Here's a pretty good explanation of the world economy and
US interest rates in a nutshell.
cifunds.com
The China Syndrome
by William Sterling (December 2003)
Earlier this year, many financial pundits were warning of deflation ahead and fretted that the U.S. would repeat the experience of Japan in the 1980s. Now some have changed their views, according to a recent story in the Wall Street Journal with the headline “Some Fear Inflation is Ready for a Comeback.”
Is there an element of truth in both fears? Could the confusion stem from the fact that some sectors of the global economy are still experiencing intense deflationary pressures, while others are merrily reflating? And what does it mean for the investment environment?
Inflation vs. Deflation
Let’s begin with a chart we call The China Syndrome (Chart 1). The chart shows the two main drivers of U.S. inflation, core services prices and core goods prices. “Core” refers to the fact that the indexes exclude volatile components like food and energy. We know that you don’t know anyone who doesn’t eat or consume energy – but humour us.
Chart 1: Inflation may be in the eye of the beholder. Services price inflation has been relatively steady at 3%, but goods prices have been falling due to intense global competition.
The chart shows that services prices rise steadily, year in and year out. Forget about recessions or stock market cycles, service prices look as if they have been on autopilot. Many service industries are totally domestic, which means they typically do not face intense international competition. For example, when your plumbing needs attention, you are unlikely to call someone in Sri Lanka.
In contrast, goods prices have gone nowhere for the last decade. Correction: They went up a bit for about seven years and then experienced steady declines for the past three years. Think about DVD players selling for under $60. Think about computers that sell for under $600. Think about all the cheap stuff in your local Wal-Mart. Think: Made in China.
So what’s the right story? Are we in a world of inflation? Deflation? Or both?
No wonder both investors and economic policymakers are confused. The U.S. Federal Reserve has eased aggressively in recent years, dropping the Fed Funds rate to 1% (See Chart 2). But the economy didn’t create any jobs – until recently. Or maybe a few million jobs were created – in China, which incidentally needs to create 22 million new jobs every year to absorb migrants from rural areas. Against this backdrop, genuine concerns about deflation arose among those focused on the decline in manufactured goods prices and massive job losses in the manufacturing sector.
Chart 2: Monetary policy has created massive economic stimulus, with interest-rate-sensitive sectors like housing leading the way.
The Bush Boom?
Now, however, numerous economic reports suggest that the global economy is finally coming to life. Notably, the U.S. economy expanded at an impressive 8.3% rate in the third quarter and profits were up 30% from a year earlier. Those are the type of numbers usually associated with emerging markets, not an $11 trillion economy. Even the beleaguered manufacturing sector has apparently staged a comeback, with the widely followed ISM manufacturing index rising in November to 62.8, the highest reading in two decades (See Chart 3). President Bush is obviously pleased.
Chart 3: Despite deflation concerns earlier this year, recent economic reports ranging from the GDP report to the ISM manufacturing index show a strong recovery underway.
But it’s not just the U.S. – the recovery appears to have gone global. We just heard from a Japan analyst that in the last few months, Japan’s industrial output has been growing at an annual rate of nearly 20% thanks in large measure to exports to China. Although Japan’s output numbers may be revised down a bit, it is remarkable that the global business cycle is now so strong that even formerly moribund Japan is posting great numbers. Of course, China has been booming this year, as have many other developing Asian nations that benefited from the big decline in interest rates and from the pickup in international trade.
Even Europe, which has been somewhat of a laggard, is finally showing signs of more robust economic activity. The closely watched IFO survey for Germany, for example, has risen sharply since April, suggesting a much-improved level of confidence among German corporate managers. In the U.K., business conditions have been strong enough that Bank of England officials recently saw fit to raise interest rates.
Attack of the 50-Foot Inflation Monster
Predictably, investors who fretted about deflation a few months ago are now worried about inflation making a comeback. “Reflation trades” have certainly worked in financial markets. Stocks have outperformed bonds, and bond yields are up since the beginning of the year. Commodity prices are up, and “commodity currencies” like the Australian dollar, the Canadian dollar and the South African rand have soared. Cyclical stocks have made a comeback as well.
We suspect reflation trades will continue to work well through much of 2004 as well, though not necessarily by as wide a margin as in 2003. Despite much stronger growth, the Fed has made it clear that it is in no hurry to raise interest rates any time soon. There is still a great deal of spare capacity around the world, and the U.S. labour market is just beginning to recover. With the Fed’s favoured measure of core inflation running at just 1.3% annually, the Fed has been legitimately concerned that the economy could be just one shock away from slipping into deflation.
Why take the risk of slipping into a Japan-style deflation, which can be very tricky to reverse? If inflation accelerates a bit, the Fed is confident that it knows how to deal with that problem further down the road. So the Fed’s implicit message to investors has been: Party on! Take some investment risk and the Fed will underwrite it “for a considerable period” with low interest rates.
The Fed’s policy has had an unpleasant side effect for foreign investors by driving down the dollar in foreign exchange markets. The 20% decline in the value of the U.S. dollar against the Canadian dollar this year is a case in point (See Chart 4). Although the dollar’s decline has been frustrating for investors, it appears to have been an unavoidable side effect of the Fed’s reflation policy – a policy that seems to have worked in restoring global growth.
Chart 4: For Canadian investors, an unwelcome side effect of U.S. monetary stimulus has been the huge decline in the value of the U.S. dollar - along with fears of more to come.
The sharp rise in the Canadian dollar and other commodity currencies also reflects the China Syndrome. On the one hand, China’s ascent has created strong deflationary pressure and job losses in major sectors like manufacturing, especially in the U.S. economy, which is particularly open to low-priced Chinese imports. So part of the dollar’s weakness is due to the low interest rates the Fed has been forced to employ as part of its deflation-fighting strategy.
On the other hand, China’s ascent has also created a boom in many commodity prices. That is a huge plus for countries like Canada that enjoy a rich resource base and can benefit directly from higher commodity prices. In fact, with the Canadian stock market much like a “barbell” – financial stocks at one end and resource stocks at the other end – Canada wins twice: resource stocks win from the commodity price surge while financial stocks win from the environment of low interest rates. And that looks set to continue for some time to come – at least until both China and the U.S. begin to tighten together in earnest.
However, here’s the key issue, prompted by the Wall Street Journal article on inflation fears along with a cartoon illustrating “The Attack of the 50-Foot Inflation Monster.” Is global inflation likely to rise sharply because China is importing a lot of copper and steel? Or will those commodities eventually be matched with China’s seemingly unlimited supply of $0.60-per-hour labour to flood world markets with more cheap products?
Chips and China
Our view is pretty simple. If you want to understand inflation dynamics, stop watching commodity prices movements every 10 minutes and just look at labour cost data once a quarter. Labour costs ultimately account for about two-thirds of production costs and labour costs are likely to stay under pressure for some time due to the China Syndrome, the India Syndrome, and other intense forces of globalization.
Oh, we almost forgot to mention technology. We were intrigued recently by a story in the New York Times about increasing customer acceptance of ATM-like automated check-in systems at airline counters and check-out counters at stores like Home Depot. The article pointed out that these systems, which are becoming increasingly easy to use, typically cost about $10,000 each to deploy. They can be used for years and, in the case of airlines, are beginning to replace customer service agents who work for $20,000 to $40,000 per year, plus benefits and vacation time.
Now do some arithmetic. Suppose the systems are used 16 hours per day, seven days per week, for four years. That works out to 23,360 hours of labour for $10,000. That equals $0.43 per hour – even lower than the hourly wage in China. No wonder businesses are aggressively substituting technology for labour.
So maybe it’s not just the China Syndrome at work here. The broader theme is “Chips,” as in computer chips, and “China” as in China, India, Indonesia, Pakistan, Latin America, Africa and so on – about five billion people who are trying to join the global economy all at once.
Somehow that doesn’t sound like “The Attack of the 50-Foot Inflation Monster” anymore. Instead, it seems that the Fed has pretty sound reasons for not being in any hurry to aggressively tighten monetary policy. And it has sound reasons to encourage a boom to develop to make sure that the world doesn’t accidentally slip into deflation.
That doesn’t mean that the Fed won’t raise rates again. As we discussed last month, odds are rising that Greenspan & Company will have to back away from their ultra-low interest rate policy sometime by mid-2004. However, given the large amount of slack in the global economy and still-intense global competition, we would not be surprised to see 2004 as a year of robust global growth and continued low inflation.
And for investors, that would represent a Happy New Year.
Best wishes for a joyous holiday season and a peaceful and prosperous New Year.
William Sterling, Global Strategist
Trilogy Advisors, LLC |
