- China's economy continues to decelerate as it transitions from being manufacturing-based to service-based.
- China is the world's largest user of raw materials. A slowdown in China directly impacts smaller, more commodity-driven developing countries.
- Developing countries now make up 40% of global GDP. The impact of these countries buying less goods is felt by larger, more developed countries.
- The U.S. Federal Reserve continues to hem and haw on raising interest rates. When rates do finally increase it will be because the U.S. economy is on solid footing, which is generally a net positive for equities.
Amidst concerns of a global economic slowdown, worldwide equity markets faltered in the third quarter. No country more embodied this economic malaise and equity market pullback than China. The world’s second largest economy has been one of the drivers of global growth for much of the past several decades but, as we have highlighted in previous reports, is in the midst of a transition from a manufacturing-based economy to a consumer-driven one. Given the impact China’s economy has on the global economy, we will dedicate a fair portion of this commentary to discussing the current state of the Chinese economy and its potential impact on other developing and developed economies.
China has reached a critical point in its economic transformation. Its three mainstays of growth over the last several decades have all stalled at the same time. The real estate sector is contracting after a lengthy expansion; local governments, needing to deleverage, have dialed back on making investments; and many components of the manufacturing sector have been shrinking. Fortunately, the contraction in these three sectors is being largely offset by growth in the service sector, new infrastructure investments and growth in consumer consumption motivated by escalating wages. Mounting wages and more sustainable employment have led to household consumption overtaking investment as the main contributor to China’s GDP growth, which is precisely the type of rebalancing that China’s transitioning economy needs.
Investors have been further rattled by the unconventional responses by Chinese policy makers that have led to fears of a bubble. Chinese officials have cut interest rate four times in the past 12 months, increased the amount of money banks can lend out, pumped funds into the stock market and, surprisingly, devalued the yuan, presumably to boost Chinese exports.
As we have noted in previous commentaries, China’s growth has been moderating for some time and the previously seen double-digit GDP growth was not sustainable as its economy continued to expand. Many economists are now forecasting annual growth rates of 6-7%. However, given the size of the existing economic base, 6%+ growth is significant and should continue to support global growth. Nevertheless, there are bound to be bumps in the road during this transiton period and any setbacks may continue to have a reverberating effect on other emerging market economies.
As China is the world’s largest user of raw materials and the economies of many of the smaller emerging market countries depend upon commodity exports, these devoloping markets have suffered. Developing countries now make up approximately 40% of global GDP. When these countries buy fewer capital good and higher-end products from developed countries the impact is significant. Recent data suggests that the impact of troubled emerging markets buying fewer goods is already affecting the economies of developed countries. Industrial output is falling in the Eurozone, factory output is weakening in China, and U.S. exports are slowing to levels last seen in 2011.
Potentially adding fuel to the fire is the expectation that the U.S. Federal Reserve will raise interest rates over the next few months. The Federal Reserve was widely expected to begin raising rates at its September meeting, but, on the heels of China’s devaluation of the Yuan and general concerns about the decelerating Chinese economy, did not act. Whereas in the past such a decision might have been cheered by investors, the move backfired this time as equity markets sold-off following the Fed’s decision to not raise rates.
The Fed may have thought they were being market friendly, but instead stoked concerns of a global economic slowdown at a time where many investors felt that the U.S. economy was strong enough to absorb a rate increase. A spate of recent economic data would seem to support this sentiment. The unemployment rate has fallen to 5.1%, a seven year low and in the range considered by the Fed to be full employment, and jobless claims have fallen to its lowest level in more than 41 years. Wage growth, a missing ingredient in the long recovery since the 2008-2009 recession, is finally showing signs of picking up due to the tightening labor market. The housing market, buoyed by low mortgage rates, a healthier labor market, and escalating rents that are making home ownership more attractive, continues to improve. New home sales are at a seven-year high and existing home sale-prices are at record highs. The wealth effect created by a strong real estate market could provide further support to what has been a very resilient U.S. consumer who has propped up the U.S. economy and, to this point, cushioned it from the global slowdown.
While it’s been proven frivolous to try to predict when the Fed will begin raising rates, the Fed has been less ambiguous about its tactical intentions. Fed chief Janet Yellen noted that she is more inclined to move rates up soon and proceed slowly than to wait a long time and move aggressively to catch up if the Fed finds itself behind the curve in preventing the U.S. economy from becoming unduly inflationary. When the Fed does eventually raise interest rates for any considerable length of time and degree, a reasonable expectation would be that money will flow in to the U.S. as investors chase higher yields. This could cause the U.S. dollar to rise against foreign currencies, which could benefit companies overseas that export goods to U.S. consumers.
While international export companies might more directly benefit from rising U.S. interest rates, rising rates do not necessarily imply a negative scenario for U.S. equities. History has shown that stocks tend to be volatile around rate increases, but typically do well during the tightening cycle. (As a standard disclaimer, we remind you that past performance is no guarantee of future results). Conversely, as we have pointed out numerous times over the past several quarters, the underlying conditions to allow for an interest rate increase are really a positive for companies and their capacity to earn profit. Rates would increase to temper inflation and inflation is generally caused by increasing demand. Thus, if the central bank determines interest rates should go up, it would be for reasons that are fundamentally more positive for stocks. Also, we would view moving the economy off of zero interest rates as allowing the fed to put some ammunition back in its arsenal, which we would consider to be a positive.
Benjamin Franklin once said there were only two things certain in life: death and taxes. Based on his date of birth, there was a third certainty he left out: equity market volatility. Fortunately, the investment policy suggested for your portfolio is appropriately allocated and diversified to weather this certainty. We have been through such periods of volatility before, will outlast the current situation, and will remain ready for the next events to come down the road.
Urban Financial Advisory Corporation - October, 2015