Andrew Baron, Butterfield
Global financial markets have begun 2016 with relatively substantial losses. The declines in equities markets have been remarkably broad-based across the developed markets, with no particular stand-out performer across the globe. Commodity prices, notably oil, have also declined substantially. When global asset markets decline in direct correlation with one another, does this impart information about the state of the global economy, or not?
The short answer is “sometimes,” but that in itself clearly isn’t very instructive.
Often, equities market returns do not correlate well with the global economic cycle, and indeed until the last decade there was little correlation between individual countries’ economic performance and anything that could coherently be called the “global economy.” In fact, the American economist Paul Samuelson once famously quipped “Wall Street indexes predicted nine out of the last five recessions.”
While it may seem like our interconnected world, made smaller by advances in communications infrastructure, is able to transmit the real effects of a recession on the other side of the world, this is not always an accurate assessment of the situation. In order to come to an answer, one must look at the facts on the ground through careful parsing of the economic data in individual countries and regions and come to a decision about whether the markets are discounting fair value for the companies within each economic system. In this article we will look at the two largest economies in the world.
The United States
Let’s start with the U.S., which remains the largest economy in the world. The U.S. economy is predominately driven by consumer expenditure, at roughly 70 percent of GDP, and secondarily by the provision of services. Goods production in manufacturing and resource extraction, for example, are dwarfed by the service sector and consumption. Of the angst over the direction of the economy at the end of the year and continuing into the first few weeks of January, focus has squarely been on difficulties in the oil and gas extraction sector and the impact of the strength of the U.S. dollar on U.S. manufacturing output. Conversely, very little attention has been paid to the fact that U.S. employment growth accelerated into the second half of 2015 from a three-month moving average of 231,000 jobs in June 2015 to 284,000 jobs by December 2015. Over that period, wages improved at a reasonable rate above measured inflation, and the unemployment rate fell to 5 percent. Strong employment is the backbone of the U.S. economy, especially as it relies heavily on consumption.
Additionally, housing markets are strong, building materials purchases are running at a 4.8 percent annualized pace of growth, home furnishings are rising at a 6.8 percent annual pace and new automobile purchases are at record levels. The oil price declines mentioned above, far from being damaging to the U.S., as a net importer, have given American consumers a major boost in disposable income. Americans are clearly not concerned about the well-being of the domestic economy, and if they are concerned about stresses in oil exporting countries that stem from the decline in oil, their concern is not showing up in the hard data.
This brings us, naturally, to China. It is impossible to have avoided recent media reports that Chinese growth is slowing. The intention here is not to deny that the growth of the Chinese economy is slowing – it clearly is – but merely to discuss the ramifications and the scale of the decline. China is attempting to adjust its economy from an unsustainable pace driven by a long-term misallocation of capital. Over the last two decades capital was allocated to massive infrastructure projects, to state owned enterprises and to the build-out of manufacturing capacity with little regard to efficiency or environmental impact.
The Chinese government is attempting to rein in some of the worst excesses of that period of rapid modernization while supporting the burgeoning middle class and a shift to a more balanced economy. Indeed, at present, consumption represents roughly 50 percent of the Chinese economy, which is low by Western industrialized nations’ standards, but represents a sharp climb over the past several years. Needless to say, achieving this balance has not been without difficulty, and recent Chinese policy has been opaque at best and inept at worst. Still, it bears remembering that Chinese growth was 6.8 percent in 2015 and estimates are for 6.3 percent in 2016. This pace of growth is two-and-a-half times that of the U.S. and six times what the Eurozone is set to achieve, so when we talk about a “decline” in China’s prospects, it should be taken in that context. China is at once a powerful engine of growth for the global economy as well as a risk for the world – the successful re-balancing of the economy is imperative to get “right.”
At present, the financial markets seem content to wholly focus on the risk that China will exert negative pressure on trade and industry that will spill over into the broader emerging markets. Markets are predicting that this phenomenon has the ability to stall the long and somewhat unimpressive global recovery that has followed the credit crisis period. However, very recently revised International Monetary Fund estimates for global growth in 2016 are forecast to rise to 3.4 percent from 3.1 percent in 2015. If the global economy can still improve as forecasted and there is not a high probability of global recession, without a disastrous out-turn from China and the U.S., financial markets, and equities markets specifically, may be focused too much on the risks to the downside and not enough on the positives.