Do you see the iceberg ahead?

It is very easy to feel complacent at this time, as Western economies seem to be past the worst, and equity markets are soaring to new highs each day. What could possibly go wrong and cause another downturn? Surely a downturn would be relatively mild anyway, just a brief pause en route to a sustained, long-term period of global growth?

Allow me to present a different view.

Are you aware of the threat of deflation? How about we call it the reality of deflation to be more accurate. The source of this deflation is not the Western world, but increasingly we are noticing its impact.

The problem is China, and other parts of the developing world, which have issued huge levels of debt since the 2008-09 crisis, aided by artificially low interest rates and hot money from the West. Much of this Chinese debt has been issued by government entities, with no profit incentive, just a vague aim to make life better for the citizens of China. The problem with this debt (and of course with all debt) is that it carries an interest charge which someone has to pay, and it inevitably leads to massive oversupply. Here are a few items of data regarding China’s debt levels:

  • In a long-awaited report, China’s National Audit Office said local government debts had increased almost 70 per cent to reach Rmb17.9tn ($2.95tn) by the end of June. The NAO, whose last survey put the burden at Rmb10.7tn at the end of 2010, added that government debt levels were generally “under control” but identified “potential risks in some places”.
  • The China Banking Regulatory Commission said non-performing loans (NPLs) made by Chinese lenders reached Rb592bn (£58.3bn) in the final three months of last year. The last time NPLs were at the same level was September 2008. Loans by Chinese lenders have grown at an unprecedented rate in the past five years, with banks increasing the size of their balance sheets by Rb89 trillion, an amount roughly equivalent to the size of the entire US banking industry.
  • Borrowing by Chinese property developers has caused a surge in high-yield bond issues in the last 18 months, according to Moody’s, with more than half of the country’s corporate and project infrastructure debt rated at ‘speculative grade’. Hong Kong’s financial regulator has also warned about the increased use of foreign-currency borrowing to fund China’s continued growth with the stock of non-domestic currency loans, mainly US dollar-denominated, estimated to now be in excess of $1 trillion (£601bn).
  • Growth in Chinese company debt has been unprecedented. A Thomson Reuters analysis of 945 listed medium and large non-financial firms showed total debt soared by more than 260 percent, from 1.82 trillion yuan ($298.4 billion) to 4.74 trillion yuan ($777.3 billion), between December 2008 and September 2013.

We all saw the impact of risky loans during the credit crisis in 2008, yet the world’s investors appear willing to ignore the risks in China, trusting perhaps that the mighty Chinese government has a plan to tweak things a little here and there to avoid a bursting credit bubble. I seem to recall investors also believed Chairman Bernanke when he claimed there was no housing bubble, and no risk of a nationwide collapse in house prices in America. Trust your eyes, not their lying mouths.

The debt bubble is already starting to burst in China, and investors need to be very wary in our opinion. Here are a few results of the bubble bursting:

  • Iron ore slipped below $100 a ton for the first time in almost two years on speculation a home-price growth slowdown in China, the biggest user, will dampen demand and worsen the global seaborne glut.Ore with 62 percent content delivered to the Chinese port of Tianjin fell 2.2 percent to $98.50 a dry ton today, the lowest since Sept. 13, 2012, according to data from The Steel Index Ltd. The commodity dropped 27 percent this year, after falling 7.4 percent last year.
  • The global seaborne surplus will jump from 14 million tons last year to 77 million tons in 2014 and 145 million tons in 2015 as exports from Australia and Brazil increase, according to Goldman Sachs.
  • Authorities hope to reverse a downturn that has led to a 9.9% nationwide drop in housing sales by value in the first four months of the year, compared with a year earlier. Construction starts for housing have fallen 24.5% over the same period.Property investment directly contributes 12% to the country’s gross domestic product, analysts said. The total is more than 20% if items such as wages paid to construction workers and output from related industries are included.Some property developers have expressed concerns about the market. Earlier this week, Chinese media quoted property tycoon Pan Shiyi’s remarks at a forum, where he compared the nation’s property market to the Titanic. Mr. Pan, chairman of Beijing’s Soho China Ltd. said on his Weibo social-media account that he wasn’t aware reporters were present.
  • Supply will outpace demand by 316,000 metric tons in 2016, compared with 483,000 tons in 2015, according to the London-based The Rubber Economist. The adviser increased its forecast for this year’s glut by 78 percent in March as output in Thailand, the largest grower and exporter, surpassed predictions. The International Rubber Study Group also raised its estimate saying production will increase as trees planted between 2006 and 2008 mature.
  • China’s 21st Century Business Herald reports (via MNI):
    • China Beijing Safe Bank Investment Funds is unable to repay investors on a CNY600 million product
    • Was due back in March
    • Officials are now saying they are still unable to pay out, despite the three month extension
    • The company has around CNY4 billion in outstanding products, with 2,000 investor; most are set to mature in June
    • The company’s former legal representative has said the company is working on disposing of its assets but can’t guarantee how much investors will get back.

You may be thinking: so what? You may view deflation as helpful to the global economy, with falling prices providing some welcome relief to squeezed households. You would be correct that consumers would welcome some lower prices, but sadly they will also suffer other consequences as investment projects around the globe fail to due falling prices, with property being the most obvious asset class to suffer. Unemployment will rise, debts will default, companies will go bust, demand will begin to fall, banks will become insolvent. All of the inevitable results of a busting debt bubble, with contagion spreading like wildfire across the world.

The coming downturn will be at least as bad as that of 2008/09, probably worse, as we have the ECB gearing up to clean up the banks in Europe in the midst of the worst of it. I wonder if you have any idea of European banks’ debt exposure to the developing world? Hundreds of billions, with no chance of plugging the holes on their balance sheets as assets become worthless. Large depositors in European banks really need our urgent assistance now, the intelligent will save themselves, the unaware will be wiped out. Such is the nature of evolution.

So, some food for thought perhaps? How confident are you that a repeat of 2008-09 doesn’t lie ahead? Is everyone sat with their finger on the ‘sell’ button I wonder? Would you like to hold the ultimate hedge against this outcome? Contact us.

The deflation crisis the world faces will be met with the most elegant of solutions, one that virtually nobody will see coming, and why would they, when they were unable to see the crisis as it loomed in the first place.

We are ready.

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