Volume 59, Number 2 | April 8, 2011
As the equities market climbs a wall of worry we see a lot to worry about. Not enough to push this budding expansion back into a double dip – but enough to limit 2011 growth to a steady and unexciting 3.0% growth pace for real GDP. The strength in the US economy so far in this cycle has been largely from exports, and now the outlook for that sector is darkening. Europe has started to tighten monetary policy to slow inflation in the North, while even greater calls for fiscal austerity will continue to hamper the South. China is still raising interest rates and reserve requirements to rein in its inflation, which is likely to have a cooling effect on Asia’s high growth rate. And Japan is obviously seriously hampered in the near term, with reduced demand shifting to domestic reconstruction. With oil and other commodity prices soaring, world buying power for American exports is likely to cool –especially in real terms. With one of the strongest drivers of US manufacturing demand slowing it is up to domestic demand to become the locomotive. However, with stimulus fading and wage generated income barely keeping up with prices, it looks like the US may have flubbed that baton pass.
We currently expect real GDP to grow 3.25%-3.5% in the second quarter, after a 2.25% rise in the first. We still see the risks to growth on the downside for the second quarter as we continue to assess the disruptions in the supply chain following the Japanese earthquake – but expect some catch up in the second half. Real GDP growth in the first half of 2011 is unlikely to exceed the pace in the second half of 2010. As noted last week, growth in total hours worked should remain steady at 1.8%, though with somewhat more job growth as there will be no further gain in hours for existing employees. We see no inflationary pressure from higher oil prices, but rather the equivalent of a tax imposed by foreign producers which will reduce the income available for domestic purchases. Strong profits growth makes it too early to call for an end to the expansion, but margins are being squeezed and fiscal policy is already tightening in the US. To expect faster growth in the economy at this point means the US private sector would have to be steeping on the accelerator even as the government and foreigners are stepping on the brake. Rather, it looks like ISM and other indicators of strong manufacturing have topped out. True the level of activity is strong, but the outlook looks increasingly cloudy rather than bright. We see sustained growth in 2011, but wonder how much the twin brakes of higher oil prices and rising interest rates will slow global growth and the US in 2012.
No Stone Houses
The European debt crisis has now claimed the last of the three little PIGs as Portugal is negotiating a bailout. Some see the fact that the ECB would raise rates despite the Portuguese problems as a sign that the situation is manageable. We simply see it as using two different policy tools to answer two different problems. Higher rates are needed to slow inflation in Northern Europe, but clearly not called for in the South. However, by allowing Portugal to join Ireland and Greece as subsidized borrowers from the EFSF, the question of market rates in the PIGs is moot. Now, the question is how much fiscal austerity will be called for in the PIGs and how much that medicine trims growth in Northern Europe. UK fiscal austerity is already reining in growth more than expected – but as the UK runs a trade deficit, some of the loss in retail activity shifts the burden of the correction to the world’s exporters. A weaker currency helps as well. The US is trying this same game, but unlike the UK we are not energy independent, so what is gained through austerity is lost through higher import prices. Higher energy costs are less of an issue in Europe where heavy taxes mute the impact of raw material price increases.
Thus, the real issue is who in Northern Europe will bear the cost of the bailouts, the workers or the investors. The European game has been to lend the equivalent of vendor finance to the three little PIGs — and bigger ones in Spain and Italy as well. This sustained production in the North, but overtaxed the ultimate spending power of the South, so now they can’t buy the same amount of goods as before at any positive interest rate. Imposing austerity makes more of the PIGs remaining spending power available for interest payments to bondholders at the expense of income for the workers who earlier produced the North’s exports. Clearly, some of the burden of the cutbacks will fall on local workers and businesses, but the key is that the decision on who loses will likely be made outside of the PIGs.
We attended a Global Interdependence Center conference in Rome this week to get a better read on the European crisis. One of the points that hit closest to home noted that it wasn’t so much the level of debt that mattered – but rather to whom it was owed. Japan has a much higher level of debt than most countries, but still enjoys low rates as the debt is self-financed. Belgium is another example of high debt, but low concern. However, if the debt is financed by those outside of the domestic political system, volatility increases as foreign creditors influence policy via interest rates, the currency, or the ability to dictate taxes and spending. Uncertainty is never good for economic growth and the normal checks and balances of any economic system can be upset when new players are introduced. Unfortunately, this observation leaves two countries with high debt and significant foreign financing exposed – Spain and the US.
Is the Chinese Locomotive Slowing?
China has reported a trade deficit in the first quarter of 2011, the first in six years. The trade gap came on the back of booming imports in the first quarter, both due to rising international commodity prices and strong inventory building by Chinese firms. The surge in Chinese imports provided a boost to international growth and profits. However, now China once again is converting those imports into exports – as the trade gap swung back into surplus for the month of March with exports up 32% year on year. The stronger than expected jump in exports suggests that: 1) the surge in imports was not a ploy to manage the trade gap; and 2) that in a world faced with inflation, China still gains share as the low cost producer. Despite rising wages inside China, it can still export deflation to the world by replacing more expensive labor in the developed world.
The March surge in exports also suggests that the tightening of reserve requirements and raising of interest rates may be having a profound effect on Chinese domestic GDP. Indicators such as the Purchasing Managers reports (both official and HSBC), though better in March, have been soft in recent months. If the weakness was not due to exports, perhaps it is domestic investment which is responding to the central government’s increasingly blunt attempts to rein in real estate. Car sales have also been softer, up just 6% from a year ago in March – well below the 15% expected for 2011 – as the government removed incentives. Indeed, though most cars in China are purchased with cash, the slowdown in credit availability may be indirectly affecting sales as tighter credit hampers growth in high income households.
Bottom line, it may be that China is shifting back to export led growth and losing ground in its domestic economy. This is not likely to bother the Chinese leadership in the short run if it sustains growth while slowing inflation, though it may lead to more aggressive currency adjustments later. Meanwhile, strong demand for Chinese goods from developed countries looking for lower prices will sap their much needed recoveries at home. Stronger export led manufacturing in China may give the misleading appearance that commodity demand is rising again, when there is simply a shift in where goods are produced. However, the slowdown in China’s domestic growth should temper demand for building oriented materials like copper and iron ore. In any case, Chinese trade patterns must be closely watched as they are now the driver of the global economy – for better or worse.