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The debate about China really revolves around whether they can successfully slow down to that lower growth rate without overshooting it on the downside, particularly in the face of weaker demand from Europe, one of the core markets for Chinese products. The chart below though, shows that China is effectively engineering this ‘soft landing’ and, more importantly, is actually starting to show a re-acceleration of growth from the low levels of January and February of this year.
We saw a surge in Chinese steel production in March which will lead to further imports of metallurgical coal and iron ore. Copper inventories have been reduced substantially and will need to be re-built while the demand for uranium, oil and agricultural commodities continues to increase. China is in the process of a long-term rebalancing of its economy to one dominated less by investment in fixed structures and more by domestic consumption. This will not occur quickly though and the slowdown in 2012 is just a prelude to an era of slower growth. China’s government is trying to accommodate this trend by adjusting growth targets and moderating public expectations. But, in the end, they need to continue to grow. With inflation now under better control (below a 4% annual rate), the government will be quick to use stimulative measures such as lower interest rates and reduced bank reserve requirements if they feel that growth is falling below plan. The Chinese economy also reacts well to stimulus, as demonstrated by the quick resurgence of growth following the 2008 downturn.
The U.S. economy has also been expanding nicely since last summer. The surprisingly strong numbes have prompted the International Monetary Fund (IMF) to upgrade its overall assessment of global economic growth for this year. The report reflects the IMF’s view that the euro area, while still facing an economic downturn and the “hard to quantify” potential risk of a country’s default, has stabilized since last year. For the last six months the world economy has been on what is best described as a ‘roller-coaster’. The IMF last raised its quarterly projection for world growth in January 2011, when it increased the forecast to 4.4 percent for that year from 4.2 percent. “Improved activity in the United States during the second half of 2011 and better policies in the euro area in response to its deepening economic crisis have reduced the threat of a sharp global slowdown. Weak recovery will likely resume in the major advanced economies, and activity is expected to remain relatively solid in most emerging and developing economies.” The European economy is now projected to decline by 0.3 percent in 2012, an improvement from the 0.5 percent in the IMF’s previous forecast. China is projected to grow 8.2 percent and Japan 2 percent this year. “However, the recent improvements are very fragile. The most immediate concern is still that further escalation of the euro-area crisis will trigger a much more generalized flight from risk,” the IMF said.
While the 2.2% growth rate for the U.S. in the 1st quarter of 2012 was slightly below expectations, consumer spending numbers within that report were actually stronger than expected. The weakness came from reduced government spending, probably a good thing since government debt needs to be brought down and the only ways to do this are through higher taxes or lower spending. The latter is clearly the alternative favoured by stock investors.
Another tailwind for stocks is much better than expected first quarter corporate earnings, which has been offsetting the headwind from some recent disappointing economic releases in the U.S. as well as the EU debt crisis. With about 70% of reports in, the results have beaten consensus estimates by 6.3% and have earnings up 11.8% year-over-year. Apple’s 22% earnings surprise alone added 1.3% to the total! Corporate guidance, which was very negative in January and February, has turned much better in the past 6 weeks; the Guidance Ratio (downgrades to upgrades) has dropped to 1.1 from 2.8 in late February, when we reduced stock market exposure slightly in anticipation of some risk of a short-term pullback in prices.
The bigger question for profits is whether margins will be able to hold at current levels, which are higher than any seen since the early 1960s. While input costs are expected to continue to rise, companies have been offsetting this with higher productivity, lower financing charges and, most importantly, increased profits from foreign operations. Our view is that there is a secular (long-term) improvement in corporate profitablity that will sustain growth going forward. While we can see that there is always some cyclicality to profit margins, the overall trend over the past thirty years has been higher.
