We spent the last couple of days in New York visiting with traders, investors, economists and entrepreneurs. First, one should note that these are four quite distinct groups with significantly different outlooks on the economy. Our strongest take away is that Wall Street’s optimism about the positive impact of the recent rise in the equities market is not shared by all. Investors in the bond markets, some economists, and many entrepreneurs – especially those operating in the emerging markets – feel the rise in interest rates has gone too far, too fast, and is more than offsetting the positives from rising equities and home prices. Of course, the market is always made up of many opinions, but the disparity in views seems more pronounced – particularly on the question of whether and when the Federal Reserve will begin to reduce quantitative easing. At one end of the spectrum, some note that it cannot go on forever and so markets must begin to anticipate an end. At the other, some argue for even more QE noting, like Rosengren, that with unemployment too high and inflation too low the Fed is missing both its targets. The consensus appears to be that tapering will not occur until year end – but many in New York believe that it will have to be addressed by the September FOMC meeting. Despite Chairman Bernanke’s best efforts, most still see tapering as a mono-directional and moderately paced removal of bond buying – and virtually all see a reduction in the pace of QE as restrictive, even though the Fed’s balance sheet would still be increasing. Thus, most market participants are primed for a rise in interest rates, viewing the recent volatility as just the first episode.
The key question is how high interest rates will go before it damages the economy – both here and abroad – and forces a change in perception, as it has in each of the past three years. Optimists see the US returning to a 5% nominal growth path as early as the third quarter – which, by the way, starts in three weeks. They argue for a rebound in third quarter growth after a soft second quarter, and for a fading of government drag after the sequester ends leading to a brighter outlook for 2014. Even stronger housing activity, energy independence, and a pickup in profits, which generates nonresidential investment and increased hiring, lie at the core of this view. We see this view as very US-centric, basically arguing for a reversion to normalcy after an extended period of correction due to the deep Lehman recession. Interest rates will go back to normal, with long term rates somewhere near nominal GDP growth. PE ratios will go back to normal, providing lift to wealth and a positive underpinning for spending. True, we would climb a wall of worry, but with labor available, commodities prices easing, and interest rates still low by historical standards, growth would prevail and generate a self-fulfilling expansion. We are not in this camp.
We are not pessimists, in that we do not see the end of this economic cycle for at least another year or two. However, we do believe we already saw the best growth for this cycle following the peak of stimulus in 2009. We believe that we are in the wind down phase, where a lack of profit growth will erode CEO’s desire to hire or invest – and that is especially true in the emerging markets, which have been the engine of growth for the post-Lehman expansion. We had this view reinforced by enough New York voices that we do not feel we are out of consensus. Indeed, we think we are at a critical point because there does not seem to be one consensus, but rather many competing views that will be worked out over time – and perhaps soon given the volatility in the financial markets.
At the core of our view on the economy is the belief that you can no longer look at the US as an independent or isolated market. We live in a global economy, and one of the most prevalent issues today is the need to adapt global politics to match the global reach of multi-national corporations, banks and non-bank lenders. We see the shift to a global economy as the logical extension of the expansion of the US economy below the Mason-Dixon line and beyond the Mississippi that occurred in the postwar period. WWII defense needs had already broadened the industrial base in America, and when the rebuilding of Europe and Japan required ongoing US production, private businesses tapped the previously underutilized resources of the south and west, leading to a long investment boom. In that transition, the northeast become the financier and service provider for the US, but over time lost much of its manufacturing base to lower cost regions. In effect, the northeast became the suburbs, while the south and west increasingly became the factory floor. When we worked on Wall Street in the early 1980’s with Gary Shilling, one of our main jobs was to travel around the country to Atlanta, Texas, California, upstate NY, St. Louis and Minneapolis advising industrial companies on the shifting economy. We covered interest sensitive areas like housing and autos, and focused on the firms in heavy industry that were most sensitive to the economic cycle. What we learned is that to see a recession coming, you have to be on the factory floor. Recessions are milder and come later – if at all –in the suburbs. Wealth provides a great deal of protection and insulation. Today, we see the US as the northeast and the suburbs, and Asia as the global factory floor.
What worries us most is the credit crunch and rapidly rising interest rates that we see underway in Asia and other commodity producing emerging markets, like Brazil. Since its admission to WTO in 2001, the rise of China has been the driving force behind the global economic cycle. Cheap Chinese labor provided a deflationary burst to consumer buying power in the developed world even as it competed away manufacturing jobs. Growth in finance and other service related jobs – including government post 9/11 — accounted for most of the growth in the US and Europe. Only technology oriented industries were immune from the influx of Chinese goods – which merely replaced the floods of Japanese, Korean and Taiwanese goods that had preceded them. The lower cost of Chinese labor also called out higher prices for global commodities, expanding the boom in the emerging markets. Multinational companies and lenders followed the money and expanded their operations in these emerging markets – pumping up returns to investors back in the developed world. The tried and true pattern of broadening the existing economy to cover a wider audience reached a massive scale with China and the emerging markets. Indeed, the importance of this shift was so great that China played a major role in stemming the Lehman crisis with its overzealous stimulus in early 2009. After going to another round of infrastructure building in mid-2012, it is increasingly clear that China has reached the end of its boom phase and will be growing far slower in the next decade, like Japan, Korea and Taiwan before them. Just as the Nikkei crash marked the top of the cycle in 1990, and the Asian crisis in 1997 was the beginning of the end of that cycle, we look for problems in China to be the proximate cause of the next downturn – probably still several quarters off given their strong reserves.
However, economic cycles end – after a lag – when interest rates start rising and new investment slows. In the recent back up in global interest rates, there has been a rush for safety to the financial markets of the suburbs. Investors in the emerging markets include risk-takers and those reaching for yield. When they return to the US, they are not going to move all the way down the risk curve to 2% ten year treasuries. Investing in multinationals is the safer way to play emerging markets. The rise in EM interest rates has been profound as it includes not only the rise in the risk free rate, but a significant widening of risk premium as well. Moreover, the rush to the exit drives down demand for local currency while strengthening the dollar (or Euro) – adding translation costs and risk to borrowing in foreign currencies. With the global commodity super cycle apparently at an end after high prices proved the cure for high prices, the EM is looking a lot riskier – at these prices.
Nowhere have interest rates risen as quickly as in China. True, the government has not raised interest rates – but the cost of new credit has jumped for provincial governments and state owned enterprises who are the major takers of bank credit as lending has moved from bank loans to wealth management products. A recent evaluation of state finances indicated more than two-thirds of the $50 billion in new provincial debt in 2011 was via these high rate products. Given that 10 provinces have debt in excess of 100% of their revenue and 20 have debt service in excess of 20% of revenues, higher interest rates will require central government intervention sooner than later. China has vast reserves, but the new leadership appears to want slower, more manageable, growth as a centerpiece of its ten year plan. Bottom line, we see trouble from higher interest rates on the global factory floor, and we expect an economic correction as a result within two years. The correction will be felt less in the suburbs, but we doubt that it will be avoided completely. Every cycle has its seasons, and we see the global economy as past Labor Day, but not yet Halloween.