DABERIAM LXXVIII

August 2013

After the excitement of visiting Los Angeles and Beijing, with a side-trip to North Dakota to see a fracking spread, all in July, returning has been less depressing than I had expected.  The European economy, including the UK, seems to have stabilised.  There were some small signs of this in June but now one can see improvements in the economic indices; for example, manufacturing from the UK to Greece improved, French car sales rose for the first time in two years, and forecasts for corporate earnings in general have ticked up.  The animal spirits of industry and commerce look as though they are beginning to stir in spite of the over-burden of European governments.  One of the headwinds for Europe is the mad green energy policies.  British and German governments seem to be determined to destabilise the electricity production industry.  Present policy, coupled with a good economic upturn, is likely to see major shortages of electricity develop in the next five to ten years.

The change in mood in Europe contrasts with the feeling in Beijing.  The contrast is interesting to observe, the muddle and conflicting messages caused by western governments and the heavy depressing blanket of bureaucracy is debilitating to enterprise, but nevertheless the animal spirits do recover of their own volition.

The Chinese directed economy is brilliantly managed, but great confusion and alarm is caused when the decision is taken to change direction.  The new government announced a year or so ago that change was needed, but this is now being implemented.  Unlimited credit to state industries is being restricted, a genuine purge on government corruption is under way, and a policy of forcing the shutting down of excessive production in the state sector industries such as steel and aluminium is starting to bite.

Naturally, a huge push against these policies is being generated by the cosy vested interests between regional government and other locally sponsored industries.  A new period of economic reform has been started and the political difficulties that this will generate are likely to be considerable.  While the economic planning is engineering a decline in growth from double digits to a selected optimum of between 7 and 7.5%, it is not clear that the mandated and necessary changes can take place smoothly.  I suspect the decline of economic growth will overshoot and we could see growth figures as low as 5%, or lower for a period (although the figures may never be published!)

Along with huge changes in economic direction, I had the privilege of meeting with the People’s Bank of China (the central bank) which turned into a fascinating discussion about the policy for the freeing up of the exchange rate by 2015.  This is easily said, but the consequences are in reality wholly unpredictable.  It is equally likely that the currency could depreciate rapidly as it is that it could increase.  Liquidity in world markets far exceeds the ability of even the Chinese central bank to intervene to control the flows.  It is also not clear that the central bank will have the ability to stop regional banks, and come to that, any banks, from rushing to make overseas investments.  Banks have a well developed herd instinct and without a sophisticated regulatory environment, can easily get out of control – as we know only too well in the West.

The slow down in China is changing the economic dynamics of the rest of the world.  For at least the last ten years China has been the major force in driving up commodity prices.  This trend is reversing, the consequence of this for countries producing raw materials, primarily copper and iron, is serious.  It is likely even that the world’s gold prices are also being depressed by a reduction in Chinese demand, although this is more difficult to analyse.  The beneficiaries are the US and Europe.  Lower raw material prices feed through into increased corporate profits and of course government tax revenues.  These trends are helping to stabilise Europe but are having a major impact on the US economy.

The US in general is seeing rising corporate profitability, and rising federal and state income, which is reducing budget deficits.  There are signs that corporate capital expenditure is at last starting to pick-up.  The headwind for US business is a very high tax rate (35%) compared with just over 20% in the UK.  However, a huge advantage for American business is very low energy costs compared with the rest of the world.

Overall, the USA is well on the way to strong and sustained growth and the UK and Europe has certainly turned the corner.  The change in Chinese government economic policy is having a major impact as it depresses commodity prices.   Add to this the impact on oil and gas production resulting from the fracking in the US which is holding down, and could further depress, prices.

These factors together are likely to help hold down inflation in the near term, but the outlook in South America, India and Africa looks less good and we can expect difficult times in China.  There are dramatic changes afoot in the world order.