Things are certainly looking up for the world economy. The US House of Representatives has proposed a three month extension to the debt ceiling – in exchange for a budget from the Senate as opposed to another continuing resolution. Chinese economic growth surprised to the upside in the fourth quarter with ongoing stimulus promising further improvement as the year goes on. Japan has engineered a sharp decline in the value of the yen, providing needed stimulus for their long moribund economy. Even in Europe, where a cheaper yen hurts the most, lower interest rates and economic reforms in the Southern tier are paving the way to recovery. True, there is still bad news, but it is increasing concentrated in the lagging sectors of the world economy – and that includes the capital goods intensive north of Europe – while leading interest rate sectors like housing and autos in the US, bank lending in China, and exports in Japan look brighter by the day.
We anticipated several months ago that the doom and gloom that prevailed in the world economy late last year would bring about new stimulus that would lift 2013 (and probably 2014) — and it has. For the next several quarters, the direction of world growth should be unambiguously better. What happens latter in 2014 depends on how effectively various international policy makers remove their stimulus as the private sector improves. We do not expect a 1937 style mistake. Rather, the risk lies in too much stimulus for too long – especially in China, where thanks to financial market liberalization, new lending is happening at far higher interest rates than in past cycles. If we had to pick a most likely reason for the next downturn, China’s mismanaging its first free market banking crisis would be at the top of the list. Few other countries have managed their rise to global locomotive well and China has less experience and less depth of leadership in policy areas than most. However, that is a discussion for much later this year. It is not what might go wrong, but what is going right that dominates the economic outlook in the near term.
For the US the dual disasters of the fiscal cliff and the debt ceiling have apparently been avoided. By kicking the can down the road, Congress is buying time for the economy to recover and provide alternative policy paths. This is a tried and true method of governing – which has worked to maximum effect in Europe where can-kicking has delayed, perhaps permanently, a Lehman like disaster from the break-up of the Eurozone. Business leaders are making it clear to their political allies that they can deal with the higher taxes now enshrined in law — but not if the economy rolls over due to another political blunder like 2011’s downgrade debacle. Meanwhile, Congress is already lining up to do what it does best by increasing spending for disaster relief and voting to increase federal employee pay. Spending restraint, if it ever comes, will be beyond the horizon of the next election. Indeed, the battle over spending restraint may well be delayed until the next election cycle and no impediment to growth in 2013 or 2014.
Meanwhile, businesses appear to be moving from the clean-up stage of the recovery to actual expansion. Various financial firms have reached settlements with their creditors, clearing the decks for new lending. Both the housing and automobile sectors are testing production levels that are above their currently atrophied capacity. Thus, though both industries are well below their peaks in 2007, they now need to expand to meet demand driven by low interest rates. Competing for the benefits of a growing pie is always a more productive phase for growth than fighting for market share. Similarly, state and local governments will enjoy their first year in five without cutbacks. We still expect state and local government to be a drag on overall growth – just less of a drag as they expand very modestly instead of contracting at a 4% annual rate. Overall, the economic tide appears to be rising – though high tide is still a long way off. Hopefully, the rising tide will raise all boats.
Full Steam Ahead
China appears to be ramping up its already considerable stimulus with plans to increase lending in January by one trillion yuan. This is in part because the Chinese New Year has moved from January last year to February this year, but it also reflects the pent up demand for lending needed to conduct the infrastructure projects already underway. In China, provincial governments only account for 30% of their own spending – the rest is imposed by the Central Government. Weak real estate markets has crimped provincial government revenues – which have primarily come from selling land – forcing the Central Government to fund more projects directly. This was fine last year, as Central Government revenues were growing far faster than GDP. However, as the Central Government has moved to shore up consumer income by raising thresholds on various taxes and increasing payouts to the most impoverished, revenues are now shrinking as a share of GDP. Opening Chinese financial markets to foreign investors thus serves both to advance the development of the industry and to provide the government with greater sources of funds.
China reported 7.9% growth in the fourth quarter compared to a year ago – and can be expected to report even stronger growth in the first quarter. That is simply because they stuck all the weakness back in the first quarter of 2012, which reportedly grew at just a 6.3% annual rate, while growth over the rest of the year was north of 8%. When the first quarter is dropped from the yearly calculation, first quarter year on year growth will certainly be above 8% — maybe as high as 8.4%. But then again, revisions are likely to redraw this path as necessary. The key is that China was surprised by European export weakness last year and then distracted by the Bo Xilai incident and infighting over the transition of power. Like the fiscal cliff, that is all in the rear view mirror now, and 2013 should offer a clear path to expansion – with the first clouds on the horizon somewhere late in 2014.
Why a Weaker Yen Works
We have never been a fan of beggar thy neighbor policies like engineering a decline in one’s currency to boost export sales. It is short sighted in nature, lifting sales in an already exposed and weakened industry, while making it easier for foreigners to acquire and control those technologies that show real promise in the future. One of the ways that Japan has survived its long economic malaise is that the strong yen was a constant threat to export dominance which forced their international companies to remain at the cutting edge of technology. Now, Japan is committed to a policy of weakening the yen to ignite inflation and end its long economic slumber. Surprisingly, it might work for three reasons: 1) the weakening of the yen is not really a weakening, but rather — like Switzerland before it – a reversion to prior standards. Between the Asian Crisis and Lehman, the yen never traded at parity to the dollar (below 100 yen per dollar) but since Lehman it always has. 2) A sharp decline in the yen will significantly increase the price of imported oil, accelerating the pressure to restart the nuclear reactors shut down after the Tsunami. This is right in Prime Minister Abe’s wheelhouse as it provides an immediate improvement in trade and lowers energy costs to domestic users effectively cutting taxes. 3) Japan’s second biggest import after energy is foreign earnings on capital, which will also be enhanced by the weaker yen. Money put out since Lehman will actually come home at an appreciated value. Bottom line, Japan’s big foreign investors (banks and insurers) will be strengthened, as will small investors’ and pensioners confidence in these institutions. Any boost in confidence based on better foreign returns should help domestic consumption – long the weakest link in the Japanese economy. The end of the strong yen may slow Japan’s corporate competitive drive over the intermediate run, but right now it will provide a much needed boost to growth.
Drawing the Short Straw
The improvements going on in Asia and the US leave Europe the odd man out – especially Northern Europe. They are already crying foul about the strengthening Euro after their timid quantitative easing left them with the strongest currency in the developed world. However, for global growth the certainty of knowing who drew the short straw is a plus. An economy is at its weakest when growth is imploding and everyone is at risk of losing their jobs or their profits. However, the bottom comes when it becomes clear who was the biggest loser — as someone goes out of business and the rest can limit their layoffs. At that point profits start to recover for those who survived, and reduced fear of unemployment limits further reductions in consumption. Once the unlucky few have been identified, like in a game of musical chairs the survivors can start to play again. Until the recent round of elections, it was not clear who would be left holding the bag. Now that we know it is Northern Europe – and most importantly, since Northern Europe has the wherewithal to survive its losses – the great global economic game can start anew.