Part 2 continued...
The American economy is still the most powerful economy in the World, even in its current weakened state. And, in spite of the many grave injuries it suffered in the crash of 2008, its insane partisan politics, and the crushing debt that it is piling on, it is probably still the most resilient out of all the other major economies. The reason for this resilience is its sheer economic size, its wealth generating capacity, its aggressive culture of individualism and entrepreneurship, cutting edge innovation, global trend setting cultural icons and multinational brands. But more than anything else, America has a huge wealthy captive consumer base that has more buying power, even in their diminished state, than any other single block of consumers in the World today. But, regardless of its strengths, America is failing to recover in a sustainable manner and the aggressive monetary policies of the Federal Reserve are becoming counterproductive after five years of extraordinary stimulus. The recovery is questionable while asset and financial market bubbles are growing.
Post the 2008 crash, the percentage of the civilian population, fully employed, has declined significantly, and in spite of all efforts by the Government and the Federal Reserve to create jobs, the recovery in employment is poor and flat at best.
What did come back fully after the crash were the equity markets. The Dow and the S&P 500 have unrelentingly climbed over the past five years, setting new records. The Chart below (CHART XII) shows the record breaking run of the Dow (breaking 16,000 in November 2013).
The following Chart (CHART XIII) shows the three major runs that the Dow has had since the Tech crash of 2000. The formation of the ‘Triple Top’ is a warning sign in technical analysis, forewarning of an impending deep correction, as in the past two runs, at the least.
In our view, what has been particularly worrying for the past three years has been the long and significant bull runs in the equity and the bond markets, without the economic fundamentals to support the run-up. As the GDP growth started its slow and steady decline, in spite of the escalating monetary stimulus, from its post crash high in 2010, the asset markets have just kept going, based on the liquidity pouring into the markets. So much so that any talk of reducing the stimulus rocks the markets. But, as the gulf widens between the S&P 500’s record bursting performance, and the falling underlying economic growth rate (GDP growth rate), as depicted in the following Chart (CHART XIV), the risk of a serious correction mounts daily. In our view the current situation as shown in the Chart below, is unstable and unsustainable. If the correction is significant and deep it will affect global financial markets, which have been similarly buoyant due to excessive liquidity.
The Chart below (CHART XIV) shows the growing disconnect between the negative economic growth rates, and the inverse record setting rise in the stock market.
The next Chart (CHART XV) shows the importance of Quantitative Easing(s) for the stock market run-ups. It also clearly shows the inevitable result of such run-ups when QE ends.
The following Chart (CHART XVI) shows the consequences of the Federal Reserve holding interests - too low - for too long, in relationship to economic (GDP) growth rate, and the bubbles that form and inevitably collapse.
China is now the second largest economy, having surpassed Japan a few years ago, and if there are no severe setbacks in the near future China may surpass America as the World’s largest, most powerful economy. In some respects it is already the most influential economy. It punches far above its weight in contrast to its current economic size, which is approximately half of the U.S.
China’s many strengths are: its sheer overall size (economic, population and geographical); and as a command and control economy, over the last two decades, it has proven stunningly effective in implementing its vision and policies, and in transforming itself; its irresistible lure as a market to do business with for foreign governments, investors and international conglomerates; the sheer speed of its change; its wealth generating potential; its growing military power; and its softer attributes, its culture and history.
China’s many weaknesses at this time are equally as numerous and compelling: its sheer size and diversity are unwieldy; it is not quite homogeneous (something like the former Soviet Union); as an economy it is currently very unstable; it has too much public sector participation and control in its economy, making it increasingly inefficient; it is too dependent on exports, has huge over capacity and redundancy. It is currently wrestling a dangerous banking, credit and property bubble; it is riddled with corruption and extreme social imbalance; and it has a calculatedly belligerent foreign policy to whip up national sentiments when needed, but which then surround it with less than trusting neighbours. So far, China has been able to control its many weaknesses and exploit its strengths, rather commendably. But the current global economic situation and its internal flaws, will surely test its capabilities to the extreme.
The Government of China knows, and increasingly and more openly acknowledges its weaknesses and challenges. And, the new leadership is wasting no time in trying to address and correct, to some degree, its most dangerous imbalances. And given enough time, it may be able to effectively deal with the transformations needed in rebalancing its economy and its social inequalities. But, there may not be enough time. Its own unwieldy financial and business structure may not be manageable given all the negative forces currently working on it, and it is vulnerable to external financial shocks. China realizes this and lately its leadership has rolled out an ambitious agenda of potential reforms. Additionally, it has called upon the U.S. to have discussions on coordinating policies. This unprecedented move in-of-of-itself speaks to the gravity of the situation. But the danger to China also comes from the U.S. It is heavily dependent on the U.S. market for its exports, it holds too many U.S. dollars (over $3Trillion), and it is heavily invested in the U.S. debt (over $1Trillion), and increasingly, directly and indirectly, is invested in the U.S. market. So, whether it is the U.S. financial markets that further bring it down or whether it is its own credit and banking system, or some other event, suffice it to say that China currently is highly vulnerable to internal and external disruptive events.
In the following Chart (CHART XVII), the steady decline in its GDP over the past three years is quite apparent. Only, in China’s case we would venture to guess that the actual numbers are worse than the Chart suggests (Sources: Quartz, data FactSet).
The primary problem that China faces today is its credit boom, both official and nonofficial (known as shadow banking). The following Charts pictorially show the problem. Not only is the credit/debt growing to record levels (CHART XVIII), since the later part of 2012 it is growing inversely to the GDP growth (CHART XIX).
Since 2003, as investment speculation took hold in China, the various government bodies and the much smaller private sector started to make silly money. Shadow banking became an increasingly popular financing alternative to circumvent the official banking regulations. CHART XX shows the dramatic rise in shadow banking since 2003 to 2013. CHART XXI shows the growth of shadow banking now surpassing total conventional lending. This is why, for China watchers the dramatic growth in official and particularly unofficial credit, poses a very clear and present danger.
While credit is growing at an alarming rate, capacity utilization is plunging. The next Chart (CHART XXII) is from an IMF study released towards the end of 2012 that estimates China’s average rate of capacity utilization to be 60%, by the end of 2011, dropping from 80% in 2007. Given the Authority’s penchant for massaging such numbers, one could fairly safely conjecture that China’s capacity utilization currently is probably at 50% or less.
The Chart (CHART XXIII) below shows the dramatically rising cost of new credit in Renminbi required (over 4 Renminbi) to produce one Renminbi worth of GDP growth. This is to illustrate the rapidly growing inefficiency in the Chinese economy.
The following Chart (CHART XXIV) shows the sharp spikes in the Chinese overnight interbank rate, as the Bank of China tried to tighten credit to suppress the rampant speculation in the banking and non banking markets.
In the past two decades, the Chinese Government chose the path of extraordinary capital investment to achieve and maintain stunning GDP growth rates. That led to the now infamous highways and bridges to nowhere, entire empty cities, empty malls and apartment buildings etc. The following Chart shows the thrust of investment shifting in 2009, from infrastructure building, to real estate and manufacturing.
But keeping in mind the previous Chart XXV, showing serious, growing and across the board under-utilization of capacity, we are not sure that greater investment into manufacturing or the rising investment in real estate is such a good idea either. The ratio of real estate under construction to units sold is climbing dramatically (below).
The Chinese leadership completed its ‘Third Plenum’ meeting on November 9th, 2013. Coming out of this meeting the Leadership has announced sweeping reforms to try and restructure China’s many critical imbalances. It is a good start, but we fear as in the past, the Communist Party’s absolute political control, and its pervasive vested interests, kill most such good intentions towards any real reforms.
China is significant in today’s global affairs as much for what it potentially contributes to the World economy, as the danger it poses to it. For if it comes off the rails, a very possible likelihood in the current global economic scenario, from an adverse internal or external event(s), China poses a great risk to the global economies.