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Review of Industries
Review of industries
Below are our comments on various industries and companies
Improving industries
Yet another company from the H. C. Equipment & Supplies industry in the broadly defined Health Care sector of the Standard Industrial Classification list is, we believe, worthy of favorable mention in this space. Hill-Rom Holdings, Inc. (HRC), whose sole operating subsidiary is Hill- Rom Co., Inc., is perhaps best known for its hospital beds in patients' rooms, but the product line also includes specialized operating-room and intensive-care beds, and non-invasive devices to improve circulation and treat bed sores - problems often experienced by bed-confined patients. The HRC entity was formed in March 2008 with the spin-off of Batesville Casket Co. from Hillenbrand Industries. Batesville kept the Hillenbrand name, while the health care business adopted the Hill-Rom moniker. HRC's revenues have grown at a 5.6% CAGR in recent years, but in view of a now-declining trend in hospital admissions management expects a top line smaller by 7.3% - 8.6% this year, and is guiding to an EPS range of $1.03 - $1.13 vs. $1.40. HRC's net debt of $80M compared to a market cap of $1.2B indicates a high degree of flexibility. Ultimately, the financial condition of the nation's hospital system is a key determinant of HRC's growth and profitability going forward; major pressures on the system include declining elective procedures, reimbursement pressures and patient mix, significant declines in philanthropy and endowment funds, and of course the impact of health care and/or health insurance reform. Egan-Joness recent review of HRC saw fit to upgrade its rating from BBB- to BBB.
Consumer Staples – We commented recently about the diametrically opposite strategies that Coca-Cola (KO) and PepsiCo (PEP) were following with respect to their relationship with their distribution organizations, noting in the course of our report a $6B cash offer for the balance of shares of Pepsi Bottling Group Inc. (PBG; 67%) and PepsiAmericas Inc. (PAS; 57%) that it does not already own. Rejection of the offer as "grossly inadequate" by its independent board of directors puts several issues on the table relating to PBG's credit quality. One is weak and declining interest coverage as a result of an aggressive, debt-financed acquisition program. Other issues are more positive: purchase by PEP would be a major positive, as would a higher bid from a third party if it were to materialize. We note in this connection that PBG's market price has been trading at a premium to the rejected offer's $29.50/share. Egan-Jones's recent reviews of both bottling organizations resulted in upgrades, PBG from BBB to A- (subsequently affirmed, assuming an increase in the offer price) and PAS from A- to A.
Neutral industries
Information Technology – IBM was one of nine companies selected as "safe" investment ideas in our January 2009 issue of this monthly review, with more recent discussion of "Big Blue" that focused on its aborted merger negotiations with Sun Microsystems. Citing IBM's strong credit ratios and the high level of financial flexibility that supported an increase in the common dividend from $2.10 to $2.20, Egan-Jones affirmed its A+ rating. Now, we have the unusual situation of a 12% increase for June quarter earnings despite a 13% y-o-y decline (down 7% ex-currency) in revenue. The dramatic margin improvement (18.3% pretax vs. 14.2% last year) driving this result clearly justifies management's strategic shift to emphasis on services and software; sales of mainframes and other computer hardware declined 26% compared with 2Q08. Confidence in the near-term outlook prompted management to raise full-year EPS guidance from $9.20 to $9.70. Egan-Jones, meanwhile, has upgraded IBM's rating from A+ to AA-.
Drugs – As the concluding sentence of our review of this industry in January 2008, we wrote, "Five years from now, this industry will look very different." In less than two years, this statement has been validated as a result of two mega-mergers that reduce the roster of major drug houses from eight to six, namely, the combinations of Pfizer with Wyeth, and Merck with Schering-Plough. In that article we described how a long-established and highly successful business model has shown increasing evidence of breaking down under intense and persistent competitive pressure. For many years a strategy of massive research effort, rigorous efficacy and safety testing to obtain regulatory approval, and intensive marketing under patent protection to health care providers has delivered steady earnings growth at wide profit margins. The main component of the aforementioned competitive pressure has, of course, been the growth of generic versions of off-patent drugs, now reinforced by the terms of most health insurance plans as part of a collective effort to restrain the rapid growth of health care costs. The current threat has elements of each of these issues: a marked slowdown in the development of new drugs with "blockbuster" potential just as the industry is facing a surge in patent expirations over the next five years. Its strategic response will likely involve some mix of diversification, intensive cost reduction, more focused research, and perhaps consolidation. Industry-specific strategies involve the combination of new-drug pipelines and therapy expertise in the hopes of reviving slowing revenue growth, and cost reduction achieved through the elimination of duplicative sales and market development staffs. Egan-Jones rates Pfizer, Wyeth and Merck at A+ (the latter recently upgraded from A), and Schering-Plough at A-/positive.
Banks – Capital adequacy and the various issues that affect it has once again moved front and center as a key determinant of banks' credit quality, what with the number of bank failures at 81 thus far this year and the FDIC's list of endangered banks now at 416 following the addition of 111 lenders during the latest quarter. A major risk is the ticking time bomb of commercial real estate loans, mentioned twice in this space in recent months. Our June comments cited a recent Wall Street Journal analysis of 940 small and mid-size banks using methodology similar to the Fed's stress test of nineteen major banks, and its finding that close to half of the more than $200B in potential losses was attributable to commercial real estate loans that have been a traditional specialty of regional banks. The FDIC data also reveals that the total of non-performing assets and net charge-offs is rising faster than loan loss reserves are being increased, so that the industry's ratio of reserves to bad loans, at just 63.5%, is at its lowest level since 1991.
Arrayed against this negative picture, there are positive developments to report. With respect to capital adequacy, nine of the nineteen large banks included in the stress test exercise have now paid back a total of $67B of stock issued to Treasury under the TARP program with funds raised in the private capital markets. And although Citigroup's (C) management may find political considerations affecting its decision-making process (see Autos below) as a result of the preferred-for-common exchange that gives the government a 34% voting stake in the bank, that transaction at least had the benefit of substantially increasing C's tangible common equity balance. C, along with Bank of America (BAC), Goldman Sachs (GS), and J. P. Morgan Chase (JPM) all reported June quarter bottom-line earnings in the $3B - $4B ballpark, all four showed solid profits from trading operations during the quarter, and all four passed the Fed's recent stress-test program. Also making a positive contribution to the industry's better-than-expected earnings reports was the change in accounting rules - the notorious FAS 157 - announced at the beginning of April that essentially allows the deferment of mark-to-market losses. Most positive of all was the aggressive activity by strong banks as markets began to show signs of recovery. Benefiting hugely from management's decision to put more risk capital to work as markets revived, GS delivered the most profitable quarter in its storied history. The absence of many former competitors had the predictably beneficial impact on profit margins in trading markets for credit and interest rate products as well as currencies. JPM, like GS, benefited from more aggressive activity in its traditional businesses such as investment, commercial, and retail banking and asset management, and from acquisitions of Bear Stearns and Washington Mutual at bargain-basement prices. GS, JPM, C, BAC, and Morgan Stanley (MS) have all been recently upgraded by Egan-Jones.
Defense/Aerospace – Some time ago, we commented favorably on L-3 Communications Holdings, Inc. (LLL), including an admonition to our readers not to confuse LLL with Level 3 Communications Inc. (LVLT) because the gap in credit quality between the similarly-named entities has widened significantly. LLL is the sixth largest defense contractor, a solidly profitable and well-capitalized communications systems company, whereas LVLT, operating one of the world's largest internet protocol-based fiber-optic networks, has reported losses in each of the last five years and nine of the past ten quarters through June 30, 2009. Since early 2007, LLL has been upgraded twice, from BB+ to the recently affirmed BBB, while Egan-Jones has lowered LVLT from B- to C on four separate occasions. We believe the strong contrast between LVLT and LLL is actionable, and accordingly suggest switching LVLT into LLL.
Declining industries
Autos – Last month in this space we discussed our belief that political considerations could carry increasing weight at all levels of the decision-making process at GM, now that the company has emerged from bankruptcy with 60.8% of its stock owned by the U. S. Treasury Department, with the ultimate net result being highly inefficient operating performance and grossly inadequate returns for taxpayers. We sense the presence of such considerations in the publicity behind GM's Chevrolet Volt, simply because there are so few sound economic reasons for its development and marketing on the one hand, and for its purchase and use by consumers on the other. The climate-change component of the Obama Administration's domestic policy goals is visible in GM's promotion of the Volt's projected 230 miles per gallon fuel economy from a power plant that will utilize new hybrid electric-and-gasoline technology and likely win plaudits from the "green" special interests, but we question the size of the potential market for a new, non-luxury vehicle with a distinctly luxury projected price of $40,000. Even after a $7,500 government subsidy for buyers, the Volt will be too expensive for the vast majority of the car-buying public when it is launched late next year as a 2011 model. We have often cited GM's steadily shrinking market share as an important negative credit quality issue; it does not appear that the Volt is capable of contributing to stabilization, much less to reversal, of the trend. Egan-Jones's most recent review affirmed the D credit rating for GM that has been in place since 11/19/08 when it was lowered from C to its present level.
Building Materials – The industry's construction spending reports for June show a mixed pattern, with total construction down 10.2% on a y-o-y basis but up 0.3% for sequential months. Also, the public construction component of total spending was up 5.1% y-o-y, offsetting to some degree the 16.3% y-o-y decline in private construction. Private residential construction, not surprisingly, was very weak (down 30.0%), while public health care construction spending was a bright spot with a 24.0% y-o-y increase. Departing from our usual focus on the two industry leaders, Vulcan Materials and Martin Marietta Materials, our comments this month highlight Texas Industries (TXI) and U. S. Concrete (RMIX). Following the spin-off of Chaparral Steel in 2005, TXI became a pure play in building materials, with 42% of its sales provided by cement (largest producer in Texas with a 30% market share), 35% by ready-mix concrete and consumer products, and 23% by aggregates. RMIX, as its ticker symbol implies, is virtually a pure play in ready-mix, concentrating in major markets including California, Texas, New York, New Jersey and Michigan. Increased government spending for infrastructure improvement will, we believe, be focused more on highway resurfacing than on new building or rebuilding, and is therefore likely to have a greater impact on demand for asphalt than for crushed rock or stone or cement. Although both companies' recent operating results have been depressed by the weakness in overall construction activity, comparative analysis finds TXI with greater financial flexibility than the much smaller RMIX. Egan-Jones accordingly rates TXI at BB and RMIX at B-/negative.
Energy – As we learned from their 2Q09 earnings reports, the supermajor status widely accorded ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP) offered scant protection against the damage to profitability caused by weak oil and gas pricing that pervaded the industry's international scene during the quarter. When the dust had settled, XOM's earnings were down 66% y-o-y, CVX's down 71%, and COP's down 76%. Clearly, oil and gas prices were by far the primary driver of bottom-line results. XOM revealed that its global upstream earnings of $3.812 billion were $6.200 billion lower than last year, of which difference $6.100 billion was attributable to lower prices. The higher production volumes achieved by CVX (+5.1%) and COP (+7%) (XOM was down 3.1%) did not come close to offsetting the negative impact of prices. Despite currently depressed earnings, credit quality of these U.S.-based supermajors remains strong. The AA ratings for XOM and CVX that have been in place since 2003 remain fully justified, in our view, with the former's cash position of $$15.6 billion as of June 30 continuing to exceed debt of $9.2 billion, even though the company has drawn down somewhat a balance that exceeded $30 billion at each of the prior three year-ends and fell just shy of $39 billion as of June 30, 2008. XOM's market cap, meanwhile, is $332.46 billion. CVX is next in line with a market cap of $138 billion, cash of $9.2 billion, and debt of $12.2 billion. CVX's Board of Directors recently increased the common dividend by 4.6% from a $2.60 annual rate to $2.72. Relatively speaking, COP is the weak sister here, with a market cap of $65.5 billion, cash of $802M, and debt of $29.5 billion. Even so, Egan-Jones rates COP at the A- level.
Machinery – Caterpillar's (CAT) 2Q earnings report included a number of unusual aspects, beginning with a bottom-line net income figure that declined y-o-y by 66% on 41% lower revenue, but on an EPS basis ($0.60, after redundancy costs of $0.12) still blew away the Wall Street consensus ($0.22). We say unusual, but CAT's operating performance exemplifies what may have become the standard corporate financial model whereby intensive cost reduction trumps sluggish or non-existent revenue increases at least temporarily as the principal driver of profit growth. In CAT's case lower SG&A and R&D expenses lessened the y-o-y decline in 2Q operating profit by $291M, while an $832M reduction of CAT's inventory during the quarter was the source of a $110M LIFO profit ($0.14 per share). Although changing currency values had a negative impact on dollar-denominated revenue, the net result for operating profit was favorable by $89M due to the beneficial effect on costs. Finally, CAT's 2Q tax rate was just 10.0% vs. 28.2% last year; the income tax line item was $40M vs. $434M. In updating its guidance for full-year sales and earnings, management cited "improved expectations" in tightening the sales forecast from "about $35B" to a $32 - $36B range vs. $51.3B in 2008, and EPS in a $1.15 - $2.25 range (before redundancy costs of $0.75), vs. $5.66 last year and up from $1.25 three months ago. All this looks like CAT may be near the trough of this cycle, for which reason Egan-Jones recently upgraded its rating from BB+ to BBB-.
Chemical – We have kept a close eye on Monsanto (MON) during the past year for several reasons. One, because its fiscal year ends August 31, its quarterly earnings reports are more visible than those from the much more numerous companies on the 3-6-9-12 cycle. Two, global agriculture is the principal driver of MON's earnings rather than the spread between volatile petroleum commodity prices that define much of the industry's raw material cost structure, and demand for industrial and consumer products that, together with highly competitive global pricing, generate the industry's revenues. Finally, Egan-Jones has carried a solid A+ rating for MON since 1/3/08 that, in our opinion, continues to be justified by persistently strong operating performance. Recently-reported operating income was essentially flat for the May quarter, despite an 11% decline in revenue, as MON's very profitable seeds business offset a 50% reduction in sales of glyphosate-based herbicides (including Roundup). In significant contrast to many other companies that have either reduced EPS guidance for the current year or withdrawn it altogether, MON management expects to report full-year results in a $3.76 - $3.92 range vs. $3.62, the former after write-offs of $0.60 - $0.66 for restructuring and acquisition-related in-process R&D. Egan-Jones's recently affirmed A+ rating for MON also includes a positive-outlook modifier.
Auto Suppliers – Back from the brink - American Axle & Manufacturing (AXL) will receive up to $210M from GM, its principal customer, an agreement that could help the supplier of axles and driveshafts stave off bankruptcy, and could also allow GM to acquire a 19.9% stake in AXL. Three entities are involved in the transaction: AXL, GM, and AXL's lenders, who so far have twice waived a deadline for a breach of AXL's loan covenants. If the loan's terms can be satisfactorily revised, GM can pay AXL $110M for pre-bankruptcy contracts and also make available a loan facility of up to $100M that initially grants GM five-year warrants for up to 7.4% of AXL stock. Then, if AXL draws the full $100M, GM's option increases by a further 12.5% of AXL stock, giving GM a potential holding of 19.9% of this key parts supplier. Egan-Jones review of these developments resulted in an upgrade of AXL from D to CC, continuity of GM support going forward was cited as a key issue. We see it as likely as long as GM remains under government control.
Retail – Although most of the current news stories about cautious consumer spending identify Wal-Mart (WMT) as the store where a lot of those folks do spend the lesser amounts of cash that they are willing to part with, we'd like to discuss another discount store chain that is more than holding its own in this very difficult environment for retailers. TJX Companies, Inc. (TJX) recently reported a 4% sales increase for 2QF1009 (ended May 1) supported by a 4% positive quarterly same-store sales comparison, and a 23% boost in net income. TJX's four domestic retail chains include the two largest off-price clothing retailers, T. J. Maxx and Marshalls; HomeGoods, focused entirely on home furnishings; and A. J. Wright clothing stores aimed at lower-income shoppers. Clothing and footwear contributed 62% of F2008 revenue, home fashions 25%, and jewelry and accessories 13%. Financially, the company presents a very strong picture with cash exceeding debt, rent-adjusted coverage ratios around 30 times, and a market cap of $14.4B. Egan-Jones-s recent review of TJX resulted in an upgrade from A- to A/positive. A fashion/style disclaimer should probably be included in our suggestion of a switch from Saks, rated at the D level since earlier this year, into TJX.
Home Builders – Don't look now, but a plus sign actually appears in front of one year-over-year percentage change figure for an important industry metric. Toll Brothers' (TOL) net new orders rose 3% for 2Q09 vs. 2Q08, the first such increase for the company since 2005. Lest this be interpreted too positively as a harbinger of improving market conditions in this beleaguered industry, TOL's net new orders in dollar terms were down 5%. Pricing is still under severe pressure from a vastly oversupplied market that now includes a significant segment of banks' sales of foreclosed homes. Rating reviews by Egan-Jones since our last comments included Centex (CTX, affirmed at CC/negative), D. R. Horton (DHI, affirmed at C), Pulte Homes (PHM, affirmed at B-/negative), and Ryland Homes (RYL, affirmed at B-/negative). No ratings were changed during the past month for any of the ten homebuilders we follow.
Source: Egan-Jones Ratings And Analytics
Saturday, September 5, 2009
China and the OIL market?
This may turn out to be big:
Excellent article. I have replicated from the above link below:
Excellent article. I have replicated from the above link below:
Thursday, September 3, 2009
CHINA AND THE BUZZ OF A PENDING BANK DEFAULT
Let’s put the pieces together here. Just this past weekend China announced that State Owned Enterprises (SOEs) will be allowed to default on commodity derivative contracts. Think of that. China has given the green light and authorized the defaulting on commodity derivative contracts.
This story broke over the weekend but has not gotten much mainstream media attention on this side of the pond. (North America). The only inference to it was the talk or “buzz” on the Wall Street floor that another bank was rumored to be close to defaulting. As Art Cashin of UBS Securities indicated in the video clip I posted earlier, normally when a market sells off on a rumor and the rumor turns out to be false, the market will tend to correct itself. IT DIDN’T.
The Reuters report cited 6 foreign banks that received letters indicating that the Chinese State Owned Enterprises would be given the green light to default on their derivatives.
A look at what a derivative actually is may be useful here. A Derivative is a financial instrument that is derived from some other underlying asset, index, event, value or condition. Rather than trade or exchange the underlying itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date. Commercial and investment banks make up the foundation of the over the counter (OTC) derivatives market. Investors use derivatives to protect against risks, such as sudden changes in price or value of the underlying asset. Others tap derivatives to take on extra risk, in the hope of extra gains.
Well China owns billions of these products and it has finally come to light they have had enough of having the value of their derivatives manipulated by the manipulation of the price of the underlying asset. They have finally woken up to the fact that these derivatives have been bundled together like junk in a manner that resembles the mortgage backed derivatives that brought down the world markets last year.
Back to Reuters. Some of the State Owned Enterprises that stated their potential intentions to default were Air China. China Eastern and Cosco. Mainly in part because they took major derivatives losses over the past year but also, concerns are arising that the derivatives that they were sold by these foreign institutions are garbage, underwater and may never see the light of day. So why continue to pay for them? So the concern in the financial world is that holders of these losing products may just walk away, not unlike a home owner with a $600,000 mortgage on a home valued at $475,000 deciding to just hand in their keys. However, read on...this has nothing to do with morgtgage backed products. This time, the concern may be over Oil.
They (Reuters) cited 6 foreign banks.Where the story gets really intriguing is that among the major derivatives providers according to Reuters but also widely known in the industry, are Goldman Sachs, UBS and JP Morgan.
Here is the looming problem. These products are worth billions. One report that a good friend of mine did showed that if Goldman Sachs for example were to take this one up the rear, they could stand to lose 15 billion dollars. (This number is by no means confirmed)
An important history lesson is needed here. “Potential default” was the concern that sparked and prompted the most recent economic crisis. These intricately weaved products along with highly speculative CDOs and CDSs began to fall apart when the bubble that was in large part significantly contributed to and created by the financial institutions that were packaging this junk started to fall apart.
Imagine the impact for a brief moment if you will, on the impact to the financial landscape if China were to say “we are walking away” from those products. I would imagine that China, being the biggest purchaser of US debt, could surely collapse the US institutions that were at one point deemed too big to fail if they decide to go ahead with this plan.
This is why I don’t take tonight’s news that China purchased 50 billion dollars of IMF bonds lightly. In fact, I take it very seriously. This is why I take the buzz on the floor over the past two days very seriously as well as I do the incredible spike in Gold today. Most importantly, I do not take lightly the recent 25% correction we have seen in the Chinese Stock Market. Can all these events be interconnected some how? Is the Chinese stock collapse giving us a hint?
The Reuters story came out on Mon Aug 31, 2009 at 7:42am EDT. I find it quite interesting that the mainstream media did not take this more seriously. Reuters reported that the above noted Chinese companies have already issued letters to the banks. The Reuters article cites 4 clear points.
• State-owned firms may default on commodity hedges - report
• Bankers dismayed, confused by report; seek more details
• Lawyers question legality of the move
• Traders suspect lurking losses may have prompted warning (Adds analysts comments)
Analysts are fearing that if these three big companies came out and spelled out their losses and dismay at these products then this might prompt other large Chinese corporations to do the same.
Let’s take a closer look at the companies that have been mentioned in these news articles out of China. They are Air China, China Eastern and Cosco. If you ask me, this conundrum might have to do with oil. I deduce from this that if there is a problem brewing it has everything to do with their Oil Derivatives business.
Here’s a brief overview of what might happen should these companies, and others, default. The banks, namely Goldman Sachs, J.P. Morgan and from other accounts possibly Deutsche Bank will find themselves LONG on oil futures with no customers on the short side of the derivatives. This will most likely lead the banks to sell the excess oil futures without a care for the price. This is no different than what happened when Bear Stearns was forced to sell off their gold futures in March of 2008 which then resulted in a sharp downturn in the price of Gold.
Reuters stated:
Spokespersons at Goldman Sachs (GS.N) and UBS (UBSN.VX) declined comment, and media officials at Morgan Stanley (MS.N) and JPMorgan (JPM.N) were not immediately available for comment. All are major global providers of commodity risk management.
We have yet to hear their commentary. A Chinese statesperson was quoted as saying “"If we were among the banks receiving that letter, we would be very angry.” You bet your bottom dollar. You don’t think the firms listed above are angry, or, are they frightened that if the Chinese State Owned entities start taking affirmative action it could theoretically bring down some of the biggest remaining names on Wall Street?
Remember Reuters initial story was titled Beijing's derivative default stance rattles market. Read it thoroughly for more information.
Then, read the story that broke last Saturday to get a clearer perspective before the political and corporate spin started to enter the story. China warns banks on OTC hedge defaults –report.
“BEIJING, Aug 29 (Reuters) - Chinese state-owned enterprises (SOEs) may unilaterally terminate derivative contracts with six foreign banks that provide over-the-counter commodity hedging services, a leading financial magazine said.
China's SOE regulator, the State-owned Assets Supervision and Administration Commission (SASAC), had told the financial institutions that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying.”
On September 1, 2009 Reuters said that the Banks, not the commodities would be at risk if China followed through.
Yes, legal battles would ensue should this happen and we can also expect to have Chinese political figures downplay the story in an effort to avert panic. However, if they can prove that these derivatives or the underlying asset was manipulated in a manner to profit the bank that issued the product then that may even do more damage than the default themselves.
Perhaps the “buzz” on the floor is indeed true. Perhaps we are going to see action that could annihilate one of the biggest Wall Street firms ever.
If there is one thing I have learned of late is that when the Chinese speak, we must listen. Their list of allies is ever growing and they are simply fed up of having to swallow the US garbage that has turned out to be toxic and dangerous to their highly controlled and coveted state owned enterprises.
I leave you with these thoughts that I alluded to above. The Chinese market has corrected 25%. This news broke this past weekend. New York saw a sharp sell-off on Monday. Buzz of a bank default hit the floor. The rumor did not abate and the selling intensified. The selling carried over into Tuesday. Gold, a classic hedge against troubled times has broken out to the upside, China has purchased 50 billion in IMF bonds and has been questioning the US dollar now for upwards of a year. China was up 5% overnight and Gold has continued to climb this morning.
Where there is smoke there is often fire.
Friday, September 4, 2009
Thursday, September 3, 2009
How will China handle the Yuan?
Source: Mish
Inquiring minds are asking "How Will China Handle The Yuan?"
It's a good question, too. Lance Lewis has a conversation with Professor Ryan Krueger in How China Will Handle the Yuan describing how it might play out. Please click on the above link for one possibility.
Here is the same conversation except with me replying to Lance instead of Professor Ryan Krueger.
Lance Lewis: You notice the extra chunky volume in the Chinese Yuan ETF (CYB) yesterday at the same time that the dollar reversed violently?
Mish: This violent reversal?
That looks like normal day to day action to me.
Lance: I’m telling ya. Something is up with China and the yuan. It would explain a lot. What if it were close to revaluing against the dollar?
We know it's fed up with funding US debt, but it can’t stop funding it as long as it continues to peg to the dollar and is forced to buy dollars every day in order to hold down the yuan. The US isn’t even its largest export market anymore. The EU is. The US consumer is broke. Why does China need to keep exporting cheap goods to the US if the US consumer can’t buy them anyway?
Now look at the recent market action in August. Normally when Chinese stocks go down, the dollar rallies and commodities get hit, just like in early August when people were betting on “the usual.” But this time, after the initial knee-jerk reaction to Chinese stocks sliding, “the usual” didn’t happen. Oil is now back on its highs. Gold is close to breaking out, and the dollar is back on its low for the year. And all of this is occurring even as Chinese stocks are back on their lows as of last night?
China revaluing the yuan is the only thing that fits, and the US Treasury may even have an inkling that it’s coming, which would explain why Obama suddenly renominated Gentle Ben on a Tuesday in late August when he was supposedly on vacation. Rather odd timing, but not so if the intent was to remove as much uncertainty as possible as to who will be running the Federal Reserve going forward in order to prevent complete panic in the dollar and Treasuries if China were to one day say “I’ve had enough” to buying more dollars and Treasuries every single day in order to hold her dollar/yuan peg.
It’s the only thing that fits. If so, the dollar would get smoked, literally, “overnight” and gold would explode. Bonds would probably get crushed, too.
Mish: No, it's not the only thing that fits. China is printing more RMB (yuan) on a relative basis than the US is printing dollars. It is using that printed money to buy commodities and China is arguably on the verge of overheating.
Moreover, the Baltic Dry shipping index is collapsing. This suggests a weakening of demand for commodities.
Oil is indeed firm, but China has also been stockpiling. How much longer that can go on with little demand for China's exports is anyone's guess.
EU may have passed the US as China's biggest trading partner, but EU consumers are not in such great shape either. For a discussion of Europe and how it relates to this mess, please see Deflation Is A Bitch.
Indeed, consumers are tapped out everywhere, and arguably European and Chinese banks are in worse shape than US banks.
Moreover, there is also a not-so-little thing called peak oil that might be keeping oil firm. And it's hurricane season.
The critical issue however, is simple math.
The US runs a trade deficit with China. That means China must accumulate US assets. China does not have a choice in the matter; it is purely a mathematical function. When the US runs a deficit, mathematically someone must run a surplus.
There is no choice in the matter other than to raise the price of goods so high that consumers won't buy them. Pray tell, what would that do to unemployment and civil unrest in China? What would that do to demand in Europe? It is virtually impossible for China to strengthen its currency to the US dollar without affecting every other currency as well.
Some might suggest that China should buy oil with those dollars, but then what would the Mideast exporters do with them?
The reason China is buying fewer US treasuries recently is that the US deficit with China is shrinking. Again this is a simple mathematical equation, not some massive conspiracy to dump the dollar. Of course China could buy US ports and bridges or oil companies instead of treasuries, but such maneuvers have been blocked by Congress and last I checked no ports or bridges are for sale.
Lance: Wal-Mart (WMT) would be in trouble. It probably wouldn’t be able to raise prices on all the cheap Chinese goods, and I’d likely have to just eat it with thinner margins. That would go for a lot of retailers actually, and their pain would be compounded by higher gasoline prices squeezing the consumer even more. What fun we’ll have.
Mish: The whole world is on thinner margins. Deflation has set in and one quarter or two of massive stimulus that is likely to fail sooner rather than later does not change that fact. Deflation is a process that takes years to play out. One or two quarters of rebound means no more to the US than it did to Japan over its two lost decades, now going on three.
In spite of record worldwide stimulus, a global recession is everywhere you look except perhaps in China. The reason is simple. When the Chinese government "suggests" banks should lend, banks lend. This is how command economies "work", using the word "work" loosely. Yes, the US has massive problems, but let's have an honest assessment of problems elsewhere.
Bottom line, China is busy ramping up production for consumers that don't exist: Not here, not in the EU, and not in China (not yet). This love affair with China, a country that will not float its currency or offer freedom of speech, and hides bank solvency issues even more so than the US, is way overdone.
Ironically, over the years, I have been a staunch defender of China, on average. Remind me to reconsider decoupling when China allows freedom of speech and floats the RMB instead of pegging it.
Lance: Question is how smart are the Chinese? Dumb enough to keep printing yuan in order to hold it down versus the tidal wave of dollars that are crashing on her shores, and at the same time fund gargantuan US government-deficit spending out of the kindness of its heart? Or smart enough to say “enough!”
Mish: As discussed above, that tidal wave is a mathematical equation. More importantly, "dumb" might be in the eyes of numerous dollar bears expecting dollar Armageddon vs. Chinese officials fearing social unrest.
Please remember the other side of the coin, namely 10's of millions of workers that China desperately wants to keep employed at nearly any cost to avoid civil unrest. A weak currency helps Chinese exports, thus keeping workers employed.
A 4-Minute Tour of the China Property Bubble
What is China doing with all that printing? Please take a A 4-Minute Tour of the China Property Bubble to find out.
World's Largest Shopping Mall Sits Vacant
The world's largest shopping mall, South China Mall in Guangzhou, China, is almost entirely empty. Click on the link to see a fascinating video.
If you thought Minnesota's Mall of America was the world's biggest shopping center, think again. South China Mall is a Vegas-like spectacle built in 2005 that now sits almost entirely empty. In the current economic climate, could this be a symbol of things to come?
The entire mall sits empty save 10-12 small shops.
Malinvestments and Commodity Prices
Think about all the concrete, steel, copper, and energy it took to build that mall. This is not an isolated case either as the previous 4-minute video shows.
Let's not confuse a renewed crack-up boom in China with a sustainable recovery. And let's not pretend much of this building is anything other than malinvestment.
Decoupling Theories Way Premature
Think about the wages those store owners get. Think about wages in China in general.
For more on wages and malinvestments please see Inside China: A Sculptor's View, an email exchange with Bill Hopen, a sculptor who frequently travels to China, often for months at a time. That post and the above videos should help open eyes.
Decoupling theories are very premature, at best.
What Would Happen If China Floated The RMB?
Yes, the US is printing. However, please remember that China, the UK, and most other countries are too. And on a relative basis, China's stimulus package is greater than the US stimulus package.
It's relative differences in printing and other such factors that will help determine currency trends. And as much as commentators pick on US stats like GDP, mark to market accounting, off sheet balances, etc, bear in mind we have far less believable data on China.
For starters, Chinese GDP numbers are simply bogus.
Professor Vitaliy Katsenelson has discussed that idea on several occasions including China's Growth an Accounting Miracle.
For all the complaints about US banks hiding things (and yes US banks are hiding things massively so), at least we have balance sheets and footnotes to look at and decipher. Can we say the same about China?
US banks are in trouble, but it is a huge mistake to think Chinese banks are in better shape.
I repeat my comment made earlier: When the Chinese government "suggests" banks should lend, banks lend. This is how command economies "work", using the word "work" loosely. Yes, the US has massive problems, but let's have an honest assessment of problems elsewhere.
In light of the above, if China floated the RMB while giving an accurate assessment of its GDP and the true state of affairs with its banks, the RMB might crash.
How would China handle that? Better yet, how would the world handle that?
Such fears are the most likely reason behind China's currency peg in the first place. Yes, China is taking steps towards floating the RMB, but China seldom rushes into things, often taking years or even decades to make major policy shifts.
Gold Seasonality And Fundamentals
By the way, I happen to agree with professor Lewis that gold seasonality is favorable. I agree with him that the intermediate to long-term fundamentals for gold are positive. We simply differ as to what those fundamentals are.
At times, in unfavorable seasonality gold has rallied. At times it doesn't. And please don't think that gold does well in times of inflation and deflation because it doesn't. Proof is simple: There was inflation every step of the way from 1980 to 2000 with gold dropping from 850 to 250 while every other asset class soared.
Gold does well in times of credit stress (stagflation, hyperinflation, or deflation). I think we can all agree (one way or another) that this has been a period of high credit stress.
Short-term I do not know, nor does anyone else what gold will do. Last year at this time, in spite of favorable seasonality gold sold off. However, unlike most other commodities, gold regained nearly everything it lost. Are we in for a repeat? No one really knows.
However, should a dollar crash occur and gold soar, given that I own gold I would benefit. On the premise that gold is money and gold should do well in deflation, I did expect gold to hold up well and it did.
Prechter, who does not view gold as money, thinks gold will collapse. Thus, not all deflationists think alike.
This post is long enough. Inquiring minds may wish to consider Countdown To Dollar Implosion Madness for a discussion of how trade deficits affect the situation.
Key Take-Aways From The Discussion
1) China will act in China's best interest.
2) China, not US market theorists will make the decision. That decision is not so clear cut once one looks at both sides of the coin.
3) China tends to move slowly in such decisions.
Regardless of what happens, dollar-crash theories involving China and BRIC mandates, secret meetings, and other speculation are getting a bit out of hand in numerous places. There are easily two sides of the coin (if not more), and China is apt to move slowly whichever way it moves.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Inquiring minds are asking "How Will China Handle The Yuan?"
It's a good question, too. Lance Lewis has a conversation with Professor Ryan Krueger in How China Will Handle the Yuan describing how it might play out. Please click on the above link for one possibility.
Here is the same conversation except with me replying to Lance instead of Professor Ryan Krueger.
Lance Lewis: You notice the extra chunky volume in the Chinese Yuan ETF (CYB) yesterday at the same time that the dollar reversed violently?
Mish: This violent reversal?
That looks like normal day to day action to me.
Lance: I’m telling ya. Something is up with China and the yuan. It would explain a lot. What if it were close to revaluing against the dollar?
We know it's fed up with funding US debt, but it can’t stop funding it as long as it continues to peg to the dollar and is forced to buy dollars every day in order to hold down the yuan. The US isn’t even its largest export market anymore. The EU is. The US consumer is broke. Why does China need to keep exporting cheap goods to the US if the US consumer can’t buy them anyway?
Now look at the recent market action in August. Normally when Chinese stocks go down, the dollar rallies and commodities get hit, just like in early August when people were betting on “the usual.” But this time, after the initial knee-jerk reaction to Chinese stocks sliding, “the usual” didn’t happen. Oil is now back on its highs. Gold is close to breaking out, and the dollar is back on its low for the year. And all of this is occurring even as Chinese stocks are back on their lows as of last night?
China revaluing the yuan is the only thing that fits, and the US Treasury may even have an inkling that it’s coming, which would explain why Obama suddenly renominated Gentle Ben on a Tuesday in late August when he was supposedly on vacation. Rather odd timing, but not so if the intent was to remove as much uncertainty as possible as to who will be running the Federal Reserve going forward in order to prevent complete panic in the dollar and Treasuries if China were to one day say “I’ve had enough” to buying more dollars and Treasuries every single day in order to hold her dollar/yuan peg.
It’s the only thing that fits. If so, the dollar would get smoked, literally, “overnight” and gold would explode. Bonds would probably get crushed, too.
Mish: No, it's not the only thing that fits. China is printing more RMB (yuan) on a relative basis than the US is printing dollars. It is using that printed money to buy commodities and China is arguably on the verge of overheating.
Moreover, the Baltic Dry shipping index is collapsing. This suggests a weakening of demand for commodities.
Oil is indeed firm, but China has also been stockpiling. How much longer that can go on with little demand for China's exports is anyone's guess.
EU may have passed the US as China's biggest trading partner, but EU consumers are not in such great shape either. For a discussion of Europe and how it relates to this mess, please see Deflation Is A Bitch.
Indeed, consumers are tapped out everywhere, and arguably European and Chinese banks are in worse shape than US banks.
Moreover, there is also a not-so-little thing called peak oil that might be keeping oil firm. And it's hurricane season.
The critical issue however, is simple math.
The US runs a trade deficit with China. That means China must accumulate US assets. China does not have a choice in the matter; it is purely a mathematical function. When the US runs a deficit, mathematically someone must run a surplus.
There is no choice in the matter other than to raise the price of goods so high that consumers won't buy them. Pray tell, what would that do to unemployment and civil unrest in China? What would that do to demand in Europe? It is virtually impossible for China to strengthen its currency to the US dollar without affecting every other currency as well.
Some might suggest that China should buy oil with those dollars, but then what would the Mideast exporters do with them?
The reason China is buying fewer US treasuries recently is that the US deficit with China is shrinking. Again this is a simple mathematical equation, not some massive conspiracy to dump the dollar. Of course China could buy US ports and bridges or oil companies instead of treasuries, but such maneuvers have been blocked by Congress and last I checked no ports or bridges are for sale.
Lance: Wal-Mart (WMT) would be in trouble. It probably wouldn’t be able to raise prices on all the cheap Chinese goods, and I’d likely have to just eat it with thinner margins. That would go for a lot of retailers actually, and their pain would be compounded by higher gasoline prices squeezing the consumer even more. What fun we’ll have.
Mish: The whole world is on thinner margins. Deflation has set in and one quarter or two of massive stimulus that is likely to fail sooner rather than later does not change that fact. Deflation is a process that takes years to play out. One or two quarters of rebound means no more to the US than it did to Japan over its two lost decades, now going on three.
In spite of record worldwide stimulus, a global recession is everywhere you look except perhaps in China. The reason is simple. When the Chinese government "suggests" banks should lend, banks lend. This is how command economies "work", using the word "work" loosely. Yes, the US has massive problems, but let's have an honest assessment of problems elsewhere.
Bottom line, China is busy ramping up production for consumers that don't exist: Not here, not in the EU, and not in China (not yet). This love affair with China, a country that will not float its currency or offer freedom of speech, and hides bank solvency issues even more so than the US, is way overdone.
Ironically, over the years, I have been a staunch defender of China, on average. Remind me to reconsider decoupling when China allows freedom of speech and floats the RMB instead of pegging it.
Lance: Question is how smart are the Chinese? Dumb enough to keep printing yuan in order to hold it down versus the tidal wave of dollars that are crashing on her shores, and at the same time fund gargantuan US government-deficit spending out of the kindness of its heart? Or smart enough to say “enough!”
Mish: As discussed above, that tidal wave is a mathematical equation. More importantly, "dumb" might be in the eyes of numerous dollar bears expecting dollar Armageddon vs. Chinese officials fearing social unrest.
Please remember the other side of the coin, namely 10's of millions of workers that China desperately wants to keep employed at nearly any cost to avoid civil unrest. A weak currency helps Chinese exports, thus keeping workers employed.
A 4-Minute Tour of the China Property Bubble
What is China doing with all that printing? Please take a A 4-Minute Tour of the China Property Bubble to find out.
World's Largest Shopping Mall Sits Vacant
The world's largest shopping mall, South China Mall in Guangzhou, China, is almost entirely empty. Click on the link to see a fascinating video.
If you thought Minnesota's Mall of America was the world's biggest shopping center, think again. South China Mall is a Vegas-like spectacle built in 2005 that now sits almost entirely empty. In the current economic climate, could this be a symbol of things to come?
The entire mall sits empty save 10-12 small shops.
Malinvestments and Commodity Prices
Think about all the concrete, steel, copper, and energy it took to build that mall. This is not an isolated case either as the previous 4-minute video shows.
Let's not confuse a renewed crack-up boom in China with a sustainable recovery. And let's not pretend much of this building is anything other than malinvestment.
Decoupling Theories Way Premature
Think about the wages those store owners get. Think about wages in China in general.
For more on wages and malinvestments please see Inside China: A Sculptor's View, an email exchange with Bill Hopen, a sculptor who frequently travels to China, often for months at a time. That post and the above videos should help open eyes.
Decoupling theories are very premature, at best.
What Would Happen If China Floated The RMB?
Yes, the US is printing. However, please remember that China, the UK, and most other countries are too. And on a relative basis, China's stimulus package is greater than the US stimulus package.
It's relative differences in printing and other such factors that will help determine currency trends. And as much as commentators pick on US stats like GDP, mark to market accounting, off sheet balances, etc, bear in mind we have far less believable data on China.
For starters, Chinese GDP numbers are simply bogus.
Professor Vitaliy Katsenelson has discussed that idea on several occasions including China's Growth an Accounting Miracle.
Once China had announced its 8 percent growth target, it began to disburse funds directed at a sharp increase in public works spending. It is important to understand that the disbursal of funds is recorded as GDP growth. So the government can easily control the pace of growth by the pace at which it releases funds that have already been allocated in the stimulus package to the creation of higher production or growth numbers. Funds disbursed for fixed-asset investment by state-owned enterprises or provincial governments are counted as having been spent when they are disbursed.Professor Katsenelson was discussing China: Bogus Boom? by John Makin. It's a real gem, and well worth a look.
.... I am not convinced China will have inflation in the long-run. It appears that deflation is a more likely scenario as China is ridden with overcapacity – the country was geared for much higher global growth. I can, however, see inflation erupting in a very short timeframe as money has been thrown at the consumer/companies, and we are seeing this in the stock market and real estate. But in the long run, inflation appears an unlikely outcome: overcapacity and slower demand from the US and Europe will force Chinese producers to cut prices to increase utilization and stimulate demand.
And finally, I'm sure China doesn’t want the renminbi to be the world’s currency as it would drive up the value – a suicide for an export-based economy.
For all the complaints about US banks hiding things (and yes US banks are hiding things massively so), at least we have balance sheets and footnotes to look at and decipher. Can we say the same about China?
US banks are in trouble, but it is a huge mistake to think Chinese banks are in better shape.
I repeat my comment made earlier: When the Chinese government "suggests" banks should lend, banks lend. This is how command economies "work", using the word "work" loosely. Yes, the US has massive problems, but let's have an honest assessment of problems elsewhere.
In light of the above, if China floated the RMB while giving an accurate assessment of its GDP and the true state of affairs with its banks, the RMB might crash.
How would China handle that? Better yet, how would the world handle that?
Such fears are the most likely reason behind China's currency peg in the first place. Yes, China is taking steps towards floating the RMB, but China seldom rushes into things, often taking years or even decades to make major policy shifts.
Gold Seasonality And Fundamentals
By the way, I happen to agree with professor Lewis that gold seasonality is favorable. I agree with him that the intermediate to long-term fundamentals for gold are positive. We simply differ as to what those fundamentals are.
At times, in unfavorable seasonality gold has rallied. At times it doesn't. And please don't think that gold does well in times of inflation and deflation because it doesn't. Proof is simple: There was inflation every step of the way from 1980 to 2000 with gold dropping from 850 to 250 while every other asset class soared.
Gold does well in times of credit stress (stagflation, hyperinflation, or deflation). I think we can all agree (one way or another) that this has been a period of high credit stress.
Short-term I do not know, nor does anyone else what gold will do. Last year at this time, in spite of favorable seasonality gold sold off. However, unlike most other commodities, gold regained nearly everything it lost. Are we in for a repeat? No one really knows.
However, should a dollar crash occur and gold soar, given that I own gold I would benefit. On the premise that gold is money and gold should do well in deflation, I did expect gold to hold up well and it did.
Prechter, who does not view gold as money, thinks gold will collapse. Thus, not all deflationists think alike.
This post is long enough. Inquiring minds may wish to consider Countdown To Dollar Implosion Madness for a discussion of how trade deficits affect the situation.
Key Take-Aways From The Discussion
1) China will act in China's best interest.
2) China, not US market theorists will make the decision. That decision is not so clear cut once one looks at both sides of the coin.
3) China tends to move slowly in such decisions.
Regardless of what happens, dollar-crash theories involving China and BRIC mandates, secret meetings, and other speculation are getting a bit out of hand in numerous places. There are easily two sides of the coin (if not more), and China is apt to move slowly whichever way it moves.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Wednesday, September 2, 2009
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