Expectations and Assumption in China – 1/12/16

The slowdown in China and the collapse in oil prices are likely to cause recessions across most emerging markets having a profound effect on the global economy. So why did so few see the problem coming and fewer act to hedge against what in hindsight was an obvious risk? Why were expectations for the world’s most populous nations so far removed from reality?

The housing crisis in the US was an asset bubble situation created by the assumption that national home prices could only ever go up and perpetuated by loose lending standards that allowed NINJA loans (no income, job, or assets) to flood the market to feed the newest derivative craze of mortgage backed securities. These securities were rated almost risk-free by the credit rating agencies before people began to realize just how illiquid and risky the securities could be if many people default on mortgages in a short time. As a result, most financial managers and bankers found themselves holding a lot of assets that no one wanted while home prices, along with household wealth for regular home owners, crashed across the nation.

The government stepped at that point. It bought up the “bad” assets, bailed out a bunch of the “bad” companies. Problem solved… ? Almost a decade later, the mortgage backed securities regained value and all the companies seem to be doing well; however, the root of the problem remains.

Lots of people making terrible assumptions.

China was never going to maintain exponential growth. No tangible resource can be increased exponentially when it depends on finite resources and there is no logical reason to assume that China would be any different than the other countries that seemed set to eclipse all others only to settle down after a spurt. And yet, people trusted to know this basic truth didn’t seem to see the slowdown coming. Maybe China’s growth lasted just long enough for them to forget, or they thought they could still make their money before the time came. Regardless, the game is up.

The investors with expectations of a Chinese “rise to power” are now set to be sorely disappointed. The Chinese government is scrambling force the economy to meet growth targets and contain the damage being done to the domestic currency and financial markets. As a result, countries that relied heavily on Chinese consumption of commodities are suffering. US exports are set to fall as Chinese trading partners who enjoyed booms during high consumption times are facing recessions as overcapacity in China is finally reigned in.

Economists have long turned their noses up at data provided by the Chinese state since they know it is more fantasy than fact but when those numbers last so long and look so good, the assumption that the trends will last forever is an attractive one to investors, especially if coupled with the assumption that some other sucker will be the last one holding the bag when the crash does come.

With the collapse in expectations for China, comes the collapse in oil prices. After years of $100+ per barrel prices driven by rising Chinese demand and faith in an OPEC defense of prices, the price of oil is hovering around $30 a barrel with some analysts believing it could go as low as $20 before the year is through.

The assumption that demand increases from China and supply reductions from OPEC would keep oil prices high will cost many investors and countries dearly. It fueled a boom in the US energy industry between 2009 and 2014 as projections could reasonably be based on ranges of $80 to $100 a barrel which made many assets (land, oil rigs, etc.) look very attractive and many projects look like good uses of massive amounts of debt. Companies benefiting from the boom by providing support services and complimentary goods only found out how exposed they were after the bubble burst.

The lesson seems to be that one should always keep a realistic view on global trends as globalization becomes more important to all industries but a better one might be this: get cautious, not complacent, when an improbably good trend seems to be going on indefinitely. And look hard at assumptions about sustainability.

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