just in in-tray, per jim walker
Egypt on fire – The Bernanke effect
In Section 4, Emerging Markets – Fall guys, of our year-end 2010 strategy report (Asianomics No 8, Currencies – Trench warfare) we wrote the following:
“But where global monetary policies are producing war zone effects is in the emerging markets, Here the fight between local economic policymakers and global capital managers could turn serious. The fact is that most emerging markets do not have the depth in their capital markets nor the policy instruments to neutralise capital unleashed by decisions taken in Washington, London, Frankfurt and Tokyo. It is this battlefield where money managers have become the biggest winners (short term) while the countries themselves are potentially the biggest losers.”
We went on:
“Of course, for farmers and plantation owners these price changes are good news. Rural incomes should rise as a direct result. But one of the ‘positive’ stories about the emerging market universe centres on increased urbanisation and the productivity improvements that come with it. For the urban poor the inflation in soft commodity prices is disastrous. As Mr Wang, the Beijing apple seller found, “people are buying less with prices jumping up”. Remind us again why Ben Bernanke wants to create inflation?”
Certainly Egypt is awash with these ‘war zone effects’, as was Tunisia a couple of weeks ago. The BBC, in one of its weekend news programmes, put up a graphic showing why Egyptians had taken to the streets and were demanding the resignation of President Hosni Mubarak. The words ‘Poverty’, ‘Unemployment’ and ‘Rising food prices’ came up across the three horizontal stripes of the Egyptian flag. Had there been a fourth stripe no doubt the word ‘Corruption’ could have been included. Exactly the same allegations could have been laid at the feet of President Ben Ali of Tunisia and exactly the same allegations could still be laid at the doors of most of the Middle East’s despots and those further south in Africa. But the fact is that the only new problem is ‘rising food prices’, the rest have been around for decades.
Ben Bernanke’s policies are to blame for these rising food prices and the problems are about to soar with the announcement over the weekend that autocratic governments are desperately attempting to stockpile foodstuffs. Why single out the Mad Hatter? Because when the world’s reserve currency country makes clear its intent to debase its own currency and try to create inflation it sets up forces of capital flows that its naïve Chairman (and surely that is what academic Ben is because if he knew what he was doing he might be labeled as big a genocidal maniac as Stalin and Mao) is powerless to control. Maybe someone should send Mr Bernanke a book on Chaos Theory, or at least one on the unintended consequences of human action. The weak, cheap dollar has been flooding emerging markets – partly asset allocator inflows and partly attempts to keep their currencies weak that have led to domestic money explosions eg, China – and producing relative price effects that were entirely predictable. Poor people spend much more on food and basic commodities than rich people. Little wonder the demand for such basic goods have gone up disproportionately. And when smart fund managers see the way the wind is blowing they pile in to take advantage thus inflating the prices even more.
The result? Cairo, Alexandria and Suez are burning. We can be pretty sure that government unease is growing in a number of other Arab states and it is clearly on the rise in many other emerging markets. Food prices are the catalyst bringing years of frustration and discontent to the surface. Our recommendation? Sell China and Chinese consumer plays in particular. If there is one thing that Beijing is alive to it is conditions in the outside world. We hear from good sources that it was concern over the European financial system and its potential harmful effects on European growth that stayed Beijing’s tightening hand for most of last year. Well, if it was concerned about European growth it must be triply concerned about popular uprisings in autocratic states. Rising food and housing prices are features of the Chinese economy every bit as much as in Egypt and Tunisia. If Beijing needed any more reasons for tightening decisively it certainly has them now. Look out for a 50 basis point rise in lending and deposit rates in the near future.
US GDP – Stripped gears
4Q10 US real GDP advanced 3.2% - lower than the consensus expectation of 3.5%, and at the lower end of the range of estimates from 2.9% to 5.2%. Predictably, the usual talking heads have attributed the shortfall to a very slim increase in the stock of inventories of $7.2 billion. With final sales to private domestic purchasers up 4.4% in the quarter, the assertion is being made that an inventory slingshot has been set up to drive first half 2011 US growth. We believe this perspective misses several key elements. First, we know private sector spending is still under the influence of the QE2 doping and its related financial “wealth” effects. The 4.4% advance in fourth quarter real consumer spending growth had little to do with organic job growth, and much more to do with a drop of 1% in the gross personal saving rate since the summer. With home price deflation deepening, emerging market equity indexes largely flat since mid October, and Treasury bond yields lifting, wealth effects must be diminishing and the QE2 related doping must be wearing off. January weekly chain store sales, along with anecdotes from retailers, suggest a bit of a hangover has set in following the holiday related splurge. Extrapolating the above trend growth in Q4 consumer spending indefinitely into the future strikes us as an especially dubious proposition.
Second, it has already been forgotten that the Q3 change in the inventory stock was over the top. The $121.4 billion bulge in Q3 inventories is rivalled only by a $117.2 billion surge way back in Q1 1998. Suffice to say producers must have been shocked by this overbuild as it became apparent and they are likely to be reticent to repeat this mistake anytime in the near future. In fact, as displayed in Figure 1 in the attached WeeBits charts file, on a YoY rate of change basis, business inventory growth is now much more in line with total business sales growth. Real GDP growth has been unusually dependent on this inventory rebuilding dynamic – this appears to be largely true in Europe as well – and that tailwind is due to taper off in 2011. True, the production component for the ISM survey has migrated higher in recent months, and Q1 auto production schedules are strong but the bulk of the inventory rebuilding story is largely played out, with the possible exception of the small business sector, which remains under siege.
Third, while ample lip service is paid to the globalization of production over recent decades, many have yet to realize that large swings in US inventories have tended to be associated with offsetting swings in imports. With more production chains stretching across more continents, a step up in the pace of US inventory building is frequently accompanied by a similar increase in the flow of imports. Since an increase of imports represents a “leakage” of domestic sales (and hence income flows) to foreign economies, they are subtracted from GDP flows in the calculation of net exports. Prior to the current scale of globalization, more new orders would be placed with domestic producers, and so inventory cycles would have a much more powerful impact on US real GDP growth. Now, those gears of growth are stripped.
While much attention was focussed on the slim Q4 inventory gain, and how that ostensibly held back real US GDP growth in Q4, we find little recognition that this decline in the rate of inventory accumulation was offset by a 13.6% annualized rate of contraction in Q4 real imports. The trade deficit, as measured by real net exports, shrank by $113 billion in Q4 as a result of this inventory related import shrinkage. We find those who are eager to tell the Q1 2011 inventory rebuilding story have yet to draw out the offsetting implications for the Q1 US trade deficit, as inventory replenishment will be accomplished in no small part through higher imports.
Finally, we come to the main stripped gear in the US economy. In capitalist economies, money makes the mare go round. Production is set into motion by risk taking and resourcing mobilising entrepreneurs who are in search of money profits. Without production, there can be no consumption, except of the existing stock of inventories and productive capital. Austrian School analysis places the search for profits at the heart of economic analysis, and the reinvestment of profits in tangible productive capital at the heart of economic growth.
This is arguably the main gear of growth – the signal profits provide to expand production, and the retained earnings (and collateral values) that profits provide to reinvest in the productive capital stock, are what lies at the heart of the capitalist machine. Strip this gear, and an economy will become unusually dependent upon persistent fiscal deficit spending, foreign deficit spending (the flip side of running a current account surplus with trading partners), or household deficit spending. These usually require serial asset bubbles to be nurtured and sustained by central banks and trend following investor behaviour, if these flow imbalances are to persist. Over the past three decades, with the exception of the New Economy bubble in the late ‘90s, the reinvestment of US corporate profits into the expansion and upgrading of the US productive capital stock has diminished. As figure 2 displays, the profit share of GDP has generally achieved a pattern of higher lows and higher highs since the double dip recession of the early ‘80s. The equipment and software share of GDP, however, now stands close to the lows following the 1990-1 recession. The incentive structures that managers and investors face are too short term oriented, the expected returns on capital abroad are more compelling, and the policy environment is simply too uncertain to favour a high rate of reinvestment of profits in productive capital equipment.
Policymakers have cranked down nominal policy rates and Treasury yields to historical lows. Corporate bond spreads are unusually tight. 100% expensing of capital equipment has been put into place for 2011. Assuming the effects of QE2 doping on consumer spending are due to tail off in 2011, US growth will need capital spending to reaccelerate if consensus expectations of above trend growth are to be achieved. While of the developed nations, Germany and the US are the most likely candidates to deliver growth near historical trends , the main gear of capitalist growth has been worn down over the years. US real GDP prospects hinge on the repair of this stripped gear – something President Obama appears to be waking up to as well. While new orders have picked up of late in the ISM survey, we remain concerned by what we find shaping up in the more detailed Commerce Department results on new orders.
US durable goods - Weak
One of our eight recession indicators for the US is durable goods orders. Last week the data for December were released and these showed a 2.5 % MoM fall against expectations of a 1.5% MoM gain (although the November MoM decline of 1.3% was revised to just 0.1%). While our indicator is still not signalling recession (it is up 6.9% YoY in December and needs to go negative to send a recession signal) in absolute terms durable goods show just what a struggle this recovery is for the United States (see Figure 3 in the attached WeeBits charts file). Durable goods orders have recovered to 2005 levels, that is all. Indeed, the same level of durable goods orders as were placed in December last year were first registered in 2000. Capital equipment in the US seems to have been treading water, with cyclical ups and downs, for a decade. These are not the signs of a fast reviving economy. Looks like Mr Bernanke’s monetary policy is set to do plenty more global damage before Mr Obama gets round to asking for his resignation later this year – by that time the President might not have any totalitarian allies left in the Middle East though.
Japan downgrade – Late but understandable
So, Standard and Poor’s has finally caught up with the reality that Japan’s fiscal position is untenable in the long run. In a move that surprised the markets – why? – the company lowered Japan’s long-term sovereign-debt rating to double-A minus. This is the same as the rating given to China. With a 200% gross public debt: GDP ratio it is just amazing that Japan’s long-term rating is still considered investment grade. But what prompted S&P’s to move at this time was the increasingly muddy political picture in Japan. This confirms the views of our Japan expert at last week’s MasterIntelligence meetings which we wrote about in Friday’s Insight piece. There is no political leadership worth the name in Japan which means that there is no resolution in sight for the increasingly problematic fiscal deficit. We reckon that domestic funding sources will fall short of government debt demands within the next three years. That will cause a crisis in Japanese fiscal funding. Perhaps S&P’s should be looking at the rating attached to Japan’s short-term sovereign debt. It is too soon to sell the yen but Japanese 5-year CDSs look like a raging buy.
Korea GDP – Trade dependent
Last Wednesday Korea released its fourth quarter 2010 provisional GDP numbers. The 4.8% YoY growth rate in real GDP was marginally ahead of analysts’ forecasts of 4.6%. Leading the way, as has been the case for most of the last two years, was the net export contribution (see Figure 4). It is this component that most domestic commentators refer to when they say that 80% of Korea’s incremental growth is associated with China. We would be taking profits in Korean equities as prospects for Chinese growth weaken throughout this year. Domestically speaking there was much less to write home about. Gross capital formation fell at a 10% annualised rate in 4Q10 while final consumption expenditure increased at just 0.25% annualised. Of the latter, the private sector was growing at just 1.2% annualised, the slowest increase since 1Q09. We support the Bank of Korea’s moves to normalise policy rates in Korea but it has to be said that domestic monetary conditions and domestic real growth signals are hardly supportive of an inflationary growth spiral. We suspect that is the way the Bank of Korea wants to keep it: saving its domestic banking system from itself. Monetary conditions will stay tight this year with the won fully supported by modest rate increases. Growth, on the other hand, is likely to disappoint. Another reason to be taking profits in equities.
Happy Monday
Jim
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