Boom, Gloom and the New Normal

Taxes, like death, are inevitable. But very few people have much idea of how their money is spent.

Thus the blog applauds the UK government’s decision this week to send every taxpayer a ‘receipt’ showing the key spending areas (chapter 5, for those who wish to see the detail).

The chart above shows a sample developed by The Guardian :

• It is based on someone with average earnings of £25.2k (€33.4k, $40k)
• It itemises the use made of the £5702.12 tax they will pay in 2011-12

Of course, no one example covers all taxpayers. Nor will the UK position be the same for other countries. But the table is the best guide we have.

It shows that the 2nd largest single area of expenditure is in fact “old age”, mainly state pension payments. Their cost has already risen 35% since 2006/7, according to the government.

The table highlights the core argument of our ‘Boom, Gloom and the New Normal’ ebook. The ageing of the Western BabyBoomers is causing major changes in spending and demand patterns.

Latest data confirms the growth slowdown now underway in China:

• Rmb bank lending (purple column) is down 8% year to date versus 2011
• The leading indicator (red line) for the economy fell further

Bank lending has been the main growth engine for the economy since 2009. But it led to major inflation problems, particularly on food prices, and a housing bubble. So the government has little choice. It has to slow things down, or risk more social unrest.

This slowdown is now being confirmed by the OECD’s leading indicator. It is well below the 100 level, which divides slowdown from expansion.

Western financial analysts continue to wait for another major stimulus programme. But as the blog has argued, their wait may be a long one. Last week’s purge of Bo Xilai shows that China’s leadership have more important issues on their mind at the moment.

On 29 June 1987, the blog was in S Korea on a business trip. With its ICI Korea colleagues, it arrived at the company we were due to visit, to find the gate open. The offices were also deserted.

Surprised, we walked into the factory to find 500 people watching a small black and white television. It was a momentous day in the political life of S Korea. President Chun was announcing that, for the first time, the next president would be directly elected under a new constitution.

Since then, Korea’s economy has blossomed. Even the 1997 Asian Crisis proved helpful in hindsight. It further weakened the ‘crony capitalism’ that still existed between the powerful industrial chaebols and the government.

China, of course, still has to go through this process. But the starting gun was fired on Thursday, when it was announced that one of the Communist Party’s top officials, Bo Xilai, was being fired. Premier Wen then went on live television in his annual press conference to warn:

“Without successful political structural reform, it is impossible for us to fully institute economic structural reform and the gains we have made in this area may be lost. New problems that have cropped up in Chinese society will not be fundamentally resolved and such a historical tragedy as the Cultural Revolution may happen again. The mistake of the Cultural Revolution and impact of feudalism are yet to be fully eliminated.”

The background to this intense debate, as in Korea in the 1980s, is the need for political reform to accompany and support economic growth.

The chart above, from chapter 6 of ‘Boom, Gloom and the New Normal‘, highlights the insight of West Indian, Sir Arthur Lewis. He won the Nobel Prize for his work showing how early growth (y-axis), based on the supply of cheap labour, comes to an end after ~20 years (x-axis):

• This ‘free labour’, which kick-starts industrial development, has to be replaced by more labour intensive manufacturing
• In turn, this means people have to be allowed to think for themselves

Since 1987, Korea (red dot) has successfully followed Japan (blue dot), in moving up what has become known as the ‘Lewis Curve’. Now China (green dot) has to try and follow the same path. It will not be easy, and as Wen warned, success is not guaranteed.

Bo’s dismissal shows that China’s leadership is starting to move in the right direction. But it is just a first step. The new Politburo leadership, due to emerge in October, has a major task ahead of it.

Nissan, Japan’s No2 auto maker, provides further evidence for our argument in Boom, Gloom and the New Normal that affordability is becoming the key driver for sales and profits.

It is now considering reviving the low-cost Datsun brand as it seeks to grow its sales in countries such as India, Indonesia and Russia. The Wall Street Journal notes that Nissan is “seeking to grab 8% of the global market by 2017″ by focusing on “China, India and other emerging economies with low per capita incomes”.

As the picture shows, the Datsun was originally aimed at the market for small, sporty and fuel-efficient cars. This makes it well-suited to today’s market. Apparently the new model will retail at $6k, and be launched in 2014. Nissan hopes to sell 300k a year.

Nissan’s move highlights a growing trend amongst automakers such as Ford and Renault, as we highlighted in chapter 7. They have all recognised that the phrase ‘middle class’ means something very different in emerging economies. Typically it refers to someone with an income under $20/day.

Companies who follow them in focusing on affordability will likely find themselves rewarded with long-term sales and profit growth. But those who rely on policymakers returning us to the 1982-2007 supercycle, when ‘value-in-use’ ruled, could find life becoming very difficult indeed.

The US housing market collapse has wiped out $6tn in wealth since it began in 2006. But even today, little is being done to solve the critical issue – that homeowners took on too much debt, which will never be repaid.

As a result, the situation continues to get worse, not better. And some influential commentators are beginning to worry that today’s falling prices, and rising debt levels, present a real challenge to key elements of the post-war American Dream:

• Prices fell again in December, and are now down 34% since their peak
• S&P warn that “we might have re-entered a period of decline”
• 5 million homes have owners who are either delinquent on payments, or already in foreclosure
• In addition, 3 million homes are vacant but not yet listed for sale

One key problem is highlighted in the chart from the Wall Street Journal. It shows how foreclosure delays have risen dramatically since 2008:

• In 2008, the foreclosure process took an average 251 days for mortgages under $250k, and 261 days for those over $1m
• Last year, it took 611 days for $250k mortgages, and 782 days for $1m

• Most people heading for foreclosure stop paying the mortgage. So those with $250k mortgages gained an extra 12 months of ‘rent-free living’, and those with $1m mortgages gained 18 months
• This gave them more money to spend in the shops and on new cars

• But this is not ‘real demand’, as it relies on people not paying rent

There are many reasons for the extra delays. The system is overloaded by the large volumes of homes now threatened with foreclosure, and the paperwork covering the loans is often faulty. But now it seems to be moving back into top gear again. 24% of all home sales were foreclosures in Q4 2011, compared to 20% in Q3.

Equally, as former US Labor Secretary Robert Reich notes:

“We are witnessing a fundamental change in the consciousness of Americans about their homes. In the late 1960s and 1970s, baby boomers took out the largest mortgages they could afford. Homes morphed into ATMs, as Americans used them as collateral for additional loans. Most assumed their homes would become their retirement savings.

“The plunge in home values has changed all this. Young couples are no longer buying homes; they are renting because they are not confident they can get, or hold, jobs that will reliably allow them to pay a mortgage. Middle-aged couples are underwater or unable to sell their homes at prices that allow them to recover their initial investments. They cannot relocate to find employment. They cannot retire.”It clearly suits policy makers and financial markets to ignore these issues and hope they will go away. But their lack of attention is making an already difficult problem even worse as we transition to the New Normal.

China’s economic growth has become more and more unbalanced over the past 10 years, as we discussed in chapter 6 of Boom, Gloom and the New Normal. Its domestic consumption is now only around a third of GDP, compared to 50% a decade ago. Instead, the leadership has focused on achieving growth via exports and infrastructure investment.

THE SHORT-CUT HAS BECOME A DEAD-END
This ‘short-cut’ to higher growth is now looking more and more like a dead-end. Exports are falling, as the ageing Western babyboomers cut back their spending. Whilst the surge in bank lending has often led to purely speculative activity, such as the housing market bubble.

Now, not for the first time, China’s leadership are flagging that they may move away from their GDP-driven policies. Bloomberg report premier Wen may announce a GDP target of less than 8% in his National People’s Congress speech on 5 March. The problem is that the move, if it comes, may well be ‘too little, too late’ to put China back on course.

Wen himself recognised the issue 5 years ago, when he described the economy as being “unstable, unbalanced, uncoordinated and unsustainable“. But hard choices were deferred when the financial crisis hit in Q4 2008. Instead, lax lending made the problems worse, not better.

Policymakers discussed a possible new approach at December’s economic work conference, which highlighted that “the country is poised to make some significant policy changes”. As Yi Xianrong of China’s Academy of Social Sciences noted then:

“The country has shown more determination than ever to shy away from any enormous economic stimulus packages in an endeavor to decelerate its fast pace of GDP growth”.

FIVE KEY RISKS TO FUTURE GROWTH
‘Better late than never’ is probably the sensible response to this potential policy change. But unwinding the legacy of the previous past decade will not be easy, and creates 5 major risks:

• China’s current policy saw its share of global exports hit 10.5% in 2011, up from 8.8% in 2007. Replacing this volume, and the jobs it created, will not be easy
• Similarly, its wasteful infrastructure investment, which rose to 48% of GDP in 2011 from 42% in 2007 means money has been spent which cannot be recovered
• China’s new short-cut to help boost consumption is to increase wages by 13% a year. But this will reduce profit margins and jobs
• It is also difficult for any country to manage a smooth transition on such a scale. There is a strong risk that the uncertainty created may reduce future investment spending
• Finally, there is the really big risk, that China may hit the ‘middle income trap’ we described, and simply fail to make the transition required

THE WORLD BANK’S WARNING
This latter risk is not just the blog’s concern. Yesterday, the World Bank and China’s Development Research Center (DRC) published their major China 2030 report which warned explicitly that:

“China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the ‘middle-income trap’.”

The chart above, from the Wall Street Journal, highlights the scale of this risk. The blue columns show GDP/capita pre-1970 in countries including China, Thailand, Malaysia, S Korea and Japan. The orange column updates this to the 2007/9 average. Some countries have clearly done very well. Korea, for example, has moved from having a GDP/capita of only 10% of US levels to almost 60% today.

Following Korea’s example will not be easy for China. The blog was a regular visitor to Korea in the 1987-92 period, when a key part of this transition took place. It saw major political change taking place, as ordinary people were allowed to vote for their president in a direct secret ballot. This will not be happening later this year in China, when President Hu is expected to be replaced by Vice President Xi.

Yet as Sir Arthur Lewis’ work has shown, political change of this kind is essential if the economy is to continue to grow. Equally, China’s ‘one child policy’ means it has no choice – it cannot continue to rely on cheap labour, and has to become more capital intensive.

The World Bank/DRC report highlights the key question. Can China manage this transition? Equally, it warns that “A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, and could prompt a crisis“.

January was not a great month for auto sales in the 3 major markets of the USA, EU and China. These amount to over 50% of global auto sales, and are a key indicator of underlying consumer demand.

As the chart shows, sales were just 3m (red square), down from 3.2m (green line) in 2011:

• China’s volumes were down 17% to 1.2m from 1.4m
• EU fell from 1.04m to 0.97k
• Only the USA saw a rise to 0.9m from 0.8m

Of course, China’s sales were much slower than last year due to the Lunar New Year taking place earlier than in 2011, and combining with the Spring Festival. But even so, China’s auto industry is only forecasting 8% growth this year – in line with the 6% seen in 2011. This is well down on the 33% and 49% increases seen during the stimulus period.

It is also difficult to be optimistic about EU sales, with auto companies forecasting sales declines of 6% or more this year. Whilst sales growth forecasts in the USA will be tested by today’s high gasoline prices.

This time last year, the petchem industry stood on the edge of an unseen precipice. Life seemed good. Prices were racing ahead and demand appeared buoyant. But in reality the buyers were only buying forward to protect margins, whilst end-user demand was slowing fast.

This year, the blog fears, we may be about to take one step forward.

As last year, the evidence comes from ICIS market reports. The highly experienced Linda Naylor last week reported buyers commenting as follows in European polyethylene and polypropylene markets:

“‘We expect an increase for ethylene in March, so we are buying our full contracted volumes in February, and also in January, even though our demand is poorer than we expected. That way, we won’t have to buy so much in March.”

“‘Our demand is below what we expected but we are taking our full contracted volumes to be able to have a buffer next month.”

Similar warning signs are reported by Becky Zhang in China’s ethylene glycol markets, and Helen Yan in Asian butadiene:

“‘The market is full of offers and this [has worsened the] bearish sentiment’, a major regional trader said. China’s port inventory reached a historic high of over 750KT, with increased import volumes arriving from all over the world. This is almost exceeding China’s maximum storage capacity of around 800KT.”

“‘BD prices are higher than BR and this is not sustainable,’ another synthetic rubber producer said.”

The chart shows how prices for the benchmark products have seen 3 major rallies since 2009. These followed the 3 major stimulus packages.

Today’s rally began with Q4′s US Federal Reserve’s $400bn Operation Twist programme. It is clearly much weaker than those which followed the March 2009 and August 2010 quantitative easing programmes.

Product price changes since the 29 April peak, with ICIS pricing comments, are below:

HDPE USA export (purple), down 11%. “Offers for re-exports from China were heard at lower prices than offers from the US Gulf”
PTA China (red), down 11%. “The current supply and demand balance as well as volatile external markets did not support a solid upturn”
Naphtha Europe (brown dash), down 7%. “Vitol continued its naphtha buying spree, taking 5 cargoes after it bought eight cargoes last week”
Brent crude oil (blue dash), down 5%
Benzene NWE (green), down 4%. “Continued buoyancy on crude and energy numbers counterbalanced by lower demand.”
S&P 500 Index (pink dot), no change

China’s bank lending fell 7% in 2011, following a 17% decline in 2010. As the chart shows (red column), the government is clearly trying to stabilise the position, after the panic increase in lending in 2008/2009. (January lending, impacted by Lunar New Year, was down 29% vs 2011).

Electricity consumption growth (blue line) also seems to be stabilising. It is a lagging indicator, as it takes time to expand electricity production. But the ending of subsidies for rural home appliances helped to push their sales down 33% in January versus 2011.

The reason for the government’s caution is that food price inflation remains out of control. It was up 10.5% in January, reversing recent declines. In a country where 96% of the population earns less than $20/day, food prices matter a great deal.

Those analysts with a purely financial outlook seem to have missed this critical point. They have been forecasting further stimulus programmes for some months. But very little has yet happened. Instead, the government remains focused on maintaining social stability.

This is particularly important in the run-up to the major changes that will take place in politburo membership this year. Thus, instead of reductions in interest rates, the government has instead announced minimum wages will rise 13% a year until 2015:

• In Beijing, it is currently $200/month, and $140 in urban Chongqing
• The aim is for it to be at least 40% of average wages by 2015
• At present, it varies between 20%-30%, depending on region

This will boost domestic spending power. But, as we argue in our Boom, Gloom and the New Normal eBook, affordability will be the key factor. Those companies who focus on meeting the population’s basic needs for food, water, shelter, health and mobility should do very well indeed.