China, India and Brazil
China is facing a secular transition and cyclical problems. Over the next decade China needs to shift its economy from being driven by exports and domestic infrastructure development, to becoming more reliant on domestic consumption. 
Wages have increased by almost 250% since 2004, but the average Chinese worker still earns less than $4,000 a year. The costs for land and power have also increased and China has allowed the yuan to appreciate by 30%. China is no longer the lowest cost producer in Asia so it is losing export market share to Indonesia and Malaysia. With export demand down from Europe and the U.s., China’s export engine is being throttled back. This will slow the secular transition and make it more difficult.
Over the next two years, China must address a cyclical problem. In response to the financial crisis in 2008, China’s banks increased lending by more than $1 trillion in 2009 and 2010 to finance infrastructure building, increase industrial production capacity and boost real estate. The surge in lending goosed industrial output growth and new building construction. As Europe recovered in 2010, exports to the European Union rebounded smartly. Things have changed.
After its bout of reckless lending, which amounted to 25% of GDP, we warned more than a year ago that China faced problems with excess capacity and bad loans. The International Monetary Fund estimates that Chinese capacity utilization has fallen from 80% before the 2008 crisis to its current level near 60%. Low capacity usage is hurting overall industrial profitability and crunching the sectors that expanded and benefited the most from the post-crisis surge. Total industrial profits were down 2.2% from a year ago, with profits in the chemical sector off by 22.5%, down 50% for cement companies, and down 9S% for steelmakers.
The squeeze on profits has begun to increase nonperforming loans, which rose 7.6% from September to March ofthis year to $68 billion. This small number somewhat masks a larger problem since $340 billion, or 29% of new loans this year, have been prior loans that were rolled and extended.
China has cut rates twice since June and lowered the reserve ratio, and we expect more accommodation before year-end. Our view has been that monetary easing would stabilize China’s growth rather than result in an acceleration of growth. In July, China’s exports rose just 1%, primarily due to Europe’s recession, which is China’s largest export market. In July 2011, exports were up 20.4%. The sharp deceleration in China’s export growth engine will keep capacity utilization weak, causing profit margins to be squeezed and result in a further increase in non performing loans.
The slowdown in China is being felt through the rest of Asia as Chinese demand for raw materials and preassembly parts has weakened over the last 18 months. Indonesia has seen its trade surplus swing from more than $3 billion to a deficit of $1.2 billion in June, the largest ever. Taiwan and South Korea have seen their export volume turn negative from year-ago levels, after routinely growing strongly in 2010 and the first half of 2011. Exports account for SO% of South Korea’s GDP, where home prices have started to fall and department store and auto sales are shrinking. 
Last month we noted that India was not only dealing with global and domestic slowdowns, but also a domestic energy crisis as it moves to provide electricity to 400 million rural residents. Five years ago, India said it would add 78.7 gigawatts of capacity to its power grid by March 31,2012, but only achieved 70% ofthe goal. During the same five-year period, China added 418 gigawatts of power to its grid. A gigawatt is equal to one billion watts. The chronic shortage of power may shave up to 2.0% off India’s annual GDP.ln several large states, electricity demand outstrips supply during peak hours by more than 12%. In early August, two major blackouts affected up to 680 million people. It would be an understatement to say the Indian government’s energy policy isn’t lighting things up.
India is also suffering from a drought, with rainfall about 17% below the 50-year average. However, in areas which grow grains, the rainfall is more than 60% below average. Agriculture accounts for 17% of India’s GDP, so the drought will hurt an already slowing economy. The Confederation of Indian Industry estimates that more than a third of Indian food rots before it reaches a market, which increases food prices. Even though inflation dipped to 6.87% in July, down from June’s 7.25% rate, the drought is likely to push food prices higher in coming months. The Reserve Bank of India lowered its policy rate to 8% in April, but may not move again when they meet in September.
In 2011, Brazil’s GDP slowed to 2.7% from 7.5% in 2010. It has slowed further in 2012 and is expected to grow only 2% for the year. Although Brazil’s central bank would like to lower interest rates from 8%, they are being constrained by a pickup in inflation. Although the official IPCA~15 consumer price index is up 5.24% over the last year, an inflation gauge that normally loads the “official” index was up a robust 6.67%. Normally, Brazil’s inflation dips from May through July as the southern hemisphere’s autumn causes food prices to decline. This year, however, the severe draughts in the u.s. are causing grain and oil prices to soar. No matter how skillful in conducting monetary policy, central bankers around the world have yet to learn how to make it rain on command.
Food for Thought
Rising food prices will have a negative impact on consumer spending in the U.s., where food comprises 10-12% of the average budget. But they have the potential to cripple spending in developing countries, since food often consumes up to 40% or more of the average family’s income. The combination of high unemployment and slow economic growth, along with higher food prices, could prove particu larly destabilizing th roughout the world if it persists as we expect.
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The new direction of investing
The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward’s investment solutions are built around the outcomes we believe investors need to be pursuing-nan-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of June 3D, 2012, we manage $5.4 billion in a diverse product set offered to individual investors, financial advisors and institutions.
Disclosure: Investing involves risk, including possible loss of principal.
The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results. This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.
The new direction of investing
The world has changed, leading investors to seek new strategies that better fit an evolving global climate. Forward’s investment solutions are built around the outcomes we believe investors need to be pursuing – non-correlated return, investment income, global exposure and diversification. With a propensity for unbounded thinking, we focus especially on developing innovative alternative strategies that may help investors build all-weather portfolios. An independent, privately held firm founded in 1998, Forward (Forward Management, LLC) is the advisor to the Forward Funds. As of March 31, 2012, we manage more than $5.2 billion in a diverse product set offered to individual investors, financial advisors and institutions.
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