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What Will Be 2012's Blind Side? China


Europe and Iran will draw most of the attention in 2012, but pay attention to news of real estate turmoil in China. It could spiral well beyond the subprime crisis in the US.


The holiday season is over and I'm heading back home. We had the traditional Swedish Christmas Eve dinner, followed by opening presents on Christmas Eve. The kids got presents to open, but between the adults, gift giving has pretty much degenerated into the passing of gift cards which seems rather pointless. Pulling out a $100 bill and just passing it around would accomplish the same thing.

I decided this year to try to break this unfortunate "new" tradition and asked my sister to buy me some books, as in actual physical paper books. After seeing Moneyball and The Blind Side as movies last year, I decided I wanted to read Michael Lewis's The Big Short and Boomerang. I started reading The Big Short Christmas Eve, and I can't remember the last time I actually enjoyed a Christmas present right after I got it.

The Big Short started me thinking about the whole subprime crisis which evolved into the European sovereign debt crisis in 2011. Nevertheless, there was nothing shocking about Europe in 2011. As a tribute to my current favorite author, nobody got "blindsided" by European events in 2011. The blind-side winner was obviously the earthquake and tsunami event in Japan which were clearly unpredictable with incredible damage both locally and to the future of nuclear power.

If Europe couldn't blindside the US in 2011, it certainly can't blindside it in 2012. However, if there is a Richter Scale 9 earthquake offshore, you can be pretty sure a tsunami is coming. That is not a blind-side moment. It is time to scramble to higher ground.

There has been talk that the US economy is decoupling from the continuing problems in Europe. What exactly does decoupling mean? It means that a tsunami is coming, but you believe that the US coastal dikes will not be overtopped by the waves. In other words, impressive waves, but no systemic damage to the US institutions or economy.

It's easy to measure the height of physical assets above mean high tide, but how do you measure the height of financial strength to weather the European tsunami? Here are the one-year charts for Bank of America (BAC), Morgan Stanley (MS), and Goldman Sachs (GS).

Click to enlarge

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Got sandbags? You believe in decoupling? The market is not voting that way in the financials.

My purpose of this article is not to try to game the evolution of the European sovereign debt crisis. There are way too many variables and policy decisions that will influence markets in 2012 and beyond. My question is what could be an ankle-breaker (my apologies to Joe Theismann) that is clearly a blind-side hit in 2012?

Obviously, earthquakes and volcanic eruptions are prime blind-side candidates, but looking beyond geophysical to geopolitical events, there are two choices. First the Iran situation gets out of hand. An attack on Iran's nuclear facilities, perhaps initiated by Israel, and then a strong US response to any Iran provocation, especially with regards to the Strait of Hormuz certainly is possible, but it hardly is a blind side now.

My blind side pick is China. Let me lay out the blind side case which is much more than a hard landing. I've never been to China. I never expect to go to China, but I've watched the Internet and real estate booms evolve and the combination looks explosive in China.

I'll lay out my overlying thoughts about China and then try to tie those together into a scenario.

First, China is a rapidly growing country with a prosperous upper and middle class of roughly 300 million people, just about the same size as the US. Unfortunately, they also have another billion peasants back on the farms.

Second, the original growth model for the economy was based on very cheap labor to manufacture goods for export. I have a hard time rationalizing how you build a strong dominant global economy on the backs of peasants coming off the farms. I believe Henry Ford said, "I need to pay my employees enough so that they can afford to buy a Ford." To me, that was/is the definition of middle class.

Third, the new middle class in China saves a huge amount of their earnings because there is no safety net for retirement or health care in China.

Fourth, the middle class had no place to put savings but into real estate, and besides, real estate prices never drop in China. (See California and subprime, circa 2007.)

Finally, this might be the most important: Protesting peasants still have pitchforks and torches, but they are starting to get wireless Internet.

Moving on to the scenario, there is growing evidence that real estate prices in China have peaked and are starting to rapidly decline. Patrick Chovanec, an American professor teaching at a Chinese university, writes a blog that recently has been focusing on real estate in China. This link describes how rapidly real estate is unraveling from a number of sources.

I think Chinese real estate is exactly where the US was in January 2007, except it's on steroids. Reading The Big Short, you can see that some smart guys were figuring it out by 2005-2006, but subprime didn't hit the financial press until early 2007 when the subprime mortgage originators, like New Century suddenly imploded. In March 2007, Henry Paulson declared subprime was "largely contained," followed by Ben Bernanke saying in May 2007, "Subprime mortgage woes won't seriously hurt the economy." We know how that worked out.

In 2005-2006, housing companies were building new empty neighborhoods in California, Nevada, Arizona, and Florida. Chump change compared to the Chinese, who's cities built for a million people remain empty.

"If you build it they will come." That was the definitive phrase for the baseball allegory movie, Field of Dreams. The Chinese regional governments were given GDP goals to meet, and the only way they could be met was to build it. Well, it worked for a while, but they are not coming and buying anymore. The empty city of Ordos was the poster child for a while, but it sounds like it has spread across the country.

With respect to a real estate boom, it is different this time. Back in 2006, in the US you could get a mortgage with no money down. All you had to do was to be able to fog a mirror. Those subprime borrowers had nothing to lose. They really were just renters. In China it is totally different.

In the Western world, especially in the past few years, gold has been viewed as a store of value. In China, the middle class had few attractive choices for investment, so concrete (i.e. apartments) was the investment of choice. The big difference is that the new middle class has been paying cash for these investment apartments! The big losers in the US subprime fiasco were not the borrowers, but the institutions that bought the mortgage-backed nonsense that was packaged by US investment banks. In China, the losers look to be the middle class. Millions and millions of irate people are being driven back to poverty.

How they handle this remains to be seen, but there is another interesting data point that developed last month: Wukan, a fishing village of 20,000 in southern China, fairly close to Hong Kong. Back in September 2011, the villagers of Wukan discovered that their local corrupt leaders sold farm land without informing them or providing adequate compensation. Since they couldn't vote their local officials out of office, they performed the only other option and ran them out of the village. The normal approach to this type of revolt would be a heavy-handed crackdown by the regional authorities, but in this case villagers cut down trees to block the roads into the village.

The villagers were armed with the proverbial pitchforks and torches, but they were also Internet-savvy. They called in foreign journalists that had to skirt the blockade of the village but they got in. The villagers set up a wireless Internet media center, and all of a sudden the world got to hear about the villagers' plight. (The New York Times had an article last month about just how media-savvy the villagers are.)

With the foreign journalists in town, guess what happened? A settlement, no crackdown -- at least not yet.

A potential real estate collapse with the ability of the internet to deliver a message far beyond the local confines of local protest leads me to the possible blind side. Could the suddenly wiped-out middle class, with far better communications skills and ability than the residents of Wukan, lead to civil disruptions (on the scale of Greece?) that disrupts the supply chain of Walmart (WMT), Apple (AAPL), Dell (DELL) and countless others?

Your Apple iPad costs $499 because the assembly in China saves Apple what, $75 bucks? Less? Apple and every other manufacturer has bet there will never be supply disruption problems out of China.

This is the blind side, not to mention Apple's. All you need is Apple to say it couldn't hit its quarterly numbers because of supply chain problems in China. That will end the Chinese export business model. The ramifications of being unable to trust the China supply chain will move jobs back to the Western hemisphere. Some will return to the US, others to Latin America.

Will it happen? I don't know. But if it does, there will be a resurgence in American manufacturing jobs which will only be a positive to the American economy and stock market. Of course, there is a negative side to this scenario. If the Chinese need to start selling the US Treasuries they hold, that will have a negative effect on interest rates in the US.

This is my blindside pick that is not on many radar screens. Europe and Iran will draw most of the attention in 2012, but pay attention if you start to hear about significant real estate turmoil in China. It could spiral well beyond the subprime crisis in the US.

No positions in stocks mentioned.

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