Goldman Sachs Market Update: Pondering Ahead of the Autumn, Especially on China
August is coming to an end, and what a relief for some of us that it has been so calm. For the first time since 2007 it has allowed those in the northern hemisphere to enjoy some summer calm. Not that this means anything for the weeks and months ahead of course, with all the usual fears and concerns persisting.
While I have been a bit removed in the past fortnight, I have been doing lots of pondering, and amongst the various topics such as the US election, US fiscal cliff, the vast array of Middle Eastern issues, global food prices, the Euro Area of course, various issues in some Growth Economies and large emerging economies, there is one that has taken up more of my concerns than any other: China.
During August, the S&P reached new marginal 4 year highs, and many other markets rallied (at one point, Italy was in small positive territory). At the same time, China weakened notably and now stands out as a significant relative underperformer for the year as well as one of the few markets in absolute negative territory. Additionally, we’ve seen persistent underperformance since the 2007-08 peaks.
Along with this poor equity market performance, many published indicators have disappointed, most recent being the “flash” HSBC PMI for August slowing to 47.8. The lead indicators that I prefer continue to look soft, and amidst evidence of some political instability by their standards, policymakers don’t appear to be in a rush to change much. Not surprisingly, the China bears are busy saying they “told us so”. They are citing both the absence of a democracy as well as deep fundamental flaws in the Chinese model as the reasons keeping China from adapting to the current and probable state of the world. Put simply, for China to export cheap goods, invest the revenues in various infrastructure projects, allow the cream of society to benefit in terms of luxury consumption is all well and good when the rest of the world is benign and full of apparent limitless credit. However, when the world is having to move away from that, it is not possible for China to adjust its economy and society without dramatic and destabilizing change. Or at least so goes the bearish argument.
I spent some of the past fortnight reading a book from the Cairncross Foundation, edited by Edwin Lim and Michael Spence, entitled “Medium and Long Term Development and Transformation of the Chinese Economy”. This involves a collection of chapters on topical issues published back in 2010. It was undertaken at the invitation of the Office of the Central Lending Group on Finance and Economics, and the hugely important National Development and Reform Commission (NDRC), and relates closely to the 12th 5 year plan that is currently underway.
Refreshing Some Simple Number Compounding.
One rainy day this past week I found myself revisiting some simple numbers I had played around with a few times before to put the China issue into context.
At the end of 2011, the Chinese economy stood at around $ 7,300 billion, making it the 2nd largest economy in the world. Over the previous decade, China has shown astonishing real GDP and US$ denominated growth, growing from “just” $ 1,324 billion in 2001. As I wrote in a few of my previous viewpoints this year, the change of more than $ 1.3 trillion in 2011 alone was remarkable in terms of its global impact. Its contribution to the world in 2011 was close to creating the equivalent of another Australia, Spain, Mexico, South Korea, or about 2 new Turkish economies, or never mind the one I cited earlier this year, another Greece every 11 and ½ weeks.
It would seem that the Chinese stock market does not believe China will carry on down this path, or if it does, there won’t be any profit from publicly quoted companies. China’s US$ nominal GDP growth in 2011 was nearly 24%.
I looked at 3 different simple paths for the rest of the decade out to 2020, along with different paths for the role of the Chinese consumer, ranging from a low 35% of GDP to a more optimistic 45%.
It would seem sensible to assume that China’s 2011 contribution to world growth was extraordinary. In fact, even the most “optimistic” growth estimate of 15% I considered, is below 2011 figures. This is not that different from the estimates given in the 12th 5 year plan: 7.5% real GDP, inflation of 4%, which if you assume 2.5% “average” RMB appreciation against the US$, takes it to 14%. If China were to go down this path, by 2020 it would be around $ 25.68 trillion in size, probably bigger than the US. If the consumer were to become 45% of that GDP, the value of Chinese consumption would be a staggering $ 11.56 trillion, an increase of about $ 9 trillion over the nine years. Suffice to say, most markets, especially the Chinese local equity market, seem to think this has effectively zero chance of happening.
I also looked at a middle path of around 10% nominal US$ average growth, which of course, gave less dramatic numbers, but still an impressive $ 7.7 trillion increase in consumption if China rebalanced to 45% of GDP , and $ 3.5 trillion if the consumer were stuck around 35%.
Even a Chinese Hard Landing is Better than What Others Contribute!
For the “hard landing” path I assumed an average 7% US$ nominal GDP growth rate over the remainder of the decade. This would be the case if real growth persistently undershoots, deflation sets in and the currency doesn’t rise. I imagine that in such a scenario, at some point, the currency could weaken significantly, but you get the gist. What was intriguing in this pessimistic scenario is that China’s GDP would still be some $ 13.5 trillion in 2020, and even if the consumer remained stuck at 35% of GDP, it will have increased by another $ 2.1 trillion. To put this in perspective, the total size of India is yet to breach $ 2 trillion.
I tried to ponder this hard landing scenario more as it appears to be closest to what Chinese equity-markets are assuming. I find it very difficult to see the Chinese consumer representing such a low share of GDP with such low overall nominal GDP growth. As we are likely witnessing in 2012, Chinese GDP growth is slowing but it is primarily because of weakness in exports and investment, which are past areas of real strength. I suspect private consumption is already close to 40% of GDP.
I guess some will fear the hard landing scenario even more if US Republican candidate Romney were to be victorious since he is pounding the anti China rhetoric pretty noisily. When I think this through, it tends to support a rebalancing scenario for China even when considering the possibility of a less than soft landing due to trade issues (of course, there are strong arguments to be made that such a path is not at all good for the US due to potential Chinese retaliatory measures involving no bond purchases, etc).
Anyhow, hopefully the above demonstrates the point. Even in a really persistently weak Chinese nominal GDP scenario, the numbers increase quite a lot, creating plenty of income for some.
I have been pondering so much about China’s future, especially if the worst of the above scenarios starts to take hold. Presumably, at some point, Chinese policymakers would try to “do something” about it. When I consider this path, it leads me to believe the Chinese leadership isn’t excessively bothered about what markets necessarily imply (as many European policymakers seem to occasionally think too). I also believe they are focused on trying to genuinely rebalance the economy and not rush to stimulate parts of it which they have regretted doing too much and/or quickly in the past. This suggests that at some new point of equilibrium, markets start to become more impressed. Alternatively, and especially if one of the reasons is policymakers have not understood the transition challenges, when they realize genuine GDP growth is under performing their assumptions and desire, the policymakers will do something about it. In turn, key leading indicators, and both economic and financial conditions will start to improve notably.
An alternative explanation of course is, as some argue, that especially without the government-backed support for monopolistic-type behaviour for State Owned Enterprises (SOE’s) going forward, it is distinctly possible that China will continue to have robust growth. However, it will be very difficult to make money by investing directly in Chinese equities. Non Chinese based businesses that do the hard work for an investor could continue to be the better bet.
Anyhow, this China issue strikes me as still the most important in the world by some distance.
Implications for Investing. Short Aussie/Long A-Shares?
Obviously a Chinese hard landing versus a now surprisingly strong expansion has many different implications for markets. However, the one idea that settles into my mind is the rather odd cross trade I mention here. It seems clear to me that China will rebalance, and along with this, that the rate of growth of private consumption is more likely to be stronger than exports or investment. If I add on the commitment that the Chinese policymakers have for better “quality”, which amongst other things means less polluting production, alternative and more efficient energies, it is not clear to me that the largely positive terms of trade of the past decade for the likes of Australia will continue. It is interesting to see the debate escalate about whether the resource boom is peaking inside Australia. Without the peak, what is the Aussie $ so high for? And if the China A-share market has priced in the likelihood of a hard-ish landing, surely the Aussie $ should be priced lower? Alternatively, if the positive scenario for China emerges, then surely A-shares will finally turn higher?
We shall see.
Still Many European Issues.
To a very large extent, those of us hoping for a quiet August have got ECB President Draghi to thank, as much of the market’s calm goes back to his highly welcome and soothing words made in London ahead of the Olympics. Next week’s ECB meeting on September 6th will probably reveal what they are planning. Lots of people, media and ECB policy types included, continue to air their own biases, including the rather predictable and dull caution coming from the Bundesbank. It seems reasonably clear to me that their opposition will not hold back the ECB. Draghi has made it quite clear that the ECB will not allow any market pricing of a Euro breakup risk to interfere with their monetary policy operations. Something to influence shorter end peripheral bond spreads is coming.
Beyond the ECB meeting, the September PMIs will be as interesting as each month, especially given the weakness exhibited in the flash estimates and the latest weaker German IFO business confidence survey. Against this, one rare ray of Euro data sunshine came from recent money supply numbers which showed a welcome increase to 3.8% in the latest month.
In addition to these issues, obviously the German constitutional court vote on the ESM on the 12th is keenly anticipated, but -famous last words- I would be surprised if this is a real event risk. What is more interesting is the growing noise about major German constitutional reform and a referendum coming from all parties as the debate about a more fiscally and politically coordinated Euro Area seems to intensify. It is quite interesting in this regard to see the fresh strengthening of bilateral ties between the French and German Finance Ministries.
The UK. Fresh Complexities.
I focused on the UK in my last Viewpoint a couple of weeks ago, and since then, the Olympic spirit has not lived on despite the start of the Paralympics in recent days. Hopefully it has been just the August silly season but there appears to have been elevated squabbling once more about all sorts of big policy issues ranging from wealth taxes to Heathrow airport expansion. Much of the fresh angst might be a consequence of the latest public sector borrowing figures which were much worse than expected, and in no shape or form can really be regarded as demonstrating a great deal of policy success. Taken at face value, the fiscal deficit is getting worse despite the coalition regarding deficit reduction as its major economic policy goal. Of course it might simply be because the economy has been so weak as a result of that goal (and other influences). Government spending has been slightly stronger than planned, and government revenues notably weaker than expected in the fiscal year to date. This said, I continue to be in the camp that certainly doubts the weakness of the official GDP data and am suspicious as to whether the public borrowing figures really are so weak. Next month’s figures are eagerly awaited by all.
The US. Fiscal Cliffs and the Fed.
I have written this Viewpoint ahead of the much anticipated Jackson Hole from Ben Bernanke and strong expectations following recent FOMC minutes, that the Fed is about to “ ease” further. I am not sure why but I have suspicions that the Fed Chairman is not quite as keen as some of his colleagues these days, but we shall see. With the strong rhetoric coming from some quarters of the Republican Party and all the uncertainties ahead including those related to the “fiscal cliff”, why would the Fed want to pull the trigger now? Particularly when considering that the economy appears to have shown some improvement recently. Perhaps he may signal that the Fed still has a clear bias, but whether they pull the trigger again is less obvious to me.
South Africa, G20 and food prices, G7 and oil prices, the ongoing Middle Eastern issues, and the list goes on. What a wall of worry this stock market is enjoying climbing.
Let’s see what lies ahead.