Q3 2016 Market Update and Outlook: A Golden Summer

At the end of Q2 2016, uncertainty was on the rise, the geopolitical environment was fragile and financial markets appeared highly susceptible to exogenous shocks. Global stock indices wobbled, safe haven trades such as long Japanese yen and long US treasuries gained steam, all while gold rallied in tandem with investor uncertainty. We expected much of the same for the summer months of Q3 2016 as the US election cycle unfolded. Yet, the resilience of financial markets has truly been phenomenal. The US stock market, as represented by the S&P 500 TR index is up over 8% for the year. The NASDAQ composite hit another all-time high in September. Truly, this resilience may not be an anomaly after all. Excluding 2008, the US stock market has been up every year since 2003, many of these years it’s been up double digits, though past performance is no guarantee of future results. For those of us who value fundamentals and see the current economic landscape as a highly intricate house of cards, the continued rally, and subsequent drop in equity market volatility, is perplexing. Chairwoman Janet Yellen punted on increasing interest rates this quarter. Although the yield on the 10-year treasury was ultimately up in the third quarter, it also hit an all-time low in July of 1.36% in the post Brexit flight to quality. Ongoing massive global central bank stimulus (bond buying) led to an even larger supply of negative yielding bonds globally, making our US 10-year treasury look like a high yielding security relative to our foreign brethren. Can this continue forever? Surely, at some point in the not too distant future, negative interest rates will be viewed as some kind of insane experiment where we all should have known better. Yet, we feel that the financial markets seem as complacent as ever, comfortable and warm in a central bank security blanket.

We firmly believe the Fed should raise interest rates this year; yet, this assertion is materially dependent on the strength of economic data as we move into Q4. At the same time, the US is not an economic island. We could see economic data continue to improve; but if Europe continues to struggle, growth in China slows further, or other global forces take hold, the potential for a Fed rate hike could disappear. As we sit here today, the yield curve continues to flatten; which has been an economic harbinger. What’s nearly for certain in our minds is that global central banks will intervene with appropriate liquidity to prevent any political crisis from turning into a financial crisis. But, with zero to negative interest rates globally, central banks are already constrained and have limited tools to stabilize markets.

Accordingly, we believe investors should look to diversify portfolio risks away from long-only holdings in stocks and fixed income, dependent of course, on the individual’s goals and risk tolerances, among other factors. The traditional 60/40 portfolio has been a winning asset allocation since the depths of the financial crisis but in our opinion has overstayed its welcome. We are in no way predicting a crisis; rather, we view this as a market in which preemptive thinking is paramount.

The Times They Are A-Changin’

As we approach the end of summer, here’s my perspective on economic issues worth watching.

Employment
The big new noise is the July employment report. Job growth surged, according to the Department of Labor. The US economy added 255,000 positions, according to the Department of Labor, far more than the 180,000 increase that economists had been predicting. Average hourly wages rose 0.3 percent, also higher than expected. The unemployment rate remained unchanged at 4.9 percent.

I am going a bit out on a limb here, but I go back to what appears to be some changes in the pattern of hiring and layoffs as the US has shifted from an industrial to a service economy. Ordinarily July is a big layoff month as factories historically shut down for a good part of that month to install new, more productive equipment. In addition, some service entities, including educational facilities, also have reductions in force around that time. But the times they are a-changin’. School facilities are altering their schedules, and factories don’t necessarily have to close for upgrading. Typically, close to one million people leave the work force in July. That gets seasonally-adjusted to a positive number about which we all talk. As I have said, I have never met a seasonally-adjusted person. It will be interesting to see what happens this year with the labor market relatively tight and the patterns changing. This affected the numbers in May and June with May being understated while June more than made up for that understatement. The pattern YTD is about 100,000 short between the seasonally-adjusted numbers and the unadjusted numbers. Let’s see how the job numbers play out in coming months—revised numbers will be released in September. Meanwhile, I think we should pay more attention to the wage numbers, which are rising. Over the year, average hourly earnings have risen by 2.6 percent. Higher wages are a big component of the Fed’s inflation gauge. Both the July employment numbers and higher wages could affect the Fed’s thinking in September.

Brexit
In the meantime Brexit continues to be newsworthy. Bank of England Governor Mark Carney has taken precautions to ease the potential downside for Britain. In response, instead of punishing the UK, the EU has an opportunity to move toward a more United Europe. It has to take a harder look at what has to be done throughout Europe on the fiscal side and with regard to the debt and negative rates. The question is, will it? I think it has to. Raw democracy may get in the way.

What else?
As I have previously observed, I think the emerging markets with some volatility are where the growth is. India has to fall in that camp. The reform steps are a start. One has to remember that India is the world’s largest democracy. Whether Indian Prime Minister Narendra Modi can navigate his way through this is another question. I think he can, but it will be a volatile road.

As I have said before I find the Americas the most interesting set of markets. They have had quite a run in anticipation of change from Cape Columbia to Tierra del Fuego. Just think if our focus was to make America great in the broadest sense of the definition. We still have long-term issues of growth globally. It will be a slower pace overall, but the opportunities may prove to be broader. Maybe a measure of stability in real assets and some understanding of the value of illiquidity premiums become a focus. So, pay attention to the Americas, all of them.

Commodities at a Crossroads

Our CEO, Jack Rivkin, recently revisited his thus far prescient view of economic issues facing “The Rest of the Americas.” There are several key drivers one should pay attention to when evaluating the Americas, most of which ultimately lead to the commodity markets.

From the Fed’s decision on interest rates (which is highly data dependent), currencies, the dependence of Chinese demand for commodity exports out of Canada and Latin American countries, and nearly ubiquitous political disharmony, commodities are at an inflection point. Here is why:

 

US Economic Data and the Fed
April retail sales were up 1.3%. Job creation is improving and wages are starting to improve as well. Economic data is getting better, but it’s not necessarily good enough for the Fed to take action. What are the possible scenarios and impacts on commodities?

  • Good Data: If we continue to see decent economic data, it could spur the Fed to raise interest rates at the upcoming meeting in June. An increase in the Fed Funds rate generally leads to strength in the US dollar (USD) relative to other currencies. Conventional wisdom stipulates that a strong USD is typically a negative for commodity markets; the two are negatively correlated since commodities are priced in USD. If the USD strengthens, commodities tend to suffer because it will take more dollars to buy the commodities. While that’s been true the majority of the time, it’s not always the case as one can see below:

Fig1of3_Charts_USD+CommoditiesCorrelation_051916

  • Great Data: That said, if the data out of the US is very positive—one could view this as a growth theme. In this case, the Fed will almost definitely raise rates in June; the USD will rise; but if the US is consuming more, spending more, and on an improved economic growth trajectory, that could spur increased demand, which could actually push commodity prices higher.
  • Bad Data: The last scenario is if the US data gets worse. We don’t think this is all that likely, but low inflation could make the Fed blink. Where we may see bad data is globally. With global markets more intertwined than ever, it would be bold for the Fed to ignore any further and significant global weakness. Moreover, the big Brexit vote shortly after the June Fed meeting could give Yellen pause, ultimately postponing a hike until July.

 

China
According to both the World Economic Forum and the Wall Street Journal (WSJ), in 2015, China consumed “roughly an eighth of the world’s oil, a quarter of its gold, almost a third of its cotton and up to a half of all the major base metals.” In addition, as Jack pointed out in his Perspectives piece, China also produces about half the major base metals. One cannot discuss commodities without discussing China.

Fig2of3_WorldEconForumGraphic_low-res

All eyes are on Chinese growth to continue fueling this impressive demand. Chinese growth is less than it was in prior years but their growth target remains between 6.5%-7.5%. While momentum has slowed, 6.5%-7.5% is not insignificant. To give some obvious context, the U.S. economy grew 0.5% on an annualized basis for the first quarter of 2016.

As Chinese demand for and production of commodities vacillates and its growth moderates, we could see more idiosyncratic Chinese market movements. For example, during September of 2015, China’s National Administration provided new standards for the use of aluminum cables. Aluminum is significantly cheaper than copper and China is rich in aluminum resources—substituting aluminum for copper allows for lower costs and less importing. Prior to September of last year, copper and aluminum prices moved fairly closely together. Since this time, however, we’ve seen more dispersion, periods in which aluminum rallied and copper declined. Thus demand may be increasing right now for base metals, but one may continue to see more substitution versus base metals moving in concert.

The remainder of 2016 should be interesting. If China backs off stimulus or increases local production, it could spell trouble for commodities given their significant share of commodity consumption. We tend to agree with the team from Gavekal Research, who recently stated the following:

 

 

“Since GDP growth in 1Q16 remained above the 6.5% target, it seems likely
that policymakers will now focus more on averting a major bubble and
dialing back leverage, than adding fresh stimulus. This is not to say that
the central bank will cause another interbank liquidity crunch, but it will instead
focus on keeping rates low and stable. Hence, do not expect more easing
policies in the next 3-6 months; after accelerating for the last year credit growth
is likely to stabilize at the current level.”

Gavekal Research, Chen Long, The Daily—“No More Easing Likely,” May 15, 2016;
http://research.gavekal.com/author/chen-long

 

If this is true, we may not see more stimulus from the Chinese central bank. Yet, a complete economic slowdown followed by stunted commodity demand seems unlikely.

Political Unrest
With the exception of Trudeau’s white knight status in Canada, much of the rest of the Americas’ leadership remains on shaky ground. Democracy in its raw form is coming to the USA, Rouseff is on her way out of Brazil, while Mauricio Macri is still sorting out the pieces in Argentina—and he’ll be doing that for a long time. Any perceived weakness in leadership could be viewed by investors as a sign of a weak economy. This too matters because as faith in these governments declines, so may their currency as we witnessed several times last year. For example, one of Brazil’s largest exports is coffee. A weak Brazilian real led to lower coffee prices. In fleeting moments of real strength, coffee rallied alongside.

Fig3of3_Charts_Brazil Real+CoffeePrices_051916

For countries that rely heavily on commodities for exports, a weak currency is not necessarily a positive. Therefore the impact of political unrest on commodities could make for a bumpy ride, at least in the short-term.

Commodities Now?

One may ask, is this a good time to get into commodities? The reality is, it depends on what sector, what commodity, and when. The question also assumes that investors only have the option to go long commodities. Imagine if you could have been short crude oil over the last two years? Our preference is to invest in strategies that can go long and short, such as trend following managed futures strategies. These strategies are systematic in nature with the goal of following price trends. If gold continues to rally, trend following systems will likely add more and more long gold exposure. In fact, most managers we follow are positioned long after gold’s rally this year. If the trend abates, these systems will typically reduce exposure and if the trend reverses strongly, these systems will follow the price trend in the other direction. Investing in systematic trend following strategies allows for long and short investing while taking out the discretionary judgement of trying to time these often volatile markets.

Commodities are indeed at a crossroads with some dispersion likely. Much of what can move individual commodity markets for the remainder of 2016 remains to be seen, as various other cross currents make it difficult to predict. In other words, even if we get Fed clarity, China and other variables could remain uncertain. Investors may want to look for trend following managed futures strategies that have the ability to follow commodity markets directionally once the fog clears.

The Rest of the Americas: Reprise

We are continuing our review of what has happened since we laid out our expectations in our Perspectives at the beginning of the year. We had a view that one could find all manner of investment opportunities, long and short, without moving beyond the continents of the Americas. Given the volatility of the markets and the currency and commodity movements since then it is time to take a fresh look—particularly at the rest of the Americas. Below is a reprise of our expectations and our update of how the expectations have changed. Commodity and Currency movements as well as specific governance issues may cause a greater dispersion in results for the rest of the year.

 

CIO PERSPECTIVES RECAP: JAN 2016

The Rest of the Americas: Still some Economic Issues but an Improving Picture as One Moves from North to South 

Canada, in many ways, is a large natural resource company. Until the energy picture improves, there remain issues as a new and different government starts to grapple with the current environment. In addition, while the Canadian banks avoided much of the turbulence experienced in the US from the mortgage fiascos, their housing market has gotten somewhat extended from growth that occurred under the umbrella of high energy prices in the early part of this decade.

On the other hand, we see elements of reform and a better competitive environment globally in Mexico. Lower energy prices have slowed development and reform in this sector, but other sectors continue to move forward. This remains a good story of growth, reform and development.

Moving further south, if the project stays on schedule, by mid-year the expanded Panama Canal should be in operation with the ability to receive the Post-Panamax cargo ships that carry two to three times the previous loads that could make it through the canal. This will change patterns of traffic to the east and west coast ports of the US from East Asia, reduce transportation costs, and, most likely, produce a shift of traffic via the Suez Canal back to Panama. It could likely result in some increased infrastructure spending for some of the US ports as well as the supporting rail and truck traffic from these new patterns of shipping. An under-the-radar change that could have some unintended consequences positive and negative.

With the Argentina election leading to major change combined with elections in Venezuela and pressure on Brazil to change, the center of gravity on reform and a better investment environment in South America may be moving in the right direction. There is no question that the overall economic situation in South America is quite dependent on exports of hard and soft commodities. Until the commodity supply/demand picture improves, it may be difficult for the overall investment environment to improve significantly. We may be entering an environment where some prices are falling below operating breakeven. Let’s keep in mind, though, that energy is a big part of the cost of extraction and refining for most hard commodities. Miners and refiners will keep producing if there is a dollar contribution toward fixed costs. With the metals priced in dollars for the most part, the currency weakness many of these countries have seen is a further reduction in costs. It is possible as we get later into the year modest increases in demand combined with reductions in supply may shift the patterns. At the same time, it is highly unlikely that we will see major improvements in governance and economic results early in the year in these three countries mentioned. However, the tone has shifted. This is an opportunity for the US to affect the rate and quality of change in these three important South American countries with an impact on the whole continent.

While the change in our relations with Cuba gets media attention, a similar reaching out by the current administration to change relationships with the three countries is a real possibility. One will be able to find all of the varieties of investment opportunities within the Americas with similar risk characteristics as exist throughout the rest of the world. This is a slight overstatement, of course, but just saying…

One does have to be careful of what is going on with capital flows. The countries in South America are dependent on export growth primarily tied to commodities. While Argentina may be coming out the other side of its ability to access the capital markets, it is not clear that other countries can make it through this period without some degree of financial stress. But, the Americas represent an unusual somewhat isolated set of investment opportunities across the equity, fixed income, and fixed asset markets, both public and private.


 

TODAY: MAY 2016

Commodity Movements push much of the Americas to Unsustainable Levels—too Fast, too Soon

 Below are three bar charts showing returns in local currency and dollar-based YTD for most of the capital markets worldwide as well as a specific focus on the Americas and commodities.

 

Fig1_2016-Equity-Market-Americas_051616

Fig2_2016-Equity-Market_perf_051616

Fig3_2016-HardSoftCommodities_051616

In part, the commodity run has to do with the weakness of the dollar against many currencies. Gold and possibly other precious metals are primarily moving because of the dollar, but also because they can act as sources of real returns against an expectation of rising inflation, low interest rates, and, maybe low equity returns. Our expectation had been a likely shift occurring on the commodity front as we moved into the second half of the year. In part, this was based on a step-up by China on the fiscal side which would increase demand and prices for a variety of commodities as infrastructure and support of inventory building took place. It would appear that China has already started that process. Unfortunately, I think this could lead to some disappointment later as China backs away from this fiscal push, much as they did after the 2008-2009 debacle. China did keep things going with prices peaking in 2011. There has been some slowdown on the supply front, with much uncertainty about OPEC and Saudi Arabia, specifically regarding oil, but other supply slowdowns elsewhere including the fires that rage in the Canadian oil sands region. Of course, the rise in prices could reflect concern about the Cushing Fault—one of our cocktail conversation expectations. Even 60 Minutes is now talking about earthquakes in Oklahoma.

That aside, as we pointed out in our Perspectives piece, China is the biggest source of supply and demand in the hard commodities, and effectively, controls the markets. Higher prices may lead to bad economic decisions regarding maintaining or even increasing production in response to the prices. These increases will likely end when China stops supporting the price and/or the dollar begins strengthening as it becomes clearer that a recession is unlikely—slow growth, but growth, wage increases and hiring pushing up consumption but not necessarily profits. Last month, for example, total compensation for all those employed was actually up 0.7% March to April. That’s a pretty healthy annual rate.

So what does one do now? The Americas look a bit ahead of themselves. While we are seeing change in Latin America, there will be some major hurdles for the major countries on governance and fiscal budgets. Commodity prices could continue to provide a lift if what is going on in China continues. I think we will start seeing more dispersion in the results in Latin America as the year unfolds.

We have already indicated that we expect the slower growth of the global economy to produce dispersion among country and company results. Below are two tables that show what has happened in the US specifically by industry with the energy industry as a poster child.

 

Fig4_Blog_S&P-Dispersion-by-Sector_051716

Fig5_Blog_S&P-Dispersion-by-Sector_EnergyBreakout_051716

This does require a broader and more specific look across more asset classes and more managers to take advantage of the dispersion and the spread we could likely see between the liquid markets and those with an ability to buy into less liquid sectors. The opportunity set is getting broader and requiring a real understanding of risk and a real understanding of liquidity requirements.

Lastly, so much of what I discussed depends on what happens here in the US as well. As my colleague, Lara Magnusen, recently pointed out in Bloomberg, any positive economic data out of the US may convince investors that the Fed will indeed raise rates at their next meeting. The knock on effect here is that you could see some real strength in the dollar, and thus reversals in commodity markets generally.[1] The rest of the Americas are thus dependent on a highly correlated set of variables affecting commodity markets, and, ultimately, the broader economic landscape.

[1] Bloomberg.com, May 1, 2016, Gold Keeps Shining as Funds Miss Out on the Best Rally in Two Months

Markets are Macro Right Now, but the Details Don’t Support Those Bets

Just a few observations:

Volatility

I was waiting for the numbers this morning. As one can see, the US consumer seems to be doing just fine. They are actually buying real goods and services, taking advantage of increased income, transportation costs are down, and there is a generally okay outlook.

I think we are seeing some major macro bets being made and pressed, which is pushing up volatility. The big macro bet seems to be that we are heading toward a global recession. I just don’t see it at this stage. We are clearly in a global industrial recession already with oversupply relative to demand and an inability or unwillingness of countries to spend on infrastructure as an offset to the lack of corporate expansion. But this is in a global economy that is more and more services oriented of which the US is a poster child and China is on an accelerating path in that direction. China may also be one of the few countries that has a major infrastructure initiative around the Silk Road.

In addition, as I have said before, given the low prices of oil and other commodities, I believe we are seeing liquidations of sovereign wealth portfolios from those countries dependent on revenues from these commodities, in order to meet fiscal budgets. Oil prices at these levels are not a company problem away from the oil patch, but they are a country problem, which will add to volatility globally.  The volatility is actually opening up some very interesting investment opportunities for those investment managers who actually look at individual companies on both the credit side and the equity side. When we get into these slow growth, but volatile periods, we begin seeing real dispersion. Look at last year: 250 of the S&P 500 stocks up on average 18% and 254 down on average 17%. I suspect we will see the same this year and for many years to come as we work our way out of the overcapacity on the industrial side and the heavy debt burden that has been accrued during this low interest rate environment. WE have started off this year with less dispersion. Anytime you see the market move up or down in double digits you do get less dispersion, although it doesn’t totally disappear. There are close to 100 stocks up this year—even 25% of the energy stocks.  It’s a different environment and we are somewhat captive to a very heavy bet being made that the world is collapsing. I don’t think that is the case.

 

China

This is a very thin market and therefore, should show greater volatility than broader markets. The Chinese have tried to manage the market similar to the Limit Up/Limit Down rules that we have on our markets, but theirs is much smaller and can expect to see high volatility given the lack of transparency. I think the Chinese stock market is a side show; what is actually going on in their economy is not. China is on a path to slower growth. The mechanics are complex, but the objective is achieving a high enough level of employment against a decline in the savings rate, which by itself, should be a stimulant for growth. The rest of the world, which has been dependent on this high rate of growth, will have to adjust. That is what we are going through now globally. This is complex and my level of knowledge (frankly, most people’s level of knowledge) is very superficial. It is an important driver for the global economy, but folks cannot count on it being the super driver and it is not the only one.

 

A Side Comment

I don’t quite get Janet Yellen’s remarks regarding the “surprise” low oil prices and how low negative rates have gotten in Europe. I also do not understand her giving any weight to the possibility of the US moving to negative rates. This is not good for the markets. We are in a slow growth environment that could go on for a long time, and without much fiscal help, the Fed has managed to get the employment numbers back up to a decent level. We need to get into the spring to really see how the numbers look given the bizarre seasonal adjustments that take place in December and January. I am looking forward to the spring. It might take a little longer for us to understand exactly where we are, but I don’t see us in a bad spot. I think the second half of the year could be very different from the first half if we can get the macro bets under control. We just have to Pay Attention.

 

 

China’s Economic Path

Dr. Barbera has appeared on our blog before with some prescient thoughts. We now have two new posts from him—one on China, and the second on the Fed. Bob’s thoughts on China, published at Johns Hopkins, December 24, 2015, lay out a slightly different view than we are hearing. In the piece below, Bob brings up an interesting suggestion: perhaps global growth fell more in 2015 than data reflects, and China may be on the other side of the story, but moving toward Michael Pettis’ view  of several years of slower growth. Worth paying attention to this view. —Jack Rivkin

 

China’s Economic Path by Bob Barbera

Commodity price collapses tend to be a reliable signal of a broad-based global slowdown. For example, drops of 15 to 20 percent in CRB raw industrial commodities index [1] have reliably been associated with significant slowdowns in growth (Fig. 1).[2] The recent fall in commodity prices exceeds any decline since 1980 save the one registered during the depths of the global crisis of 2008-2009 suggesting a major slowdown.

Ex1_ChinaBlog_sourceBarbera

Notes: Growth in red (right scale), commodity prices in green (left scale). Four-quarter change in the log of the quarterly average CRB/BLS raw industrials index; source: Bloomberg. Year on year percent change in world GDP at constant prices; 2015 data are forecast; source IMF WEO Oct. 2015 database.

 

So far, though, official tallies only suggest a modest global growth slowdown in 2015, and a popular storyline envisions a sharp 2016 GDP growth slowdown that would validate the powerful fall for commodity prices. This may turn out to be correct, but the timing would be peculiar. Historically, commodity prices have moved largely coincident with big shifts in growth, and have not led them.

Another possibility deserves serious consideration: perhaps global growth fell substantially more in 2015 than is reflected in the data. How? Think China.

Nearly all commentators on China acknowledge that Chinese GDP figures are a political confection. One bit of evidence on this is that announced growth seldom deviates from the preannounced target by more than a tenth of a percentage point or two. But exaggerated Chinese growth numbers can substantially change your view of global growth. Over the last 20 years, China has grown to have about a 15 percent weight in standard global GDP measures, implying that 3 percentage points of phantom growth added to China boosts global growth by about half a percentage point.

Despite the fact that most China watchers acknowledge that official Chinese figures are not to be trusted, China’s offer, a 6.8% pace of expansion, seems to be the starting point for anyone offering up opinions about the Middle Kingdom. Nobel Prize winner Daniel Kahneman reminds us that anchoring can profoundly affect judgments. The official Chinese target for 2015 was 7% and in September the IMF put Chinese growth at 6.8% for 2015. While private forecasters suggest a slower pace, few seem to be talking about adjustments of more than a percentage point or two.[3] Again, if your point of reference is a 6.8% claim, the gravitational pull of that figure may be understandable. But given that the official number mainly seems to reflect what Chinese officials pledged GDP growth would be, it probably should not bear much on your tally of the outcome.

We see good reasons to think that Chinese growth may have been very weak in 2015. There are certainly powerful theoretical arguments that suggest that China’s growth rate has been destined to slow sharply. For example, Michael Pettis, at the University of Beijing has been making the case that unprecedented reliance on debt to prop up expansion would force a sharp slowing. If we ignored the GDP figures and focused on other economic barometers, we’d see a sharp slowing in 2015. Growth in electricity production and growth in rail shipments (shown in Figs. 2 and 3) have plunged, with declines that are far more than would be consistent with a modest slowdown in GDP growth. Rail shipments fell 16% over the four quarters of 2015. Electricity production was flat. The deterioration of both indicators far exceeds the retrenchment recorded during the depths of the Great Recession. Nearly seven percent GDP growth amid flat electricity production? One needs to believe in an unprecedented advance in efficiency, or embrace the notion that the GDP number is a fiction. [4]

Ex2_ChinaBlog_sourceBarbera

Note: Growth in green; shipments in red. China year on year percent change in electricity production; source: Bloomberg. China year on year percent change in real GDP from IMF WEO Oct. 2015 database; the 2015 data are forecast.

 

Ex3_ChinaBlog_sourceBarbera

Note: Growth in green; electricity in red. Year on year percent change in China rail freight traffic; source: Bloomberg. China year on year percent change in real GDP from IMF WEO Oct. 2015 database; the 2015 data are forecast.

 

Chinese officialdom, since late 2015, may be giving us the best indication, admittedly obliquely, of the fanciful nature of the 6.8% claim. Policy steps are now being taken, in an effort to right the ship in China. The Chinese have allowed the Renminbi to depreciate significantly against the dollar. And word of plans to deliver significant stimulus in 2016 have been announced in recent days. If your target was 7% growth and 6.8% arrived, would you be in the ’big additional stimulus’ business?

Let’s suppose that Chinese growth was more like 2.5 percent in 2015. This would put world growth at about 2.5 percent, which would be much more in line with the story told by commodity prices (Fig. 4).

Ex4_ChinaBlog_sourceBarbera

Note: This repeats Fig. 1 with a dashed line added for world GDP growth in 2015 after setting China’s GDP growth to 2.5 percent in 2015.

 

Lest we sound like the Grinch on the eve of Chistmas [sic], let us emphasize that there is a bright side to this story. Accepting that China’s economy was already in deep distress in 2015 could significantly improve your world outlook for 2016. If we stick with the official Chinese data, then the collapse in commodity prices and those other Chinese indicators suggests that there may be another shoe to drop in 2016. If the shoe has already dropped and Chinese authorities are now committed to rekindle growth in 2016, as some discussion suggests, then both global and U.S. prospects actually look a bit brighter. Thus, from a global and U.S. policy perspective, the story we are offering holds out the hope of somewhat better news in 2016.

But this outcome is far from guaranteed. Even if the possibility we are raising is correct, there remain important questions about where growth will come from in China in 2016 and thereafter. Many argue that the transition to a new engine guarantees several years of, at minimum, slow growth. One thing, we believe, is clear: China policies and outcomes are likely to be a main storyline driving policy all over the world in 2016.

 

Notes:

  1. The CRB raw industrials index excludes energy commodity prices. Wars, embargos and other non-economic momentum developments, on many occasions, have driven energy prices. The CRB raw index, by excluding these items, better captures signals of economic momentum. Obviously, in current circumstances, including energy commodity prices would bolster the case for a sharp fade in global momentum. 
  2. The main exception over the 1980-2015 span occurred around 1985, a period in which the dollar rose by a spectacular 55%. Over the latest 12 month’s [sic] the dollar’s climb is roughly 10%. 
  3. For example, see the discussion in Josh Noble, Doubts Rise over China’s official GDP growth rate, Financial Times, Sept. 16, 2015. 
  4. China is attempting to shift the mix of output away from investment and toward consumption, and this could account for some slippage in the link between rail shipment or electricity and GDP growth. But even in China such transitions happen relatively slowly and could only account for a small part of this dramatic change. 

Not Quite Impotent, but a World Away from Omnipotent

In this blog, Bob says let’s not blame all today’s problems on the US Fed (although some find that tempting). We are in a complex, idiosyncratic, interlinked world. This supports Bob’s view that we have to look at the pieces. Of course, China is a big one.—Jack Rivkin

 

Not Quite Impotent, but a World Away from Omnipotent by Bob Barbera

Suppose the world’s economic policy makers ceded authority to a central entity, in recognition of the fact that national economic prospects, increasingly, are largely influenced by global developments. What would a Keynesian benevolent despot do, if she had control of all nations’ economic policy levers?

She would embrace the notion that the world suffered from an insufficiency of demand. She would acknowledge that three striking imbalances are in place, one international, one financial and one within most nations. She would impose policy changes meant to resuscitate global demand and unwind global imbalances.

She would acknowledge the obvious and point out that in the aftermath of the Great Recession, global recovery has been strikingly sluggish. Only China and the United States registered meaningful recoveries. China embarked upon a state government financed real estate boom, which temporarily lifted its economy and other emerging economies. When this stimulus ended, so did recovery for China and the rest of the developing world. The USA embraced fiscal stimulus, early on, but reversed course soon. Aggressive monetary policy stimulus, did deliver modest expansion through 2015. Europe has failed to deliver any meaningful recovery.

Equally obvious, she would note, China and Germany run large and destabilizing trade surpluses. The USA and Europe are saddled with large and still deteriorating trade deficits. So, too, is it obvious that monetary policy, alone has limited ability to right the global ship, in a world where the most common short term interest rate is ZERO. Financial system excesses are a genuine risk, when central banks are forced to deliver ever more liquidity into asset markets, in their attempts to lift real economic activity.

Finally, she would lament the violent shift toward income inequality, noting that the super-wealthy spend very little of their income, worsening demand deficiency, even if one ignores any notion of equitable outcomes.

She would declare, therefore, that policies would need to do the following:

  1. Jump start global demand.
  2. Reduce global trade imbalances.
  3. Relieve pressures on central banks.
  4. Reverse income inequality pressures.

She would declare China and Germany as the new places to look for demand stimulus. Major tax cuts would be enacted in both nations. Tax cuts would be super progressive.

Large tax adjustments would be made globally, so as to shift after tax incomes toward low and middle income earners. She would slowly remove developed world monetary policy stimulus. This would occur, however, only after clear evidence of strong global growth and a return to inflation rates above 2% in developed world economies.

Alas, our savior is a fiction. Nations have no intention of ceding control of their policy levers. Any one nation, therefore, pursues a policy that is focused solely on its nation, while accounting for global influences on its nation, arriving in part a consequence of policy moves taken by other nations.

Worse still, policy makers in many nations are likely operating with many self-imposed constraints. Fiscal stimulus? Tax changes to modify income inequality? In most nations the only game in town is monetary policy. That is, of course, excluding European nations. European nations don’t even have an empowered central bank that they can alone control.

It is in this spirit that one has to feel genuine empathy for Janet Yellen. Monetary policy in the USA has delivered modest recovery. And after over seven years of zero interest rates, USA central bankers, recalling the financial bubbles that precipitated the last several recessions, decided they might try to slowly wean markets away from full throttle liquidity provision. But increasingly it appears that China’s efforts to create a new growth engine have failed and the rest of the developing world is contracting as a consequence. In Europe, Germany steadfastly refuses to pursue any sort of pro-growth policies. As a consequence, the U.S. dollar has resumed its ascent. Thus the USA faces both faltering rest-of-world demand and rising dollar rising [sic]. As a consequence the mismatch between USA spending gains and output gains is destined to worsen. Likewise, despite low U.S. unemployment, inflation looks set to fall in the quarters ahead, not rise.

Should Yellen reverse course, end the plans to tighten and hint at a potential reversal for short rates? That may be in cards. But is it the issue of the hour? More to the point, did a 25 basis point move up for short rates in the USA doom China’s economy? Did a promise of perhaps four tightening moves in the USA over the next year shut down European growth? In sum, is the Fed the precipitator of emerging evidence of a global reversal of fortunes? If Chair Yellen were our global Keynesian benevolent despot, and global barometers were heading south, we could confidently say yes. Given her complete inability to adjust the many policy levers around the globe that are wrongly positioned, how can you lay today’s madness at her feet?