I had the pleasure this week of attending the quarterly meeting of NBEIC in Dana Point and discussing the outlook for the US and global economy. It was attended by many of the best economists in the country representing a wide array of industry and regional expertise. The strongest conviction I came away with is that the real economy does not feel nearly as optimistic and up beat as the equity markets perception. Housing and the oil and gas industry are booming. Related industries that benefit from their liftoff are doing better as well. State and local government appears to be finally moving out of its malaise as the hard work done over the past two years takes hold. However, for every good story, a headwind remains. The federal government will become as big a drag as state and local was when the hike in payroll taxes, high income taxes and the sequester (even if muted) begin to work on the economy in 2013. Capital spending in the nonresidential construction and producer durable equipment sectors is fading as profit growth ebbs. Internationally, China is expanding – but the rest of the BRICs do not look as healthy. Japan looks promising, but Europe is still teetering on the edge of recession and has significant imbalances to work through. From our point of view, it looks like 2013 will be a year of moderate growth with risks mounting as we move into 2014. Bottom line, we see the recovery as well underway – if underwhelming – and that the cycle is nearer its end rather than just beginning.
In our view, it is the stimulus coming from China that is the greatest locomotive to global growth. The 25% of global GDP that falls in their sphere of influence is likely to grow some 3%-4% faster in 2013 as the infrastructure led building boom takes hold and lifts commodities temporarily. By comparison, Europe’s 25% of global GDP may improve 1.5%-2% as they barely exit recession and the US’s 25% may grow 0.5%-1% faster as headwinds fade. The one-eighth of world GDP represented by Japan, South Korea and Taiwan should outperform Europe – in part, because it will be stealing share from Northern Europe via the currency war. It is noteworthy that China surpassed the US as the leader in world trade (imports plus exports) in 2012 – while running a $231 billion trade surplus in comparison to the US $728 billion trade deficit. Historically, it is the leader in world trade – Persia, Greece, Rome, China, Spain, the UK, the US – which is also the world’s economic leader. Protecting trade routes also typically takes a projection of military power and makes the transition from one world leader to the next a difficult period for economic stability. We expect to face a volatile economic path in coming years as China struggles with its destiny as the world’s largest economy – yet still far from the world’s greatest military superpower.
In particular, we believe that the most important price in the world today is neither gold, nor oil – but the price of pigs in China. As most prices are controlled in China, food prices make up the biggest source of inflation – and with pork as the meat of choice, wholesale pig prices are the biggest consideration in consumer buying power. Pork prices hit peaks in 1997, 2000, 2004, 2007 and 2011 following a boom bust pattern of supply as farmers follow a mob psychology with respect to breeding. Spikes in pork prices, especially in 2011, cut deeply into even double digit wage increases. The combination of soaring wealth for the privileged – especially after the 2009 stimulus – and a real buying power squeeze on the wage earner increased tension and caught the Party’s attention. Food price inflation affecting the masses was the proximate cause behind the broadening of Tiananmen Square from a student protest for reform to a real threat to Party control. Thus, squeezing out food (and housing) inflation to improve income and wealth distribution were key reasons China did not shift to easier monetary and fiscal policy earlier in 2012.
Indeed, the economy slowed far more dramatically than expected in 2012, as the result of far weaker than expected exports to Europe. That weakness is clearly reflected in the Chinese Yuan, which actually depreciated during the spring months, before Chinese authorities became comfortable enough with the European policy shift to allow renewed appreciation. As the Yuan is still a managed currency, it is in many ways the best indicator of Chinese economic thinking and policy. Though now appreciating again, it is at a far slower rate than pre-Lehman or in the eighteen months from the start of the US recovery in July 2010 to the caution on Europe starting in 2012. Chinese authorities are so uncertain about the future strength of the export economy that they reverted to the tried and true surge of infrastructure led stimulus later in 2012 that we expect to drive world growth in 2013 and 2014.
Bottom line, being at the bottom a hog cycle allows China to be aggressive on monetary and fiscal policy. We are seeing major moves on income redistribution via subsidies for the poor, taxes on the wealthy, demands for higher dividends from state owned enterprises, and the first vote for an independent (as opposed to company) union at Foxxconn. Agricultural reform is also at the top of the list for the new leadership, especially concentration into larger farms as they move the people into cities from the countryside. We expect 2013 to be a year of increasing stimulus as the Chinese move to address their most pressing imbalances. An opening of domestic financial markets to allow greater competition should lead to higher interest rates, especially as wealth management products grow in importance. There are likely to be more moves to increase internationalization of the renminbi exploiting their leadership in international trade. Investments in foreign sources of raw materials – by both state and private sources – and resource stockpiling are likely while inflation is still low. We see a lengthening lag between policy implementation and its inflationary consequences in China as the result of deeper financial markets. Despite calls for slower more balanced growth within China, we expect the reality to be more growth than expected (as a result of strong stimulus, but low inflation) in 2013 and then more inflation late in the cycle.
While many will be waiting on a rise in interest rates to mark the end of the US cycle, we will be watching Chinese monetary and fiscal policy. By late 2014, when we expect the next global downturn to begin, China will be 25% larger than today in nominal dollar terms – and the emerging Asian market and global commodities producers within their sphere will be at least 15% larger as well. A tightening to head off renewed food inflation – or worse a policy mistake – will have significant global repercussions. The ripples in economic policy emanating from the Lehman crisis in 2008 have been the dominant driver of policy and economic growth in recent years. Even China’s massive policy stimulus in 2009 had less global impact than the Greek crisis a year later or the Japanese tsunami two years later. However, we believe that the next big ripple in the global markets will come from Asia – in part because Europe and the US will be enjoying less volatile growth in the next two years as earlier ripples work out of the system.
Ultimately, it may be that the US never gets to the point of significantly tightening monetary policy before the next global slowdown hits our shores. Chairman Bernanke has virtually guaranteed that he will not raise rates before late 2014, and we take him at his word as it does not look like falling unemployment will be a source of significant US based inflation until then. It is far more likely that already tight Chinese labor markets will generate inflation in China as any world rebound increases demand for their exports and pushes their wages higher. The interaction between Chinese wages and food prices will determine when and how aggressively China tightens fiscal and monetary policy. They are almost certain to be the first major trading nation to begin tightening, and likely well before there is any need to in the developed countries. How Chinese tightening will ripple through the commodities markets, especially oil, and effect consumer spending in developed economies will determine the shape and depth of the next world slowdown. Fortunately, we expect to have many quarters to prepare for that culminating event.