Volume 59, Number 12 | June 24, 2011
It is always darkest before the dawn, and the outlook is pretty gloomy right now. Financial markets were unimpressed by Europe’s kicking the can down the road on Greece despite the successful vote of confidence for the current Administration. Rather, it seems that brinksmanship is all in vogue now that Angela Merkel was forced to back down by the French and the ECB. The rating agencies are upping the ante in Europe by bringing Italy into the mix, giving a whole new meaning to “too big to fail”. Meanwhile, US deficit reduction talks are unraveling with Rep. Eric Cantor walking away from the Biden meetings over the issue of any tax increases. We have long argued that it takes crisis to generate consensus, but no one said that the process was pretty.
Pressure is building on governments everywhere to do something. With no new monetary or fiscal stimulus in the pipeline, and the risk of Lehman-like defaults in Europe and government shutdown in the US, equity markets are reflecting the business community’s displeasure — down 7.5% over the past eight weeks. Ten year notes trade at 2.87%, down sharply from their February high of 3.71% when the consensus was convinced imminent inflation would send them even higher. The latest bolt from the blue was for the IEA to promise a release of 60 million barrels of oil – half coming from the US Strategic Petroleum Reserve. Only the third release in the SPR’s history (the first during the Gulf War and second after Hurricane Katrina), it seems a risky politicization of the Reserve rather than a step forward. This comes after the Fed and the even more fiercely independent European Central Bank have been forced by politicians to buy government debt. The efficacy of those moves is still under debate, and with oil prices already falling due to weak growth, we will surely long debate whether this move was necessary as well.
The key lesson to be learned is that politicians will try anything when they feel the situation has become desperate. FDR tried to pack the Supreme Court during the Great Depression. Nixon used wage and price controls in the 1970s. Britain abandoned the Empire after World War II. Deng Xiaopeng allowed capitalism back into China. Today we are debating the unwinding of the euro and default by the country which has the reserve currency of the world. Meanwhile, China is in Europe with an open pocketbook, already the prime investor in development projects and bailouts around the world. Germany is increasingly looking to the east for energy and growth. Savvy investors are looking at populous Moslem nations like Indonesia and Turkey. For better or worse, the rules are changing and for both protection and expansion of one’s assets it is critical to think outside the box.
The Fed is Still Boxed In
As the tech bubble was bursting, many Wall Street analysts still sang its praises. As the housing crisis was growing in 2007, the National Association of Realtors remained the industry’s cheerleader. As a result, their reputations were irreparably tarnished. This week the Federal Reserve issued an economic forecast range with a midpoint of 2.8% real GDP growth in 2011, 3.5% in 2012 and 3.8% in 2013. To achieve this year’s goal, given roughly 2.0% annualized growth in the first half, would require 3.6% annualized real GDP growth in the second half of the year and beyond. We know of no private sector forecast that is nearly so upbeat. During the best ten quarters of the past cycle real GDP growth averaged 3.5% growth and that was aided by a stimulus tailwind while we are now facing a headwind. In both this and the April revision, the Fed clung to their robust forecast for the future despite missing growth by 1% in each quarter of the first half of the year. In the world of professional forecasters, those who are consistently too weak or too strong earn reputations as Dr. Doom or as defenders the rosy scenario. The Federal Government is already in the rosy scenario camp for its unrealistic forecasts in the budget process. If the Fed’s outlook on GDP growth is perceived as faulty, how long before we head down the slippery slope of their inflation forecasts being disregarded as well?
Is China Coming Off the Brake?
Chinese Premier Wen Jiabao is in Europe this week visiting Hungary, The UK and Germany. In preparation for the trip, the Chinese set the stage with three events: 1) the release of high profile dissidents Ai Weiwei and Hu Jia; 2) a speech by Premier Wen arguing that concentration of power in government had caused corruption; and 3) another pronouncement from Premier Wen that Chinese inflation was under control. China is seeking greater involvement and leadership in world affairs, and has a wallet to back up its efforts. These actions are designed to show that China is sensitive to what others perceive as their global shortcomings, which gives foreign politicians cover as they compete for badly needed Chinese funds. They also serve as a warning at home – the speech on corruption specifically mentioned the 1952 campaign under Mao that resulted in the first executions of senior officials for corruption. The high profile trial of former railroad boss Liu Zhijun comes at a time of rising public unrest about government corruption and increased political infighting as the party prepares for its fifth generation of leaders. An example is being made for both the public and the party. In a similar corruption trial in 2006, the head of the Shanghai party Chen Liangyu – a sitting politburo member with ties to then President Jiang Zemin and opposed by then Vice-president Hu Jintao – was sacked. His replacement was Xi Jinping, now the expected incoming President of China.
These actions also come at a time when China may be shifting back from the brake to the accelerator, as their economy continues to slow. Early in the year when growth was running red hot, it was easy to tighten credit and slow growth in an effort to bring down the rising inflation rate. Now, leading indicators like the HSBC flash PMI suggest that China has slowed to just above breakeven with a reading of 50.1 for June. Similarly, ISI’s weekly China survey has been falling for the past eight weeks. Still, even breakeven growth in China is still stunningly strong by global standards, running at about 13% growth for industrial production according to HSBC. However, it is problematic inside China where stability is more important than anything else. Better to have workers angry about inflation than to have unemployed workers – especially if they are still angry about inflation or corruption. Idle hands make the devil’s work.
Whether inflation is under control or not, acting now to ease up on credit is not a bad idea – primarily because so little lending goes on in the second half of the year. The vast majority of lending comes right at the start of the year as SOEs load up on credit and store it in various pockets for use through the year. By the fourth quarter, new funds are very limited (due to an annual quota) so controls like interest rates and reserve requirements are less important. It is party discipline that is most important now in bring down housing inflation – which remains largely an issue of provincial land control and whether governors are abiding by the central government demand for lower prices on luxury units and greater building of low-cost housing.
With the transition to the fifth generation of Chinese leaders coming in late 2012, the top echelon of party officials are vying to move up the ladder as retirement empties critical slots on the Politburo and central committee. Connections to these officials is the path to power for everyone lower down the pecking order – so it is over the next year that central government power is at its maximum. There are no hard and fast rules on the structure of the Politburo or central committee, but there are – like the pirate’s code – guidelines. On the past two central committees, these were nine members adhering to a retirement age of 68 and chosen from the existing politburo of 25 members. Only 11 of the current 25 politburo members will remain in 2013, so most will move up to the central committee – as was planned five years ago. However, only four of those eleven will make the cut in 2018, so they are planning now who will join the wider politburo to replace them in five years on the central committee and help decide the sixth generation leadership in 2023. The Chinese leadership is very hierarchical and takes the long view, so unlike the western world where anyone might win an election these leaders are cultivated from a very early age through mentoring and connections.
Maintaining a balance between the various factions within the party is critical to stability and preservation. Deng Xiaoping appointed first Jiang Zemin from the Shanghai clique and then Hu Jintao from the China Youth League faction as Presidents. Jiang’s faction successfully negotiated Xi Jinping into the Vice-president position five years ago side tracking Hu’s favorite Li Kejiang to Vice-premier. It is expected Hu will want to control the choice of sixth generation leader and to hold four of the seats on the next central committee for CYL protégées. Similarly, the current 25 politburo seats are split with six representing the party (including the President), six the state (including the Premier), six the regions and three the military. In filling the 14 slots on the new politburo, likely five regional leaders will be advanced, and then three each from party, state and military. Each move opens up slots lower down and complicates the chessboard. Bottom line, mentors are reminding their students that now is the time to toe the line strengthening the central governments control over its increasingly independent provinces at a critical time for the economy.