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Market View

Devaluation and a return to infrastructure investment could revive China’s growth, while higher interest rates may benefit the U.S. economy.

 

In Brief

  • The economy is slowing in China, and is likely to have impacts worldwide. But the U.S. economy is growing moderately, and Europe is improving, making a global recession unlikely.
  • China will take steps to keep its economy from slowing too much. One option is to return to the infrastructure-development program that has helped drive the economy for decades. The recent yuan devaluation should also help boost China’s exports. The impact on the U.S. market likely will be minimal, unless devaluations are continued.
  • Many observers are beginning to ask whether low interest rates are hindering, not helping, the economy. Even the U.S. Federal Reserve has published papers arguing that low interest rates for an indefinite period can distort investment decision-making.
  • Oil prices remain relatively low, and are unlikely to rise much, given that most producers around the world are pumping at capacity. In the United States, additional capacity in the form of wells that have not yet been “fracked” is likely to come online if prices rise too much.

 

A number of signs are suggesting to some observers that a global recession is possible. China’s stock market collapse and economic slowdown, combined with the country’s high debt levels, may even point to possible financial crisis, some believe. What impact will China’s recent devaluation of the yuan have on global growth? A worldwide slowdown could challenge policymakers in developed markets, where record-low interest rates and high government debt levels mean that the usual monetary and fiscal policy tools may not be available. But there are hopeful signs as well. Addressing these topics are Lord Abbett Partners Milton Ezrati, Senior Economist and Market StrategistZane Brown, Fixed Income Strategist; and Harold Sharon, International Strategist.

Q. China’s economy has slowed, and growth is sluggish in the United States and Europe. Is the global economy in danger of slipping into recession?

Zane Brown: China really does have an economic slowdown, and that is influencing emerging markets as well as the U.S. market. But I think that the persistent 2.0–2.5% economic growth that we have here in the United States1 and the 1.4%-plus growth rate that Europe is now experiencing2 as a result of the weak euro will offset, to some extent, the impact of China’s slowdown. So, we may see a global slowdown, but probably not a recession.

Milton Ezrati: China is not going to see negative growth; it will be slower than before, but still faster than the developed world. So, even with Europe stumbling and the United States shuffling, that won’t produce a global recession.

Though the yuan devaluation has received a lot of attention, and may smack of desperation, it is nothing more than Beijing’s way of balancing the scales with the euro, the yen, and other currencies that already have depreciated against the dollar. Though far from a full answer to the country’s stimulus needs, it is one tool by which the government will see to it that the economy continues at an acceptable growth rate.

Harold Sharon: I agree with Milton. The country’s regional competitors have certainly enjoyed the fact the yuan has been tied to the strong dollar. The yen has depreciated close to 50% versus the yuan since 2012.That's a huge competitive shift in the terms of trade. The current yuan move seems modest compared with that, and brings the yuan only half way back to where it was 12 months ago in real exchange-rate terms versus the dollar.4 The ultimate implications won't be clear until we see where the People’s Bank of China holds the line. The larger the devaluation or the quicker the devaluation, the more that risk assets will negatively react.

But it’s a bit premature to be talking about a global recession. It’s very rare to actually have a recession when real interest rates are negative [see Table 1]. Inventories, other than in China, don’t seem to be blown out of proportion, and the consumer is generally healthy in most parts of the world, having deleveraged over the last six years. 

Costs aren’t getting out of control at the corporate level yet, so I’m not even sure if we’ll see the proverbial “earnings recession” that markets react negatively to. But could we see an “earnings expectation recession”—that is, a period when the optimistic assumptions about some parts of the equity market are not met—because we’re in that phase of the cycle where market optimism is high.

 

Table 1. Real Policy Interest Rates Tend to Be Positive before a Recession
Real fed funds rate (fed funds rate minus core Consumer Price Index), 04/1960 –06/2015

Source: St. Louis Federal Reserve Bank and FRED database.

 

Brown: As long as China’s devaluation remains contained at less than 5%, the consequences, especially to the U.S. market, should be manageable. A weaker yuan will allow China to export some deflation, but the Fed has been focused more on domestic considerations than international ones. At the margin, China's moves push the Fed's 2% inflation target a little farther out of reach, but unless devaluations continue, the Fed is unlikely to be dissuaded from its intent to regain higher short rates as a policy tool.

The deflationary impact of China's devaluation on Europe could prolong the European Central Bank’s [ECB] quantitative easing beyond its current end date of September 2016. The ECB is more focused on inflation as its key policy objective, so the deflationary influence of yuan devaluation may have a more visible impact on policy in Europe, especially if there are additional rounds of yuan devaluation in the coming months.

The most direct impact is to other Asian nations who compete with China as exporters and who are also dependent on China as an export market. A weaker yuan can hurt other Asian nation exports on both fronts.

Historically, a lot of China’s growth has been due to exports and to infrastructure development, but the government has been trying to shift the economy to one that is more consumption-based. Unfortunately, that has coincided with some sharp declines in property values, which has produced a negative wealth effect, making Chinese consumers reluctant to spend. And that has now been exacerbated by the drop in the stock market. 

So, there isn’t as much domestic consumption occurring as expected. According to China’s automakers association, auto sales are expected to be up only 3% for the year, instead of the 7% expected at the beginning of 2015.

If China’s exports are sluggish because of slow growth in the rest of the world, and if its domestic consumption is also weak, then one thing the government can do to resurrect the economy is to return to its infrastructure development program. 

Ezrati: Regarding a return to the infrastructure program, China certainly has the resources to do that. Its outstanding public debt is only about 25% of gross domestic product [GDP].5 Chinese firms took on a lot of debt during the financial crisis of 2008–09, but the government did not. The Chinese also have about $4 trillion in foreign exchange reserves.6

So, the government can remount the kind of effort it put forth in 2009 to fight off a recession, and I would argue it needs to because it can’t afford not to create jobs for people.

Q. But isn’t China’s infrastructure already overbuilt? It’s been reported that many office buildings and shopping centers are standing empty. Wouldn’t restarting the infrastructure program just produce more of these unprofitable investments?

Ezrati: In 2009, the infrastructure program did generate a return; it extended the economic growth inland. It’s easy to see why that would pay for itself. When you put macadam on a dirt road, it improves the ability of farmers to get their products to market. So, I think a revival of the infrastructure program could also produce a payoff.

But to Zane’s comment about shifting the economy to domestic consumption, it’s not that easy to make that shift, and so that will mean slower growth. The problem is that the government has to get Chinese consumers to spend. But they don’t have many insurance products or 401(k)-type programs, so they have to save a lot. And their economy has been built on exports, so aside from the luxury goods that are available in the cities, there is no great Walmart-type selection of goods for the consumer to purchase.

As for China’s stock market crash, it’s easy for Americans to conclude that that is going to hurt their economy. But their market is not as connected to their economy as our market is to our economy. Most of their businesses are state-run and get financing from the banks; they don’t raise money in the market. So, the Chinese don’t have the same kind of direct link between the market and the economy that we have.

Brown: But there will still be a slowdown, and it is still likely to impact the rest of the world. Emerging markets that depend on exports of commodities to China will see their exports decline, and companies that depend on China have already seen their sales decline. So, there will be an economic impact, but growth in the United States and Europe will prevent a global recession.   

Sharon:  One area of infrastructure spending that China has been quite clear about is the ongoing reach westward toward the “land of the 'stans” [e.g., Kazakhstan, Tajikistan, Kyrgyzstan, and Uzbekistan]. They refer to this as the New Silk Road, where they hope to build a network of rail links and motorways from Chinese industrial bases to places such as Bangkok, Singapore, Karachi, Almaty, Moscow, and Kolkata. They’ve spoken about pipelines, power plants, and dams in eastern Siberia, Pakistan, and Myanmar. The new Asian Infrastructure Investment Bank (based in China, by the way) is up and running and has close to 60 founding members. The only objective is to string together infrastructure throughout the Asian Pacific region. 

Q. Some observers are beginning to ask if low interest rates are actually hindering, not helping, economic growth. One view is that slow growth is a result of a misallocation of capital that occurs when interest rates are kept low for long periods.

Brown: That assumes that lending standards have been compromised. But I’d suggest that banks have been very stingy in lending and money has not been made freely available. Commercial and industrial loans have grown over the last few years, but the growth has not been hand over fist.

But low interest rates might have hurt the economy through “financial repression” in which investors who depend on interest payments see their income reduced. Ultra-low interest rates might also discourage banks from lending, and that could hurt the economy.

A lot of that new debt has been issued by energy companies and mining companies. But was that a misallocation of capital? No, it was just a matter of their assumption about the price of oil being derailed. Most of the issuance occurred when oil was at $100 per barrel, and that was used to invest in new, more efficient rigs. It made all the sense in the world to do this because the cost of producing the oil was only $45 a barrel. The same thing has happened in the coal industry. So I don’t believe there is a lot of cheap money out there that has been stupidly placed with companies that are wasting it on poor investments.

Ezrati: Put yourself in the shoes of a banker. He’s probably still scared by what happened in 2008–09, and he’s got regulators telling him not to take any risk. So why shouldn’t he just borrow the money at zero percent and lend to the government at 25 basis points?

The Fed has written a paper saying that keeping short-term interest rates at zero for an indefinite period will distort fundamental investment decisions. What those other observers that you mentioned are saying is that keeping rates low for a long period will lead to disaster.

But while there has been a lot of high-yield debt issued in the last few years, not all companies have invested the proceeds. They’ve put it in cash. They’re losing money because rates on deposits are so low, but they haven’t invested it in unprofitable projects.  

Brown: [Fed chairwoman] Janet Yellen recently said something in her congressional testimony that lends credibility to this idea that interest rates are too low. She said the economy may actually need higher interest rates, and that’s the first time we’ve ever heard that from the Fed. That suggests that she believes that low rates amount to financial repression, and that higher interest rates would allow those depending on their savings to earn a little more and spend a little more. And higher rates could also force more lending to occur because those risk-free returns that banks are earning currently would become less attractive.

Ezrati: Papers published by the Fed have concluded that keeping rates at zero for an indefinite period is bad for the economy. And that might be what Yellen was referring to in her testimony.

Brown: So, she’s adamant about raising rates.

Ezrati: And there also has been an acceleration in wage growth. Wages have risen about 2.1% in the last 12 months versus 1.8% in the prior 12 months, according to the Bureau of Labor Statistics. What compounds that is that productivity is sinking. So unit labor costs are rising that much faster. So Fed policymakers must be saying the first signs of inflation are here.

Brown: The Atlanta Fed Wage Index is also up 3.3% over the last 12 months. The Labor Department’s Job Opportunities and Labor Turnover Survey [JOLTS] Index also shows that the labor market is tightening, and that’s one of Yellen’s favorite measures. Back in 2009, the ratio of job openings to job seekers was 6:1. By December 2014, it had fallen to 2:1, and most recently it has dropped to 1.6:1. Historically, when the index falls below 2:1, wages start increasing six months later.

Q. Low oil prices have benefited U.S. consumers and have helped the economies of net oil importers around the world. How likely is it that prices will stay under $50?

Brown: I think oil prices are unlikely to get back up to $80–85 a barrel. A lot of the oil that is produced by hydraulic fracturing [“fracking”] is breakeven at around $45 a barrel. So, prices don’t have to be $80–85 for supply to continue to be plentiful. Prices may get back up to $60–65, but they probably would not get much higher than that because a lot of emerging markets are dependent on oil production to keep their currencies stable. Venezuela, for example, will sell no matter how low the price of oil goes. The same is true for Russia.

Ezrati: Right now, everybody, even the Saudis, is producing flat out, except us. In the United States, frackers have stopped their exploration, but they haven’t stopped production. Some are still pumping in order to generate cash flow and pay off their debts. They may not be making much money with oil priced below $50 a barrel, but they’re still producing because their investment, the cost of drilling the well, is a sunk cost.

I agree with Zane that prices are likely to stay low, but Iran is a risk. If the nuclear deal with Iran is not stopped, and Iran puts a lot of oil on the market, the price could go back down. But if there’s trouble in the Middle East, the price could go back up. And I can’t make that forecast.

Sharon: OECD [Organisation for Economic Cooperation and Development] demand has been falling for decades, so it’s the developing world where incremental demand will come from to soak up all this supply. Of course, this assumes OPEC keeps on pumping, which is what they’ve been doing. With China slowing, the next big boom in oil demand will come from India when the country gets wealthy enough and has adequate highways to drive on. That will be the last great demand bump for oil demand, given their population and the size of the country. When will that be? Your guess is as good as mine, but not for many decades, and maybe when it comes around, non-OECD demand will actually be in decline, so that overall demand remains flat.

One interesting point our analysts have found, though, is that many of the oil companies we talk to are actually making more money per barrel at $60 than they did at $100. So, because of reduced transport costs, lower overhead, and cheaper fracking technologies, the cost side has really come down, and could make for a very positive margin expansion opportunity should we see prices move back up a bit.

Q. Thank you, gentlemen.

 

1 Bureau of Economic Analysis.
2 Eurostat.
3 Bloomberg.
4 Bloomberg.
5 Government of China, www.gov.cn/english/.
6 People’s Bank of China.

 

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