Everything’s slowing down.
US shoppers aren’t buying as much stuff. China’s expansion is easing up. The Federal Reserve is already getting a little bit twitchy, cutting its growth forecast for the US economy.
We’re still not heading for a double dip, according to most pundits. But we’re getting closer. And as David Rosenberg of Gluskin Sheff points out, “these same double-dip deniers never saw the recession coming in 2007 to begin with.”
So what does it mean for investors?
The news from the US isn’t good
US retail sales fell for the second month in a row in June. Sales fell by 0.5% on the month, worse than the 0.1% fall expected. Meanwhile, businesses aren’t rebuilding their stocks as rapidly. That’s bad news because it suggests they don’t feel confident about consumer demand. Business inventories rose at their slowest rate this year in May, while factory gate sales were down 0.9% on the month.
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As the FT put it, “inventories provided a big boost to output as the economy emerged from recession, but businesses are restocking less aggressively as they brace themselves for weaker consumer demand.”
The Federal Reserve is clearly getting a little worried. The minutes from the Fed’s latest interest-rate-setting meeting showed that fears about deflation are starting to trump concerns over any further monetary easing.
There’s no suggestion that the central bank has its finger hovering over the ‘restart’ button on the printing press quite yet. But as the FT reported, “if the economic data continue to weaken, suggesting this is not just a soft patch in the recovery, then the Fed debate about further easing will become intense.”
None of this should come as a huge surprise. Unemployment is still high in the US, and the housing market looks like it’s heading for another fall. It’s amazing that people are spending any money at all.
The world’s hopes are pinned on China
China on the other hand – that’s where the global growth hopes lie. Trouble is, China is slowing down too. Now to be fair, saying that China is slowing is a bit like saying that a car travelling at 120mph is slowing down when it decelerates to 100mph. Chinese GDP growth slowed from a rampant 11.9% in the first quarter to a merely astounding 10.3% in the second quarter.
But it’s the direction that’s important. And the economy is also slowing more rapidly than investors had expected. Again, given China’s reliance on exports, this shouldn’t come as a massive surprise. Chinese stocks slipped on the news and the rest of the world followed suit this morning.
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So what now? Well, around about now we often hit the point where investors start getting excited about bad news. Because bad news means looser monetary policy. Already many pundits are saying they expect China to relax the recent lending curbs it has put in place. “There’s no more tightening happening in China,” as Stephen Green of Standard Chartered told Bloomberg. Credit Agricole said that “modest” extra fiscal stimulus might lie ahead.
However, it might not be that simple. Credit rating agency Fitch argues that “Chinese lending has not slowed nearly as much as official data suggests.” Why’s that then? Because Chinese banks are shifting credit off their balance sheets via that old trick of repackaging loans and selling them to investors.
I won’t go into the details right here – my colleague Cris Sholto Heaton delved into some of the intricacies of Chinese banking in a recent edition of his free MoneyWeek Asia email – but it boils down to a couple of implications.
Firstly, Chinese bank lending hasn’t been curbed by as much as we might think. And secondly, the quality of the lending is probably not great, even by Chinese standards. That’s partly because of a lack of scrutiny, and also because investors have been buying these off-balance sheet products for the sake of chasing higher yields – similar to what drove the purchases of sub-prime mortgage-backed securities in the States.
As Joseph Cotterill puts it on FT Alphaville, “this doesn’t sound like it will end well.”
Cris reckons China is big enough to handle all this. We’re not talking another global credit meltdown here. I simply can’t say for sure. My gut instinct is that China has a rocky road ahead of it. But there are too many people suggesting that it’ll implode for me to feel comfortable backing the Armageddon argument.
China can’t replace America as the driver of global demand
But one thing I am sure of – as I’ve mentioned before – is that while China might be able to muddle-through, it’s not going to emerge as the huge driver of global demand to replace the US in the near future.
What does this mean? Well, it suggests that, despite some decent earnings reports from US companies Alcoa and Intel recently, this is unlikely to be sustained. As Ed Harrison notes on the Credit Writedowns blog, a key reason for solid earnings is record profit margins. But margins are so high partly because employment costs have been suppressed by one-off events – such as upgrades to technology, or outsourcing – and also ongoing unemployment. These gains can’t be sustained.
“Bottom line… the economic data we have seen of late – manufacturing, employment, personal income – all suggest a slowing in economic growth.” Stocks may continue to rally “if companies put in a decent quarter of earnings.” But “anticipated earnings growth into 2011 is very high given already record profit margins. Unless economic growth picks up, this growth is unlikely to be met.”
We’ve said it before, and we’ll say it again – stick to defensive, high quality stocks. They outperform in a downturn, and it seems likely that this is what we’re facing. My colleague David Stevenson picks a few juicy, high-yielding candidates in the next issue of MoneyWeek magazine, out tomorrow – If you’re not already a subscriber, subscribe to MoneyWeek magazine.
Oh, and hang on to gold. You’ll want it when the next phase of quantitative easing is announced.
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