U.S. Review
No Straight Line Expansion
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For the next six months, adjustments in fiscal policy, inventories and the Fed’s exit strategy will create a tricky pattern of economic growth and financial changes.
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For decision-makers, this pattern suggests increased volatility in growth and interest rate expectations. Information on both the economy and policy will reinforce this volatility pattern.
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The patterns of growth and interest rates will differ by sector as cyclical and structural changes continue to influence the information landscape.
Markets seldom move in a straight line and it is much the same for an economy. For the next six months, adjustments in fiscal policy, inventories and the Fed’s exit strategy will create a tricky pattern of economic growth and financial changes. Fiscal policy will be front and center as the federal deficit continues to reflect a pattern of weak revenues and steady spending. This pattern will bias interest rates upward and weaken the dollar if nothing else changes. However, investors, especially global investors, do expect a change. The testing time for the economy will be in early February when the Obama administration presents its budget proposals. We are watching for signals that the administration will be focused on long-term fiscal discipline and how that discipline is to be achieved. Are the out-year deficit estimates reliable and do they suggest smaller deficits over time? What is the balance between tax increases and spending cuts to achieve these smaller deficits? Market disappointment here would suggest higher interest rates and a weaker currency.
Slower inventory depletion should boost growth in the second half of this year as firms move closer to matching inventories to final sales. However, this boost to growth will diminish over time. Volatility here is likely, however, since the pace of final sales is still very uncertain and matching sales and inventories is notoriously difficult.
Finally, the Fed’s exit strategy will have a very uncertain impact on the capital markets given the state of the economy and the large size of recent Fed interventions. Volatility here is also likely to be significant given the uncertain nature of market expectations, and the Fed’s response to the market’s reaction to the exit strategy.
For decision-makers, these three factors suggest increased volatility in growth and interest rate expectations. Information on both the economy and policy will reinforce this volatility pattern. What makes all this susceptible to unusual volatility is the unique size and variety of fiscal and monetary intervention that is being unwound. Moreover, the patterns of growth and interest rates will differ by sector as cyclical and structural change continues to influence the information landscape. Interest rate variability will impact housing and auto sales in different ways, and will affect housing in weak markets (Florida for example) differently than in strong markets such as Washington, D.C.
Our outlook remains for moderate economic recovery and low inflation for the year ahead. However, the pattern of the recovery could be very volatile from quarter to quarter given the complex interactions between market expectations and policy actions.
For anyone developing their annual outlook at this time, the economic background is anything but a straight line. Therefore the wise choice is to allow for a range of possible scenarios that would recognize that the economic path would likely be volatile around both a pessimistic and optimistic scenario. The range of outcomes is wide and our strategic vision for the year ahead must allow for that.
Global Review
Chinese Growth Probably Strengthened in Q3
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Recent monthly indicators, including industrial production, exports and bank lending suggest that overall GDP growth in China strengthened in the third quarter. Official GDP data will be released next week.
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Could China experience its own credit market implosion over the next year or so? Probably not. While some of the new loans ultimately will go bad, the Chinese economy is not overly leveraged at present. Although a lending bust could surely happen, such an eventuality will probably not occur for a number of years.
Growth in China Appears to Have Strengthened
Real GDP growth in China, which matched a 10-year low in the first quarter of 2009, strengthened in the second quarter and recent monthly indicators point in the direction of further acceleration (see chart on front page). Therefore, most analysts expect that official GDP data for the third quarter, which will be released next week, will show the year-over-year growth rate rising to about 9 percent. If China does indeed post a stronger growth rate, it will not be the first Asian economy to do so. In Singapore, real GDP growth rose from 0.5 percent in the second quarter to 0.8 percent in the third quarter.
Returning to China, growth in industrial production (IP) rose to 12.3 percent in August, the strongest growth rate since the global credit meltdown last autumn, and the rise in the Chinese manufacturing PMI in September suggests that IP strengthened further (middle chart). In addition, exports appear to have risen as well in September. Yes, the value of Chinese exports is still down on a year-over-year basis (bottom chart). On a seasonally adjusted basis, however, it appears that exports rose at a very strong rate in September relative to the previous month. Presumably, a sharp increase in exports would have translated into stronger growth in industrial production in September.
However, exports are not the only reason for stronger growth in China. Domestic investment spending has also been very robust due in part to a surge in bank lending this year. As shown in the graph on the front page, bank loans are up more than 30 percent relative to last year. This sharp rise in bank lending has raised concerns among some observers that China may be setting the stage for its own credit bubble. Although we have some sympathy for these concerns, we do not lay awake at night worrying about a near-term credit market implosion in China.
First, about a half of the new lending appears to have been used to finance infrastructure spending. Although there is a danger that some “bridges to nowhere” may be built, most of the infrastructure spending will end up as a productive investment in China’s economy. Second, as we showed in a recent report, the Chinese economy, especially the consumer sector, is not overly-leveraged at present. (See “Is China the Next Bubble?”, which is posted on our website.) Could some of the loans that have been extended in recent months end up going bad? Sure. Will enough loans go bad to trigger a complete meltdown of the Chinese financial system during the next year or so? Probably not. Although China could eventually experience another banking crisis—it had a lending boom in the late 1980s/early 1990s that was followed by a bust—we believe that any banking system meltdown, should one indeed occur, is still years in the future.
In the meantime, the Chinese economy should continue to accelerate. The government will eventually begin to remove monetary and fiscal stimulus, which will lead to some slowing next year, everything else equal. By that time, however, recoveries in many foreign economies should lead to stronger growth in Chinese exports.
