Stephen Roach: China Market ‘Overheated’

Stephen Roach, chief global economist at Morgan Stanley, in an interview on The Charlie Rose Show yesterday said that China's stock market is "overheated" and predicted the U.S. economy will be "lucky" to grow 2 percent in 2007.

Roach told Charlie Rose that the hit China's stock market took in trading two days ago shouldn't come as a surprise to investors. In fact, we agree, having warned Financial Intelligence Report subscribers to stay out of China and focus on global stocks in India, Singapore, and Malaysia instead.

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"China has an overheated investment sector. This is not just a random event out of the blue, Charlie. The government's been trying to slow down investment now for almost three years," points out Roach. "They've taken a lot of actions. They're starting to work in terms of slowing down investment. At the start of 2006, investment was growing at 30 percent. At the end of last year, it was growing at 14 percent. But guess what, the bank credit growth, which they're also trying to slow because that's what funds investment, is accelerating. So the excess bank credit growth is now sloshing into the markets. The Chinese stock markets are rising parabolicly. They've got to slow that down as well. And there were some rumors that the Chinese government was doing that overnight."

Roach added, "I hate to comment on rumors, but it looked like they were looking at some unseemly speculative activity, there were talks about putting some taxes on stock market transactions. But make no mistake; the government does not want an out of control asset market in China. The domestic market in Shanghai is up 100 percent in the last six months. It's along the likes of which you rarely see. And the Chinese can't afford to let this get away from them."

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When asked why the decline in China's markets spread to the rest of the world's stock markets, Roach replied, "China's one of the two key engines in the global economy right now. The Chinese producer and American the consumer probably accounted for over 60 percent of all the global growth we've seen in the last five years, so if one of these engines starts to sputter, we have to watch out."

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Roach said there are fundamental problems in China that could affect the rest of the world. "[Fixed] investment in China, the plant and equipment spending on infrastructure, residences, and factories rose last year to more than 45 percent of the Chinese economy. We've never seen a number that big. If they keep growing this sector as rapidly as it has been growing, that ratio keeps going up and up, then China has excess capacity, which is a very deflationary problem for them. So they can't afford to let this sector get away and that's what's going on right now."

"But we learned something else today in the market and that is not just that we had a problem in China, but that we had a very disappointing data release on the capital goods outlook – 4 of the last 5 months the order series has fallen a lot and in January, the number that came out [yesterday] it was a significant downside surprise," notes Roach. "This is important because most people believe that the U.S. can take a hit in the housing sector, a hit in the auto sector, but it doesn't spill over anywhere else. And this draws that view into question. Maybe we are seeing some spillover effects into sectors that we thought would hold things together in the U.S."

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Chief market strategist at Pequot Capital Management Byron Wein, who was also a guest on the show, then asked Roach for his prediction on economic growth for 2007.

"I think we'll get lucky if we get 2 percent, Byron, and the risk is we may go below that," warned Roach. "The interesting thing that's happening right now is that the growth rate of the economy is slowing to 2 percent and consumers are continuing to spend like there's no tomorrow. What happens if the Teflon American consumer throws in the towel? Then the growth rate gets a lot weaker and we could have a recession."

Wein then pointed out to Roach that he's been warning about the collapse of the consumer for years, and it hasn't happened yet.

"I'll keep talking about it until I get it right. Look, people have jobs today and the unemployment rate is low, but that's no guarantee of where it's headed. As the housing sector weakens, as the capital-spending sector weakens, the industries that generate the capital goods and the building activity lay workers off. That hits the income stream, which affects consumer confidence, and consumers right now with negative savings rates, record debt ratios particularly vulnerable. So I'm worried about the consumer going forward. And you're entirely right, I've been worried about the consumer longer than I care to remember," explained Roach.

Editor's note:
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Sir John Templeton first warned of housing crash – Read More Here
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