Dear Clients and Friends,
McVean trading will be participating in a Global Interdependence Center conference in Buenos Aires, Argentina on November 1st. The conference, co-sponsored by the Argentinean stock exchange, was planned to examine what lessons the European periphery might glean from Argentina’s default and subsequent experience without access to global credit markets. Given the recent turn of events in Argentina with nationalization of their oil industry and fears of pesification of their economy, we expect a vibrant discussion. Add in the recent parabolic price movements for corn and soybeans and the discussion on the outlook for next year’s South American crops will be center stage.
We hope that your travel plans allow you to attend. Registration and a preliminary agenda are available at GIC’s website:http://www.interdependence.org/programs-and-events/event-registration/programs/argentinas-economic-experience-lessons-for-europes-periphery/.
McVean Trading & Investments, LLC
Incoming Program Director
The Global Interdependence Center
I have had the pleasure of spending much of the past two week with two separate groups of roughly 50 top shelf economists each: first, at Leen’s Lodge in Grand Lake Stream, Maine during Camp Kotok; and then, as the newest member of the National Business Economic Information Council (NBEIC) in Seattle. The mood was definitively subdued, as the outlier forecast among these nearly 100 economists is now anything above 3% real GDP growth in 2013. The vast majority has acquiesced to a muddle through at 1.5%-2.5% growth, and more than a few are calling for recession before the coming year is out. Obviously, Europe and the fiscal cliff were among the most often cited reasons for downside concern, but China and the regulatory uncertainty caused by political polarization followed close behind. Optimism centered around specific industries like the shale gale and the housing rebound rather than from a grand solution on the deficits or more QE in either Europe or the US. Optimism was greatest that China would stimulate its way out of trouble, but those with the most expertise were the most sanguine. We note this negativism primarily because economists — and particularly business economists at industrial firms — are usually a very upbeat group. Many seemed to have been muted into conformity by serial over-optimism in the past. We wonder if this is not the classic Sports Illustrated cover, for when everyone is pessimistic – and especially when normally upbeat economists are telling their strategic planning associates to be careful, that the downside is fully discounted.
There was clearly reason for concern, as those best connected in Europe noted a sharp decline in activity over the past two months as the problems in Spain escalated. Some European sources indicated that the Spanish government was in near panic as they realized their debt financing problem was spinning out of control – a la Greece, Portugal and Ireland. This was the reason for the jawboning expedition by Draghi, Merkel and Hollande two weeks back. Yet, while many have concluded that this is just the start of something bad, we are increasingly curious if we are not finally reaching the point where fiscal authorities cannot kick the can down the road, or shift the burden of correction onto the monetary authorities, and will finally be dragged kicking and screaming into action. Some European sources indicated that in Germany, industrialists are now feeling the pain of a declining Europe (along with a receding upside from China) and are no long defending the Bundesbank in its staunch never-surrender position on Eurobonds. While there will not be capitulation, it seems likely that another round of slipping toward the fiscal union that the Eurozone needs will occur shortly – with the Germans gaining ever more control in return for their hard earned cash.
One of our favorite annual exercises is to step back from the debate during the August lull and observe what corporate CEOs are likely to be looking at as they return from their Labor Day vacations and start planning for 2013. Given our recent tour, we will address from biggest to smallest, the consensus concerns and our views on them. Given the high level of uncertainty, CEOs have to be particularly nimble in staging for 2013, as it might bring more severe pain or be the start of something great. We lay out our pluses and minuses – which are not always in line with consensus – it trying to look into the murkiest crystal ball in years.
We start with Europe, largely because we think that their drag has been a major component of the weakness in both China and the US. If they can right their ship, the end of drag could be a major positive – at least for 2013. This will be a major theme in all of our observations, because it seems to us that an end to negatives is more likely to allow already improving sectors to shine through, rather than for robust growth to burst forth. It is unlikely one could design a better stimulus package for the North of Europe than what the invisible hand is doing now. Interest rates are at rock bottom. Risk premium in the safe havens are abnormally low, because so much of the world’s money is in flight to safety. An influx of immigrants is holding down labor costs and inflation, while stimulating growth. Of course, this is all at the detriment of the periphery, and it is there that a rebound is likely to come if the sovereign debt/banking crisis can be solved.
We remain optimistic, primarily because Europe has options – not options that they want to use, but options none the less. They could create Eurobonds and collapse the spreads between periphery and core interest rates. They could give the ESM a banking license. The ECB could buy troubled securities. Any of these would be the classic solution to debt crisis – move the debt into stronger hands and allow that investor (even if it’s a government) to earn a tidy arbitrage issuing new debt and buying in riskier existing assets. We are not interested in the supposed barriers to each of these ideas. Crisis will alter the institutional thinking and force politicians to do what the invisible hand wants. We have seen a steady drumbeat of unacceptable solutions occur in Ireland, Greece, and now Spain. At my meetings, Greece leaving the Euro was barely mentioned this year – though it was the center of discussion a year ago. The August 20th payment may raise concern again, but Europe has already committed to bailing Greece out. Bottom line, as the problem got bigger – Spain and maybe Italy – the original plan has been revised. We note that in the face of crisis monetary authorities have adopted a number of unconventional policies, just as military leaders faced with defeat will adopt unconventional weapons. Why would it be any different for the politicians? Faced with a rapidly deepening crisis in Europe – and particularly as it spreads inexorably to France and Germany – we expect bigger guns to be brought to bear. Will they be successful? I am not sure in the longer run, but like TARP plus stimulus in the US and the grand 2009 stimulus in China, they should buy a strong rebound in the near term.
Next in line is the US, facing an election, a fiscal cliff, and a funk over regulatory uncertainty. As one particularly astute analyst pointed out – all that stuff will be over in six months. The real question for US CEOs is will they be winners or losers in the policy game, or will we remain in the same stalemate. Staying the same may maintain a muddle through, or at worst a brief crisis as we temporarily go over the fiscal cliff, but no politician – especially a newly elected one with a mandate (they all have mandates even if they win by one vote) will stand still. If a grand solution is achieved or one party control gets us all moving in one direction, firms will have to adjust to whatever the new environment is – and the current position of sitting on the sidelines will not work. Bottom line, as we expected, the approach of the fiscal cliff has the US economy frozen in the headlights. For better or worse, that uncertainty will be eliminated very soon.
In our mind the biggest plus for the US will be an end to the drag from the 20% of the economy that is direct government spending and the 10% that is medical transfers. Declining state and local government employment has been a major – though needed – drag on the economy since 2009. The fact that layoffs slowed to -9,000 a month over the past two months from a peak of -30,000 in mid-2011, suggests we are approaching the day that government jobs stop contracting. They may never again grow as fast as employment in the private sector, but the spread does not have to be as wide as during the corrective period. Meanwhile, medical transfer payments – which account for 10% of personal income — have been flat for nine months, explaining why health care retain sales have been weak and industrial production of pharmaceuticals is the worst performing sector relative to its long run trend. Again, a return to any positive growth – even weak positive growth – would be a sizable boost to the US economy given the size of the sector. To put this in perspective, a 0.7% improvement in growth for the 30% of GDP represented by government spending and medical transfers (which would still leave them a net drag on real GDP) would provide as much oomph as a 20% increase in the growth rate for single family residential construction. Keep in mind, single family residential construction is already growing at a 10% plus annual rate, so we would need to accelerate to 30% growth. In fact, home building may have trouble maintaining its current robust pace for another year. We see the best hope for stronger US growth as from reduced drag from the ongoing government correction, not from even stronger growth in the already sound private sector.
Finally, on China, the sleeping dragon has awoken to the reality of a more profound slowdown than anyone had anticipated. They are already fighting to offset the drag from a slowing Europe and a weak US. They are also trying to redirect their own economic growth away from centrally planned projects to more small and medium businesses. So far they have taken only baby steps by lowering their interest rates and reserve requirements slightly. They fear a repeat of the 2009 boom, not just because of the inflation – but because the disparity in wealth it created generated a real threat to the Party. The crackdown on housing and the slide in the equity market have the rich distressed – but it is not the rich the Party is concerned about. They already owe their soul to the company store, and due to capital controls and the weak convertibility of the Yuan, it is hard to take their money elsewhere. Indicators such as the decline in activity in Macau, a sharp falloff in sales of Rolex watches (a traditional gift in sealing business relationships), and still declining prices for real estate show the nouveau riche of the upper income class is intentionally being reined in by the Party.
Meanwhile, reductions in taxes and new support programs have sustained high income growth among the China’s less well endowed. The Party will not want to throw that away by allowing a weaker economy to slow employment growth. Tight labor markets may hurt corporate profits – but in reality they are just another way to shift income to the poor and reduce the risk of Arab Spring in the Middle Kingdom. China has interest rates and reserve requirements it can lower. It still has taxes it can cut — even if they start running deficits. It has a currency it can weaken – even if the world complains. It has started doing all three and there are no barriers to it doing more. We expect growth will rebound from say 6% today (yes, I know the reported numbers are higher) back toward the goal of lucky 8% growth.
For the global economy, what happens in China is likely far more important than what happens in Europe or the US. Though the Chinese economy is only half as large as either of the major western economic blocs, its impact on the commodity producing regions – which basically match China in size — is far more profound. As we have noted, the improvements in the US and Europe are most likely to come from a reduction in drag. Growth rates in these blocs will still be heavily restricted by high debt loads, with the durables and investment sectors perennially weak by historical standards. It is China and its impact on the developing commodities producers that is most likely to be the engine of stronger global growth in the coming decade. After that, demographics become a challenge for all, but that limitation – including the true onset of US entitlement problems — is still some ways off.
Bottom line, in the near term, we are decidedly more optimistic than we have been since early 2010. Back then as now, we felt that the global stimulus would provide a significant lift. Unfortunately, Europe proved to be out of step, and the start of the Greek tragedy pulled everyone back down. The Japanese Tsunami performed the same function in 2011. And Spain is the reason for weakness this year. Now, everywhere in the world is facing crisis. Either politicians pull together to resolve what monetary policy cannot, or we go to war – perhaps only economic war, but a spiral into protectionism and nationalism nevertheless. Some of this is reflected in negative US/UK spin on the euro, for should Europe fail it opens opportunities for others. More likely, domestic politicians in every country are going to have to undertake the hard work of compromise and change, because they have no one left to blame. Any move toward long term structural stability in US budgets and Eurozone fiscal unification would reinforce the positive momentum China should provide, and a virtuous, though still relatively muted, synchronized global recovery could begin in 2013.