Global Economies Decoupling
MASECO’s view of the world has not changed much recently, but we think now is a good time to reiterate our global perspective. In general, we believe that the world is in economic recovery but that the pace of recovery will vary substantially across the globe.
Countries with ‘balanced economies’ that are not heavily indebted (most emerging market countries) have the most positive outlook and countries that are ‘unbalanced’ or heavily in debt (most developed countries) have a less favourable outlook.
That being said, most of the world is currently in recovery but the structural issues faced in the most heavily indebted countries will limit the growth in those countries. The composite leading indicator (CLI) index has just hit a 30 year high and is indicating global growth is anticipated to be stronger than at any time since the early 80’s.
The unbalanced US economy
The US economy grew at a better than expected 6.9% in the fourth quarter of 2009, primarily stemming from increased productivity and inventory restocking. The Purchasing Managers Index hit a 5 year high but the unemployment rate has stayed stubbornly high at 9.7% even though the employment picture finally started to improve in March when 162,000 jobs were created. Because of falling payroll taxes, the Congressional Budget Office announced that social security will pay out more in benefits than it receives this year.
2010 will also see the US government try to issue a record amount of new debt while the Fed is expected to exit their quantitative easing program. On March 31st, the Fed also stopped buying mortgage securities and has already started closing their special lending facilities that were created at the height of the financial crisis. This should result in higher government bond yields as more supply hits the market, demand from the Fed wanes and the demand from China and Japan (the two largest holders of US government debt) remains either flat or down. Yields on 10 year government bonds hit a 9 month high at the end of March and were yielding close to 4% as the Chinese and Japanese were actually net sellers of US government bonds in the first quarter of 2010.
Locally, California and other states have struggled with recent debt issuance and California government bonds are yielding more than Kazakhstan government bonds – Borat would be laughing.
The first quarter was a very busy quarter for legislation in the US. Not only was the HIRE Act (see closing article) passed, but so was the controversial Patient Protection and Affordable Care Act which will usher in the most dramatic change to health care since the 1960’s. To fund the additional estimated $940bn in annual costs, there will be a new 3.8% investment income tax and payroll tax of 0.9% for families that earn more than $250,000 which will start in 2013.
Consumer confidence which tumbled to 46 in February down from 56.5 in January rebounded back to 52.5 in March. At the same time the number of foreclosed properties in the US continued to surge as both subprime and prime borrowers continued to walk away from properties with negative equity. The number of troubled banks also increased to 702 in the fourth quarter up from 552 as problem assets exceeded $400bn up almost $60bn during the quarter. Loan losses at banks also swelled to $53bn, up 37% from a year earlier. To put this in perspective, the FDIC took over 140 banks in 2009, but during the savings and loan crisis of 1987 there were 2,165 troubled banks and troubled assets totalled roughly $830bn.
The souvlaki state
In Europe the mood in the first quarter was ominous as Greece tried to avoid a debt crisis and rolled €10bn of government debt in March. Prior to the auctions, Greece was forced to accept EU and IMF assistance and even with this support needed to pay 5.9% on the medium term debt issued on March 24th. In the rest of Europe, euro zone governments borrowed a record €110bn in January, the largest amount ever, which exacerbated the Greece debt issue and pushed up borrowing costs in many of the weaker countries.
While that was happening, the IMF released a report predicting that gross government debt in the G-7 advanced economies (excluding Germany and Canada) would rise from about 75% of GDP at the end of 2007 to about 110% of GDP at the end of 2014. During the quarter, Standard & Poor’s put Japan’s long term debt on negative credit watch and reiterated its negative stance on the UK. We have been discussing the looming sovereign debt issue for over a year now and do not see any light yet at the end of the tunnel for countries such as the US, the UK, Japan and some of the euro zone governments with large structural deficits.
The rise and fall of the free markets
In the UK, the Bank of England halted their programme of quantitative easing which commenced in March 2009. During the past year, the Bank of England has injected more than £200bn into the economy by buying bonds, mostly Gilts. At the same time inflation hit 3% as the pound fell substantially during the first quarter.
The UK government’s share of GDP has risen from 37% in 2000 to 52% in 2009. In parts of the north, the government’s share of GDP is greater than it was in the Eastern Bloc countries when these countries were socialist. During the fourth quarter of 2009 employment in the public sector rose by 7,000 while in the private sector it fell by 61,000. Since 1997 the government has added 50% more jobs than the private sector (Source: Office of National Statistics) and having been on an insatiable hiring binge despite the soaring budget deficit. The government deficit and its involvement in the economy is also poised to grow as the baby-boomer generation continues to age and healthcare and government entitlements continue to increase.
So where did all the money go?
In mid March Forbes magazine published their annual Rich List detailing the wealthiest people in the world and where they hailed from. Carlos Slim, the Mexican tycoon, unseated Bill Gates to become the wealthiest person in the world further demonstrating the rise of wealth in the emerging markets. Of the 97 new billionaires in the past year, 62 came from Asia. In 2001, 80% of the top 10 were Americans and now only 30% come from the US and 40% from the emerging markets (Slim from Mexico, Ambani and Mittal from India and Batista from Brazil).
The continuing rise of China and the emerging markets
The economy is growing so quickly in China that the People’s Bank of China (PBC) increased the bank reserve requirement twice in the quarter in a bid to cool down the economy. Real estate prices in Hong Kong and China are approximately 50% higher than a year ago and Chinese inflation jumped higher than expected to 2.7% in January, raising speculation that the PBC may increase interest rates earlier than expected.
World trade also rebounded significantly in the past year. In January China saw imports and exports both increase close to 45% year over year confirming the growth in global trade over the past year. China also became the largest importer of Japanese goods as imports surged 44% year over year.
In India growth is also brisk. India’s industrial production rose 11.7% which was more than expected and led to the Reserve Bank of India raising interest rates. Many other countries with balanced economies such as Malaysia, Brazil and Australia also raised their interest rates. In sharp contrast to Europe, emerging market governments had an easy time rolling over their debt. In January (when euro zone governments issued more debt than ever before), the Philippines sold $1.5bn worth of debt and the auction was 7 times oversubscribed. Turkey also easily raised $2bn, Indonesia easily issued bonds on a few occasions this quarter and S&P raised their credit rating; even Vietnam had little problem raising money. Foreigners have recently started buying more emerging market debt at good yields as many emerging market currencies are expected to appreciate and the prospect of an investment grade rating looms ahead for a number of these well balanced economies.
Chile in the OECD
Growth and strong economic activity was also present in most South American countries. Chile became the first South American country, the first country in a decade and the 31st member of the Organization for Economic Co-operation and Development (OECD).
While we firmly believe that the global economy turned a corner in the second quarter last year (see our Investment Quarterly Q2 2009) we still do not believe that all economies will rebound to the same extent. The countries that gorged themselves on debt in the past decade or so will not rebound as quickly as the countries that have been growing without the use of leverage. We continue to believe that there is a structural shift happening and that emerging economies will continue to grow more quickly than developed countries and continue to offer better long term prospects in their equity, fixed income and currency markets.
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