Andy Xie: New Bubble Threatens a V-Shaped Rebound

[WildspitzE]

Another piece by Andy, following his China piece.

http://english.caijing.com.cn/2009-08-20/110227359.html

I know many of you are fans of Schumpeter ;)

"In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.

The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.

Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so."

A double dip or "W" (for bart, as he's the first on record here that I can recall calling for one, which I think many of us agree):

"This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn't believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.

Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down -- and keep them down for a long time."

[pianodoctor]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

I notice that in the previous article Mr Xie (the subject of
Debate: Are China’s stock and property markets dual bubbles that are about to pop? - Eric Janszen) called for the downturn Q4 2009. Now he is just saying "next year".

I was thinking about using a bearish ETF to short the market, but I wonder how much certainty there is that shorting at today's prices is a good idea? Could the market run up a lot more yet, and when it does fall, not go much below today's price?

Concerning China and U.S. stocks, will EJ be giving us more of those "time to short the market" warnings (should that time come), or should we consider the recent commentary to be our warning? (For instance EJ calling a "top" in the article analyzing Andy Xie's work).

Comments from Fred or EJ on the iTulip position, or others welcomed.

[ASH]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

Comments from Fred or EJ on the iTulip position, or others welcomed.

See this comment from FRED, posted in the select section.

[Starving Steve]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

I have this feeeeeeeeeeeling, just a feeeeeeeeeeling that $200 oil may be out there in the not too distant future. And when the Fed raises interest rates, they will go up just a little and far too late. The whole Keynsian house of cards will come tumbling down, but this is just a feeeeeeeeeeeeling that I have.

After all, in my pea-brain, I can not imagine Bernanke raising interest rates to 8 or 9% when inflation rises to 5%. Imagine what the inflation would be when oil spikes again?

And to stop the oil spike, Bernanke would have to kill the recovery NOW. But he won't.

My pants are wet laughing at what may be just about to unfold..... And then the windmills and solar power on top of all this!

[jk]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

i think this is a very interesting, worthwhile article. however, it is a bit of a slog, so i've reproduced it below, highlighting what i think is especially important. btw, it is entirely consistent with itulip's analysis and projections.

Andy Xie: New Bubble Threatens a V-Shaped Rebound



A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.

By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
Some analysts are expecting China to repeat Japan's bubble experience, which occurred in the late 1980s. At that time, Japan's export-led growth model was stymied by a doubling of its currency value after the Plaza Accord. It tolerated a massive asset bubble to stimulate domestic demand and stabilize its economy. China's export-led model is facing a rising savings rate and declining U.S. demand for its exports. Asset inflation could be a way out in the short term.
China doesn't need to repeat Japan's experience. One reason is that the circumstances are not the same. First, Japan was a developed country when its bubble started getting out of control in 1985. It couldn't divert its vast savings into infrastructure investment. But today, China's national urbanization project still has up to 30 percentage points to go. If the right mechanism can be implemented, China could divert more savings into urbanization.
Second, China can decrease its savings rate substantially through structural reforms. Half of China's gross savings are in the public sector. The government and state-owned enterprises should decrease revenue-raising and increase borrowing to finance investments. For example, China's high property prices are based on the investment-fund revenue needs of local governments. If China's property prices were cut by one-third, the national savings rate could decrease by two to three percentage points.
Third, the Chinese government could give its shares in listed state-owned enterprises to the household sector. The subsequent increase in household wealth could lower the national savings rate by three to four percentage points.
China's exports are down by roughly one-fifth. It needs the national savings rate to fall by about six percentage points for the economy to function normally. Otherwise, the economy will experience either a recession or a bubble. And the purpose of a bubble, as mentioned, would be to temporarily decrease the savings rate.
This discussion may seem to digress from the analysis of sustainability in the current economic recovery. But it brings out two points: The old equilibrium cannot be restored, and many structural barriers stand in the way of a new equilibrium. The current recovery is based on a temporary and unstable equilibrium in which the United States slows the rise of its national savings rate by increasing the fiscal deficit, and China lowers its savings surplus by boosting government spending and inflating an assets bubble.
This temporary equilibrium depends on government action. It does not have a market foundation that would support sustained and rapid growth. Nevertheless, improving economic data will excite financial markets.
China's stock market is cooling because the Chinese government is jawboning it down, based on fears of a big bubble downside. And the economy is beginning to slow. Markets outside China will likely do well for the next two months; diverging trends reflect that China's market recovered four months before others, and adjusts before others as well.
Financial markets will turn down again when investors realize that the global economy will have a second dip in 2010, and that the U.S. Federal Reserve will raise interest rates soon. The turning point may well come sometime in the fourth quarter. By then, it would become apparent that China has slowed. U.S. unemployment will not have improved and, hence, its consumption will remain stagnant. And production data that's pushing expectations now will cool after the inventory cycle runs its course.
Most analysts would argue that central banks won't raise interest rates before the recovery is on solid ground. The problem, though, is that fiscal stimulus can't resolve structural problems blocking a sustained recovery. Liquidity is the wrong medicine for the global economy right now. Overusing it encourages its side effect -- inflation.
Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.
Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.
Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don't respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.
If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don't think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.
This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn't believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.
Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down -- and keep them down for a long time.

[touchring]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

I notice that in the previous article Mr Xie (the subject of
Debate: Are China’s stock and property markets dual bubbles that are about to pop? - Eric Janszen) called for the downturn Q4 2009. Now he is just saying "next year".

I was thinking about using a bearish ETF to short the market, but I wonder how much certainty there is that shorting at today's prices is a good idea? Could the market run up a lot more yet, and when it does fall, not go much below today's price?
.

the chinese stock index has fallen a lot since the start of August, you just can't create a sustainable market using loans when so many chinese public companies are going insolvent - http://finance.yahoo.com/q/bc?s=0000...=on&z=m&q=l&c=

[WildspitzE]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

Thanks JK, it was a bit of a PITA in its composition - it was probably not written in english to begin with, so, it's not so bad in that context.

Although I agree that he does point out several things that are in line with this site's ideas/forecasts, etc. Others are not so much. Initial ones that come to mind are highlighted in red (in the quote below):

i think this is a very interesting, worthwhile article. however, it is a bit of a slog, so i've reproduced it below, highlighting what i think is especially important. btw, it is entirely consistent with itulip's analysis and projections.

Andy Xie: New Bubble Threatens a V-Shaped Rebound



A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.

By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
Some analysts are expecting China to repeat Japan's bubble experience, which occurred in the late 1980s. At that time, Japan's export-led growth model was stymied by a doubling of its currency value after the Plaza Accord. It tolerated a massive asset bubble to stimulate domestic demand and stabilize its economy. China's export-led model is facing a rising savings rate and declining U.S. demand for its exports. Asset inflation could be a way out in the short term.
China doesn't need to repeat Japan's experience. One reason is that the circumstances are not the same. First, Japan was a developed country when its bubble started getting out of control in 1985. It couldn't divert its vast savings into infrastructure investment. But today, China's national urbanization project still has up to 30 percentage points to go. If the right mechanism can be implemented, China could divert more savings into urbanization. [Wildspitze: I may have missed this view on itulip.]
Second, China can decrease its savings rate substantially through structural reforms. Half of China's gross savings are in the public sector. The government and state-owned enterprises should decrease revenue-raising and increase borrowing to finance investments. For example, China's high property prices are based on the investment-fund revenue needs of local governments. If China's property prices were cut by one-third, the national savings rate could decrease by two to three percentage points.
Third, the Chinese government could give its shares in listed state-owned enterprises to the household sector. The subsequent increase in household wealth could lower the national savings rate by three to four percentage points.
China's exports are down by roughly one-fifth. It needs the national savings rate to fall by about six percentage points for the economy to function normally. Otherwise, the economy will experience either a recession or a bubble. And the purpose of a bubble, as mentioned, would be to temporarily decrease the savings rate.
This discussion may seem to digress from the analysis of sustainability in the current economic recovery. But it brings out two points: The old equilibrium cannot be restored, and many structural barriers stand in the way of a new equilibrium. The current recovery is based on a temporary and unstable equilibrium in which the United States slows the rise of its national savings rate by increasing the fiscal deficit, and China lowers its savings surplus by boosting government spending and inflating an assets bubble.
This temporary equilibrium depends on government action. It does not have a market foundation that would support sustained and rapid growth. Nevertheless, improving economic data will excite financial markets.
China's stock market is cooling because the Chinese government is jawboning it down, based on fears of a big bubble downside. And the economy is beginning to slow. Markets outside China will likely do well for the next two months; diverging trends reflect that China's market recovered four months before others, and adjusts before others as well.
Financial markets will turn down again when investors realize that the global economy will have a second dip in 2010, and that the U.S. Federal Reserve will raise interest rates soon. The turning point may well come sometime in the fourth quarter. By then, it would become apparent that China has slowed. U.S. unemployment will not have improved and, hence, its consumption will remain stagnant. And production data that's pushing expectations now will cool after the inventory cycle runs its course.
Most analysts would argue that central banks won't raise interest rates before the recovery is on solid ground. The problem, though, is that fiscal stimulus can't resolve structural problems blocking a sustained recovery. Liquidity is the wrong medicine for the global economy right now. Overusing it encourages its side effect -- inflation.
Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.
Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.
Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don't respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.
If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don't think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. [Wildspitze: Doesn't jive in light of his unemployment forecast above somewhere. I wonder how much this fed rates call is influencing his view re: double-dip, meaning a fed created second-recession] Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.
This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn't believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.
Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down -- and keep them down for a long time.

[jk]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

agree that xie's analysis is not identical. i only said "entirely consistent." i think itulip's analysis has been that eventually the fed would raise interest rates, but - as xie says -would stay behind the curve for the most part. see some of the early kapoom charts for that. i think xie's double dip is not caused by the fed raising. i read him as saying the second dip is from the artificial stimulus wearing off, then oil prices go up anyway, then the fed must make a showpiece raise to demonstrate its anti-inflation stance. but i think these delicate issues of timing are 2o to the overall analysis.

[goadam1]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

i think this is a very interesting, worthwhile article. however, it is a bit of a slog, so i've reproduced it below, highlighting what i think is especially important. btw, it is entirely consistent with itulip's analysis and projections.

Andy Xie: New Bubble Threatens a V-Shaped Rebound



A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.

By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
Some analysts are expecting China to repeat Japan's bubble experience, which occurred in the late 1980s. At that time, Japan's export-led growth model was stymied by a doubling of its currency value after the Plaza Accord. It tolerated a massive asset bubble to stimulate domestic demand and stabilize its economy. China's export-led model is facing a rising savings rate and declining U.S. demand for its exports. Asset inflation could be a way out in the short term.
China doesn't need to repeat Japan's experience. One reason is that the circumstances are not the same. First, Japan was a developed country when its bubble started getting out of control in 1985. It couldn't divert its vast savings into infrastructure investment. But today, China's national urbanization project still has up to 30 percentage points to go. If the right mechanism can be implemented, China could divert more savings into urbanization.
Second, China can decrease its savings rate substantially through structural reforms. Half of China's gross savings are in the public sector. The government and state-owned enterprises should decrease revenue-raising and increase borrowing to finance investments. For example, China's high property prices are based on the investment-fund revenue needs of local governments. If China's property prices were cut by one-third, the national savings rate could decrease by two to three percentage points.
Third, the Chinese government could give its shares in listed state-owned enterprises to the household sector. The subsequent increase in household wealth could lower the national savings rate by three to four percentage points.
China's exports are down by roughly one-fifth. It needs the national savings rate to fall by about six percentage points for the economy to function normally. Otherwise, the economy will experience either a recession or a bubble. And the purpose of a bubble, as mentioned, would be to temporarily decrease the savings rate.
This discussion may seem to digress from the analysis of sustainability in the current economic recovery. But it brings out two points: The old equilibrium cannot be restored, and many structural barriers stand in the way of a new equilibrium. The current recovery is based on a temporary and unstable equilibrium in which the United States slows the rise of its national savings rate by increasing the fiscal deficit, and China lowers its savings surplus by boosting government spending and inflating an assets bubble.
This temporary equilibrium depends on government action. It does not have a market foundation that would support sustained and rapid growth. Nevertheless, improving economic data will excite financial markets.
China's stock market is cooling because the Chinese government is jawboning it down, based on fears of a big bubble downside. And the economy is beginning to slow. Markets outside China will likely do well for the next two months; diverging trends reflect that China's market recovered four months before others, and adjusts before others as well.
Financial markets will turn down again when investors realize that the global economy will have a second dip in 2010, and that the U.S. Federal Reserve will raise interest rates soon. The turning point may well come sometime in the fourth quarter. By then, it would become apparent that China has slowed. U.S. unemployment will not have improved and, hence, its consumption will remain stagnant. And production data that's pushing expectations now will cool after the inventory cycle runs its course.
Most analysts would argue that central banks won't raise interest rates before the recovery is on solid ground. The problem, though, is that fiscal stimulus can't resolve structural problems blocking a sustained recovery. Liquidity is the wrong medicine for the global economy right now. Overusing it encourages its side effect -- inflation.
Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.
Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange traded funds individually or in baskets of commodities.
Oil is uniquely suited as an inflation hedging device. Its supply response is very low. More than 80 percent of global oil reserves are held by sovereign governments that don't respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.
If central banks continue refusing to raise interest rates during these weak economic times, oil prices may double from their current levels. So I think central banks, especially the Fed, will begin raising interest rates early next year or even late this year. I don't think it would raise rates willingly but wants to cool inflation expectations by showing an interest in inflation. Hence, the Fed will raise interest rates slowly, deliberately behind the curve. As a consequence, inflation could rise faster than interest rates, which is what the indebted U.S. household sector needs.
This fool-the-market strategy may work temporarily. Its effectiveness must be reflected in oil prices; the Fed needs to target oil prices in its interest rate policy. If oil prices run from current levels, it means the market doesn't believe the Fed. That would force the Fed to raise interest rates quickly which, unfortunately, would trigger another deep recession.
Instead of a V-shaped recovery, we may instead get a W curve. A dip next year, although perhaps not statistically deep, could deliver a profound psychological shock. Financial markets are buoyant now because they believe in the government. The second dip would demonstrate the limits of government power. The second dip could send asset prices down -- and keep them down for a long time.

I think this is dead on. But how does a saver deal with it? Emerging markets and oil are destined to absorb and destroy liquidity. So will any run at commodities. We know inflation is being created to kill old debt but every hidey hole is going to be flushed out as soon as it is full of enough rats.

[goadam1]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

agree that xie's analysis is not identical. i only said "entirely consistent." i think itulip's analysis has been that eventually the fed would raise interest rates, but - as xie says -would stay behind the curve for the most part. see some of the early kapoom charts for that. i think xie's double dip is not caused by the fed raising. i read him as saying the second dip is from the artificial stimulus wearing off, then oil prices go up anyway, then the fed must make a showpiece raise to demonstrate its anti-inflation stance. but i think these delicate issues of timing are 2o to the overall analysis.

Time it how. Is it time to put more cash into 13 week rolling over t-bills? Sit in cash and gold and see where you net out when the storm is over?

[jk]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

Time it how. Is it time to put more cash into 13 week rolling over t-bills? Sit in cash and gold and see where you net out when the storm is over?

i think xie's implicit recommendation is identical to ej's- gold [he doesn't say that, i know, and a case could be made to sell gold temporarily if you feel courageous], tbonds til the sell off, then gold and oil.

[metalman]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

i think xie's implicit recommendation is identical to ej's- gold [he doesn't say that, i know, and a case could be made to sell gold temporarily if you feel courageous], tbonds til the sell off, then gold and oil.

that is my read as well.

[goadam1]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

that is my read as well.

Can we hold hands when we time the trade?

[Jim Nickerson]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

Here is a contrary view as I take it to Xie's perspective, from an emailed report via John Mauldin dated 8/17/09. There probably is a web link somewhere, but I ain't going looking for it.


Daily Observations from GaveKal

We are hearing concerns, from some clients and friends, that the brutal corporate cost-cutting seen in the wake of the subprime crisis will delay the recovery, because this trend is killing the US consumer. In other words, how can one spend if he has lost his job or fears as much, or has seen his work hours drastically reduced, taken a pay cut, or expects his company pension system is about to implode? For us, this all boils down to a crucial question: do we need consumption to pick up in order to achieve a rebound in growth? The answer to this question very much depends on whether one accepts a Keynesian view of the economic process, or a Schumpeterian (or classical) view. We hope our readers forgive us, but we are now going to have to get a tad theoretical....

* In a Keynesian view, consumption is the motor of growth. If companies slash their payrolls, consumption contracts and we enter into a vicious cycle in which the subsequent decline in demand leads to a second wave of cuts, which then leads to a further decline in consumption, and so on and so forth. The Keynesian cycle may have been useful from 1945 to 1990, but in the past 20 years, globalization and just-in-time technologies have changed the nature of corporate management, which is why we believe a classical, capital-spending led view of the economic cycle will reassert itself.

* In a classical view, as exemplified by "Say's law" and reinforced by Schumpeter, corporate profitability is the cause, not the consequence, of economic growth. Thus, Schumpeter would see the current cycle as the destruction phase in the creative-destruction processes that propel the economic cycle. Capital and labor are currently moving from the sectors in decline (e.g., McMansions) to the sectors in expansion (e.g., tech, alternative-energy infrastructure, etc.). Once momentum in the growth sectors overwhelm the decaying ones, then macro growth resumes. Under this framework, consumption kicks in at the end of the cycle (for more on this, see the very first paper published by GaveKal, Theoretical Framework for the Analysis of a Deflationary Book).
Within our firm, Charles is the major proponent of the Schumpeterian view, and this thinking was apparent in his and Steve's recent ad hoc, A V-Shaped Recovery in Profits. Due to the quick reflexes that new technologies allow, corporates are managing their cash flow better than ever. Rarely ever, for instance, have companies (ex-financials) remained in such strong positions during a recession, which is yet another reason why we believe that capital spending, rather than consumption, will spark the recovery.
Indeed, the scale at which corporates have been able to cut costs and return to profitability, has laid the groundwork for a deflationary boom of epic proportions (which would be a major surprise for those who fear an easy-money inflationary nightmare). Of course, there is a major threat to this deflationary-boom scenario-and that is the increased government intervention we are seeing in most corners of the world. If government intervention manages to kill off return on investment capital, as it did in the 1930s, then the current opportunity will go up in smoke. Regular readers know we tend to err on the side of optimism; at this point we still hold out hope that a major lurch to a big-government era can be resisted-as exemplified, for example, by the unexpectedly strong fight we are seeing against the health-care bill, or the ability of so many US financials to pay back their debt to the US Treasury, thus lowering the extent of government influence on their business decisions. Thus, in our view, a period of deflationary boom is the likeliest scenario, and investors should focus on sectors and countries that will see the largest resurgence in capital spending.

[WildspitzE]

Re: Andy Xie: New Bubble Threatens a V-Shaped Rebound

Can we hold hands when we time the trade?

HAHAHAHAHA