I was right! Cotton prices are falling!

On the 12 November I wrote about cotton prices being a bubble (http://ravendragon.wordpress.com/2010/11/12/cotton-prices-are-a-bubble-all-bubbles-burst/), and pointed out the bubble like shape of the cotton price chart. I suggested that this particular bubble (like all bubbles) would burst at some stage.

Check out the chart below. Since that writing on the 12th November, cotton futures are down 20% from their height.

I cannot pinpoint one specific reason (other than common sense finally kicking in!), but I’ve read that measures have been taken by the Chinese authorities to temper speculation in the commodities market, especially in cotton.

As an analyst you hope to be right more often than not. So while I’m not trying to brag, it is nice to get it right…. sometimes.

Zai Jian

Cotton prices are a bubble – all bubbles burst

I couldn’t help but notice some economists point out that clothing was one of the reasons for the upside surprise in China’s October CPI figure (4.4% vs. 4% consensus, and 3.6% in September). I would expect continued policy responses in this inflationary environment, including the chance of price curbs in addition to the market’s expectations of increased bank RRR rate.

I want to take a step back in this article and talk about cotton. The price of cotton is above $1/lb for only the second time since the US civil war! In fact look at the Bloomberg chart below – the price of cotton futures have almost doubled since July! Why?

Well there are some long term secular trends at work here.

• I can’t deny that cotton demand in both China and India has doubled since 1995 – the result of increased urbanization and GDP/capita.
• Over the past few years the prices of other soft commodities, such as corn and soy have also increased. This is the result of (1) improved diets in emerging markets (corn feeds animals, and animal consumption rises as nations grow wealthier); (2) a growing world population; (3) reduced arable acreage; and (4) bio-diesel production. As the prices of corn and soy have increased, farmers are naturally compelled to replace cotton production with the likes of corn production, which reduces cotton supply.

However I can’t ignore that the price of cotton smells like a bubble. Just look above at the chart again. Then look below at the chart of the historical price of potash.

When the prices of corn and soy increase, it makes economic sense for farmers to apply more potash to increase their yields. As a consequence the price of potash similarly increases. Over the period highlighted, the price of crops and potash increased dramatically. Now I know hindsight is a wonderful thing, but the price of potash eventually came crashing down – history shows us that was a bubble. During the years before the recent economic crisis market participants were well aware of the long-term soft commodity cycle (which I explained above).   Yet some kind of over exuberance grasped the imagination of market participants. The cotton chart looks like the left hand side of this potash chart before the price tumbled.

In my opinion short-term drivers of the cotton market have been overplayed. It has led to an over exuberance in cotton futures, and created a bubble. I’m not the first person to posit that when things are good the market thinks they are better than they are, and when things are bad the market thinks they are worse than they are.

What are these short-term drivers?

• Weakened USD, which I believe is more likely to strengthen in the medium-term. Why?
  • I am against the consensus and believe that QE2 was over done. I think there’s a chance that all USD600bn might not be used. Why? Corporate tax receipts are healthy and indicative of strong profits in the next quarter. Unemployment is a lagging indicator, and always stagnates at this stage of a recovery – what’s more recent data has been encouraging and revised up. Employment agencies are seeing growth in profits, especially in temporary work (which as a quasi-lead indicator). IMS data highlights the inventory cycle is close to an inflection point (which will be great for employment). When the market sees this the USD is sure to strengthen. Also consumer confidence indexes are forecasting a solid consumer Christmas.

• Potential for prolonged Indian cotton export bans
• Bad weather in China and Pakistan
  • This is clearly cannot be factored in as a long-term issue!
• The weather and Indian story have lead to short-term purchases by mills not wanting to be left short.

So you see there’s a decreased supply in the short-term, a short-term increase in demand, and a short term FX issue.  This must have led to massive speculation pushing up the price of those cotton futures. It simply can’t be the case that these short term elements could double the price of an asset on a fundamental basis, especially considering the fact that the long-term drivers have been known for years.

Now, I can’t tell you how long the price will remain elevated, or whether it will go up another 10%, 25% or 50%. But what I will say is that this is a bubble, and bubbles always burst.

So on the one hand beware. And on the other hand, look for stocks that have been hit and see if they present a good entry point – for example clothes retailers or manufacturers.

Zai Jian

PS – I hope soon to return to writing about building a core China portfolio. All articles on the subject can be found here -http://ravendragon.wordpress.com/category/building-a-core-china-portfolio/)

 

What’s the word on the street Johnny?

Andy Xie is an independent Economist.  In 2006 he left his job as Morgan Stanley’s chief Asia-Pacific economist under ‘interesting circumstances’.  He is known for his strong and normally contrarian views, and has sucessfully called a number of bubbles over the past few decades, including the recent recession and the dotcom crash.

I’ve cut and paste a fantastic piece penned by Xie this week in which he discusses a friend’s maid’s rush into the Chinese real estate market.  Enjoy!

“My maid just asked for leave,” a
friend in Beijing told me recently. “She’s rushing home to buy
property. I suggested she borrow 70 percent, so she could cap
the loss.”
It wasn’t the first time I had heard such a story in China.
Some friends in Shanghai have told me similar ones. It seems all
the housemaids are rushing into the market at the same time.
There are benefits to housekeeping for fund managers.
China’s housemaids may be Asia’s answer to the shoeshine boy
whose stock tips prompted Joseph Kennedy to sell his shares
before the Wall Street Crash of 1929.
Another friend recently vacationed in the southern island-
resort city of Sanya in Hainan province and felt compelled to
visit a development sales office. Everyone she knew had bought
there already. It’s either buy or be unsocial.
“You should buy two,” the sharp sales girl suggested.
“In three years, the price will have doubled. You could sell
one and get one free.”
How could anyone resist an offer like that?
The evidence in official-corruption cases no longer
involves cash stashed in refrigerators or starlet mistresses in
Versace clothing. The evidence is now apartments. One mid-level
official in Shanghai was caught with 24 of them.
China is in the throes of a vast property mania. First, let
me make it perfectly clear that calling China’s real-estate
market a “bubble” isn’t denying China’s development success.
As optimism is an essential ingredient in a bubble, economic
success is a necessary condition. Nor am I saying that prices
will drop tomorrow. A bubble evolves and bursts in its own time.
When it is about to burst, I’ll let you know.

Free Lunch

Expectations of a Chinese currency revaluation are,
perhaps, the most important force inflating the bubble. First,
it plays to the latent human desire for a free lunch. You just
need to exchange your money for Chinese yuan. According to all
the experts on Wall Street, you can only gain. The money has
been gushing into China.
Second, the revaluation story has kept Chinese money inside
the country. The dollar has always been the safe-haven asset for
Chinese. This is why Chinese banks had a large dollar deposit
base. Of course, anybody who was somebody had dollars offshore.
Now all that money is back. More importantly, any income, legal
or otherwise, now stays in China.

Flats Beat Cash

Why would corrupt officials keep apartments rather than
cash? Well, according to Wall Street, the yuan is going to
appreciate. So holding dollars is out of the question. And why
hold Chinese cash when property prices are always going up? The
corruption money can be turbocharged in the real-estate market.
Only when they are caught do they understand the downside of
holding fixed assets.
The massive liquidity waves have prompted Chinese banks to
lend as much as possible. One Wall Street tradition adopted
quickly in China was bonus recipients signing company checks to
themselves. All you need is to report eye-popping quarterly
earnings. It is an easier game than on Wall Street: The Chinese
government keeps the lending spread wide by fixing both the
deposit and lending rates. You just have to lend. The earnings
will follow. Might the loans turn bad in three years? Well, I’m
not going to give back my bonuses, right?
For a bubble to last you need a force to hold it together
when it stumbles. Wall Street kept pumping out new natural or
synthetic products to turn debt into demand for assets. Local
governments play this role in China.

Future Profits Now

When it comes to interested parties, Chinese governments
are knee-deep in the bubble. They get all the money from land
sales. Land values have risen to half of the development cost.
In hot spots, land costs more than the development — the
governments want to collect the future price gain immediately.
When properties are sold, transaction and profit taxes kick
in. Developers pay more levies to the governments than they
earn. When developers finally book their earnings, they must put
it to work, as good Wall Street analysts would recommend, so
they buy land. As land prices are much higher, their measly
earnings aren’t enough, so they have to borrow. The governments
get all their earnings and debt repayments. Can you blame them
for boosting the market whenever it slips?
Land obsession is another force at work. China was a rural
economy not so long ago. The most important asset was always
land. “Be a government official and become rich” is a
millennium-old Chinese saying. It didn’t explain where the money
went. It always went into agricultural land. In cities, you only
see buildings, not paddy fields. But the buildings sit on land.
Now housemaids are in the market. Who else? Never
underestimate 1.3 billion people. In China, they say you should
take the shoeshine boy’s advice. Many would listen to him.
Welcome to China, the land of getting rich quick!

“My maid just asked for leave,” a

friend in Beijing told me recently. “She’s rushing home to buy

property. I suggested she borrow 70 percent, so she could cap

the loss.”

It wasn’t the first time I had heard such a story in China.

Some friends in Shanghai have told me similar ones. It seems all

the housemaids are rushing into the market at the same time.

There are benefits to housekeeping for fund managers.

China’s housemaids may be Asia’s answer to the shoeshine boy

whose stock tips prompted Joseph Kennedy to sell his shares

before the Wall Street Crash of 1929.

Another friend recently vacationed in the southern island-

resort city of Sanya in Hainan province and felt compelled to

visit a development sales office. Everyone she knew had bought

there already. It’s either buy or be unsocial.

“You should buy two,” the sharp sales girl suggested.

“In three years, the price will have doubled. You could sell

one and get one free.”

How could anyone resist an offer like that?

The evidence in official-corruption cases no longer

involves cash stashed in refrigerators or starlet mistresses in

Versace clothing. The evidence is now apartments. One mid-level

official in Shanghai was caught with 24 of them.

China is in the throes of a vast property mania. First, let

me make it perfectly clear that calling China’s real-estate

market a “bubble” isn’t denying China’s development success.

As optimism is an essential ingredient in a bubble, economic

success is a necessary condition. Nor am I saying that prices

will drop tomorrow. A bubble evolves and bursts in its own time.

When it is about to burst, I’ll let you know.

Free Lunch

Expectations of a Chinese currency revaluation are,

perhaps, the most important force inflating the bubble. First,

it plays to the latent human desire for a free lunch. You just

need to exchange your money for Chinese yuan. According to all

the experts on Wall Street, you can only gain. The money has

been gushing into China.

Second, the revaluation story has kept Chinese money inside

the country. The dollar has always been the safe-haven asset for

Chinese. This is why Chinese banks had a large dollar deposit

base. Of course, anybody who was somebody had dollars offshore.

Now all that money is back. More importantly, any income, legal

or otherwise, now stays in China.

Flats Beat Cash

Why would corrupt officials keep apartments rather than

cash? Well, according to Wall Street, the yuan is going to

appreciate. So holding dollars is out of the question. And why

hold Chinese cash when property prices are always going up? The

corruption money can be turbocharged in the real-estate market.

Only when they are caught do they understand the downside of

holding fixed assets.

The massive liquidity waves have prompted Chinese banks to

lend as much as possible. One Wall Street tradition adopted

quickly in China was bonus recipients signing company checks to

themselves. All you need is to report eye-popping quarterly

earnings. It is an easier game than on Wall Street: The Chinese

government keeps the lending spread wide by fixing both the

deposit and lending rates. You just have to lend. The earnings

will follow. Might the loans turn bad in three years? Well, I’m

not going to give back my bonuses, right?

For a bubble to last you need a force to hold it together

when it stumbles. Wall Street kept pumping out new natural or

synthetic products to turn debt into demand for assets. Local

governments play this role in China.

Future Profits Now

When it comes to interested parties, Chinese governments

are knee-deep in the bubble. They get all the money from land

sales. Land values have risen to half of the development cost.

In hot spots, land costs more than the development — the

governments want to collect the future price gain immediately.

When properties are sold, transaction and profit taxes kick

in. Developers pay more levies to the governments than they

earn. When developers finally book their earnings, they must put

it to work, as good Wall Street analysts would recommend, so

they buy land. As land prices are much higher, their measly

earnings aren’t enough, so they have to borrow. The governments

get all their earnings and debt repayments. Can you blame them

for boosting the market whenever it slips?

Land obsession is another force at work. China was a rural

economy not so long ago. The most important asset was always

land. “Be a government official and become rich” is a

millennium-old Chinese saying. It didn’t explain where the money

went. It always went into agricultural land. In cities, you only

see buildings, not paddy fields. But the buildings sit on land.

Now housemaids are in the market. Who else? Never

underestimate 1.3 billion people. In China, they say you should

take the shoeshine boy’s advice. Many would listen to him.

Welcome to China, the land of getting rich quick.

1H09 – record Y7.37bn lending – pinpointed measures expected

Growth spurred by lending
Last week economists were busy increasing their 2009e China GDP forecasts to around the magic 8% figure.  The hike in new credit during 1H09 was surely a major contributing factor. During the first half of the year Chinese banks lent a record Y7.37bn, 300% larger than 1H08, and 47% higher than the government’s full-year 2009 Y5bn target.

Walking the tight-rope
The government is walking a tight rope, and will have to manage the economy to prevent assets bubbles, bad loans, and inflation, whilst simultaneously accounting for potential deflation (currently a concern in the US), and damaging shocks to the flow of capital.

President Hu Jintao told the Politburo on Thursday that the recovery was still nascent, and as such China would maintain its “relatively loose” monetary policy and proactive fiscal policy.  On Saturday the People’s Bank of China (PBOC) said it “would guide loans to grow appropriately” and “will aim at better allocation of credit in the real economy.

Mopping up liquidity: Y100bn of notes announced
The PBOC has announced the issue of Y100bn of one-year bills to prevent a surge in lending in 3Q (note: July is historically China’s slowest month for new loans).  According to Caijing magazine the PBOC has ordered the Bank of China (the county’s third largest lender) to purchase Y45bn of the notes, after the bank lent more than any of its competitors during 1H09.  The notes carry 1.5% interest rate (lower than the general 2.25 deposit rate).

Expectation: measured approach – reserve rates to rise
I expect the government and its organs to continue taking a measured and pinpointed approach to ensure growth and suppress bubbles.  As well as the new notes, I see banks reserve rates increasing from their current 15.5% for larger lenders, and 13.5% for smaller banks.  I see an increase in reserve rates most likely to wait until 2010, unless data for credit extended in July and the coming months exhibits any significant spikes.