Will China Save The World?

The Office of Federal Housing Enterprise Oversight (OFHEO) was created as an independent entity within the Department of Housing and Urban Development, a department of the Government of the United States. OFHEO's primary mission is to oversee the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) -- the nation's largest housing finance institutions.

Earlier this week OFHEO released its most recent House Price Index (HPI) data, of which the director of OFHEO, James B. Lockhart, said: "These data are a strong indication that the housing market is cooling in a very significant way. Indeed, the deceleration appears in almost every region of the country." The decline in the quarterly increase in home prices was also the sharpest since the beginning of OFHEO's House Price Index in 1975.

OFHEO's report lists higher interest rates, a drop in speculative activity and rising inventories of homes as reasons for the decline in home appreciation. There is only one thing we know for sure about economics and that is the interplay between price, supply and demand. With respect to real estate it seems certain that price appreciation is slowing down and inventories are rising because demand is falling. We can therefore restate the first sentence of this paragraph by saying that home price appreciation is slowing down and inventories are rising because of reduced demand. This may sound like I'm splitting hairs, and maybe I am, but I do think it is important to realize that price appreciation is not slowing because of rising inventories -- both declining price appreciation and rising inventories are a result of reduced demand.

Now let's also make sure we know what this data is telling us. The decline in home appreciation does not mean house prices are falling; it only means that house prices are not rising as fast as they used to. According to the HPI data, home prices increased by an average annual rate of 10.06% in the second quarter (from the second quarter of 2005). And if we measure the increase using purchase transactions only (just a different method) then home prices still rose an average of 8.27% in the second quarter. So there is no reason to be alarmed, right?

The real estate market got completely out of control. In Arizona, for example, the average increase in home prices from the second quarter of 2005 to the second quarter of 2006 was 24%. It was 21% in Florida, 20% in Idaho and 19.5% in Oregon. I have been an investor for long enough to know that when average house prices increase by 20% to 25% then something is wrong.

Even if average house prices do not fall we can most certainly expect to see the average increase in house prices come back to somewhere in the 2% to 4% range. Personally I think that is being overly-optimistic, but the point I am trying to make is that even if home prices don't fall, the wealth effect of rising stock prices and rising house prices is over; and with it goes consumer spending.

Consumer spending accounts for 70% of the United States' gross domestic product, so if consumer spending takes a hit because the real estate refinancing tap is turned off, the economy is going to struggle. Can China save the world?

Many people, particularly investors in natural resource stocks, pin their hope on the expanding Chinese economy. I have long maintained that China is just another bubble looking for a pin and that the Chinese economy is too closely tied to the US economy to withstand a slowdown in US consumer spending without getting dragged down.

A simple calculation will tell you that if China's exports are growing at 30%, and exports account for 30% of GDP, then the growth in exports alone will increase GDP by 9%. But hold on, that's how much China's entire economy is growing! So where is the internal demand? Where is all the Chinese consumption that is going to propel base metal prices? Either the World Bank's data is completely useless, or else China's economy is far more dependent on exports that what some people think. I don't know which it is, but I am not going to bet that it's the former and not the latter, so I'll stick to my prediction that the bull market in base metals is over or, if not, very close to being over.

Incidentally, the IMF released a report this week saying that they think copper is going to fall by 57% over the next few years. I think I'll stick to gold. Hopefully the gold price will keep trending down in the short term so I can buy some more.

Paul van Eeden

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