Will China
really save the world?
Paul van Eeden
Sep 9, 2006
The Office of Federal Housing Enterprise Oversight (OFHEO) was
created as an independent entity within the Department of Housing
and Urban Development, a department of the Government of the
United States. OFHEO's primary mission is to oversee the Federal
National Mortgage Association (Fannie Mae) and the Federal Home
Loan Mortgage Corporation (Freddie Mac) -- the nation's largest
housing finance institutions.
Earlier this week OFHEO released
its most recent House Price Index (HPI) data, of which the director
of OFHEO, James B. Lockhart, said: "These data are a strong
indication that the housing market is cooling in a very significant
way. Indeed, the deceleration appears in almost every region
of the country." The decline in the quarterly increase in
home prices was also the sharpest since the beginning of OFHEO's
House Price Index in 1975.
OFHEO's report lists higher
interest rates, a drop in speculative activity and rising inventories
of homes as reasons for the decline in home appreciation. There
is only one thing we know for sure about economics and that is
the interplay between price, supply and demand. With respect
to real estate it seems certain that price appreciation is slowing
down and inventories are rising because demand is falling. We
can therefore restate the first sentence of this paragraph by
saying that home price appreciation is slowing down and inventories
are rising because of reduced demand. This may sound like I'm
splitting hairs, and maybe I am, but I do think it is important
to realize that price appreciation is not slowing because of
rising inventories -- both declining price appreciation and rising
inventories are a result of reduced demand.
Now let's also make sure we
know what this data is telling us. The decline in home appreciation
does not mean house prices are falling; it only means that house
prices are not rising as fast as they used to. According to the
HPI data, home prices increased by an average annual rate of
10.06% in the second quarter (from the second quarter of 2005).
And if we measure the increase using purchase transactions only
(just a different method) then home prices still rose an average
of 8.27% in the second quarter. So there is no reason to be alarmed,
right?
Chart 1: Annual rate
of increase in house prices in the US
When I look at the chart above
the deceleration of house price increases is not what strikes
me, although it seems to be what struck OFHEO officials. What
strikes me is the tale home prices tell of capital flows, the
wealth effect and the Fed's interest rate policies. I have written
about international capital flows during the 1990s many times
before (see: "The
Greater Depression" and "Putting
the US debt into perspective."
Briefly, more and more capital
migrated to the United States during the 1990s as a result of
currencies around the world falling like dominoes. It started
in 1992 with Brazil, picked up substantially during 1996 with
the Southeast Asian Crisis and continued right through into the
21st century. The influx of capital caused a boom in bond prices,
stocks prices and real estate prices and the rise in bond prices
also meant lower interest rates which intensified the impact
of capital flowing into the country.
As we look at the above chart
we can see how moderate annual home price increases of 2% to
3% in the early 1990s gave rise to much sharper price appreciation
in the latter part of the 90s as the wealth effect of the stock
market bubble and falling interest rates spurred a buying frenzy.
When the decade drew to an end and the Tech Bubble popped the
Fed decided to drive interest rates down artificially in order
to prevent an economic downturn. Basically the Fed was pouring
jet fuel on an already red-hot real estate market and home prices
soared. The average annual increase in home prices across the
entire country rose from an average of 6.93% in 2002 to 13.23%
in 2005.
The real estate market got
completely out of control. In Arizona, for example, the average
increase in home prices from the second quarter of 2005 to the
second quarter of 2006 was 24%. It was 21% in Florida, 20% in
Idaho and 19.5% in Oregon. I have been an investor for long enough
to know that when average house prices increase by 20% to 25%
then something is wrong.
Even if average house prices
do not fall we can most certainly expect to see the average increase
in house prices come back to somewhere in the 2% to 4% range.
Personally I think that is being overly-optimistic, but the point
I am trying to make is that even if home prices don't fall, the
wealth effect of rising stock prices and rising house prices
is over; and with it goes consumer spending.
Consumer spending accounts
for 70% of the United States' gross domestic product, so if consumer
spending takes a hit because the real estate refinancing tap
is turned off, the economy is going to struggle. Can China save
the world?
Many people, particularly investors
in natural resource stocks, pin their hope on the expanding Chinese
economy. I have long maintained that China is just another bubble
looking for a pin and that the Chinese economy is too closely
tied to the US economy to withstand a slowdown in US consumer
spending without getting dragged down.
Chart 2: Economic Growth
in China
If you look at the above chart
you will see two interesting things. One, China's economic growth
has been spectacular. Their economy has been growing at an average
annual rate of almost 9% since 1996. Yet, notice that the rate
of growth has been relatively stable - at least according to
the data I got from the World Bank. But also notice how the export
of goods and services has become larger and larger as a percentage
of China's GDP. From 1996 to 1999 exports accounted for about
20% of China's economy. By 2004 (latest available data) exports
accounted for 34% of GDP. I wonder who is buying all that stuff
that China makes? Notice that China's exports are growing at
almost 30% per year, and have been for the past three years (2002,
2003 and 2004).
A simple calculation will tell
you that if China's exports are growing at 30%, and exports account
for 30% of GDP, then the growth in exports alone will increase
GDP by 9%. But hold on, that's how much China's entire economy
is growing! So where is the internal demand? Where is all the
Chinese consumption that is going to propel base metal prices?
Either the World Bank's data is completely useless, or else China's
economy is far more dependent on exports that what some people
think. I don't know which it is, but I am not going to bet that
it's the former and not the latter, so I'll stick to my prediction
that the bull market in base metals is over or, if not, very
close to being over.
Incidentally, the IMF released
a report this week saying that they think copper is going to
fall by 57% over the next few years. I think I'll stick to gold.
Hopefully the gold price will keep trending down in the short
term so I can buy some more.
***
Special Event:
I will be speaking at a special event organized by the Discovery
Group on September 26th in Toronto. Cocktails will be served
from 6:00 PM and dinner at 7:00 PM, after which I will give a
talk on gold, the economy and investing in the mineral exploration
sector. A donation of $50 per person is requested with the proceeds
going to "Water for the People". If you would like
to attend, please contact Rebecca Page at (604) 646-4523 or rebeccap@discoveryexp.com
without delay, as space is limited.
Conferences:
The next conference I will be speaking at is the Newfoundland
Resource Investors Forum to be held from September 12th to the
13th and after that I will be at the Toronto Resource Investors
Forum on September the 24th and 25th. For more information please
visit http://www.paulvaneeden.com/conferences.php.
Paul van Eeden
email:
pve@publishers-mgmt.com
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