Correction at home and in China

Wall Street continues to position itself for a typical rebound from a typical inventory-led recession. The groupthink among Wall Street strategists shows astonishing consensus in a recent research piece published by Birinyi Associates.

Birinyi compiled all of the 2010 strategist forecasts and calculated the following averages: a yearend S&P 500 target of 1,222, $76 in S&P 500 earnings, and 3.1% GDP growth. The deviation from these averages was not wide. These numbers might be plausible if this were a typical rebound from an inventory-led recession. But this is not what we’re experiencing.

Just consider today’s weak nonfarm payroll report. Government number crunchers estimate that the economy lost 85,000 jobs in December. Of course, this figure is highly massaged by seasonal adjustments and the “birth/death model,” which assumed that new businesses created 59,000 new jobs in December. Without the birth/death adjustment, the headline would have been 144,000 jobs lost.

The civilian labor force participation rate fell to a new low — 64.6% — as more discouraged workers give up looking for jobs. If these workers were considered by the statisticians to be looking for jobs, the headline unemployment rate would jump several percentage points.

To gauge the accurate health of the labor market, check the tax withholding figures. These figures are still down significantly year-over-year.

Job creation needs to turn highly positive quickly to justify the valuation of the stock market. The employment picture is also vital to the health of the credit markets and the banking system. The popular obsession over how long the Federal Reserve is going to hold short-term rates at zero distracts many investors from the destructive influence that high unemployment will have on credit quality.

The Fed’s extremely loose policies have sparked investors to take on more credit risk in the secondary markets. This has pushed up the prices of junk bonds and junk stocks, lowering yields. But if the labor markets don’t rebound dramatically from here, we’ll see accelerating credit losses on everything from mortgages to credit cards. Those who piled into junky credits due to zero interest rate policy will flee out of them due to rising defaults.

We’re in uncharted waters when we combine stubborn labor market weakness with heavy private sector debt loads. Credit losses are likely to surprise the market on the upside in 2010. This is especially dangerous for a banking system that’s marking its own assets at “mark-to-myth” levels.

Through several examples, it’s clear that the Treasury Department’s unofficial policy for dealing with underwater real estate loans is “extend and pretend.” This means that as long as underwater borrowers are making monthly payments, most bank examiners will look the other way and allow banks to mark loans at artificially high values. Bank regulators are also likely to look the other way if banks roll over maturing loans that are underwater on a mark-to-market appraisal basis.

But this isn’t cause for celebration. Instead, this mass denial of reality will only make the ultimate credit losses even larger. But this seems to be the policy, because it’s politically expedient and painless (for now).

Just like we saw in post-1990 Japan, “extend and pretend” will commit huge amounts of scarce capital in the banking system to defend bubble-era loans. Instead of extracting this capital out of bankrupt situations to be reinvested into new loans, we’re prolonging a misallocation of capital. By defending and maintaining old underwater loans at unreasonably high marks, most banks won’t have much room on their balance sheets for new lending. This one consequence of “extend and pretend”: continued tightness in lending for small businesses, which are the biggest job creators.

A Correction in China Looms

It’s likely that the growth we saw in emerging markets in 2009 will decelerate. China’s infrastructure-heavy stimulus package put Chinese people to work and boosted commodity imports from resource-rich countries like Brazil and Australia.

But this stimulus package is leading to excess capacity in real estate and many heavy industries like steel. It’s also gone hand-in-hand with mind-boggling growth in bank lending. Rapid growth in bank lending always leads to trouble.

So the People’s Bank of China (PBOC) is just now tiptoeing towards a tightening policy. The PBOC seems worried about the real estate bubble that’s now becoming more obvious in major Chinese cities. Earlier this week, the PBOC sold three-month bills at a higher (rather than lower) interest rate for the first time in 19 weeks. This is a clear signal to the heavily state-influenced banking sector that it should tighten its loose lending policies. Much of this lending went to finance large infrastructure projects deemed by (often corrupt) communist bureaucrats — not the free market — to be necessary.

This kind of activity can go on for much longer than logic would dictate, but eventually, misallocated resources become too obvious to ignore. Just as the U.S. housing bubble continued a few years beyond when it became obvious (say, in 2005), so can the excesses in the Chinese economy.

The potential catalysts for a correction in China are many, but the most likely would be continued escalation of trade protectionism. This protectionist trend could offer several attractive short ideas in 2010. For example, on Dec. 30, The U.S. International Trade Commission ruled that growth in imports of Chinese-made drill pipe and casing materially injured the U.S. steel industry. The commission imposed 10%-15% tariffs on imports of Chinese steel pipes, with the possibility of further tariffs in the coming months. The Chinese government is allegedly subsidizing its steel industry. This is probably true, but China will likely respond with its own protectionist measures anyway.

The interference of governments into free trade — in the form of both subsidies and tariffs — is not good for the future of globalization. Many of today’s big transnational corporations are built on the assumption of unending globalization. These big corporations are establishing closer ties to politicians around the globe, and many are seeking to game the system or pursue government subsidies rather than serve their customers.

Regards,
Dan Amoss

January 15, 2010