Further Warnings & the China Bubble - August 2009


The Beryl Consulting Group LLCAugust 21, 2009

Further Warnings and the China Bubble
It is our view that the world’s combined government stimuli have completely distorted the global economy in the short term, and have encouraged a false sense of hope in the stock market. Either investors are discounting an incredible economic recovery that is just around the corner, or the extra liquidity injected into the economy (i.e. economic stimulus deployed by global central banks) has found its way into the stock market. We’re leaning towards the latter alternative.
China deserves special mention here, because on a percentage of GDP basis, their government is the greatest stimulator of all. While the US has made significant commitments, its $2.8 trillion capital deployment to date only represents 20% of its 2008 GDP. However, Chinese government spending (combined with Chinese bank lending) is three to four times higher when compared to its GDP, hence far outweighing the US stimulus in scale and scope (See footnotes 1, 2 and 3). Is it any wonder then that the Shanghai stock exchange has more than doubled from trough to peak since its November lows?
We have been writing about our fears of a China bubble for four months. For four months we have watched risk bubbles inflate. Way back in May we pestered the ebullient with a review of basic facts and figures. We said it then, and will say it again now, Chinese market performances and growth faith are not rooted in any discernable secular reality.
The Chinese are over producing. Over-production runs despite massive global demand weakness. Production drives their GDP numbers, investor fantasy and commodity demand. The China and oil trades are driven by irrational exuberance regarding global demand, Chinese growth and US Dollar weakness. Oil, commodities and China are exactly the same trade. Speculation, hope and supply drive all three markets.
We all knew that other little bubbles would replace the grand housing/debt/consumer/emerging markets growth bubble that spectacularly exploded from mid 2007 to early 2009. Few of us thought the new bubbles would be concentrated in all things risky, led by oil and China. This is exactly what we have seen develop. Crude oil and Chinese shares went on a tear between February 2009 and August 2009. The Shanghai Composite started August 2009 75% above its February 2009 lows. From February 2009 through August 2009 crude oil moved from $32.40 to $70 per barrel.
A note on Chinese listings – they always trade at a premium to Hong Kong listings. Chinese shares are driven by Chinese nationals only and momentum is set by waves of retail investors entering the market. Before the last crash and now again, hundreds of thousands of new investors have been flooding into the market each week. Earnings multiples top 25 generally and favored firms often trade at multiples above 40 times forward earnings. Hong Kong’s Hang Seng is less wild and is traded by many non-Chinese investors.
We believe it is time to consider the possibility that fundamentals and economic conditions might barge in on this party. Across the first half of 2009 China displaced the US as Japan’s leading trade partner. This has been much cited as evidence of the rise of China. Less widely discussed is that China’s trade with Japan fell significantly, if significantly less than Japan’s trade with the US. China’s imports from Japan fell 25% while her exports declined by only 18%. In the 12 months through June 2008, US imports from China fell 13.5% while US exports fell by 15% (see footnote 4). EU16 nation exports to China fell by 6% January-May 2009 versus January-May 2008. EU 16 area imports from China fell by 9% across the same period (see footnote 5). 37% of China’s GDP in 2008 came from exports. This number is widely rejected by official Chinese economists and China boosters the world over. They argue for using value added statistics that suggest around 11% of China’s GDP is export driven. The best measure of exports to GDP lies somewhere in the middle. Internal Chinese retail sales account for around 15% of China’s GDP. Consumption accounts for less than 35% of Chinese GDP. Chinese internal consumption cannot fill the void created by 
slowdowns in the EU, US, South Korea and Japan. If you see 8% to 11% GDP growth for years to come, you believe that $108-$111 of government spending and domestic consumption exist for every $100 lost in exports. 
To be comfortably long Chinese equities you must believe the following:
·         Supply creates its own demand
·         Buying and stockpiling inputs creates sustainable commodity demand
·         Producing without selling, certainly without selling for a profit, is good business
·         The world economy is set to sharply rebound, buying Chinese goods with a fury
·         The US, EU, Japan will endlessly sacrifice trade balance and job demands from their increasingly angry publics
·         China only grows, Chinese shares only appreciate and there is no bubble
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