8/4/2015 - Within the past few weeks, things have been looking moderately better in the U.S. and Europe. U.S. GDP is reporting stronger growth and European quantitative easing seems to be working, despite the recent Greek debt drama. So, shouldn’t the market bulls be off to the races? Not quite. For one, after a historic 6 1/2 year market rally fueled in part by QE, things might have gone up too far, too fast. U.S. stock valuations are not cheap and bond markets are definitely in bubble territory. Furthermore, September will see the first interest rate hike in more than 9 years, a headwind to both stocks and bonds. However, most troubling for us, the second largest economy in the world, China, is slowing down.
Much of the world depends on China for supplying raw materials and for selling goods and services. Is the rest of the world discounting a slowing China? We think so.
The Risk of China
China was the 10th largest economy in the world in 1990. Today, it is the second largest, behind only the United States. Since 1990, China has not experienced a sub-7% GDP growth rate. What China has accomplished in 25 years is remarkable, especially as they are a “Socialist Market Economy.” They have transformed their agriculture-driven economy to a global demand-driven economy.
To put things into perspective, it helps to see compare Chinese growth to that of the rest of the world. Global growth has averaged a ho-hum 3.0% since 2008, while Chinese growth has averaged 8.8%. Many countries and global companies have come to depend on China’s demand for raw materials and goods and services for growth. In short, China has driven global growth within the past decade. From our viewpoint, there are three very important million-dollar questions:
- How serious is the Chinese economic slowdown?
- Can the Chinese government stop an economic slowdown through economic and market intervention?
- What impact will a Chinese slowdown have on the rest of the world?
The first two questions are very difficult to answer. China is very cautious about what data is released, and the data that is released cannot always be fully trusted. Though, it is clear that China is currently experiencing 3 bubbles: housing, credit, and investment. According to Ben Ritchie at Aberdeen, the housing build-to-demand ratio is at 22%, which is a massive oversupply of housing. Further, housing accounts for ~23% of China’s GDP, triple that of the US at its peak (Moodys). Quantitative Easing in the Western economies has led to a vast Chinese credit explosion. According to Credit Suisse, China is currently experiencing the third largest credit bubble in recent history.
And finally, rapid industrialization has led to the investment share of GDP to be extremely high.
So, what is the impact to the rest of the world? According to the OECD, “a two-percentage-point decrease in the growth of Chinese domestic demand for two years would reduce world GDP by 0.3 percentage points a year. Including market corrections (a 10% decline in global equity prices and a 20-basis-point rise in equity risk premiums), global growth would be around half a percentage point lower.”
(Source: “Impact of China Slowdown“ The Economist)
Of course, countries with stronger ties to China (e.g. Japan) will experience a more severe impact, while others will not. The OECD predicts GDP in the U.S. and the EU would decline by 0.25 of a percentage point.
The Western World Recovers, Sort Of
U.S. GDP expanded 2.3% during the second quarter, better than most economic projections. Furthermore, Q1 GDP grew 0.6% after a newly revised national accounts took place instead of the -0.2% decline that was previously reported. As long as U.S. company earnings continue to expand, we believe there is room for a continued stock market rally, all else equal.
The US unemployment rate also looks attractive at 5.3%, the lowest since the beginning of the 2008 financial crisis. However, the labor participation rate remains stubbornly low at 62.7% and wage growth remains nonexistent. What does this mean? This means that less Americans are working and those that are working are getting paid less in inflation-adjusted dollars. In short, the U.S. has a labor force from the 1970s. Too many individuals are simply being left out of this recovery.
A low labor participation rate is a much larger problem that will likely impact us for generations to come. Though, it currently has a minimal impact to the financial markets.
Giving confirmation of an improving economy, the FOMC is likely to raise rates this September. There is a very high probability that the Fed will announce a 0.25% rate hike immediately following their September 16-17 meeting. We believe that both the stock and the bond market are ready to accept this rate increase. In fact, this rate increase is likely already priced into the market. While this rate increase has been anticipated for years now, the more encouraging speculation is that the Fed is unlikely to aggressively raise rates thereafter. This is an act that many have been anticipating for years. While the latest announcement wasn’t groundbreaking, it did remove a lot of the uncertainty around a September decision. The real question isn’t whether or not interest rates will rise, but rather the speed and the frequency of future rate hikes. Again, this is another million-dollar question.
However, there seems to be a disconnect between the Fed Funds Rate market expectations and the Fed’s expectations. Clearly, the market is discounting future rate hikes. Will a future rate hike by the Fed surprise the market? Or is this a case of “under-promise and over-deliver” by the Fed?
While the market hasn’t seen a tightening cycle in some time now, we don’t think the Fed’s tightening will meaningfully raise interest rates at the margin. Though, we do expect higher volatility, as both stocks and bonds are vulnerable. In the end, we think the initial rate hikes will create a stronger dollar, which will slow the U.S. economy. In turn, we believe the Fed will be forced to postpone future rate hikes as the stronger dollar will negatively impact the markets. Thus, this might be a case of under-promising and over-delivering.
European QE is Working
In the European Union, the newly enacted quantitative easing program seems to be having a positive impact on economic expansion. Cheap money is pushing investors to invest in riskier assets and it is also forcing the Euro lower versus other currencies, boosting exports. Eurozone July manufacturing PMI came out at 52.4, showing positive growth despite the near Greece economic collapse. In fact, Europe’s bailed out economies are booming. Spain, Ireland, Portugal, and Cyprus are all leading the way in economic growth. All except Greece, that is.
Market performance this year has been largely lackluster. Both the bond and the stock markets have been flat, while a stronger dollar and larger inventories have lead commodities significantly lower. After a long period of strong market returns, it is normal for investors to become accustomed to double-digit returns. While the current bull market can still run, we think the odds are against it. A Chinese slowdown and a rising interest rate environment are not ideal for market returns. As I stated in my previous newsletter, don’t be too greedy. A bull market doesn’t last forever and this one is a bit long in the tooth. Additionally, valuations are rich and unless earnings growth exceeds expectations, stock market performance may continue to disappoint. It might be wise to temper expectations.
Bull Oak Capital
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