Juggling Dynamite

In his webcast titled “1984” in remembrance of George Orwell’s dystopian novel, DoubleLine Founder and CEO Jeffrey Gundlach on Sept. 10, 2024, dives “into the subject of the Fed and some of the variables that will likely underpin their logic and their thinking” at the Sept. 18 meeting of the rate-setting Federal Open Market Committee (FOMC). In his analysis, Mr. Gundlach finds both components of the Fed’s dual mandate, employment and prices, support a rate-cutting cycle. If energy prices remain near present levels, he expects sub-2% Consumer Price Index (CPI) reports in a few months, and he cites new signals of an imminent recession. Here is a direct video link.

Despite the latest University of Michigan’s consumer confidence index nearing 2008 recession lows (blue line below since 1990), the share of savings allocated to equities remains aggressively above 40% (green line). This gap has traditionally closed with equity allocations following consumer confidence down as stock prices tumble and the quest for cash accelerates.
From the highest 12-month S&P 500 forward price-to-earnings ratio (22x) since 2021 and 2000 (shown below since 1978), the scope for price-to-earnings contraction is truly epic.

And although mortgage rates are more than 100bps off their peak last October, still-high property prices mean that US home affordability remains near its worst level since the previous housing bubble peak in 2006. The downside in real estate–the most widely held and highly leveraged asset market–looms large.

Once real estate bubbles bust, prices typically fall for years, and paying down debt becomes the priority. In the process, slashing interest rates does not entice the hoped-for revival of borrowing, and it takes years to rebuild balance sheets. This is now underway in the world’s second-largest economy. Et tu, Canada?

Richard Koo, senior adviser at CSIS, chief economist at Nomura Research Institute, and pioneer of the “balance sheet recession” phenomenon, explains why he thinks China’s balance sheet recession has already begun. Here is a direct video link.

China’s M1 money supply contracted by 7.3% in August, hat tip China Beige Book.

M1 money supply (in black below since 1999) leads producer prices (PPI in red) by about six months, and suggests the trend in falling prices has further to run.

Chinese prices (GDP deflator below since 1997), contracted for the fifth consecutive quarter in the first half of 2024, in the longest period of deflation since 1999 (see blue bars below).

From 2019 to 2022, rounds of “free” money courtesy of central banks and governments fuelled gullibility and blind risk-taking in many countries. The effects were particularly short-lived in China, the world’s second-largest economy, where consumer confidence has been moribund over the past three years (below since 2016).

Hampered by relatively low household incomes and a limited social safety net, Chinese households must save large portions of their income to self-fund things like sick care and retirement.

In 2005-07, as Chinese exports expanded, hopeful households poured what they could into equities, creating a self-fulfilling bubble that drove asset valuations to irrational highs. Chinese stock prices (Shanghai Composite below since 2000) then tumbled about 70% into 2008. Despite a couple of short rebounds in 2014-2016 and 2019-2021, Chinese stocks have slumped since and are today about the same level as in 2006. Between 2015 and 2021, the masses doubled down on the housing market, borrowing as much as they could in hopes that rising prices would win them financial stability. For many, it did the opposite as debt and overhead costs ballooned.

Pressures are now intensifying as home prices fall in many areas. Chinese home prices for new and existing properties have tumbled to 2015 levels in the 70 largest cities (shown below 2011).

At the same time, Chinese real estate company shares (below since 2004) have slumped more than 80% since 2020 and are now trading at the lows of the 2008 financial crisis.

As the economic outlook deteriorates, Chinese government bonds have continued to rise on safety-seeking inflows, and the 10-year government Treasury yield has fallen to 2.11%, the lowest level since 2005 (below since 2019). With mortgage growth stalled, China’s government is trying new schemes to reduce mortgage carrying costs without wiping out bank lending profits. See China Weighs Cutting Mortgage Rates in Two Steps to Help Shield Banks.

While investment dealers benefited from a resurgence in initial public offering fees between 2019 and 2022 (shown below since 2014), crashing asset prices have extinguished investor interest again in 2024.

Amid rising unemployment and social unrest, it is common for governments to come after the finance sector once their risk-magnifying harm is widely evident. The Chinese government is leading the global charge in an intensifying ‘crackdown,’ see China Detains Investment Bankers, Takes Passports in Corruption Sweep:

Chinese authorities have been trying to clean up the country’s $66 trillion financial sector since at least 2021, when President Xi set his sights on corruption in the industry. Wide-ranging probes have led to the detentions and arrests of numerous financial professionals at Chinese banks, brokerages, asset managers and insurance companies. The most severe punishments for financial crimes have included death sentences or life imprisonment for former top executives of some institutions.

Similar sentiment will likely spread to other countries as economies contract and asset prices tumble further.