CHINA : Fragile - Handle with Care

The Dow Jones Industrial Average rallied to a new all time record high closing level of 18,312 on May 19 only to drop back and close the quarter at 17,619, a -0.1% decline for the period. The May high followed suit with other recent highs by occurring on declining volume with fewer individual stocks making new highs. This is an indication that the bull market’s momentum may be beginning to ebb.

 It is also discomfiting to the bulls that the Transportation Average last made a new high in November of last year. A sell signal from the Dow Theory has yet to be generated but this non confirmation suggests that such a signal might not be too far down the road.

 While returns in the equity sector were mixed, there were negative returns across the yield curve in the bond market as investors once again began to anticipate (jump the gun?) that the Fed will initiate a round of interest rate increases in the months ahead. The futures contract on the thirty-year Treasury bond fell almost 12 points during the period, thereby implying a yield increase from 2.14% to 2.67%.

 Commodity prices continued to rebound from last year’s sharp decline as the CRB Index rose to 227.17 from 211.86 largely due to an extension of crude oil’s price rally. West Texas Intermediate Crude increased from $49 to $58 per barrel during the quarter.

 The precious metals didn’t join the party as gold dropped from $1200 to $1170 per ounce. The dollar, which has largely moved inversely to commodity prices over the past few years, continued to do so by losing almost 3% of its value in terms of an index of trade-weighted foreign currencies.

 Returns in most risk asset prices, however, paled in comparison to the gains realized in the art market, especially modern and contemporary art. The record price paid for any painting at auction was achieved by a Picasso work that was hammered down at $179.4 million. That set the tone for what was a record amount of sales overall at the spring auction. Break out the bubbly but beware of the bubble.

 Plagued by abominable winter weather throughout much of the nation, first quarter real GDP growth was a very disappointing -0.2%. The economy should have rebounded nicely in the second quarter as the weather improved, but the jury is still out as the data released thus far have been mixed. Housing starts perked up and, after being flat in April, retail sales jumped sharply in May.

 On the other side of the coin, industrial production slumped -0.3% in April and -0.2% in May, presumably as a result of undesired inventory accumulation in the weak first quarter. Those anticipating quick action by the Fed might want to pause and consider because this indicator is compiled by the Fed’s own bean counters.

 Initial claims for state unemployment benefits fell below 300,000 and held there throughout the quarter. This typically portends improvement in the jobs market in the following weeks but the employment statistics didn’t completely jibe with the claims data. Payroll growth slowed in the spring and previous gains were pared back somewhat due to revisions. Wages also continue to lag. Hence, it appears that the recovery, albeit extant, is continuing to sputter instead of hum.

 Meanwhile, inflation remains conspicuous by its absence. The first quarter’s GDP deflator was an annualized 0.0% and the latest year-over-year changes for the PPI and CPI were -1.1% and 0.0%, respectively.

 We have noted heretofore in these pages that, if there is to be some sort of problem in the U.S. financial markets in the short to intermediate term, it is more likely to come from without rather than from within the domestic economy. The news media have been buzzing almost daily of late with a list of the usual suspects. Greece is the word (yes, pun intended) most prominently mentioned but Puerto Rico, Spain, Portugal, Ireland and Italy are also among the potential trouble spots for financial malaise. China, however, appears to us to be the most likely culprit as it is currently experiencing the largest bubble.

 The Chinese have often been described as “inscrutable” - a condition no doubt fostered by their predilection for “painting the tape” where economic statistics are concerned. They are the quintessential Cordon Bleu chefs in the methodology of book cooking.

 To impart the impression of growth during the late Great Recession, the Chinese central planners engaged in a vast number of construction projects involving manufacturing facilities, living spaces, office buildings and the like. A considerable amount of apparently shaky debt was required to finance these programs but it was thought to be worth it to help keep the population employed and not rioting in the streets. The problem is that there now exist huge tracts of what are essentially ghost towns throughout the country. Anecdotal evidence suggests that this is a large and widespread phenomenon.

 Meanwhile, beginning in the spring of last year, the Chinese stock market took off on an historic bull run that saw the Shanghai Composite rise by a factor of 2.5 times into mid-June of this year. Then, in very short order, it declined over 30%.

 Perhaps the most disturbing aspect of this is the fact that the majority of the trading has apparently been accounted for by small retail investors, many of whom are poorly educated. In addition, margin debt has soared. Some analysts estimate that the total margin debt could be as high as five million yuan, which would be in the vicinity of 20% of the total market value of Chinese stocks. That is a far larger percentage than has ever been witnessed in any other market throughout history.

 Frothy prices for contemporary art, extreme bullish sentiment, and poor market breadth may be reasons for investors to be concerned about U.S. equity market valuations. Yet, instead of asking, “How now, Dow Jones?,” it is probably more apropos to ponder, “What now, China?”

 Weaver C. Barksdale, CFA