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By Staff | Jun 19, 2015

Looking around the world for potential faultlines where financial upheaval could originate from has one’s heading spinning like the world on its axis today.

There are so many … and like the San Andreas Fault, eventually we know that there is a big one coming. It isn’t often that a magazine will make a direct prediction, but the Economist Magazine was very direct calling China’s stock market a bubble and forecasting that it will burst. Things like Greek debt default or the nuclear deal with Iran blowing up just to name a couple, are risks to the global economy but few fundamentals are as important as China to the commodity sector.

The bylines to the story in the Economist were, “Share prices in China-Flying Too High-The Long Term Consequences of China’s Coming Stock Market Correction Are the Ones to Fear.” That was pretty plain spoken for economists. Most analysts are bullish about the U.S. economy and subsequently the U.S. stock market. But the next break in equity markets may not even originate here. Chinese stock markets reek of all the characteristics of a bubble. When they burst is up to the market but they have never left one that inflated yet and China’s will be no different.

There is a mindset that somehow China is different. That’s because its economy is centrally managed by infallible technicians so they will never experience recession and that they have somehow become masters of economics. This is hubris. They have enormous problems from the environment to correct and eventually the chickens will come home to roost.

The commodity sector has no greater fear than for the Chinese economy to fail in a major recession. They are not going to stop eating, but this relentless expansion of their protein diet where they now buy half our soybean crop would take a timeout while they correct excesses during the coming recession. China has been a great market for us, but so good that we have become dependent upon it to the point that we can’t do without it. There is no one else to sell to in order to make up for a loss of that market. The next 15 top soybean export buyers do not equal China. China has a credit bubble and it has been sustaining it in order to sustain targeted GDP growth. And now it has a stock market bubble.

The stimulus sustaining the credit bubble has carried over into Chinese stock market inflation. China’s GDP growth is no longer double digit and they are trying to engineer a soft landing. They have not found the low point yet with GDP growth of likely 6.5 percent this year.

The Economist noted, “More equity financing is needed to diversify the mix of corporate funding and to take the pressure off a banking system that is weighed down by dud loans. The markets are plainly soaring too high. At some point, they will crash. Predicting exactly when is a fool’s errand, but the warning signs are accumulating.”

“The signs of overvaluation are everywhere. Stocks listed the Shenzhen exchange, home to most tech firms, have an average price-earnings ratio of 64; for those on the exchange for small and medium-sized enterprises it is 80. (For most stocks a P-E ratio above 25 is considered expensive.) ChiNext is now priced at nearly 140 times last year’s earnings, a valuation that puts it in the same league as NASDAQ, America’s tech-heavy exchange, at the height of the dotcom frenzy.

Credit Suisse estimates that credit-financed share purchases have reached as much as 9 percent of market capitalization, five times higher than the level in most developed markets. Nevertheless, the immediate damage from a crash should be manageable for China. The free-float capitalization of the stock market is just about 40 percent of GDP; in rich countries it is typically more than 100 percent.”

The last line offers some solace, but I bet that it will not stop the short term panic when the bubble deflates. The U.S. has never imported an economic recession but there is always a first time. Many think that U.S. stocks are overvalued but nothing like Chinese stocks. When the Chinese stock market crashes there will be contagion in global markets around the world. Frankly, with US economic growth struggling to sustain annual 2-2.5 percent GDP there is fragility about this growth that makes it extremely vulnerable to a shock from Asia.

The Fed has described recent fundamentals such as a bad winter or port disruptions as transitory. Wonder what it would call a Chinese stock market collapse? … I don’t think that would qualify as just transitory. It would send the dollar sharply higher which would kill commodity prices too. The Japanese economy is groveling as well and would not stand a Chinese devaluation. Japan is still our biggest Ag customer.

The U.S. Ag sector has been trying to get its head around how bad things can get. I don’t think we have dialed anything like what the Economist Magazine forecast into their model as an inevitability of a Chinese style financial meltdown. Frankly, it is not a matter of if, but when, so that again argues for aggressive hedging by commodity producers.

David Kruse is president of CommStock Investments Inc., author and producer of The CommStock Report, an ag commentary and market analysis available daily by radio and by subscription on DTN/FarmDayta and the Internet.

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