The core theme underpinning our global strategy, as articulated in our Investment Strategy Committee meetings, is our belief that the Asian region can withstand a US economic slowdown this time around and by decoupling the first blow for global economic leadership should be struck. It is already well known that hedge fund and traditional asset managers alike are already heavily invested in the Asian economic region. The coming US slowdown will test their resolve but providing nerves are held we would expect global growth to hold up pretty well (with a marked Asian bias) and Asian currencies, generally, to appreciate against the dollar. In the case of the Chinese renminbi this is something we and many others have been waiting for some time. Now it’s time our strategic view was tested.
The US economy is slowing. Most are already aware of the weakness in the residential housing market which has led a number of commentators to describe conditions as being as bad as at any time in the past seventy years. We have used this Weekly publication to point out that in the US consumer spending and business spending are closely correlated. The anticipated consumption slowdown should lead to a slowdown in business investment too.
Critically, however, what differentiates this coming US slowdown from those of the recent past is that it is property (i.e. domestically) led.
Whilst there will inevitably be an adverse reaction around the world, particularly if business investment contracts too, the impact on Asia is likely to be very much less severe than the headwind caused by the tech or manufacturing-led slowdowns of the recent past (most readers will be well aware of the devastating impact on the Asian region of the tech bubble burst of 2000-2001). At the same time and thanks in no small part to China’s rapid emergence as an economic force, domestic demand has been transformed. This, coupled with the scope enjoyed by many of the region’s new-found wealthy countries to limit any US-inspired economic damage through offsetting policy measures, gives us some comfort that things really will be different this time!
How will the US economic slowdown impact on Asian currencies?
The US economy, still the engine room of global activity, is scheduled to grow by c3.5% in 2006, from 3.2% in 2005. However, the adverse impact of aggressive monetary tightening is now beginning to be felt and, given its lagging effect on overall activity levels, the ultimate impact could be pretty severe. Judging by the financial futures markets, professional investors are now ascribing a 45% probability to a “hard” economic landing next year. This implies that the base case remains for a “soft” landing but that the probability of something worse is now sufficiently large as to turn even a soft landing into something more bumpy. Merrill Lynch (yes, the thundering herd!) is itself forecasting growth of just 1.8% in 2007. Crikey! If an organisation as optimistic as Merrill historically has been is battening down the hatches then those others, still in denial, have quite a shock in store. We, having often been accused of pathological bearishness, merely watch from the sidelines (without a hint of schadenfreude!).
A US economic slowdown will, inevitably, have significant connotations for the global fixed interest and currency markets. Clearly, investors are keeping a very close eye on all US data releases for indications as to how the Fed’s Open Markets Committee might respond. Our expectation is that the longer the Fed leaves it before cutting base rates the greater the risk that the landing will be hard. Our best guess is that the Fed will remain “on hold” at 5.25% until January at which point it will begin the process of monetary easing. Policy makers are, however, data dependent and could act (either way) if sufficient data evidence supported it. The process of US rate cutting should flatten the now aggressively inverted bond yield curve and remove a major support for the dollar. Our expectation remains that Asian currencies should, over time, appreciate against the dollar and that the process will be swift should the Chinese currency peg be removed.
What is the extent of Asia’s exposure to the US?
Over a long period to about 2002 Asia’s exports to the US tracked US demand very closely. From 2002 the close correlation has broken down dramatically. In percentage terms around 9% of regional exports were destined for the US in 2000. Now that figure is down to just 6%. In large part this reflects the reorientation of export activity from within the region to China and the trend towards outsourcing from a resurgent Europe to Asia resulting in a progressive switch in that region’s focus away from the US to Europe.
None of this is to say that the Asian region won’t be affected by the US slowdown, but this time around the region is unlikely to be the epicentre of any global fall-out. Hong Kong and Taiwan, with close historical links both in terms of trade and political affiliation, are probably the areas likely to be most adversely affected while the large population centres of China, India and Japan should be able to weather the storm. Australia should continue to benefit from its position as a major exporter of scarce raw materials to the Asian region.
Is Asia ready? China
The Chinese economic growth story is, of course, the big story for the region and the great hope that this time that growth proves sustainable. The country continues to grow strongly according to official data and a substantial current account surplus has built up, particularly reflecting increased trade with the USA. Exports account for c8% of Chinese GDP, up from 5% in 2000, thus the first point to make is that the Chinese economy will be impacted by a US slowdown, the question is by how much?
The key to China’s escape lies in the strength of its own domestically created demand. Notwithstanding still strong investment growth the Chinese remain, for the moment, a nation of savers. Whilst consumption levels have increased, income growth has increased by more, resulting in a substantial savings pool to be dipped into in the future. Readers should also note that following China’s inclusion in the WTO in 2001 overseas direct investment has increased exponentially.
The official policy response from the Chinese authorities has been to curb fears regarding inflation by raising base rates. What else can the country do while the currency peg remains intact? It is suspected that a US slowdown would require a more meaningful policy response from the Chinese authorities, by which we mean the removal of the renminbi’s peg. Were that not to happen the country’s massive current account surplus would be expected to rise to even greater records and the threat of eventual bust to follow the current boom would increase too. As a counterweight, the Chinese budget deficit has fallen to just 1% of GDP this year (from 2.5% four years ago), providing the authorities with the scope, if necessary, to pull fiscal levers in order to drive domestic consumption growth.
Is Asia ready? India
Much has been written regarding India’s ability to match China and become an economic giant in its own right. There are a number of significant political and economic impediments to this happening in the near-term, however, it should be noted that, at just 2% of GDP, exports to the United States are very low by regional standards and thus the country enjoys considerable immunity to a US-driven slowdown. The outsourcing of call centres to the sub-continent is an issue in as far as the service sector does have greater exposure than the export sector to any slowdown and could have an adverse impact on the country’s trade balance.
As with China, substantial latent domestic demand exists even if that potential has yet to be realised. That said, the country has begun to experience an upward shift in long-term consumption activity and business investment is picking up too. Here too inflation is exercising the authorities and interest rates are rising. This, more than any exogenous shock brought about by a US slowdown, is likely to hamper growth in the near-term. Note too that with a substantial budget deficit, the authorities’ room to use fiscal policy to generate an upturn in domestic demand is more circumscribed than in China.
Is Asia ready? Australia
Australia, despite its size, remains a relatively small player, economically, on the world stage. Exports to the US amounted to just 6.5% of GDP in 2005 compared with 20% to Japan and 11.5% to China. Australian exports are dominated by scarce raw materials and the largest source of demand is the relatively local Asian economic region. Australia has forged closer economic ties with the region, a move which has resulted in a significant improvement in its balance of payments and allowed for the switching of resources towards stimulating domestic demand, a move which has enabled the country to grow strongly in recent years.
Australia’s ability to weather a US-led slowdown depends entirely on whether demand for commodities holds up in Asia. Our expectation is that it will and thus we suspect that the Australian economy should emerge relatively unscathed. Note, too, that Australia enjoys a substantial budget surplus which the authorities may decide to utilise in the event that the US slowdown becomes more contagious and relatively high short-term interest rates also provide the scope for a monetary response. Whilst the currency floats freely, the adverse impact of any exogenous weakness is likely to be cushioned.
Is Asia ready? Indonesia
A quick look at the Country’s demographic profile, its population and the relatively closed nature of the economy (exports to GDP ratio is just 30%, low for the region) might suggest that the geographically dispersed nation could withstand a US-led downturn well. However, our enthusiasm is tempered by the possible fall-out from the coup in Thailand. The Economist magazine carried an article (Thursday 21st September) raising concerns that the same undercurrents which resulted in the recent Thai coup could easily surface in Indonesia.
The country’s economy has suffered from higher short-term interest rates to offset the potential inflationary impact of higher energy prices over 2005. While the authorities are now cutting short-term rates and retail sales data indicates a mild recovery from depressed levels, the fragile current account surplus is at risk, as is the currency and overseas investors, who flocked to the country in 2004/05 may rein in their horns in the context of higher US Fed Funds rates.
Is Asia ready? Hong Kong and Taiwan
Both Hong Kong and Taiwan’s relatively small economies are vulnerable to a US slowdown, both for economic and historical / political reasons. Hong Kong’s export to GDP ratio to the US is c35% and policy response is limited by the currency’s dollar peg. Should the dollar weaken (as we expect) and the renminbi appreciate (as we expect) the Hong Kong dollar would be expected to depreciate on a trade-weighted basis. Given likely weakness in the former colony’s property and financial centre, overall activity would be expected to slow, limiting the scope for any fiscal policy response.
Over in Taiwan the authorities are in an even more tricky position hamstrung as they are between the hostile Chinese regime and exposure to the US economy. Direct exports to the US totalled some 10% of GDP in 2005 while indirect exports added a further 2.5%. Exports to China are negligible while those to Japan represent just 4.5% of GDP, limiting the countries exposure to that country’s recovery too. The authorities have little room for manoeuvre as local interest rates are already at stimulative levels and fiscal policy is already being tightened in an attempt to correct many years of public sector deficits.
Can Asia come through the US slowdown unscathed?
This article has been prepared to add flesh to Charles Stanley’s strategic weighting in its Select Portfolio. Yes, the Dow Jones Average has just recorded a new all-time high, however, we suspect that dollar weakness will limit the euphoria for sterling-based investors. The key tenet of our strategy is the Asian region’s ability to pick up the global growth baton from the place where the US economy drops it. This analysis indicates that the region has the wherewithal to overcome the oncoming US economic slowdown relatively unscathed, leaving global growth forecasts fairly unscathed. The analysis goes further and concludes by suggesting that, across the region, varying economic strength and political manoeuvrability could result in a disparate economic performance. On balance we continue to favour the potential economic giants and would recommend that deeply long-term strategic investors continue to build exposure.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley