Monday, June 30, 2008

China, and Decoupling and US Equity Markets

Recession Risks and the US Market Before 2008 began, most thought that the 1st half would be tough for the US stock market, but mostly due to the hangover from the credit crisis that had unfolded in the 2nd half of 2007. However, while most believed there was a danger of the US slipping into a recession, there was hope that perhaps the consumer would spend its way to a softer landing versus a recession.

Decoupling the US from the World But an even more ambitious theory was the idea that even if the US slipped into a recession, perhaps the rest of the world would continue to grow. And as an investor, you might be able to weather the slowdown in the US by investing in companies that had international "footprints". Most in this camp hoped for "de-coupling" which was a fancy term for "I hope the Chinese, India, and the rest of the emerging economies in the world will continue to grow so US companies can continue to sell to these economies to keep us all employed."

Well fast forward to June 2008, and you know what has happened. The US markets are 20% off their lows of 2007. The bears are firmly in place, as they should be. Please see my post about Bill Priest's walkthrough on corporate profit deceleration, and why it has to happen.

The "Conundrum" Alan Greenspan used to speak often about the "conundrum." At the time, the conundrum attempted to capture the idea that yields on long-term, US Treasury bonds continued to fall, suggesting that demand was very high for these bonds despite their low yields relative to the rest of the world. If the world was awash in liquidity, why would foreign investors, specifically the Chinese, buy our Treasuries at such low rates when they could buy a comparable safe, higher yielding instrument??

A Strategy to Grow and Employ... Well maybe the clue to Alan's conundrum (*snicker) lies in a more simplistic idea. The Chinese entered the WTO December 2001 and made quite a few concessions to do so. But having been granted WTO status, the Chinese had a bigger issue on its hands, namely, a large population that was seeking employment. The Chinese, it's theorized, took the approach that Japan did back in the 80's, which was to grow its way through exports. They have succeeded admirably in this effort, and as such, its population continues to gain employment. Remember, they are the low-cost labor pool that the world "outsources" to.

The Chinese currency is undervalued relative to our US dollar. So many thought the Chinese buying of US treasuries was an effort to keep its (the Chinese) currency cheap, and thus make its exports cheaper relative to US goods. This situation is perfect if you want to export your way to prosperity. And that is what we have witnessed over the past decade.

Demand for US Treasuries and M.A.D. But an even more difficult question still lingers, which is why would the Chinese want our low yielding, long maturity treasuries? Well, by buying these treasuries, the Chinese do achieve its goal of keeping its goods cheaper than ours. But the potentially simpler, deeper answer is that by buying our treasuries, the Chinese continue to fund our deficit. We borrow from the world, because we consume more than we produce as a nation, and as such, the Chinese are, in effect, our bank. And they have every motive to do so because in the end, we are the customer they sell to. By selling their cheaper stuff to a nation that can't afford what it's buying, why not, as America, borrow from the bank that has every incentive to give us the financing? By doing so, the Chinese economy continues to grow and keep its population employed. And the US continues to gain access to cheap labor and maintain "growing profits" via lower costs and thus stabilize the China's working population from an indirect, economic perspective. China and India offer the world a deep, low cost labor pool that keeps US company costs down to keep profit growth in tact. It's, as Bill Priest puts, a form of economic "Mutual Assured Destruction", or MAD. The Chinese need us, but we need them just as much.

Globalization is What We Wanted Globalization is what the West wanted. Everyone in the West has said that China represents an untapped market of 1 billion people. But as is often the case, it's never as simple as that, and there are always unintended consequences. What's most troubling is the potential issues we face politically as a nation should the rest of the world de-couple and support the Chinese labor pool by buying Chinese goods at the level of the US. The Chinese would potentially have no incentive to support or finance us to the extent they have. That's the thought that should keep policy makers in Washington up. And the point is, decoupling is just hoping against hope. That's not being US centric, it's potentially more fact than fiction. The Chinese markets have fallen quite a bit, so check in again to see how well the world has "decoupled" after the Olympics.

Ultimately what I'm arguing for is the idea that there is no such thing as de-coupling if you believe the theory of China's financing us for the "triple purpose" of 1) keeping their currency devalued relative to ours, 2) to finance the consumer of their goods, the USA, 3) all which keep its population employed and its GDP growing. China is like the credit card company that sends the US a new flyer for a new card with teaser rates. We're in trouble when they decide to unwind this as is the rest of the world economy given the linkages. The conspiracy theorist might argue that the "lead" in toys from China has always been there, but there might be more to Congress's recent interest via a very public message.