It is getting very hot in the political kitchen as the world economy is slowing far faster than consensus had expected – particularly in Europe and Asia. The US is hanging on with its muddle through at roughly 2% real GDP growth, but virtually everyone here has a negative outlook because of fears about Europe and China. Interestingly, there is relatively little fear in the US about the fiscal cliff – as most expect the newly elected whoever will surely clean up that mess. I guess everybody else’s politicians look even more incompetent than your own; a kind of the opposite of the grass is always greener. We remain more optimistic that the current unexpected weakness will force politicians in Europe to adopt policies that are less than palatable to all, but that will result in significantly stronger economic growth a year from now. Keep in mind that is a low bar to hurdle as Europe in now universally in recession. Similarly, we expected accelerating stimulus out of China and the rest of Asia, providing a lift to European and Japanese capital goods (note the US is not mentioned here) which will help lift the global economy back to better, though far from booming, growth. Even with renewed government stimulus, private sector deleveraging will continue over the next several years providing a headwind that is just as tough as the tail wind of falling interest rates and declining tax rates were over the past thirty years. We see a global rebound coming, but like the US’s current 2% muddle through, it is likely to disappoint by historical post-war standards.
Ich Will Europa
Who saw this coming? On the eve of “Get tough on the Greeks” week, German Chancellor Angela Merkel – the staunch proponent of austerity – has released a video titled “I want Europe” backed by several German industrialists who feel that austerity has gone too far. With the Troika (IMF, European Commission and ECB) about to rule on whether Greece should get any more money, and the German High Court about to rule on whether the European Stability Mechanism (ESM) is constitutional, Germany’s defender of the faith says keep Helmut Kohl’s dream of European unity alive. Merkel knows full well that only 50% of German’s now believe in the Euro – far less than in Greece. She also knows that if her government falls, it is not to the right that the government will move, but rather to the left of the Reds and Greens. They are much more likely to settle with Greece on Hollande’s terms than on those close to Merkel’s. So she is rallying the troops to the center. Forget the Bundesbank and the nationalists on the far right, she must move to the center to survive politically long enough to achieve her dream of a fiscally united and sound Europe based on strong German guidelines.
A nasty feedback loop has developed over the course of the summer. The weakening in import demand from the cash strapped European periphery has tanked export sales from formerly robust (and cheap) Asia. As a result, Asia has curtailed demand for a wide variety of industrial materials – and commodities producers and Asian exporters alike have slashed demand for European and Japanese capital goods. Export demand has been much weaker than expected recently in Japan (running a trade deficit), China and South Korea. The global slowdown has fallen especially hard on German and Italy (also Sweden and Switzerland) the Euro zone’s two main capital goods exporters. As the European economy has weakened, demand for durable goods produced for domestic consumption – like cars – has tumbled as well, hitting Germany and Italy hardest again. In 2010, Germany was protected from the downturn by its unique work spreading policy. In 2011, they benefitted most when their prime competitor, Japan, was sidelined by the Tsunami. So far in 2012, they have been cushioned by the flood of cheap money and labor into Germany as the last safe haven in Europe. Now, the offsets are no longer holding back the storm. German industrialists are more worried about recession than inflation and so the Bundesbank finds itself a voice in the wind. Merkel needs voters next year, and the unemployed do not like incumbents – so she is moving to the center. She has seen Holland win in France, a do-over election in Greece to save the middle from the left, and is aware of the crumbling coalition in the UK as Clegg threatens to remove his liberals. Politics is a business of strange bedfellows, so Merkel finds herself defending the Greek’s demand for more time in order to buy more for herself.
The risk in Europe is shifting from a potential financial crisis to an actual reduction in real GDP. Even if Greece defaulted, by itself that was never a concern of the industrialists. Greece – even adding in Portugal and Ireland and Cyprus – was too small in terms of real demand. The risk was always of financial markets contagion, especially if it led to a default of the French banks. The Germans were always less concerned about financial crisis than the French, because they had been more risk averse in their lending. However, as the crisis spread into Spain and Italy – and especially recently as Poland, the Czech Republic etc. have slowed (not to mention Brazil and India) – the possibility of a bank run has been replaced by the reality of a profits squeeze. Now even German institutions that do not need bank lending are feeling the pinch. They want Europe – to buy their heavily exported goods and services!
China Goes Pedal to the Metal
We have long argued that monetary and fiscal policy in China is like a youngster driving an electric golf cart on a pathway with curbs. They are either on or off the pedal and tend to over react or under steer depending on their last mistake. China has been slow to restart stimulus in 2012 because they did way too much last time in 2009 and set off a big inflation spiral in 2011 that obliquely threatened the Party’s control. As inflation remained a problem until very recently, they remained on the sideline. Unlike Chairman Bernanke, China’s policy makers have not yet understood that policy acts with a long and variable lag. This is in part because earlier stimulus packages have always acted quickly, due to the small size of China’s capital markets and the totalitarian nature of its banking system. When leaders said lend, the banks lent – and since there were few financial markets to practice arbitrage games, the money quickly found its way into real economic activity. However, in China now (as in many developed countries), the earliest beneficiary of stimulus is the bond market, as borrowers can refinance and investors can leverage long positions in existing bonds. Even when lending to the real economy does increase, it will be with a longer lag than usual because banks are being forced to find new conduits. They are being strongly discouraged from lending to the residential real estate market (especially developers) and they are directed to increase lending to small and medium sized businesses – an area in which they have little expertise. Lower rates and easing reserve requirements have had little effect so far, so more cuts are likely on the way – but that will not be the main thrust of policy.
Rather China is going back to the tried and true – infrastructure projects. Yes, they will talk about stimulating a consumer economy, and they will lower taxes and raise subsidies for the bottom tiers of the income ladder. They will undertake reforms in agriculture and the Hukou system of transient workers, but these will take years to generate fruit – not months or quarters. Meanwhile, China is ramping up infrastructure. In May, the disgraced railway system announced it would borrow two trillion yuan for new projects. More recently several city and provinces have announced outsized infrastructure building budgets – with one and a half trillion yuan in Tianjin and Chongqing and one trillion each in Shanghai and Zhejiang Province. Wuhan, Guangzhou and others have also announced packages. In China’s 40 Trillion yuan economy, this is a very significant stimulus even when spread over three or four years. Most projects are not shovel ready, but they ramp up over the next year should be substantial — more than offsetting the continued drag from residential real estate restrictions and getting the fifth generation of leaders off to a solid start.
Releasing the US’s Pent Up Demand
There is going to be an election on November 6th and it will clear away a great deal of the uncertainty that has been holding back the economy for the past six months. The year started strong on warm weather and then gave it back over the next three months. Recent indicators suggest the US economy is still muddling along at 2% real GDP growth — not good, not bad. The Fed indicated in its latest minutes that maybe more stimulus was on the way – probably more quantitative easing – but the data have improved since that meeting and the hawks are backing away. Meanwhile, Presidential hopeful Romney has clearly stated that he would replace Chairman Bernanke (in 2014) and doesn’t think much of QE. We expect the Fed will jawbone, and remain in a twist, but that they will await the outcome of the election on fiscal policy just like everyone else. The Fed knows fiscal policy acts with a shorter lag than monetary changes, and they do not know the degree of restriction or ease that new laws will bring in 2013. Meanwhile, while unemployment may still be too high, core PCE inflation is at the top of the Fed’s range – not threatening deflation as it was during QE1 and QE2.
Recent economic data show strength in the interest sensitive leaders – like housing – and weakness in the laggards, like capital spending and government. Unfortunately, the laggards are much bigger than the leaders these days, so the most likely path to recovery is less drag from the back of the economy rather than more lift from the front. However, less drag is a low bar to hurdle as both government spending and recent capital investment have been negative. This week’s non-defense capital goods orders report showed a 3.4% decline in July after a 2.7% decline in June. Industrial firms are on hold for capital investment and hiring until they know which fork in the road politics will take. Keep in mind that all firms are on hold and some will win no matter how the election turns out. Agreed, the business community is rooting for Romney – but even confirmation of businesses’ “worst case” outcome, with Obama reelected and Democrats maintaining control of the Senate, will provide certainty about the direction of tax rates and Obamacare. The uncertainty around these two items have hamstrung the US for the better part of the year, and no matter what the result we expect a release of some of the fortress balance sheet funding held by corporate America as they move to maximize profits in whatever regulatory environment they face. Bottom line, we believe the US is unlikely to remain in a muddle through once the correct fork in the road has been identified. There is simply too much money to be made satisfying the pent of demand of whoever wins. Meanwhile, the losers will gripe, but they are unlikely to reduce activity from already moribund levels. 2013 is starting to look like a pretty good year – we just don’t know for whom!