Contrary to majority expectations a China Hard Landing would eventually boost the US Economy
It is hardly surprising that the US stock market has been outperforming China and emerging markets in recent months.
The predominant view amongst commentators is that a hard China landing would be bad news for the US equity market and US economy. In fact the proportional impact on the US economy is fairly small. The much bigger issue is whether US business spending will gain in dynamism. The view here is optimistic
Contrary to popular thought, a China hard landing could provide an impetus to US business spending via increasing the relative attractions of domestic production.
On balance market opinion is still slanted towards putting the highest probability weight on China’s so-called “soft landing scenario”. But those with this view are becoming increasingly uncertain. Investors who are more inclined to focus on a hard landing scenario are gaining in overall market importance. Evidence to support that market observation includes the stream of commentaries, the weakness in Chinese stocks and some commodities highly related to the China boom in the past, selling of stocks in Europe, the US and Japan whose earnings are highly geared on China growth.
The noted swing towards pessimism on China has been fuelled in part by the flow of data releases, though none of these in themselves prove that a hard landing is taking place or imminent. (Absence of proof does not mean that the landing is in fact soft!). Also powering the swing towards caution (on Chinese economy) has been the political turbulence including the death in suspicious circumstances of a British businessman who might have exposed rampant corrupt practices and extortion. These events have strengthened the case of those China watchers who would stress similarities with Putin’s Russia rather than agree with those in the West who admire the “Chinese way of doing things”. Those admirers have been in the forefront of the chorus singing the theme that the Chinese communist party can prevent the credit and real estate bubble from being followed by a hard landing, though this has never happened previously in the long history of manias, panics and crashes.
If there is a hard landing, what are the implications for the US economy and US capital markets? On the face of it world economic growth, especially in the Asian Pacific region and Brazil would decline. On the positive side of the equation, slower Chinese growth would cut demand for key raw materials, causing price declines that would benefit the US, Japan, Europe and other importing nations.
We know from the previous history of global economic turbulence that financial linkages are sometimes more important in transmitting shocks around the globe than changes in trade. The concern here, is whether a China hard landing would bring a fall in the US equity market which would in turn slow the rate of US economic expansion. Pessimists fret about the hit to earnings of US multinationals who are heavily involved in the China economy and in other linked economies.
No doubt there will be some losers in the US equity market space, but overall perspective is important. The impact of Chinese trade impacts on the US are dwarfed by potentially much bigger swings in business spending by US corporations within the US. If US business spending were to increase by 12.5% in each of the next two years that would add near $400bn to US GDP compared to the cumulative $30 to $40 billion of net exports which might be lost in the course of a China hard landing. If US business spending were to increase by only 5 per cent p.a., the cumulative addition to GDP would be only $150 billion. So the much bigger question than China hard landing or not in assessing the likely prosperity of the US economy is the dynamics of US business investment.
It is hard to see why a China hard landing in itself should weaken the dynamic of US business spending. This is driven fundamentally by the combination of corporate profits (now very high), the cost of equity capital (arguably now back to historically average levels), the pace of technological change (now vibrant), entrepreneurship (alive and well but subject to constraints of intensified regulations as imposed by the Obama Administration and also potentially hurt by threat of higher taxation) and labour market flexibility (high in terms of relative wages between sectors and regions). The case is still fundamentally bullish for a US economic upturn led by business spending, which in turn becomes the engine of employment growth.
And there is the strange possibility that a China hard landing might actually increase the power behind the potential US business spending boom ahead. More US businesses will decide that transferring operations to China and elsewhere in the emerging market world is not the best strategy. Amidst new revelations of financial and economic chaos – and higher labour costs – in China, why not take advantage of in fact cheaper overall production opportunities at home or Mexico? And global investors who had so long been entranced by the Wall Street sales forces waxing about the attractions of emerging market equity might re-focus on domestic equities. Chinese investors might help give Wall Street a lift as Beijing removes restrictions.
Bernanke, the menace to economic recovery
When Professor Bernanke told Congress that it risked taking the economy over a massive fiscal cliff, the pity is that no-one shouted back “you risk taking the economy over a much bigger monetary cliff”. The US public can count on common sense prevailing in Congress but not at the Fed.
The dangers for the private-sector driven engine pulling the US economy back towards prosperity is that it becomes wrecked eventually by market turbulence related to monetary normalization – yet if this normalization is long delayed then there is the bigger menace of asset price inflation and higher goods and services inflation.
Without the monetary instability generated by the Bernanke Fed the equity market might well have found a considerably higher level than the present. And yet it is still true that when the tools are put back in the box the markets could fall. The damage from the monetary instability was already known, but the fanning of speculative temperatures by monetary tricks whilst it lasted caused markets to trade at a somewhat higher level than justified by fundamentals.
Day-to-day action in global financial markets suggests that actors there are not focused primarily on the looming monetary cliff. Rather the focus is on whether Professor Bernanke (who leading US monetarist Professor Meltzer has described as the most political chairman in the history of the Federal Reserve ) will resort to further monetary ease to promote the election chances of President Obama. Thus every small signs of slowdown triggers speculation on further Fed “stimulus”.
When further quantitative easing or further manipulation of long-term interest rate expectations are “taken off the table”, bond yields and the dollar are likely to jump. This could hit exporters, but would help the domestic economy eventually.
In the meantime Professor Bernanke is running scared of the stronger dollar and possibly a short-lived fall in equity prices which a start of the return to monetary normality could bring. Unfortunately the potential cliff gets larger the longer monetary normalisation is delayed.
Professor Bernanke is highly dependent on a second Obama term. But a Hollande presidency in France leading on to a full-blown crisis in the French capital markets could prove to be a bonus to Governor Romney. Just as the Greek crisis starting in early 2010 – and the TV images of political and economic collapse in Athens – helped to reinforce the warnings of the Tea Party and the Republicans against the dangers of President Obama’s spending spree and contributed to their successes in the Congressional elections of November 2010, a French crisis could awaken the US public to what Obama’s populist tax crusade might mean in the US.
Fears about US jobs growth misplaced
Markets are fearful that US nonfarm payrolls increased by only 120,000 in March, compared with 200,000 plus job growth in preceding months. Details of the latest report show that fears of an economic slowdown are exagerated and fluctuations are normal in an economy that has experienced boom and bust. The US labor market report is not produced by the Chinese statistics office!
Key positive factors in the labour report include:
* Total private sector hours worked in the first quarter of 2012 increased at an annual rate of 4 per cent.
* The average workweek in US manufacturing industry at 41.8 hours is back to near the peak of 1998/9 (and well above the peak of the last business cycle in the 2000s).
* The number of persons employed part time (sometimes referred to as involuntary part-time workers) fell from 8.1 to 7.7 million during March.
* The overall unemployment rate fell from 8.3 to 8.2% in March, still very high, but down from 8.9% a year ago.
* Unemployment amongst of graduates over 25 years is only 4.3 per cent compared to 4.4 per cent a year ago. Unemployment for 25 years and over with only a high school diploma has fallen to 8 per cent from 9.5 per cent a year ago.
Bottom line the latest US labour market report taken together with previous months’ evidence is consistent with the story that there is no longer excess supply in some segments of the working force while imbalances in others are being rectified.
Despite the uncertainties of the Obama Administration’s neo Keynesian high tax policies and dangerous policies of Professor Bernanke’s Federal Reserve Board, the private sector is managing to boost profits, savings and investment. The result is uneven growth in the economy and hence employment.
Mr Brown is London based chief economist at Mitsubishi UFJ Securities International