Volume 60 | Number 2
The economic data released this week lead us to focus on three key themes we believe underpin the fundamental structure of the current world economy. First, that China is the economic driver of the global cycle and that its importance is growing at an exponential rate – far faster than financial markets are currently adjusting to that status. Second, that rising prices of commodities are a relative price shift and not inherently inflationary – although the upward pressure will persist for a generation. Rather, given limited real income growth, they crowd out increases for services (both prices and volume) in the developed world as those consumers seek to preserve consumption of cheaper emerging market labor. Third, that the primary adjustment to rising commodities prices will be reduced consumption of shelter and falling home prices – continually undermining developed nations banking systems and stunting their growth. These three forces act together to collapse the gap between unskilled labor in the developed world and the emerging markets, while rewarding skilled labor and investors who exploit this very long term trend.
The Chinese Juggernaut Rolls On
China reported this week that real GDP grew 9.5% over the past four quarters, and that it grew at a 9.1% seasonally adjusted annualized rate in the second quarter after 8.7% growth in the first. We learned that nominal GDP grew 17.9% over the past year, while the value of the yuan appreciated 5.0%; boosting dollar denominated Chinese GDP to $7 trillion – up 23.8% since this time last year. The US nominal GDP (roughly $15 trillion) grew 4% over the same period. The first question is whether this data is credible or not. Solid 16% growth in bank loans and M2, plus 12% growth in electricity sales and 6.4% growth in rail traffic all point toward recent real GDP growth in China near 9% — basically what it was growing before Lehman. At the current pace, dollar denominated Chinese GDP will be 50% of the US level by the end of the year – but growing more than five times as fast. If sustained, the US President who takes the oath of office in 2016 will do so as the leader of the second largest economy on the planet.
We believe one of the key fundamentals of the next five years is that China simply cannot maintain this growth pace due to their size – but that the bottlenecks and price increases which will eventually throttle back their growth will wreak more profound consequences on the rest of the world. China is not only the second largest economy in the world, but the driver of growth in many commodity producing economies like Brazil, Russia, Canada, Australia and Indonesia – which collectively have fast growth and account for another $7 trillion in dollar denominated GDP. Indeed, the strongest parts of the US economy are agriculture, energy, mining, and capital goods exports – all driven by outsized growth in the developing world. The strength in Europe –particularly Germany’s $3.3 trillion economy, which is growing at 3.5% — is also in capital good exports. Meanwhile, the weakness in the other two-thirds of the world’s economy is also the result of rapid Sino-centric growth as it drives up commodities prices and erodes real buying power in developed economies.
One byproduct of all the Chinese data released this week is the observation that their GDP deflator is still accelerating rising from 7.4% at an annual rate in the first quarter to 8.7% in the second quarter. This is still lower than at the peak of the last cycle, but more concentrated in the consumer sector. Inflation typically follows real growth in China with a short lag, and then persists even after growth has slowed significantly. China is currently trying to rein in growth to control inflation – but obviously more work remains to be done. Much of the focus has been on food prices, but food only accounts for 33% of consumer spending and consumers account for only 33% of Chinese GDP. Thus, food inflation is only 10% of the GDP deflator. The bulk of Chinese inflation is in the government dominated sectors like construction materials and public labor costs. The surge in bank lending in early 2009 went almost entirely into state owned enterprises who squandered a lot in inefficient, costly projects driving up prices – especially for labor. Now, that hike in labor costs – combined with some weather – is spurring food inflation as the poor improve their diets. Meanwhile, booming incomes at the high end are driving up housing prices as the rich seek ways to safeguard their burgeoning wealth. Higher interest rates may rein government spending and rising labor costs, but the real relief must come through increased supply. The government is pushing heavy investment in low cost housing and in water projects directed at reducing drought and flooding. These projects suggest that labor will remain employed, and so reining in inflation may be difficult. The government has already alluded to acceptance of a 5% inflation rate in CPI, but the GDP deflator will undoubtedly remain higher.
The Chinese have great confidence in their ability to manage the current inflation and are committed to sustaining growth through 2013 when the new leadership takes over. Price controls and the recent tax cut for low income households are only band-aids to kick the can down the road until supply – especially of pork, which represents 10% of consumer prices – catch up with demand. However, consider that government revenues grew 31% over the past year while nominal GDP rose just 18%. Revenues accounted for 28% of GDP in the first half of 2011. China remains in the enviable position of having a significant trade surplus, a huge $3 trillion in foreign reserves, hefty government revenues, and a relatively low debt/GDP burden which is entirely financed domestically. It remains the low cost producer for much of the world’s exports – despite the fact that it has raised the value of its currency by 25% relative to the dollar since 2005. Countries that have 18% growth in GDP do not have imminent banking crises – it is when the tide goes out that we discover who is swimming naked, and it is still high tide in China.
Services Suffer, Goods Gain
Many investors worry that persistently rising commodity prices means higher inflation, because that is what happened in the 1970s. However, the real lesson of the 1970s is that inflation is a monetary phenomenon. When central banks print money to ease the impact of rapidly rising commodity prices (or any price) it just causes all prices to rise, but the squeaky wheel still gets the grease. Monetary ease amplifies the price increase in the sector that was already in short supply relative to demand – hence, the runaway oil and housing inflation of the 1970s. However, if the monetary authorities do not print more money, as is largely the case now, the squeeze on spending power from higher commodity prices forces consumers to decide between increasingly more expensive commodities and relatively less expensive services. Over the past twenty years, commodities deflation allowed consumers to increase their purchases of both goods and services – and allowed service providers to pass along price increases largely caused by tight labor markets. Today, the tables are turned and higher priced commodities are being accommodated by reduced growth in consumption of both goods and services with less service inflation due to slack labor markets. This shift is noticeable in the lower level for the nonmanufacturing ISM relative to the perky manufacturing index. It is also clear in the CPI report, where sharp increases in prices for core commodities has led to smaller price hikes for core services.
Just as the squeaky wheel got the grease in the inflationary 1970s, the greatest slack leads to the slowest price adjustments in today’s tight credit conditions. Labor and housing appear to be the markets with the greatest oversupply, but within these broad categories it is unskilled labor and single-family homes that are the most out of balance. Unfortunately, this imbalance is reinforcing as it is previously middle-class unskilled labor that supported single-family home values via easy credit. Moreover, the lack of real income growth for unskilled labor leads them to cannibalize their own wage potential as they opt to sustain consumption of cheap Asian imports while cutting back on domestic labor by choosing to eat at home – firing the waitress – or shop at cheaper retail locations – firing the store clerk – or to reduce government spending –firing thousands more low hanging fruit. Indeed, even among these newly unemployed, the items given up first as income is decimated tend to be education, medical care, entertainment, travel and other labor intensive services.
Rising Rents Hobble Housing
Unfortunately, the largest purchase that any household makes is housing, and so shifting to a less costly housing arrangement is the fastest way to relieve the pressure of reduced real spending power. Housing is one of the most domestically produced of all goods, so the shift to less housing is a significant long term drag on potential growth – just as the shift to more housing was a key driver of the past cycle. Many analysts are focused on the rise in rents in recent months as a positive. Nothing could be farther from the truth. The rise in rents is caused by increased demand for smaller housing accommodations as consumers choose or are forced to abandon larger homes. The growing stock of empty single family homes is a major threat to the value of all remaining similar units, undermining the collateral value of the banking system and the risk appetite of these lenders. Meanwhile, the rise in rents is calling out a fresh construction of new rental units which will only increase the competition with already empty single family units. While in a perfect world single family units would quickly fall in price or shift into the rental market, any number of market inefficiencies, including warehousing of foreclosures and the unattractiveness of renting single family units, exacerbate the problem.
Builders build, and so they will naturally respond to the market signal to create more affordable housing units, especially as labor costs are low. However, every new rental units produces only 40% of the construction value of a traditional single family unit and takes longer to complete. Thus, in recent months though housing starts have stabilized, the shift from single family to multi-family means that the value of residential construction put in place will continue to fall. Moreover, even if household formation returns to one million units a year, every 10% shift toward more multi-family housing reduces the benefit of the rebound by 6%. Many econometric models are still counting on housing to drive a strong recovery in coming quarters based on reversion to the mean. Yet, if the shift to cheaper housing persists, it will limit growth potential, limiting any gain in buying power and reinforcing the demand for smaller accommodations. We see little reason to be optimistic about the single family housing market based on rising prices for rentals. That is like being bullish SUVs because rising gas prices have small cars flying off the lot. In our mind, declining single family home prices – the largest asset for the shrinking middle class — are still the greatest threat to this already wobbling economic expansion and we expect a protracted period of softer growth as mortgage debt is paid down as the most likely scenario.