THE TAIL OF THE DRAGON: THE NIGHTMARE RISING IN THE EAST

THE TAIL OF THE DRAGON: THE NIGHTMARE RISING IN THE EAST

Being the world's second-largest economy, China's slowing growth is steadily becoming a problem in the country, there are increasing concerns over the spread like a virus that affect the global economy. While the devaluation and the successive weak economic data of the said country are scaring the investors, the causes and the results of the more visible depression nightmare are given below.

The current phase is the third phase of the global economic crisis of 2008. After the bankruptcy of Lehman Brothers in 2008, the first phase of the crisis began. In this process, the United States has intervened rapidly to the crisis and through support packages, she has first recovered, then socialized the debt of the financial sector. However, because of the integrated nature of the global financial system, the crisis was not limited to the United States. The second stage of the crisis was experienced by the spread to Europe. The bankruptcy stage passed from the companies to the states. While Europe still did not emerge from the crisis, we have passed to the third stage: the deepening of the crisis. And this third stage was completed by the spreading across the world. In the production bases such as China, slowdown has become more pronounced.

In the coming period, the US Federal Reserve (Fed) and other major central banks may deepen the crisis they had postponed further with the expansion of credit, imposed since 2008. Grounding of the global economy, which had been kept afloat by credit expansion, may arise. Particularly the Fed, the major central banks do not have the primary weapon they can use this time to avoid the incoming wave. Productive investment will be destroyed. This recession could mean further spreading. The process will not be limited to one region, like the 1994 Asian crisis. Asian markets after the 1994 crisis were included in the global financial architecture. Therefore, a problem arising in one part of the system can quickly spread to the other parts.

Fear of a global slowdown triggered by China, which already causes a drop in commodity prices, has pulled the world financial markets to the bottom. From Asia to Europe, from the US to the emerging countries, the stock markets across the world witnessed record losses. Oil prices fell more than 4 percent.

While the stock market in China has recorded a loss close to 9 percent, it was the sharpest decline since the financial crisis in 2007.The indexes that were positive by 50 percent in June compared to the beginning of the year, have retreated to the Christmas time levels.

Asian stock markets, on the concern of the ongoing decline of China's stock market in three months is going to be out of control, went down to the bottom of last three years. Losses in the European stock markets exceeded 6 percent during the day, thus experiencing the most drastic decline since the most severe period of the global financial crisis of October 2008.

The problems in China are not only limited to the stock market; the country has accumulated a lot of serious problems. Previous growth rates in China could not be sustained. With the devaluation and the gradual deterioration of the data, the market began to see it clearly. Even if the Bank of China takes the necessary steps, it will not change this fact. China will replace the preceding 10 years of growth model. While replacing it, she will decrease her economic growth rate to 3 or 4 per cent. A choice can be made between a sudden decline and a decline spread over time but she does not have an alternative as to not decline. But if they lose the control of Yuan's adjustment, it will be a very dangerous phenomenon for the world: China will begin exporting deflation. The producer inflation rate is already very negative since 42-44 months. This could bring a harder wave of deflation. The Fed will increase interest rates in September. America will enter a crisis without increasing interest rates.  There is already now a crisis in emerging markets. Global trade is expected to have the lowest growth of the last 10 years. There is an economic crisis coming from emerging markets. US can protect herself for a year or a year and a half but not more...

CAN CHINA LEAD THE WORLD INTO A NEW ECONOMIC CRISIS?

The Chinese slowdown could plunge the world into a new crisis, many economists believe. Is China so bad, and does she have such a power of influence?

When China will fall asleep ... the world will tremble. The Chinese recession, if confirmed, will drag that of Brazil, which will cause the same for the US and Europe. The expected Chinese slowdown will have colossal consequences, since China makes up a third of global growth since the beginning of the century. China is seriously ill, and the global contagion is inevitable.

China's growth is slowing. Even if it falls to 6% or 5% this year, one can not speak of recession. This is a relatively difficult transition between two growth schemes. Since 2011, China is trying to be less dependent on exports and develop its domestic market. Domestic demand remains weak, however.
This slowdown questioned China's ability to switch to an endogenous growth. The economy has excessive debt, speculative bubbles have multiplied. China has failed to initiate something virtuous on the domestic front. Meanwhile, the rise in wages that made its exports less competitive, forces it to devalue its currency to boost its foreign trade. China is in midstream, not knowing in which direction to turn.

Perhaps it is only a crisis of growth. But why China would lead the world into turmoil, starting with Brazil? Brazil is already in recession because of China. The growth was led between 2005 and 2012 by massive raw material exports to China. The decline in Chinese imports has been fatal. In return, Brazil imported Chinese products, contributing to the dynamics of world trade.

This dependency of China is evident in the case of Brazil, but it is the case in all countries. China accounts for 11% of imports in world trade. When it slows purchases, all exporters receive a kickback. This is the case of Germany, particularly exposed, where industrial productivity has been falling since 2011 and Europe is indeed threatened: one can not say that emerging countries need to support Europe's growth by purchasing their products. China's closure feeds a judgement of globalization.

China's influence on emerging markets is considerable, and the global economy is not going very well. Europe is a big stone. A new crisis is not impossible, but a return to recession could come from many poles. The eyes of the world have turned to the United States, where growth occurred for the last six years. Or to India, cited as a possible relay of China.

If China's failure does not necessarily plunge the world into recession, it seems to question the model of growth driven by trade flows. There will be more growth in the manner of the past. Anyway, the world has achieved the environmental limits; the Tianjin explosions just remind it.

THE WORLD ECONOMY: DEPRESSION OR RECOVERY?

THE WORLD ECONOMY: DEPRESSION OR RECOVERY?

In the financial circles, a story is being told regarding the world economy emerging from the long recession it had entered after the financial crisis. But what is happening in China's economy with the last week's unexpected devaluation and the state of the labour market in the OECD countries refute this story.

Until last week, the Chinese currency Yuan was considered to be overvalued by 15 percent against the dollar. When this level of the Yuan was coupled with the economic growth, it served as a control valve of the deflationary pressure (lack of demand) in the world economy. The devaluation of the Yuan by more than 3 percent last week shows that this valve has been broken and the Bank of China is warning that there could be a continuation of strong fluctuations regarding the value of the Yuan. 

Despite that the Chinese officials try to show that the devaluation is "a reform to facilitate the functioning of the market economy", one can  easily reach a different conclusion. First, the devaluation is not suitable for the Chinese government' project of redesigning the economy towards the domestic consumption, other than encouraging exports. On the other hand,   in today's world economic environment, one cannot expect to have the devaluation to make a significant contribution to China's exports nor to the growth based on investment. 

Second, this devaluation  is an expression of the crisis of capitalism in China. July data show that the growth rates of industrial production, exports, fixed capital investments and retail sales are falling. In short, while the economic growth is going towards below the projected 7 percent, the deflationary pressure and excess capacity problem is getting more pronounced.

Because the Chinese government has chosen the devaluation as a solution and as a tool to encourage exports, one thinks that she has chosen to "export" the deflation at the same time. This devaluation will not only have adverse effect upon the export capacities and growth of the countries in the region, it will also have a negative impact upon Europe's and United States' economies as well as upon the financial stability. The probability that United States' economic growth falls below 2 percent will delay Fed's decision to raise the interest rates and will strengthen the instabilities in the financial markets. In short, the economic recovery story is far from being true.

The story of "recovering from the recession" is also supported by certain declines in the unemployment rates. In reality, not only the unemployment rate is still far below the pre-crisis levels, but also the "recovery" burden of this story, which has a dark side, is imputed upon the workers, especially upon the young people of 15-24 age group. 

Within the newly created jobs, the temporary jobs, which are not standard, while representing 33.4 percent across the OECD, Italy, Greece and Spain have figures that go beyond 40 percent. This ratio is 38 percent in Germany, the strongest economy of Europe. The share of temporary jobs in the total new employment in the 15-24 age group, can reach 69 percent in Spain and 53 percent in Germany. And the chance of the persons who enter into the temporary job market to jump to a permanent job is less than 50 percent. Finally, the average income of workers in temporary jobs is lower than the employees of the permanent jobs. Across the OECD, 22 per cent of family workers in temporary jobs live below the poverty line. 

In summary, OECD is dominated by low growth, high and fragile unemployment, impoverishment and deflation... This situation is not called "recovery" but depression. 

THE YUAN IN PERSPECTIVE: THE PATH TO A NEW GLOBAL CURRENCY AND NOT A CURRENCY WAR.

THE YUAN IN PERSPECTIVE: THE PATH TO A NEW GLOBAL CURRENCY AND NOT A CURRENCY WAR.

Chinese currency Yuan has lost 1.8 percent on Tuesday, losing 1.6 percent Wednesday. This exchange rate movement  is considered as being the highest daily rate movement since 1994. This movement involves more than a devaluation; it is likely that it is an effort to open the door to  the floating exchange rate regime, that is the "world currency".

The reason why the world had raised the eyebrows when saying "China launches currency war",  was the appreciation process that had continued for a long time; did China change its decision?
Did China support the idea of providing a stimulus to its exports and growth through devaluation which has seen its export fall by 8.3% in July compared to the previous year, its economic growth shrinking to the lowest on the last 10 years to the figure of 7.4%?

This step is a strong probability; it suggests that China's strict foreign exchange regime, which magnifies the wave of reforms in recent years, is approaching the brink of leaving the Yuan to fluctuate in free market conditions. In the medium term; she will increasingly open the currency band and will allow the establishment of the value of money in market conditions.

Yuan did not reflect the country's economic equilibriums for a long time; China's government, even though the country has a surplus of foreign trade, made an effort to keep the money worthless. Despite its huge trade surplus against the US dollar in nominal terms during the period from 1995-2005 the money was kept constant at 8:27. During the 2005-2008 crisis, under the pressure of the US administration with the blame of currency manipulator, she has permitted a controlled appreciation of its currency. Yuan, which approached 6.82 by the end of 2008, stayed there until May 2010. After June 2010, its resumeD its appreciation process; it appreciated up to 6.05 by the end of 2013.  With the wave of reforms at the end of 2013, from the beginning of 2014, it was observed that she allowed a loss of value in its currency from time to time. It closed at 6.21 on Monday against the dollar, it dropped to 6.44 with the depreciation that occurred on Tuesday and Wednesday.

The Bank of China set a mid-point in its currency rate on a daily basis and allows the currency rate to fluctuate up and down by 2 percent. When the midpoint shifts, than the currency rate fluctuates in the band that was set up around the centre. The following day's currency rate which is determined according to the previous day's official currency rate (mid-point), the Bank of China has declared on Tuesday that it will be determined according to the "previous day's market closing". This has created a currency bounce, of course, but it will result in the currency rate being determined by the market conditions.

The Bank of China will probably expand this band which is determined now by the market conditions and Yuan will reach its value under the market conditions without intervention. The currency rate will thus drop or rise.

As China approaches the free exchange rate regime and also removes the currency exchange controls, Yuan will start to become an international currency. In this regard, this development which is seen as a devaluation, must be an important gateway to the convertibility transition of China. The allowance given to such a currency move in China has been described as a devaluation; it was an unprecedented overnight high loss of value.

This exchange rate movement in China, triggered the depreciation in neighbouring countries. The currencies of the giant countries such as Malaysia, Korea and Indonesia have lost roughly 2.5 percent. But China's impact will gradually decrease. Bank of China's intervention which happened yesterday and where she intervened by selling against the depreciation of the Yuan, reveals that the Chinese government's aim by changing the system determining the exchange rate does not carry the intention of devaluation. As this becomes clear, the reflections upon other countries will disappear.

Ultimately on Tuesday, China has opened the window  of a new global currency...

WORLD ECONOMY AND EMERGING COUNTRIES: THE END OF THE FINANCIAL TANGO

WORLD ECONOMY AND EMERGING COUNTRIES: THE END OF THE FINANCIAL TANGO

As of the end of April, the world economy is going to have great difficulty to reach 3.5% yearly growth as forecasted by the IMF in its latest report. Despite all these favorable conditions, why doesn't the economy recover?

The indicator most closely followed by the world economy on a monthly basis is the JP Morgan global composite PMI index: it has declined by 0.6 on year-to-year basis and reached a point near the six month zenith with 54.2 but 54.2 seems to be inadequate. Oil prices have declined by 30% since the beginning of the year, the Fed no longer prints more money. But more than 30 central banks have filled his gap. The tightening period of budgetary policies has taken an end.

Everyone can sense a number of reasons. For example, the US economy has left behind a terrible 1^st Quarter due to the temporary shocks, and could not contribute enough to the global demand. China has no longer the same power. Japan is still trying to recover from the impact of the increase in VAT introduced last year which had a negative effect upon the demand, developing countries are delaying the supply-side reforms, etc.

But these are very superficial explanations; a more structured and somewhat alarming causes lie beneath. First, the global production chains are no longer prolonged. That is, the production does not diversify from one country to another, in a sense the globalization has slowed down and the world trade has started to grow slower than the world output. The export-based economies such as South Korea, Taiwan and China are the ones that suffer the most from this. Even worse, the US began to import manufacturing to his country thanks to cheaper oil and natural gas and the multiplier effect has been reduced.

The second reason for the sluggishness of the world economy was due to the slowing down in the global trade and liberalization of the investment and capital flows. With the countries returning to the protectionism, the world economy is growing slower.

The third reason is the cheapening of oil that has not yet been fully reflected in consumer prices. In some countries, the state confiscated the cheap oil bonus through the budget savings, consequently the oil prices did not drop enough due the appreciation of the Dollar Index, so the consumer who has not prospered ultimately does not spend. In parallel with this, the global liquidity did not expand enough. Because the rich OPEC and Russia have seen their petrol-dollars evaporate and this has sucked some of the additional liquidity that ECB’s monetary expansion had provided.

But the biggest reason is the evolution of the global trade credit system. After the Lehman crisis, the banking supervisors of major countries have been very successful in their duties. The banks were denied giving risky loans. As a result, the commercial loans are no longer supporting enough the world economic growth. This weakness has been partially offset by the inflating dollar and euro-denominated private sector bond market but for many SME, nothing can take the place of the commercial loans. Rather, a series of giant banks are now narrowing their operations in the emerging countries and are turning to more profitable areas and the weakness in the growth of this region seems to be as permanent.

What will happen in the future? The cyclical recovery of US, Japan and China's spring-summer is inevitable (if of course China does not participate into this). To these, the secular recovery of the euro-zone and developing countries benefiting from the partial rally in commodity prices will participate and in the coming months a more optimistic global landscape will be shaped. However, the world economy will continue to produce light output in the 2015-2016 period.

What will be the repercussions upon the developing countries? This output deficit will delay the Fed’s decision to increase the interest rate by keeping the inflationary pressures weak or the expectation that it will keep the interest rates of US-German government bonds low is a clear illusion. The second noticeable feature of the world economy is the shifting of the recovery’s main axis from the emerging countries to developed countries. That is, the inflationary pressures will this time begin to appear first in the US and the EU. If the rise in oil prices continue, the emerging countries may join this towards the end of the year. This scenario poses a series of adversities for the emerging markets. As the growth does not occur to its full consistency, the rise in the yields of US-German government bonds which set the precedent for the entire world, is negative for the emerging countries’ fixed income securities. Second; with the closing of the growth gap between emerging countries and developed countries in favor of the second, the speculative capital will move to the second and has started already. Third; in the period when the Fed will raise the interest rate, the shocks in the emerging countries that did not reinforce sufficiently their real and financial structures may take place much harder than expected.

Then the following questions should be asked: is the 10-year reign of emerging countries over? Despite all the generosity of the ECB-BOJ and now PBOC together with the historically lowest inflation rates and bond yields, are we entering into a 5-year period where the speculative capital is not entering into the emerging markets and the financial crisis as well as recessions will start to show up again?

OIL AND GOLD: A SHORT TRIP INTO THE STORM

Some of the Canadian energy stocks may see a price appreciation in a merger & acquisition activity if OPEC’s meeting on June 5 results in the continuing of keeping oil production stable. But if a decision is reached as to reduce the production ceilings and the non-members follow suite, one can then see a recovery of crude oil price up to 60 USD to 70 USD per barrel. This will give some room to the companies whose finances are not in good position with oil prices trading below 45 USD.

If this price appreciation does not materialize during the current year, the said companies will have to revise downwards the value of their assets thus narrowing the margin between the offer and the demand in the merger & acquisition activity. Of course, this very expectation is the fuel for the mergers & acquisitions activity.

Under these conditions, it would be logical to look for companies whose costs and debt levels are low but which have seen their share prices unreasonably depreciate to bargain levels.

As far as the mining industry is concerned, the drop in the metals prices prompted industry leaders to look for a rapid rebound by relying on China’s possible massive demand thus considering it as the ultimate solution to the industry’s current problems. But several monetary stimulus undertaken by major economic regions did not affect gold prices despite some expectation regarding a rise in the inflation.

The energy investors had parallel thoughts on the matter; the recent crash in oil prices had burst a bubble and investors expected that Saudi Arabia would solve the problem through production cuts but that was not the case. The Canadian and U.S. companies have expended vastly their production. And the energy prices had appreciated substantially by insufficient resources; now the process has reversed.

This was followed by the deterioration of the assets of the energy companies. In turn, they issued new shares and convinced the investors that the proceeds would be used to liquidate debt. On the other hand, the mining companies opted to wait for a recovery in the metals market for some time. But the current situation forces them to write down their overvalued assets thus incurring massive losses.  The prolonged downturn in the mining industry will also affect the low-cost producers, despite blue chip names and dragging their share prices to bargain levels. Then one will have to wait for substantially higher prices in order to see some improvement in the cash flow and debt levels of the said companies. But when?

The successful recovery of the oil industry depends on the extent of supply cuts which should be triggered by bankruptcies or shutdowns. This in turn may cause a temporary drop in the energy indexes but once the balance is restored, the current trend should reverse itself favorably. The long-term trend is favoring increases in the curve steepness in the price of oil thus a strong rally in the near-term commodity prices, say, this summer…

The next question would be the following:

Will oil price reach 80-90 USD level? Will gold reach 1550 USD level?

BOND MARKET CRASH AND THE CONTAGION EFFECT

BOND MARKET CRASH AND THE CONTAGION EFFECT

The prices of long-term government bonds have been trading at high levels during the last years (implying that their yields have been very low). In the United States, the 30-year Treasury bond yield has reached a record low of 2.25% on January 30.

Despite the fact that this yield has recently moved slightly higher, it remains exceptionally low. It is almost impossible to provide an explanation as to why investors carry on placing their savings in these 20 or 30 years bonds in order to earn a mediocre return which is close the Fed’s 2% target rate for annual inflation. But the bond market is fragile at the wake of an interest hike and could undergo a major correction. Consequently, the investors are worried as to whether this correction could turn into a crash which in turn would bring down the housing and the equities altogether.

Market participants in the housing and equity markets tend to set prices with a view to prices in the bond market. Thus, a contagion from one long-term market to another seems to be likely...

In theory, long-term rates in the US bond market should be even lower because of the very low levels reached by the inflation and the short-term real interest rates (close to zero or negative). In today's environment, the impact of the quantitative easing which has been incepted in 2008 should have translated into lower long-term rates but it is the opposite now.

A crash in the bond market can only be possible under two conditions: a sharp tightening of Fed's monetary policy through a hike in the short-term interest rates or a dreadful rise in the inflation.

Bond-market crashes are rare but not dramatic. Consequently, one has to look for a possible event that may ignite a crash in the long-term bond market. But the threat lies somewhere else: private bonds.

During the low interest rate environment, companies have built a substantial long-term debt in the liabilities by issuing bonds massively in order to finance their investment projects. As long as their IRR stays above the interest rate, they load their long-term liabilities with bonds. On the eve of a Fed's interest rate hike, the whole picture will start to reverse and those companies will have to roll-over their bonds with higher interest rates which may cause a wave of default. This, in turn, will spread over the equities and we may actually see the dreaded erosion of the assets.

After all, the investors who lose in one of the assets will try to limit their loss by moving in than out of the stock market. We have seen this before in 1929 where the real-estate bulbs burst in 1928 and the investors rushed to the stock market with the related consequences. Same held true in the 1973-1974 crash and 2006 house bubble which triggered the 2008-2009 crash. Anyhow, such a crash should start towards the end of this year or early in 2016 and may last well into the first half of 2018. In such an environment, the initial correction may be 20% - 30% range but the rest will follow up thus turning it into a crash with a total correction of more than 50% at its depth.