Market Outlook: From Dutch tulips to Chinese real estate

China’s cities are in the midst of an unsustainable housing bubble Imaginechina/REX/Shutterstock

If you go all the way back to March 1637, some single tulip bubbles sold for ten times the annual wages of a skilled craftsman in Holland.

Wind the clock forward to China’s debt-charged economic growth in 2008-2013, when house price to earnings ratios reached 14:1 in the country’s Tier 1 cities (Tier 1 cities are the biggest cities in China, such as Beijing and Shanghai).

To place this 14:1 into the right context, at the height of the sub-prime bubble in the US, house price to earnings ratios reached 9:1.

The Dutch back in 1637 had an excuse for being suckered in to the tulip investment mania, as it is widely thought to have been one of the very first investment bubbles in global economic history.

There is no such excuse this time around as today’s economic difficulties – which are centred on the bursting of the China investment bubble – are the third such episode in the space of just 16 years.

In 2000, as everyone knows, the dotcom bubble went pop, followed by the collapse of the US housing market, which led to the 2008 global financial crisis.

We might be lucky on this occasion and get away with only a prolonged period of lower global growth rather than another full-blown economic crisis.

But every day almost, new data emerges indicating the scale of this most recent bubble – and thus the danger of something at least as big as 2008 – perhaps even bigger.

Take a 10 January article in the UK’s Financial Times as a very good example. Quoting Institute of International Finance data, the FT said that emerging market debts in the decade to mid-2015 had risen from $5.4trn to $24.4trn, which left borrowing equivalent to 90% of the region’s GDP.

IGNORING THE WARNING SIGNS

Emerging markets in general were involved in this bubble, with their recent economic success primarily resting on events in China. Think of Brazil and what was once its strong commodity-led growth as China bought every tonne of iron ore it could get its hands on.

The problem, as is always the case with these bubbles, is skewed incentives. On this occasion we can blame these skewed incentives on Western central banks, and particularly the US Federal Reserve. Here is how it worked, or, rather, did not work:

■ The Fed’s quantitative easing programmes drove interest rates to record lows, while also devaluing the US dollar. This did what the Fed intended, which was to force investors to seek “stores of value” in higher-yielding investments. Money poured into emerging markets, where yields were better, resulting in this alarming build-up of debt.

■ Because just about everyone believed that this bubble would go and on, petrochemicals companies, most notably in the US, were tempted into major new capacity investments, particularly in polyethylene (PE). There has also been major over-investment in oil, which explains today’s collapse in oil prices.

“People tend to ignore the warning signs during these bubbles. But in retrospect, they should have been obvious to every single one of us,” said a Singapore-based business planner at a global chemicals company.

One of the warning signs that was flashing a very bright shade of red was, as we said, the rise in earnings to house price ratios to no less than 14:1 in China’s biggest cities.

Here is another much broader-based statistic on China’s credit boom that should have been widely noticed: between Q4 2008 and Q1 2014 China’s total social finance (TSF) rose from 129% to 207% of GDP, according to Washington DC-based think tank the Brookings Institute. TSF is a measure of total new credit creation in China.

And, as we discussed in our last China Monthly, as leverage increased, its effectiveness in delivering growth declined: China’s government estimated that in 2014, each dollar of new debt was adding only 10 cents to GDP growth.

But as the bubble inflated, as is the case in every investment mania, a theory emerged to justify why the bubble would go on and on – almost indefinitely.

Remember how during the US sub-prime bubble, most people thought that US house prices would continue to rise, making even the most shakily put-together mortgage deals serviceable?

This time around, the China and wider emerging markets bubble was based on the notion that hundreds of millions of people in these countries were rapidly become middle-class, under the definition of what it means to be middle class in the West.

THIS IS NOT ANOTHER DOWNCYCLE

“The key moment was probably 2011, when the myth began to take hold that China had suddenly become middle-class,” wrote Paul Hodges, chairman of the UK-based chemical consultancy, International eChem (IeC), in a 3 February post for the FT’s Beyondbrics blog.

“Companies and investors devoured the headlines from the Asian Development Bank’s 2011 report, which suggested that the majority of Chinese households had become middle-class by 2007,” he added.

They chose to ignore the detail of the report, which was that being middle-class in the emerging world actually meant per capita daily incomes of $2–20, based on purchasing power parity, said Hodges.

“Even with two adults earning $20 a day, every day of the year, they would have an annual combined income of just $14,600, well below the poverty line in any Western country,” he added.

The Chinese government’s National Bureau of Statistics also placed average per capita high-end urban incomes in China at just $9,000 per annum in 2013.

Anybody earning that amount of money in the developed world would probably be on welfare payments.

As we all now know, of course, the bubble began to burst from early 2014 when China started to reduce credit growth in an effort to rebalance its economy away from investment and towards domestic consumption.

This decision largely explains the collapse in oil and other commodity prices. The hard reality is that too much oil and other commodities supply is chasing demand growth that will now simply not happen in China and the rest of the emerging world.

In the case of US PE expansions, placing all of the extra volumes always felt like a risky proposition, given what is a very mature US market – as the graph above illustrates.

Here we have taken just one of the three major grades of PE – linear low density polyethylene (LLDPE) – as an example .

US consumption is forecast to rise from around 4m tonnes in 2010 to approximately 4.8m tonnes in 2020. Meanwhile, capacity is set to increase from 4.5m tonnes/year to 7.9m tonnes/year.

The majority of US PE capacity expansions were always going to have to be exported, with emerging markets an obvious big target because of their strong economic growth.

What will now happen when these new PE volumes arrive in the global market from 2017-2018 onwards? We will consider some scenarios in our next China Monthly report.

A more pressing question is how petrochemicals companies in general get through the next 12-18 months.

One widely held assumption is that this is just another downcycle of several recent downcycles. The feeling is that all that is needed is to hunker down, cut costs and wait for business conditions to return to normal.

But in a new study – 5 critical questions to answer to survive in today’s chaotic petrochemicals markets – ICIS and IeC argue that cutting costs in the wrong areas would be a big mistake.

We have entered a new global economic era, during which growth and profit drivers will be very different.