Bert Dohmen's
WELLINGTON LETTER

CHINA: BOOM WILL TURN TO BUST

Excerpt from the WELLINGTON LETTER, August 18, 2008

Now that the end of the Olympics is near, it's important to see what the Chinese economy is likely to do. Will it have a gigantic hangover from the frenzy of construction activity ahead of the Olympics?

In my view, China was already on the path of sharply reduced growth before the Olympics. Now we hear that industrial production expanded in July at the slowest rate in 17 months. In China, tire sales growth has dropped from 16% annual growth to 12% growth. I consider tire sales, just like freight, a very sensitive barometer of economic activity. The bulls will say that this is still terrific growth. But longtime subscribers know that when you come down from 12% economic growth to 7% growth, it seems like a depression.

China will not stop growing, but reduced growth will be very painful when "expectations" are so high. The China bulls will continue to say that growth is far stronger than in Western nations. But that won't keep the stock market from declining, or the economy from producing severe turmoil.

Here we have that word again, "expectations." I often talk about them, and the fact that the markets work on "expectations," not necessarily reality. Expectations change more frequently than reality. And expectations are usually wrong. Eventually, reality always wins out over "expectations."

As the major customers of China go into recession, manufacturing facilities in China will be in deep trouble. The government will try everything not to have millions of unemployed people in the street, because the unemployed often get nasty and overthrow their government. That means big price cuts in order to maintain sales levels. That results in huge financial losses. The government-operated facilities can take that, but private firms cannot. They are highly leveraged with very expensive debt.

I just heard an analyst recommending investing in the emerging markets, especially China, because of the stocks being "cheaper now than U.S. stocks." Yes, after the 50% decline in the Chinese market, stocks are cheaper. But isn't that justified? Much of the reported earnings of Chinese firms include profits from speculating in the stock market. Those large profits have now turned into big losses as the stock market is down more than 50%. When CEO's of firms in countries with few accounting standards are confronted with desperate situations, they do desperate things, such as "cooking the books." We will hear about many accounting scandals in Asia over the next several years.

Another important factor to consider is the "platform" companies, which we have discussed in these pages. These are the large U.S. or European firms which largely outsource production to the emerging countries. This has many advantages, such as low wages. But in my view, the greatest advantage is what happens during a recession. Instead of the U.S. firm having to lay off tens of thousands of employees, which is very expensive, and closing factories, now that burden has been transferred to the emerging countries. That spells great danger to the emerging countries over the next several years.

This is probably why the current financial crisis has not produced a deeper recession in the U.S. The layoffs are occurring abroad. But it will make a global recession that much worse for the emerging countries, especially China. Manufacturing is about 50% of China's economy, twice that of the industrialized countries. Slowing orders from the U.S. and Europe will produce a killer wave in China's economy.

Many of the Chinese factories built lately are geared towards "future" demand. In other words, they are betting on demand continuing to grow at double-digit rates. But it’s clear that this won't happen now with the major economies in the first stages of recession. Eventually Chinese factories may be running at 10-20% of capacity. And that will cause not only economic problems in China, but civil unrest.

I just read an article in John Mauldin's excellent "Outside the Box" that was very interesting. In 2005, the N.Y. Times wrote about the world's largest shopping centers now being in China. Four shopping malls in China were already bigger than the Mall of America. Two, including the South China Mall, were bigger than the world's largest mall up to that time, the Edmonton Mall in Canada.

That was in 2005. Now the South China Mall, the largest in the world, which has space for 1500 stores, has only "a dozen stores open for business."

Over the near-to-intermediate term, we have the Olympics. There will be a significant hangover. Soon you will read stories of many of the new office buildings, especially in Beijing, standing totally empty. Some of the large developers will go out of existence.

The bulls point to the post-Olympic experience of Greece, which produced a nice gain in the stock market. But Greece was a widely ignored country, which finally got some attention. With China, we have exactly the opposite. More people will now realize that this "holy cow" of growth stories has a lot of warts.

CONCLUSION: China is one of the greatest "expectation bubbles." The very greatest is probably Dubai. Recessions are nature's way of taking care of hubris and excessive enthusiasm. You can bet that there has been huge stockpiling of commodities to meet the demand from China. As commodity prices decline, these inventories will be dumped on the market, resulting in further declines.

One of the best bets for the next two years is not shorting the U.S. market, but short selling the emerging markets, especially China, and the minor Asian countries. They will suffer tremendously.

A GLOBAL RECESSION IS AHEAD

Excerpt from the WELLINGTON LETTER, August 5, 2008

While economists spend their time debating whether the U.S. is in a recession, the U.S. and other economies around the world are weakening and on their way to long-term recessions.

How can I say this? Well, it's simple: credit makes the world go around. Tens of trillions of dollars of credit were created during the 5 years of global boom. And now that credit creation has come to a screeching halt. It's that simple. Individuals took $900 billion of equity out of their homes last year through refinancing, using the money for various things. That refinancing is now down about 90%. Therefore, the consumer has no choice but to retrench.

At the same time, financial institutions don't want to create more credit because they are loaded up with so much bad paper already. They are desperately searching for money to raise their capital base. But it appears that the former sources of capital, to a large extent the Sovereign Wealth Funds of foreign countries, are becoming reluctant.

Bridgewater Associates’ recent estimate of losses from mortgage-related securities in the financial institutions is $1.6 trillion. If you look at the leverage ratios of these firms, they seem to average around 25 to 1. That means each dollar of capital supports $25 of assets. If $1.6 trillion has gone up in smoke, than we multiply that times 25, and get a reduction in lending capacity of $40 trillion.

The world's economic product (similar to a country's GDP) is around $55 trillion. So we can see that the reduction in lending capacity is 80% of what the world produces each year. However, we also have to consider how many institutions, banks or financial firms, have severely cut their lending voluntarily just to be more cautious.

And then we have Wall Street's incredible money machine, which pooled loans of all types and resold them via certificates, coming to a screeching halt. In fact, that was one of the largest contributors to worldwide liquidity creation. European banks also participated in such techniques. This involved trillions of dollars.

The result is that money will be very tough to borrow over the next many years. The bad stuff has to be liquidated first before new credit can be created. And when money creation flips from creating tens of trillions of dollars to liquidating similar amounts, you have a drastic change in liquidity. And that can only result in a serious, long-term recession, globally.

People ask me, why haven't we seen the U.S. economy plunge into a deep recession? There are several reasons:

1. The recession is being hidden by the government intentionally depressing the official inflation numbers. We are already in a meaningful recession. I have discussed this many times in past issues. GDP is calculated by taking the numbers for goods and services, and then deducting the rate of inflation. But actual inflation, as calculated in 1980, is now at 12.6%. Deduct this from the 5% nominal GDP growth, and we get negative 6-7% GDP.

James Turk of the excellent FGMR report, calls attention to an interesting website for this. John Williams, who publishes Shadow Government Statistics, (www.shadowstats.com), writes: "Inflation Explosion Likely to Continue...Adjusted to pre-Clinton (1990) methodology, annual CPI growth rose to roughly 8.3% from 7.5% in May, while the SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to a 27-year high of roughly 12.6% in June, up from 11.8% in May."

2. U.S. firms have outsourced a lot of manufacturing to firms abroad. In other words, large U.S. firms have become "platform" companies, which do research, design, and then market. Ex.: Nike. But they don't manufacture very much. These foreign outsourcing firms now have the burden of having factories and tens of thousands of employees. When sales decline, the U.S. firms just reduce orders. The outsourcing firm has the problem of firing employees and idling the factories. In other words, we have pushed many of the problems of a recession to the less-developed countries. That's why we think that the emerging stock markets will have a much more severe plunge over the next several years.

3. Individuals had substantial monetary reserves from the refinancing boom. I wrote over one year ago that these reserves might last a year or so, and then the consumer would see his assets depleted. The home ATM machine is closed. Corporations will follow the same path. They had large cash reserves going into the recession, but as it becomes more difficult to get loans or sell commercial paper, the cash hoards get depleted in a recession as profits turn to losses. This is a lagging factor, and may take another year to fully emerge.