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posted on 03 November 2016

Investing While On The Path To Fiscal Perdition

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Macro Factors and their impact on Monetary Policy, the Economy, and Financial Markets

Macro Tides Investment Outlook - November 3, 2016


In this year’s Presidential election, neither Hillary Clinton nor Donald Trump has addressed the baseline increase in federal debt due to the increase in spending in the Social Security and Medicare programs. According to the nonpartisan Congressional Budget Office (CBO), if politicians do nothing during the next 10 years, (continuing a trend of the past 30 years), Federal debt will increase by $9 trillion. In 2026, total Federal debt will be near $28 trillion. The CBO’s projection assumes there won’t a recession in the next 10 years, which seems optimistic. Should a recession occur at any time during the next decade, annual budget deficits could soar above $1 trillion, lifting total Federal debt well above the CBO’s projection.

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The number of people aged 65 and older is expected to increase from 49 million in 2016 to 85 million in 2046, which will push spending on social Security and Medicare will climb from 10.4% of GDP in 2016 to 15.1% in 2046. Federal debt is projected to rise from 75% of GDP to 146% in 2046. Over the past 50 years, debt has only averaged 39% of GDP, and was 35% of GDP in 2007. Neither political party is willing to address the most important economic issue the U.S. faces, but never fail to profess their love for America. Our country is on the road to fiscal perdition, but both political parties are only interested in getting reelected.

U.S. Economy

According to the Commerce Department, the economy grew 2.9% in its first estimate of third-quarter GDP, after chugging ahead by 1.4% in Q2 and .8% in Q1. The rebound is not likely to accelerate further in the fourth quarter due to a number of headwinds, after recovering from a slow 1.1% growth rate in the first half of 2016. Average hourly earnings have been creeping higher over the last year, which has been a positive since consumer spending represents 70% of GDP. However, the modest 2.5% increase in income growth during the past year is being eroded by a higher cost of living. Healthcare costs have been rising faster than wages for the 150 million workers who pay for their health care insurance from their employer. Since the end of 2010 deductibles have increased 63% compared to an increase of 11% in workers’ earnings, so a greater share of health care costs are coming out of workers pockets. Among employers with fewer than 200 employees, deductibles rose 12% in 2016, almost 5 times faster than wages.


Of the 150 million workers who get health coverage from their employers, 65% are now in high-deductible plans. According to the Kaiser Family Foundation, a typical high-deductible family plan in 2016 cost $16,737, while a PPO plan cost $19,003. Annual health care premiums have risen at an annual rate of 5% since 2005, which is almost double the rate of average wage growth. In addition, employee’s portion of the total annual premium has increased from 26.7% in 2004 to 32.0% at the end of 2015, according to the Bureau of Labor Statistics. For the 97 million workers covered by a high deductible plan, the annual premium was $5,350 for a typical family plan in 2015 and $6,090 for a PPO plan, according to the Kaiser Foundation. Since 2005, the premium for a typical plan has risen from $3,050 to $5,350, while median income has shown no growth.welsh.2016.nov.03.monthly.fig.03.04

According to Sentier Research, inflation-adjusted real median income was $57,616 in September 2016, compared to $58,500 in 2007 and $58,608 in 2000. No wonder so many American workers think the economy is not working for them and believe the country is headed in the wrong direction.

Much attention has been afforded the projected 25% increase in premiums for the Affordable Care Act in 2017. While this is significant from a political perspective, it will only affect the 11 million enrolled in the ACA. The real crisis for middle-class Americans is the annual increase in premiums and deductibles which have been rising far faster than wages.


As usual, the political class and media choose to focus on the smaller problem. According to the Brookings Institution, spending on health care by middle-class families since 2007 has increased 24.8%, while spending on other essentials has declined. For some families, the decrease may have been dictated by the need to spend more on health care. The shift to high deductible plans is transforming healthcare from comprehensive coverage to skimpier insurance with higher out-of-pocket costs. This may work for those who are relatively healthy, but exposes those with modest incomes or those surprised by medical emergencies to a serious financial burden or outright crisis. The change to high-deductible plans has nothing to do with the Affordable Care Act, since it is confined to employer plans.

The large decline in gasoline prices between April 2014 and February 2016 likely increased net income by more than the biggest tax cut the middle class has ever received. For those driving 12,000 miles a year in a car getting 25 m.p.g. using regular gasoline, the annual savings peaked near $900.

Those living in the Northeast and Midwest who heat their homes with heating oil or natural gas realized additional savings of $750 last winter and will save more than $500 in the coming winter if heating oil remains near current prices. These estimates are based on national figures from the Energy Information Administration. For families earning the median income of $57,616, the savings from lower gas prices amounts to an increase of roughly 2.3% of disposable after-tax income, and double for those living in cold climates. Since the low in February, gas prices are up 23.5% for regular gasoline, and premium gas prices have risen 29.6%. That works out to an annual increase of $245. While modest, this is a headwind to consumer spending and reverses the tailwind falling energy prices represented.


This net income windfall for middle and lower class families was made possible by fracking, which lifted U.S. oil production from 5 million barrels a day in 2008 to over 9 million barrels a day in 2014. In a world 4 that consumes 91 million barrels of oil a day, the increase of 4 million barrels of daily new supply from U.S. frackers is what caused the cascade in oil prices from $105 a barrel in 2014 to under $50 dollars a barrel currently. The Democratic Party holds itself out as the champion of middle and lower class families. And yet, fracking is a 40-year-old technology the Democrats heartily oppose because of global warming.

Obviously, most Democrats haven’t read the March 2016 report from the World Resources Institute (WRI) a liberal world based non-governmental global research organization. Of the 170 countries WRI analyzed, the U.S. was one of only 21 countries that lowered carbon emissions even as GDP grew from 2000 through 2015. WRI noted that carbon emissions in the U.S. declined 16% between 2000 and 2014, even though GDP grew 9%. This is a first since emissions have always increased whenever GDP rose. The WRI report cited the glut of cheap natural gas for the decline in U.S. carbon emissions, as that enabled electric utilities to shift from coal to natural gas. When burned, natural gas produces about half of the carbon pollution of coal. Natural gas prices fell as supply increased due to fracking. The benefits of fracking - a boost to lower and middle-class incomes AND a cleaner environment - is an inconvenient truth Democrats never acknowledge since it doesn’t fit into their global warming narrative. On the issue of energy, Democrats prefer ideology over common sense pragmatism. For the record, on other issues the Republicans have their own ideological addictions that trump common sense too.


The Federal Reserve’s Labor Market Conditions Index is a composite of 19 labor market data points. It peaked in December 2015 and has marginally turned lower. This suggests that job growth and average hourly earnings are more likely to moderate in coming months than accelerate.

Retail sales have slowed modestly during the past year, as job growth decelerated from a monthly average of 229,000 in 2015 to 178,000 this year through September.

Restaurant traffic has declined 2.8% in 2016 through September according to a survey of 25,000 restaurants by the Restaurant Industry Snapshot.

According to Civic Science, 47% of the respondents to their September survey cited increased healthcare costs for the main reason they had reduced visits to restaurants. Those whose health insurance costs had increased over the past year were 30% more likely to say they were significantly cutting back on restaurant spending.


Since 2010, auto sales have climbed from sales of 10 million vehicles to more than 17 million. In recent months, sales have softened and the nine-month moving average has rolled over. In order to boost sales in 2015 and 2016 automakers have increased incentives for each car sold. In September the per-vehicle incentive rose to $3,888, 25% higher than during 2008. Increasingly, new car sales have been financed by subprime auto loans, which were up 11% in 2015 and a stunning 124% since 2010, according to Equifax.

Car makers have also become more reliant on leasing to boost sales. Since June 30, 2009, leasing grew from 13.5% of sales to a record 31.5% of sales in June 2016, according to Experian Automotive. Since most leases are for 2 or 3 years, 3.1 million cars are expected to come off a lease in 2016, an increase of 33% from 2015, according to NADA Used Car Guide. With so many cars hitting used car lots, used car prices are down 3.6% through September.

The decline in used car values led Wells Fargo to write off 1.37% of its outstanding loans in the third quarter, up from 1.01%, a year ago. J.P Morgan reduced the number of 84-month auto loans it was making in the third quarter, and on October 25 Capital One Financial said it had boosted its provisions against loan losses and a decline in used-vehicle values.


The increase in lending standards by auto lenders will lower sales in coming months, and falling used car prices will pressure new car prices, which will squeeze automakers profit margins. The coming slowdown in car manufacturing will turn what had been a positive growth sector into a modest drag on GDP growth in coming quarters.

Small businesses create more than 60% of new jobs, which is why the recent decline in the National Federation of Independent Business’s Small Business Optimism Index is a concern. Some of the decline is likely related to the potential of an increase in the minimum wage to $15.00, which would disproportionately impact small business owners. The unique nature of this presidential election is also a factor. However, until optimism improves, small businesses are likely to remain reticent in hiring additional workers, which will put a lid on job growth in coming months.


The first estimate of GDP suggested the economy grew at a 2.9% annual pace in the third quarter. The year-over-year increase was 1.5%, up from 1.3% in the second quarter. The 2.9% Q3 estimate was boosted by 0.61% from an increase of inventories. Businesses had pared inventories during the last five quarters, which subtracted from GDP in prior quarters, so the increase in the third quarter seems warranted. The large contribution from exports is the questionable aspect of the GDP report. In the first and second quarter, exports added 0.01% and 0.18% respectively to GDP. In the third quarter, exports added 0.83%, primarily due to a significant one-time jump in soybean exports. More importantly, personal consumption only rose 2.1%, down from 4.3% in the second quarter. This suggests the squeeze from higher health care costs, rising gas prices, and mediocre wage growth is forcing many consumers to pare spending. I don’t expect this dynamic to improve in coming months, which suggests GDP growth is unlikely to accelerate either.

Federal Reserve

One way to compare the effectiveness of monetary policy’s impact on economic growth is to compare GDP growth since the current expansion began in June 2009 to its long-term historical trend. The chart of Real GDP and its Historic trend was computed and created by Doug Short of Advisor Perspectives. Based on regression analysis of GDP since 1949, GDP was $16.7 trillion as of September 30, 2016. Had growth maintained the historic trend the size of the U.S. economy would have been $19.6 trillion 17.6% larger. This disappointing divergence in economic performance is all the more distressing in light of the Fed’s extraordinary monetary accommodation and a doubling in Federal debt from $9.0 trillion on September 30, 2007, to $18.15 trillion in 2015. GDP growth during the prior 10 recoveries since World War II averaged 3.3%, which is 50% faster than the 2.15% annual increase since June 2009.


While the Fed’s efforts have only managed a mediocre recovery, the Fed has been quite good at generating bubbles. Lawrence Welk would have been impressed. Comparing the increase in household wealth to the increase in GDP shows there have been three bubbles since the late 1990’s. The bubble was driven more by an investment mania for technology stocks, and less so by the Fed’s injection of liquidity prior to Y2K. The housing bubble was launched after the Fed kept the Federal funds rate pegged at 1% until June 2004 and then the Fed failed to supervise lending practices, even as liar and no doc loans flourished. Investor psychology also played a role as too many people were swept up by the easy profits generated from using 30 to 1 leverage.


The Federal Reserve was the choreographer of the Central bankers’ bubble since it was the first central bank to use quantitative easing to increase stock and home values, and lower bond yields as an integral facet to spur economic growth. After the and housing bubble, the Fed was not able to prevent bear market declines of more than 50% in the S&P 500 that followed. These significant declines unfolded even as the Fed cut the Federal funds rate from 6.5% in 2000 to 1% in 2002, and from 5.25% in 2007 to near zero percent by the end of 2008.

With the Federal funds rate at just 0.37%, the Fed will need to rely on more quantitative easing and other unconventional policies to stabilize stock prices, after the next bear market commences. In the next few years, the Federal Reserve and other central banks will be challenged to unwind their dependence on unconventional monetary policies to support economic growth and asset values, without destabilizing global financial markets. For investors to assume there won’t a bump or two as the unwinding unfolds is naïve, which could prove disastrous for their portfolios.


By maintaining low interest rates for extended periods of time, the Fed has encouraged corporations to load up on debt. In the second quarter, corporate debt, exclusive of liquid assets, was 71% of revenue, the highest ever. Corporate bonds plus non-financial business loans now total 44.88% as a percent of GDP, which is above the 2001 peak of 43.5% and higher than 43.96% in 2008.

In the last 4 quarters corporations have repurchased $620 billion of their stock and spent $1.69 trillion on capital expenditures. This is a problem since it exceeds corporation’s free cash flow and net borrowing by $248 billion. During the last two years, revenue growth has been difficult to come by, and with debt levels already high, corporations may be forced to pare stock buybacks in coming quarters. If they do, a big support for the stock market in recent years will be a smaller positive factor.


Since November 2008, the Federal funds rate has been below 0.5%. This has hurt Americans 60 years and older especially hard, since safe investments like Certificates of Deposit have provided a lower return than they had expected during their retirement years. The lack of interest income has forced older workers to continue working to make up for the shortfall due to low interest rates. Since 2000, the number of workers between 60 years old and over 75 years old has increased by 21.7% and 60%. For the majority of these older Americans, the Golden Years have been tarnished by the Federal Reserve.Welsh.2016.nov.03.monthly.fig.15.16

There has been one clear-cut beneficiary from the Fed’s monetary policy since 2007: the U.S. Treasury. Each year the Federal Reserve transfers its net income to the Treasury. The amount has soared from $29.1 billion in 2006 to $97.7 billion in 2015. Even though Federal debt has exploded from $9 trillion in 2007 to $18 trillion in 2015, interest expense of $223 billion in 2015 is almost unchanged from 2007. In 2015, the net income remitted by the Fed to the Treasury amounted to 43.8% of the government’s 2015 interest tab, up from 13% in 2008.

This comes close to being a free lunch for the Treasury and could prove an irresistible temptation. What better way to fund infrastructure spending with the Federal Reserve buying all the bonds issued, so the government's interest expense is nothing? A decade ago it would have seemed incomprehensible for the Federal Reserve to expand its balance sheet from $900 billion to $4.5 trillion. No one in coming years should be surprised if the Fed, out of expediency or in response to economic duress, expands its balance sheet from $4.5 trillion to $8 trillion, $10 trillion, or more to facilitate large budget deficits and fiscal largesse.

China’s Methadone Clinic

During the past 16 years China’s economy had an outsized impact on global growth as it became the second largest economy in the world. The next 16 years are not going to be as good, and, along the way, China will have to navigate a number of speed bumps that are likely to impact global financial markets. Fifteen months ago it appeared China’s economy might be headed for a hard landing. After topping in June 2015, the Shanghai Composite crashed from over 5150 to under 3000 in August, a plunge of 40% in less than three months. Economic growth was slowing, real estate prices were sagging, excess capacity in basic industries - cement, steel, glass, aluminum - were high and rising, corporate profits were falling, especially for state-owned enterprises, and bank’s nonperforming loans were climbing sharply. In August 2015 policy makers panicked and devalued the Chinese Yuan by more than 4.4% in one week, causing equity markets around the globe to plummet.


The problems that led China to devalue its currency were precipitated by China’s increasing reliance on debt to fund economic growth, particularly after the 2008 financial crisis. According to McKinsey Research, China added $26.1 trillion in debt between 2000 and 2014, which is more than the combined GDP of the U.S., Japan, and Germany. Most of the increase occurred in the wake of the 2008 financial crisis. Between 2005 and 2015 total debt rose 465%, rising from 160% of GDP to 247%, according to Bloomberg Intelligence.

Capital Economics has studied more than 25 years of collapses in developing economies. Their conclusion is that the pace of debt accumulation is more important than the overall level of debt in determining whether a country is vulnerable to a financial crisis. China’s pace of debt accumulation is well above the threshold Capital Economics identified as the potential for a crisis.

In the summer of 2015, policy makers in China were dealing with an economic slowdown and faced a difficult decision. They could extend more credit to inefficient debt-burdened state-owned enterprises, fund a ramp up of infrastructure spending, and expand credit to consumers to spur demand for housing or allow credit and economic growth to slow. While this second option would lay a stronger foundation for China’s economy for the next decade and beyond, it would be painful in the short term and feel a bit like going cold turkey for an economy addicted to credit.

Nonperforming loans at banks would mount as would bankruptcies, if China consolidated state-owned enterprises (SOEs) burdened with excess capacity and too much debt. In the longer term, the elimination of excess capacity concentrated in the least productive state-owned enterprises in basic industries would improve China’s overall productivity and the profitability of the surviving companies.

But closing inefficient plants would cause bank bad loans and bond defaults to soar, and more importantly, unemployment to rise for tens of millions of workers. Restructuring state-owned banks sidled with non-performing loans and inefficient companies swamped with excess capacity would probably be manageable for China. But a surge in unemployment and the political backlash it would inspire was a risk China’s leaders were not willing to assume.

Rather than enduring a short-term slowing in GDP growth below their target of 6.5% - 7.0%, and the subsequent attendant problems, Chinese policy makers decided to expand China’s credit methadone clinic again. In an effort to rejuvenate GDP growth, the Peoples Bank of China has sold bonds to commercial banks to shore up their balance sheets so they can lend more to SOEs and consumers, and authorized local governments to issue bonds to fund an increase in infrastructure spending.

Construction crews are now working on the seventh ring road 100 miles outside of Beijing as part of plans to create a super city of 130 million people. China’s high-speed rail network is already more extensive that the European Union’s and is being expanded rapidly. Hunan province built the world’s highest and longest glass-bottomed bridge to attract tourists. A Changsha developer built a 57 story building in 19 days.

While China’s infrastructure prowess is stunning, it has come at a cost. According to the University of Oxford’s Said Business School, China’s full speed infrastructure building has produced cost overruns equal to one-third of the China’s debt of $28.2 trillion at the end of 2014. After examining data on 95 major road and rail projects throughout the world, Oxford reports that cost overruns are usually about the same in democracies. This is an interesting tidbit since infrastructure spending has been promoted by both candidates in the U.S.’s presidential election, and as a panacea for lifting growth in the European Union and Japan. Oxford notes that, while China wins at speed in building, it comes at the expense of quality, safety, and the environment.


Chinese consumers are fully participating in another housing bubble. In the third quarter, new medium and long-term household loans soared 60%, up from 47% in the second quarter, and 23% in the first quarter. Most of the new lending was for home mortgages.


The surge in mortgage debt has fueled a surge in new home prices. In July, six major cities reported home price gains of more than 20% from the prior year, while 20 cities registered gains of 20% in August. Homes prices rose 7.5% in August from the prior year in 70 cities, suggesting the fever is more concentrated in the larger cities.

China bans borrowing for down payments, but some banks, nonbank lenders, and developers are willing to skirt the rule by reporting that a separate line of credit is for decorating or other projects, rather than part of the down payment. This represents a decline in lending standards, which is another symptom of bubble mentality. The decline in lending standards was a major contributing factor in the U.S.’s housing bubble and subsequent demise.

In August, a small piece of land in Shanghai sold for $2,000 a square foot, three times the average land price in Manhattan. When a rumor spread that Shanghai authorities would make it harder for couples with one home to buy another, many couples decided to get a divorce so they could buy a second home! Wang Jianlin, one of China’s richest property and entertainment moguls, recently told CNN that China’s property market was “the biggest bubble in history". However, a slowdown may be afoot. In the first half of October, 24 cities imposed higher down payments and other restrictions to “control asset bubbles".

As of June 20, mortgages were $2.53 trillion, up 25% in just the past 12 months, according to ANZ. A study by Haitong Securities shows that home loans are expected to make up 30% of GDP by the end of 2016, up from less than 20% three years ago. Household debt has risen to 40% of GDP, up from 25% in 2010. The increase in household debt could become troublesome since real disposable income growth among urban consumers has slowed to 5.8% as of September 30, down from more than 10% growth a decade ago when debt levels were far lower.


State-owned banks have been providing unproductive state-owned firms with more loans so the existing non-performing loans can be paid off. This gives the appearance that non-performing loans are not increasing, so China’s banks look healthier than they really are. In March 2016, China said it was considering letting companies swap bank debt for equity in the companies.

The attraction of this questionable scheme is twofold. It allows over-indebted companies to free up cash flow no longer needed to service bank loans, and it lowers banks’ non-performing loans. On October 14, the National Development and Reform Commission (NDRC) announced it was proceeding with the debt-for-equity program. The NDRC acknowledged that giving banks equity stakes would increase their risk but said banks won’t participate directly. The program will be administered by agencies that will use guidelines specified by China’s State Council. I doubt the ‘guidelines’ allow influence peddling, kickbacks, and other favors, but who’s kidding who? The NDRC said getting the program off the ground would take a long time. I suspect circumstances may expedite the launching of the program.

The attraction of this questionable scheme is twofold. It allows over-indebted companies to free up cash flow no longer needed to service bank loans, and it lowers banks’ non-performing loans. On October 14, the National Development and Reform Commission (NDRC) announced it was proceeding with the debt-for-equity program. The NDRC acknowledged that giving banks equity stakes would increase their risk but said banks won’t participate directly. The program will be administered by agencies that will use guidelines specified by China’s State Council. I doubt the ‘guidelines’ allow influence peddling, kickbacks, and other favors, but who’s kidding who? The NDRC said getting the program off the ground would take a long time. I suspect circumstances may expedite the launching of the program.

According to the China Banking Regulatory Commission, Chinese banks’ nonperforming loans are 2%, the highest since 2009. The International Monetary Fund (IMF) estimates China’s nonperforming loan ratio at 15%. The difference is due to the way bad loans are recognized. I suspect the IMF’s estimate is more accurate. In the first half of 2016, China’s top four banks wrote off $19.5 billion of bad loans, 44% more than a year ago. While the percentage increase is large, that’s a drop in the bucket compared to what these banks are going to write off if S&P’s Global’s analysis is in the ballpark.

On October 11, S&P Global reported that rising debt levels will worsen the credit profiles of China’s top 200 companies in 2016. China’s banks may be required to raise as much as $1.7 trillion to cover the coming surge in bad loans by 2020. S&P Global’s study sees little improvement in 2017 amid worsening leverage and excess capacity in almost all sectors.

Of the companies analyzed by S&P Global, 70% were state owned and accounted for $2.8 trillion of respondent’s debt, 90% of the total.

Since new lending is primarily used to pay off prior loans, as opposed to funding new investment, the expansion in credit is not contributing to a sustainable increase in China’s economy. According to Wind Information, a data provider, only $1 of additional GDP is being generated by every $4 of new credit. This explains why China’s debt to GDP ratio has increased so much, while economic growth slides.

The failure to address excess capacity is a short-term and long-term problem. In the short run, excess capacity encourages excess production which then leads to price discounting to unload excess inventory inside China and globally. In recent years China has been exporting deflation, as they have flooded global markets with steel, ceramic tiles, and other products at cheap prices. This has resulted in an increase in anti-dumping charges against China from India for ceramic tiles and from the U.S. and the European Union for dumping a number of steel products. Chinese steel makers were saddled with import duties of 522% after the U.S. discovered that products were being sold in the U.S. for prices below cost. Fixed investment has declined from more than 20% in 2014 to -1.2% in July. Private sector investment makes up more than 60% of fixed-asset investment. Long term the lack of private sector investment will lower productivity growth in coming years, which will weigh on GDP growth.

Productivity plus population growth equals GDP growth, so China’s demographics will play an increasing role in affecting economic growth over the next 20 years. In 1979, China instituted its one-child policy to slow its population growth.


Fertility rates fell from an estimated 5.9 births per woman in 1970 to 1.5. The reason it didn’t drop to 1.0 was due to the difficulty in enforcing the law especially in rural areas. Couples in the countryside whose first born was female were often allowed to try a second time for a son. The preference for boys resulted in the abortion or death of millions of female babies since the one-child policy took hold in 1979. Now the ratio of boys to girls is 120 boys for every 100 girls. As a result, 20 to 30 million young men are not going to find a wife.

China’s workforce, those between 15 and 59, shrank by 3.7 million in 2013 due to the decline in births since 1979, and will continue to shrink for years to come. China’s one-child policy has created a demographic time bomb. According to United Nations population projections, by 2050 440 million people will be over 60 years old, and the median age will climb from 37 in 2015 to 50 years old. By comparison, the median age in the U.S. will only increase from 38 to 42 years old in 2050. The rapid aging of China’s population will hurt productivity growth in coming decades and place strains on the state-sponsored pension system.Welsh.2016.nov.03.monthly.fig.22.23

China ended the one-child policy in October 2015, but a number of factors will keep the birth rate from materially rising. Demographers have found that fertility rates generally fall as wealth and women’s educational levels rise. The percentage of women with at least a secondary education in urban areas has grown from 36.1% in 1990 to 54.2% in 2010. As more educated women China establish a career, the need to marry for financial security is lower, which is why total marriage registrations have fallen in the last three years.

The cost of housing, especially in urban areas, will influence couples not to have a second child. Even if the birth rate climbs in coming years, those babies won’t be old enough to enter the labor force en masse until 2040, ten years after China’s population is expected to peak.

In the next three to five years, China will need to confront and manage its reliance on debt to spur growth, and it won’t be easy. Closing state owned enterprises that are overly indebted in order to eliminate excess capacity will force China to recapitalize its banking system. Maintaining economic growth that keeps unemployment low enough to minimize social disruptions, while not restricting freedom, will be a major challenge for China’s leaders. The potential for another Tiananmen Square will be real. The demographic imbalance created by China’s one-child policy will make their task more difficult. Investors should expect there will be missteps that will affect global equity markets in coming years.


Despite the enormous stimulus during the last 15 months, the Shanghai Composite has lagged the majority of other emerging equity markets. Since bottoming in February, the Shanghai Composite has been in a modest uptrend. One indication that China’s economic troubles are surfacing anew might be signaled when the Shanghai Composite breaks below the trend line connecting the February low with the low in June.

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