Bearish News

The always-insightful Simon Johnson  explains why this recovery is fueled by moral hazard, and will end badly. Talks about possible bubbles forming in BRIC — especially China.

Posted by an American serviceman in Iraq.

See the discussion at Reddit.com, where I found it, for more info. The submitter used the title “Equipment bought for Iraq, paid for by the US, stretching as far as the eye can see – this is just some of it”

Here’s the submitter responding to questions about who took it, and why they created a new acct to do so:

Oh no, Im in the military and I took this photo myself. Posting things that are controversial can get you in deep shit (of one form or another). Things over here are very political.

This was too moving too keep under wraps though.

Further down the thread he says, “I got in trouble with a blog my first few months here, hence the paranoia.”

Dubai’s man-made islands are stunning technological achievements. But they may end up as the poster-children for this era’s reckless real estate ventures. These projects are playing a big role in the ongoing debt crisis in Dubai.

Here’s “The World” island project:

And here’s one of the three palm tree islands, where you can see construction underway:

I remember being struck by the scale of the project while watching a Discovery Channel documentary. What a cool concept. Unfortunately, it looks like reality is catching up to this pipe dream.

Recent revelations show that the islands’ parent company, Nakheel PJSC, is in trouble. Their attempt to delay debt payments sparked a global selloff on 11/27. Fears of a debt crisis in Dubai spreading to other emerging markets (EM) roiled stocks.

Investors collectively paused the day after Thanksgiving, “Wait a sec… I thought emerging markets were going to be the engine driving us out of this mess… Now their bubbles are popping? Uhhh-Ohhh.”

Bloomberg provides a detailed example of island building gone-wrong:

Samsung C&T Corp., builder of the world’s tallest tower in Dubai, said it stopped work on a $350 million bridge in the city after a unit of Dubai World halted payments.

Construction of the half-finished bridge, to the man-made Palm Jebel Ali island, was suspended earlier this month after Nakheel PJSC made no payments for about two months, Cho Keun Ho, a spokesman for the Seoul-based builder, said today. Calls to Nakheel’s spokeswoman Anna McGovern went unanswered.

Not all emerging markets have the same debt issues Dubai does, of course. But there are tons of risky investments lurking out there, and they’re not just in EM (hint – many are hidden off US bank’s balance sheets).

Some are speculating that Dubai’s debt problems will be a catalyst, sparking major selloffs worldwide, particularly in EM. If so, I would think those countries with stronger balance sheets, like China, will fare better than those with high debt loads. That said, I am considering reducing my personal EM holdings, but haven’t done so yet.

China’s massive infrastructure rollout has been hailed by many as brilliant. Helping its case is the inevitable comparison to America’s dismal emergency spending, the majority of which is being spent propping up black hole zombie-banks.

China, meanwhile, is pouring resources into projects some think could catapult them into superpower status. It will take decades if it works. And there are plenty of skeptics of China’s infrastructure-based recovery plan. There is also a growing chorus of China bears warning of a bubble in equities and real estate.

The Good

It’s hard to ignore some of the projects going on in China. One of the more impressive is a $200b high-speed rail network.

Efficient public transportation is a no-brainer for China. Combine rising energy costs with 1.3 billion citizens in need of transportation, and you have a socialist’s dream-project. If well-executed, it will provide superior transportation options and a lower cost of living for hundreds of millions.

The alternative, a highway-based system, is not feasible. Currently only 3% of Chinese own a car. Boosting that number to anywhere close to America’s 44% would be disastrous. Energy prices and pollution would skyrocket.

Here’s a map of the rail project, scheduled to be complete within 10 years:

U.S. legislators have made noises about a high-speed rail plan of their own, but only $8b of a $787b package was earmarked for it. I suppose projects like tunnels-for-turtles need funding too.

AIG vs. Rail

I can’t resist noting that America has spent nearly the same amount bailing out AIG ($170b), as China will on this huge rail project.

America’s $170b “investment” in AIG allowed us to dodge some of the pain that would have resulted if (god forbid) banks were treated like real businesses, and forced to eat losses on deals with insolvent counterparties.

It also allowed bonuses to keep flowing on Wall Street, and bought some breathing room for near-death firms. The moral-hazard implications are immeasurable. It’s safe to say that our economy will never see its true potential with shenanigans like this going on.

When you reward failure and punish responsible parties, the consequences will be predictably bad.

Said and done

At the end of the day, America will still have our horribly inefficient and only quasi-solvent banking system. Chances for meaningful reform are still bleak, crony-capitalism alive and well.

China, meanwhile, will end up with 16,000 miles of energy-efficient railway connecting their major cities. Plus, they get to brag about badass 236-mph trains. If the U.S. insists on throwing piles of money at something, shouldn’t it be for something cool like really fast trains?

Some would counter that the U.S. strategy has worked. After all, the Dow is above 10,000 again. So everything must be preachy. I would reply that while America’s response has provided a temporary boost, it also sowed the seeds for another disaster. It will feature many of the same players, and involve even more debt.

This is the key difference between Chinese and American stimuli. Neither is perfect, but America’s fails to address fundamental problems – too much debt and banks who only exist thanks to taxpayers and accounting gimmicks. It’s a patch to buy time until the next bubble pops. Nothing more.

The Bad

China’s plan is not perfect by any means. It will be fraught with waste and inefficiency. That’s the nature of government projects, and China is a proudly socialist country. Bureaucrats generally make awful businessmen. With little stake in the outcome of their actions, workers inevitably get careless and make bad decisions. Corruption also tends to creep in.

Exhibit A – China’s Ghost City (skip to 1:15)

This project should serve as a cautionary tale for China. Big missteps like this will be costly. If leaders aren’t more judicious in the future, they could end up with a thousand bridges to nowhere.

American Bear in China

At Buttonwood last month, head of Morgan Stanley Asia Stephen Roach took many of us by surprise with his bearish comments on China. He noted that he moved to Asia because he was bearish on America, but now he’s starting to get bearish on China. He was critical of their infrastructure spending, hinting that much of it may be going to waste.

Roach is still long-term bullish on Asia, but we should listen to his warning. He’s certainly not alone. China-bashing is becoming quite the rage among contrarians these days. China bears are probably onto something, but I think fears of massive bubble are overdone.

I liked Chinese stocks earlier this year, when their valuations weren’t quite so lofty. In January I started buying PGJ (my favorite China ETF) around $13-$14. Since then it’s risen to $24, and like most Asian indexes, looks toppy. The 12-month trailing P/E for Shanghai stocks is currently around 30x. That’s not cheap.

So I recently sold some Chinese stocks from my portfolio. That said, I’m not giving up on emerging markets (including China).  Three reasons for this. Number one – it’s where the growth is. Number two – A falling dollar should benefit American owners of foreign stocks. Number three – it’s still working.

Disclosure: Long PGJ

Chart via The Transport Politic

So, there are six asians and one american on an island together….

From 2007. Features Peter Schiff and Stephen Roach making calls that seem to be playing out today:

Peter Schiff has been busy today. First he officially announced his bid for Senate, and I hope he wins. A little rabble-rousing and fiscal discipline certainly wouldn’t hurt our government.

He also announced the launch of a Chinese Mutual Fund. Schiff won’t be managing it directly (obviously), but will sit on the investment board. It’s a joint venture between Euro Pacific Capital (where Schiff is President) and Halter Financial Investments, who specialize in Chinese equities. The manager is Rusty Hoss. From the announcement email (no link yet):

As most of you know, I feel that the most promising economic growth is taking place in China. With its focus on savings, production, and investment, the Chinese are getting right so many of the things that we are getting wrong. As a result, I have come to believe that Americans must invest more in China if they hope to be part of the global economic expansion.

But for many investors, especially those with limited funds to contribute, it’s not easy building a balanced portfolio of China-focused stocks. To provide a simpler pathway to make these investments, Euro Pacific has combined forces with Halter Financial Investments L.P., a consultancy and money manager with operations in the U.S. and China, to launch the EPH China Fund, a mutual fund designed to give investors access to companies doing business in China. This is the first mutual fund that bears our name, and I have high hopes for it.

Peter notes that most Chinese ETFs are heavily invested in financials, as we noted about in this piece about PGJ when it was almost half what it trades at today (PGJ only holds 5% financials). Schiff promises his fund will avoid this mistake as well:

Unlike many of the popular U.S.-listed Chinese ETFs, which are heavily concentrated in the financial sector, this fund is a broadly diversified portfolio focused on identifying those sectors and companies that we believe will lead when China finally focuses more intently on its domestic consumers.

The mutual fund’s symbol is EPHCX. I don’t think it’s widely available yet, but will be watching this one. My preferred way to play the broad Chinese market PGJ (specifically domestic growth potential). But a well-managed China fund would be tempting. FYI, the fund minimum is $2500, quite reasonable these days.

For more on his Senate Run: SchiffForSenate.com