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The focus last week was on the US debt ceiling debate but of greater importance is the slowdown in global economic growth. The US GDP report Friday showed just how weak the US economy was over the first half of 2011 but this isn’t just a US problem. Canada and Australia are also slowing - probably due to a slowdown in China despite that country reporting rosy numbers - and Latin America is developing a severe case of inflation. Meanwhile Europe’s debt problems continue to fester with Italian and Spanish bond yields both rising last week. The deal put together to save Greece won’t be approved throughout Europe for several more months and passage, especially in Germany, looks iffy at best. Even if it is finally approved, the EFSF - Europe’s sovereign bailout fund - isn’t large enough to handle Spain or Italy much less both. Growth in Europe is already anemic and higher interest rates in the periphery won’t help.
Canada reported last week that GDP fell by 0.3% in May and second quarter growth is now expected to come in much less than the BOC’s forecast of 1.5%. The strong Canadian dollar is adversely affecting their manufacturing sector while mining and oil and gas production are also falling. Growth estimates for Australia are also falling with private sector economists now expecting growth of just 2% over the next year. In addition, inflation is near a 4% annual rate, consumption is stagnating and business confidence is falling. Stagflation is a real possibility.
In Latin America, the problem is inflation. Brazil’s most recent read on inflation showed prices rising at an annualized 6.7% and the central bank just hiked rates to 12.5%. The Brazilian Real is still rising as capital continues to flow into the country but stocks have stagnated for nearly two years. Consumer debt burdens are higher than the US and probably as high as they can go. The Brazil Development Bank has fueled a spending boom ahead of the World Cup and the Olympics by ramping up subsidized corporate loans. Brazil’s boom is built on state directed credit and selling raw materials to China, neither of which looks sustainable. Peru, Colombia and Chile have similar capital inflow and rising debt problems. Argentina and Venezuela are economic basket cases with high inflation and weak growth. Argentina has taken to criminally charging private economists who dare to question the official inflation rate of 10%. As for Venezuela, it’s economy is as sick as its Caudillo.
In Asia, the key to growth is obviously China and while we believe it may offer significant opportunity over the long term, there is ample reason for concern near term (read John Chapman’s weekly update for more detail). China has been fighting an inflation problem with higher bank reserve requirements and interest rates but continues to restrain a needed rise in the Yuan. The measures so far seem to be hitting growth more than inflation. In addition, the new five year plan calls for a shift to greater domestic consumption from the investment fueled growth of the last decade and that transition seems unlikely to occur without some disruptions. The rest of Asia will be affected by a slowdown in China but countries such as Korea, Taiwan and Japan should be less affected than, for instance, Thailand and Vietnam which are more directly dependent on China for growth.
A slowing in China, if it were coupled with a pick up in US growth, would likely be very beneficial for the global economy. A big part of the problem in Latin America, Australia and Canada is an excessive capital inflow as investors have fled the US dollar. Much like the US in the late 90s, these capital inflows have raised growth through investment - and to a lesser degree consumption - and created an inflation problem. Much of the investment has gone to resource extraction to meet Chinese demand. If China slows as we expect, the demand for natural resources will fall and at least some of the investment will prove unprofitable or even foolish in hindsight. Better growth in the US would cushion the blow of slower Chinese growth while also drawing investment back to the US dollar and relieving the inflation problems.
The question, of course, is whether growth in the US will improve from the first half malaise. On that score, I had hoped that our politicians might finally see the light and strike a grand bargain on spending and tax reform. It appears as I write this that I may have been overly optimistic on that front. The debt ceiling deal being discussed today doesn’t cut spending (it merely slows the rate of growth minimally) and defers more substantial reform to a later date. I don’t believe we have to suffer a new normal of slow growth but major policy changes are needed to avoid it. Right now, I just don’t see it.
In the short term, however, there is still some hope of a cyclical rebound in housing that could support higher growth over the next year or so. Last week’s economic data hinted at that possibility although most of the attention was on the backward looking GDP figures released Friday. As a whole the data continues to be mixed to weak with relatively weak consumption and slowing - but still growing - manufacturing.
The Goldman and Redbook retail reports showed decent if not exciting growth in same store sales. Year over year gains are in the neighborhood of 3.5%. Durable goods orders were much less than expected at -2.1% with most of the decline in transportation. Ex-transport sales were up 0.1%. On the investment front, non defense capital goods ex transportation fell 0.4% but shipments were up 1%. The Chicago Purchasing Manager’s report was more positive at 58.8. There was growth in new orders and backlog although the employment component fell to 51.5 from the recent readings over 60. Overall, manufacturing is still growing but at a slower pace.
The hope for a cyclical rebound in construction was bouyed by the New Home and pending home sales reports. New home sales were down 1% to a 312k annual rate but prices rose with the median price up 7.2% and the average up 4.8% year over year. Supply remains very low on an absolute basis at 164,000 so even at this low rate of sales homebuilders have just 6.3 months of supply. The pending home sales index was up 2.4% month to month and 19.8% year over year. This is a seasonally strong time of year but the year over year rise gives some hope.
For the housing market to truly rebound though will require more growth and more jobs. On the jobs front, new jobless claims finally fell below the 400k level to 398K. That is still way too high and there may be some problems with seasonal factors due to the auto industry but claims at least appear to be heading in the right direction again.
As for growth, the headline numbers were pretty bad and hard to argue with but there were some positives. Overall, 2nd quarter growth was 1.3% which was up from a revised and dismal 0.4% in the first quarter. The big drag was on the consumption side with drops in both durables and non durables. The drop in durables was in autos and household equipment while the non durable side was mostly in gasoline. By contrast, it was all positive on the investment side with GPDI rising 7.1% led by an 8.1% rise in structures. Even residential investment added to GDP rising 3.8%. While the headline growth rate is disappointing, the underlying data is more positive. If the slowdown in autos is Japan related - and I have no idea whether it is or not but that seems to be the consensus - and construction starts to pick up, growth may surprise on the upside in the second half.
Stocks sold off last week based on the lack of a debt ceiling deal and the weak economic data. The S&P 500 is now near the low end of its recent range and if a deal is struck next week a relief rally seems likely. Whether it is sustainable will depend on the outlook for economic growth and earnings. For now, it seems more likely that the economic data will continue to worry for a while longer. Earnings have been good again this quarter so far, but with profit margins near all time highs, further upside is dependent on sales growth. With the global economy slowing that seems less likely. We remain very conservative in our allocations as we wait for more evidence that US growth is picking up.
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