Is it the 1980s all over again?
Then, it looked as if Japan was going to take over the United
States. They were buying up property left and right, including
gems like Pebble Beach and Rockefeller Center. Alas, their
own real estate and stock markets collapsed, and they were
forced to liquidate, and at losses. Now it’s China’s
turn. First it was a small personal computer manufacturer
that they purchased from IBM (Lenovo). That was nothing. Now,
however, they have invested $3 billion in a US private equity
firm (Blackstone) that has filed for an initial public offering.
Apparently, they have had their fill of low-yielding US Treasury
bills and bonds and have decided to assume more risk. Should
we be worried? Not really. China is still new at this capitalism
game, and they will face many pitfalls on their economic journey,
just as we have. Like Japan in the 1980s, China is staring
down two giant economic bubbles – real estate and the
stock market. They are trying desperately to keep a lid on
both of these excesses, but it is difficult to keep investors
from wanting to catch a ride on the boom. History is fraught
with these bubbles from the tulip bulb craze in Holland in
1634 to our own stock market bubble in 1929.
It is difficult to obtain accurate data on the Chinese economy.
We know they desperately want to put on a good face for the
2008 Olympics which has no doubt resulted in over building
of commercial real estate in Beijing. There is also no doubt
that their stock exchange is over heated. The best information
we can get is that their stocks are selling at an average
of forty-five times earnings compared to our stock’s
average of seventeen times earnings. On June 4th the Shanghai
Composite Index dropped 8.3% amid fears of the government’s
steps to cool the stock market. The Shanghai index doubled
in 2005 and doubled again last year. Our stock market reacted
but we don’t expect a collapse no matter what happens
in China. The Chinese market is very closed, so overseas investors
have little exposure to this very speculative market. These
are some unpleasant realities that will be addressed soon.
How would this impact us and the rest of the world? There
would be some initial pain but not of a lasting nature. We
are still the strongest and most stable economy in the world
and believe it or not the most politically stable. We are
prepared better than any other country to withstand any outside
shocks.
However, we are feeling some shocks brought by China’s
recent actions. Their moves to diversify away from our Treasury
issues has caused our interest rates to rise; when demand
for bonds drops, interest rates must necessarily rise. We
now have a positive sloped yield curve with three month treasuries
at 4.75%, ten year treasuries at 5.12% and thirty year treasury
bonds at 5.25%. Those that have been concerned about the negative
yield curve for the past year leading to a recession can now
breathe a sigh of relief. China’s actions, plus interest
rates rising around the world, will force our rates up. In
addition, Fed head Ben Bernanke recently stated that he sees
no need to cut interest rates at this time. Inflation is still
his chief concern as labor costs are rising and productivity
is slowing. The consumer price index for May will be released
Friday and is expected to be up 0.5%. New Zealand recently
raised their overnight interest rate to 8% (yes 8%). The current
rate of inflation in New Zealand is 2.5%, and they have a
two year target of 2%. Let’s hope the Fed isn’t
using that as one of their indicators.
Investment in pools of adjustable rate mortgages is attractive
at this time. With fixed rates on mortgages rising, there
will be less inclination to re-finance and hence slower pre-payments
which leads to higher over-all returns. Stricter lending guidelines
will also lead to slower pre-payments.
Random thought for June 2007:
And speaking of Hollywood, “When they discover the
center of the universe, a lot of people will be disappointed
to discover they are not in it.”
- Bernard Bailey
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