The die is cast

Now that Royal Assent has been gained, the European Union (notification of Withdrawal) Act 2016-17 is in force and the only impediment to Britain leaving the EU is for the Prime Minister to write to the EU to trigger Article 50 of the Maastricht Treaty. This is expected in the next two weeks.

The die has been cast and this British action will lead to many repercussions, not all of which are visible today. It is however true that whilst leaving the EU is a very clear demonstration of British sovereignty, it is those repercussions that will determine just how effective and valuable that sovereignty is in today’s world.

Firstly, with regard to the EU, the deal we gain through the next 24 months of negotiations will primarily be a function of what sort of relationship the EU wishes to have with Britain. It may well make economic sense for both sides to have an essentially free trade regime in goods and services, very similar to that which exists currently. However the EU also has political objectives, prime amongst which is that any deal must look and be worse than remaining within the EU and its single market, in order to deter other countries from following the UK out of the exit door. Anti-EU views are gaining ground in France, Italy and Holland, all founding members of the EEC. Some degree of economic loss will be acceptable to the EU in order to achieve these political objectives, and though this may be higher in absolute terms than the loss to Britain, that economic loss would be much smaller as a share of their total economy than for Britain.

Britain’s economic fortunes are thus dependent on the political calculations of the rest of the EU.

Secondly, with regard to the USA, a “special relationship” may or may not exist, but if it does it has always been on US terms. Pre-Trump, the UK was an invaluable bridge between an inherently individualistic US political philosophy and an inherently social European one. – Britain was able to explain and translate each side’s thinking to the other. By leaving the EU this role is hugely diminished, though may still apply to defence matters.

With Trump as President, the picture is more complex. Trump sees Brexit as part of the same changing political tide that saw him elected and Britain’s need for a series of bilateral trade agreements fits very neatly into his philosophy that the US should only negotiate bilaterally in order to maximise its own influence. He clearly enjoys visiting his properties in Scotland and he may wish to be seen rapidly concluding a trade deal with Britain in order to contrast trading relationships with other developed world economies with those of less developed economies such as Mexico and China which he believes have been detrimental to US jobs.

He is though very unpredictable, and would likely seek some painful concessions from Britain, in order to demonstrate that he had “won” the negotiation. Britain would thus be dependent on his capriciousness, both in any trade deal and more widely in global affairs.

Thirdly, China sees itself as a key world power that is happy to make agreements with other countries, but is not very interested in negotiating them. It prefers to set out its terms and wait for others to agree to them. British sovereignty would extend to deciding whether or not to agree to what the Chinese want.

These 3 giant entities (EU, US, China) account for 57% of the global economy and an even greater percentage of UK goods exports – the fate of the British export sector and thus the wider economy is very much in their hands. Britain can only “take” what they wish to “give”. In relation to the size of these economies, Britain, though the 5th / 6th largest economy in the world, has little negotiating power.

Of the other countries who have expressed an interest in early free trade deals with a Britain outside the UK, both Australia and India have indicated that a key objective in any such negotiations would be greater freedom for their citizens to come and work in the UK. This is directly counter to the British government’s policy to substantially reduce immigration. In addition all the nations seeking trade deals are a very long way from Britain and international trading relationships display very strong correlations to geographic proximity.

British sovereignty has been dramatically exercised – the die has been cast – Britain is about to set out on a new independent path for its economic development – its fortunes, however, certainly in the next few years, now depend very heavily on the actions of others. Re-asserting sovereignty may feel liberating now but be economically painful in the future.

 

Reasons to be fearful… The German economy

Since the onset of the eurozone crisis in 2011, and the ensuing austerity across the Mediterranean, the health of the eurozone economy has been dependent on Germany and the desire of the German consumer to buy goods and services from the rest of Europe. Given the German cautious savings mentality and aversion to spend this has rarely been a winning economic strategy, but in fact the strength of the German labour market has given some succour to the eurozone economy in recent years.

This strength came from the jobs and pay from the German capital goods and autos sectors, demand for which held up due to strength from two key export markets, China and the Middle East. Over the last eighteen months, however, both of these economies have seen significant weakness. The Chinese government has reversed course on the massive public infrastructure investment programme it undertook from 2009 onwards and is now looking to rebalance its economic demand away from exports and investment and towards domestic consumption, where apart from autos, German industry is not well represented. While the oil price was comfortably above $100, then the oil exporting nations of the Middle East had lots of money to finance investment spending in their economies, but now that oil is trading below $50, this spending has dried up.

So these cyclical trends were already pointing to a slowing in demand for German goods and a consequent impact on German consumer confidence. In recent weeks there have two further hits to the German economy.

First, the extraordinary response of the country, led by Angela Merkel, to the refugee crisis, which will see 800,000, or 1%, of the population, immigrants allowed into the country in the near future. In the long term, as these people find jobs and pay taxes, this will be seen as supporting the German economy that was beginning to worry about its ageing population, but in the short term the economic impact is more likely to be a burden to the German government, since it will widen the budget deficit and this will likely lead to a tightening of fiscal policy elsewhere to remain with the balanced budget rule that Germany has now put in place.

Second is the Volkswagen scandal which erupted last week over the software coding in VW’s diesel cars that was designed to deceive regulators testing the emissions of these cars. This appears to drive a stake through a core German industrial USP, that of reliability, trustworthiness and quality. VW is the country’s largest employer and embodied much that the Germans felt good about themselves. It is too early to judge the effects of this scandal but they could be very significant not just on export demand for VW cars, but all German cars and possibly other German products too. Aside from this is the neagtie impact on the psyche of the German worker and consumer, who has never needed much excuse to feel they must save more now and spend less.

The new balanced budget rule means that a weaker German economy now leads directly to German austerity, and a further hit to the outlook for the eurozone economy.

The world economy needs more German spending not less. The German and Chinese economies are the two major creditor economies left in the world today – with the other major world economies running trade deficits, new demand in the global economy needs to come from consumers in these creditor economies. Without it, as is now looking increasingly likely, the global economy will remain very weak, and policy makers have few policy levers left to pull to boost it.

ECONOMIC AND MARKETS OUTLOOK FOR 2014

Economic outlook

Five years on from interest rates being cut to almost zero in most Western economies, and the introduction of QE programmes in the US, UK and Japan, the global economy finally seems to be moving onto a more secure footing.  Risks remain though, particularly the high levels of government and consumer debt in most Western economies, which remain a constraint on future growth.  In addition, the weakness in inflation indices and continued high levels of unemployment, mean that a renewed global economic downturn, in the immediate future would be very damaging, as there would be very little policy flexibility to offset economic weakness.  Our regional views are as follows:

  • The UK economy has been recovering strongly since last spring when the Help to Buy scheme was announced.  This recovery has been led by housing and mortgage demand, rather than by the business investment that is required for a healthy and sustainable economic recovery.  However, the consumer can drive a continued recovery through 2014 and up to the 2015 election, if savings rates continue to fall.
  • The US economy has entered 2014 growing at a near 3% pace, and this is expected to continue for 2014.  As in the UK, business investment is still a problem, as companies appear far more concerned with growing dividends and buying back shares to boost their share prices than by investing for future growth.
  • The European economy is still struggling. Growth should be positive in 2014 after close to zero in 2013, but recovery will be constrained by continued austerity by most governments, negative inflation rates in many peripheral economies, and by banks still seeking to reduce their loan books ahead of the ECB’s Asset Quality Review later in 2014.
  • The Japanese economy continues to respond to Abenomics.  The increase in the National Sales Tax from 5% to 8%, which will take place in April, will mean a strong first quarter but a weak second quarter.  However, the Bank of Japan has indicated that it is ready to increase its already large QE programme to mitigate any economic weakness.
  • In Asia, Chinese growth is slowing as the  authorities there are seeking a rebalancing of growth away from the wasteful over-investment seen in recent years towards greater consumer spending.  Higher wages have been a key part of this, but this has been funnelled into property speculation rather than consumption.  The central bank is trying to deflate the housing market without deterring the consumer from spending.
  • Other emerging economies are facing problems as the improvements in growth elsewhere are impacting the flows of financial market liquidity, which have been supporting them.  Current account deficits in Brazil, Turkey and South Africa, are now causing falls in their currencies and higher interest rates in response, which will lead to weaker growth in 2014.

2014 should see the world economy move back towards a more normal pace of growth.  For central banks, the dilemma is when to move back to more normal settings for monetary policy.  We believe that official interest rates are unlikely to rise in the West during 2014, as it is likely that central banks will err on the side of risking creating inflation rather than risking creating more unemployment.

Markets outlook

Entering 2014, the consensus amongst most investors on the prospects for the global economy and for stock markets in 2014 is one of greater optimism than for several years.    However the two factors of improved economic prospects and stronger financial markets, do not necessarily occur simultaneously.  Indeed, stronger economic growth has already led to the Fed tapering its QE programme, and investors bringing forward their expectations of when interest rates will begin to rise.  Typically, the financial markets perform well in expectation of improved growth, but when that growth appears, the liquidity in the financial markets is then needed by the real economy for investment.  This tends to mean rising bond yields and falling P/E ratios, and subdued investment returns.

For the UK markets in particular, the domestic pension funds have experienced a significant improvement in their funding position from the combination of rising equity prices and rising bond yields. Many schemes are being advised by their actuaries to take advantage of this improvement and to “de-risk” their portfolios by reducing equities and buying index-linked bonds.

Within bond markets, we are not particularly hopeful of much in the way of returns in 2014, and hold UK index-linked bonds for their favourable tax treatment, and the option they provide should UK inflation expectations increase.  Emerging market government bonds issued in US dollars now offer attractive yields for the level of credit risk that they bring (such as those witnessed in the recent poor economic developments in Turkey and Argentina).

We favour UK commercial property, where we believe that the market cycled has reversed from falling rents and capital values to one where rents and capital values are rising.  The yields on commercial property are also attractive compared with those available on bonds and equities.

Within equity markets, we favour: (i) Japan, but with the yen exposure hedged, as the Bank of Japan will continue to print money until economic recovery and inflation appear well-set; (ii) UK smaller companies, which for many years have not delivered the extra performance over large and medium-sized companies normally achieved from such investments – the current strength we are witnessing in the UK domestic economy should be reflected in better performance from smaller companies;  and (iii) Asia, where valuations are historically below average in absolute terms and long term growth prospects remain strong.  We have a neutral view on the larger companies in the UK equity market, with valuations on the FTSE100 Index near their long term averages.  The market would benefit from weakness in the pound, as profits in the second half of 2013 have been hurt by the strength of Sterling against the Dollar, Euro and Yen.  We expect the Dollar to be the strongest currency in 2014, but would expect a stronger Pound against the  Euro and Yen.

We are more cautious on the US and European equity markets.  In the US, corporate earnings expectations are already very high, and the valuations on those expectations are also at historically high levels, so strong performance from US equities will be difficult to achieve.  In Europe, in addition to high expectations of earnings growth and above-average valuations, as in the US, the growth outlook also remains subdued, bringing an extra degree of risk to European share prices.

We expect equities to outperform bonds during 2014, as they did in 2013 but expect the year to be both less profitable and more volatile for investors.

 

China Gold; Asia Hold

One of the themes emerging from the Chinese press in recent weeks has been their call for the world economy to become “de-Americanised”.  This was especially apposite during the debt ceiling crisis when it appeared possible that the US might default on a repayment of Treasury debt, because Congress would not extend the debt ceiling.  The knock-on effects throughout the derivative and financial markets might have been as cataclysmic for the global economy as was the failure of Lehmans five years ago.

It is the primacy of the dollar, acting as the world’s reserve currency, which gives the US such huge influence over the world economy, and the Chinese have been steadily seeking to reduce this hegemony.  They have reached agreements with Russia, Brazil and Australia, their key sources of commodity imports to transact in Renminbi, rather than US dollars, the usual currency of account for commodities.  In addition, they have been working closely with the UK to establish London as the major financial centre for offshore renminbi transactions, with the long term objective of making the Renminbi a key currency in global markets.

It is not in China’s interests however, to destabilise the US dollar.   In 2000, China owned about $600,000,000,000 (six hundred billion dollars) of US government debt, which was then about 2% of the debt owned by the general public).  By July this year, that had increased to $1,300,000,000,000 (one thousand three hundred billion dollars), about 11% of the publicly owned debt, and another $700,000,000,000 (seven hundred billion dollars) in US mortgage agency debt. This has made the Chinese quite critical of the US on occasions, with regard to the inflationary impact of the QE policies pursued by the Fed, and recently when there was the possibility of a default on Treasury debt.

In fact, the share of US dollars in the Chinese foreign exchange reserves has been falling as they have diversified into other currencies, including gold.  China’s gold reserves were disclosed at 1,054 tons in April 2009, but since then China is thought to have been producing more gold than any other country, none has been exported, and imports of gold into Shanghai and Hong Kong have been consistently strong. Gold commentators believe that China has about 3,000 tons of gold currently and may be targeting 10,000, which is in excess of the US reserves of 8,000 tons.

This month sees the Third Plenum of the Chinese Communist Party’s 18th Central Committee. Traditionally the first two Plenums for each Committee are concerned with personnel matters for the government and party leadership.  Third Plenums have historically been used to announce new structural reforms for the Chinese economy  and to reveal the major economic policies and direction that they would like to follow over the remaining 4 years in power.

For Xi Jinping, the Chinese President, the Plenum comes at a critical time in China’s economic development.  After two decades of rapid export-led growth, the 2008 crash saw China implement a massive debt-funded infrastructure spending programme, much of which has been inefficiently used by the state-owned enterprises.  Western demand for its exports remains muted, and the only long term solution to maintaining rapid Chinese growth is through Chinese domestic consumption.

However, Chinese consumers are huge savers, since there is no pension system and falling ill in China is a very expensive matter – the development of a welfare system is important in encouraging Chinese consumers to spend more and save less.  Further, there are few legitimate outlets for their savings – interest rates on bank deposits are below inflation and the stock markets have been poor performers standing well below the peak levels seen in 1993 and 2007.  Property has become the favoured investment class, which has resulted in an enormous house price boom across the whole country, even in the cities where nobody currently lives.  Alongside economic reforms, the Plenum will be closely watched for any proposed political reforms, though experience suggests these will be very limited.

We expect the Third Plenum in November to continue to emphasise that China’s growth will increasingly come from its domestic consumers, so that companies will be expected to continue increasing wages and some small steps towards a larger welfare state.  Financial market reform, aimed at extending the reach of the Renminbi is also expected.  Such moves will give consumers the confidence and ability to boost their spending and support the development of the Chinese economy and the surrounding Asian economies.  Growth in Asia should be stronger than in any other region of the global economy and led by businesses meeting the needs of the Asian consumer rather than merely seeking export markets.   This was the phase of Western economic development that had the greatest impact on asset prices and supports our long term optimism for Asian financial markets and the significant role they play in our portfolios.

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

China – now the world’s most important trading nation

Recent data have shown that in 2012, China overtook the USA to become the world’s most important trading nation. On the basis of aggregating total imports and total exports, China’s total international trade amounted to $3.87 trillion, and that of the US was $3.82 trillion. Given that the Chinese economy is only one third the size of the US economy, China has become the most significant trading nation on the planet in terms of both absolute trade and its importance to their economy.

The turn of the twentieth century was when this title last changed hands, when it moved from the UK to the US, and in the following decades the more populous and faster-growing economy (then the US) meant that it became a more and more powerful force in the world economy, culminating in its currency becoming the world’s primary reserve currency.  This status accords a huge advantage to the holder, in that there is an underlying demand from all other nations to hold the reserve currency in order to maintain the ability to trade.  This has been clearly visible for the US, as the dollar makes up the largest proportion of foreign exchange reserves, and most trade in commodities is conducted in dollars.

The dollar is not going to lose its reserve currency status overnight – the yuan is not yet freely convertible and today barely features in the international financial markets. However China’s stated ambition is that it will become the world’s primary reserve currency and take on that role from the dollar.  Since 2005, however, China has slowly but steadily been internationalising its financial markets by (i) allowing more foreign exchange trading, (ii) the issuance of yuan-denominated bonds and (iii) giving more access to foreigners wanting to invest in China’s stock markets.

Just as London maintained its presence as an important centre for financial markets as the US economy and New York overtook it in the twentieth century, though losing market share, so in the this century will Asia and China become the key centre for financial markets.  Success in the investment world in the next few decades will require substantial exposure to Asian markets and an increasing understanding of the impact of Asian economic policies and decisions on our own economy and markets.  We maintain a heavy commitment to Asian equities in portfolios.

Buy Asia

It has been well understood for some years now that the driving force of global growth over the next decade is most likely to be the rise of the middle class consumer in the larger emerging economies, mostly in Asia.  This argues for heavy exposure, on a long term or secular view, to Asian stock markets and those Western companies that are successful in selling to the Asian consumer.

This secular view does however, from time to time, encompass cyclical periods of weakness, and the Asian stock markets have endured such a period over the last year and a half.  Current price levels in Asia provide an excellent opportunity for investors to buy into the key secular trend at a cyclically opportune moment.

The recently announced change in Chinese leadership has, arguably, inhibited the Chinese leaders from taking stronger policy action to support its economy, as attention within Beijing in the last year has focussed on internal Party matters, rather than the state of the economy.  The economy has been surprisingly weak for several quarters, and the official data was even permitted to show the last quarter as delivering 7.4% growth, which is slightly below the government’s 7.5% target. Other data from non-government bodies have appeared to show a much weaker economy this year.

The two major issues holding back a more supportive economic policy have been sharply rising food and house prices, both of which hurt the poorer sections of Chinese society.  In recent months however, both of these areas have shown distinct slowing in their inflation rates, and this has given policymakers more scope to ease policy. The economic data published over the last two months have also indicated signs that the tide of the economy is clearly stabilising and may be turning up.  The reason for this upturn seems to be an improvement in Asian consumer demand, rather than export demand from the West.  China’s new leadership team will thus be taking over at a good moment.

The Shanghai stock market has been a very poor performer since its peak in 2007, and has only been lower than current levels in late 2008.  Turnover in the Shanghai market is currently very low and is dominated by private Chinese investors seeking to make short-term trading profits.   Interest could easily be revived by some good news from the Chinese economy as valuations are historically low.  The other Asian markets, with their greater base of institutional shareholders (particularly foreign) and more-established, better-governed companies, have outperformed the Shanghai market, but valuations are still well below historic averages at a time of above-average profitability.

The secular thesis of much stronger growth in Asia than in the West is still very much intact; the recent cyclical weakness caused by a tightening of Chinese policy in 2011 and the slowdown  in Europe, China’s largest regional trading partner, has led to underperformance of the Asian equity markets over the last eighteen months. Recent data give grounds for believing this cyclical weakness is ending and that now provides an excellent opportunity to increase investment exposure to Asian equities.

The time is ripe for politicians to act

Next month’s US Presidential election has been a very firm check on any significant economic policy action by politicians not just in America but also in Europe and China.  It has been left to those in charge of the Central Banks to make all the policy running this year.  In response to the weakening economic data and political stalemates over the last six months, both Bernanke and Draghi have taken it upon themselves to take significant policy action and encourage their politicians to do the right thing.

This year, being an election year, it proved impossible to get any bipartisan agreement in the US on anything to do with the budget deficit – the Republicans insisted on no tax rises of any kind, and the Democrats were not prepared to contemplate any spending cuts.  Instead, they created an outcome of Mutually Assured Destruction, in which in the absence of any other agreement before the end of this year, substantial tax increases and spending cuts will automatically take effect from the start of next year.  If fully enacted, these policies would undoubtedly push the US economy into recession in 2013. It is only after the election in early November that the politicians will begin to get to grips with this issue.  The world economy needs a compromise to be effected between the two parties, assuming, as currently appears likely, that one party does not hold all three of the Presidency, the Senate and the Congress.

Markets are currently expecting that such a compromise does in fact occur.  The best time for any politician to make a politically difficult decision is immediately after an election, when any future electoral consequences are as far away as they will ever be.  Mr Bernanke has indicated that he holds an insurance policy in the event of no agreement and he will become much more aggressive with his QE programme, further to concentrate the minds of the Republicans.

In the Eurozone, the politicians have clearly adopted stalling tactics with regard to making a decision on whether to give further help to Greece, and have delayed receiving the Troika report from an initial late August date until mid November, just after the US elections.  The much smaller Cyprus bailout has also been delayed to be sorted out at the same time as Greece.  The Spanish bailout has also been delayed, first by the Spanish Prime Minister, who has regional elections on October 21st and who does not want to be seen asking for money before then. Also by Germany and some EU officials who are concerned about the knock-on effects in markets of a Spanish bailout request, most particularly for Italy.  Dealing with all of these together in November appears to be the preferred strategy, and as in the US markets are expecting there will be a satisfactory resolution (at least for now).  The longer term issues of enforced austerity weakening growth prospects and the lack of competitiveness in the Southern European economies will no doubt create further crises in due course.

China too is going through leadership change, with the new Politbureau team being unveiled just two days after the US elections.  Here too there has been evidence of policy drift this year with the slowing Chinese economy met by silence from the politicians, though the Central Bank have been easing policy a little during the year.  It is not known what the economic priorities of the new leadership team will be, but markets would appreciate an idea of the direction of policies that will be followed.

The last two months of the year thus provide the opportunity for politicians around the world to resolve several uncertainties about economic policy that have been allowed to build up ahead of the electoral time frame.  Some clear leadership in the next few weeks should boost market confidence, but political indecisiveness would be very damaging to markets. The time is therefore ripe for politicians to act.

The Falling Oil Price – mirror on China, geopolitical football or beacon of hope?

The oil price has fallen from $128 on March 1 to below $90 in recent days, but this sharp decline has received little news coverage.  There are good reasons from both supply and demand perspectives why this 30% fall has occurred:

On the demand side

  • Economic data since March have disappointed expectations, following a burst of optimism in January and February on the back of the ECB’s dramatic action to offer a trillion Euros of extra 3-year liquidity at the start of the year. However none of this liquidity made it into the real Eurozone economy – it went into the banking system and the banks used it to support the government bond markets in Spain and Italy as many other investors used the opportunity to exit from their Euro assets.
  • Austerity continues to drive the peripheral countries deeper into recession and the German economy has seen its export engine struggle as the rest of the world slows down.
  • In the US, the improvement in the labour markets that appeared to be taking place at the start of the year has stalled as austerity from the individual states, which are forced to run balanced budgets, has reduced domestic demand. Growth expectations for 2012 have been steadily reduced over the course of this year.
  • It is however the Chinese economy which is the key driver of oil demand, and although not clearly reflected in the official statistics, which are aggregated from local regions all keen to show themselves in a good light to the centre, there is increasing anecdotal evidence of a major slowdown in demand from manufacturing companies for raw materials with the appearance of large inventories of coal and copper within China, together with continued weakness in demand for electricity.

On the supply side:

  • Saudi Arabia has pumping record amounts of oil over the last three months and shown no sign of reducing this rate of production as the oil price has fallen  close to levels (generally assumed to be $80-90 per barrel), which make it difficult for them to balance their budget. They have declared this to be part of a policy aimed at helping the Western economies – closer to the truth might be that the American authorities have requested a much lower oil price, which would boost consumer disposable income and confidence and thus give more room for the Federal Reserve to ease policy and for Obama to win the election in November.
  • Oil production and exports from both Iraq and Libya have been expanding rapidly this year as calm has returned to these countries and with it a focus on rebuilding export earnings.

So weaker demand and increased supply have occurred together and prices have fallen sharply. For Western economies trying to deal with the after–effects of a major banking crisis, this is positive news.  Lower petrol prices leaves more money in consumer pockets to spend in other areas of the economy, at a time when consumer incomes are otherwise under pressure, and allows the Central Banks to be more relaxed about any inflationary pressures. Should Europe be able to find a way through its problems in the next few weeks, there may be scope for an equity market rally.

In the longer term, it should be noted that the USA is moving aggressively towards being energy self-sufficient). The new fracking technologies are significantly increasing the productive potential of its own gas reserves, which will, over the long term, ensure that it will not be dependent upon the Middle East for its energy requirements. Structurally this bodes well for the US relative to Europe and Japan, which will remain more beholden to political developments in those regions, and therefore for the dollar relative to the euro and the yen.

Whilst the world watches Europe, it is missing the Chinese slowdown

The official Chinese GDP data show economic growth of 8.1% in the year to end March, as always a little above the recently-reduced official target of 7.5%. There is though a considerable degree of scepticism over this number (in 2007, the GDP data series were described as “for reference only” by Li Keqiang, who becomes Prime Minister in November) as other data series are much weaker. Power output (a data series likely to be accurately measured and very significant in a manufacturing-based economy) rose by only 0.7% over the same period, car retailers are reporting a huge build-up in inventories indicating a fall in consumer confidence, and sales of bulldozers are down by 51% compared with a year ago which indicates weakness in construction. These are worrying figures.

In the very worst of the global economic crisis in 2008/09, China embarked on a staggeringly large investment and infrastructure spending programme in a bid to maintain demand in the economy in 2009 and 2010 whilst they hoped that the rest of the world would sort out their banking crises and associated problems. They were hoping that by the time their own stimulus programme had run its course, the rest of the global economy would have regained its poise and would once again provide the strong consumer demand for Chinese exports. With the US also spending heavily, the world did come out of recession in 2009, and 2010 was also a reasonable year. However Western consumer confidence has not recovered and consumer spending has not returned to make the recovery self-sustaining – and the eurozone’s problems have only made things worse. So the hoped-for recovery in Western demand for Chinese exports has not occurred.

Worse still for the Chinese, the enormous stimulus they delivered has had two serious negative consequences. First was a house price boom in the major cities of China, as the extra spending engendered confidence that Chinese growth would continue to be strong, interest rates were held at low levels and banks were strongly encouraged to lend. In 2011 the authorities became concerned about this and sought ways to reduce the flow of credit for speculative house purchases. Secondly, the infrastructure projects that were built were brought forward from plans for several years hence, and so there are now many entire “ghost” towns built with roads, houses, and shops where nobody lives or works – the infrastructure of China is now years ahead of its current stage of economic development and the demand for that infrastructure. In economic terms the returns from much of the investment boom China undertook have been very low or possibly zero.

China’s economy is now hugely imbalanced with consumer spending just 35% of the economy. Contrast this with the UK and US where consumer spending represents nearly 70% of the economy. If China’s growth story is to be sustained it will need to produce its own consumer demand rather than rely on the Western consumer, and a major rebalancing between investment spending and consumer spending is required. Wages have been growing very quickly, but the Chinese love to save and encouraging them to spend has so far proved difficult. Ironically, whilst the West’s problems are an unaffordable welfare state system and a crumbling infrastructure, China currently has too much infrastructure and not enough of a welfare state. The cost of healthcare in China is very high and pension provision is poor – a stronger safety net might encourage Chinese workers to hold lower savings and go on a mini-consumption boom.

China’s economy is slowing more dramatically than the official data show; commentators have been assuming that in this situation, further economic stimulus would be the policy response. Such a stimulus should not however be a repeat of the government-directed investment spending. Instead to be effective, more subtle policies aimed at boosting consumption are required. Until then, whilst the world watches the Eurozone fall apart they may be missing the problems that are emerging in China. Chinese and Asian equities are the preferred asset class over the next decade, and long term investors should be seeking a heavy exposure in their portfolios. Over the next few months however, there remains scope for investors to be disappointed with Chinese economic developments, and a better buying opportunity is likely to emerge.