Navigating a Tricky Market – Part I: My Crystal Ball

September 9, 2011

This is Part I of a 2-part series. In Part I, I’ll describe my best guess for what might happen to the market in the near future. I’ll probably look like a fool if none of this actually happens… but whatever 🙂 In Part II, I’ll describe my selection of currency, investment instruments, and tactical positions if Part I actually comes true.

My hobby of analyzing market data to speculate its next move has been yielding some interesting results lately. Couple of weeks ago, I decided to step back, re-formulate my macro view and then engage with the market on the short side. Regardless of whether or not my new macro view survives the reality test, it’s a mind-bending exercise to try to predict the outcome of a complex chaotic process. Some might call it a fool’s errand. Time will tell.

What’s the nature of this crisis?

There are at least two forces working simultaneously: 1- Sovereign debt crisis and particularly European debt issue, 2- Global recession caused by our stagnant consumption.

I think sovereign debt will be a big problem down the road but not right now. The cost of servicing US debt is small and we have no problem rolling over our debt for now (I’ll give more specific reasons for this in Part II). Europe is in a much worse shape but even that can be controlled for now by massive money printing by ECB. The second issue, however, will cause a massive exporter-led meltdown soon.

The Crystal Ball

The scenario would look like this:

Prelude: Per my previous post, I strongly believe the total demand from US and other developed nations will be stagnant. We might experience a really long but somewhat mild recession. It won’t be catastrophic. Consumption and income will be flat and unemployment will be high regardless of what Obama and the Fed do.

The First Act: China, however, will be hit really hard by declining exports. The so-called decoupling (Chinese consumption picking up as US consumption vanishes) has clearly not happened. To keep renminbi undervalued and exports up, PBOC over the past decade has been injecting tons of currency into the economy by buying dollar and dollar-denominated assets. The excess liquidity has overheated their economy and created a massive asset bubble, including bubbles in real estate, stocks etc. I know this might sound unbelievable to some but much of China’s growth recently has been driven by this asset bubble and related economic activities such as house construction. After the US housing bubble burst, in the face of declining exports, PBOC further increased the money supply to maintain their bubble and prevent a crash. They have also instructed their banks to relax their lending standards for real estate loans (anyone remembers sub-prime mortgages, liar loans, ARM during the real estate bubble in US?) Furthermore, they have started massive infrastructure construction projects. This has further inflated the bubble. Beijing has one of the most expensive real-estate markets in the world relative to the income of its citizens (WSJ article). The average price of an apartment in Beijing is now worth 57 years of savings by an average worker. The current bubble in China is eerily similar to the US real estate bubble. It is clearly unsustainable, and in my opinion, a bubble of magnificent proportions that is about to pop. And the continued decline in demand from US and the rest of the developed world will, at some point, trigger a spectacular downward spiral.

The Second Act: This will immediately hit resource exporting countries (Brazil, oil exporting countries etc) in a major way because China is their biggest customer. Capital will fly out, their currencies will weaken, followed by recession and unemployment. Their central banks will have to defend their currencies and control rampant inflation by deleveraging (selling their assets to drain liquidity). This will further push them into recession. China’s popping of the bubble will also hit major exporters of capital goods (e.g. industrial machinery) such as Germany and Japan but the impact will be somewhat less pronounced (mild recession maybe). Commodity prices (copper, oil) will drop sharply.

The Final Act: The final act is less pronounced and may or may not happen depending on how badly this hurts the German economy. Germany is currently playing superman in Europe by effectively bailing out the periphery countries. This will be the end of that. In other words, even though for now the European debt crisis can be managed, once China falls, Germany hurts and all bets are off. Some of the GIIPS countries (Greece, Ireland, Italy, Portugal, Spain) might default as the German exports and therefore its ability to absorb a relaxed monetary policy dwindle. If I wanted to guess, I would say that might be the final death blow to Euro. Australia and other more diversified exporter economies will be hit too but the impact will less than the blow to Brazil, Venezuela, and middle eastern oil exporters. The funny thing is, as I’ll explain in Part II, US might come out of this stronger than before!

In summary, this will be an exporter-led crash caused by a popping bubble in China, followed by recession in Brazil and other resource exporting countries. The further you go down the chain, and the less diversified an economy, the harder the impact of this crash. So for example, Brazil will probably be hit harder than China. As a side effect, Germany gets weaker and Euro might fall apart and some of the periphery countries might default on their debt. But like I said, sovereign debt default will not be the original cause, just a potential side effect. And if it happens, it will be limited to highly indebted countries on the peripheries. US will come out of this almost untouched.

Do others agree with this prediction?

Well, obviously if the majority of people agreed with me, the bubble had already burst. But more and more people are getting worried these days. There are the bearish economists who are predicting doom and gloom (Nouriel Roubini a.k.a. Dr. Doom, Garry Shilling etc). Economists from the so called Austrian school of thought mostly believe that this will be a US-led implosion caused by our looming national debt and a weakening dollar. They argue that our Feds two rounds of quantitative easing combined with real-negative interest rates will debase dollar and create inflation in US that will lead to our economic collapse. While there might be some truth to that in the long run, in the short term I think the exact opposite will happen. USD will stage a rally against other currencies (more on this in Part II). Furthermore, I think US debt issue has no part to play in this current crisis.

A few days after I established my short positions, this really interesting memo leaked from Goldman Sachs:

It’s an interesting analysis of the state of China and Europe with supporting research (good summary at Zerohedge). I agree with most of their conclusions but some of their currency bets strike me as really odd. The memo was written before SNB pegged CHF to EUR couple of days ago. But still, even if SNB didn’t actually peg its currency, they should have known that CHF was already stretched.

Coming up next: My view on future currency moves and speculative profit opportunities. (Spoiler: I think USD will stage another strong rally just like it did in 2008. Brazil’s stocks and Chinese REITs might do a massive correction.) Now only if I find some free time to actually write it all up…

Disclaimer: This post is a summary of my current and near-future positions in the market. I’m not a financial adviser or an expert and this is not meant to guide anyone’s investment decisions. This post is highly speculative and risky. You should not treat any opinion expressed here as an inducement to make a particular investment or follow a particular strategy, but only as an expression of my opinion.

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