The market will come back only when China and the U.S. have completed sufficient structural reforms to create a sustainable growth cycle.
By Andy Xie, board member of Rosetta Stone Advisors Limited 20 January 2009
By now a barrage of economic and corporate data is showing unequivocally that the global economy is in a hard landing. The United States lost over half a million jobs in both November and December 2008, and the unemployment rate surged to 7.2 percent, the highest it’s been since 1993. Over the entire year, the U.S. lost 2.6 million jobs, more than it has since 1945. Chances are that its GDP contracted by 1.5 to 2 percent in the fourth quarter of 2008 alone.
China’s economy too has tumbled since October 2008. The leading signals were falling export orders from Europe and Japan in September 2008. Industrial consumption of electricity may have declined by around 10 percent in the fourth quarter of 2008, compared to a previous growth rate in the mid-teens. Auto sales probably declined 10 percent. Home appliance sales probably dropped more. Property markets came to a standstill. And even department store sales may have fallen. On top of it all, millions of migrant workers have returned home from the coast due to factory closures. Considering this, it looks like China’s economy also went into a hard landing in the fourth quarter of last year.
Only demand side data from consumption-driven economies like Australia and the U.K. add information to what we know from China and the U.S. The situation in export economies like Japan and Germany reflects entirely what’s going on elsewhere. The rapid contraction of their manufacturing is self-evident from the global situation. The demand side situation in the U.K. is even worse than that of the U.S. I have argued for years that the property bubbles in Australia and the U.K. were bigger than in the U.S., possibly twice as big. Australia could cushion the blow by devaluing its currency, as it is a small economy and has a large export sector. The U.K. doesn’t have a large export sector anymore and mostly depends mostly on capital inflow. Hence, devaluation wouldn’t work for it, leaving them facing a catastrophe.
There are three forces driving the global hard landing. First and foremost is the bursting of the global asset bubble. Paper wealth worth roughly 100 percent of the global GDP has evaporated. The negative wealth effect on demand is roughly 5 percent. Take away 3.5 percent trend growth rate for the global economy, and the wealth effect alone should cause the global economy to contract by 1.5 percent in 2009. As the loss is mostly permanent, i.e., the high asset value before was a bubble and the current level is normal, the 1.5 percent contraction represents a permanent loss.
The second force is the slowdown or reduction in bank lending. Governments around the world blame the recession on banks’ unwillingness to lend. They may be barking up the wrong tree. Lack of capital could be a major factor in their unwillingness to lend. But with government injections, capital is not a major issue anymore, unlike six months ago. The main impediment to lending expansion is the credit worthiness of the borrowers. They have less collateral due to asset devaluation and less revenue due to recession. Ceteris paribus, banks would be less willing to lend to them. The credit contraction is part of the adjustment after the bubble burst. Banks lent too much and bankrolled the bubble. It is not surprising that they would contract afterwards. Governments should not hope to revive the economy by pressuring or incentivizing the banks to lend. As a corollary, interest rate cuts won’t be so effective in stimulating demand.
The third force is the inventory cycle. When commodity prices were rising, wholesalers and manufacturers were hoarding inventories either as a hedge against rising prices or for speculative profit. At the peak of commodity speculation in 2007 the shipping cost for iron ore tripled from the level in 2006. A major reason was that the sellers in the spot market refused to unload the cargo in anticipation of price appreciation for iron ore. The daily shipping rate was effectively supported by the expectation of iron ore price appreciation. I am giving this example to illustrate how strong inventory demand was. When prices turned around in mid-2008, wholesalers and manufacturers tried to run down their inventories, which depressed final demand. The dramatic collapses of steel prices and shipping rates, for example, were driven by this force.
All three forces are still at work in the first quarter of 2009, meaning the rapid pace of economic contraction will continue. Financial markets have not fully priced in the magnitude and length of the recession. This is why the barrage of bad economic and corporate news is weighing down stock market everywhere. During the rapid globalization period the shares of corporate earnings and tax revenues in global GDP surged, led by the financial sector earnings and China’s government revenue. Of course, on the other side of the coin were declining share of labour income and the diminished consumption power of workers. Rising household borrowing, backed up by rising asset prices, sustained the growth trend for a decade. Naturally, as the bubble bursts, the ensuing economic downturn affects corporate earnings and tax revenues first. As businesses try to cut costs to recover their profits, they lay off workers, and the laid-off workers cut consumption, which causes the second round of economic contraction. Obviously, this vicious cycle could go further than necessary without government stimulus to prop up demand.
This is where the announced stimuli by China and the U.S. could play a major role in stopping economic contraction. Stock markets hit major bottoms in November 2008: the S&P 500 hit 750, and Hang Seng touched 11,000. S&P 500 bounced up by 22 percent and Hang Seng 42 percent afterwards to their recent peaks. The slowdown in leverage reduction initially drove the bounce. The optimism over the impact of the stimuli announced by China and the U.S. drove markets up further in December 2008 and continued into the first week of January 2009. Markets have since been coming down in response to the bad economic and corporate news. The downward trend may last for one or two months until the bad economic data are digested. In 2009, markets will fluctuate on the hope for stimulus impact and the fear of a worsening economic situation.
The first positive kick for the global economy will come from the inventory cycle. We don’t know how much de-stocking is contributing to the current contraction. There is good evidence that the current inventory cycle is quite dramatic.
The Baltic Dry Index (BDI) that measures the average shipping cost in global trade was under 2000 for two decades before 2003, surged above 5,000 in 2004 on strong Chinese demand for resources like iron ore, declined to around 2,000 in mid-2005, skyrocketed again in 2007, peaked at 11,400 on May 30, 2008, and has collapsed dramatically afterwards to the low 800s, over a 90 percent decline. In the long run, the BDI is determined by the ship building cost and fuel price. In the short term, the shipping capacity is fixed, and demand drives shipping cost. When demand is below shipping capacity, shipping costs drop to operating costs and fuel-plus-labour costs – i.e., a fixed cost cannot be recovered.
The dramatic rise and fall of the BDI partly, if not entirely, reflects the speculative demand, even though classified as inventory demand. When the Fed cut interest rates in August 2008 in response to the sub-prime crisis, it launched another wave of speculation in commodity market. It spooked the users into hoarding inventories to hedge against price increases. For example, many steel producers had legitimate fear of iron ore prices escalating and scrambled for more inventories. Of course, a rising iron ore price drove up steel prices, which caused steel users like automobile companies to store up more steel. When the recession brought down commodity prices, everyone had the incentive to sell or use the inventory. That force exacerbated the downturn. It was probably the most important force in bringing down the global economy in October 2008.
Before the middle of 2009, de-stocking will likely have finished and re-stocking may kick in. That extra source of demand may give the global economy a significant kick. I wouldn’t be surprised if the BDI doubled or even tripled from the current level by then. East Asian economies experienced a similar force in the fourth quarter of 2008. De-stocking was actually the most important source of contraction in early 1998. Like now, the reversal of price expectation and the rising capital cost incentivized manufacturers and distributors to run down their inventories as low as possible.
Adding to the upward force of re-stocking, the impact of stimulus will probably be felt in the second half. Obama’s stimulus plan is likely to be US$ 750 billion over 18 months. The quickest part of the plan is a US$ 350 billion, or 2.5 percent of GDP, tax cut. Even though the Obama stimulus plan initially focused on investment, it is now backing the tax cut to support consumption, because it is the only way to boost demand quickly. The U.S. doesn’t have the machinery to boost investment quickly. Targeting investing areas, identifying projects, and establishing implementation organizations will take a long time. Even though excessive consumption has got the U.S. economy into trouble, it has to boost consumption again to stabilize the economy.
China doesn’t have the same problem. It has a vast machine comprised of government agencies, state owned enterprises, and private contractors to implement investment projects quickly. Hence, the easy short-term fix is to issue fiscal bonds and pump the money into the investment machine. Many railroad and highway projects were started in early 2008. By the middle of 2009 some stimulus impact should be felt by the economy. Even though China’s economic imbalance is excessive investment and insufficient consumption, the economic stimulus is still to boost investment, because China has the machinery to do it and doesn’t have the personal income tax base to do what the U.S. is doing.
So there will be an economic rebound in the second half of 2009, but it is not sustainable. Inventory re-stocking is obviously a temporary force. The stimulus that China and the U.S. are implementing will not address the structural imbalance within or between them. Indeed, the stimulus prolongs the unbalanced growth model that got us into trouble in the first place.
Some may ask why not. There is a popular theory that China and the U.S. have effectively become one economy, and the imbalance between the two is not a problem. As long as China is willing to buy the U.S. treasuries, that ‘China produces and the U.S. consumes’ could be a lasting equilibrium. But even if China’s willingness to buy treasuries remains intact, the U.S.-China block is not self contained. In particular, if the ‘China produces and the US consumes’ block tries to grow fast, oil prices will surge, which will suck money out of the axis and bring it down. The property-cum-credit bubble in the axis burst because high oil prices sucked too much money out of it. Like an old motorcycle, it can’t go fast anymore.
This is why I believe that the bounce in the second half of 2009 would be unsustainable. Stock markets are being weighed down by bad economic and corporate news now. In two to three months, they may smell economies improving in the second half and start to rally again. However, the rally may fizzle out in the third quarter, as the economic pickup was merely a bounce and not sustainable. In 1999, East Asia recovered first on inventory re-stocking and then was on export surge, as Europe and U.S. economies were strong. Now the whole world is weak and can’t export out of its problems.
It takes time for the global economy to find a new and sustainable growth path. The necessary changes are that the U.S. expands production and China expands consumption. Neither is easy. And it takes time to implement changes to achieve the desired objectives. Institutional inertia is hard to overcome. The U.S. is stimulating consumption again to boost its economy because it has the system to do it. And China is stimulating investment again because it has the system to do so. It requires in-depth changes to their political economies for them to move in different directions. The time-consuming nature of structural reforms is why the sustainable economic recovery will take time.
The combination of inventory cycle and stimulus may give us a ‘playable’ bounce between the second and third quarter of 2009. ‘Playable’ is market jargon that refers to a bear market rally that lasts for several months. The bounces that we have seen are all very short-lived and not considered playable. There may be a playable bounce in 2009, but markets will fall again on bearish economic expectation about 2010. Indeed, the bear market is likely to last through 2009 and most of 2010. The market will come back only when China and the U.S. have completed sufficient structural reforms to create a sustainable growth cycle.
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Hard Landing vs. Stimulus
The market will come back only when China and the U.S. have completed sufficient structural reforms to create a sustainable growth cycle.
By Andy Xie, board member of Rosetta Stone Advisors Limited
20 January 2009
By now a barrage of economic and corporate data is showing unequivocally that the global economy is in a hard landing. The United States lost over half a million jobs in both November and December 2008, and the unemployment rate surged to 7.2 percent, the highest it’s been since 1993. Over the entire year, the U.S. lost 2.6 million jobs, more than it has since 1945. Chances are that its GDP contracted by 1.5 to 2 percent in the fourth quarter of 2008 alone.
China’s economy too has tumbled since October 2008. The leading signals were falling export orders from Europe and Japan in September 2008. Industrial consumption of electricity may have declined by around 10 percent in the fourth quarter of 2008, compared to a previous growth rate in the mid-teens. Auto sales probably declined 10 percent. Home appliance sales probably dropped more. Property markets came to a standstill. And even department store sales may have fallen. On top of it all, millions of migrant workers have returned home from the coast due to factory closures. Considering this, it looks like China’s economy also went into a hard landing in the fourth quarter of last year.
Only demand side data from consumption-driven economies like Australia and the U.K. add information to what we know from China and the U.S. The situation in export economies like Japan and Germany reflects entirely what’s going on elsewhere. The rapid contraction of their manufacturing is self-evident from the global situation. The demand side situation in the U.K. is even worse than that of the U.S. I have argued for years that the property bubbles in Australia and the U.K. were bigger than in the U.S., possibly twice as big. Australia could cushion the blow by devaluing its currency, as it is a small economy and has a large export sector. The U.K. doesn’t have a large export sector anymore and mostly depends mostly on capital inflow. Hence, devaluation wouldn’t work for it, leaving them facing a catastrophe.
There are three forces driving the global hard landing. First and foremost is the bursting of the global asset bubble. Paper wealth worth roughly 100 percent of the global GDP has evaporated. The negative wealth effect on demand is roughly 5 percent. Take away 3.5 percent trend growth rate for the global economy, and the wealth effect alone should cause the global economy to contract by 1.5 percent in 2009. As the loss is mostly permanent, i.e., the high asset value before was a bubble and the current level is normal, the 1.5 percent contraction represents a permanent loss.
The second force is the slowdown or reduction in bank lending. Governments around the world blame the recession on banks’ unwillingness to lend. They may be barking up the wrong tree. Lack of capital could be a major factor in their unwillingness to lend. But with government injections, capital is not a major issue anymore, unlike six months ago. The main impediment to lending expansion is the credit worthiness of the borrowers. They have less collateral due to asset devaluation and less revenue due to recession. Ceteris paribus, banks would be less willing to lend to them. The credit contraction is part of the adjustment after the bubble burst. Banks lent too much and bankrolled the bubble. It is not surprising that they would contract afterwards. Governments should not hope to revive the economy by pressuring or incentivizing the banks to lend. As a corollary, interest rate cuts won’t be so effective in stimulating demand.
The third force is the inventory cycle. When commodity prices were rising, wholesalers and manufacturers were hoarding inventories either as a hedge against rising prices or for speculative profit. At the peak of commodity speculation in 2007 the shipping cost for iron ore tripled from the level in 2006. A major reason was that the sellers in the spot market refused to unload the cargo in anticipation of price appreciation for iron ore. The daily shipping rate was effectively supported by the expectation of iron ore price appreciation. I am giving this example to illustrate how strong inventory demand was. When prices turned around in mid-2008, wholesalers and manufacturers tried to run down their inventories, which depressed final demand. The dramatic collapses of steel prices and shipping rates, for example, were driven by this force.
All three forces are still at work in the first quarter of 2009, meaning the rapid pace of economic contraction will continue. Financial markets have not fully priced in the magnitude and length of the recession. This is why the barrage of bad economic and corporate news is weighing down stock market everywhere. During the rapid globalization period the shares of corporate earnings and tax revenues in global GDP surged, led by the financial sector earnings and China’s government revenue. Of course, on the other side of the coin were declining share of labour income and the diminished consumption power of workers. Rising household borrowing, backed up by rising asset prices, sustained the growth trend for a decade. Naturally, as the bubble bursts, the ensuing economic downturn affects corporate earnings and tax revenues first. As businesses try to cut costs to recover their profits, they lay off workers, and the laid-off workers cut consumption, which causes the second round of economic contraction. Obviously, this vicious cycle could go further than necessary without government stimulus to prop up demand.
This is where the announced stimuli by China and the U.S. could play a major role in stopping economic contraction. Stock markets hit major bottoms in November 2008: the S&P 500 hit 750, and Hang Seng touched 11,000. S&P 500 bounced up by 22 percent and Hang Seng 42 percent afterwards to their recent peaks. The slowdown in leverage reduction initially drove the bounce. The optimism over the impact of the stimuli announced by China and the U.S. drove markets up further in December 2008 and continued into the first week of January 2009. Markets have since been coming down in response to the bad economic and corporate news. The downward trend may last for one or two months until the bad economic data are digested. In 2009, markets will fluctuate on the hope for stimulus impact and the fear of a worsening economic situation.
The first positive kick for the global economy will come from the inventory cycle. We don’t know how much de-stocking is contributing to the current contraction. There is good evidence that the current inventory cycle is quite dramatic.
The Baltic Dry Index (BDI) that measures the average shipping cost in global trade was under 2000 for two decades before 2003, surged above 5,000 in 2004 on strong Chinese demand for resources like iron ore, declined to around 2,000 in mid-2005, skyrocketed again in 2007, peaked at 11,400 on May 30, 2008, and has collapsed dramatically afterwards to the low 800s, over a 90 percent decline. In the long run, the BDI is determined by the ship building cost and fuel price. In the short term, the shipping capacity is fixed, and demand drives shipping cost. When demand is below shipping capacity, shipping costs drop to operating costs and fuel-plus-labour costs – i.e., a fixed cost cannot be recovered.
The dramatic rise and fall of the BDI partly, if not entirely, reflects the speculative demand, even though classified as inventory demand. When the Fed cut interest rates in August 2008 in response to the sub-prime crisis, it launched another wave of speculation in commodity market. It spooked the users into hoarding inventories to hedge against price increases. For example, many steel producers had legitimate fear of iron ore prices escalating and scrambled for more inventories. Of course, a rising iron ore price drove up steel prices, which caused steel users like automobile companies to store up more steel. When the recession brought down commodity prices, everyone had the incentive to sell or use the inventory. That force exacerbated the downturn. It was probably the most important force in bringing down the global economy in October 2008.
Before the middle of 2009, de-stocking will likely have finished and re-stocking may kick in. That extra source of demand may give the global economy a significant kick. I wouldn’t be surprised if the BDI doubled or even tripled from the current level by then. East Asian economies experienced a similar force in the fourth quarter of 2008. De-stocking was actually the most important source of contraction in early 1998. Like now, the reversal of price expectation and the rising capital cost incentivized manufacturers and distributors to run down their inventories as low as possible.
Adding to the upward force of re-stocking, the impact of stimulus will probably be felt in the second half. Obama’s stimulus plan is likely to be US$ 750 billion over 18 months. The quickest part of the plan is a US$ 350 billion, or 2.5 percent of GDP, tax cut. Even though the Obama stimulus plan initially focused on investment, it is now backing the tax cut to support consumption, because it is the only way to boost demand quickly. The U.S. doesn’t have the machinery to boost investment quickly. Targeting investing areas, identifying projects, and establishing implementation organizations will take a long time. Even though excessive consumption has got the U.S. economy into trouble, it has to boost consumption again to stabilize the economy.
China doesn’t have the same problem. It has a vast machine comprised of government agencies, state owned enterprises, and private contractors to implement investment projects quickly. Hence, the easy short-term fix is to issue fiscal bonds and pump the money into the investment machine. Many railroad and highway projects were started in early 2008. By the middle of 2009 some stimulus impact should be felt by the economy. Even though China’s economic imbalance is excessive investment and insufficient consumption, the economic stimulus is still to boost investment, because China has the machinery to do it and doesn’t have the personal income tax base to do what the U.S. is doing.
So there will be an economic rebound in the second half of 2009, but it is not sustainable. Inventory re-stocking is obviously a temporary force. The stimulus that China and the U.S. are implementing will not address the structural imbalance within or between them. Indeed, the stimulus prolongs the unbalanced growth model that got us into trouble in the first place.
Some may ask why not. There is a popular theory that China and the U.S. have effectively become one economy, and the imbalance between the two is not a problem. As long as China is willing to buy the U.S. treasuries, that ‘China produces and the U.S. consumes’ could be a lasting equilibrium. But even if China’s willingness to buy treasuries remains intact, the U.S.-China block is not self contained. In particular, if the ‘China produces and the US consumes’ block tries to grow fast, oil prices will surge, which will suck money out of the axis and bring it down. The property-cum-credit bubble in the axis burst because high oil prices sucked too much money out of it. Like an old motorcycle, it can’t go fast anymore.
This is why I believe that the bounce in the second half of 2009 would be unsustainable. Stock markets are being weighed down by bad economic and corporate news now. In two to three months, they may smell economies improving in the second half and start to rally again. However, the rally may fizzle out in the third quarter, as the economic pickup was merely a bounce and not sustainable. In 1999, East Asia recovered first on inventory re-stocking and then was on export surge, as Europe and U.S. economies were strong. Now the whole world is weak and can’t export out of its problems.
It takes time for the global economy to find a new and sustainable growth path. The necessary changes are that the U.S. expands production and China expands consumption. Neither is easy. And it takes time to implement changes to achieve the desired objectives. Institutional inertia is hard to overcome. The U.S. is stimulating consumption again to boost its economy because it has the system to do it. And China is stimulating investment again because it has the system to do so. It requires in-depth changes to their political economies for them to move in different directions. The time-consuming nature of structural reforms is why the sustainable economic recovery will take time.
The combination of inventory cycle and stimulus may give us a ‘playable’ bounce between the second and third quarter of 2009. ‘Playable’ is market jargon that refers to a bear market rally that lasts for several months. The bounces that we have seen are all very short-lived and not considered playable. There may be a playable bounce in 2009, but markets will fall again on bearish economic expectation about 2010. Indeed, the bear market is likely to last through 2009 and most of 2010. The market will come back only when China and the U.S. have completed sufficient structural reforms to create a sustainable growth cycle.
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