We Focus on the USA, Europe, China and Japan
Despite the early wobbles during January 2014, global equity markets had largely recovered all lost ground by the end of February and as of this writing are somewhat ahead of where they were at the start of the year. Heightened concerns about the U.S. housing sector, emerging markets and especially China, and extreme weather conditions around the world have left investors jittery.
As we celebrate the 5th anniversary of the Global Financial Crisis, the S+P 500 ® is at approximately 300% of where it was at its low point and this trend is widely echoed in the major global bourses. Many believe that this year will end with the global equity markets higher. Of course the bull’s ride will not be smooth and there are many “Black Swans” threatening to cross its path. However there are three powerful components to the tailwinds for US equities: corporate profits are solid and growing steadily, monetary policies are accommodative and interest rates are low. With the earnings yield on the S+P 500 at around 6.5% and many companies paying higher dividends than the interest that their bonds carry, equities still look attractive to many.
Tempering the optimism however are mounting concerns about the prospects for the U.S. housing market. The recent figures have not been encouraging. Given the important role that housing has played in the U.S. recovery so far, a new phase of sustained weakness would clearly be a concern for the broader economic outlook.
US equity investors seem willing to ignore weak fundamental macro data which reflects sluggish but steady growth, and are focusing instead on corporate earnings. The “Labor Force Participation Rate” which reflects those actually working or seeking employment is at 62% , a rate not seen since the dismal days of 1978. The Federal Reserve continues to reduce asset purchases (tapering Quantitative Easing), although it is clear that this has had minimal impact on interest rates. Most observers believe rates will stay in the current range until well into 2015 and Janet Yellin has indicated that is now core inflation rather than unemployment that the Fed will be watching most closely.
With both corporate America and the consumers having rebuilt their balance sheets, the USA now has a “2-speed economy” with big business generating enormous and sustainable profits, while the man-in-the-street has seen very little of it and job creation is sluggish. The big story in the USA is the return of manufacturing onshore made possible by the dramatic impact of fractional drilling (“fracking”) on energy prices. The price of natural gas in the USA is approximately 1/3 the price in Europe and 1/5 the price in China.
Turning to the international picture, the economies of resource-rich countries continue to lag, largely impacted by the slowdown in China, the world’s second largest economy. The Eurozone will continue to recover in 2014, as leading economic indicators and confidence continue to improve. The European Commission’s latest economic forecast paints a mildly optimistic picture, with growth on the continent steadily improving, unemployment gradually easing, and inflation remaining low but never tipping over into deflation.
The U.K. is tracking the steady US recovery closely .The Bank of England’s latest quarterly report presented an upgraded economic outlook including continued benign inflation along with stronger GDP growth in 2014 and more quickly falling unemployment. The drop in prices in countries such as Greece is a natural outcome of their “internal devaluation,” where economic adjustment is accomplished through a drop in prices within the country, rather than by a weaker currency. However, subdued prices have extended to stronger countries, with German real wages (net of inflation) actually falling in 2013.
The emerging market economies are a mixed bag with a 30‐percentage‐point equity performance deficit compared with developed markets last year, which is continuing. Civil strife in Ukraine, Venezuela, Thailand and Egypt (among others) has once again cast doubts over institutional stability across broad swathes of the emerging world, while five major countries‐‐ Brazil, India, Turkey, Indonesia and South Africa—will face leadership elections this year. As central banks in emerging markets including India, South Africa and Turkey move to battle inflation by raising interest rates, their own growth prospects are diminishing. After growing 7.5% in 2010, Brazil grew only 1% in 2012 and around 2.5% in 2013. Prospects for 2014 appear to be no better.
Disappointing growth reports out of China, the world’s second-largest economy after the U.S., have also weighed on markets. The recent severe drop in the value of the Yuan will inevitably have significant effects on damping exports. China, from an external perspective, promises to look and feel like a different economy in the year(s) ahead. Greater focus on China’s household demand and less focus on its industrial demand will change China’s impact on the global economy slowly but surely.
The rapid growth of their shadow banking system has resulted in market distortions and the risk of widespread defaults. With the recent first default on a publicly traded corporate bond (Chaori Solar), the authorities have indicated to the markets that they will not bail out feckless borrowers. The Chinese government has increased regulations and oversight, which could moderate credit issuance, increase borrowing rates, and slow economic growth in 2014.
They will have to determine the optimal way to engineer the deflation of the credit bubble in China. There are indications that banks are cutting back lending as a result. In particular lines have been cut to natural resource wholesalers, traders, and importers (iron ore, steel, cement, etc.). These borrowers in turn are forced to sell inventory that is often used as collateral for these loans. Inventory sales depress prices of some of the raw materials, generating further losses for these businesses. This is compounded by the nation’s slack industrial demand, with steel mills now running at 50-70% of capacity.
The depressing and worrying statistic out of Japan is that they are now selling more adult diapers than children’s diapers because of the aging demographics. In fact the two Japanese paper companies—Daio, and Nippon Paper—are currently expanding their manufacturing facilities for what are politely called “incontinence products” Japan has the highest percentage of over-65s in the world, making up more than 20 percent of their population. Despite the stimulating policies of “Abenomics” Japan still seems to be unable to decisively move beyond the stagnation of the past two decades.
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