If we’d been around in the 15th and 16th centuries we could have watched in amazement as the world slowly came to grips with the fact that the earth wasn’t flat after all. We would have noticed that there is a big difference between the sudden realization that the old, flat-earth idea was clearly wrong, and the much slower process of internalizing all the implications of this new truth. The thirty years between Columbus and Magellan would alter human history profoundly, but humans only gradually glommed on to how important it was.
On a much smaller scale, we can observe the same phenomenon happening today. The world changed profoundly in August, but it will take a good long time for investors to internalize the implications.
What changed, of course, was that the optimistic case for China – the “soft landing” hypothesis – fell off the table. That’s important because a soft landing in China was the base case for almost everybody: the IMF, the World Bank, the world’s central bankers, almost every investment firm on the planet.
It’s not that everyone blithely assumed that all was well in the Chinese economy. We knew that China’s economy was slowing from over 10% a few years ago to about 7.5% last year and about 7% this year. Some of China’s problems were a legacy of the vast spending spree the Chinese government launched after the Financial Crisis. China had spent money willy-nilly to prop up its economy, save jobs and avoid social turmoil, and while the spending was successful in the short term, the long-term result was massive and unsustainable debt (roughly 250% of GDP, the point at which crises have struck many other economies) and vast overcapacity in the already-inefficient industrial sector.
The other main problem was the difficulty of making the transition from an industrial economy that could be managed simply by building more and more plant and equipment to a consumer-driven economy that relies on more and more human capital. I’ve written ad nauseam about this, so suffice it to say that if China’s central command economy manages the transition it will be the first time in history that such a top-down society has done it. In other words, either it won’t happen or the Chinese Communist Party will lose its grip on power.
By the end of August, we knew the following facts:
* We knew that China was slowing far more rapidly than we had been led to believe and that the size of its GDP was lower than we had believed. Many thoughtful observers think China is actually growing at 2-3%, not the advertised 7%.(1)
* We knew that slowing growth in China made even the low existing expectations for global growth obsolete. The IMF and World Bank are already preparing reduced estimates.
* We knew that the economies that had most prospered during the commodity supercycle, and which had already been hard-hit by a slowing China, were now going to be much harder hit. Brazil, Venezuela, Argentina, Russia, Malaysia, Indonesia are all in for very rough times. Even Australia and Canada, whose economies are much broader-based, are looking at considerably slower growth. The humiliating downgrade of Brazil’s credit to junk status is just the first of many such downgrades to follow.
* We knew that the broader emerging markets were being buffeted by a powerful double-whammy: a slowing China and a resurgent US. The slowing of Chinese imports and the weakening Chinese currency following the devaluation were one side of the double-whammy. The other side was the prospect of higher interest rates in the US, which would only accelerate capital flight out of the emerging world.
* We knew that any country whose economy was based on exports would be affected. This includes Germany, where exports represent 70% of GDP and where the overall economy was only growing at about 1.5% anyway.
* We knew that if Germany slowed, all of Europe would slow, because Germany remains the main economic engine of Europe. This is bad news for the periphery, of course, but it’s also bad news for France. Seven years after the crisis, France still isn’t growing, and its unemployment numbers continue to rise.
* We knew that even before the Chinese slowdown Japan was mired in zero-growth mode. The country has been enervated for two and a half decades, of course, but there was a lot of optimism around Prime Minister Abe’s “Three Arrows.” Two of the three were launched shortly after Abe took office: a 10 trillion yen stimulus package and a vast quantitative easing program, far larger than US QE relative to the size of the Japanese economy. The result was that Japan promptly fell into recession. It grew in 1Q15, but fell back into negative growth in 2Q15. In other words, both fiscal stimulus and QE were failing. Add slowing growth in China and a weaker renminbi, and matters will only get much worse.
* We knew that the US was far better positioned than any other country to weather turmoil elsewhere in the world. Only 30% of our economy is export-based, so we were better-positioned than Germany. We were growing at nearly 3% annualized, better than any other developed country (and possibly better than China). Only about ½ of 1% of US GDP is represented by exports to China, so we were insulated from any direct hit from slowing Chinese growth (unlike Europe and the emerging markets). But we also knew that the US is no island. Our export economy will slow, due both to China and a strengthening dollar. If global growth slows and Japan and Europe fall into recession (see above) American consumers will pull in their horns. This will happen not just because people will worry about losing their jobs and therefore will need to start saving. It’s because American consumers are staggeringly in debt and if the US economy slows they won’t be able to repay that debt. It’s not just a reduced lifestyle that consumers would have to worry about, it’s possible insolvency. The US Fed, aware of all this, blinked on Thursday and declined to raise rates.
But it’s one thing to suddenly know a bunch of facts we didn’t know a month earlier; it’s quite another thing to understand the implications of those facts. We’ll turn to that in next Friday’s post.
(1) E.g., The Economist: “The [Chinese] government’s claims that the economy is chugging along at 7% now elicit derision. * * * Some think China has, in fact, already suffered the hard landing dreaded by economists. * * * Add it all up, the skeptics say, and China’s annual growth looks to be just 2-3%.” See also Felix Zulauf, a member of Barron’s Roundtable: “China’s economic growth decelerated from more than 10% to about 2%, although the targeted figure is 7%, but that’s baloney.”
(2) The “arrow” that might actually have helped the Japanese economy – the “Third Arrow,” or economic reform – won’t happen because the failure of the first two arrows has caused Abe’s popularity to plummet and he no longer has the political chops to push through unpopular reforms.
Next up: When the World Changes and We Don’t, Part 2
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