We are all stimulators now. In response to a rapidly deteriorating economic environment in Europe and China both regions adopted aggressive new stimulus programs, which should provide a significant lift in 2013. Not to be left behind, both the Bank of Japan and the US Federal Reserve have chosen to undertake new quantitative easing. With stimulus now gone global, the potential for growth in 2013 is significantly enhanced – but by no means guaranteed with the US fiscal cliff, European austerity, and uncertainty about governmental leadership in China, the US and Germany still to be overcome.
In Europe, the ECB has agreed to buy sovereign debt with a maturity of less than three years, in unlimited amounts – conditional on the issuing nation having agreed to a reform program administered by the EFSF or newly empowered ESM. The ECB will not expand its balance sheet in this new program, but rather will neutralize the purchases of new securities by selling existing assets from its vast $4 trillion dollar portfolio. The ECB recognizes that it is not deflation (against which quantitative easing is a powerful weapon) that is the key problem, with European inflation currently bumping against the 2% ceiling. Rather, the program is a geographical Operation Twist, as the ECB is expected to buy the securities of Spain and Italy while selling those of Germany and the Northern tier of Europe. The effect of the program will be to narrow the spreads between the two regions – basically a tax on the wealth of the Northern tier to pay a subsidy to the Periphery. Who said central banks could not carry out fiscal policy? As with the earlier rounds of quantitative easing and operation Twist, the fact that the central bank will be a guaranteed buyer means the private sector will move in advance reaping a significant transfer of wealth from the government when the central bank ultimately buys. In return, the government issues future debt on much better terms. Note that even though Italy currently says it will not ask for help from the ESM, as it does not want to submit to externally managed reforms, the markets will still buy their debt knowing that if they get in deeper trouble the ECB stands ready to buy unlimited amounts of Italian short term paper. Long term yields should fall across the periphery as they shift to issuing more short term debt at much lower rates, reducing both the supply of longer term debt and the comparative rate for the early years. Moreover, as the ECB sterilizes it purchases in the periphery, it is likely to have a considerable capital gain on some of the Northern tier debt acquired earlier ago at higher rates. Indeed, even some of its more recent purchases of peripheral issues may have substantial capital gains. Those securities pledged by banks against the LTRO may also have gains, increasing those banks desire to unwind that operation. Lots of moving parts, all suggesting stronger bank balance sheets and a resumption of credit lending in Europe.
This week the other shoe dropped in the US, as the Federal Reserve moved far more aggressively into the stimulus game promising not only more quantitative easing – but an open ended program combined with an expectation that interest rates would remain extremely accommodative through mid-2015 (matching the ECB’s three year horizon). The Fed will buy housing asset backed securities, rather than Treasuries. This is QE plus a twist, as it will narrow the spread between record low Treasuries and already record low mortgage rates. The use of open ended QE when inflation is already near the top of the Fed’s target range implies far more concern about the current situation and the possible consequences of the fiscal cliff than is reflected in their upwardly revised expectations about the real economy. However, bailing out the still suffering housing sector and lifting home process is critical to enhancing the value of banks existing capital and getting them back into the lending game. The Fed is effectively doubling down on its success with Operation Twist, which helped spark some revival in housing sales and prices via sharply lower long term interest rates. That trot may now become a gallop in 2013, unleashing a more traditional credit-led US business cycle recovery. The key is not the level of mortgage rates, which are already quite attractive to borrowers and buyers – but rather the willingness of banks to lend as their existing capital base improves and the risk on future housing investments is mitigated by asset appreciation. The Fed is clearly willing to accept a somewhat higher inflation rate in the near term so long as it is housing centric. The real question is whether it is higher home prices or something, less palatable like food and energy inflation, which comes from increased liquidity. If the fiscal cliff (or some part of it) depresses inflation just as the Fed injects targeted monetary ease it may be a very effective program – but battlefield strategy often does not survive first contact with the enemy.
Closing the Trade Gap
We spent the last week visiting economists and business leaders in Hong Kong and Tokyo to judge the depth of the correction in Asia. We believe that the weakness in China is primarily export oriented and closely tied with downside surprises from Europe since the start of the year. Now, European stimulus may lift their demand for Asia imports just as China begins to stimulate via increased infrastructure projects. China has a large multiplier effect from its export sector, and a rebound in European demand will also ramp up demand for commodities globally, sparking stronger consumer and capital goods demand from those traditionally strong takers of Chinese exports. Bottom line, a recovery in China’s export sector should raise growth from our current estimate of 5% real GDP up to the announced target of 7.5%. A key byproduct will be continued wage pressure as the inland economy has remained strong and will get stronger due to infrastructure stimulus at the same time the coastal exporters demand more labor. A developing structural increase in Chinese labor costs will lower their potential growth in 2013 and beyond from the 10% range seen earlier to 7.5% — but a cyclical recovery from current 5% growth to the 7.5% potential will still provide a significant thrust to global recovery in 2013.
A key take away from this trip is the importance of shifts in relative labor costs and energy prices in narrowing the trade gap between the US and its two biggest sources of imports – China and Japan. We had an epiphany while discussing the future of nuclear power in Japan (not good) with some experts. We realized how heavily Japanese business was dependent on cheap nuclear energy, which no longer exists – and now they are paying very high prices (especially at the margin) for crude oil based energy. Crude oil prices that are elevated in part due to heightened Japanese demand, which exacerbates the price effect of shortages caused by instability in the Middle East. Moreover, these goods must be shipped, which uses even more expensive crude oil.
Meanwhile, the US finds itself with flush with natural gas reserves and increasingly fracking technology is being used to expand production of domestic crude oil. The shift of electrical production from coal and oil to natural gas is a key competitive edge for the US during the upcoming recovery. The fact that Japan’s toughest competitor, Germany, also has started to shut down its nuclear facilities as its shifts to greater use of Russian natural gas adds to that advantage. It is important to understand that much of US electrical power comes from nuclear sources, 20% nationally on par with Japan and Germany pre-Tsunami. However, those plants are heavily concentrated east of the Mississippi, in America’s most industrial zones. Now, with fracking the US had added another energy advantage for most of the rest of the country as well. For those products where energy is a significant input, shifting plants from Europe and Japan to the US is now far more likely. Add in easier access to end user markets (logistical savings) and the desire to cluster operations and the movement of core businesses means more will follow. It is no wonder five Governors of Southern US states showed up in Japan one year after the Tsunami this week, courting potential movers with their states competitive advantages.
Meanwhile, the rising cost of labor in China is about to set off a new wave of export deflation. What? How can higher labor prices push costs down? Because the world is dynamic and firms and nations are just beginning to react to the reality that some production is being priced out of China’s traditional export market – Guangdong. Some of these facilities are moving inland to seek cheaper labor – but they are competing with state financed infrastructure projects and incurring higher logistical costs. Hence, the need for even more infrastructure investment in the western part of the mainland, where the returns will be highest. Others are relocating out of China, a handful to the US, but most to other low cost Asian markets like Indonesia and Vietnam. I was told that Burma is now the hottest location for Chinese businesses looking for new opportunities with low cost and plentiful unskilled labor, but the Burmese (including the Generals) would prefer a bit more diversification. Outside of Asia, Mexico is the greatest beneficiary of the rising labor cost in China – reversing its role as the greatest victim when the opening of China by WTO in 2000 wrecked the Maquiladora plants along the border. The proximity to a manufacturing rebound in Mexico is critical for the US as it also reduced logistics costs. Moreover, the success of Mexico’s revival has reversed the flow of immigrants – legal and illegal – just as the rise of Chinese labor costs is reversing the flow of workers from Guangdong back to the provinces. Labor mobility has always been a key comparative advantage in the US, Mexico and China not to be found in Japan or Germany.
Where does all this leave us? It appears the world is entering into a significant stimulus which should lift economic growth in 2013 from depressed levels in mid-2012. Real GDP growth, now negative in Europe, meandering at 2% in the US, and rising at a disappointing 5% rate in China could see a 3% improvement in China, 2% in Europe, and 1% in the US. True, even after the cyclical gains growth rates around the world will be less robust in 2013 that they were before Lehman’s fall, but it will feel a lot better than it has in five years. Growth raises taxes and reduces safety net spending, narrowing budget deficits far more quickly than forecasters ever predict. It also will lower the pace of new issuance in an environment when quantitative easing is absorbing a greater share of fresh debt and holding down interest rates. The healing process will still take years, but 2013 should provide a good start.