Volume 58, Number 3 | January 21, 2011
A confluence of events this week has focused my attention on the fundamental trends driving the global economy. I returned from my first trip to Chile, which was eye-opening in helping me understand their success – especially after a devastating earthquake just a year ago – as well as the failure of most other Latin American economies to achieve the same. The trip was sponsored by the Global Interdependence Center and allowed for many thoughtful discussions of the big picture, rather than worrying about the latest wriggle in the financial markets. I arrived home the same day that Chinese Premier Hu Jintao landed, bringing Sino-US relations to the fore. Finally, the Chinese released a wave of economic data including their fourth quarter GDP numbers, which is what sparked this observation.
In the fourth quarter, nominal Chinese GDP exceeded $6 billion, up 21.3% from a year ago – when we were arguing about when they would pass Japan (at $5 billion) to become the second largest economy in the world. This Friday, the US will report fourth quarter GDP at roughly $15 billion, which means that China’s economy is already more than 40% as large as the US economy. When I first visited China, just six years ago, their economy was only $2 trillion. A combination of roughly 10% average annual growth in real GDP, plus 6% domestic inflation and roughly 5% (though volatile) appreciation in the yuan versus the dollar has lifted dollar denominated nominal Chinese GDP at an average 21% annual rate over the past six years. At that pace, the next $4 trillion in Chinese GDP growth will occur in less than three years. The events of the past three years are likely to seem like child’s play compared to the pressure, volatility and disruptions in global financial markets – especially commodities markets – that are to come as China continues to demand resources (and has the money to pay for them) at the same time the rest of the world seeks to return to expansion.
A number of analysts have estimated when China will surpass the US as the world’s largest economy, usually looking at dates like 2020 or beyond. We believe the object in the side view mirror is much, much closer than it appears. While we were in Chile, it was noted that China had recently become the #1 importer of Chile’s major export, copper – although the US remained the pre-eminent end market for most other goods. This type of report has become so commonplace that one becomes inured to them. However, the bottom line is that it is not when China statistically passes the US in GDP that matters, but rather the effect of the ongoing shift away from the US as the dominant global leader – politically, financially or militarily. As Louis Pasteur noted, “Chance favors the prepared mind.” Investors must quickly adapt to rapidly changing global dynamics in order to protect their assets, let alone prosper in this volatile world. Note that at current growth rates, the US President elected in 2016 will be sworn in as the leader of the second largest economy in the world!
A Trend that Can Not Continue, Will Not
Herb Stein’s Law notes that, “If something cannot go on forever, it will stop.” The growth of China (like the growth of Cisco during the tech boom) appears to have reached a threshold where the combination of large size and high growth rate are no longer possible without serious ramifications. Change in prices, changes in profits, and changes in policies will all occur to slow or derail a runaway train. The question for investors is which changes are most likely to occur, when, and what are the consequences? I surely don’t have all the answers (or even most of them) but I offer the following observations:
• In the short run it does not look like the China boom will be derailed. China expects 16% growth in M2 (closely correlated with GDP growth) and the US expects them to appreciate the yuan by at least 5%. Neither trend is like to be violated until much larger imbalances develop. Higher prices, especially for commodities, seems the most likely path as supply is already behind rapidly rising Chinese demand. Commodity producers, including the US Oil Patch, Midwest and Mountain states, should do very well in 2011. One consequence should be a narrowing of both the Chinese trade surplus and the US trade deficit. I am still working on how that development will affect Chinese and others purchases of US Treasuries.
• The importance of Sino-US relationship is likely to come to dominate US politics more than the divisive attitudes over domestic issues now in Washington – and maybe even before the 2012 election. By that time, China’s economy should be more than half as large as the US and 50% larger than the second contender, Japan. Even a slowing China is likely to throw off more global GDP growth in 2012 than the US and Euro-zone combined. Observers from Sun Tzu to Machiavelli have noted that a common enemy will bring even bitter rivals together.
• Very tough decisions are going to have to be made much more quickly than the consensus is often willing to consider. In the US, tough budget decisions will be forced by a growing exposure to China as a source of both funding and competition. The collision between US military and entitlement commitments is upon us. In Europe, whether the savers of the North continue to carry the debtors of the South will be complicated by both the advent of China as a potential White Knight and the rise of Russia as a commodity power to the East. Traditional ideas will be constantly challenged as the global economy seeks a new balance.
Shrinking to the Core for More Profit
Two news stories in the restaurant industry caught our eye this week. First, YUM! Brands announced that they would sell A&W and Long John Silver’s to focus on KFC, Pizza Hut and Taco Bell. Then, Wendy’s/Arby’s announced that it would sell Arby’s to concentrate on the faster growing Wendy’s – which Arby’s owners purchased just two years go. Bottom line, these restaurant chains are shrinking to a more profitable core, following the examples of the airline and auto industries. While this is good news for profits, it is not so good for job growth or the sustainability of the US expansion.
In today’s economic environment, fast growing firms are often successful because they are the low cost producer and taking share from their less efficient competitors. Use of technology and imports as well as more part time and temporary workers are all common strategies to cut costs, some of which is passed along as lower prices (or less inflation) to win market share. While this is an admirable exercise in market economics, it leaves behind the growing problem of persistent unemployment in the US. Where profits would hopefully be reinvested to create the new industries that open new opportunities, these funds are increasingly being invested overseas where growth opportunities are better. Both of the restaurant chains noted above are focused on overseas expansion, and the chains being sold off don’t have international cache. This is good for the global economy and global investors, and good for consumers who benefit from less inflation, but for the domestic employment base – not so much.
The One and Only
Chile is widely seen as a success story by international investors, especially since the economy survived the effects of a devastating earthquake a year ago. President Pinera, elected in January 2010, is the first conservative elected since the country returned to democracy in 1990. He is one of the country’s richest men and a trained economist (defying all logic), who has chosen a pragmatic group of ministers (rather than politicians) to run economic policy. The central bank is constitutionally mandated and not subject to legislative control. It has a 3% inflation target, which it has successfully achieved this year after a burst of inflation late in the last President’s term. With copper and other mining accounting for 13% of the economy, Chile has a strong economic backbone. However, it is the commitment to free trade and open investment that has led to its success – in contrast to most of the rest of Latin America.
In discussions with businessmen operating in Chile and throughout Latin America, a disturbing picture took hold. Only Brazil can be counted an economic success within the region, and concern is growing even there as a new Socialist President has replaced Lula. While Lula was almost legendary for crossing over to embrace business, a long history of exploitive Socialist governments in the region has made businesses wary. Rising interest rates, fees for moving money in and out of the country, and a widening trade deficit despite growth are also worrisome signs. Unfortunately, when asked which country would rank third in Latin America, one answer was “Columbia, as long as you don’t drive between the major cities.” Bottom line, barring Chile’s open and inviting (though small at $150 billion) economy, Latin America has a long way to go in attracting investor interest.
A final thought on the combination of Latin American foibles and Chinese growth is the potential future of Mexico. Mexico is on no investor’s short list, having devolved into a narco-economy with major drug gangs openly warring for market share. However, it is critical to remember that Mexico, maybe more than any other country, has suffered from the rise of China as a low cost producer due to the decline of the Maquiladoras. Despite proximity and low cost, Mexico could not compete with China’s free trade zones. Now as inflation and currency revaluation drive up Chinese costs, Mexico may be the biggest beneficiary. So far rapid productivity growth has sustained China’s exports despite rising costs – but trees don’t grow to the sky. China’s era of cheap labor coming in from the farms is ending, both due to the demographics of the one child policy and the rising incomes from agriculture. Moreover, rising transportation and logistics costs are eroding China’s competitive lead as factories must move further into the mainland to keep down labor costs. As an oil exporter with proximity to the US, Mexico may be regaining the comparative advantages that slipped away a decade ago. Only time will tell, but change is coming quickly.