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What made the economic expansion from 2002-07 so strong was the fact that the global economy was running with ‘all cylinders firing’ in terms of the major regions all participating. The fact that the U.S. was adding significant debt on at the same time made the expansion even more robust, but also helped to make the downturn that much worse when it eventually came in 2008. Since the financial crisis ended in 2009, the global economy has been expanding, but not nearly at the same rate as prior to the crisis. China was actually the first to move in 2009 as they instituted massive capital spending which, in turn, helped the rest of the global economy. That is why the resource sector came out so strongly in 2009/10. The U.S. economy, driven by massive government spending initiatives and record low interest rates, took the global growth baton from China and kept things moving ahead, but at a much more subdued pace. Then the Euro-zone threw a wrench into global recovery story in 2011 as the Greek economic crisis brought more attention to shaky sovereign debt positions in many southern European nations, including Portugal, Italy and Spain (giving rising of course to the ‘PIGS’ nomenclature). The global recovery saw another hiccup in 2012 when Chinese growth started to slow down after the government clamped down on the expansion in the housing sector, which had driven inflation in China to over 6%, versus their targeted maximum of 3%. So while the move to record low interest rates in most of the world started to drive investor funds out of cash and bonds and into stocks, the move was a tepid one at best, since most investors remained unconvinced that the global economy was truly on the mend. The stock market winners over the past two years had been the defensive stock groups (utilities, consumer staples, telecom) where slow growth, high dividend yields and non-volatile earnings are trademarks.
What we’ve seen since mid-May though, has been a change in leadership in the stock market which appears to be driven by a greater degree of comfort among investors about the global economic outlook. The U.S. economy continues to chug along, despite the Sequester in the first half of 2013, as the housing market has clearly recovered and employment growth has started to pick up, leading to stronger consumer confidence. The auto sector recovery has also helped propel growth in the U.S. Europe may have seen its worst days for now as well. The closely-watched PMIs in Germany as well as the Euro-Zone overall, moved about the critical ‘50’ level last month while the French and British economies have also added some sharply higher growth. Even the numbers out of Spain suggested the recession might be winding down there. The biggest surprise though has been the resurgence in Japan. ‘Abenomics,’ aptly named after Japanese Prime Minister, Shinzo Abe, has lead to the best growth in that economy since before the Fukushima disaster in 2011. Although Japan continues to have one of the highest sovereign debt levels among the developed economies (around 180% of GNP) it also has one of the highest savings rates and a highly-skilled work force. Despite being the world’s 3rd largest economy, Japan has not been a force on the global scene since the late 1980s. If the recovery there is indeed real, then we will have the U.S., Europe and Japan all growing again.
In order to make the expansion truly global though, we need to see China, the world’s 2nd largest economy, maintain its robust growth rate. That is where the biggest question remains and is also what has kept a lid on the commodities sector over the past two years. Our view continues to be that the question of continued growth in China is not an issue; the move from a rural to an urban economy (or from developing to developed economy) still has many years ahead. The urbanization rate only recently crossed 50%, whereas it is above 85% in most developed economies, suggesting that the economy will continue to expand at ‘above-normal’ rates. Moreover, since China is now the 2nd largest economy in the world, the impact of their growth is even more pronounced on the rest of the world. We doubt we will see growth anywhere close to the 8-10% rate that we saw coming out of the financial crisis, but to have the 2nd largest economy growing at even 6-7% will still contribute positively to the global picture. More importantly, stronger shipping rates recently indicate demand is on the rise. Also, China has high cost curves for most key commodities, meaning that it is still cheaper for the country to import key resources such as met coal, iron ore, copper, etc. as opposed to producing those same products themselves. We have seen that in their commodity demand recently where, despite the slower growth, monthly imports of copper, cement and met coal all remain near record levels. Vehicle sales rose at an annual rate of 11.2% in June while steel production was up 9.9%. Copper imports rose 9.7% to a 9-month high of 379,951 tonnes.
The phrases that we hear most commonly out of China recently that have investors worried are about ‘reform.’ The new government in China is trying to control the risk in their economy by slowing down the excessive growth sectors in order to make their growth more sustainable in the long term. The goal is to have consumers contribute a larger portion of the overall growth. Obviously the economy can’t continue to growth by only building government-funded bridges, road and housing. The bearish view is that they already have spent too much on ‘highways to nowhere’ and ‘ghost cities’ that will never be inhabited. The chart below shows some of that trend over the past few years. Capital formation (which includes all that infrastructure spending) ramped up sharply in 2009 to almost 47% of gross national output (GNP), while consumer spending has been on a downward slope over that same time. Even in a developing economy, consumer spending should be tracking at over 50% of the total so there clearly has to be more of an emphasis going forward on domestic spending in China.
