Decoupling or Recoupling?
US slowdown could have global implications.
You know that a country's economy is headed for trouble when its commander in chief achieves only a 19% approval rating. It must be tough to rank lower than even Tricky Dick at the end of Watergate as he waved his final, hunched-over goodbye from the White House lawn.
But politics aside, its economics that really interests us and the key economic question facing the markets in 2008 is will the US slowdown snuff out the flame of global growth? The last four years have been heady times for global economy, as free markets and advances in telecommunications created wealth form from Vladivostok to San Paolo and all the points inbetween. Beijing now puts 1,000 new cars on the road every day, while Russia – the drab gray, cinder block, Stalinist Russia – is now the home of the Moscow Millionaires Fair, which is described as "the largest exhibition of goods and services of the class Lux, offered by the world luxury industry."
So will the party come to an end this year? Will the world go into a recession once the US consumer stops his orgy of buying? Perhaps. Or perhaps not. We take up the argument in this week's column.
Decoupling Was Yesterday's Story
Just like Miami Vice was so 1980s, decoupling is yesterday's story. For the better part of last year, the US economy slowed while other countries like Australia, the Eurozone and Canada performed well. A large part of the reason for the decoupling centered around skyrocketing commodity prices and strong demand from China or India. The main argument for the continuation of this trend is a bet on a soft landing in the US economy, but even a shallow downturn may not keep the party going for Europe, Asia, BRICs and other emerging market countries. We are already seeing global growth slowing while food prices could cause the next big shock for consumers and China, the primary engine for growth over the past few years, will most likely see their bubble pop in late 2008, early 2009. So it's time to get a shave, put on a pair of socks and get with the times. The decoupling story is older than Don Johnson's career.
Recoupling is hardly a party... Can You Spell D-E-C-O-U-P-L-I-N-G?
Hey, Don Johnson is still cool and so is the decoupling story. Yes, I know all the arguments.
1. US economy makes up 25% of Global demand
2. US consumer is 70% of the US economy, ipso facto down goes the US consumer down goes the world.
But the fact of the matter is that the world is changing rapidly and every year, every day, every hour the U.S. matters less and less. Even China, which would seem to be so vulnerable to a US slowdown, already exports more goods to Europe than the United States and while the US is an important market for the Chinese, it is not the only market. The last five years have seen new centers of new wealth appear in Asia, the Middle East and even parts of Latin America and all of those places are beginning to trade with each other. So it is by no means a foregone conclusion that just because "Joe and Jane Six Pack" stop spending the rest of the world will roll over and die.
China: Hear Her POP!
We all know that part of the reason why the Chinese economy has been growing at double digit rates is because she is racing to put her best foot forward at her coming-out party in August 2008. Unless you have been living in a cave, you should know that in August China will be hosting the Olympics. For any country that is bestowed this honor, growth tends to accelerate in the years leading up the Olympics because of strong public spending. Private companies have been contracted to produce millions of Olympic related paraphernalia, leading to overall growth and falling unemployment in urban areas.
Most of the publicly available data on Chinese unemployment is for urban areas only, because if it added non-urban areas, the country's unemployment rate would be far higher than the CIA World Factbook's estimate of 6.1% for 2006. In urban areas, less than 10 million people are registered as unemployed and both you and I know that with over a billion people living in China and 800 to 900 million of those living in rural areas, the real unemployment rate is even higher. Every country that has hosted the Olympics has seen a sharp rise in unemployment and drop in GDP the following year.
Take Greece, for example. Athens was the host city for the Olympics in 2004. In 2003, the unemployment rate was 9.7% (down from 10.3% the year prior). In 2004, the unemployment rate shot up to 10.5%. GDP growth also slowed from 4.2 to 3.7%. The biggest decline that I remember was in Korea in 1989, when growth fell from 10.5% in the Olympic year to 6.1% the year after. If history repeats itself and public spending in China contracts significantly, late 2008 and early 2009 could be a scary time for China and the rest of the world.
Maybe, but the Chinese have a lot more construction to do before they are fully developed. Here is the key difference between now and times past. For the better half of the 20th century the US had an enormous lead in technological know-how and engineering. In fact, if you had to boil down the difference between advanced nations and the Third World it would all come down one thing - engineering. Better roads, better buildings, better communications, better infrastructure facilities. Not any more. I see kids in Abu Dhabi shopping for jeans, listening to their iPods and texting on their cell phones just like any mall rat in Southern California. The rest of the world is quickly catching up to the US in wealth and infrastructure and that means that other nations no longer need to rely on the US to stimulate demand. China may still be poor in parts of the country but Shanghai is hardly a shanty town. Furthermore, unlike just ten years ago, almost all of Asia has massive FX reserve surpluses. Chinese have more than $2 trillion USD and that means it can spend some of that money to prop up local demand if its export growth slows.
Watch Out for a Shock in Food Prices
Everyone was worried about oil and metal prices in 2006 and 2007 – and they are still worried, but the next crisis may be over food. Food prices keep climbing, climbing and climbing. Milk prices, for example, have increased 15% from last year while wheat prices just this year have increased 13% and they are up more than 100 percent since June. US consumers, who live in a developed world, are just beginning to feel the pinch but in the developing world, the pain is hitting home. Looking beyond the impact on consumer spending, countries around the world have raised interest rates at a time when they should really be taking measures to soften the blow of any potential downturn. Take China, for example: Inflation hit a 12 year high. Not only will this hit the pocketbooks of Chinese consumers, but it will also cause them to raise interest rates.
The beautiful thing about food is that farmers can grow more. We had some nasty weather conditions this year and when the droughts pass prices will collapse just like they did in the 1980's. Besides, what is food – about 6% of an average person's budget? It's hardly a deal buster. On the other hand, I agree that the US consumer is in real trouble. He's just stretched too thin by housing costs. However, if the housing situation can be renegotiated through a combination of lower rates and some debt forgiveness and the monthly mortgage burden can actually be lowered, then consumers will have more disposable income than they do now and that means that they will continue to consume albeit more moderately and that will continue to contribute to global demand.
Growth is Already Slowing
Growth is already slowing in the Eurozone, the UK and Canada. Two out of three of these central banks have cut interest rates by 50bp and the Eurozone or the European Central Bank is expected to be next. According to the latest forecast by the ECB, growth should slow to 1.8% this year from approximately 2.6% last year. This is only marginally above the mid range of the Fed's 1.6% forecast for US growth. The world cannot rely on China alone, especially since their growth could slow materially in 2009. The world is still very much dependent on US growth and the Eurozone is no exception. Asia is already finding itself impacted by the financial market crisis and I expect this to continue. According to Morgan Stanley, the correlation between Asian export growth and US/G3 non-oil has increased 2.1 times over the last 20 years. Stock market correlations also stand at 30 year highs which tells me that decoupling will not continue.
No, things are not nearly as bad in Europe and Asia. Yes, Spain has a housing bubble, but Germany and France are quite healthy. As a matter of fact, despite the huge exchange rate differential are so productive that their stuff still sells in Asia and Middle East. With their consumer balance sheet much healthier than the US and with retail demand still very muted in Europe, the downside is far less severe. That means just as in Japan in the 1990s the US can be in a slowdown but will continue to grow. Just take a look at today's UK Retail Sales – blowout number best in 11 months – that 's hardly a carbon copy of US slowdown even if the BoE is lowering rates. You want decoupling? Look no further than the Great White North. Last month the US lost –17k jobs while Canada gained 49k new jobs. No country is more dependent on US growth than its hockey-loving friends, but somehow they managed to skate circles around the US when it comes to growth. Decoupling anyone?
Where are the currency plays?
The U.S. dollar is weakening, consumer spending is slowing which means that demand will stay domestic. I believe that we will have one more push lower in the US dollar because there will be another round of disappointing US economic data. Service sector ISM plummeted in the month of January and the last time we saw ISM at these levels, non-farm payrolls dropped by 300k. Weakness in the labor and housing markets should slow consumer spending even further, necessitating more rate cuts from the Federal Reserve. I would not be surprised to see the US dollar fall to a new record low against the Euro, before we see a second half recovery. My favorite play continues to be Long Australian dollars against the US dollar. By June, US economic data should begin to show stability. At that time, the US should see a new trend of weaker Eurozone, Australian and New Zealand economic data. This will be the time when I start buying dollars.
Ironically enough, I agree. If you don't buy the world going on a breadline scenario then the Aussie is the bomb. A bet on the Aussie Kiwi and Loonie is basically a bet on the bright prospects of global growth and the power of capitalism to create more wealth. Now what could be more American than that? On the other hand, I don't buy the whole dollar comes back in second half of the year story. This puppy is sick and will be lying down for a while. Say hello to the new yen - it called the US dollar and it will be funding carry trades for a long time to come.
What Does this Mean for My Stock Positions?
Continue to stay long multinationals or US companies that do a lot of business abroad because they will be benefitting from dollar weakness. Companies that produce luxury goods could also be good shorts. Sharper Image just filed for bankruptcy protection. I think we will see more bad news from other high end retailers or retailers in general that produce goods that people only spend discretionary income on. For example, RedEnvelope (REDE), an online retailer of upscale gifts, just reported a third quarter loss and unless the US economy rebounds, their sales could remain weak.
Mickey D's (MCD). Mr. Softee (MSFT) (if it can just drop the dumb bid for Yahoo (YHOO) HP (HPQ) and any other well run multi-national that sources in dollars but profits in euros and yen should continue to do well, especially if the US economy does not tank but just slows. In that case rates will remain low, but demand won't drop off too much so profits won't be badly hurt. In fact, if you believe that scenario, just buy the Diamonds – they are the best bet on decoupling in the market because these days most of the companies in Dow Jones Industrial Average are American in name only.
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