China Indicates Confidence in Global Growth

On June 19 the Peoples Bank of China announced that it was removing the peg between the yuan (100 yuan = 1 renminbi) and the U.S. dollar (i.e. the currency would be allowed to fluctuate) following 2 years of a fixed exchange rate.

What is the importance of this change in policy by the Chinese government to Marietta’s investment strategy, which encourages investors to take a global perspective in general and favor the stocks of the leading emerging economies, including China, in particular?

• The announcement increases financial market conviction in the sustainability of the global economic recovery. The Chinese government originally put the peg in place during the 2008 global financial crisis to protect the Chinese economy against a further currency appreciation, which would increase the cost of Chinese goods sold abroad and decrease the cost of imported goods sold to Chinese consumers. In explaining their action, the Chinese policy makers stated that the global economy is “gradually recovering and the upturn in the Chinese economy has become more solid.”

• Global stock and commodity prices immediately responded positively. Led by a 3.1% jump in the Shanghai stock market, global stocks extended their current advance to a 10th consecutive session, which marked the longest rally in the MSCI World Index in 11 months. Oil, copper and other industrial commodity prices also rose (China is the world’s largest consumer of copper and ranks 2nd only to the U.S. in its demand for oil). The announcement also signals another step by Chinese authorities towards domestic demand and away from exports as the major engine of future economic growth. Stocks of U.S. and international companies that support the huge Chinese infrastructure programs or cater to the needs of the country’s mushrooming middle class rose dramatically the day of the announcement. The Indian, Brazilian, and most international stock markets also rallied.

• The announcement reduces international tensions, thereby diminishing the risk of trade wars that could retard seriously the global economic expansion. The timing of the announcement is also propitious, coming on the eve of this week’s G20 summit in Toronto.

• The announcement improves the U.S.-China relationship, which is key to the global economic outlook. In recent weeks U.S. congressional criticism has mounted that China is manipulating its currency and engaging in other unfair trade practices detrimental to U.S. industry and labor. The Chinese announcement should disarm demands for retaliatory action. In another gesture of good will, China boosted its holdings of U.S. Treasury notes and bonds by 2.6% to $900 billion in March and April (after reducing its stake by 6.5% from November through February). Renewed Chinese purchases will help the U.S. Treasury finance the huge U.S. budget deficit and assist the Federal Reserve’s policy to keep U.S. interest rates low until U.S. economic growth strengthens.

A cautionary note: Investors should not expect a dramatic and sudden jump in the yuan. The Chinese government will almost surely take a conservative and cautious approach, especially now that the U.S. and European recoveries are suspect. As a consequence, Chinese currency is likely to remain a topic of international controversy and the economic impact of the yuan’s appreciation will likely be gradual and limited.

Small Business Confidence Rising; ISI Remains Optimistic

We share the view of most economists that the major deterrent to a strong and sustainable U.S. economic expansion is the lack of healthy job growth. High unemployment and underemployment has dampened consumer confidence and spending, and is clearly having a serious negative impact on stock prices. The key to employment gains in this as in past economic recoveries will be small businesses. According to the U.S. Small Business Administration, its members represent more than 99% of all U.S. employers and have created 64% of all new jobs in the past 15 years. The problem is that small business owners have been very reluctant to hire in the current economic recovery.

The announcement on June 8 by the National Federation of Independent Business that their small business optimism index increased from 90.6 to 92.2 in April, which marks a 20 month high, is a very encouraging sign. 7 of 10 components in the index rose, led by a significant gain in expectations for business conditions six months down the road. Most noteworthy is that job creation plans registered the first positive reading in 19 months. Other positive responses include an improvement in profits, plans to increase capital spending, and an expectation of easing credit conditions.

A caveat is in order: even with April’s advance, the Index trails levels reached in past economic rebounds. On the other hand, a pick up in hiring led by small businesses would be a powerful antidote to the currently fashionable thesis that the U.S. economy is heading into a double-dip recession.

Separately, The International Strategy and Investment Group (ISI), highly respected and influential among institutional investors, has taken a strong stand against the prospects of a double-dip. On June 7, ISI distributed their forecast for U.S. GDP growth of 3.5% in 2010 with an additional 3.0% in 2011. Key to this forecast is their weekly survey of companies, which last week rose to a new high and indicates that “a powerful, broad-based recovery is unfolding.”

ISI is well aware of the headwinds: the Eurozone economy is likely to see a double-dip, U.S. tax rates are headed up, U.S. state and local budget cuts and tax hikes are likely, and they foresee a slowing in China real GDP to 7.5%. Despite these and other negatives, they cite continued strength in manufacturing, strong corporate balance sheets and profit growth, lean inventories, low inflation and interest rates, and an accommodating Federal Reserve in addition to their company surveys to support their positive outlook.