Reject the Consensus: ‘V’ Means Vulnerable

Andy Xie is a former Morgan Stanley analyst now living in China


Major economies reported strong growth for the first quarter. In the United States, for example, GDP grew 3.2 percent from the fourth-quarter level. Year-on-year growth rates were not far behind.

East Asian export-oriented countries reported even stronger data than those in the West. As a group, they probably grew twice as fast as the United States. And their second-quarter reports are likely to reflect similar strength. Meanwhile, the International Monetary Fund has upgraded its global, 2010 GDP growth forecast to 4 percent.

All these positive statistics raise an important question: Are we in the midst of a V-shaped recovery following the economic collapse that began in the second half 2008?

The answer is no. I think the current recovery is merely based on government stimulus and low-base effect. And given the amount of stimulus spending, this is not a strong recovery. More importantly, structural problems exposed by the financial crisis were merely covered up, not resolved, by stimulus spending. This is why the recovery is not sustainable.

Since stimulus will eventually lead to inflation, interest rates will have to be raised. That will lead to another dip in the global economy. I expect this second dip in 2012, which means we are en route to a W-shaped economic phenomenon, not a V-shaped recovery.

When so many people are bullish about an economic outlook – and offer lots of data to support their optimism – it is easy for little people like you and I to be persuaded. But one should always question the consensus. You don’t have to poke too deep to find holes in the latest recovery story. One year ago, the consensus was that the financial crisis was the most serious in 60 years. Now, the doomsayers have changed their tune. How can things change so dramatically in just a year?

In early 2009, I predicted the people who were panicking at that time would declare everything fine by the end of the year. I also thought that, in the middle of the crisis, policymakers around the world had decided to err on the side of too much stimulus rather than too little. These predictions have come true. So the latest growth rates should be analyzed in that context.

Here’s what’s really happening: Major economies such as the United States and Britain are running fiscal budget deficits exceeding 10 percent GDP. Deficits in Europe and Japan are half that amount. Interest rates around the world are close to zero. When viewed in this context, 4 percent global growth is not impressive. Actually, we should be asking why the global economy isn’t growing faster.

But can individuals like you and I make sense of what’s happening in our huge global economy, with its roughly US$ 60 trillion in gross output and more than 6 billion people? More importantly, can we identify unsustainable trends and make the right decisions to avoid collective or personal losses?

In fact, it’s impossible for an individual to gather and analyze all the data needed to reach meaningful conclusions. We have to rely instead on government agencies. But bureaucrats are slow, and they’re usually too late in delivering data and analyses. In addition, some agencies massage data to achieve desired financial market reactions. As a result, a lot of little people have been force-fed misinformation. They’ve been left to search for answers in the dark before being led to the slaughterhouse.

Look at Prices

Yet we can improve our odds of success while navigating the vast global economy and avoid being fooled by consensus views. This is possible if we always remember that the economy is guided by a price system. Multinational companies have arbitraged away production cost differences over the past two decades, so price information about a company or a product can shed light on macroeconomic trends.

Let’s look at China’s auto industry to prove the point. Everyone says the industry is booming. Meanwhile, automakers are depressed everywhere else around the world. How should we read the difference? What facts are true and sustainable, true but not sustainable, or false?

It’s true that auto demand is booming in China. This is line with the global industry’s trend. Whenever a country’s per capita income rises above US$ 6,000, auto demand tends to take off. And that income level has been surpassed in many Chinese cities.

But is this growth rate sustainable? It is not. China’s auto market is new, which means many consumers are buying their first car, creating a spike in demand. Demand for replacement vehicles will be the market’s next development, and that will be a long time coming.

On the supply side, which includes auto dealers and manufacturers, China’s auto sector seems highly profitable. One can be easily enticed to think this profitability is due to strong demand. But it is not. Autos are a globally traded product, so supply and demand sides in any single country don’t have to reflect each other. China-based auto producers and distributors are profitable due to trade barriers that keep global competition out. The telltale sign is that prices are higher in China than elsewhere.

What’s the significance of this story? From an investment perspective, one should be cautious about China’s auto sector. Most analysts pushing auto stocks cite strong demand growth and high profitability. But this profitability is due to trade barriers.

Hence, one must consider the sustainability of the barriers. If they come down one day, Chinese automaker profits will reach the levels of counterparts elsewhere. Further, demand growth will surely slow due to market saturation. We don’t know where the high-water mark lies, but we’re certain only a limited number of people in China can afford cars. And skyrocketing auto production capacity will likely lead to overcapacity.

What can be taken away from this story is that the profitability of China’s auto industry is highly vulnerable. The practical implication is that auto company stocks should trade with heavy discounts to market averages. For example, if the market PE ratio is 20, auto stocks may need to trade at half that level.

Macro Mystery

Yet the auto industry story is relatively easy to tie together because it’s all about microeconomics. Macroeconomic stories are a different sort of animal. Unless an analyst has special and significant insight, a macro forecast is all about extrapolation. This is why there are so many views of the future, and why the macro thinking noise level is so much greater than what’s heard at the micro level.

But listening to most analysts who predict the future can be a waste of time. Indeed, economics itself says economic prediction is useless. If it were not, the predictors would use their insight to make money rather than share information with you for free.

Nevertheless, from time to time, macro trends don’t make sense. This is when predictions can become meaningful. For example, almost everyone thought U.S. property prices could only go up. That prompted many people to act on a belief in borrowing money to increase property holdings. Thus, it was reasonable to bet that the opposite would happen. Predicting the turning point would have been hard, but insight into the errors of consensus reactions could have helped at least some investors think before chasing market momentum and suffering the consequences later.

So here’s my attempt to make sense of the latest economic data and paint a picture that differs from the consensus, while concluding that the current recovery is unsustainable and another dip in 2012 is likely.

The U.S. economy has been rising on consumption, which means its growth is more dependent on a declining savings rate than income growth. This is exactly what happened before the burst of the real estate bubble. The U.S. property market is still in the doldrums, and there aren’t asset gains ahead to support the declining savings rate. Furthermore, the nation’s income growth is quite small compared to the rising government deficit.

In fact, the data is hiding weaknesses in the economy. These weak spots can best be found buried in household balance sheets and home foreclosure data. The U.S. household sector lost about US$ 10 trillion in net worth in recent years. A recent rise in the stock market prevented additional declines, but the market bounce is predicated on an optimistic economic outlook that depends on government stimulus. It’s unclear whether this stock market momentum can be maintained.

The U.S. economy’s main trouble is painfully evident in home foreclosure data. The foreclosure rate this year is on course to surpass the historic high 2.8 million, or 2.2 percent of all households, reached last year. Soon more blood may be shed.

Housing prices have fallen 30 percent, but they’re still high relative to wages and GDP. If historical patterns hold, U.S. housing prices could fall another 30 percent. This has not happened so far because the Federal Reserve has kept interest rates near zero and has held down mortgage rates by buying one-tenth of the country’s mortgages. Essentially, mean reversion or normalization is being prevented through policy action.

The question is, will such actions change the long-term norm? I suspect not. What they could do is increase inflation and thus push wages higher so that they more closely match property prices. Yet if the Fed allows a rise in inflation, people may panic and trigger another financial crisis.

Almost all East Asian economies attribute their latest growth to a recovery for exports, U.S. consumption, and China’s investment drive. Standout GDP growth figures for the first quarter include South Korea’s 7.8 percent increase from last year, Singapore’s 7.2 percent, Australia’s 2.7 percent and China’s double-digit rate jump.

This trend is no different than what we’ve seen in the past. And it’s sustainability is questionable. One major detour from the past course is that China’s property market’s infrastructure is now larger than the nation’s investment composition. However, this fact only makes the story more fragile.

As East Asian governments are concerned about the recovery’s staying power, they have been extremely reluctant to increase interest rates from the super-low levels set while dealing with the financial crisis. But inflation is pushing against this strategy. Inflation seems to be accelerating everywhere, even though most governments emphasize relatively low inflation levels and say current economic activity levels are not high enough for an accelerated round of inflation.

I have argued many times that this line of thinking is wrong. Keeping interest rates low is a mistake and will have negative consequences down the road.

Australia is probably the only country doing the right thing on monetary policy. Its central bank raised its policy rate to 4.5 percent – twice China’s. Australia’s unemployment rate is higher than China’s and its growth rate is only one-fourth as high. But inflation rates are about the same in each country.

Even though Australia’s central bank cites economic strength as a reason for an interest rate hike, there is little doubt that it’s actually based on concerns about overheating in the property market. When the property market rolls over, Australia’s economy will soften. The central bank knows that if it doesn’t act now, at a time when commodity prices are high, the property market may crash if prices for the nation’s exported natural resources fall. Australia is clearly thinking ahead.

Negative news out of Europe is centered on the Greek debt crisis. The market is worried about Greece’s solvency and a bailout package that would require a spending cuts equal to 10 percent of GDP. But the social backlash could trigger a political change. So Greece is better off defaulting.

More important than Greece’s crisis is Britain’s economic weakness. Its fiscal budget deficit exceeds 10 percent of GDP and its economy stagnated, showing just 0.2 percent GDP growth in the first quarter. Britain is not benefiting from the global trade recovery because it hollowed out its industries during the financial boom and grew a massive property bubble that’s since deflated. Now, its economy depends on government spending to stay afloat. It could face a debt crisis like Greece’s, prompting the central bank to print money to pay government bills, which could lead to a crash for the pound that may feature prominently in the next global crisis.

One factor is common globally: the central role of stimulus. Most governments have been counting on stimulus to resuscitate their economies. As I have argued many times before, an economy tends to have a major misalignment of supply and demand after a big bubble phase. An adjustment takes time.

Trying to regenerate high growth through stimulus, rather than patiently waiting for a market realignment, leads to rising inflation rates. When inflation sparks panic, rapid tightening becomes inevitable. And that triggers another crisis. I’m afraid this is exactly what’s in store for 2012.

Reject the Consensus: ‘V’ Means Vulnerable
Andy Xie 05.10.2010 18:54

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