Weekly Market Commentary - Global Gridlock

With the power transitions taking place last week, it has become apparent that gridlock is now a global phenomenon taking root in the United States, Europe, and China. Fortunately for them, the Chinese possess an advantage that other countries do not: economic growth seems to be improving.

Investments that benefit from China’s growth may do well, namely commodities such as precious metals and oil, along with stock market sectors that benefit from solid export demand from China, like information technology.

 

 

Global Gridlock

 

Last week’s post-election press conferences from the President, Senate Majority Leader Reid, and House Speaker Boehner offered some hope of a bipartisan deal to mitigate the budget bombshell of tax increases and spending cuts known as the fiscal cliff, due to hit on January 1, 2013. The status quo election outcome is likely to result in a deal in the lame duck session, but this is not assured given the gridlocked Congress. Last year’s August breakdown between these same parties over an increase to the debt ceiling is not encouraging. The battle is likely to result in a compromise that averts the worst-case outcome, but the negotiations themselves, coming on the heels of hard-fought election battles, may drive market swings in the days and weeks ahead.

While there were no televised attack ads or public debates, the second-largest economy in the world after the United States is also experiencing a political transition and faces some tough challenges ahead. The Chinese Communist Party’s 18th Congress, a week-long transition of power that started last Thursday and is set to end this Wednesday, is the most important political meeting in China in at least a decade. A new generation of leaders, headed by Xi Jinping, is replacing the current top bureaucrats and their chief Hu Jintao.

In his departing speech last week, President Hu Jintao cited many of the challenges China faces: a wide gap between the rich and the poor, imbalanced development between the wealthy cities of the east, and the struggling farms of the western countryside. Rather than redistribution, the departing head of the Communist party’s remedy was faster growth. He announced a commitment by the government to a doubling of China’s Gross Domestic Product (GDP) this decade, a goal that would bring China to two-thirds the size of the U.S. economy, a tall order given recent slowing trends.

China’s “Fiscal Cliff”

Much like in the United States, China’s political transition is taking place amid a looming crisis. China is experiencing its own version of a “fiscal cliff.” China’s growth rate has declined dramatically from double-digit rates to an official, and “politically-adjusted,” 7.4% — although externally verifiable measures of economic activity in the third quarter appeared to slow even more sharply. Inflation has weakened China’s competitive position in many product categories with other emerging market Asian nations. And China continues to sacrifice domestic consumption for the benefit of export growth, which is very weak, given soft demand from key customers due to the European recession and below-average U.S. growth.

 

As in the United States, factions within China have competing visions for how to combat these challenges. One party does not mean one vision. China’s new leadership must address the country’s economic problems, but there is no agreement on the path to take. Some constituencies want to reverse some of the decentralization that they argue has contributed to wasteful spending and re-establish central control over the economy. Others want to further westernize China’s version of communism, but that would lead to some still antithetical outcomes, like bankruptcies and unemployment, and risking social order that Chinese hold above all else.

With the power transitions taking place last week, it has become apparent that gridlock is now a global phenomenon: ƒƒ

  • * In the United States, the two parties with two different visions on how to mitigate the fiscal cliff control different sides of Capitol Hill.
  • ƒƒ* There is a lack of a consensus on action in Europe, with Northern Europe struggling with Southern Europe on how to best manage budgets and emerge from recession as the downturn deepens. Even Germany is increasingly feeling the downward pull on growth.
  • ƒƒ* The Chinese Communist Party seeks to always create a consensus, but different constituencies that control different parts of the economy have conflicting visions on how to reverse the country’s slowing economic momentum, which risks paralysis.

The political systems of all three of the world’s major governments are finding it difficult to make decisions vital to economic growth.

 

China’s Advantage

Fortunately for them, the Chinese possess an advantage the other countries do not: growth seems to be improving. The re-acceleration of growth can paper over a lot of structural problems and alleviate the near-term need for tough decisions. Starting over a year ago, Chinese policymakers began a series of stimulative policy initiatives that have accumulated and had time to work. They appear to finally be making a difference in growth; China posted the second month in a row of improving economic data late last week. ƒƒ

  • * China’s Index of Leading Economic Indicators (LEI) rose again. Key measures such as rail traffic, bank loans, and money supply growth continued to show healthy signs.
  • ƒƒ* Manufacturing and non-manufacturing Purchasing Managers’ Indexes (PMIs) improved, industrial production rose by 9.6% from a year ago, and fixed asset investment rose by 22.2%.
  • ƒƒ* Retail sales rose by a better-than-expected 14.5% year-over-year in October 2012 — very impressive and pointing to strong underlying spending trends given the low rate of inflation compared with a year ago.
  • ƒƒ* China’s pace of inflation, measured by the Consumer Price Index (CPI), over the past year has slowed from a peak of +6.5% that threatened any ability to provide economic stimulus to just +1.7%. In October, the monthly CPI reading was a drop of -0.1%. Importantly, food prices have stalled over the past 15 months from growing at a 14% year-over-year pace to just 1.8%.

China has appeared to stop its economy from slowing further.

The improving trend in inflation gives China the flexibility to provide more stimulus without risking social unrest. The ability to cut interest rates and implement new spending programs or tax cuts to drive an acceleration in growth and ensure the recent stabilization is sustained is a luxury not enjoyed by policymakers in the United States or Europe.

While a moderately defensive stance may be desirable for some investors, investments that benefit from China’s growth may do well, namely commodities such as precious metals and oil, along with stock market sectors that benefit from solid export demand from China, like information technology.

 

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Chinese Purchasing Managers Index: The PMI includes a package of indices to measure manufacturing sector performance. A reading above 50 percent indicates economic expansion, while that below 50 percent indicates contraction.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Information Technology: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.

The index of leading economic indicators (LEI) is an economic variable, such as private-sector wages, that tends to show the direction of future economic activity.