China Kettle, Dryer and Scale, Inc.

Big bubbles can be hidden behind seemingly irrelevant observations.

I happened to walk into a large appliance store yesterday; I wasn't looking to buy anything, just filling 15 minutes before an appointment. As I strolled down one aisle, I was struck by the huge number of different counter-top plug-in water kettles for sale. There were 32 different makes and models and the display took the entire length of the aisle. I thought that was odd. As I rounded the corner, I came to the hair dryer section: 42 models. Right next to them were the bathroom scales: 16 models. Nearly every item was Made in China.

By now I was baffled as well as bemused: who needs to choose amongst so many nearly identical items? My first reaction was to chuckle and blame our consumerist society; but that sentiment was immediately replaced by my curiosity for all things economic. Here was a major manifestation of the Chinese economy, on display as Kettles, Dryers & Scales. My conclusion, after some thought, is that its manufacturing-export economy has now reached a level that can best be described as absurd. Let me explain.

The sheer number of makes and models means that there must be dozens of different Chinese companies that make small appliances. There is apparently nothing to distinguish one from the other - there are no name brands that we would recognize as such - so the price competition must be incredibly fierce. Furthermore, the fact that the store is stocking and displaying so many of them must mean that the marginal cost of doing so is nil. Let me put it this way: a few days or weeks ago the store carried 41 dryers - what induced it to accept number 42? The answer is even lower prices and better payment terms - and this pressure is then immediately transmitted back to the makers of the other 41 dryers.

If you are China Kettle, Dryer and Scale, Inc. - one of the dozens of similar companies - what can be your sole business strategy for profitability under these conditions? Make it up on volume, of course. So you keep expanding your manufacturing capacity in the hope that, when the bubble bursts, you will be one of the lucky few that survives. Because it is quite clear that the system is now forcing the creation of a bubble - no way out, except perhaps to take advantage of another bubble and sell out by listing your shares on the Shanghai Exchange.

Can the manufacturing bubble continue? Given the intensely marginal nature of the business, the only way it can continue is by achieving constantly higher sales, i.e. by constantly enlarging the bubble. But if there is even a small slowdown in retail demand, and keeping in mind yesterday's post on the prevalence of the global Just In Time network, the negative effects on profitability are going to be instantaneous and highly destructive. The bubble will explode - not merely "pop".

What is the probability of this happening? Well, given that the largest consumer market on the planet (the US) is now definitely weakening and that the second largest (the EU) is not very far behind, I calculate that a slowdown in total consumer demand has already started. I certainly would not want to be an shareholder in CKD&S, Inc.

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P.S. The "eagerly awaited" BLS employment report came out exactly as expected at +110.000 jobs for the month, though the month of August was revised at +89.000 vs. -4.000. The revision had to do almost entirely with the number of teachers going back to work, which was originally estimated too low. However, the relevant data one needs to look at in order to gauge the economy is the number of jobs added by the private sector.

Here is a chart comparing the jobs created during each of the first 9 months in 2005, 2006 and 2007. For the 9m year to date, 2007 is down 49% from 2005 and down 40% from 2006.

In other employment news, the Monster Index came out unchanged at 186 for September, while the BLS did its "birth/death" model revision and subtracted 297.000 jobs from what it had originally reported as created during the 12 months up to March 2007.

The Phoney Recession

World War II officially started when the Nazis invaded Poland in September 1939, forcing France and Britain to declare war on Germany. French and British troops manned the Maginot Line, Germans faced them from their own Siegfried Line and ... nothing much happened - until the cataclysmic attack on France in May 1940. This intervening period was dubbed the Phoney War.

The unfolding global economic crisis started back in early 2007 with a warning shot from US sub-prime mortgages. Viewed as an isolated event, this first crisis quickly quieted down - only to flare up again in the fall, engulfing the financial sector and sending money markets reeling. Still, the global economy was deemed healthy because BRICs were at full speed, US consumers kept spending and jobs were plentiful. In addition, rate cuts and liquidity injections provided by the Fed and ECB worked to reassure equity markets, soothing otherwise frayed nerves. The majority of economists and market analysts were sceptical, but not unduly alarmed. The truth is, however, that they have been lulled into complacency by a "phoney economy".

In the past two weeks the armies of the Global Recession have finally attacked the main front, the US economy. Holiday shopping was flat, housing and manufacturing weakened further, private employment dropped - Americans are reeling from high debt, rising fuel and food prices, low incomes, negative saving and dropping house prices. The blitzkrieg is in full blast now and the center of the defensive line is rapidly caving. In this election cycle no fiscal policy reinforcements can be expected, either (e.g. tax cuts). The Bush administration is politically bankrupt and may only manage a retreat. Given its past record of incompetency, from the Iraq war to New Orleans, chances are it will botch even this badly.

With the center gone, the wings made up of European and Asian auxiliaries are not going to be able to withstand by themselves the full force of the global recession. Decoupling is an illusion, another myth of the phoney economy that will prove as effective as the static Maginot Line was against Guderian's tanks and the Luftwaffe. The main reason is that at the core of decoupling stands, once again, the US consumer - a force that has now crumbled from within.

Oh, decoupling happened, all right: production moved abroad, but consumption - fuelled by easy vendor credit - stayed home. A simple statistic: minimum wage is $5.85 in the US and 55 cents in China. Even ignoring the fact that more Chinese make minimum wage and save more of it than Americans, it is obvious that China simply cannot consume more than a fraction of what it produces.

Let's look at those "wings" more closely. Europe is as much dependent on artificial growth boosts as the US: Club Med (Spain and Greece) fed on the familiar recipe of zooming household debt and real estate bubbles, newer EU members also borrowed with abandon (in yen and Swiss francs, no less), Russia is a hollowed-out economy entirely reliant on oil and gas and Britain, anchored as it is on the City's financial industry, is already reeling from the American disease. Germany, France and Italy are stalling at 1.6%-1.8% GDP growth; the strong euro is killing their exports. Inflation at 3.1% is far above the ECB's 2% target, and this only because the euro is somewhat cushioning the damage from imported oil and Chinese goods.

In Asia, Japan is similarly dependent on exports for whatever growth it can eke out. Its goods are almost entirely focused on affluent consumers (i.e. the US and Europe) and cannot be marketed to China and India; likewise for South Korea and Taiwan. The second (or third, depending on counting methodology) largest economy in the world is thus a basket case, growth-wise. China is growing on capital spending/investment steroids (around 50% of GDP), mostly because it is building factories and infrastructure to support exports going to America and Europe (readers may remember an older post titled China Kettle, Dryer and Scale, Inc.). The confluence of lower export demand and PBoC's tighter monetary policy are going to reduce growth much faster than people think, in my opinion.

India doesn't really "belong" to the BRIC bloc, except for a small percentage of its otherwise agrarian and backward economy, located in a couple of big cities and tech service enclaves. Australia, Canada, Brazil and the Gulf Arab economies are in a class by themselves. They are essentially pure commodity plays, one or two dominoes further removed from faltering US and EU consumers.

This is not to say that every country is solely dependent on the state of the American and European consumerist economies. But unlike recent decades, when the capitalist and free market system affected directly only a minority of the global population, globalization has today exposed the entire world to the vagaries of the business cycle. Dominoes falling in New York and London are once again affecting Moscow, Shanghai and Mumbai even more than they did during the glory days of laissez faire in the 19th century. Communism and interventionist statism certainly created a lot of dead weight, but it also provided inertia that attenuated the ups and downs of the global cycle.

I fear the phoney recession period is ending and the main attack of the Global Recession is about to commence.

More Kettles and Such

Yesterday I visited the same electrical/electronics store as last October, when I posted the original China Kettle, Dryer and Scale, Inc. piece. This time I did a little more research on small appliances, casually strolling down the aisles...

The same conclusions apply as in the first post, with the added observation that MP3s are in a bubble all of their own. I noticed that the two most expensive models were iPods, whatever that means for competitive conditions in a sector so crucial for Apple.

The price spread from low-to-high in each appliance category is roughly 1-to-10, excluding a few very top-end models that are not really comparable with the rest. Corollary: tapped-out consumers can trade down in their selections as never before; for example, why pay ten times more for the simple task of boiling water? Again, whatever this means for retail sales and profits...

Speaking of appliances, stainless steel demand is dropping, even in Asia. The region's largest steelmaker (by market value) announced lower sales and a 20% drop in profit, blaming less demand from appliance makers and builders. Other steelmakers in Asia are reporting similar trends. Decoupling, where art thou?