In the January 1, 2007 edition of the Market Overview, As the World Turns, this author stated:
“Globalization and the free movement of capital, goods and services across national borders have caused the economies and financial markets of the world to become increasingly interconnected and entwined with each other.”
This statement is even truer today since the globalization process has interconnected the world to such an extent that what happens on one side of the globe affects someone on the other side.
A good example of this phenomenon would be the events that started on September 15, 2008 when Lehman Brothers fell. As our financial markets reacted and fell sharply, the financial markets in Europe were immediately dragged down into the muck along with us. This contagion then quickly spread to other parts of the world.
So how are we affected today? Part of the process of the past thirty years is that the world is becoming increasingly divided between developed countries - including the U.S., Europe and Japan - verses China and the emerging economies of the world.
This division has resulted in a slow growth trajectory within developed countries while emerging economies are growing at a much faster pace.
One reason why these developed economies are experiencing slower growth is because they are facing similar realities that stunt growth.
Understanding the Similar Components Individually
In order to understand these similarities and the interconnectivity of today’s economic landscape, each component needs to be viewed individually. In our opinion some of these components would include:
The euro zone (the 17 countries that utilize the euro as their common currency) seems to be in a perpetual state of recession. This does not only apply to the peripheral countries such Greece, Italy and Spain, but it also includes France, which is looking more like a peripheral country every day.
Their inability to escape their current situation is a result of the three underlying realities they face, including:
Chronic structural problems
The number one problem facing the euro zone is debt and the cost of servicing that debt while trying to lower annual deficit spending. The additional problem is that even though several countries are trying to institute some sort of austerity measure, their debt levels are still growing much faster that the growth of their economies.
There is also an underlying structural flaw in the composition of the euro zone in that the peripheral countries should never have been allowed to join in the first place. However, now that they are in they can’t leave without inflicting financial havoc within the zone.
And finally, Western European socialism and liberal labor laws make it difficult for these countries to enact effective policies that would return their economies to prosperity.
Dysfunctional political system
Europe’s leaders have held over twenty “emergency” summits in Brussels since the European crisis began over three years ago. However, most of their problems remain unresolved even though pronouncements have been made to the contrary. This has resulted in a “kick the can” down the road mentality within the minds of politicians and bureaucrats.
One exception would be the December 13, 2012 meeting whereby they agreed to let the European Central Bank serve as the banking regulator for the euro zone. Yet, even with this positive move forward, there is still no mechanism in place for the actual implementation of the agreement.
Accommodative monetary polices of the European Central Bank (ECB)
Due to the failure of fiscal policy within the euro zone, the ECB has had to implement an easy monetary policy in order to prop up the euro zone.
This has been accomplished by pumping liquidity into the banks with cheap loans; installing a safety valve through an open-ended sovereign bond-buying program known as the Outright Monetary Transfer (OMT); and through rhetoric, such as ECB president Mario Draghi’s July 2012 pronouncement of doing “whatever it takes” to protect the euro.
We are stuck in a slow-growth economy with high unemployment. We have discussed the reasons for this New Reality in detail over the past four-and-half years.
However, in broadest terms, we are currently facing three underlying realities:
Chronic structural problems
The underlying problem that ties most developed countries together is excessive debt. This would include the U.S.
As stated by this author in the November 25, 2012 Market Overview, An Era of Debt and Uncertainty: “The problem is that we are taking on enormous debt in a slow-growth economy, which has resulted in an outstanding debt balance that is growing much faster than our total economic output.”
Today our debt-to-GDP ratio is already over 100% and is destined to hit 120% within four years. At this rate, we could – and probably will – break the all-time record of 121% that occurred in 1946 as the result of debt accumulation during WWII.
We also seem to be moving toward Western European style socialism and entitlement and away from capitalism. These socialistic policies have created an absolute mess in Europe, so why are we moving in this direction?
Dysfunctional political system
Washington has become dysfunctional as our politicians continue to “kick the can” down the road when it comes to addressing our underlying structural problems. They also have the tendency to place personal agendas ahead of the interests of the country.
This has resulted in Congressional polarization, bickering and deadlock that have put fiscal policies in limbo. At least euro-zone leaders have an excuse for their deadlock. They come from 17 different countries with different economies, governmental and financial systems, political systems and cultures. Heck, they even speak different languages. What’s our excuse?
Accommodative monetary policies of the Federal Reserve
Due to ineffective fiscal policy and with our politicians in deadlock, the Federal Reserve has been forced to adopt accommodative policies in order to keep our economy afloat.
Anyone with a bank account knows about our historically low interest rates. By now everyone is also familiar with the Quantitative Easing (QE) - or printing of money - programs that have been put in place to pump liquidity into our system.
We have already seen QE1, QE2, Operation Twist, QE3 and what we call “QE Infinity” whereby the Fed is currently buying $85 billion per month in mortgage-backed and Treasury securities. The Fed has stated they will continue this program until unemployment falls below 6.5% or inflation rises above their targets. To put this in perspective, the sequester requires fiscal spending cuts of $85 billion this year.
Japan has experienced two “lost decades” of slow economic growth coupled with bouts of recession and deflation. Some of the underlying realities that have caused this situation include:
Chronic structural problems
Japan has the highest debt-to-GDP ratio of any developed country on earth. They have been able to maintain this level of debt since most of their debt is held by the Japanese. Conversely, most of U.S. debt is held by foreigners.
Why do they have such a high level of debt? Beginning in the 1990’s, Japan embarked upon a massive infrastructure construction program building roads, bridges and airports as a means to stimulate their economy. Now, twenty years later they are drowning in debt in an economy that has gone nowhere. Even though they revised 4th quarter GDP upward yesterday to show a +0.2% gain, they are still in a state of recession and deflation.
What they did not recognize is that stimulus spending is like a drug since its effects are short-lived and do not result in any long-term positive impact. Therefore, they kept injecting themselves over and over again to get the same short-term high until stimulus spending and debt were totally out of control.
Japan also has the oldest population of any developed nation, which reduces productivity and places strain on the economy due to the costs associated with an aging population.
Dysfunctional political system
Partially due to their political structure and partially due to their culture, Japan has been mostly led by a string of consensus-seekers that are protagonists that “kick the can” down the road and never make hard decisions. They can’t even uniformly decide on a leader having just re-elected their seventh prime minister since 2006. This has resulted in a Diet that has mostly been in a state of stalemate over the past two decades.
The new Prime Minister, Shinzo Abe who was also PM in 2006, has announced aggressive measures to create inflation, weaken the yen and stimulate the economy. This involves additional stimulus spending and more aggressive easing by the Bank of Japan.
Accommodative monetary policies of the Bank of Japan (BoJ)
The BoJ has announced a quantitative easing program, i.e. to print money, to re-inflate their economy to a target of 2% inflation and to weaken the yen.
By now the similarities between these developed countries should be apparent. Each has a set of chronic structural problems that revolve around excessive debt and a dysfunctional political system that is unable to deal with their structural problems.
This has forced the central banks in Europe, the U.S. and Japan to print money in order to pump liquidity into their economies to counteract the dysfunctional effects of their fiscal polices.
All of these factors combined have resulted in slower growth, higher unemployment, greater government intervention, and the potential for currency devaluation and future inflation.
And then there is China. While China still has a current growth rate of 7.6%, this is far below the double-digit growth experienced during the prior twenty years. They also have a different agenda as opposed to the developed countries, such as:
Shift in economic focus
The central planners in Beijing are trying to shift China’s economic focus away from exports and infrastructure towards domestic consumer demand. This was reflected in the announcements from the new government on March 5, which set a very conservative GDP growth target of just 7.5%. Also, at the opening of the annual National People’s Congress, the finance ministry said it plans to increase the country’s budget deficit to 1.2T yuan, or about 2% of GDP.
Why would they want to make this shift? This has actually been slowly taking place over the past few years since Beijing recognizes that as the second largest economy in the world, they cannot continue be a pure export-driven economy indefinitely. They are also feeling the effects of Europe’s recession, since Europe is their number one export destination (the U.S. is number two.)
As part of this shift, the yuan has been appreciating since 2005. This has been done gradually and in three phases in order to suppress investor speculation. This is a radical shift in policy since the yuan was tied to the U.S. dollar for over twenty years. By allowing appreciation in the yuan foreign goods become cheaper to the Chinese. This in turn will hopefully spur consumer demand.
How this effects U.S., Mexico, and El Paso
So how do these developments of the world affect the U.S., Mexico, and El Paso?
First let’s look at China. Wages in the coastal cities of China increased 500% between 2000-08. This caused a shift in thinking as noted by this author in the March 31, 2006 Market Overview, The Perfect Storm:
“As manufacturers are priced out of developed cities such as Shanghai and Suzhou, they will look to the interior or will look toward Southeast Asia and Indonesia in order to find lower cost labor and lower land values.”
However, with the price of oil tripling in this decade a third option became viable: move manufacturing closer to the product’s final or value-added destination, which meant Eastern Europe and Mexico.
There are several macro-economic factors in play that improve the attractiveness of Mexico from both an investment and manufacturing perspective. For example, while wages in China have been exploding, wage growth in Mexico has been muted for the past several years. Therefore, the difference in the cost of labor between China and Mexico has narrowed greatly, thus reducing China’s labor cost advantage.
There is also a time element involved. Since the price of oil has increased, transport ships move slower in order to conserve fuel, so it can take two months or more for a product to move from plant to its final destination. Therefore, the proximity of Mexico to the U.S. becomes a distinct advantage.
And finally, China’s currency is appreciating, which increases the price Chinese manufactured goods in the U.S.
It is these four factors - 1) the reduction of China’s labor cost advantage, 2) the price of oil and distance from plant to destination, 3) delivery times, and 4) yuan appreciation - that increase Mexico’s attractiveness.
So, whereas we saw an exodus of manufacturing away from Mexico around 2001 when China joined the World Trade Organization, we are now seeing a “reshoring” of manufacturing back to Mexico.
Now let’s take the broad current view. With Europe in recession, exports from the U.S. to Europe are decreasing. More importantly, exports from the export-driven economies of Japan and China are also falling forcing the Bank of Japan into a radical easing program to weaken the yen, and forcing China to accelerate its efforts to increase domestic consumer demand.
With the developed world printing money in addition to low interest rates, investment capital will be drawn into the emerging economies, including Mexico and South America, in order to seek out higher returns. This will fuel their growth and increase the growth differential between developed and emerging countries.
In Mexico, the four factors listed above will continue to have a positive impact upon the growth of manufacturing within that country.
In the U.S., we will probably experience slow growth in the first half of the year due to fiscal policy and regulatory uncertainty. However, housing prices have risen 9.9% year-over-year and the stock market is up. This dual “wealth effect” makes households feel better, which further translates into increased consumer demand.
Therefore since consumer consumption makes up 70% of GDP, we could see some acceleration in both GDP growth and imports in the second half of the year.
With Mexico’s expanded manufacturing base, a higher percentage of these imported goods that are moving into the U.S. will come from Mexico. These goods will need to move north from Mexico through El Paso.
This puts the world at El Paso’s doorstep.
Turning back to our economy, the economic data released yesterday showing a drop in the unemployment rate from 7.9% to 7.7% is misleading and needs to be put into perspective.
One underlying statistic not widely publicized - but now being recognized - is the so-called participation rate, or percentage of the population that is considered to be the potential labor force.
According to statistics, our potential labor force has shrunk tremendously over the past five years even though our population has grown. This statistical slight-of-hand has been accomplished by reducing the participation rate from 66.2% in 2007 to 63.5% today. If the 66.2% rate from 2007 is applied to today, then our unemployment rate becomes 12.1%.
The numbers also ignore the 8 million people who are working below their skill levels or are working part-time even though they would prefer to work full-time.
When these factors are taken into account, the employment picture appears worse than the very rosy picture that was presented. Even though employment as well as housing are improving, the underlying unemployment numbers suggest that the slow-growth environment that we have experienced since 2008 will continue into the foreseeable future.
As for the stock market, investors have ignored the dire predictions put forth by our politicians concerning the so-called sequester of across-the-board cuts in Federal discretionary and defense spending. This is contrary to investor reaction to the serious implications of the fiscal cliff, when the consequences were more definable and apparent.
Probably 60% of the stock market movement in recent months has been due to the Federal Reserve and QE Infinity, while 20% is potentially due to corporate earnings and 20% is due to recent economic data. Therefore, if there is even minimal rhetoric coming out of the Fed suggesting an alteration or slow-down to current monetary policy, this will have a very adverse affect on the stock market. This is something we will be watching closely.
- David B. Prilliman
Professional Investment Counsel, Inc. Principals: Gary M. Borsch (email@example.com) and David B. Prilliman (firstname.lastname@example.org)
Copyright 2013, David B. Prilliman. All rights reserved. All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice. Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed. This report is for information purposes only.