Tags: Janet Yellen | Federal Reserve | China | bubble

Yellen's Worries About China Should Be Heeded by All Investors

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Friday, 17 July 2015 09:05 AM Current | Bio | Archive

Federal Reserve Chair Janet Yellen, in her testimony before the Senate Banking Committee, said: “We also want to be careful not to tighten too late because, if we do that, arguably we could overshoot both of our goals and be faced with this situation where we would then need to tighten monetary policy in a very sharp way that could be disruptive … if there is a negative shock to the economy with interest rates pinned at zero, we don’t have great scope to respond by loosening policy further, whereas with a positive shock of course we can tighten monetary policy.”

Investors should not overlook the fact that in in 1994 Yellen was a Fed board member, when the Fed funds rate was raised in February by 0.25 percent to 3.25 percent. The move 1994 surprised markets, causing a 150-basis-point rise in bond yields, which translated into U.S. bond price losses of about $600 billion.

With good reason, Yellen will remain cautious.

Now, when the “liftoff” finally will occur isn’t of great importance to long-term investors.

Chinese Debt Trap

What’s maybe much more important for most portfolios is Yellen’s statement: “China continues to grapple with the challenges posed by high debt, weak property markets, and volatile financial conditions.”

This week we were informed Chinese economic growth during the second quarter was 7 percent annually, the same as in the prior quarter, but that didn't give us the whole economic picture of China.

When we look deeper into the gross domestic product numbers, we see corporate and household debt in China has risen by 12 percent on a yearly basis, which is simply not sustainable anywhere in the world.

The real blinking red light is that China’s private sector debt-to-GDP now stands at 196 percent, which is about 40 percentage points above trend.

From the Bank for International Settlements, we know when the difference between the credit-to-GDP ratio and its long-term trend, rises above 10 percentage points, this kind of situation has usually been followed by serious banking strains within three years.

To put it simple, China has a high probability of potential trouble.

Besides, when we look at China’s GDP growth rate in “nominal” terms we see it has fallen on a yearly basis to 5.8 percent, which is only at a third of its average levels and close to a 30-year low.

Long-term investors should remain aware China is at present the “biggest risk” to the global economy.

China has still to deal with the biggest investment bubble, the second-biggest real estate bubble and the third-biggest credit bubble for which no satisfactory outcomes seem to be on the horizon.

Bubble Warning Signs

We’ve learned bubbles are at risk of bursting when:

  • Excess investment leads to deflation, and China faces at present close to record deflation.
  • House prices are falling, and today prices are down by record amounts.
  • There are very substantial foreign-exchange outflows, and today we see record FX outflows.
  • There is a very important slowdown in deposit growth, and today we are close to a record low in deposit growth.
  • Labor markets signal full capacity, and today we see the job-offer-application-ratio is at an all-time high.

Long-term investors need to be vigilant on China. If house prices should fall by 15 percent, or deposit growth should fall to zero, China’s real GDP could drop below 3 percent, which would be nothing less than a “hard landing” and would represent a dangerously contagious negative event to the global economy.

Of course, we aren’t there yet, not by a long shot.

Nevertheless it might be helpful to any long-term investor not to forget what Alan Greenspan said: “Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart.”

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HansParisis
Long-term investors need to be vigilant on China, and keep an eye on warnings signs that an asset bubble is collapsing.
Janet Yellen, Federal Reserve, China, bubble
664
2015-05-17
Friday, 17 July 2015 09:05 AM
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