DABERIAM XCII

August 2015

Most of July was spent in California and China – two economies at extreme ends of the business cycle.

As I mentioned in June, the current Chinese leadership embarked several years ago on the reorientation of their economy.  This is having a profound effect.  I didn’t mention that this reorientation included the liberalisation of markets and the freeing up of the exchanges.  We saw in July the stock market crash, which was a by-product of this new freedom.  Many individuals, and some who I met on the trip, had bought shares for the first time and, as is so often the case, the new punters called the top of the market and lost money.  In itself, the crash is not economically important, however it rattled the bureaucracy.  The important question now is whether the anti-reformers and the bureaucrats can push back on market liberalisation.

Liberalising markets is always difficult as individuals and institutions with little experience of a free market will almost inevitably feel pain from market volatility.  China is also trying to free up the foreign exchanges and here again there is a danger that the novelty of being able to buy dollars will cause a rush into foreign currency and lead to unsuitable asset purchases. 

Other side effects of the government policy are causing the shut down of old rust belt industries and inevitable regional unemployment.  On the plus side, I visited several factories that service the “new” motor-car industry; huge impressive clean factories with modern Chinese machine tools and a high level of automation.  The management, concerned with rising wages and the need to improve working conditions, are rapidly adopting western manufacturing techniques.  These changes are also being pushed by the companies they are supplying, e.g. Volkswagen, Audi, Chrysler, etc.

Western complacency about competing at a high level with Chinese manufacturing is worrying.  We see economic comment in the US and the UK about the lack of productivity in manufacturing.  Both countries suffer from a tax system that disincentivises capital expenditure on production machinery.  Financial institutions and private equity funds, encouraged by the tax system, are also a headwind to decisions to invest in new plant and machinery, which often takes a considerable time to bring into production.

Overall, the Chinese government is on the right track and the national cohesion means it is unlikely that we will see changes in government policy, even if the pain of bringing economic growth from the mid-teens down to probably 5 or less percent growth will inevitably cause disruption.

The direction of the American economy is intriguing: the economy is growing but the huge decline in oil prices is distorting statistics.  Private individuals are saving more while the energy industry has dramatically cut back on capital expenditure; this depresses GDP numbers causing worries for the financial sector but is by and large good for the economy in general.  Profits for domestically orientated companies look healthy but American multinationals’ profits suffer from a stronger dollar.  The biggest worry for the US economy is likely to come from the financial sector.  Mutual funds, pension funds, and insurance companies have been tending to invest in bonds rather than equities; at the same time bank and brokerage regulation has greatly reduced the amount of liquidity in the markets.

As the underlying economy strengthens, interest rates will start to rise and there is increasing danger that, when the institutional herd mentality switches from buying to selling bonds, markets will be unable to absorb the change in direction, potentially causing a crisis.  It is surprising that funds are still tending to buy bonds rather than equities. 

The decline in growth in China is contributing to depressing the prices of commodities and the knock-on effect for Africa, Latin America and even Australia is depressing their economies.  The economic pain in Latin America is of course exacerbated by Socialist governments who always seem to be economically illiterate!

This brings us to Europe where the political structure is using every means possible to avoid facing up to economic imbalances that are inherent in the system.  Greece has yet again been bailed out but no fundamental restructuring of its debt has been undertaken.  I suppose we need to anticipate Europe coming back from its summer holidays and discovering that the Greek problem is alive and well.

UK, for the moment, is proving an economic exception.  In spite of a small majority, the Chancellor, against all odds, seems determined to curtail government deficit expenditure.  Luckily the political opposition is non-existent, so hopefully he can achieve some of his objectives regarding the deficit, even though his lack of understanding regarding manufacturing means that his “re-balancing” of the economy is not likely to go very far.  As things stand, the UK economy looks to be the best placed in the European context while the US remains overall at the top of the chart, and Asia in the long term, if you have strong nerves, may be the place to start dipping a toe in the water.