Feature Stories | Jan 11 2011
(This story was first published for subscribers on December 16, 2011).
By Greg Peel
2011, say the Macquarie economistss, probably won't look a lot different to 2010. But it will be a year of increasing divergence between the developed and developing economies.
Macquarie's view is not a new one. As the twenty-first century plays out an undertone of expectation is growing that the “old world” is on the wane and the “new world” is rising to fill the void. Only the blindly parochial disagree. While the economies of China, India and Brazil, for example, are yet to reach what we might call “maturity”, it has come to the point where the tag “emerging markets” is looking somewhat dated. It's hard to not to concede that China has well and truly “emerged”, if not yet fully “developed”.
But it has certainly developed enough that after a couple of decades of rollercoaster economic growth Beijing is much more experienced at keeping its economy in check. It has learned from observation, from history and from its own trial and error. It has been a persistent theme of 2010 that markets have momentarily panicked every time Beijing pulls in the reins. This says two things.
Firstly, it underscores the tremendous reliance being placed on China to support global growth at a time when, were there no emerging markets, the old world economies would be on a slippery slope to ruin. Pre-GFC it was all about a strong Chinese economy providing cheap exports to the world. Post-GFC it's all about the world being able to sell exports to China. China's domestic economy is that component of its overall economy which is truly “emerging”.
“Chinese consumers,” suggest the economists at Danske Bank, “are starting to have a real impact on the world”.
Private consumption in China is estimated to have grown by 10% in 2010. Danske forecasts 9.5% GDP growth for China in 2011 and 8.4% for India. Asia, the economists expect, will provide over 50% of global growth in 2011 and adding the other emerging markets brings that number to over 75%.
The twentieth century was all about US consumption. The US economy has been, and still is, by far the largest on the planet, and the consumer represents some 70-80%. But in coming years, Danske suggests, Chinese consumers will add more to global retail sales than their US counterparts.
Secondly, panicking markets tell us there remains a lack of faith in Beijing being able to do “the right thing”. There is a fear Beijing will go too far and bring the Chinese economy in for a hard landing. Yet Beijing is simply trying to restrict its economy from growing at dangerously booming double-digit rates and is targeting a growth rate closer to 8% as sustainable. All through 2010, Europe threatened to again bring the global economy to its knees. Yet China managed its way successfully through this mine field, easing on and off the brakes as the year progressed where appropriate.
The People's Bank of China is nevertheless not yet the world's foremost monetary policy manager. It is still learning. Societe Generale's economists suggest Asian central banks are still “behind the curve” when it comes to tackling inflation. They thus expect a “good deal of catch up” in 2011. Danske Bank is forecasting four Chinese interest rate rises of 27 basis points in 2011.
SocGen and Danske both thus suggest Chinese monetary policy will serve to keep global risk appetite constrained. But consensus among all economists is that the Chinese economy will not be derailed. It will lose some steam, but otherwise continue to grow sufficiently.
India, on the other hand, is still in its “emerging” phase and running in China's wake. Macquarie expects Indian growth in 2011 to be around the same as 2010, which looks like being about 8.9%. Macquarie expects that Brazil will see a more notable slowdown, but still only to levels of growth that would still be high by developed world standards.
Macquarie believes Beijing's new “five-year plan” will be most important to the global economy in 2011. Its aim is to boost Chinese domestic demand partly through a sharp improvement in household income. If ever the theme of global divergence ahead is clear, it is in attitudes towards household spending. The US is now working on a largely opposite plan.
The dilemma for Washington is that it wants US consumers to spend in order to avoid deflation and recession, but it does not want them to run up any more debt. That's how it got into such a mess. But to spend without debt Americans also need greater income and that's not going to be easy when unemployment is running at 10% and likely to stay that way for a while. Washington's focus, notes Macquarie, is thus on strengthening business investment and net exports. In the latter case, customers like China offer a wealth of opportunity.
And that's where QE2 comes in. QE2 is designed to maintain low funding levels for businesses so that they may invest, grow, and thus hire, and to weaken the US dollar so that US exports can be competitive.
There are many who nevertheless fear that QE2, on top of QE1 and past and recent fiscal measures (such as extended tax cuts), will lead to an inflation problem down the track. Macquarie notes, therefore, that at some point US fiscal policy will turn “contradictory” – stimulus measures will need to be reversed and fiscal policy tightened lest the inflation genie is let out of the bottle. The challenge here is to have put a good dent in unemployment before that point.
Can the US really reduce unemployment in a traditional, cyclical sense? Or is the issue more of a structural one? From the late nineties and into the noughties, US companies outsourced their manufacturing businesses to China and their call centres and IT maintenance to India. The objective was to remove the costly elements of the business to locations where labour was cheap, keeping the lower cost/higher profit elements at home. China and India took the ball and ran with it, but with 10% of Americans now seeking unemployment benefits, and an estimated 17% actually out of work, America wants those jobs back.
How can it get them back, particularly when labour costs and benefit burdens in the US are still far more onerous than those in emerging markets?
Yet the signs are that the US economy is actually on the mend. 2010 featured much fretting over the potential for a “double dip” into recession, but those fears have now eased. Combining recent positive US economic data and the two-year extension to the Bush tax cuts, Macquarie's economists have revised up their 2011 GDP growth forecast for the US from 2.9% to 3.5%. Other economists have at least shuffled up to the high twos from earlier low twos. As Danske puts it, “Overall we see increasing signs that the [US] recovery may finally be gaining some traction”.
And Danske points out that it is the services sector, not the manufacturing sector, which is vital to US growth. Despite the traditional focus on manufacturing, services represent 70% of US output and account for 70% of the jobs. Yet every month Wall Street jumps at the shadows of manufacturing index data from New York State, and Philadelphia, and Richmond, Dallas and Chicago, and every month the US manufacturing purchasing managers' index (PMI) has far greater sway over Wall Street sentiment than the equivalent services PMI. The services sector, says Danske, is imperative for reviving the US labour market. But progress will be slow. Danske is forecasting a US unemployment rate of 9.1% by end-2011.
Global divergence has us at the point where the US is desperately trying to encourage asset prices higher, and China is desperately trying to keep asset prices in check. Indirectly, QE2 is a response to China's artificial currency peg. While never stating it publicly, Washington wants a weaker US dollar to assist its export market and shift away from reliance on domestic consumption. Beijing wants to increase domestic consumption, so it stands to reason that the renminbi should be revalued. But Beijing does not want to make any rash moves that may threaten its GDP growth at a time when there is still uncertainty in the “old world”. And for the US, a weak euro will not help in its goal to weaken the US dollar. Which brings us to the swing factor for 2011, or to use that now hackneyed analogy – the elephant in the room.
We began 2010 with Greece providing a wake-up call over the extent of European sovereign debt, which by April had derailed the global stock market recovery which had begun in March 2009. A Greek bail-out followed, but then concerns of contagion surfaced. Those in turn were quelled by the establishment of the EU-IMF emergency fund, but by August the jig was up again as Ireland went to the wall, prompting yet another bail-out.
Westpac notes the eurozone crisis is no longer simply a case of “bond vigilantes” trying to make a buck at the expense of weak nations. Most of the troubled members are now in multi-year recessions and global markets are recognising the structural shortcomings of the common currency. Austerity nevertheless looks like the best medicine, suggests SocGen, “although unpleasant”.
But when it comes to austerity, SocGen believes the only real effort is being made by the UK with its “ambitious” plans. Europe, as well as the US, “remain hamstrung by vain and ever more desperate attempts to maintain living standards”. Without sufficient austerity imposed, Europe is flirting with default. And default is just not an option for countries like Greece and Ireland which still need to fund large running deficits, as far as SocGen is concerned.
There are other commentators who disagree, citing Russia's default in 1998 and subsequent recovery as evidence. But then the ruble was and is Russia's alone and its default did not threaten 15 other common currency partners and their banks.
The current EU-IMF emergency fund is enough to cover Ireland, Portugal and Spain for the next three years, says SocGen, but that's it. On Germany's insistence, eurozone members have until 2013 to shape up or default or restructure will be necessary. The European Central Bank will not venture into heavy Fed-style QE unless it becomes an absolute prerequisite to save the euro, the economists suggest.
Danske notes, in less alarming terms, that the PIGS (not including Italy) represent only 20% of the eurozone and that the other 80% is doing much better. Germany is “shining”, and the French economy is also gaining pace. Danske believes that things can still get worse in Europe before they get better, but that the EU and IMF will do what is necessary to protect Spain – the largest of the PIGS – from a full-blown crisis.
Recently there was also talk that if necessary the Fed would implement even more QE to direct to the IMF with the intention of providing indirect support for Europe. Nothing has ever been said since, but the US is just as susceptible to a European collapse as anyone else.
Macquarie also has Europe on its list as a major concern, and expects the first half of 2011 will see ongoing fear escalation. But with Spain “too big to fail”, Macquarie sees the “distinct possibility” of large scale intervention by European authorities.
This consensus of views suggests that 2011 is offering up a similarly bumpy road to 2010 as far as investors are concerned. Westpac suggests global GDP growth should reach 3.9% in 2011 but the risk trade will be a case of ups and downs.
It is not hard to envisage drifts up into complacency territory if the eurozone goes quiet, Germany surges on and US data continue to improve. But each Chinese rate hike will threaten such complacency in the short-term, and further eurozone blow-ups will potentially lead to more dramatic pullbacks until order can be restored.
[It is at this point I always note that perhaps the most valuable stock market trade in 2010 has been to buy insurance in the form of equity put options when markets are strong and VIX volatility levels fall into the teens, meaning such insurance is “cheap”. That trade has not failed this year and will again be something to look for in 2011. Remember that option insurance, like fire insurance, is not something you want to come good for you but you are relieved when it does, and also you can sleep more peacefully.]
I opened this article by noting Macquarie's not lone suggestion that 2011 will be a year of continuing divergence. No doubt investors will have noticed over the last year or two that Australia's markets still use Wall Street as a guide, but are no longer tethered necessarily. More and more traders are keeping a weather eye on the Shanghai index during the Asian time zone irrespective of what may have transpired in the North Atlantic time zone overnight.
The truth is that while Australia is arguably more “old world” than “new world”, its fortunes are more effectively now tied to the “new world” rather than the “old”. Westpac is forecasting 3.5% GDP growth for Australia in 2011, up from 2.7% in 2010. Central to Westpac's view is the “major boost to national income driven by the terms of trade”.
Westpac also believes US dollar weakness will persist on the back of QE2 in 2011, with periodic bursts of strength resulting from ongoing European dramas. This implies a stronger Aussie in general tempered by volatile drops due to panicked risk aversion. But Westpac goes on to suggest, “It is arguable that a view on the Chinese cycle could eventually supplant the USD trend as the key external determinant of attitudes towards the Australian dollar”.
In reflecting on QE in the US, austerity measures and possible heightened QE in Europe, and opposing policy tightening in Asia, Macquarie suggests a similar trend in in equity markets.
“The diametrically opposed policy stances between developed and developing economies,” suggests Macquarie, “could mean that equity markets, for example, also move in opposite directions. This could be one sign that increased financial market correlations that took hold in the past decade may start to decrease”.
In other words, US dominance may be difficult to shake in the short-term, and Europe will continue to give all and sundry the heebee-geebees, but 2011 is shaping up as a year in which Australia will be looking to hitch its little red wagon more firmly to the Asian steam train.
