Chinese Food For Thought
If China sneezes, the rest of the world will surely catch cold.
After a 300% rally since the start of '05, you can't turn the corner without bumping into a discussion about China. It's near the top spot in terms of global growth, which makes it a hot topic for media channels and the investors who watch them.
There are endless angles to debate, from the bubble potential to the piracy of goods to the eventual consumer of all things manufactured. They've got leverage in the political arena, influence on stateside policy directive and muscle in the markets. If China sneezes, the rest of the world will surely catch cold.
As investors, a proper perspective is a function of context. In order to appreciate where we are, we must first understand how we got there. While many investors believe they have a handle on the stateside dynamic, most folks are largely unaware of the Asian equation.
In the spirit of education and understanding, we thought it might be helpful to familiarize ourselves with the gorilla in our midst.
The "Haves" and "Have Nots"
The erosion of the middle class is no longer a secret, with the rich getting richer and the poor paying the price. The top one percent of the world's population owns about 40% of the wealth with America, at five percent of the global population, owning roughly 33% of the world's assets.
The chasm in this two-class society has manifested in many ways, including the persistent bid to high-end real estate. From Park Avenue to East Hampton, there is precious little inventory available while, at the same time, steady housing supply continues to litter Middle America.
The average income in Shanghai was 29,569 Yuan (about $3,810) last year. The top earners, those in finance, legal services, transportation services and energy exploitation, earned roughly 100,000 Yuan (about $12,500) on average. $12,500. Think about that, it's the upper crust of a massive society.
A two-bedroom "middle class" apartment in Shanghai rents for between 2,000 and 6,000 Yuan a month. Ergo, in four months, the average person would have spent their entire year's income on rent for an average apartment.
The Chinese consumer, widely credited for creating demand for things needed to feed, fuel and educate the world, may not be the crutch that we believe they are. It's purely a numbers game, based largely on their burgeoning population and popular perception.
The last leg of our global upside run was spurred by fiscal and monetary stimulus. That created a debt bubble that has resulted in over $3 owed for every dollar earned. When the elasticity of debt slows in the U.S., the natural assumption is that China will carry the consumption torch.
Perhaps a more pertinent question is begged. Given the income gap in China, will the quantity of their consumers be able to absolve the quality of the U.S. balance sheet?
The Transfer of Risk
A funny thing happened on the way to the other side of our business cycle. Risk was reinvented by transferring to the investing public. And as long as companies such as Fortress (FIG) and Blackstone (BX) tap into the public markets, the musical chairs will introduce another layer of liquidity into the marketplace.
I've learned through the years that the basis of valuation on Wall Street is a matter of psychology. That, no matter the metrics assigned or assumed, a company is worth as much as someone else is willing to pay for it. Just ask Mark Cuban. Or the lucky ducks at YouTube. Or the sorry lads from Enron.
At the end of the day, supply and demand validates a vision or a venture. It's capitalism in its purest form.
The U.S. is now urging China's central bank to buy more mortgage-backed securities after a surge in defaults by risky borrowers eroded demand for such instruments. China already owns $414 billion in U.S treasuries so their appetite for similar instruments seems like an intuitive fit. As long as the music continues to play, the thinking goes, everyone will seemingly find a seat.
"It's not a matter of whether they're going to do more business in mortgage-backed securities, it's who they're going to do business with,'' U.S. Department of Housing and Urban Development Secretary Alphonso Jackson recently told reporters in Beijing, offering that mortgage securities offer China's central bank better returns than U.S. Treasury bonds at the same level of credit risk.
With U.S. financial institutions sitting with unfavorable mark-to-markets on large amounts thinly traded securities, you can bet that there are plenty of sellers waiting in the wings.
Pardon our Exchange
Everything has an attendant cost and for holders of dollar-denominated securities, the other side of the asset class ascent has been the basis of valuation. The greenback is down 33% since the beginning of 2002, a mirror image of the gains in the S&P.
The popular retort to this dynamic is that we earn and spend dollars and, by extension, the dollar demise isn't worrisome. That may apply to the U.S. investor but it couldn't be farther from the truth for the rest of the world.
Let's say you were running the U.S. Central Bank and foreigners held monstrous amounts of dollar-denominated assets. They're upset because the basis of those holdings--the reserve currency of the world-is steadily eroding in value.
Let's further assume that, on the back of the tech bubble, the U.S. consumer was encouraged to borrow (in order to consume) with hopes that a legitimate economic expansion took root.
You, as the FOMC, would now be faced with a difficult decision. Do you raise rates to appease the global holders of your debt, or do you lower rates in an attempt to spark further demand?
And if you had to raise rates--if your hand was being forced by those who owned dollar-denominated inventory--how would you posture your actions?
Odds are, you would keep the collective focus centered on the risks of inflation and spend a fair amount of time trying to convince your constituency that the devil you know is better than the devil you don't.
To be sure, there is toxic inflation in things needed to feed, power and educate the world as the equal-weighted commodity index continues to power to all-time highs. But there is coincident deflation in things we want such as plasmas, cell phones and laptops.
As the U.S. digests this dichotomy and looks around the world for help, there are few partners that have the magnitude to offer potential solutions. A natural glance has been cast to the Far East, a region with a history of stepping in when the U.S. needs them most.
The Co-Dependent Tenants
We've already seen seeds of Nationalization sown from Venezuela to Bolivia to Ecuador to Russia. Those aren't small economies, per se, but they pale in comparison to China, which boasts the largest foreign exchange reserve at $1.4 trillion.
The United States is the largest debtor nation in the history of the world, with a negative personal savings rate and consumers that, thanks to Alan Greenspan, are now tied to adjustable-rate mortgages.
If China engineered a significant fall in the dollar, it would suffer sharply diminished exports as Americans lose spending power, in addition to a loss in value of their dollar-denominated assets. If China tried to cut its US dollar holdings, it would inevitably assert upside pressure on interest rates.
If China let its currency rise against the dollar, imported Chinese goods would become more expensive for the average American, hurting US consumption and by extension, the Chinese economy. When the going gets tough, the tough tend to take care of themselves.
That's a dicey dilemma when there is no easy out.
Globalization was the buzzword on the front end of the bubble and the other side of that ride is seemingly upon us. It's a classic case of co-dependency in an interwoven finance-based economy where every action has an equal and opposite reaction.
While there are no easy or apparent solutions, it's incumbent on us to understand the stakes.
While the U.S. is not yet at the Chinese checkmate, one thing is for certain.
There are only so many moves that can be made before one of the players walks away.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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