Yesterday, we drew your attention to the massive common sense disconnect between what’s happening in US equity markets and the economy. Maybe Mr Market was listening; the major US stock indexes suffered their biggest loss in weeks. The Dow shed 1%. The S&P 500 lost 1.3%. AIG also took lumps – the failed insurer dropped 13%.
“All eyes on Fed statement” read the headlines. Investors are waiting to see what the Fed’s policy announcement tells them about the health of the economy. That’s the official story anyway. More likely, investors are waiting to see if the Fed’s easy money spigots will continue to pump liquidity into the ailing US economy. As long as they do, the logic goes, stocks will rise.
We’re back to Occam’s razor, dear reader. William of Occam was a fourteenth century English Franciscan friar who came up with the logical principle that the simplest answer is usually the right one. (“Of several acceptable explanations for a phenomenon, the simplest is preferable, provided that it takes all circumstances into account.”)
Stocks are booming along with commodities such as oil. But at the same time many countries are seeing the worst declines in GDP in generations. And in the US unemployment, corporate profits and bank lending are all pushing historic lows. So what gives?
Using the principle of Occam’s razor, the “green shoots” hypothesis (that the worst is over for the economy and that we are now well on our way to a recovery) is far too complex and questionable to be considered the simplest explanation. Instead, the answer to our puzzle is likely something a lot simpler: money.
As Ian Campbell pointed out recently in Britain’s The Daily Telegraph: “In their anti-deflationary fervour, central banks may be creating more money than depressed economies require” and this excess liquidity “may be feeding a new series of stock, commodity, property and bond bubbles.”
This may seem strange. After all, the US is experiencing a contraction in credit, a massive deflation in real estate and record unemployment. But, again, the concept is simple. This from Campbell (emphasis added):
[T]he very decline in GDP may be causing the excess money problem. Economic activity has contracted sharply and consumer prices are deflating, so a constant stock of money buys more, in real terms, than it did a year ago. This deflationary money adjustment may be generating excess liquidity - and feeding buoyant markets.
Sebastian Becker, an economist with Deutsche Bank in Frankfurt, defines excess liquidity as money supply that is surplus to the needs of real economic activity, and therefore free to be invested in financial assets. Becker combines monetary growth figures for the US, Japan, the euro zone, the UK and Canada and finds excess liquidity – measured as a rising stock of money to GDP – in these economies is now being created more rapidly than in the late 1990s stock-market bubble, or during the subsequent house price boom.
What might this excess of cash lead to? This is where the plot thickens. Because it’s unlikely that all the funny money created by the world’s busy central banks will show up in consumer prices. Weak demand, a giant industrial capacity overhang and scary levels of unemployment will keep a lid on consumer price indexes.
But money must find a home. And the money that is surplus to the needs of real economic activity will wind up in financial assets. That means asset price inflation (the kind of stuff we’re seeing now in commodities and equities markets) and, ultimately, in financial bubbles… bubbles that will sooner or later burst, inflicting further shocks to the already teetering world economy.
Nowhere is this pattern more noticeable than in China. The M2 money supply growth rate in China is running at 28.5% right now. And it doesn’t take a genius to find out where all that extra money is flowing to. The Shanghai stock market is up a staggering 80% so far this year and China’s real estate market is up 60% this year. The problem is Chinese exports – the backbone of the country’s economy – are down 23% since this time last year.
“The Chinese government realizes,” says Dan Amoss, editor of Strategic Short Report (hat tip, Agora Financial’s 5 Min. Forecast), “that its stimulus spending and pressure on banks to expand lending is inflating a massive bubble in the Chinese stock and property markets. The problem with unsustainable economy activity is, of course, that it must eventually end.”
But for now, the Chinese have much more room to borrow and inflate than the United States (which has spent the last few decades doing so). Eventually, the market will cut them off. The end will not be pretty, and at some point in the future, shorting Chinese stocks may be one of the best short-selling opportunities in history.
In the meantime, it makes no sense to bet against China. The Communist government has proven very efficient at stealing the resources of its people (via inflation and taxation) and channeling them into whatever infrastructure project they deem necessary.
This process could end next week or next year.
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