Our Down and Dirty on the World Economy

A couple of days ago a friend and client suggested we were just too darned upbeat in our economic briefs. He was right. We do indeed try to see the positive aspects of the economy, leaving the the doom & gloom and the sensational to the ad-selling media.

We prefer to remind our readers that the stock market is a long-term proposition and that today’s bumps have very little impact on the confidence they can have in meeting their long-term goals. We believe life is far richer if we focus on areas where we can impact positive change and avoid worrying about those areas we cannot control or impact.

But when one person speaks up, there are always others who feel the same way, right? So here’s our down-and-dirty the world economy.

The Chinese economy is not going to come back soon. The property, stock market, and the commodity bubbles have burst and the landings in all three could be hard. It will likely be three or more years before China’s growth is back on track, regardless of the numbers the government throws out. It takes years for an economy to recover from just one bubble, much less three.

While there is plenty of capacity for the Chinese government to pour on stimulus measures, they simply will not do the job this time. The government represents nearly half of the economy, sucking efficiency and productivity out of the growth machine. The only way to accelerate the recovery trajectory is for the government to re-structure toward privatization.

China’s recent currency devaluation (which makes China’s exports cheaper in comparison to other countries’ goods) will not help much either because the rest of the world is not buying. Their economies are slow or slowing and consumers are pulling back.

Compounding the problem of China’s slowing is the unfillable void they leave as buyers of raw materials. Countries in South America and the Middle East are will face huge economic and political challenges as their export-driven economies shrink.

The most immediate fallout could be loan defaults. Falling oil prices endanger countries like Venezuela and Nigeria. Falling commodity prices will take a huge toll on countries like Brazil, Ecuador, and Argentina. On Wednesday S&P downgraded Brazil’s sovereign debt to junk for the first time since 2008.

Europe, never having fully recovered from the financial crisis of 2007 and 08 have a new set of challenges. A flood of migrants from the Middle East and Ukrain are entering the border states of Greece, Spain and Italy in huge numbers that pose special challenges for them as well as all of Europe. The passport-free zone offered by Schengen may become a divisive political issue as migrants take advantage of free movement throughout Europe.

Considering the economic problems the EU Central bank has addressed with Greece and faces with countries like Italy and Spain as well as a referendum coming up for Great Britain remaining in the Union, it’s not a huge leap to question the Union’s long-term viability. Daniel Gros of the Brussels-based Centre for European Policy Studies was quoted in the Wall Street Journal as saying “The euro was not made to withstand a financial crisis of these proportions” In particular, it wasn’t built to deal with governments on the brink of default. And “nobody thought we would have hordes of refugees taking advantage of the passport-free zone.”

So what about Fortress America? The title to the August 28 Brief was more a question than a declaration. Our economy is growing, but not so fast that it could be called strong. The slow growth characterizing this 9-year expansion is both a strength and a weakness. The tepid growth rate has suppressed the usual excesses and speculation that mark the end of most recoveries. The longest expansion on record was the decade of the 90’s which ended with a bang in March of 2001. It was by contrast a fast growth recovery where the economy was literally firing on all cylinders with a few new ones added to the line; like the Internet and computer-run businesses known as dot coms.

The current recovery has beaten the post-war average of just under five years, but it has been doggedly slow with annual growth of 2% to 2.5%, well below the pace of post-war averages. The problem with slow recoveries is that is doesn’t take as much economic bad news to slow or stall them. Anyone who has ever raced a sailboat in light air knows how only a small mistake can slow or stop forward progress.

The latest survey of 31 economists by Bloomberg revealed that two thirds of them predicted a recession within the next three years. Now economists are not great at predicting business cycles, but the evidence for a similar conclusion is mounting. The preceding paragraphs suggesting a slowing global economy alone present significant headwinds for the US.

Our economy is 75% consumer-driven, so what the consume believes and does is of vital importance to our economic future, especially if exports and manufacturing fall off due to a shrinking global economy. Consumer sentiment declined in September to the lowest level in year as Americans anticipated a weaker economy in face of a global slowdown and turbulent financial markets. Stock market turmoil and bad global economic news have weighed on consumers’ confidence. The University of Michigan’s preliminary index which measures consumer confidence dropped to 85.7 from 91.9 in August, the largest one-month decline since the end of 2012, according to Bloomberg.

Given the stock market volatility of August, investors showed considerable restraint, withdrawing a net total of $4.9 billion from stock mutual funds last month, which was down from $9.6 billion in July, and a year high of $25.9 billion in April, according to Morningstar.

The mutual fund reporting giant also reported that last month investors pulled $14.5 billion from actively managed funds, while adding $9.6 billion to passive US-listed funds. Bloomberg notes that “Active fund managers have been losing ground to the far-less-expensive index funds, especially since the last financial crisis. The exodus from active managers accelerated after 2008, as investors learned the hard way that paying for stock-picking expertise didn’t shield them from losses.”

Last, but not least there’s the Federal Reserve and their widely expected commencement of rate increases to reach a policy-neutral level. Nearly half of economists polled by the WSJ expect the Fed will keep interest rates near zero next week. There are more doves on the Fed board than hawks, suggesting the majority is more concerned about growth of the economy and avoiding deflation than there are those who fear inflation. The minority have a much harder case to make given the events of the last few weeks.

This observer would not be a bit surprised to see the Fed increase rates just a tiny fraction next week or in October (perhaps 1/16th of a percent) just to put the question of when to rest and let markets dwell on other matters. In the Friday Brief entitled Tempests in Teapots we reviewed all of the Fed’s monetary tightening cycles (raising rates) for the past 30 years. In it we suggested that the most likely scenario would be for them to spread some very small rate increases over a long period of time. From June 2004 through September 2007, the Fed increased rates 17 times from 1% to 5.25%. I don’t believe they will have to go anywhere close to 5.25% this time before they have to drop again in response to the next recession (economists predict within the next 3 years).

Note: The preceding 1187 words have nothing to do with our process and in no way, shape, or form should imply any concern on our part that we will be unable confidently guide our clients through the inevitability of business and economic cycles ahead – up and down.