Dragon Recessions, The Setting Sun, Elephants Politics, The Lion in Stride, A Real Beat, The Old Man Stumbling, and The Summit Approaches
Global rebalancing continues to accelerate. For now, this represents only an assault on the economic relationships set up under the WTO (World Trade Organization). Ultimately, this will lead to a wholesale rearrangement of the global political order. This latter will occur as the economic and political order set up by the victors of World War II and the Cold War continues to crumble under the reality of a world in which the Emerging Markets represent the majority of world economic output. This reality stands in contrast to the assumptions behind many of the rules under the WTO as well as the World Bank which still provides Emerging Market Countries significant advantages compared to Developed Countries. For example, China continues to benefit from rules under the World Bank which consider it an Emerging Economy. As the second largest or perhaps the largest economy in the world, depending how it is measured, such special status stands inappropriate in light of the size and development status of its economy. Given economic reality, there stand numerous outdated rules, institutions, and relationships that will break under this weight.
China, which stands at the epicenter of these changes, will face the full gale force of this coming storm as the United States and other Western economies respond, for the first time, to the economic warfare waged against them over the past 20 years. With just the limited actions the US took over the past year, China’s economy took a blow as the strategy it followed over the past 30 years to grow its economy came under assault. And with the US and other Western countries viewing Made in China 2025 as a significant economic and strategic threat, actions to stymy its success and limit its reach will accelerate. While the US and other countries began to move against Chinese technology companies over the past year, such as ZTE and Huawei, more actions will occur as Developed Economies move to protect their intellectual property and shut Chinese firms out of their markets. The most likely scenario sees Chinese technology products systematically shut out from Western markets and manufacturing, that does not find itself re-domesticated for National Security reasons, moved to other nations. While these developments will not occur overnight, they will produce a long term drag on China’s economy, reducing its growth significantly. (For more details, please see The Great Game of Power: Trade Networks & The Rise of Mercantilism, The Re-Emergence of the Cold War, & The Return of the Yellow Periloriginally published on December 31, 2017.)
With long term growth slowing due just to its rivalry with the US, China’s economy faces two other massive problems in its Debt to GDP and its Industrial Overcapacity. They are both intimately linked to each other. Since the 2008 – 2009 Recession, China stepped on the Investment lever whenever its growth slowed. This ensured the country met its growth targets. However, this left China with massive overcapacity, as it built plants when the economics said not to do so. Reflecting this reality, China’s Productivity Growth stands at less than 1% according to several major banks and less than 0% according to several well-respected private economics firms, such as The Conference Board. Whichever is correct, growing the economy at over 6% with no population growth, little to no productivity growth, and no internal demand to absorb the production creates assets unable to produce a return. Due to this, China funded over 100% of its growth through debt guaranteed either implicitly or explicitly by the government. This meant that Debt to GDP rose massively despite the country’s rapid reported GDP growth, currently sitting at over 260% of GDP. This style of growth stands similar to the Potemkin Villages that Soviet Russia built to meet its growth targets. A couple of examples will make this clear. With auto sales in China running ~28 million in 2018, including both passenger and commercial vehicles, overall capacity in China stands at almost 60 million units. Despite this, China continues to build new auto plants. In steel, despite US tariffs and European safeguard quotas, China’s production of steel rose 10% in 2018. In addition, according to government forecasts, Chinese steel capacity, despite pledges to rationalize its massive production, will rise in 2019 by almost 10%.
Given China’s growth targets, changing its behavior to address this major economic issue will not come easy. Most analysts of Chinese debt estimate that 25% to 35% of the debt is non-performing. As a result, China possesses numerous Zombie Banks and Zombie Companies starring in a modern reprise of Night of the Living Dead. Were international accounting standards applied to Chinese banks and companies, a significant portion of the banking system would be declared insolvent and a significant number of companies would be declared bankrupt and liquidated. To admit to this, would require a major recapitalization of the banking system as well as shuttering a significant portion of the Chinese economy. Neither of these appears palatable to a Chinese leadership focused on social stability.
To understand the costs of addressing just the banking system, a quick look at what occurred in other Asian countries can prove illuminating. When South Korea faced a similar crisis, the recapitalization of the banking system ultimately cost the government 31% of GDP. When Indonesia faced a similar crisis, the recapitalization of its banking system ultimately cost the government 57% of GDP. With China a $14 – $15 trillion economy and debt at $39+ trillion, whatever the number, it will prove massive. To prop up the banks today, without recapitalizing them, and to fund the loan growth in 2019 to underpin more Investment spending, as China sits in a recession despite reporting more than 6% growth, the regulators authorized insurance companies to buy perpetual debt of the Chinese banks. This will provide the banks liquidity. And to make this regulatory asset palatable and not bankrupt the insurance industry, the Chinese regulators declared that the insurance companies can use these perpetual bonds as collateral with the central bank. While this may provide liquidity to fund short term growth, this does not address the cost of rationalizing the systemic overcapacity in the economy. While China continues to build out industries where it is not yet self-sufficient, such as medical devices, China will complete their buildout by the early 2020s. At that time, with no more industries to build out, growth should slow massively, putting huge pressure on the country.
Despite this future, China’s leaders once more stepped on the Investment lever over the past few months to counteract what would be called, anywhere else, a recession. These measures included cutting Required Reserve Requirements, lowering taxes, authorizing more Local Government Debt, increasing infrastructure spending, and more. All told this stimulus adds up to more than 5.5% of GDP, with more expected. This should, by the second half of 2019 at the latest, exhibit a positive impact on the economy. However, the true government budget deficit will rise to over 11% of GDP. And, despite hitting some growth target of 6% or more, Debt to GDP will continue to rise. While it may push out the day of reckoning, it does not mean that it does not rapidly approach. And with a global recession likely in the early 2020s, just in time for China to finish building out every industry, growth will come under massive pressure creating huge issues in the banking system. And this will occur on top of economic pressure from the US and other Western countries. With China attempting to stave off the inevitable, Dragon Recessions will produce more and more pain as the heat of the Dragon’s flame approaches.
For Japan, which hitched its export growth to China over the past decade, the benefits of this relationship may no longer outweigh the costs. In the short term, companies such as Nidec reported a collapse in orders in Q4, feeling the full brunt of China’s recession. As Chinese stimulus begins to impact its economy this year, Japanese companies should benefit from the turn. However, as China matures in the early 2020s, there exists insufficient demand elsewhere to take up the slack. In addition, the move by China to a more militaristic posture with aggressive moves against Japanese held islands in the East China Sea will force Japan to underwrite an expansion of its military. This will put further strain on its government budget and its Debt to GDP. At the end of 2017, Japan’s Government Debt to GDP stood at 236%. By the end of Q1 2019, it is expected to hit 254%. While the Japanese Central Bank continues to monetize the debt, eventually such a strategy will create issues for the economy. For example, the VAT, which stood at 5% in 2013, will reach 10% in 2019. Inflation, which currently stands close to zero, will eventually rise to reflect all the pieces of paper being printed by the government. Lots of other good things like this will occur. And should interest rates ever rise, the ability of Japan to service its debt will come into question. For Japan, the Setting Sun will bring a night with potential nightmares for the average Japanese citizens.
In India, which sits where China stood two decades ago, fundamental growth drivers stand abundant. And thus, India’s reported economic growth of over 7% appears realistic unlike China’s growth numbers. Reflecting this growth, areas such as air conditioners, water heaters, capital spending, manufacturing orders, and retail sales continue to exhibit strong growth. However, with a national election ahead and the ruling party under pressure, politicians will act like politicians unable to resist the temptation to meddle with the economy to goose growth, despite its positive fundamentals, to boost their election prospects. Thus, government pressure on the Monetary Policy Committee led to a 25 basis point cut in interest rates with more expected in 2019. In addition, the government engineered an 8% trade weighted depreciation of the rupee in 2018. When it comes to the levers the government directly controls, the F20 budget moves to hand out largess to voters by providing cash transfers to farmers. This stands similar to actions by numerous African democracies, whereby the government hands out cash in an election year. Of course, at some level, there exists a government budget with revenues and expenses. For India, the official budget deficit stands at a mere 3.5% of GDP and looks quite reasonable. But that number belies the true deficit as it does not include “Off Balance Sheet” borrowing. Somehow, if the government borrows money but does not include it in its balance sheet, it does not count. When the budget includes this debt, the countries budget deficit rises to 8.5% of GDP. And even that number understates reality. In order to get to this number, the budget assumes tax growth well in excess of recent trends. For example, GST collection grew less than 7% over the past six months, yet the government assumes it will grow 25% over the next year. And while personal taxes grew 16% this year due to increased tax enforcement against the underground economy and the currency changeover, the government assumes 20% growth next year. Lastly, the 8.5% of GDP deficit excludes SOEs. With Elephant Politics in ascendance, Indian growth should remain strong in 2019, with the unpleasant consequences of these actions put off to some future year that does not include national elections.
African growth continues to chug along. With $2.2 trillion in stated GDP and over $6 trillion using PPP (Purchasing Power Parity) growing overall at 3% to 5%, depending on the year, the continent’s impact on global growth continues to rise, especially given its 1.25 billion population. Numerous countries, such as Tanzania, Senegal, Ethiopia, Ghana, Kenya, …, are expected to grow above 5% in 2019 and even Nigeria is expected to grow above 3%, despite the drop in oil prices. And while a number of economies remain resource focused, quite a few have diversified away from these areas in order to create a more sustainable growth platform. By 2030, a number of countries, assuming they maintain their growth, will reach middle income status, putting them on a path to create the same type of growth that China experienced over the past 20 years and India currently experiences. With The Lion In Stride, this continent bears careful watching for the future.
While official data look great one month and mediocre the next in Brazil, on the ground data indicate a fundamental recovery of the economy. Carrefour, the large French hypermarket company, possesses significant operations in Brazil. These stores just reported an acceleration to over 10% same store sales growth in Brazil for the fourth quarter. America Movil, the Mexican wireless company, reported growth of 1.2 million post-paid subscribers here while mobile ARPU increased over 10% year over year. They commented that even pre-paid subscribers rose, indicating a broadening out of the economic recovery. Brazilian farm equipment sales continue to soar. January tractor sales rose 73%. Combine sales rose 66%. Even if the numbers are adjusted for the 20% drop in the prior year, assuming it did not occur, sales for both tractors and combines stand ~35% above their January 2017 level. Given the massive drop in the Brazilian currency, making Brazil’s soybeans hypercompetitive globally, such economic statistics make sense. In addition, Foreign Direct Investment (FDI) remains strong, which should come as no surprise due to the currency move. Underpinning this fundamental growth stands a new government focused on reforming the excesses of the government and adopting more pro-business and pro-economic growth policies. For Brazil, the music grows stronger as the economy exhibits A Real Beat.
For the Old World, economic growth continues to disappoint, as the shackles of the Euro coupled with the slowdown in China prevent the Continent from sustainably growing. Italian GDP shrank in Q4 with no better outcome expected in Q1. Germany’s Industrial Production (IP) fell year over year in Q4 at a 4% to 5% rate. While the official political excuse points to the auto changeover testing to meet emission standards after the diesel emission scandal, the real culprit hides a continent away, in Asia. Foreign Manufacturing Orders fell almost 5% in November with December no better. With German IP comprising almost 25% of the country’s GDP, German growth likely turned negative in Q4 as well despite reporting 0% growth. Combined with a negative Q3 GDP report, Germany likely experienced a recession. While the French can maintain their elan under almost any circumstances, their economic growth took a hit from the difficulties in Italy and Germany coupled with Brexit. French IP turned negative year over year in September and never looked back. French Q4 GDP grew less than 1%. And if one wishes to understand the Mouvement des Gilets Jaunes (Yellow Vests), one need look no further than the economic numbers. This type of economic result for the major European economies on top of the “robust” results of the past five years will continue to put increasing strain on the political bonds in the EU.
And with the EU attempting to impose its will on countries over their national governments, the breaking point appears close. Already, Britain headed to the exits. The next most likely attendee to leave the movie theater is Italy. With Italian growth worse than that during the Great Depression, the populace continues to grow restless. And the latest actions of the EU will only increase their restlessness. The EU treated Italy harshly on their budget deficit while giving France a pass. This differential treatment did not go unnoticed by the citizenry. At the opposite corner of the EU, Poland stands aghast as the actions of the European Commission on electricity exhibit gross insensitivity to the nation’s electric market. For those unaware, the EU created CO2 Permits in order to push electric production towards non-carbon, green energy sources. For whatever reason, CO2 Permit prices rose over 70% in 2018. For Poland, this created a disaster. Over 80% of Poland’s electricity comes from coal/lignite and Poland’s electric companies needed to buy these permits at any price. To prevent Poland’s citizens from bearing the cost of these EU permits, the government capped electricity prices and provided compensation to electric producers so they did not lose money. This seems a reasonable approach in light of a market discontinuity. The European Commission does not agree with this and appears ready to challenge these actions as illegal state aid. Whether the Italian budget deficit or the Polish electricity market, frictions within the bloc continue to grow as the EU attempts to impose its decisions on countries and those decisions infringe on basic national sovereignty. With the Old Man Stumbling both economically and politically, the EU comes closer and closer to flying apart.
For the US, the actions of the Federal Reserve coupled with the slowdown abroad, in Asia and Europe, represent a significant challenge to the economy, much as occurred in 1998. Numerous economic data points to underlying weakness in the economy. And while observers point to the Trump Administration pressure on the Federal Reserve for a change of heart in monetary policy in January, the early look at the actual data, prior to their publication, likely skewed the Federal Reserve to the side of caution, as the data undermined their case for continued tightening in monetary policy. These data include Housing, Exports, Manufacturing, and Unemployment or, more simply put, almost every area of the US economy. And while some of this can be laid at the feet of the government shutdown, much of it finds origin in either the tightening by the Federal Reserve or the economic turmoil outside the US. The following chart on Existing Home Sales makes clear this point:
Chart courtesy of tradingeconomics.com.
As the chart makes clear, Existing Home Sales appear to have peaked for this economic cycle. And while the recent pullback in mortgage rates may cause a short term pickup in home sales, as first time buyers are very sensitive to mortgage rates, Existing Home Sales will remain under pressure as limitations on the mortgage interest deductions as well as the State and Local Tax (SALT) deduction for federal tax purposes impact the economics of housing on the two coasts as well as in other select markets.
And while the US will benefit from the massive stimulus in China, with its spillover effects globally, as well as a more accommodative central bank, the sequence of economic events in 2019 looks more and more like 1967, 1988, and 1999. In those years, the US economic cycle, after bear markets triggered by Federal Reserve tightening, went on extension. However, the extension was brief, lasting 2 ½ Years on average. After which, the inevitable plunge into the deep freeze occurred. While there are many reasons why this length of time occurs, it generally comes down to the lag between cause and effect. There are a number of economic cycles within the economy. And, when enough of these cycles crest and move into the downcycle together without other parts of the economy to offset them, the economy shrinks in what is more commonly called a recession. As the above chart indicates, Housing has moved into a late cycle position, where, at best, it will move sideways. In addition, autos appear in a similar position, whereby they will not add to economic growth as the following chart indicates:
Another area that typically adds to late cycle growth, but appears near its peak, is Commercial Real Estate Construction. As the following chart from the Federal Senior Loan Officer Survey in January 2019 indicates, loan demand for CRE Loans, has peaked:
With Real Estate and Autos done for the cycle, this leaves only a few areas to maintain economic growth. They include Government spending, Corporate Capital Investment, and Consumer Spending. With the tax cut for the Consumer coupled with the typical late cycle increases in real incomes, Consumer Spending will stay strong as long as Employment grows. For Corporations, Capital Spending remained inordinately low this cycle. While some spending by certain sectors, such as Defense or Steel is in the works, in general this area has not driven growth at all. The following chart shows Real Investment into Manufacturing Structures:
As the chart unfortunately demonstrates, Real Corporate Manufacturing Investment stands no higher than in early 2009, almost a decade ago. (While nominal spending has risen, it merely rose in line with inflation.) Given the growth in the economy, this is a disappointing result. And, given the massive tax cuts large corporations received to foster investment in the economy, this decision by the Fortune 1000 to buy back stock and not invest into plant and equipment, as Congress intended, is even more disappointing and will have real world consequences. But that is for another day. In addition to the lack of Manufacturing Investment, other Investment Cycles, such as heavy duty trucks, appear to have peaked while technology spending on areas such as the cloud appears to be experiencing decelerating growth based on company reports. This leaves the Federal Government and the Consumer to carry the baton for the economy. Federal spending will head higher for now, as automatic payments under Social Programs rise with the number of retirees and the significant increase in Defense spending continues through 2021. However, should there be a changing of the guard in 2020, there likely will be a change in direction starting with the Fiscal 2022 Budget, with less defense and higher taxes. Thus, this leaves the Consumer carrying the load. As long as corporate profits hold together, employment should continue its upward course. But, once the Federal Reserve begins to raise rates again to slow the economy, the slowdown will likely lead to the classic late cycle margin squeeze. In response, corporations will cut back spending and cut back people. This will put an end to the Consumer, leaving the economy one direction to follow.
With the US economy moving into extra innings, the countdown clock has begun. However, there still remains time before the buzzer sounds, likely in 2021. With the Government and Consumer carrying the baton for the final laps, the economy should make it through the normal late cycle extension despite the international noise and the lack of corporate capital spending. Beyond the end of this cycle stands a brave new world that likely will look different than the past two decades. But, until then, the US should make The Climb To The Top. (Data from US Census Bureau, Federal Reserve, OECD, Eurostat, company reports, and public sources coupled with Green Drake Advisors analysis.)
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