The Next Market Earthquake

Just the other night, I enjoyed one of the most enlightening dinners of my lifetime, thanks to the company of two analysts who recently joined Weiss Research — Boris Schlossberg and Kathy Lien. (For more on Boris and Kathy, click here.)

Separately, I also interviewed them in depth about the next earthquake that’s likely to strike the U.S. markets, and Kathy was the first to speak.

Kathy Lien: China is the epicenter, and the first tectonic shifts actually began months before the latest decline in the U.S. market — in June of last year. That’s when China’s Shanghai Index peaked. And now, just over a half year later, it’s already down 70.6%.

But the reason this is so important goes beyond the impact it has on U.S. stocks. It’s also because we’re seeing very large declines in the Chinese currency, the yuan.

In fact, the latest plunge in the Chinese yuan was one of the deepest in modern history, second only to the historic devaluation last summer.

This has major global ramifications because China is one of the most important consumers in the world, and their diminished purchasing power — due to the weaker yuan — is hitting virtually all the pocketbooks of the world.

Martin: Just last week, Abby Cohen at Goldman Sachs said the China bust is simply creating a buying opportunity for U.S. stocks. Others are saying that China’s growth recession is not a deal-breaker for the global economy. How do you respond to that?

The Single Biggest Nemesis of the World Economy

Boris: What they don’t seem to realize is that China is the world’s single most important marginal buyer.

Martin: Please explain.

Boris: Go back a couple of decades — before China was such a big player in global markets. The supply and demand for commodities and goods were essentially in equilibrium. But as China’s growing demand kicked in, it emerged as THE critical new factor that drove prices higher, that drove global growth higher. It was the extra bonus that transformed the world economy.

Martin: So what happens now that the extra margin is taken off the table?

Boris: It suddenly becomes the single biggest nemesis of the global economy. It has already pulled the rug out from under emerging markets. And it’s also one of the main reasons Shanghai stocks have collapsed.

Martin: What are the other main reasons?

Kathy: Their growth is slowing. Their imports are slowing. And for people who understand how thoroughly Beijing controls the economy, what’s most concerning is the fact that China is engineering its own slowdown.

Martin: I think our readers would like to understand that better.

Kathy: The slowdown is virtually cooked into their new 5-year plan; and the 5-year plans in China are a very big deal!

Martin: Because …

Kathy: Because China is an intensely government-controlled economy. Because these plans have shaped the Chinese economy for over three decades. And because they always do everything possible to abide by the plan — very, very strictly.

Here’s the key: The new 5-year plan begins this year. It will continue until the year 2020. And it’s deliberately designed to transition China from a fast-growing manufacturing economy to a slower-growing consumer economy.

Boris: Let me put that into a global perspective. What China wants — what China is planning for — is a massive, national upgrade. They want to jump from a low-income, emerging-market-type country to the high-income, high-consumption-type country.

Martin: Like Western Europe.

Boris: Yes, like Western European economies, the United States and other advanced countries. The difference is huge. In the low-income countries, most people are delighted to make something close to the average, say, $10,000 per year. In the high-income countries, many snub an average of $50,000 or higher.

Kathy: If they can achieve those levels, that alone will cut deeply into their growth rates.

Martin: Do you mean their growth rates will start looking more like America’s or France’s? Instead of 10% or even 7% per year, more like 3% per year?

Kathy: Yes, and never forget: China does not look at the world as a charity case. All they care about is what’s in it for them — a higher standard of living. As long as their goal is achieved in the end, they don’t care much about what their slower growth is going to do to the rest of the world.

So there will be pain, and there will be mistakes. They will learn from those mistakes. And in the end, they could achieve their goal.

Big Blunders

Martin: Tells us more about the mistakes.

Kathy: Look at the blunders they’ve just made in the way they manipulate their financial markets. We’ve seen stock market circuit breakers that imploded. We’ve seen stock market collapses, which the government made even worse with its fumbled controls. We’ve seen those market controls suddenly slapped on, taken off and then slapped on again.

If they also make big mistakes with the economy, the danger is that they could wind up in a trap like Eastern European countries — unable to compete in the export markets but also unable to achieve high incomes for a robust domestic economy.

Martin: A long-term problem, right?

Boris: Yes, but there are also two immediate problems:

First, they’ve already seen a scary drop in their export growth. But their consumer economy has not yet picked up enough; it’s nowhere near filling the gap. That’s why Beijing is so nervous, and that’s why they devalued the Chinese yuan in August.

The other immediate problem is that they’re burning through their reserves like crazy. In the month of December alone, it’s estimated that they spent about $3.5 billion per day in order to prevent an even deeper plunge in the currency. That means they’re shedding reserves at a yearly rate of about $1 trillion, a massive flow of flight capital out of China.

Martin: And the fastest way to accelerate that outflow is to tell investors they can’t sell — precisely what the Chinese government has done.

Kathy: Another blunder! Overall, they’re taking a lot of clumsy steps in order to stem the bleeding, but there’s little confidence they’re going to work.

Now here’s the biggie: One of the most effective things they could do to fix their economy is precisely the same thing that’s the greatest risk to investors: Another massive devaluation in the yuan.

With the click of a button, they’d wipe away enormous value from the portfolios of any investor with any kind of assets in China and Hong Kong: Major U.S.-based multinationals from Starbucks to Apple. Domestic and international banks.

Speculative Bubbles

Martin: Years ago, there were many speculative bubbles in China, but just as they were beginning to burst during the debt crisis, Beijing jumped in with huge amounts of cash to patch them up. What about today?

Boris: It will be far more difficult. The amount of mal-investment in the economy is too big — too many ghost cities, too many highways to nowhere, too much capital theft, way too much lending to state-owned enterprises that are de-facto bankrupt.

Martin: Zombie companies.

Boris: Yes, which, in my opinion, is reminiscent of the Japanese deflationary shock of the last two and a half decades. But probably in a much more vicious form.

Martin: More vicious? Why?

Boris: Japan was rich enough to absorb the economic shocks. China is not, especially considering the fact they’re already drawing heavily from their reserves just to defend the currency.

Five Bubbles

Kathy: There are actually five bubbles in the Chinese economy.

Martin: Name them please.

Kathy: First, real estate, which is already sputtering. Home prices, for example –in some of the largest and medium-sized Chinese cities — dropped 3.7% last year.

Martin: Not horrible. But when you consider they were going up at double-digit rates, it’s a sharp swing to the downside, right?

Boris: Right. The second big bubble is in stocks, and I think it’s worse than real estate.

Martin: Why worse?

Boris: Because the Chinese stock market is where there’s been more buying on debt, and because that’s where the bubble has already been blown to smithereens. This hits consumer spending because investors are also big consumers.

Kathy: A third big bubble is exports, also starting to implode.

Fourth, there’s the bubble in excess infrastructure — all those ghost cities and highways to nowhere Boris talked about.

Martin: Fifth?

Kathy: The state-owned enterprises, the walking dead companies.

What to Expect

Martin: Please put it all together for our readers: The sinking export economy. The falling yuan. The crashing stock market. The big bubbles still hovering over China’s economy. Tell us what to expect.

Kathy: Expect a growth slowdown. Then, if they don’t get things right, look out for the possibility of a deflationary collapse.

Boris: Agreed. The deflationary collapse is not written in stone. But the chances of that scenario have increased just in the last few months.

Look at it this way: Until a couple of years ago, China was still enjoying a virtuous cycle — more exports, generating more speculative capital, more investment in factories, and then still more exports. But now that cycle has ended. And as I told you earlier, when global exporters lose the demand from China, it has a massive impact on their sales and profits.

Ask U.S. auto companies. What do they care about? They care about China.

Ask Apple why their recent keynote video was about China.

Or even ask Hollywood big-ticket production companies, which now feature more Chinese actors.

They’re all counting on the new consumers in the world — the Chinese consumers — to enjoy better income and buy more. But what you’re seeing now is the exact opposite. You’re seeing an implosion of income of Chinese consumers that’s likely to get much worse — because all that misallocation of capital is going to have to work itself out.

And this time, Beijing is not going to be able to paper over it.

Martin: What you’re talking about for China reminds me of what we saw in the U.S. and Western Europe in 2008.

Boris: Yes, but there’s one important difference. During the worst of the 2008 crisis, the U.S. and Western Europe closely coordinated their bailouts. They virtually pooled their resources to yank the West from the jaws of chaos. There’s no way that’s going to happen between the Western nations and China, even if they wanted it. Their political culture is too different; their banking system, too closed to the outside world.

Disaster for the Dow?

Martin: Let’s connect the dots to the American investor.

Kathy: On a day-to-day basis, there’s a very strong correlation between the sharp drops in the Chinese market with those of the S&P 500 Index.

And certain sectors get hit harder: You’ve already seen energy and steel clobbered. In the next round, I think financials are going to be hurt. Other victims could include electronic manufacturers and chip makers. These are the industries that feed China. Stay away.

Boris: Apple dropped below $100 per share for precisely that reason — because of rumors from their suppliers that they’re just not putting enough iPhone 6s into the China channel.

Martin: So I should avoid companies that are heavily export-oriented?

Boris: Yes, but this story is about more than just rotation among sectors. Since the end of last year, we’ve been in a “sell-the-rally” stock market. And for most of the year to come, I think the Dow or the S&P are going to be bad places to put your money.

Kathy: Until Shanghai bottoms, you’re not likely to see a bottom in U.S. stock averages either.

Martin: That’s the bottom line — literally, and I want to thank you immensely. I also want to remind readers to join your urgent online briefing next Monday at 2:00 PM Eastern Time.

The title of our event is “The Ultimate Wealth-Building Tool for a World Gone Mad,” where Boris and Kathy will reveal more than one dozen reasons why stocks and bonds are likely to crash and burn in the year ahead.

More importantly, they’ve developed a brilliant strategy to help you insulate your savings, investments and retirement; and for you to multiply your money as the world grows even more insane in the year ahead.

There will be no promotion, nothing to buy; just the facts you need to preserve and grow your wealth.

Simply save this issue of Money and Markets to your desktop, then CLICK THIS LINK at 2:00 PM Eastern Time next Monday, January 25 to attend for free.

Good luck and God Bless!

Martin

I look forward to doing this again.

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