We are approaching the Spring and the Persian New Year - known as Norooz. And we made it through the predicted Mayan apocalypse and the transition from the fourth “sun” to a fifth. But now scientists are warning that the sun is out to get us. According to NASA, the sun’s current cycle, known as Solar Cycle 24, is expected to reach its peak in early- to mid-2013. Powerful solar flares have begun to have a significant effect on Earth. They can cause long-lasting radiation storms in the atmosphere—disrupting electrical infrastructure and temporarily rendering cell phones useless.
But can they cause financial market pullbacks? The most notable stock market pullbacks of the past two years coincided with spikes in solar activity. In particular, recent stock market pullbacks have coincided with solar flares: August 2011, November 2011, May 2012, and October 2012. However, it was not the consequent electromagnetic storms that disrupted the stock market. Instead, it was flare-ups of a different sort: the debt ceiling debacle (August 2011), the European financial crisis (November 2011 and May 2012), and the U.S. election and fiscal cliff concerns (October/November 2012).
The potential flare-ups we are monitoring at GGA this year are:
Exacerbating these potential flare-ups, currently high energy prices can make the economy and markets more vulnerable to a negative event that drives stocks lower. Every 10 cents gasoline prices rise takes more than $10 billion out of U.S. consumers’ pockets over the course of a year.
However, it is important to note that the potential negative impact of these risks is limited by the fact that they have been known for some time. Though they may contribute to market volatility this year, the forewarning of them makes a bear market unlikely. Bull markets do not tend to end with the S&P 500 stocks valued as low as they are today, which is the lowest price-to-earnings ratio at a bull market peak since World War II. Therefore, based upon these factors, while ups and downs may continue, we believe the bull market is unlikely to be over.
In an up-and-down market environment, investors may seek to benefit from volatility in several ways, including:
Despite these flare-ups, I believe the sun will still be shining by year end, and stocks and bonds may deliver modest gains for investors in 2013. As always feel free to call or email if you have any questions or comments.
President Obama’s State of the Union (SOTU), scheduled for tonight - Tuesday, February 12, is unlikely to be a big market mover. In fact, most SOTU speeches see less than a 1% move in the stock market on the following day, and the average move is only 0.15%.
I think this year, President Obama will present key themes that may impact certain industries and asset classes. While gun control and immigration will likely comprise important themes, they have minor market impact. The two major themes that we will be listening for with potential to impact the markets are: the fiscal cliff and energy independence.
Early in his speech, the President will be forced to talk about the second part of fiscal cliff. There are three remaining components to the fiscal cliff that are yet to be resolved:
The President will likely restate his recent comments about replacing the spending cuts that kick in on March 1, known as the sequester, with some combination of tax increases and spending cuts. However, this has little chance of passing the House after Republicans supported tax increases in the first fiscal cliff deal. The Congressional Budget Office estimates that the fiscal drag from the sequester in 2013 would be about $85 billion, or about 0.5% of gross domestic product (GDP.) This adds to the roughly 1.5% drag on the economy from the fiscal cliff tax increases that went into place January 1. That is a materially negative impact for an economy that registered a contraction in the fourth quarter and is on track for only sluggish growth in the current quarter.
Comments that suggest the President is open to mitigating the defense cuts in exchange for cuts elsewhere, rather than tax increases, may be a positive for the markets—especially for stocks in the defense industry, which have been pulling back lately as the cuts have loomed. Unless changed, defense spending (other than for military personnel) will be cut by around 8% across the board, while non-defense funding that is subject to the automatic reductions will be cut by between 5% and 6%.
The continuing resolution funding the government expires on March 27 and could prompt a government shutdown (though certain essential components like the armed forces will continue to operate). While tax collections will be reaching their seasonal peak as the April 15 deadline approaches, tax refunds processed by the IRS may take much longer than usual and could cause consumer spending to drop and negatively impact stocks in the consumer discretionary sector. In 2012, the average tax refund check was nearly $3,000, all together totaling $175 billion. The drag on incomes could be felt since consumers have lacked the confidence to fund spending with credit cards in recent years. During the previous two government shutdowns, it was short-lived. It lasted five days in November 1995 and was followed by 21 days in January 1996. As long as talks are proceeding, we expect another continuing resolution to be passed to fund the government for a few more months or until September 30 to avoid a lengthy shutdown.
While the debt ceiling has been pushed back to May 19, it will soon be upon us again. If no further action is taken before May 19, the Treasury will once again resort to extraordinary measures to allow the government to continue operating. As precursor to restating these negotiations, President Obama will likely talk about a “balanced package” of spending cuts and tax increases to reduce the deficit and need for additional borrowing. With the potential for additional tax rate increases on the horizon, high dividend-paying stocks and municipal bonds (given the potential elimination of some deductions) could react negatively, which may present a buying opportunity.
These fiscal cliff issues leave little likelihood that other recurring themes in the President’s SOTU address see any legislative action that otherwise could impact certain asset classes. For example, the President is likely to again tout the need for greater infrastructure investment—a potential positive for some stocks in the industrial and materials sectors were it to actually take place. Another example is a new program to modify underwater mortgages that could act as a negative for mortgage-backed securities, if implemented.
The President is likely to highlight the need for U.S. energy independence, noting the increasing domestic oil and gas production and voicing his continued support for sources of clean energy. Given their dependence on federal support programs, the stocks of producers of wind, solar, and other clean energy sources often tend to be volatile around the SOTU addresses in recent years—sometimes seeing a big bounce that soon fades.
Regarding traditional sources of energy, investors are unlikely to hear anything on natural gas or coal that may turn around slumping coal stocks, but probably nothing that would accelerate their decline either. However, the President will likely highlight energy tax incentives for elimination known as the “percentage depletion allowance” and “expensing of intangible drilling costs.” These incentives exist to encourage small companies to produce oil from marginal wells that become profitable with the tax breaks. These marginal wells are old or small wells that do not produce much oil individually, but in total constitute most of the U.S.’s domestic oil and gas production. The percentage depletion allowance was eliminated in 1975 for the major oil companies, and their ability to expense intangible drilling costs expensing is very limited. Therefore, the potential elimination of these tax breaks would be unlikely to have a major negative effect on the major companies in the energy sector. However, the exploration and production industry of the energy sector could be negatively impacted, were these incentives to be eliminated, which we doubt will happen in 2013.
Last week, I talked about the shift from the "Financial Crisis" to the "Economic Crisis" in the Eurozone. This week, I'll focus on Washington, where the Federal Reserve's (Fed's) policymaking arm, the Federal Open Market Committee (FOMC), wil meet, the first of eight FOMC meetings this year. Whith several new voting members on the committee, this week's meeting is likely to receive plenty of attention from the media and markets Of note, however, Fed Chairman Ben Bernanke will not hold a press conference, nor wil the FOMC release a new economic forecast at the conclusion of this week's meeting.
Still, in recent weeks, markets and the media have been buzzing about this meeting and, in particular, whether or not the fed wil adopt formal thresholds to monitor the effectiveness of the latest round of quantitative easing (QE) - $85 billion in monthly purchases of Treasuries and agency mortgage-backed securities (MBS). The FOMC has already set thresholds for monitoring its "highly accommodative stance of monetary policy" (fed funds rate traget between zero and .25 basis points).
Public appearances by several of the more hawkish members of the FOMC since the release of the FOMC minutes in early January 2013, have only increased the drumbeat for the FOMC to adopt some type of quantitative threshold for measuring the impact of QE, or even for ending the purchases altogether by mid-2013. Thus far, however, only the hawks on the FOMC - Philadelphia Fed President Charles Plosser, Dallas Fed President Richard Fisher, Kansas City Fed President Esther George, and Richmond Fed President Jeffery Lacker of Dallas - have openly called for an end to QE by mid-2013. More important, in my view, are the views on QE by the center of gravity at the FOMC - Beranke, Vice Chair Janet Yellen, and New York Fed President William Dudley. All three are in favor of continuring the current pace of QE, and are all voting members this year.
So, will the FOMC vote this week to adopt thresholds for QE that might lead to QE purchases being scaled back or ended by mid-year 2013? Maybe, but that is not likely to be an outcome of this week's FOMC meeting, especially since there is no post-meeting press conference for Fed Chairman Bernanke to provide more color around such a shift. However, ending QE early - or at least providing thresholds for ending it - is likely to be a topic of lively conversations among FOMC members this week. Unfortunately, those conversation (or a high level recap of those conversations) wil not be made public until the minutes of this week's FOMC meeting are released on Feb 20, 2013. In the meantime, markets will continue to speculate on if QE will end early and, if so, when. In my view, the Fed will likely continue to purchase $85 billion in Treasuries and MBS monthly in 2013.
Ultimately, however, an end to or scaling back of the pace of QE by the Fed wil depend on the health of the economy and labor market, the pace of inflation and behavior of inflation expectations, and the functioning of financial markets (Treasury and agency MBS) most closely impacted by QW. Thus, if the Fed does have to scale back (or cease) QE in mid-2103, it would only do so against the backdrop of a rapidly improving economy, and/or a sharp move higher in inflation and/or inflation expectations, or a malfunction in the Treasyry or MBS markets. In my view, given all the factors pushing down on inflation, and the deep and liquid markets for Treasury and agency securities, an early end to QE3 would likely occur against the backdrop of aneconomy that was growing more rapidly that we, the Fed, and the consensus thought possible in late 2012. For now, my view remains that the economywill grow at around 2% this year, far below the Fed's 2.65% GDP growth projection for 2013.
This week I will be looking in Brussels- Belgium to determine market direction, since this week holds the first meeting of the year for European finance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in the Eurozone.
However, this year may be different. In 2012, the European Union finally took two important steps to halt the financial aspect of its ongoing crisis. One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market. Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress.
With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, I do not expect market participants to fear a European financial crisis this spring and drive a 10% decline for U.S. stocks as they have in recent years. But Europe’s crisis is far from over, and market participants may drive stocks lower later this year.
In my opinion, Europe has traded a financial crisis for an economic one. The ECB is able and willing to only fight one crisis. The price Europe has paid to avoid a financial crisis is in the form of recession and unemployment rising above 10%—including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Inflation is still over the 2% target.
This is not just a shift in the crisis facing Europe’s southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment.
The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of financial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require financial aid. Germany, the de facto decision maker as a result of making up the lion’s share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis.
In early 2012, the European fear gauge was the bond yield of southern European countries rising as the financial crisis worsened. But now that a financial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European financial crisis has eased, Portugal’s 10-year bond yield fell from 16% last summer to 6%, and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germany’s 10-year bond yield fell below 1.5%. This is not a sign of crisis averted, but of a different one brewing. Economists’ estimates for Germany’s gross domestic product (GDP) in 2013 are still coming down. Europe’s 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years.
The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europe’s evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the financial crisis was averted last summer, we may be increasingly better off focusing on emerging market stocks, in particular in Latin America as the year matures and the European economic crisis deepens.
While I have been focusing on the US Presidential Election and its ramifications on a potential budget bombshell of tax increases and spending cuts known as the fiscal cliff, my colleagues in our Beijing Office have been focusing on China. Therefore, I have decided to focus on China’s Communist Party Congress that is taking place-taking place now.
The second largest economy in the world after the United States is also experiencing a political transition and faces some tough challenges ahead. The Chinese Communist Party’s 18th Congress, a week-long transition of power that started last Thursday and is set to end this Wednesday, is the most important political meeting in China in at least a decade. A new generation of leaders, headed by Xi Jinping, is replacing the current top bureaucrats and their chief Hu Jintao.
In his departing speech last week, President Hu Jintao cited many of the challenges China faces: a wide gap between the rich and the poor, imbalanced development between the wealthy cities of the east, and the struggling farms of the western countryside. Rather than redistribution, the departing head of the Communist party’s remedy was faster growth. He announced a commitment by the government to a doubling of China’s Gross Domestic Product (GDP) this decade, a goal that would bring China to twothirds the size of the U.S. economy, a tall order given recent slowing trends.
Much like in the United States, China’s political transition is taking place amid a looming crisis. China is experiencing its own version of a “fiscal cliff.” China’s growth rate has declined dramatically from double-digit rates to an official, and “politically-adjusted,” 7.4%—although externally verifiable measures of economic activity in the third quarter appeared to slow even more sharply. Inflation has weakened China’s competitive position in many product categories with other emerging market Asian nations. And China continues to sacrifice domestic consumption for the benefit of export growth, which is very weak, given soft demand from key customers due to the European recession and below-average U.S. growth.
As in the United States, factions within China have competing visions for how to combat these challenges. One party does not mean one vision. China’s new leadership must address the country’s economic problems, but there is no agreement on the path to take. Some constituencies want to reverse some of the decentralization that they argue has contributed to wasteful spending and re-establish central control over the economy. Others want to further westernize China’s version of communism, but that would lead to some still antithetical outcomes, like bankruptcies and unemployment, and risking social order that Chinese hold above all else.
With the power transitions taking place last week, it has become apparent to me that gridlock is now a global phenomenon:
The political systems of all three of the world’s major governments are finding it difficult to make decisions vital to economic growth.
I believe, the Chinese possess an advantage the other countries do not: growth seems to be improving. The re-acceleration of growth can paper over a lot of structural problems and alleviate the near-term need for tough decisions. Starting over a year ago, Chinese policymakers began a series of stimulative policy initiatives that have accumulated and had time to work. They appear to finally be making a difference in growth; China posted the second month in a row of improving economic data late last week.
China’s Index of Leading Economic Indicators (LEI) rose again. Key measures such as rail traffic, bank loans, and money supply growth continued to show healthy signs.
The improving trend in inflation gives China the flexibility to provide more stimulus without risking social unrest. The ability to cut interest rates and implement new spending programs or tax cuts to drive an acceleration in growth and ensure the recent stabilization is sustained is a luxury not enjoyed by policymakers in the United States or Europe.
While in my opinion a moderately defensive stance may be desirable for some investors, investments that benefit from China’s growth may do well, namely commodities such as precious metals and oil, along with stock market sectors that benefit from solid export demand from China, like information technology.
As I'm writing to you this week my fellow New Yorkers as well as others along the eastern portion of the United States are dealing with the devistation caused by hurricane Sandy, I sympathize with them during these extremely difficult times. Although the focus has been diverted away from the presedential elections due to Sandy's media coverage - rightly so - but we are only a week away from arguably an important day for the United States and partially the global economy. I have written extensively this year on the looming fiscal cliff, the potential for the upcoming elections to influence the resolution of the fiscal cliff, and the fiscal cliff’s impact on the economy today and early in 2013. I think it's important to discuss to what extent the nation’s longer term budget calamities have been part of Mitt Romney and Barak Obama campaigns, and how the election outcome may help to influence how these longer term issues get addressed.
In late 2010, after the mid-term elections that saw Republicans take control in the House of Representatives and narrow the Democrats’ seat advantage in the Senate, three different groups released detailed plans addressing the nation’s long-term budget issues. Each of the plans was received with a great deal fanfare from market participants, the media, and many of the so-called “think tanks” in Washington. For a brief time, there was some conversation about our longer term budget deficit issues.
However, the longer term debate over the budget waned in the “lame duck” session (the time between the congressional election and when the newly elected Congress convenes) following the 2010 congressional elections. And in place of that debate, the scramble to address the expiring Bush tax cuts, the risk of a government shutdown, and the extension of the funding for emergency unemployment benefits took center stage.
Ultimately, the 2010 lame duck session did extend the Bush tax cuts and the unemployment benefits, and a government shutdown was avoided. But in doing so, the session set the stage for the toxic debt ceiling debate in August 2011, and set up the fiscal cliff that the economy faces in just over two months. What has been almost forgotten in the two years that have passed since these deficit reduction plans were announced is how we, as a nation, are going to address our long-term budget problems. How did the candidates do on this issue during the debates?
I use the word cloud that is derived from the transcripts of the three presidential debates between President Barack Obama and Governor Mitt Romney, as well as the vice presidential debate between Vice President Joe Biden and Congressman Paul Ryan. Some commonly used words are eliminated from the cloud, and other words like “Obama,” “Romney,” “America,” and “American” are also excluded, to get at the true essence of the debate.
Aside from the word “people” (373 mentions), the words “jobs” (229) and “work” (170) were a key theme in the debates, suggesting that the campaigns think this election is all about jobs. Add in the word “economy” (101 mentions) and it’s clear that the campaigns believe the overall health of the economy is also crucial to the election outcome. Interestingly, the word “China” (61) was used more than “education” (54), “families” (51) or “kids” (46), and “Iran” (46) got more mentions than either “Afghanistan” (35) or “Iraq” (33). But how did our longer term deficit problem rank with the candidates during the debate?
The word “deficit” does appear 57 times, about the same number of mentions as the word “budget.” While the word “revenue” (or its variations) got 20 mentions and did not make our word cloud, “spending” (and its variations) got 53 mentions and did make the cloud.
The word “loophole” was used 23 times, often referring to portions of the tax code that allow individuals or corporations to shield income from taxation, while the word “tax” was used in the four debates a total of 250 times. The word “Medicare” shows up 91 times—more than one-third of which were in the vice presidential debate. While not indicated in the cloud, “Social Security” was mentioned 31 times across the four debates. Given their size in the budget, Social Security and Medicare will likely be part of any credible long-term plan to reduce the budget deficit. According to the nonpartisan Congressional Budget Office, by 2020, spending on Social Security and healthcare programs like Medicare will account for 60% of all Federal budget outlays, up from 45% in 2012.
Three budget plans were released in late 2010 by:
„The President’s National Commission on Fiscal Responsibility and Reform (commonly known as Bowles-Simpson);
Bipartisan Policy Center (commonly known as Rivlin-Domenici);
and „ Pew-Peterson Commission on Budget Reform.
Each plan differed on certain aspects of the longer term fix for our budget problems. However, they all generally agreed that there are no easy answers and no quick fixes. The three commissions were populated by both Democrats and Republicans. Some hold (or once held) elected office; others served in the Federal government or were on the boards of the many think tanks in and around Washington. All were all focused on finding bi- partisan solutions to the problem.
For example, both the Bowles-Simpson plan and the Rivlin-Domenici plan noted that budgets cannot be balanced by eliminating waste or earmarks (just 1% of Federal spending), nor by just cutting domestic discretionary spending, nor by growing our way out of the deficit, nor by raising taxes.
In general, the three commissions concluded that in order to successfully tackle the longer term deficit problem, formerly politically untouchable areas must be on the table in any serious negotiation. These areas include:
„Personal and corporate tax rates; and
„Personal and corporate tax loopholes (like deductions for paying home mortgage interest and state and local real estate tax, or making charitable contributions).
The plans did vary on the amount of revenue increases (via some combination of higher tax rates, fewer loopholes, and more incomes subject to taxation) relative to spending cuts (across all categories of Federal spending) needed to achieve a long-term path toward fiscal stability. The outcome of next week’s elections will go a long way toward determining the ultimate mix of revenue increases and spending decreases that will set the county on that path.
GGA Uruguay Investment Overview (2) - October 2012 -A platform from where to increase trade with China and elsewhere
China´s GDP is expected to grow in 2012 by 7.8%, the lowest in more than three years as a result of economic slowdown in the Eurozone as well as in the United States, the main commercial partners. China will consequently start to look closer at the emerging markets, particularly Latin America. Over the last ten years trade between China and the Latin American countries has grown from $15,000 million to $183,000 million, an annual average growth of 28.4%. China imports 80% of its food and has become the second market to many of these Latin American countries who are net exporters of food. For how long can this growth rate prevail when China buys from them commodities and sells manufactured goods?. 53% of Argentina's exports to China is soybeans; Brazil, soybeans, flour, coffee and sugar; Colombia, 60% oil; Chile, 55% copper; Peru, 45% copper, iron and gold and Uruguay 100% soybeans, flour and rice. These countries´ social structures, particularly in Uruguay, is made up of a growing middle class, urban dwellers, that cannot reach sustainable wages if they depend exclusively on exports of commodities. Added value is essential attainable only from manufacture and service industries. For these countries to diversify their exports adding value to their commodities they need investments in technology, manufacturing and services. China´s trade with this region can continue growing to compensate losses in other markets due to economic problems but also from protective tariffs. To benefit from increased trade with this region, it must invest in technology and capital
Products today are the result of production chains. A case sample would be the Chinese cellular phone that is designed in Los Angeles, add parts produced in Mexico and shipped to China where it is assembled and packaged to be shipped back for its sale in the United States. These Latin American countries need investment in infrastructure, develop their natural resources, start investigation centers, new processing plants and production and service companies. All can eventually be part of future production chains. What country in the region offers the overall conveniences needed to establish a trading base from where to reach markets? We suggest Uruguay as the best suited because of its size, accessibility to government support, as producer and exporter of food and commodities and because it is flanked by two giant producers of commodities: Argentina and Brazil, all active members in their regional trade association.
On May 2012 we sent our clients an overview on Uruguay that we introduced as “GGA´s choice in Latin America to look for investment opportunities ...”. We headlined our reasons for this as: the country's long-standing tradition of respect for private property; for being entrepreneurial-friendly and for its financial protective laws. Further augmenting that it is the only country in the region that offers the conveniences of a well-developed country and the drive of an emerging economy, in a safe and stable social and economic environment. It is a country where distances are short with a well connected network of roads and water transportation. Its population of three and a half million people are mostly of Spanish and Italian origin with no racial or religious conflicts and a social structure made up of a well-educated middle class, 80% urban dwellers. The economy bases its growth (2011 GDP 6.5%; projected for 2012: 6.2%) in its balanced budget and surplus balance of trade, on an efficient and diversified agricultural sector, international financial services and tourism. Access to top government officials needed to process approvals and regulatory decrees for investment projects and, unlike other countries in L.A., corruption is not an issue.
Uruguay is little known internationally. We recommend it to our clients as the most interesting in this region for investments and as a platform from where to reach other markets. Uruguay has favoured free trade, having signed several bilateral agreements and as a member in trade associations, Mercosur and Unasur. Production and assembly plants in Uruguay that add value to its natural resources and to those from their neighbours: soy oils, flour and feed; beef, mutton and pork meats; seeds, fertilizers, insecticide for agriculture; biofuel; manufacture or assembly for alternative energy plants such as wind and solar; development of IT services and innovative products; assembly plants for trucks, cars or airplanes (passenger, cargo or fumigation). To all these areas China can offer technology and capital, thus creating an important trading center for its own products.
A recent presentation in Shanghai spoke of Latin America as an “FDI hot spot” (once again in a somewhat generic version of LA.). In the presentation it stated that the whole region had over the last five years an annual growth rate averaging four percent and that this gave proof of the region's resilience to global crisis. It considered that this was made possible by these country´s exports of soft commodities such as iron ore, soybean and timber to markets such as China, and also for having applied correct macroeconomic policies such as inflation targeting and reduction of debt levels. Finally, that the growth in GNP can also be accounted to the increasing purchasing power of a growing domestic market of 600 million. Low inflation, reduced debts and budget deficits were essential for this continued growth rate. Increased purchasing power of its inhabitants gave room to a strong growth in its middle class Once again, no mention was made that the region´s society is made up mostly of middle class, urban dwellers, incapable of growing in an economy that is based exclusively on exports of soft commodities. To reach sustainable wages it needs added value to its commodities. If left unsatisfied, it may inspire some of these countries to adopt protective import tariffs at a time when globalization demands open markets, as defended by the WTO and its leading members, the US and EU. These countries in their claim apparently forget their own history of growth that allowed them to reach the status of developed countries. Protectionism was initiated by Great Britain in 1484 under Edward II, and followed by most European countries and later by the US after its independence and thereon. All these countries imposed import tariffs to protect their industries from foreign competition and export tariffs on their commodities. This is how they reached the manufacturing efficiency that resulted in surplus production that soon demanded new markets. The underdeveloped nations of Latin America and Asia where their natural targets. This exporting capacity, added to credit restrictions imposed by international lending institutions such as the World Bank and the IMF, partly explains for the late and often inefficient process of industrialization in these regions. As the main source of food in the world and producers of commodities, these now emerging nations should be the recipients of new investments from those new countries that are playing major roles in the world economy: China, India and the oil-producing countries in the Middle East. These last have oil, capital and import all their food requirements while a country such as Uruguay has an energy deficit and needs investments to add value to their commodities.
It should be noted that some countries in the region have started to tax imports to protect local manufacture and some, such as Argentina, are even taxing exports of some commodities with the excuse of promoting processing industries. Import tariffs to protect local industries are in opposition to the WTO and the IMF, but some countries will get around this and implement them. Uruguay is probably the only free trade country in the region that does not need to resort to import tariffs, yet. But it also has special legislation that allows establishing production centers in any of the several free zone areas where one can import, process and export without any restrictions. This offers the ideal conditions for the country to process and trade its own food products and that of its neighbours, as well as other commodities. These are the reasons behind why we are placing Uruguay as the country in Latin America that has more to offer to establish a platform from where to trade food products and processed commodities.
Dear Clients and Friends:
I watched the last night’s Presidential Debate in Boca Raton, Florida, which shed little light on how Obama and Romney would differ in handling Iran, Syria, extremism or the rise of China. Frankly, I do
not believe the last night’s debate will bare any resemblance to thenext four years of American foreign policy. Words like; Iran, Syria and China were used; 38, 23 and 32 times respectively by the candidates throughout the debate. Words like; Economy, Job and Budget were used 25, 25, and 39 times respectively, which shows the importance of the economic situation and its ever growing role in America’s foreign policy agenda in the future. Therefore, I would shift my attention from October 22nd to October 26th, and from the foreign policy debate to the health of the global economy.
The broadest measure of the health of the U.S. economy is Gross Domestic Product (GDP). This Friday, October 26, 2012, the Bureau of Economic Analysis of the U.S. Department of Commerce will release its
initial estimate of GDP for the third quarter of 2012. The consensus is looking for a 1.8% annualized increase in GDP between the second and third quarters, a slight acceleration in growth from the 1.3% pace in the second quarter. I continue to maintain my below-consensus forecast for 2.0% GDP growth for all of 2012. The consensus estimate for GDP growth in 2012 is now 2.1%.
While the media and politicians on the campaign trail may pay a great deal of attention to third quarter GDP, the markets will likely largely look past the report and increasingly focus on the pace of U.S. and global economic growth in the current (fourth) quarter, and, more importantly, in 2013.
Why does global GDP growth matter?
Financial markets, especially equity markets, focus intently on earnings. Broadly speaking, earnings growth is driven by “top-line,” or revenue growth, less the costs incurred earning that revenue, with labor costs accounting for more than two-thirds of costs. A good proxy for global revenue growth is global GDP growth plus inflation. Thus, the pace of growth in the global economy is a key driver of global earnings growth, and ultimately the performance of global equity markets.
The latest (mid-October 2012) Bloomberg consensus forecast for 2013 global GDP growth stands at 3.3%, down from 3.5% a month ago, 3.7% at mid-year 2012, and the 4.1% forecast made at the start of 2012. The downgrade to growth expectations for 2013 reflects several factors:
- The dramatic slowdown in China’s economy in response to the series of monetary and fiscal tightening implemented over 2010 and 2011.
- The ongoing uncertainty in Europe surrounding the future of the Eurozone, and the strains those concerns are having on the European financial system and European economy, which remains mired in
- The uncertainty in the United States over the elections, fiscal cliff, looming debt ceiling, and long-term budget outlook.
The markdown of global GDP growth forecasts for 2013 partly reflects the markdown of 2013 U.S. GDP forecasts. In late 2011, the consensus forecast for U.S. GDP growth in 2013 was 2.5%. By mid-year 2012, the consensus forecast for 2013 was 2.4%. The latest (October 2012) consensus forecast for 2013 is just 2.0%.
The Eurozone has seen its 2013 growth prospects cut the most relative to other regions over the past year. In late 2011, the consensus was looking for a 1.6% growth rate in GDP in 2013. By mid-2012, the
consensus reduced its forecast for 2013 to just 0.8%. The latest (October 2012) forecast pegs growth in the Eurozone in 2013 at just 0.3%, a very meager bounce after the 0.5% drop in Eurozone GDP in
What Could Change the Downward Trajectory of Global Economic Growth Forecasts?
In the United States, a relatively quick (and growth-friendly) resolution of the fiscal cliff, and to a lesser extent a similar outcome for the looming debt ceiling (late winter 2013) and the longer term deficit reduction task facing the next president and Congress, would provide consumers and businesses more long-term certainty around taxes and the legislative and regulatory backdrop. That lifting of uncertainty could help support U.S. GDP growth next year.
Barring a prolonged fiscal-cliff-induced recession in 2013, housing will continue to be a modest plus for the U.S. economy in 2013. However, at less than 5% of GDP, housing alone cannot push overall GDP
growth significantly higher. Consumers (nearly 70% of GDP) and business spending (10% of GDP) need to do most of the heavy lifting in the economy. Consumers will of course benefit from higher housing
prices (and equity prices) via the wealth effect, but a surge in consumer spending in 2013 after the modest 2–3% gain in consumer spending in 2011 and 2012 seems unlikely, even with a more settled
fiscal, legislative, and regulatory backdrop in place.
Business spending in 2013 is likely to be highly sensitive to the legislative and fiscal backdrop put in place by Congress and the next administration. Business capital spending has increased approximately
10% per year over the past two years—the fastest pace over two years since the late 1990s. A swift and growth-friendly outcome to the fiscal cliff and long-term certainty in the tax and regulatory codes
would need to be in place for most of 2013, in order for business capital spending growth to approach 10% again in 2013. Government spending at any level (federal, state, or local), which accounts for
around 20% of GDP, is unlikely to add to growth next year, after contracting at a 2–3% pace per year over the last two years. Net exports, which have not been a big driver of U.S. GDP growth since the
end of the Great Recession in 2009, could help boost growth next year if:
1. China turns the corner and reaccelerates—dragging the other emerging markets (EM) with it; and
2. Europe can manage to eke out any growth at all. U.S. exports to EM (including China) and Europe account for more than 70% of U.S. exports.
In order for Europe to emerge from recession in 2013, policymakers in Europe, including the European Union (EU), the European Central Bank (ECB), and governments in Germany, Spain, Italy, Greece, etc., need to hasten the pace of policy actions aimed at stemming the nearly three-year old European sovereign debt/banking crisis. The pieces of the puzzle include, but are not limited to:
- A tighter banking union across the Eurozone;
- A European-wide banking regulator and deposit insurance scheme;
- A well-funded mechanism to provide aid to countries (like Spain) that need additional help paying back debt;
- Greater fiscal union across Eurozone countries; and
- More flexible labor market rules.
Although these issues appear to be on the table, more progress needs to be made on all fronts sooner rather than later. While policy actions taken by the ECB and governments in Europe over the past year
have likely greatly diminished the odds of the worst-case scenario—a breakup of the Eurozone—a recession is still the most likely outcome for Europe in 2013, if the ongoing severe dysfunction in European financial markets continues into 2013. A modest recovery in Europe (which would help to boost U.S. and Chinese exports and lift global growth) in 2013 may occur if Europe moves faster in resolving the issues at hand. However, any backsliding by any single government, the ECB, or the Eurozone itself in moving ahead with the progress already made could push the Eurozone deeper into recession in 2013, putting further downward pressure on global growth in 2013.
In China, the once-a-decade leadership transition has thus far prevented the Chinese authorities from more aggressively reversing the policies put in place in 2010 and 2011, which were aimed at slowing
the Chinese economy. A smooth leadership transition, and more aggressive fiscal and monetary policy stimulus in China would likely put a floor on Chinese (and global) growth in 2013, providing a lift
for earnings prospects for global companies. On the other hand, if China continues to be reluctant to act more aggressively, fears of a “hard landing” (5–6% GDP growth in 2013) would likely persist well
into 2013. Very aggressive stimulus measures similar in size and scope to the measures put into place in 2008 and 2009 would likely see a sharp rebound in China’s GDP growth (to close to 10%), which wouldlikely result in a ratcheting up of the market’s global GDP growth
forecasts for 2013.
On balance, while the media and politicians may have a field day with
this week’s U.S. GDP report for the third quarter of 2012, most market
participants continue to be focused on the drivers of—and changes
to—the 2013 global GDP forecast.
As always, feel free to call or email if you have any questions.
Global Growth Advisors, LLC
New York +1.347.770.4421 - Beijing +86.186.1115.0016
Dear Clients and Friends:
This week, as my partner is getting ready to travel to Beijing, I decided to focus on China. I expect a soft landing in China in 2012, i.e., Gross Domestic Product (GDP) growth between 7% and 8%, which is below consensus estimates. When I last focused on China amongst a European audience in August, I noted that additional monetary and fiscal stimulus in China could happen at any time, and markets would welcome these additional steps.
Since then, the 2012 consensus forecast for China has continued to move lower—from 8.25% in August 2012 to 7.75% today—and is now only a bit higher than the midpoint of my long-held forecast for Chinese GDP in 2012. China, in the middle of a once-a-decade transition to new leaders, has announced a few monetary and fiscal policy initiatives since then, but it has not cut the overnight lending rate or the reserve ratio requirement—the two key monetary policy levers in China. On the fiscal side, China has not unveiled any major new government spending projects either. With each passing day and week that China does not make a major monetary or fiscal policy announcement, the market becomes increasingly concerned about a“hard landing,” or sharper slowdown in economic momentum. This week’s GDP report is a high-profile opportunity for the markets to get a read on the Chinese economy in the recently completed third quarter of 2012. In my view, it is unlikely that, even if China were in a hard landing, Chinese authorities would publish a hard-landing-like GDP report, especially after promising in March of 2012 that GDP growth in 2012 would be 7.5%.
China will release its third quarter 2012 GDP report later this week. The market is looking for a 7.4% year-over-year increase, following the 7.6% year-over-year reading recorded in the second quarter of
2012, reported in mid-July 2012. In addition to reporting its GDP data on a year-over-year basis, China also reports GDP on a year-to-date basis (YTD), tallying up GDP in the first three quarters of the year and comparing that to GDP in the first three quarters of 2011. On that basis, the consensus expects a 7.7% year- over-year gain in YTD GDP, versus the 7.8 % YTD reading in the second quarter of 2012. China also reports its GDP on a quarter-over-quarter basis, similar to the way GDP in the United States is reported. On that quarter- over-quarter basis, China’s GDP is expected to expand by 2.0% between the second and third quarters of 2012. Of the three ways China reports its GDP data (year-over-year, year-to-date year-over-year, and quarter-over- quarter), the market pays most attention to the year-over-year data.
To say transparency is not a hallmark of China’s economic data reports, is similar to saying transparency is not a major attribute of granite. Like trying to get blood from a stone, China does not release the details of the composition of its GDP data, unlike in the United States and virtually every other economy in the world.
For example, in the U.S. GDP accounts, the Bureau of Economic Analysis of the U.S. Department of Commerce—the government agency responsible for tracking, collecting and disseminating U.S. GDP data—provides detail on hundreds of categories including: consumer spending, business capital spending, residential construction, inventories, imports, exports, and government spending within the GDP accounts. This is so that the markets (and the public) can get a better understanding of what is driving U.S. GDP. China’s National Bureau of Statistics (NBS), the Chinese government agency responsible for tracking, collecting, and disseminating the Chinese GDP data, provides no such detail, leaving the public in China, as well as global market participants, guessing about the composition of the Chinese economy.
Although the Chinese government does not publish details of its GDP data, organizations outside China do provide estimates of the composition of China’s economy. The World Bank estimates that between
40% and 50% of China’s GDP is accounted for by consumer spending (versus about 70% in the United States), leaving China’s net exports to carry a large burden. The World Bank estimates that China’s exports account for one-third of China’s GDP; exports account for 15% of U.S. GDP. Through September 2012, China’s exports were up just 10% from a year ago. In the first nine months of 2012, China’s exports to the European Union were down 6% from the first nine months of 2011, and exports to the United States were up 9% in that same period. With Europe in recession, and the United States growing at just 2.0%, China’s exports have slowed dramatically this year to around 10%, after year-over-year export growth was 15 – 20% in 2010 and 2011.
The one bright spot for China’s exports continues to be emerging markets, where central banks have been aggressively cutting rates for more than a year now to stimulate growth. China sends 52% of its
exports to other emerging market nations. China’s exports to other emerging markets are still running 12% ahead of year-ago levels year-to-date through September 2012, and have accelerated through the
spring and summer months. Until the United States re-accelerates, and Europe emerges from its recession, China is likely to continue relying on other emerging markets to pick up the slack, as China continues to transition from an export-led economy to a more consumer and domestically focused economy.
As always, please free to call or email if you have any questions.
Global Growth Advisors, LLC
New York +1.347.770.4421 - Beijing +86.186.1115.0016