Chinese Sunset

John Mauldin
The jet lag from flying back from Hong Kong on Sunday is just about gone, but I’m still deep in thought about what I learned. As I said in last week’s letter, the overall tone on China was bearish for the group of very sophisticated investors I met with. There was particular mention of the quantity of currency flowing out of China and lots discussion about how that was happening. Suffice it to say that the wealthy in China have ways to move money.

I mentioned that fact at lunch today with a close friend of mine (who will allow me to tell the story but not to mention his name in connection with it), and he shared an anecdote that he had run into on a trip to Seattle the day before. It seems that one of his friends bought a rather large, roughly $8 million, new home in a nice part of Seattle and was selling his old home for a mere $4 million. Thirty prospective buyers came through to look at the property, and not one of them spoke English – they were all Chinese.

Think about that for a moment in the context of money leaving China. At the Hong Kong gathering, a Bank of America Merrill Lynch analyst noted that if the top 3% of wealth holders in China moved just 7% of their money out of the country, it would add up to $1.5 trillion. Personally, I think Chinese investors are being smart to diversify their assets and asset bases. That is something we take for granted in the West.

(My friend David Tice, founder and ex-manager of the Prudent Bear Fund, who has a killer apartment in my building – indeed, his apartment was the inspiration for my getting and building mine out – wonders how he can get prospective Chinese buyers to come see his place! The weather is a lot better in Dallas than it is in Seattle. I know from talking to friends in New York City that a lot of Chinese are also buying there, along with Russians and others from that corner of the world.)

All of which brings us to today’s Outside the Box. Earlier in the week I asked my friend Gary Shilling if he could give me a summary of his 2016 forecast. He agreed to do so and sent it on. Then this morning he sent out a special short report on China that offers what I think is a valuable perspective that differs from what we’re seeing in the headlines, and so I asked him if we could use that for the OTB instead.

Gary calls his special report “Chinese Sunset.” Towards the end he draws parallels to Japan (which I too have done in previous letters and speeches).
While I think that China will be significantly bigger in five years than it is today, its growth path is coming back to Planet Earth and will be a challenging one for a whole variety of reasons, many of which Gary discusses. (At the end of his report, you can find out how to subscribe to Gary’s letter and get his full 2016 forecast.)

And of course Gary is part of the great lineup of speakers I’ll have at my Strategic Investment Conference. As you know by now, we’ve moved the conference to my home turf here Dallas this year, and the dates are May 24-27.
Our theme this year is “Decade of Disruption: Investing in a Transformed World.” China will obviously be a topic of discussion, but we’ll cover the entire gamut of economic, financial, and geopolitical issues that will impact our performance as investors this year.

You can go to the SIC 2016 website to get all the particulars on this year’s conference and register to save $500 off the walk-up rate.

I know I mention from time to time how busy I am, which I guess is a function of how many fabulous opportunities I keep finding, not to mention all the stuff that I feel it’s important to read; but my life just keeps getting busier and better. And though I seem to have more than ever to do, I’m getting more and more excited about working on my new book, The Age of Transformation. It has been a massive learning process trying to keep up with the 120 researchers who have volunteered to help me. The book has turned into a Major Project, but it’s one of the most fun things I’ve ever tried to do. I don’t want to say that I’m running fast, but my shadow is beginning to complain about having to keep up. So I think I’ll hit the send button and get back to work! And you have a great week!

Your needing more time in the day analyst,

John Mauldin, Editor
Outside the Box

Special Report: Chinese Sunset

By A. Gary Shilling

The current turmoil in the Chinese economy and financial markets is shaking security markets globally as the yuan nosedived in the first week of this year and Chinese equities lost $1.1 trillion. What a contrast to the 13.3% compound annual growth from 1992 through 2007 (Chart 1) that propelled China’s GDP from 9% of America’s total to 59% last year (Chart 2)! So China moved ahead of Japan in 2009 to become the world’s second-largest economy as hundreds of millions of Chinese rose from poverty.

Reveling in Success

The Chinese revel in that success. They view themselves as the world’s superior society, and have chafed at being under European thumbs in the 1800s and Japanese hegemony in the last century. For years, the Chinese have lusted to be big players on the global stage, and have her yuan currency recognized by the International Monetary Fund as a reserve currency, right up there with the dollar, euro, yen and sterling. It finally was late last year.

They also have enjoyed the widespread conviction in the West that, with recent sluggish growth in North America and Europe, China was inheriting the mantle of global economic leadership. Indeed, many observers in and out of China believed that growth there would spill over to the West and spur gains in North America and Europe.

Leadership Direction

In fact, however, economic leadership has been the reverse. Like virtually all developing economies, China’s has been driven by exports that directly or indirectly are sold to North America and Europe. And those imports by the West are fundamentally curtailed by sluggish overall economic growth, the result of deleveraging, the working off of excess debt built up in the exuberant 1980s and 1990s. Annual Chinese export growth dropped from 20% to 30% in the 2000s to a 7% decline last November from a year earlier (Chart 3).

In the U.S., real GDP growth has averaged only 2.2% since the recovery commenced in mid-2009, about half the rebound rate you’d expect after the deepest recession since the 1930s. Similarly, the eurozone has limped along at a 0.7% rate with another recession in 2011-2013 following the 2007-2009 global Great Recession while Japan’s real GDP has averaged 0.9% with three more declines of a least two consecutive quarters since 2009.


Also, globalization the transfer of manufacturing and other production from the West to China and other emerging economies is largely completed, curbing that source of emerging economy advance. U.S. factory output as a share of GDP skidded from 17% in 1997 to 12% in 2009, but then leveled off when just about all the production that could be moved overseas was offshored (Chart 4).

The resulting weakness in the Chinese economy, however, was masked until recently by massive housing, capital spending and infrastructure investment.
But the residues are excess capacity, ghost cities and total corporate and government debt that leaped from 160% in 2004 to 232% in 2014. Also, China’s huge total economic size covered up its still-underdeveloped status. Even with the explosive growth in the past several decades, Chinese GDP per capita in 2014 was $7,590, or just 14% of America’s (Chart 5).

Chinese leaders want to shift to a domestic-led economy driven by consumer spending and services, but whenever overall growth flags, they resort to the same old, same old infrastructure spending. So the result is even more excess capacity and more political and economic power for the inefficient State-Owned Enterprises. And officials merge them rather than allow them to fail. At the same time, private firms are starved for capital.

These actions not only reveal Beijing’s distrust of free markets but also its reluctance to address the trade-off between heavy industry pollution generation and economic growth. Meanwhile, consumer spending in China is almost off the chart compared to G-7 and even BRIC economies. It’s 34% of GDP in China vs. 59% in India, 60% in Italy and 68% in the U.S. (Chart 6).

Financial Pygmy

China is a giant in global manufacturing, but an amateurish pygmy on the worldwide financial stage. That was evident last summer when the government clumsily intervened to arrest the one-third drop in Chinese stocks after hyping equities as the way to recapitalize debt-laden SOEs (Chart 7).

Margin selling was prohibited, brokers and state-owned enterprises ordered to buy stocks and trading halted as share prices plummeted. More recently, institutions are only allowed to sell 1% of their stock positions, and then after three weeks notice. As scared investors traded yuan for dollars to ship overseas (Chart 8), Chinese foreign currency reserves fell $600 billion since last August to $3.3 trillion at year’s end. The removal of those yuan also shrinks the domestic money supply.

Then followed currency devaluation as China attempts to spur exports to revive economic growth, which is probably running only half the official 6.9% rate (Chart 1). Additional devaluation is likely but more subtly to avoid further massive flight from the yuan (Chart 8). Export subsidies, internal devaluation through wage and price cuts, and a shift from the dollar to a trade-weighted basket of currencies are all active possibilities. Notice (Chart 9) that since 2005, that the yuan has risen 26% vs. the dollar, but 40% against the trade weighted basket of currencies. This leaves China at a 14% currency disadvantage compared with her trading partners.

Chinese officials say they want to move toward free markets but still insist on top-down control a very difficult combination to manage. Following the market turmoil touched off by the 1.9% yuan devaluation last August 11, the central bank the People’s Bank of China said it would set the yuan's daily fix, around which it is allowed to fluctuate 2%, in line with the previous day's closing level.
That would give markets more sway over its value than the previous administered rates.

But with this new mechanism, official attempts to weaken the yuan to spur exports and economic growth in early January resulted in a stampede out of the currency. So the PBOC abandoned that step toward a free market for the yuan and ordered the government-controlled large banks to buy yuan to support the currency. The daily currency fix is back to being a black box. This reality was driven home by the recent statement by a senior Chinese economic official that China has plenty of ammunition to defeat attacks on her currency.
"Attempts to sell short the yuan will not succeed," he said. "The expectations of markets can be changed." Translation: We have ways!

Recently, China security regulators instituted a circuit-breaker system to protect investors from massive sell-offs by suspending trading after meaningful market losses. But reflecting disdain for stocks inherent volatility, they set the collar too narrow, at only 7%.

So it backfired after the limit was hit twice in the system’s first four days and was suspended on January 7, only 29 minutes into the trading day. Skittish retail investors that dominate the Chinese market dumped stocks in anticipation of an early market closing, and precipitated their expectation.
That was the shortest trading day in the Chinese stock market’s 25 years.

Not Dead

China won’t shrivel up and die, but will be a much less important actor on the global stage, as she shifts her orientation from commodity-munching exports, housing and infrastructure to consumer spending and services. The same was true of Japan starting in the early 1990s. Before that, many Americans though they’d soon be working for Japanese companies or run out of business by then.
The Japanese were buying Iowa farmland, Pebble Beach and Rockefeller Center with gay abandon. But at the end of the 1980s, Japan’s stock market bubble collapsed (Chart 10) as did overblown house prices (Chart 11), and the economy fell into the still-ongoing era of tiny 1.1% real GDP growth and deflation (Chart 12).

Similarly, Chinese stocks went off the cliff last summer (Chart 7) and residential housing activity has collapsed (Chart 13). And just as Japan’s delay in cleaning up the busted zombie banks in the 1990s and 2000s contributed to business malaise, China’s delay in restructuring the SOEs will likely have similar repercussions.

Furthermore, China has yet to address the trade-off between pollution and economic growth that Japan did earlier. We remember being in Tokyo in the 1980s when pollution was so thick that even on cloudless days, you still couldn’t see the sun.

Another parallel that’s slowing economic growth, in both China and Japan, is the declining work force. Population in Japan is actually falling (Chart 14) as the sub-replacement fertility rate combines with the longest G-7 life expectancy (Chart 15). When the effects of no legal immigration into Japan are included, the proportion of the total population of working-age is headed for the lowest level among major countries (Chart 16).

Old Before Rich

In China, the earlier one child per couple policy is slashing the number of prime new labor force entrants, the 15-to-24-year-olds (Chart 17), while the supply of rural labor to move to cities and man factories has run out. Unlike Japan, however, China is getting old before it gets rich.

The earlier massive buying of foreign assets by Japan was aimed in part at securing raw materials for her manufacturing juggernaut and markets for its output. In retrospect, however, it was also due to a dearth of growth-spurring investment opportunities at home. Ditto for China, which is now buying foreign real estate and other assets in huge quantities.

We keep extensive files of newspaper clippings and other information to help in writing our own reports. In the 1980s, the Japan files were measured in feet but our China files took only an inch or two. Today, it’s the reverse. Still, as shock-and-awe over China recedes in future years, along with China’s significance on the world stage, we expect our files on China to shrink back to Japan’s size.

A Federal Reserve Oblivious to Its Effect on Financial Markets

The Federal Open Market Committee last month didn’t even mention risk from persistent low rates.

By Martin Feldstein

A Federal Reserve Oblivious to Its Effect on Financial Markets

The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy. While chaos in the Chinese stock market may have been the triggering event, it was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished.

The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.

The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment.

But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability.

Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets. Instead the FOMC stressed that the federal-funds rate will creep up very slowly and remain below its equilibrium value even after the economy has achieved full employment and the Fed’s target rate of inflation.

Fed officials say that macroprudential policies should be used to prevent financial instability.

But there are few such policies in the U.S. beyond the increased capital requirements for the commercial banks. Nothing has been done to limit the loan-to-value ratios of residential mortgages or the leverage in commercial real-estate investments. Moreover, the commercial banks supervised by the Fed represent only about one third of the total capital market. The Fed has no ability, for example, to reduce risks in the shadow banking or insurance industries.

The Dodd-Frank law imposed restrictions on bank portfolios and increased banks’ capital requirements, which have created new problems by reducing liquidity in financial markets.

When bond investors and bond mutual funds look to sell, there may be no ready buyers to prevent sharp falls in bond prices. The resulting rise in long-term interest rates could then reduce equity prices as well.

Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly in the next two years. The December FOMC minutes show that members expect to have a negative real federal-funds interest rate until sometime in 2017, much too low for an economy already at full employment. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates.

The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next.

Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock.

The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.

Getting Technical

Market Correction Could Become a Full-On Bear

Technical indicators such as support levels and market breadth suggest it is nearly time to hunker down.

By Michael Kahn     

The terms “correction territory” and “bear market territory” really irk technical analysts. Who determined that a correction begins with a 10% decline and a bear market begins when a decline crosses the 20% threshold? And what good are those labels since serious losses have already been incurred?

I consider there to be two indicators that tell us when a bear market has begun. The first is when the benchmark index violates both long-term trendlines and key support levels. In November, I discussed here that the charts looked remarkably similar to those seen at the last market top in 2007. I followed that up in December showing the same condition, complete with confirming technical indicators, at the 2000 peak.

At both of those peaks, the major trendline drawn from the start of each bull market was clearly broken to the downside. That is the case today for the Standard & Poor’s 500 (see Chart 1). The trendline from 2009 is broken and the October rally successfully tested that breakdown. Part one – the trend break – is in play.

Chart 1

Standard & Poor’s 500

Part two – the support break – will occur if and when the index drops below its August low of 1867, to the nearest penny. With the index closing at 1890 Wednesday afternoon, it doesn’t have far to go.

The important point to make is that it will be about 11.5% below the last peak, seen in November, and more than 12% below the all-time high, set in May.

The second condition needed for a bear market is confirmation in the broad market. After all, the benchmark S&P 500, while tracking about 80% of the country’s market value, only looks at about 8% of the 6,000 stocks trading on the New York Stock Exchange and Nasdaq combined.

And that does not count penny stocks trading over-the-counter on the pink sheets and bulletin board.

Admittedly, this condition is subjective. There is no real research on what percentage of stocks needs to be falling, for how long and how much they need to lose. Even if we slap an arbitrary figure of 50% for the percentage of stocks falling and use the irksome 10% price decline threshold, it is easy to see how this condition has been met in today’s market.

Just take a look at the NYSE advance-decline line (see Chart 2). It peaked in April of last year.

And the Nasdaq advance-decline peaked in March 2014, although to be fair this indicator has a natural downward bias. The Nasdaq is home to some highly speculative companies that are more prone to failure.

Chart 2

NYSE Advance-Decline

The percent of NYSE stocks trading above their 200-day moving averages has been less than 50% since June. Think about that. More than half the issues on the NYSE have been below this key average for more than six months. And the NYSE composite index itself has been in decline since May, telling us that the average stock is already in a bear market despite the fact that the NYSE composite itself is “only” down 15% since then.

For me, almost everything is in place for the third cyclical bear market in the 21st century. And that also follows the road map of the 18-year secular market cycle I’ve seen in place since a century ago. If that is a correct assessment, then 2016 is year 16 in the secular bear market that began when the technology bubble burst in 2000.

A secular or long-term bear market can contain several cyclical or short-term bull and bear cycles. The 1970s is the last great example of a secular bear. And the 1982-2000 rally was the last great secular bull.

Some analysts say that a secular bull market began in 2013 when the S&P 500 breached the highs of 2000 and 2007, but I disagree. That said, I have no evidence that any coming cyclical bear market will be as severe as the prior bears or last as long. To me, a 16-year secular bear market is close enough to satisfy the requirement of the “average” 18-year cycle.

The bottom line is that the last straw will likely be breakdowns by the big-cap S&P 500, Nasdaq and Dow Jones Industrial Average below their summertime lows. At that point, it will be hard to argue for anything other than a significantly lower market later this year.

The Return of Public Investment

Dani Rodrik

Modern conveyor belt for pedestrians

CAMBRIDGE – The idea that public investment in infrastructure – roads, dams, power plants, and so forth – is an indispensable driver of economic growth has always held powerful sway over the minds of policymakers in poor countries. It also lay behind early development assistance programs following World War II, when the World Bank and bilateral donors funneled resources to newly independent countries to finance large-scale projects. And it motivates the new China-led Asian Infrastructure Investment Bank (AIIB), which aims to fill the region’s supposed $8 trillion infrastructure gap.
But this kind of public-investment-driven growth model – often derisively called “capital fundamentalism” – has long been out of fashion among development experts. Since the 1970s, economists have been advising policymakers to de-emphasize the public sector, physical capital, and infrastructure, and to prioritize private markets, human capital (skills and training), and reforms in governance and institutions. From all appearances, development strategies have been transformed wholesale as a result.
It may be time to reconsider that change. If one looks at the countries that, despite strengthening global economic headwinds, are still growing very rapidly, one will find public investment is doing a lot of the work.
In Africa, Ethiopia is the most astounding success story of the last decade. Its economy has grown at an average annual rate exceeding 10% since 2004, which has translated into significant poverty reduction and improved health outcomes. The country is resource-poor and did not benefit from commodity booms, unlike many of its continental peers. Nor did economic liberalization and structural reforms of the type typically recommended by the World Bank and other donors play much of a role.
Rapid growth was the result, instead, of a massive increase in public investment, from 5% of GDP in the early 1990s to 19% in 2011 – the third highest rate in the world. The Ethiopian government went on a spending spree, building roads, railways, power plants, and an agricultural extension system that significantly enhanced productivity in rural areas, where most of the poor reside. Expenditures were financed partly by foreign aid and partly by heterodox policies (such as financial repression) that channeled private saving to the government.
In India, rapid growth is also underpinned by a substantial increase in investment, which now stands at around one-third of GDP. Much of this increase has come from private sources, reflecting gradual relaxation of the shackles on the business sector since the early 1980s. But the public sector continues to play an important role. The government has had to step in as both private investment and total factor productivity growth have faltered in recent years.
These days, it is public infrastructure investment that helps maintain India’s growth momentum. “I think two sectors holding back the economy are private investments and exports,” says the government’s chief economic adviser, Arvind Subramanian. “That is why... public investment is going to fill in the gap.”
Turning to Latin America, Bolivia is one of the rare mineral exporters that has managed to avoid others’ fate in the current commodity-price downturn. Annual GDP growth is expected to remain above 4% in 2015, in a region where overall output is shrinking (by 0.3%, according to the International Monetary Fund’s latest projections). Much of that has to do with public investment, which President Evo Morales regards as the engine of the Bolivian economy. From 2005 to 2014, total public investment has more than doubled relative to national income, from 6% to 13%, and the government intends to push the ratio even higher in coming years.
We know that hikes in public investment, just like commodity booms, all too often end in tears.

The economic and social returns decline and money dries up, setting the stage for a debt crisis.

A recent IMF study finds that, after some early positive effects, most public-investment drives falter.
But much depends on local conditions. Public investment can enhance an economy’s productivity for a substantial period of time, even a decade or more, as it clearly has done in Ethiopia. It can also catalyze private investment, and there is some evidence that this has happened in India in recent years.
The potential benefits of public investment are not limited to developing countries. In fact, today it may be the advanced economies of North America and Western Europe that stand to gain the most from ramping up domestic public investment. In the aftermath of the great recession, there are many ways in which these economies could put additional public spending to good use: to increase demand and employment, restore crumbling infrastructure, and boost research and development, particularly in green technologies.
Such arguments are typically countered in policy debates by objections related to fiscal balance and macroeconomic stability. But public investment is different from other types of official outlays, such as expenditures on public-sector wages or social transfers. Public investment serves to accumulate assets, rather than consume them. So long as the return on those assets exceeds the cost of funds, public investment in fact strengthens the government’s balance sheet.
We do not know how the experiments in Ethiopia, India, or Bolivia will eventually turn out; so caution is warranted before one extrapolates from these to other cases. Nonetheless, all three are examples that other countries, including developed ones, should watch closely as they search for viable growth strategies in an increasingly hostile global economic environment.


Have the BRICs Hit a Wall? The Next Emerging Markets


Until recently, when people talked about “emerging markets,” they were referring to the BRIC economies: Brazil, Russia, India, and China. Undeniably, these countries have changed the face of global business over the past twenty years. Yet lately, the BRICs have been crumbling a bit, sparking many reports about their lackluster performance.

According to Trading Economics, Brazil’s GDP shrank 1.7% in the third quarter of 2015, “worse than market expectations,” and has had negative growth for over a year. The Russian economy did even worse, contracting 4.1% year-on-year. Even China’s seemingly unstoppable growth engine is slowing down. In October, The Wall Street Journal reported that China’s economic growth had fallen below 7% for the first time since 2009.  

What about India, which a 2015 Fortune article called “the lone BRIC country that’s worth holding on to?” “I would say India has many things going in its favor,” agrees Mauro Guillen, Wharton management professor and director of the Lauder Institute. “Right now, it’s the fastest-growing BRIC, and there’s some momentum there.” But he cautions that India has “a long list of things” it needs to accomplish, including reforms, opening up its economy and investing in infrastructure.

Meanwhile, one can hear the rumblings of new economies arising. For example, in September American cereal giant Kellogg announced a $450 million joint venture with Tolaram Africa Foods to create breakfast foods and snacks for the West African market. Johan Burger, director of the NTU-SBF Centre for African Studies at Singapore’s Nanyang Business School, calls the deal “a very clear indication that there are companies that have come to realize … Africa presents a lot more than meets the eye.”

Two years ago, Procter & Gamble announced a major move in Africa as well, investing $170 million to create a new manufacturing plant in South Africa. According to CNN, the plant will make products such as detergents and feminine hygiene goods to serve markets in southern and East Africa.

And in 2014, The Wall Street Journal reported that in a survey of multinational corporations, Nigeria, Argentina and Vietnam were the “frontier markets” in which these firms expressed the most interest.

What Are the Next Emerging Markets?

“Right now, some of the fastest-growing economies in the world are not the BRIC countries,” observes Guillen. “Clearly, the geography of growth for emerging markets in the world is shifting.”

Guillen divides the potential new markets into three waves. His likely candidates for the first wave are Vietnam, the Philippines and Bangladesh. He believes that these Southeast Asian countries will become important as exporters and as manufacturing hubs. “These are countries that are benefitting from the migration of manufacturing away from China.” Specifically, it is labor-intensive manufacturing such as clothes, electronics and toys, he says. Although what is driving the trend is low wages, “like China before them,” jobs are being created, and the region will eventually develop a significant consumer market, he predicts.

In Guillen’s view, the second wave will probably consist of sub-Saharan African nations — especially Nigeria and Kenya — which he characterizes as “growing very fast, but still under-developed…. You’re talking about several countries that will very soon have more than 100 million people.” (Nigeria itself currently stands at 178 million.) “If you get the economy growing there in a sustainable way, you’ll create a large middle-class market for consumer goods.”

Guillen notes that the keys to continued growth are different for these two groups of emerging market countries. “In the Asian case, what they need is competitiveness when it comes to exports. And for the African cases, what they need is more stability, more people moving from lower-productivity occupations to higher productivity.”

Beware the Commodities Curse

Guillen and Burger agree that a major stumbling block for many emerging markets is the so-called “resource curse” or “commodities curse.” The term refers to a country’s having abundant natural resources such as oil and minerals. Although these valuable substances are readily purchased by other nations, commodities prices can skyrocket or plummet, leading to an unstable economy.

Of Latin America’s current recession, Guillen comments that it was caused in part by these “cycles of boom and bust.” He adds: “And now with commodity prices so low … there’s no clear way in which they’re going to be able to recover again quickly.” Jean-Marie Péan, a partner advisor with Bain & Company Middle East, also recalls the period when Brazil’s iron ore, for instance, was “selling like hot cakes.” He observes, “Relying on one source of competitive advantage for your revenues and growth which you do not control is very risky.”

Africa, too, is rich in valuable commodities. According to Burger, the continent possesses $82 trillion in known resources such as oil, coal, gas, copper, platinum, diamonds and gold. Many countries there are “fairly comfortable exporting commodities and living off that.” How has Africa fared against the “resource curse?” Burger states that its economies have so far been “relatively resilient” to the sharp fall of international commodity prices. However, he predicts that the slowdown of the Chinese economy will soon have negative effects, especially on Nigeria and Angola which are major exporters of crude oil to China.

A Model for Emerging Markets?

“One day, they’re ‘emerging’; the next day, they’re neither here nor there, and five years later they’re again ‘emerging,’” Péan says of developing countries and our perceptions about them.

He questions the wisdom of making lists — as the press tends to do — of the top new markets, especially given the yo-yo effect of the commodities market.

Péan recommends focusing instead on long-term success factors. For him, the qualities of a true emerging market are embodied in a country like the United Arab Emirates (UAE). He compares it favorably to its neighbors: “Why is the UAE successful when Saudi Arabia is not, when Kuwait is not, when Bahrain is not?” he asks, also naming Nigeria, Libya and others in the region.

While acknowledging that the UAE does possess key commodities — it is the world’s 6th largest producer of oil, and a major producer of natural gas — he points out that about 75% of its GDP comes from non-oil sectors. “The UAE is one of the few emerging markets that has truly diversified its economy,” Péan says. “I consider [it] to be a country that has really been able to avoid the curse of a commodity — and that’s oil — that makes a country rich at times, but prevents people from working hard, from being innovative.”

He attributes the UAE’s success to its “visionary, stable leadership” above all, which he says is reflected in its founding. In 1971, seven independent emirates came together to form a state. In doing so they agreed to give up some of their individual sovereignty, a phenomenon that Péan calls “quite extraordinary.” He notes that the UAE’s leaders “created competitive advantages” including developing Dubai as a logistics hub with a large port, free zone and airport. It was also designed and promoted as a tourist destination, and as a favorable Middle East location for international companies.

Dubai continues to attract businesses because of its good infrastructure, utilities, legal environment and real estate, and the availability of quality education, according to Péan. He points out that the UAE, a relatively small country with a population of under 10 million, had a GDP of $402 billion in 2015 and a GDP growth of 4.6%.

Looking Toward Africa

Burger, like Guillen, names Southeast Asia as currently having the highest growth potential, and Africa as having the second-highest despite the lingering threat of its “resource curse.”

Nigeria, he says, is becoming a manufacturing hub for vehicle components for Toyota and Ford. Ethiopia is pursuing a strategy of becoming less dependent on agriculture. Citing a Standard Bank of South Africa report, Burger says that in the 11 countries which represent 50% of Africa’s GDP, there are 15 million households in the middle class. The number is predicted to grow to 42 million by 2030.

“The Kelloggs, Procter & Gambles and Walmarts of the world are targeting Africa in a meaningful way to tap into this massive opportunity,” says Burger.

However, Africa’s “massive opportunity” is paired with massive challenges, according to Burger. He describes security risks and political instability in many areas including Nigeria, Somalia, the eastern DRC, Burundi, south Sudan, Mali, the Central African Republic, and Libya. In addition to these problems, Burger finds many African presidents deficient in leadership, noting that several are currently trying to stay in office against their country’s constitutional limits. “You’re sitting with leaders that somehow don’t understand that they represent the face of Africa, and what they do or don’t do impacts their countries.”

Africa’s infrastructure problems are serious, too, including insufficient access to water and electricity. But Burger points out that these issues can be seen as opportunities by investors and entrepreneurs. For example, the popular mobile payment system in Africa called M-Pesa has inspired another business called M-Kopa. With M-Kopa, people in rural areas can wirelessly pay a very small monthly fee to have solar lighting and cell phone charging in their homes.

“Countries and companies from abroad can have a look at what’s going on in Africa and invest, and get a good return on their investment at the same time that they’re helping Africa solve their infrastructure problems,” says Burger.

While the emerging markets in Southeast Asia, Africa, the Middle East, Latin America and elsewhere can do much to set themselves on the right course, some things are out of their hands, according to Guillen. Developing countries are dependent on established economies doing well so they will reliably buy the emerging countries’ manufactured goods and commodities.

“Another factor is what’s going to happen with the dollar,” says Guillen. In December, the U.S. Federal Reserve decided to raise interest rates for the first time since the global financial crisis.

“It’s going to produce a lot of changes in the world in terms of capital flows,” he noted.

The FBI’s Worst Nightmare

Justin Spittler

The bloodbath in oil continues.

Yesterday, oil dipped below $30/barrel for the first time since December 2003. Just 18 months ago, a barrel of oil cost $106.77.

Oil is off to a horrible start in 2016. The price of oil has fallen every day this year, shocking many Wall Street analysts who called a bottom in the $35-40 range.

On Monday, The Wall Street Journal reported:

Morgan Stanley issued a report this week describing an environment “worse than 1986” for energy prices and producers, referring to the last big oil bust that lasted for years. The current downturn is now deeper and longer than each of the five oil price crashes since 1970, said Martijn Rats, an analyst at the bank.

Global investment banks Goldman Sachs (GS) and Citigroup (C) now expect oil to drop below $30.

And Morgan Stanley (MS) warned earlier this week that oil could fall as low as $20 a barrel.

• The world has too much oil…

New technologies such as “fracking” have unlocked huge reserves of oil. Since 2008, U.S. oil output has jumped 74%. And last spring, U.S. production reached its highest level since the 1970s.

The Organization of the Petroleum Exporting Countries (OPEC), a cartel of major oil-producing countries, is also pumping at record levels. OPEC produces 40% of the world’s oil.

• Low oil prices have crushed U.S. oil companies…

Shares of Exxon Mobil (XOM), the largest U.S. oil company, have fallen 26% since June 2014. Chevron (CVX), the second-largest U.S. oil company, is down 37%.

The companies that sell equipment to the oil industry are down big, too. Schlumberger (SLB) and Halliburton (HAL), the two largest oil services companies, are down 39% and 55% since June 2014.

• Oil companies have drastically cut spending…

The global oil industry has already cut 250,000 jobs. And more job cuts are likely coming. Energy consulting company Wood Mackenzie estimates that $1.5 trillion worth of oil projects in North America can’t make money even at $50 oil.

• Many U.S. oil and gas producers can’t pay their bills…

The Wall Street Journal explained on Monday:

As many as a third of American oil-and-gas producers could tip toward bankruptcy and restructuring by mid-2017, according to Wolfe Research. Survival, for some, would be possible if oil rebounded to at least $50, according to analysts...

More than 30 small companies that collectively owe in excess of $13 billion have already filed for bankruptcy protection so far during this downturn…

• U.S. oil companies borrowed nearly $200 billion between 2010 and 2014…

Industry debt levels jumped by 55% during the “boom times” when oil was over $100/barrel.

With oil at $30 today, many companies can’t pay their debts. According to The Wall Street Journal, North American oil and gas producers are losing $2 billion each week due to low energy prices.

Like most commodities, oil is cyclical. It goes through big booms and busts. Right now, the industry is going through its worst downturn in decades.

Eventually, oil will bottom out. We’ll get an amazing opportunity to buy the best oil stocks at bargain prices.

But for now, oil is still in a sharp downtrend. The world simply has too much oil. We recommend avoiding oil stocks for now.

• Louis James, editor of International Speculator, has a way to profit from the oil…

Louis is our resource investing guru. His specialty is finding small miners with the potential to return five or ten times your initial investment. Today, Louis thinks the plunge in oil is creating an opportunity to profit.

But Louis isn’t buying oil companies. He likes airlines, as he explained in the December issue of International Speculator...

The airline business is very sensitive to oil prices. Airline stocks often move up when oil drops…

Going long on a great, profitable airline with lots of growth on tap is a virtual way to short oil, without risk of being forced to cover if oil rises.

Jet fuel, which is made from oil, is a major operating expense of airlines. From the third quarter of 2013 to the third quarter of 2014, revenues for Louis’ favorite airline stock jumped 17%. And its quarterly profits more than doubled.

• On December 23, we warned you of the biggest threat to your wealth in 2016…

At Casey Research, one of our key goals is to warn you about anything that can affect your finances.

That’s why we investigated a serious danger that no one else is talking about...

This threat is far more dangerous than a stock market collapse, a severe economic depression, or even a currency crisis. And it’s much more likely to happen.

We’re talking about a financial terrorist attack…an attack that could wipe out the money and stocks you own in an instant.

Think about it…if you have $50,000 in the bank, what do you really have? These days, it’s certainly not a claim to hard assets like gold or silver. And it’s certainly not real cash in a vault.

What you have are digital bytes in a computer. A cyberattack could erase these in seconds…causing your money and stocks to vanish.

• Hundreds of cyberattacks have happened in the U.S....

Here are a few:

➢ In 2013, a team of Russian hackers stole $1 billion from more than 100 U.S. banks.

➢ In April 2015, hackers broke into President Obama’s personal email.

➢ In May 2015, hackers breached the Internal Revenue Service database and lifted information from 300,000 private tax returns.

Hackers have also broken into “secure” databases of government agencies. The Federal Reserve, Department of Defense, and CIA have all been hacked.

• Recently, we learned of a cyberattack on America’s infrastructure…

Iranian hackers infiltrated a dam in Rye, New York. Rye is a small town located just 20 miles northeast of Manhattan.

The cyberattack remains classified. We don’t know all the details. But, according to The Wall Street Journal, the hackers gained access to the dam’s control system.

• A major cyberattack in the U.S. is inevitable…

Cybersecurity expert Mary Galligan recently told Bloomberg News that a U.S. cyberattack is “the FBI’s worst nightmare.”

Unfortunately, it’s a matter of when, not if, a major financial terrorist attack will happen. It’s a no-brainer for America’s enemies to launch a cyberattack against our financial system…

Think about it…funding and organizing a large-scale terrorist attack takes months or years of planning. It can require coordinating dozens of people. It can cost an enormous amount of money.

Or you could take a handful of very smart people, get them a few computers, and launch a major that could shut down entire industries, cause a stock market crash, and cause an explosion of inner-city violence.

• We recommend moving a significant amount of money outside the digital financial system…

Keep enough paper cash to cover three to six months’ worth of living expenses. You can store your cash in a safe or public storage unit. You could even bury it in a waterproof container in your backyard.

Some might call us crazy for recommending this. But remember, America’s financial system is almost entirely digital. Your money and stocks are just digital entries. They could vanish in a cyberattack.

Holding a significant amount of physical cash will allow you to take care of yourself and your family should the “unthinkable” happen.

Chart of the Day

Louis’ favorite airline stock is racing higher…

Today’s chart shows the performance of Louis’ favorite airline stock since oil prices peaked in June 2014. This stock is up 61% since then. The S&P 500 is down 1% over the same period.

As long as oil stays low, this company should continue to earn big profits. And, as we mentioned earlier, the global economy still has far more oil than it needs.

Bull Economy 2

by: The Nattering Naybob


- Discussion of the potential effects on equity, bond, commodity, capital and asset markets regarding:

- Inventories to sales; imports and exports; and manufacturing new orders.

- Industrial production; and industrial production and S&P 500.

- Real GDP; and final summation.

Continuing our journey from Bull Economy Part 1, we ferret out more "robust bull" economic indicators.
From Martin at Macronomics: "Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you. From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd," offers a good contrarian punt, given the "weaker" outlook as of late of the US economy."
Rising Inventories to Sales?
Above, note since 2011, inventory to sales ratios have spiked from 1.25% to 1.375%, demonstrating that inventory is backing up, not due to overproduction, but due to declining demand. Declining real wages, income and spending is the cause. Lacking sales, restock orders and production will decline, leading to layoffs and further declines in income and spending, resulting in further contraction in imports and exports.
Decline in Imports and Exports?
Above, note since Q2 2010, YoY growth in imports of all goods and services has contracted from 26% to -3.5%.
Above, note since Q2 2010, YoY growth in export of all goods and services has contracted from 19% to -5%. In both cases, food and petroleum are not excluded, so that is everything coming in and going out, which means the contraction is not limited to US demand, and extends to global demand, as industrial production contracts.
Negative Manufacturing New Orders
Above, note since April 2010, YoY % change in new factory orders contracting 125% from 22.5% to -4.22%. This combined with the inventory to sales build paints a robust picture of a collapsing economy.
Industrial Production Swoon?
Above, note that since 1919, the majority of times YOY growth in industrial production has gone negative, a recession has ensued.
Above, note since 1950 (modern times), when YOY industrial production growth has gone negative, a recession has ensued 10 out of 14 times. Meh, that's only batting .710...
Recessionary Industrial Production and S&P 500?
Above, note, since 1950, when YOY industrial production growth has gone negative and the S&P 500 has gone below its 12-month MA, a recession has ensued 10 out of 10 times, batting 1.000. That critical threshold was just breached for an 11th time. Get ready for a recession?
Decelerating Real GDP?
"The deceleration in real GDP in the third quarter primarily reflected a downturn in private inventory investment and decelerations in exports, in PCE, in nonresidential fixed investment, and in state and local government spending that were partly offset by a deceleration in imports." - Q3 2015 GDP Report
The deceleration in Q3 2015 real GDP to +2% reflected less investment in idle inventory, decelerating exports, partly offset by a deceleration in imports. The only accident there is the math.
Were it not for the GDP accounting chicanery of excess inventory and regulatory healthcare insurance payments being counted as a positive, and the phantom accounting of owner occupied "rent" equivalent as productive economic activity (the largest single component of services GDP and total GDP), advertised GDP would already have been negative for a majority of quarters since the crisis, already putting us in a recession.
In closing, let's add it all up from Part 1:
  • Declining average wage growth 1% below pre crisis levels;
  • since 1999, real median household income -7.2%;
  • 1.8M out of the labor force; 33% above pre-crisis levels;
  • working part time involuntarily +33%; 2007: 4.6M; 2015: 6M;
  • underemployed levels at 10%; 25% above pre-crisis levels;
  • long-term jobless 26.3% vs. 16.1% avg. 20-year pre crisis;
  • Dec. 2015 employment: Contractions in labor force, participation rate and employed. Prime earning age 25-54 years -335K;
  • last three years, savings rate declined 50% from 11% to 5.5%;
  • since July 2010, total consumer credit +$1T or 41%;
  • since mid-2014, with a -36% YoY decline in gasoline prices, YoY total retail sales growth -70% including and -58% ex-gas; and
  • advertised average +270K jobs per month in Q415, yet Q4 GDP est. at anemic 0.8%.
And Part 2:
  • Since 2011, inventory to sales spiked from 1.25% to 1.375%;
  • since Q2 2010, imports YoY growth 26% to -3.5%;
  • since Q2 2010, exports YoY growth 19% to -5%;
  • since 04/2010, new factory order YoY growth 125% to negative; and
  • since 1950, when YoY industrial production growth has gone negative and S&P 500 below its 12-month MA, there has been a recession 10 out of 10 times, and this just happened again.
None of the above is happenstance. In the creation of a "burgeoning and robust economic" or "robust bull" narrative, certain simple facts have been omitted, misrepresented and neglected.
Income is either spent on consumption, saved or invested, and one's spending is another's income. Savings and investment are future consumption or spending. The key word is FUTURE, as that discretionary income is not spent on current consumption. All the money sequestered in bank reserves and financialism (and not invested in PCE or durable economic endeavor) is not spent in the present.
If the numbers are to be believed, with real median incomes falling an advertised 7.2% since 1999, this leaves only disposable income and/or incurred debt to fuel consumption spending and provide the income of others; and with that failing, no economic foundation or future to fall back on.
From Jeffery P. Snider: "When looking back at that catalog of increasing financial and economic carnage, the pattern should be immediately recognizable to economists as "shrinking" or "tightening" money supply; all the symptoms are there and apparent. It is the classic replay of that condition, as reductions in money supply lead to monetary deflation (commodities and certain markets, including stocks that have, for almost a year and a half, gone, at best, nowhere, and for a great many places have already sunk quite significantly) and depressive economic conditions. To the orthodox economist, however, that just cannot be since ZIRP and QE are both "stimulative" while the latter is sold as "money printing."
Despite popular belief and its rhetoric, it is readily apparent that central banks have been engaging in contractionary monetary policies. A contraction or tightening of monetary conditions reduces growth in spending, revenue, production and jobs and income. With the attendant side effects of petro and eurodollar contraction or "dollar" squeeze, this is a self reinforcing loop.

"But even as the macro picture is hopelessly obscured by the mischievous tinkering of bureaucrats, the county-level data reveals the dismal truth: according to a new study by the National Association of Counties, 93% of America's counties have not yet recovered from the recession." - Zero Hedge
All the signs ahead are flashing danger red for an imminent "recession," and given the evidence, there is doubt that any meaningful recovery from the prior crisis has occurred.

Despite the "robust bull" media narrative, we may already be mired in a long running recession, which is potentially about to get much, much worse. I do believe they call it a depression? TBD.
Since the market potential is broad in both scope and scale, our conclusion could not be more specific than the discussion already had. Again, more grief in the dollar "short" or squeeze and its associated liquidity issues, with the potential to adversely affect capital, commodity, equity, bond and asset markets. Will it happen? TBD, and forewarned is forearmed.
In brief, this is the eighth in a series of thematically related missives which will attempt to identify the macroeconomic forces with potential to adversely affect capital, commodity, equity, bond and asset markets.
I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage, and insistence in not masticating and spoon feeding the baby ducks, as in learning the hard way, by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard.
As for how all of the above ties into the potential and partial list of market plays below... the market as a whole could be influenced, and this would tie into any list of investments or assets.

Those listed below happen to influence the indices more than most.
Would like to thank you folks fer kindly droppin in. You're all invited back again to this locality. To have a heapin helpin of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

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