Tags: China | euro | PMI | US

Be Patient and Don't Become Complacent, Because Danger Is Out There

By    |   Tuesday, 23 September 2014 09:12 AM

In weather terms, I'd like to qualify "visibility" for the United States remains relatively good, while the situation for the European Union and China remains "foggy" at best.

That said, the G20 finance ministers and central bank governors of the 19 leading developed and emerging economies concluded their meeting Sunday in Cairns, Australia, and reiterated, in some way, in their final communique the warning we received on Sept. 14 from the Bank for International Settlements' Quarterly Review on international banking and financial market developments. The G20 stated: "We are mindful of the potential for a build-up of excessive risk in financial markets, particularly in an environment of low interest rates and low asset price volatility."

This means that investors would do well by keeping in mind the warning of the possibilities of wild swings (bust?) occurring in the markets in the not-so-distant future. Yes, warning lights are alternately flashing amber/red.

On Monday, Chinese Finance Minister Lou Jiwei said that China would not dramatically alter its economic policy because of any one economic indicator, while also saying that China cannot rely on government spending to increase infrastructure investment.

It was interesting to see how the markets didn't like that relatively small Chinese statement and considered it a dampening declaration to their hopes for an aggressive easing of policies, which caused global downward moves underlying the markets' globally shared perception/vulnerability that one day could end up in a global "domino-effect."

Nevertheless, last week the People's Bank of China injected a record 500 billion yuan, which is the equivalent to $81.4 billion, in major Chinese banks.

The HSBC Flash China Manufacturing Purchasing Managers' Index (PMI) came in at 50.5 in September, an increase from 50.2 in August, confirming weak growth. The Flash China Manufacturing Output Index was unchanged from August at 51.8. Importantly, the employment sub-index fell to 46.9, which was its lowest reading since more than five years.

For the long-term investor, it is important to keep in mind that if China's growth further slows down to around the (real!) 5 percent mark, it would not be an overstatement to say that China is descending quickly to its hard landing area.

No doubt, China is extremely complicated to analyze, but trying to keep things simple, here are the two most important events to look for:

First, a further fall in property prices of more than 20 percent, which I think can't be excluded given the mind-boggling scale of the real estate and credit bubbles (Chinese shadow banking now stands at 66 percent of GDP!) while a further/continued contraction in economic growth should, among other things, cause a shrinking of local government revenues. This would result in a very sharp decline in government fiscal balances, which, in turn, could leave China with extremely little fiscal flexibility that in the end would oblige the Chinese central bank to use the printing presses. Take care, we aren't there yet, but we must admit China is moving in the wrong direction.

Second, when Chinese deposit inflows reverse into outflows, this would cause the banks to raise their rates over the whole spectrum of their activities, which, of course, would cause lending to become more expensive.

If these events happen, they would probably cause a Chinese hard landing that would, without any doubt, cause trouble in practically all of the most broad-based important markets in the world.

Like with almost all bubbles, by far most difficult thing to do is to pinpoint when they will burst. So, let's be patient, but don't become complacent, because the danger is out there.

On Monday, European Central Bank President Mario Draghi explained unequivocally the huge challenges the eurozone faces. "The economic recovery in the euro area is losing momentum. . . . Growth of the euro area real GDP came to a halt in the second quarter of this year. . . . Unacceptably high unemployment and continued weak credit growth are likely to curb the strength of the recovery. . . . We expect inflation to remain at low levels over the coming months. . . . We will focus in particular on the possible repercussions of dampened growth dynamics, geopolitical developments, exchange rate developments and the pass-through of our monetary policy measures."

What he's really saying is that the situation in the eurozone is not getting better; on the contrary, it's moving in the wrong direction.

The Markit Flash Eurozone PMI signals further waning of eurozone growth in September, with the Composite Output Index coming in at 52.3, a nine-month low; the Services PMI Activity Index coming in at 52.8, a three-month low; the Manufacturing PMI coming in at 50.5, a 14-month low; and the Manufacturing PMI Output Index coming in at 51, which is unchanged from August.

Employment in the eurozone failed once again to grow in any meaningful way, and prices continue to fall while raising the fear for lurking deflation in a good part of the eurozone. The PMIs hint GDP for the eurozone in the third quarter could come in at 0.3 percent at best, with stagnation in France and sluggish growth in the rest, with the exception for Germany, of course.

How long that disruptive "divergence" situation in the single-currency zone can continue is a question that no one can answer and probably no one wants to answer in Brussels and Frankfurt.

Yes, no doubt, the economic outlook for the eurozone remains disturbingly "foggy," which is not the best environment for investing.

Finally, the economic situation in the United States remains clearly the best by far of all the important economic blocs in the world. This doesn't mean that all is OK, especially when we take into account a world where global growth expectations continue to be revised further downward, with the International Monetary Fund lowering in July its forecast for global economic growth this year to 3.4 percent from 3.7 percent. No, this is not a positive for any country, but since the United States is not an export-dependent economy, the negative effects should be far less damaging than would be the case for Germany, for example.

As for last weeks' Federal Open Market Committee (FOMC) meeting, the Fed didn't change its "considerable time" language as expected, and I think it could change its language at the December meeting given that there is a press conference scheduled for this meeting, which is not the case for the October FOMC meeting.

Also not surprisingly the Fed stated economic growth is stabilizing, inflation continues to disappoint, improvements in employment are moderating and there remains slack in labor resources.

What really caught my attention was the Fed's lowering of its economic forecasts for 2015, which is now expected in a range of 2.6 percent to 3.0 percent, from a range of 3.0 percent to 3.2 percent expected in June. Last but not least, the GDP growth forecast for 2017 is now a range of 2.3 percent to 2.5 percent. If that is the case, it would oblige all of us to adapt to the "new normal" of a less spending-oriented economy, which has been until now one of the main drivers of the U.S. economy.

All that said, my investment preference for the United States remains unchanged, with a main accent on highly liquid (under "all" circumstances!) assets, because there is a fair degree of "visibility" on where we probably could go from here on, which cannot be said for the majority of the other most important economic blocs in the world.

Finally, I wouldn't be surprised to see a bounce in the euro and a downward move in the dollar in the short-term on pure technical grounds, which doesn't mean it will happen.

In my opinion, long-term, the dollar should go up and the euro down, which could go down as low as parity with the dollar somewhere in 2016 or 2017. Yes, this is important for long-term investors who have euros.

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In weather terms, I'd like to qualify "visibility" for the United States remains relatively good, while the situation for the European Union and China remains "foggy" at best.
China, euro, PMI, US
Tuesday, 23 September 2014 09:12 AM
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