Why the trade war will usher in a long, drawn-out bear market, with stocks, bonds, credit and property all at risk
- Andy Xie says the unravelling of the US-China relationship that has sustained leveraged speculation will reverse trends investors have become used to
- A close look at price-to-book and price-to-sales ratios finds the stock market is overvalued, and this will compound the downturn
Financial markets have been struggling lately. Even red-hot internet stocks have been plummeting. Is this just another scare, like the many we have had since 2008? That’s what the consensus seems to be. The reality is quite different. This is a structural bear market that could last for years. Not just stocks, but bonds, credit and property are vulnerable. This bear market will reverse the trends that investors have been used to for more than two decades.
In 1995, Alan Greenspan bemoaned the conundrum of ever-declining bond yields. That trend continued for another two decades. Declining interest rates led to a surge in demand for debt to purchase risky assets. This fuelled asset prices and validated the debt-financed speculation.
It wasn’t always smooth sailing. The 1997-98 Asian financial crisis, the 2000-2001 dotcom crash, and the 2008 global financial crisis were hiccups along the way. As markets completely recovered from each crisis and kept the trend going, leveraged speculation became more popular. People stopped questioning whether it was too good to be true.
The current market turmoil is a different animal. It undermines the pillar that sustains leveraged speculation – the mutually dependent relationship between the US and China which states, “I buy your goods, you buy my debt”. China continued the invest-and-export tradition of other East Asian economies. The overinvestment in the East was sustainable only because of overconsumption in the US. Through forced savings, the East financed its overinvestment at home and overconsumption in the US by buying American debt.
The Fed has made two fatal mistakes. It has been looking at inflation as a guide to interest rates and evaluating asset valuations against bond yields. Both benchmarks have been heavily influenced, if not determined, by East Asian economies. The Fed has basically accommodated the investment-and-export model of the East. The cumulative imbalances are not only reflected on the financial balance sheet. The blue-collar revolt in the US is a consequence of how the Fed has managed the economy.
The trade war is a political backlash against this imbalanced growth model globally. Wages in the US have stagnated for four decades while education and health care costs have skyrocketed. Trump’s “terrific” economy is no different. When real wages are stagnant at a cycle peak, labour will be harder hit on the way down. The political fuel for the conflict will increase. The continuing trade war will undermine “I buy your goods” and, hence, derail “you buy my debt”. The bond market will slide into a bear market as a consequence.
Sustained political turmoil and rising bond yields will keep risk premiums high for the foreseeable future. The periodic bouts of surging volatility will shake out highly leveraged speculators. The Chinese government urging brokers to ease up on margin calls on October 31 triggered a rebound in the market. But, knowing that the suspension won’t last forever, some speculators will take advantage of the rally to clear their tables.
Hence, forced suppression of volatility won’t work for long. The accumulation of speculation for a quarter-century is bound to hide many egregious players like Bernie Madoff. Don’t be surprised to find them unmasked from time to time.
Watch: Jack Ma calls US-China trade war ‘most stupid thing in this world’
While removing the pillar of the speculative world is the most important factor, there are others that will compound the market downturn. High valuations are one. Some may argue that price-to-earnings ratios aren’t outrageous and profit growth is strong. However, both are not sound.
When demand is financed by debt, one’s profit is someone else’s debt and could fall precipitously in a deleveraging trend. Similarly, profit growth is only as strong as debt. The profit story increasingly sounds like a Ponzi scheme. Far more reliable indicators are price-to-book and price-to-sales ratios. The stock market is grossly overvalued on both.
Declining growth will hit the market soon. A 12-year-old property bubble has begun to deflate in China. This is causing the economic slowdown, not the trade war. Soon, commodity prices will decline, affecting the commodity-dependent economies in the developing world. These two blocks have accounted for around half of global growth. The earnings story for multinational companies is bound to reverse.
In addition to traditional markets, sustained speculation has led to a gigantic tech bubble. China has over 10,000 funds investing in internet stories. Both China and the US have hundreds of “unicorns” – basically a few people making up big numbers for their investments. The amount of debt these companies support must be vast. Of course, firms can insist on their numbers when they aren’t being traded. But, when their investors or lenders want their money back, the numbers will shrink dramatically. Most internet investments are basically worthless. People will feel a lot poorer when they discover this.
While the property bubble is the main concern in China, it is largely a derivative of stock or internet bubbles elsewhere. The unusual property valuations in financial centres are one indicator. They are seeing a downturn. On the way up, prices are supported by further price appreciations. On the way down, they must be supported by yield. Judging from that, it won’t be pretty in the coming year.
The mess built up over a quarter of a century will take many years to unwind. There will be no quick fixes. Fasten your seat belt. It will be a bumpy ride.
Andy Xie is an independent economist