Europe
Europe has been off the front page for the last few months, since European Central Bank (ECB) President Mario Draghi pledged on July 26 that: “The ECB is ready to do whatever it takes to preserve the Euro.” His comment calmed the European credit markets and led to a significant decline in 10-year bond yields in Spain and Italy. We suspect the window of tranquility will be closing soon, since the eurozone economy is continuing to weaken. Slower growth will generate less tax revenue, keep government spending elevated and make achievement of the 3% budget deficit targets in Greece, Spain and other EU countries more elusive.
At the beginning of this year, we expected the eurozone to remain in recession throughout 2012. After falling 0.7% in the second quarter, GDP in the 17 countries in the European Union contracted 0.2% in the third quarter, according to Eurostat. Industrial production fell 2.5% in September from August, the largest decline since January 2009. The weakness also enveloped Germany, where industrial production slumped 1.8% from August. Retail sales in the eurozone dropped 0.2% in September, are down 0.8% from a year ago and are lower over the past 18 months. The unemployment rate rose to 11.6% in September with 18.49 million people out of work.
In Greece, the unemployment rate is 25.4%, with youth unemployment at 58%. Since 2009, Greece’s economy has shrunk by 25%. After implementing numerous austerity programs in which it received additional funding and debt forgiveness, Greece is in a depression. The goal of the austerity programs is to narrow its budget deficit from near 15% in 2010 to 3% in 2013. The debt forgiveness was intended to lower Greece’s overall indebtedness. While Greece may be able to get its budget deficit down to 3% of GDP in 2014, its debt-to-GDP ratio just hit a new high of 170%. We don’t hear anyone proclaiming austerity a success. In order to survive, Greece requires another debt forgiveness program that will be very hard to negotiate.
Spain’s unemployment rate climbed to 25% in September, with 54.2% of those under 25 without a job. In the third quarter, Spain’s GDP declined by 1.7%, after falling by 1.3% in the second quarter. Spain is cutting government spending and increasing taxes in an effort to pare its budget deficit from 9.4% in 2011 to 3% in 2013. The full impact of the government cutbacks and higher taxes will continue to weigh on its economy well into 2013. Economic conditions have deteriorated so much in Spain that Catalonia, a region in northeast Spain that includes Barcelona, is considering whether it will become independent from Spain. This is serious since Catalonia produces 19% of Spain’s GDP and 21% of its tax revenue. According to the Catalonia government, Catalonia receives less than half of the taxes it sends to Spain. Given Spain’s financial difficulties it cannot afford to send more money back to Catalonia, and it certainly can’t afford secession by Catalonia.
The ECB has significantly expanded its balance sheet and pushed liquidity into the European banking system. A recent analysis of the 12 largest European banks by The Wall Street Journal revealed those banks have $1.43 trillion on deposit with the ECB as of September 30. According to the European Central Bank’s quarterly lending survey, a net 15% of eurozone banks tightened loan criteria in the third quarter versus 10% in the second quarter. Demand for business, consumer and home loans fell in the third quarter, which is symptomatic of recession as even credit-worthy borrowers find no need to seek credit. As long as credit availability continues to contract, Europe is not likely to emerge from its recession in the first half of 2013. Eurozone banks also told the ECB they intended to increase lending standards in the fourth quarter, which suggests a turnaround in lending is months away.
China
Our view has been that China’s economy would slow in 2012, but avoid a hard landing, and that GDP growth would stabilize in the 6 to 8% range. The National Bureau of Statistics of China reported industrial production rose 9.6% in October from 9.2% in September and 8.9% in August. Retail sales improved in October, showing a gain from a year ago of 14.5% versus 14% in September. Fixed investment and electricity usage have also strengthened. These reports suggest stabilization and a modest improvement in GDP, as we forecasted previously. Although we anticipate additional signs of improvement from China, there are issues that are likely to become problematic in coming years.
From 2000 until the financial crisis in 2008, much of China’s GDP growth resulted from a surge of investment spending that significantly expanded China’s infrastructure. Cities for millions of inhabitants were built along with the power grid and power generation to keep these cities powered. China also expanded its export capacity to capitalize on its lower cost of production, expanding exports to Europe and the United States. As a result, investment as a share of GDP rose from 34% in 2000 to 49% at the end of 2011, while domestic consumption shrunk from 46% to 34%. By comparison, in the U.S., consumption is 70% while investment is 12%. China has vowed to correct its overreliance on investment, which represents an imbalance, by increasing domestic consumption. This transition is going to take many years. In the short run, weaker exports and overcapacity in many industries are going to make the transition more difficult and tempt China to revert to its old ways.
In the wake of the financial crisis, China depended on the same growth formula, only relying much more heavily on debt to finance investment spending. In the years prior to 2008, Chinese corporations held debt equal to 1.2 times GDP, according to Fitch Ratings. In the last four years, corporate debt leverage has increased to 1.9 times GDP. Servicing the additional corporate debt will be a challenge since capacity utilization rates are down in a number of key industries, squeezing profit margins and profits. According to the International Monetary Fund, China’s auto and steel industries are operating at just 60% of capacity, with many other sectors not faring much better. Since 2007, wages have surged 73% in the manufacturing sector, which will help increase domestic consumption in the long run, but near term hurts China’s competitiveness as a low-cost producer. The ratio of inventory to the last four quarters of sales was 20.4% in the third quarter, down slightly from second quarter’s 20.5% level. However, inventories are still higher than the 2009 peak of 18.3% when Chinese firms were blindsided by the financial crisis. This will continue to keep China’s demand muted for raw materials, until excess inventories are worked off. According to CapitalVue, a China data and information provider, net profits for the 2500 firms listed in mainland stock exchanges was up a thin 0.4% in the third quarter, after falling 1.8% in the second quarter.
The new leadership in China is likely to lower interest rates, probably in the first quarter, which should reinforce better news coming out of China. This might prompt some analysts to suggest that China is coming to the rescue of the global economy. Since China represents just 10% of global GDP, we don’t think China is capable of solving the problems afflicting Europe or mitigate the consequences of the fiscal cliff and fiscal grand canyon in the U.S. Besides, until domestic consumption can replace China’s dependence on investment and exports to Europe and the U.S., China is likely to be beset by its own banking problems in 2013 or 2014.
The new direction of investing
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