China’s new bank stress test is so tough it signals trouble ahead

 Now that’s a stress test.

Bank regulators in China said on August 5 that the country’s stress test of its banks will include a worst-case drop in real estate prices of 50% to 60% in the country’s most speculative markets.

Take that Euro Zone and even the United States where stress tests of the banking system that showed just seven and 10 banks, respectively, needed to raise additional capital have been widely criticized as too lenient.

But before you start cheering on the news that a country is finally getting tough on testing its banks, consider this possibility: China is publicizing how tough its test will be not because it thinks its banks are in good shape (and will pass an honest test) but because is becoming increasingly worried that investors are losing confidence in the country’s banks just when those banks need to raise billions in new capital to fix portfolios swamped with bad loans.

In other words, consider the possibility that what looks like a sign of strength is actually a loud signal of growing weakness in China’s banking sector.

Hey, it wouldn’t be the first time, would it, that a country had cynically designed a stress test with the purpose of reassuring investors that its banks were safe? The euro and the U.S. stress tests were exactly that kind of exercise, after all.

Think I’m being too cynical? (Can you be too cynical about bank accounting in any of the world’s markets?)

If China were to have a real estate bust, what would it look like?

The consensus is that China has a real estate bubble. The only argument is whether it will burst in some crash that will take down China’s economy or come in for a relatively soft landing that slows China’s economic growth but in no measure extinguishes it.

It’s tough for me to come down on one side of that debate or the other because most of the time the protagonists don’t bother to set out what the bursting of a real estate bubble would look like in China. There’s a kind of unspoken vague agreement that a Chinese bust wouldn’t look like a U.S.-style bust, but no real effort to put real flesh on the bones of a China-style bust.

And without fleshing out what a real estate bust in China would be like, it’s just about impossible to decide the seriousness of that bust or the extent of its consequences.

Let me take a run at that and see if the effort helps settle the crash vs. soft landing debate. Or at least moves it along a bit.

I don’t think there’s any real argument about this: China is in the midst of a speculative rise in real estate prices that can’t be sustained.

Inflation or deflation–or maybe something worse

Inflation is a sexy worry.

We can photograph it. A photo of a one billion dollar bill next to a pile of apples from Zimbabwe’s recent bout of runaway inflation stuns the imagination.

It’s the stuff of national nightmares.  The German electorate and German bankers are still traumatized by Weimar-era inflation.

And we know what to do about it: Raise interest rates, rein in the money supply, or, if worst comes to worst, send the economy into a recession.

Deflation isn’t sexy.

It’s hard to photograph money getting more valuable and falling prices just aren’t terribly dramatic.

Japan has been sunk in deflation for years if not decades without violence in the streets or even noticeable anguish. The period doesn’t even have a catchy name and it certainly doesn’t have any cache. \

And we don’t know what to do about it. Increasing spending, running big deficits, subsidizing spending all work in theory but they don’t seem to have done much to solve Japan’s deflation persistent problem.

About the best we can do is coin metaphors—fighting deflation is like pushing on a string—and pursue policies designed to prevent inflation from establishing a beachhead.

Which is why the possibility of deflation worries so many investors and economists right now. And why investors need to stay on guard against both of these possibilities–and well as a third alternative that mixes some of the worst parts of both.

Within six months global stock market performance will diverge–where do you want your money?

It may not look like it but the world’s stock markets are about to start moving in different directions.

That’s certainly not at all clear now. Most days recently all the world’s stock markets have moved in the same direction—DOWN. On June 29, for example, U.S. Standard & Poor’s 500 Index dropped 3.1%, Germany’s DAX Index fell 3.3%, and China’s Shanghai Composite Index plunged 4.3%.

But I think sometime in the not too distant future—somewhere in the next three to six months would be my best guess—the stock markets of the developed and developing world will start to diverge. Six months from now—or less—stocks in China, Brazil, India, and many of the other developing markets will be in clear up trends and stocks in the developed economies of Europe and Japan will still be stuck in decline. The United States will be left in the middle, straddling the divide between the two groups.

Why?

Because the underlying economies are headed in radically different directions within that time period. And where the economic fundamentals go, stocks, eventually, follow.

If I’m right, this divergence should be the cornerstone of your investment strategy over the next year or longer. And, if I’m right, how you allocate your portfolio between these two diverging blocks of economies and markets will determine how well your investments perform during that period.

Let me lay out the case for this divergence in the economic fundamentals-and stock markets. And then you can judge for yourself if I’m right or not.

Within six months global stock market performance will diverge–where do you want your money?

It may not look like it but the world’s stock markets are about to start moving in different directions.

That’s certainly not at all clear now. Most days recently all the world’s stock markets have moved in the same direction—DOWN. On June 29, for example, the U.S. Standard & Poor’s 500 Index dropped 3.1%, Germany’s DAX Index fell 3.3%, and China’s Shanghai Composite Index plunged 4.3%.

But I think sometime in the not too distant future—somewhere in the next three to six months would be my best guess—the stock markets of the developed and developing world will start to diverge. Six months from now—or less—stocks in China, Brazil, India, and many of the other developing markets will be in clear up trends and stocks in the developed economies of Europe and Japan will still be stuck in decline. The United States will be left in the middle, straddling the divide between the two groups.

Why?

Because the underlying economies are headed in radically different directions within that time period. And where the economic fundamentals go, stocks, eventually, follow.

If I’m right, this divergence should be the cornerstone of your investment strategy over the next year or longer. And, if I’m right, how you allocate your portfolio between these two diverging blocks of economies and markets will determine how well your investments perform during that period.

Let me lay out the case for this divergence in the economic fundamentals-and stock markets. And then you can judge for yourself if I’m right or not.