The pain in Spain will get us too; so forget market rallies

By Vivek Kaul

If you are the kind who reads the pink papers religiously, you would have come to the conclusion good times may be back for stock market investors in India. After all, hasn’t the finance minister deferred the implementation of the much-hated GAAR (the General Anti Avoidance Rules) to next year?.

But before you open that champagne bottle and say cheers, here are some reasons why the stock market will remain flat or fall in the days to come.

Pain in Spain: The gross domestic product (GDP) of Spain grew at the rate of 8 percent every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle. As Jonathan Carman points out in a presentation titled The Pain in Spain, “Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade.”

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[caption id=“attachment_302353” align=“alignleft” width=“380” caption=“Spain has now emerged as the basket case of Europe, but other countries in the European Union”]  [/caption]

So far so good. The trouble was Spain ended up building way too many homes than it could sell. Even though Spain forms only 12 percent of the GDP of the European Union (EU) it has built nearly 30 percent of all the homes in the EU since 2000. As John Mauldin and Jonathan Tepper point out in Endgame - The End of the Debt Supercycle and How It Changes Everything, “Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the United States, even though the United States is six times bigger”.

All this building was financed through bank lending. Loans to developers and construction companies amounted to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion, or double Spain’s GDP.

What makes the situation more precarious is the fact that house prices are still falling. Carman says prices still need to fall by 35 percent from their current levels if they are to reach normality. This will mean more home loan defaults and more trouble for Spain. The Spanish stock market is already taking this into account and Ibex-35, the premier stock market index of the country, is down a little more than 10 percent in the last one month. Banking stocks have fallen much more.

While countries like Greece may be in more trouble, they are not economically big enough to cause a lot of trouble worldwide. But if Spanish banks go bust, there will be a lot of trouble in the days to come. Spain has now emerged as the basket case of Europe, but other countries in the European Union are not doing well either and this means trouble for China.

China’s After Party: If things are not well in Europe, it has an impact on China because Europe is China’s biggest trading partner. Chinese exports to Europe in March were down 3.1 percent in comparison to last year. Chinese exports had ranged between $475 billion and $518 billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430 million. Falling exports are not the best news for China.

There are other things which aren’t looking good either. As Ruchir Sharma writes in Breakout Nations - In Pursuit of the Next Economic Miracles, “In the last decade the main driver of China’s boom was a surge in the investment share of the GDP from 35 percent to almost 50 percent, a level that is unprecedented in any major nation…The investment effort focused on building the roads, bridges, and ports needed to turn China into the world’s largest exporter, doubling its global export market share to 10 percent in the last decade.”

This spending spree which was responsible for its fast growth is now slowing down. New road construction is down from 5,000 miles in 2007 to 2,500 miles. Railway spending is down by 10 percent.

The other major factor likely to pull down growth is wage inflation -salaries are rising at a very fast rate. In 2011, the average wage was rising at a rate of 15 percent, in a scenario where consumer price inflation was around 5 percent. As Sharma points out, “hourly wages are now rising twice as fast as productivity, or hourly output per worker, which is forcing companies to raise prices just to cover the cost of higher wages.” This has led to manufacturers moving to cheaper destinations like Bangladesh and Indonesia.

Given these reasons it is highly unlikely that China will continue to grow at the rates that it has been. Since 1998, China’s economic growth has averaged around 10 percent and it has never fallen below 8 percent. Sharma says “China’s looming shadow is about to retreat to realistic dimensions.” Sharma expects Chinese growth to slowdown by 3-4 percentage points in comparison to its current growth rate over the next decade.

A Chinese slowdown will mean disaster for nations which have been thriving by exporting commodities to China. In 1998, when China was a $1trillion economy, to grow by 10 percent meant it had to expand its economy by $100 billion. This could have been done by consuming 10 percent of the world’s industrial commodities, raw materials like oil, steel and copper. In 2011, China is a $6 trillion economy. If this economy needs to grow by 10 percent, or $600 billion, more than 30 percent of the world’s commodity production would be needed. With growth slowing down, China’s commodity requirements will come down as well. As Sharma puts it, “It’s my conviction that the China - commodity connection will fall apart soon”.

China’s stock markets remain largely closed to international investors. But the Hang Seng index listed in Hong Kong has a lot of Chinese companies. This index has gone up 0.9 percent over the last one month.

The Kangaroo Won’t Jump: In fact the Aussies are already feeling the heat with a slowdown in Chinese exports. Australian exports to China in 2011 stood at A$72 billion, up 24 percent from 2010, or around 26 percent of total exports. An ever-expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21 percent to A$3.4billion. The S&P ASX/200, one of the premier stock market indices in Australia, has been flat for the last one month.

Brazil - God’s Own Country: The rise of China has led to huge demand for Brazilian commodities. As Gary Dorsch, an investment newsletter writer, points out in a recent column, “Brazil has been enjoying an economic boom based on soaring prices for its natural resources including crude oil, agricultural products such as soybeans, corn, and cattle, and metals such as iron ore and bauxite-aluminum.”

The rise of Brazil was captured very well by Glenn Stevens, governor of the Reserve Bank of Australia. Stevens pointed out that in 2006, money received from a shipload of iron ore could buy 2,200 flat screen TVs. In 2011, the same shipload could buy 22,000 flat screen TVs.

Since the start of the financial crisis a lot of money printed by Western governments to revive their economies has flowed into Brazil. This has driven up the value of the Brazilian real, and made Brazil one of the most expensive countries in the world. Says Ruchir Sharma: “Restaurants in Sao Paulo are more expensive than those in Paris. Hotel rooms cost more in Rio than French Riviera”.

An expensive currency has meant that imports rising faster than exports. This situation is expected to get worse as China’s slowdown and the demand for Brazilian commodities falls. In fact the impact is already being felt. As Dorsch points out “Brazil’s economy stalled out in the past two quarters,showing near zero growth in Q3 of 2011 and Q4 in 2012. Factory output in February was 3.9 percent lower than a year ago.” The premier stock market index Bovespa is down 4.5 percent over the last one month.

India- Done and Dusted: The economic problems of India deserve a separate article. But let me list a few. In the year 2007-2008 (i.e. between 1 April 2007 and 3 March 2008, the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012, the fiscal deficit is expected to be Rs 5,21,980 crore.

Hence the fiscal deficit has increased by a whopping 312 percent between 2007 and 2012. During the same period the income earned by the government has gone up by only 36 percent to Rs 7,96,740 crore. The targeted fiscal deficit for 2012-2013 is Rs 5,13,590 crore. This is likely to go up given the fact that the rupee is depreciating against the dollar and thus our oil bill is likely to go up, pushing up our fiscal deficit. This would mean that higher interest rates will continue to prevail.

The stock market obviously realises this and hence has fallen by 1.8 percent over the last one month, Monday’s brief rally notwithstanding.

Over the last few years stock prices across the world have moved in a synchronised fashion because international investors like to move in a herd. Whenever there has been trouble in the United States or Europe it has led to emerging markets all across the world falling. Now we are in a situation where the emerging markets themselves are in a lot of trouble. So it is a no-brainer to say there will be no rally in the stock market in the near future.

Unless, of course, a certain Mr Ben Bernanke decides to open up the money tap again and go in for Quantitative Easing Round Three - or to put it in simple English, print some more dollars. If that happens, then investors can get ready to have some fun.

(Vivek Kaul is a writer and can be reached at vivek.kaul@gmail.com)