Global Economy Slowing Again, but Accelerating Growth Coming

In each of the last 3 years, the global economy started the year with a burst of momentum, lifting global stock markets.  In each of these years the U.S. and international economies subsequently hit a spring and summer “soft patch” resulting in double digit declines for global market benchmarks.  Building evidence that the leading economies of the world are once again experiencing a “soft patch” has understandably created concerns that another sharp correction in equity markets may be imminent.  A correction is always possible, especially following the hefty gains registered since last September.  Nevertheless, we confirm the view in our April 3 Outlook that this economic “soft patch” will likely be short and shallow, and that markets will enjoy strong rallies as the year progresses (as in each of the past 3 years).  We are reducing modestly Marietta’s 2013 global GDP forecast from 4.0% to 3.7% to adjust for the current slowdown, but maintaining our outlook of 4.5% in 2014.  We also anticipate a further advance in global stock markets next year as economic growth accelerates.     

Evidence of a developing global economic slowdown is widespread, although the deterioration seems less troublesome than in past years.  In the U.S., employment data shows that in March employers added the fewest workers in 9 months.  March retail sales suffered their biggest drop since June 2012.  Regional manufacturing reports also reveal disturbing trends.  First quarter GDP growth of 2.5% came in below consensus expectations of 3.0%.  The situation in Europe is more worrisome:  auto sales are disappointing, manufacturing is weakening, construction is slumping, and unemployment has risen to a new high.  Some of the stronger economies, such as France, are teetering on the brink of recession, and the slump in the peripheral countries of Greece, Portugal, Italy, and Spain is deepening.  Even the fast-growing, leading emerging economies are exhibiting problems.  Disappointing GDP and manufacturing data in China have again kindled fears of a hard landing (see our 12/24/12 blog Chinese Economy and Stock Market Rebounding).  In Brazil, sliding consumer confidence and rising inflation and interest rates have prompted economists to scale back their growth estimates for the year.  Commodities are a good measure of the pulse of the global economy, and they have been sliding since February.    

The causes of the current “soft patch” vary from country to country.  In Europe, the Cyprus debt crisis and continuing political and economic uncertainty in Italy, Spain, and Greece are causal factors, but the primary culprits are the government austerity programs.  We attribute the slowdown in China to the bumpy progress of the government in shifting the focus of economic growth from exports and infrastructure to consumer spending.  The U.S. slump is attributed to a variety of causes, although it must be noted that there are economists who claim that the statistics are based on faulty seasonal adjustments and there is, in reality, no “soft patch.”   We think the slowdown is real, and we blame it primarily on the expiration of the payroll tax cut and the higher income taxes on affluent Americans.  In combination, they will cost taxpayers some $150 billion this year.  The government’s sequester, which kicked in on March 1 and will cut spending by about $85 billion this year, is also a brake on growth.  Any discussion of the ebbing strength the U.S. economy must include the lack of business confidence.  Businesses are sitting on record piles of cash ($1.8 trillion in U.S. corporations listed on the major stock exchanges) and are evidently too uncertain about the future economy to invest in new plants and/or employees.  In our view, political gridlock in Washington, federal fiscal irresponsibility, and excessive regulation all contribute to this reluctance to invest in the future.      

Our positive forecast, then, is based on a future improvement in the confidence and optimism of business in the leading economies.  This is the role of the policymakers, and we think they will respond appropriately.  The major supports for future global growth are the world’s central banks, which are moving decisively forward with accommodative policies.  International Strategy and Investment (ISI) has counted 379 stimulative policy initiatives around the world over the past 20 months.  More is coming.  A decline in global inflation, in part a beneficial byproduct of the decline in commodity prices, is providing central banks, particularly in the U.S., Europe, and China, with a green light to proceed.  The Federal Reserve has stated repeatedly its determination to keep rates low until unemployment, now slightly below 8%, drops to at least 6.5%, and on May 1 indicated its willingness to increase its pro-growth activities if the economy falters.  The most recent convert to a pro-growth policy is the European Central Bank (ECB), who cut interest rates on May 2 in response to a drop in inflation below 2.0% and a rise in unemployment above 12%.  The next central bank to join the parade may be India.  The Economist (April 6, p. 14) summarized the synchronized recovery program:  “The message from the rich world’s central banks is clear:  the era of ultra-loose monetary policy is here to stay.”  The full impact of these unprecedented stimulus measures, which typically takes 6 months or more to have full effect, is unclear but, in our opinion, is decisive.  

Recent developments in Japan are instructive.  Prime Minister Shinzo Abe has urged the Bank of Japan (BOJ) to combat decades of deflation by engaging in monetary easing designed to raise inflation to at least 2%.  The BOJ has responded, and the key consequence has been a dramatic decline of the yen, which in turn has increased significantly the competitiveness of Japanese exports.  In a different economic environment, Japan would be condemned as a currency manipulator.  In today’s growth threatened world, however, the International Monetary Fund, the World Bank, and the G20 leading economic countries have expressed support for the BOJ.  At home, the Japanese stock market has surged, consumer confidence is at a 6 year high, retail sales are rising, exports are rebounding, and Abe’s approval rating has soared to a record 76%.  Politicians and central banks around the world are taking notes.

Politicians in the U.S., Europe, and other countries are jumping off their austerity platforms and onto the growth bandwagon.  Partisan bickering over taxes and budget deficits among U.S. politicians has cooled and compromise to limit the negative consequences of sequester is increasingly in vogue.  In Europe, the severe and immediate austerity policy championed by Germany has come under attack.  The views expressed by The Economist are gaining adherents:  “In Europe the combination of a timid ECB, harsh austerity and minimal structural reforms is not giving growth much of a chance” (April 6, p. 16). 

We are not depending on the policy makers alone to lift the U.S. economy.  In addition to the quantitative easing activities of the Fed, the strengthening housing market and the rising stock market are bolstering growth.  The rise in residential real estate prices, which in February increased year-over-year by the most since May 2006, is especially encouraging.  Housing lifts employment, consumer net worth, and consumer and business confidence.  The same is true of rising stock prices.  In combination this “wealth effect” helps account for last month’s jump in consumer confidence.  Most investors believe the stock market is itself a forward indicator of the economy’s future, and today the S&P 500 Index closed at an all-time high with a gain of 12% since the beginning of the year.  Clearly, investors are not overly worried.

Assessing recent trends and developments, the IMF in April released its updated Overviewof the World Economic Outlook, which we consider positive and supportive.  Although the IMF reduced its global 2013 GDP projection from 3.5% to 3.3%, they left in place their 4.0% estimate for 2014.  All of the key economies, including the U.S., Euro-Area, Japan, China, India, and Brazil, are expected to achieve higher growth next year than this year.   In particular, U.S. growth is forecast to rise to 3.0% and China to 8.2%.  Even Italy and Spain are expected to emerge from recession.  We detect a note of relief at the IMF.  Looking back on 2012, they began their report: “Activity has stabilized in advanced economies and has picked up in emerging market and developing economies, supported by policies and renewed confidence.” 

In each of the past 4 years we have posted a blog regarding the then current “soft patch,” and in each case we predicted (correctly) an economic and market recovery.  We again counsel investors to exercise patience and remain cautiously optimistic.

Chinese Economy and Stock Market Rebounding

In our October 1 Outlook, we rejected the then fashionable prediction of a hard landing for the Chinese economy and, rather, we forecasted GDP growth accelerating from 7.4% in this year's 3rd quarter to about 8.5% in 2013. Since then there have been numerous indications that this economic rebound is already underway and is gaining momentum. Investors have taken note. The iShares FTSE China 25 exchange traded fund (FXI), which represents the performance of 25 of the largest company stocks that are available to international investors, has jumped 22.0% since September 5, whereas the S&P 500 Index has mustered only a 1.9% gain. We think the Chinese economy has turned the corner, and in 2013 its stock market will likely lead other emerging economy markets to a strong absolute and relative performance.

Earlier this year, the Chinese economy was slumping in response to aggressive steps taken by policy makers in 2011 to curb rising inflation. As the consumer price index retreated from over 6% in 2011 to below 2% by last September, the government increasingly shifted to accommodative policies of tax reductions, interest rate cuts and infrastructure investments. International Strategy and Investment (ISI) in November counted 63 stimulative policy initiatives over the prior year. They are clearly having an impact following a 7-quarter slowdown:

• Retail sales rose 14.2% in September with additional gains of 14.5% in October and 14.9% in November (the fastest pace this year).

• Industrial production beat forecasts with impressive year-over-year increases of 9.6% in October and 10.1% in November.

• The Purchasing Manager's Index (PMI) moved above the critical 50 level in both October and November; the latter report triggered the largest rally in the Shanghai stock market (4.3%) in 3 years.

• Fixed asset investment, a widely followed measure of capital spending, is again on the rise. Commodity imports, especially copper and iron ore, are rising and infrastructure development is experiencing upward momentum.

• Steel production, electricity demand and production, and rail freight are rising.

• Bank loans increased a blistering 15.6% year-over-year in November.

• Housing sales have picked up, indicating that the downturn in residential and commercial property has stabilized.

• Exports grew a surprisingly strong, above-consensus 9.6% in September and 11.6% in November.

Heading into 2013, the Chinese economy has the strong support of the new political leadership in Beijing as well as considerable momentum. The government's preoccupation with economic prosperity is rooted in their conviction that economic growth and political stability go hand in hand. They know that they can no longer rely on robust U.S. and European demand for Chinese exports to create adequate employment demand. A recent study by the Boston Consulting Group concludes that the potential is huge: by 2020, the middle class in powerhouses China and India is estimated to reach 1 billion and consumer spending is expected to triple to a combined $10 trillion a year.

Not surprising is the rising optimism for China's economy and stock market. A poll of 862 international investors taken by Bloomberg in November indicated that confidence in China's economy is at the highest level in more than a year: 72% of respondents see the economy improving or remaining stable - up from 38% in a September survey. They also view the Chinese stock market as the 2nd more attractive (behind only the U.S.) in 2013.

Global Stock Markets off to Strong Start in 2012 Led by Emerging Markets

So far this year global stock markets have risen at a rapid pace; extending the rally begun in the fourth quarter of 2011.  Since January 1, the S&P 500 gained 4.5%, a starting year rally not seen since 1987. Over the same time period, the iShares MSCI Emerging Markets Index Fund (EEM) gained 9.1%, the fastest rise since 2001.

Articles in the Financial Times and Bloomberg have noted a pattern in this rally. The biggest decliners last year have led the charge this year. Year to date the EEM, which lost 21.1% in 2011, has gained twice as much as the S&P 500. On a sector basis within the S&P 500, financials, industrials, and materials have been leading the recent rally. These same sectors have greater exposure to emerging markets and were among the worst performers last year. Utilities, health care, and consumer staples had been the best performing sectors in 2011 but have been among the worst performing sectors in 2012.

Economists attribute the surge to a number of reasons:  in the U.S., positive economic data continues to flow, manufacturing is growing, jobless claims are falling, and the unemployment rate is ticking down. Corporate profits remain high and Fed policy continues to be accommodating. Earnings season has begun with 60% of reporting companies beating expectations. Many global central banks are lowering rates in order to promote growth after two years of raising rates. As mentioned in Marietta’s blog Promising News from China, recent events in China indicate that economic stimulus and easing will likely come soon to this engine of global economic growth.

Three weeks do not make a year, but a continuation of current trends could result in 2012 being dramatically different from 2011.

Promising News from China

On January 17, China announced that its economy expanded 8.9% year over year in the 4^th quarter. The news triggered a 4.9% jump in the Shanghai stock market, which was the largest single session gain since October 2009. On this news, the U.S., European and other global markets also rose.

The 8.9% GDP growth is the slowest advance in 10 quarters and is attributed to slowing export demand and a weakening property market. This increases the pressure on Premier Wen Jiabao to ease monetary policy, which would be viewed by investors as a strong positive for the Chinese stock market. On the other hand, the 8.9% was above the 8.7% median estimate of a consensus of economists, and well above the 8% that policy makers consider necessary. This supports the argument that the Chinese economy will experience a “soft landing,” which would also be very positive for the Chinese and other global stock markets.

A “soft-landing” in China and other leading economies is very important to the positive economic and market forecast presented in our January 3 Outlook. Emerging economies now account for 50% of the world’s GDP and approximately 70% of GDP growth. Healthy and sustainable growth in the Chinese economy is thus necessary for a global economic expansion requisite to support a resurgence of international markets. The news is very promising, but not decisive. 

China Watch Update

Over a year has passed since we posted a blog “International Stock Markets: Searching for Goldilocks” (5/12/2010) in which we commented on the rising inflation problem in China and the damage it was inflicting on the Chinese stock market. More recently, on March 22, we issued a blog “China Watch: Is Goldilocks Waking Up” in which we pointed out that continuing stock market underperformance was a consequence of increasing concern among investors that the government would go too far and inadvertently cripple economic growth. We drew 3 conclusions:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.

• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.

• The “soft landing”would spark a strong stock market rally.

Fear of inflation and possible asset bubbles continues to be the central focus of investors and the Chinese government. Since the start of 2010 the People’s Bank of China (PBOC) has hiked bank reserve requirements 12 times, and on 4 occasions it raised the base interest rate. Nevertheless, inflation has risen steadily and is now, at 5.5%, above the government’s 4% target.

The latest important development was an article “How China plans to Reinforce the Global Recovery” in The Financial Times (6/23/11) authored by Chinese Premier Wen Jiabao. After touting the considerable strengths of the Chinese economy and the government’s achievements in promoting social reforms, implementing massive infrastructure programs, and sponsoring scientific and technology initiatives, he made remarkably confident statements regarding inflation:

There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic yes…China has made capping price rises the priority of macroeconomic regulation and introduced a host of targeted policies. These have worked…We are confident price rises will be firmly under control this year.

Investors in Chinese stocks interpreted the Premier’s confidence as a signal that the period of restrictive credit policies was over and China was headed for the desired “soft landing.” Since June 20, the Shanghai Stock Exchange Composite Index (CSEX) has rallied 4.1%, but is still down -10.6% since April 15 and over 50% from its peak in October of 2007. If the government can convince investors that it is correct in its claim that inflation can be kept below 5% and GDP growth over 8% for the foreseeable future, then the Shanghai market recovery has only just begun. The market’s P/E valuation, at 11.6 times estimated profits, is the lowest since the global financial crisis in November of 2008 and, according to research analyst estimates compiled by Bloomberg (6/27/2011), Shanghai index profits are expected to soar 32% in the next 12 months.

China Watch: Is Goldilocks Waking Up?

Almost a year has passed since we issued a blog “International Stock Markets: Searching for Goldilocks” (May 12, 2010). Here we pointed out that recent steps taken by the Chinese government and central bank to cool their economy and tame inflation had halted the sharp advance of Chinese stocks in 2009. Some investors feared that the policy makers’ initiatives would prove to be too little and too late, resulting in an inflation spike and asset bubbles. Others were concerned that the government and the central bank would become excessively restrictive and cripple economic growth. We offered three views:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
• The “soft landing” would spark a strong stock market rally. 

Since our “Goldilocks” blog, Chinese inflation has continued its ascent from 2.8% last May to its current 4.9%. In response, the Chinese government has responded with a succession of interest rate hikes and bank loan restrictions, and Premier Wen Jiabao announced recently that the highest priority of government was to reduce inflation. Our forecast for Chinese stocks was lamentably correct: since the end of 2009, the Shanghai Composite Stock Index (CSEX) has retreated -11.3% and the exchange traded fund for Chinese stocks traded in Hong Kong (FXI) is off -1.4%. For the same period, the S&P 500 Index has risen 14.7%.

We think the Chinese policy makers are making progress and will be able to pilot successfully a soft landing. We also continue to expect this soft landing to renew the bull market in stocks dating back to March of 2009. We are not alone in these forecasts. In a March 15 report issued by Deutsche Bank titled “Turning Bullish on China,” Chief Economist Jun Ma argues that “recent developments are increasingly supportive of our view that year-over-year CPI inflation will likely peak in June at around 5.8%, then fall to around 4% in December.” He expects the policy makers to take their foot off the brake and considers the risk of a hard landing to be minimal. He concludes with the prediction that in the next twelve months the Chinese stock market will “rise about 25% from its current level.”

If Chinese inflation peaks in June, will the Chinese stock market anticipate this development and rally before the data confirms the fact? Is this already happening? Since January 25, the Shanghai market (CSEX) has gained 8.6%, whereas the S&P 500 Index has slumped -0.9%. We are very aware that anticipating events that do not materialize, or are delayed, can be very painful, but is it better to be too early than too late?

We are continuously reviewing Chinese stocks to identify the most attractive candidates to participate in a renewed stock market advance. Our focus is on companies that would benefit from the government’s massive infrastructure projects and/or would prosper from the rapidly rising demand for goods and services by the mushrooming middle class.

China, India, and Brazil: When Too Much Growth is Bad

On December 25 the People’s Bank of China (PBOC) hiked both the key 12-month lending rate (from 5.56% to 5.81%) and the 12-month deposit rate (from 2.50% to 2.75%). This marked the latest effort in the Chinese government’s year-long campaign to ward off inflation by cooling its overheated economy. Although these steps were widely anticipated, the Shanghai stock market immediately retreated and triggered selling in many other emerging-country stock markets.

The related issues of strong economic growth, rising inflation, restrictive initiatives implemented by policy makers, and a disappointing stock market have been building for a year and are not limited to China. A similar set of conditions has plagued the leading emerging countries of India and Brazil. At the beginning of the year, consensus 2010 GDP growth projections were 8.6% in China, 6.3% in India, and 3.8% in Brazil; economists currently estimate 2010 growth of 10.2% in China, 8.8% in India, and 5.5% in Brazil (The Economist, 1/2/10 and 12/18/10). Along the way, inflation and fears of asset bubbles have spread: inflation in China is currently running at an annual rate of 5.1%, in India at 9.8%, and in Brazil at 5.6%. In all three countries the governments and central banks have reversed the economic stimulus initiatives of 2008-09 and are now applying the brakes.

In a May 12 blog on International Stock Markets: Searching for Goldilocks, we highlighted the negative impact that these restrictive policies in China, India, and Brazil were having on their previously sizzling stock markets. Since May, the inflation threat has grown and clouds have continued to hang over these markets: The Shanghai Composite (CSEX) is down -15.1% for the year to date, the Brazilian Bovespa (BSPI) is off -0.1%, although the India BSE 100 Index has mustered a respectable 12.9% gain. For the same period, the S&P 500 Index has rallied 12.7% despite unimpressive GDP growth of about 2.8%.

At this point the consensus view, which we share, is that in early 2011 the policy makers in each of these 3 countries will escalate their war on inflation with additional measures, and the consequence could well be stalled or disappointing markets. There will be many investors who fear that the steps taken by the policy makers will be too little and too late, and the result will be destabilizing inflation and asset bubbles. Many other investors will be convinced that the policy makers will go too far and cripple economic growth. To the contrary, our view is that the policy makers will be able to pilot a soft landing, i.e. to cool their economies to healthy and sustainable growth with reduced inflation. We note that most economists predict modest slowdowns in 2011 sufficient to arrest inflation fears: the latest poll taken by The Economist forecasts slowing 2011 GDP growth to 8.9% in China, 8.6% in India, and 5.1% in Brazil. If our view is correct, then we expect a buying opportunity lies ahead for the stock markets of these leading emerging countries and the multinational companies that supply the rising demand of their mushrooming middle classes.

China and Brazil Watch

In our January 4 Outlook, we contrasted the accelerating economic strength of China, India, and Brazil with the struggling U.S. and European recoveries. Fresh evidence of Chinese prosperity is the surprising surge in both exports and imports in data released overnight. Another indication may be found in today’s Financial Times in an article “China lenders eclipse U.S. rivals.” The article reveals that all 7 of the world’s top valued banks (ranked by bank share price to book value) are Chinese or Brazilian, and concludes the data “reflect growing [investor] confidence in emerging markets, particularly China and Brazil.” In 2000, 5 of the top 6 highest valued banks were American. To highlight the contrast among economies, another article on the same page of the Financial Times, “Lingering doubts over recovery keep European inventories low” reveals that European business executives continue to have very low confidence in their own economic future. To be sure, the latest The Economist poll of forecasters (1/9/2010) foresees an anemic 1.4% real GDP growth for Euro area in 2010.