coincidentally the low point for Chinese GDP growth rate was in Q1 2009.
If history repeats itself in a grossly similar fashion, the earliest we will get an official EU recession declaration will be in May of 2012 (or perhaps June). It is possible that the EU might barely avoid an official recession until August 2012. In either case if China repeats its recent performance, its GDP will fall dramatically for the next several quarters based on the EU recession alone. The EU is one of China's two biggest markets. Going by history, and factoring in a U.S. slowdown (but no recession), one could expect China's GDP growth rate to slow by another 2% to 4% by the end of Q4 2012. This would put the GDP growth rate at roughly +4% to +6% for Q4 2012 or Q1 2013. If the U.S. follows the EU into recession, which may happen, China's GDP growth rate seems certain to fall below +5%, and it could fall to the +2% to +3% range based on the major recessions and all collateral damage. The bad news for China is that this might not be the end.
Chinese banks over the last five to ten years have made huge loans to businesses and even government entities for construction, etc. These loans looked good when there was 10%+ per year GDP growth. Even so, China over built for the near term. There are huge numbers of commercial properties that are lying vacant. This is already creating a significant loan quality problem for Chinese banks. If the Chinese GDP growth rate falls significantly under +5%, this could bring on a real estate crash of the kind seen in the US in 2008 - 2010 (or worse). Some people will tell you that the Chinese insist on bigger down payments. They do. But nothing will really protect you real estate market from a recession, and the Chinese real estate market is not as healthy as many seem to think. First a growth rate below 5% would mean much of the excess in commercial real estate would not be able to be filled in a timely fashion (and this is actually already a big problem). It would mean huge numbers of loans would default. Huge numbers of write offs would be needed. The Chinese banking system might collapse on that basis alone.
Already many municipalities have indebted themselves beyond their ability to repay. It was last June (2011) that the figure of $464B in bad loans first emerged with regard to municipal governments. This is in rough agreement with the Shanghai Securities News report that the municipal governments' cash flow can only cover roughly 65% of the $1.44T of outstanding loans to Chinese Banks. In March 2012 the China Banking Regulatory Commission said it plans to deal with the clean up of local government debt to stop the defaults hurting the banks. I haven't heard of it happening yet, but it is likely in the planning phase. Such a bailout, if you ratio the US and the Chinese GDPs, is 1.5 times the U.S. TARP program; and this is without even considering the serious residential and commercial real estate problems.
The Chinese real estate problem poses much bigger loan issues. The residential real estate markets require a single family home down payment requirement of 30%, which one would think would make such loans safe. What many people do not realize is that there is a much higher home price to buyers' income ratio in China. For example, in Beijing and Shanghai the average cost of a new home is 16 times the average home buyer's income. This compares to 3.5 times annual income in the U.S. The situation in apartments is also out of whack with the global averages.
Fire sales brought on by slowing real estate sales due to a slowing economy are expected to lead to much lower prices. This in turn will push many loans under water. Yes, the Chinese may have paid 30%+ down payments. However, this will not protect Beijing buyers, who on a price to income basis paid 5 times the global average for their homes. Such housing could conceivably end up worth only 20% or so of its original sales value. I actually doubt this, as commodity prices will tend to buoy prices. However, this is just another argument for commodity prices to fall dramatically in such a situation.
Some have estimated that China has as much as $4T in debts that it will ultimately have to be written off. Fitch thinks $2T of the loans written since 2008 will go bad. This will likely decimate the Chinese banking system. It will have a negative "death spiral" effect on the Chinese economy. Exactly how the Chinese government will stop it if it really gets started, I am not sure. It will be hard. This purportedly mild EU recession has the potential to morph into a worldwide recession much more devastating than the last one. In all likelihood we will see more economic carnage in China than many are currently expecting. Hopefully the government will be able to contain it, but building more commercial real estate this time will not be the solution. Producing huge amounts more steel will not help. That industry is currently seeing a glut (and a severe growth slowdown) after the excess ramp up by China and some others during the recent U.S. recession. China will have to find a harder, more long term solution this time around.
I will stop the economics dissertation here as readers get bored easily. However, do worry. Do plan for at least a bad year to come (or perhaps two years). If it doesn't happen, you will still be okay. If it does, you will be infinitely better off for having planned.
How does this translate into a trading plan? It means you take at least partial profits in equities right now. It means you don't buy the hype that everything is okay in the global environment. It means you get into safe vehicles or cash. With regard to basic materials and energy, it means you should plan on a retracement as more likely than a surge upward. This is especially true of oil. Virtually every other form of energy has been falling dramatically. U.S. natural gas prices are in the basement, but may still go lower. Solar prices have been especially hard hit because the EU was the bastion of solar energy sales. Coal prices have followed the same basic pattern. Only oil has remained stubbornly high due to the Iran nuclear controversy. Not even that is likely to be able to hold oil prices up much longer.
Take profits in Exxon Mobile (XOM) and ConocoPhillips (COP) because they already have big low U.S. natural gas price exposure. Take profits in Total (TOT). It has lots of service stations, which suffer in a recession; and it is current receiving huge amounts of negative publicity for its North Sea gas leak. The prolific well associated with this leak is also shut down. Take profits in Chevron (CVX). It is fighting negative publicity in Brazil as well as criminal and civil lawsuits. Its prolific well is also shut down. CVX will suffer from the commodities plunge too. The same logic applies to basic materials. Yes, they have already been hurt considerably. Be judicious about trying to short them; but do take some profits. Cash can be your friend.
I could go on, but you get the idea. The stocks I named above were some of the leaders in the industry. If you need to take profits in them (at least partial profits), the smaller more vulnerable players are likely to be even more affected.
Good Luck Trading.
