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 Investors Turning More Optimistic

        The latest Bloomberg Global Poll (November 29) indicates that investors are increasingly optimistic due to China's improving prospects and a rising expectation that the U.S. will avoid the so-called "fiscal cliff." Highlights from the 862 poll respondents are:

• The world economy is in its best shape in 18 months. Two-thirds of investors polled think the global economy is either stable or improving (up from just over half in September).

• Three out of four respondents expect Washington politicians to reach an agreement to avoid the fiscal cliff.

• Stocks are the asset of choice, with the U.S. and Chinese markets the most attractive and European Union markets the least. About half of the investors plan to increase their exposure to stocks in 2013.

• Home prices as well as stock prices will rise in 2013, which will improve the wealth effect and boost consumer confidence and spending.

• Bonds are the least appealing asset (trailing stocks, real estate, and commodities) and almost half of those polled intend to reduce bond holdings in 2013.

        The above views expressed by participants in the Bloomberg poll echo Marietta's October 1 Outlook, indicating that our forecast has been adopted by a majority of the international investor community.

U.S. Economic Outlook

            Prospects for the U.S. economy in 2013 are brightening …unless the politicians permit the economy to go over the “fiscal cliff” (the combination of government tax increases and spending cuts scheduled to take effect at the end of the year unless the Congress and the Administration take preventive action).  We do not expect this to happen, and there may well be a significant stock market gain if a political compromise removes the danger.     

            In our last two Outlooks, we highlighted the progress underway in the multiyear restoration of consumer confidence and spending, the housing market, and the banking industry.  We emphasized that each of these three key sectors was crippled during the 2008-09 recession.  From the outset of the recovery, we referred to them as “structural impediments to growth,” which would take years to heal fully despite pro-growth fiscal and monetary policies from Washington.  Our point was that whereas they restrained recovery over the past three years, we now expect each to support growth in 2013. 

            A number of recent reports and developments lead us to conclude that the U.S. economy is already strengthening:

·                Consumer confidence is at a 5-year high.

·                Consumer spending, bolstered by 2 consecutive upbeat employment reports, is resulting in better than expected retail sales. 

·                A retreat in gasoline prices further supports consumer confidence and spending.

·                The housing market has clearly bottomed in response to rising demand, reduced foreclosure pressure, and record low mortgage rates. 

·                Bank profits are up, balance sheets are much stronger, and loans are increasing.

·                The Federal Reserve has stated unambiguously its top-priority is economic growth and has promised to keep interest rates low until recovery is assured, which many expect to be 2014 at the earliest.

·                U.S. exports may well benefit from the continuing initiatives taken by central banks around the world to stimulate growth.  International Strategy and Investment (ISI), a highly respected economics research firm, has counted 296 easing steps by central banks over the past 14 months.

The mostly positive economic news of the past 1 1/2 months supports our above-consensus October 1 forecast of 2.0-2.5% GDP growth in 2013.  This would not qualify as healthy growth, but nevertheless represents an improvement over 2012.                    

Hurricane Sandy has inflicted significant human hardship and misery, and has caused near-term economic disruption.  However, in the long-term we expect the recovery efforts and the resilience of the people and businesses affected by this tragedy to rebuild, thus mitigating the overall economic impact.

The major threat to our generally favorable outlook for continued economic expansion is the “fiscal cliff.”  We continue to think there will be a political compromise because neither party can afford the risk of being blamed for an avoidable recession.  We are encouraged that leaders of both political parties have expressed a willingness to compromise.  Nevertheless, we do not underestimate the impact of partisan politics and recommend that investors maintain vigilance and flexibility.

We encourage our clients to contact us and let us know their views.