We’re all data junkies. When a number comes out that supports our position, a rush of self-gratification courses through the veins. That’s true of investors looking at earnings reports, as well as economists looking at economies. Never mind that the data, by definition, offer backward-looking insights into forward-looking views. Never mind the quality of the data either – an increasingly serious problem with today’s information flow. In today’s mark-to-market world, when the screens flash with a new piece of information, we react first and ask questions later. It’s the reality TV of world financial markets.
This is less of a gripe and more of a plea to take a deep breath. Deciphering the incoming data flow is as much art as science. Yet, for those of us wedded to an analytical approach, only the data check can keep us honest. My own approach continues to stress two key issues in the global macro debate – America’s post-housing bubble shakeout and China’s lack of policy traction. On both counts, the latest data depict “growth friendly” outcomes. Yet in each of these cases, the analytics still provide considerable pause for thought. One way or another, I suspect these disconnects should be resolved in the year ahead.
Key macroeconomic issues: the US housing slump
Most bulls on the US economy – with the notable exception of Dick Berner – have concluded that the worst is now over for America’s housing recession. Former Fed Chairman Alan Greenspan, who has a fair amount of reputational skin in the game in this one, has recently led the charge in that regard. September’s bounce in housing starts and home sales offers a couple of data blips in support of that conclusion. But with inventories of newly sold homes still 14% above year-earlier levels, that conclusion may be a bit premature. In fact, I would argue that the recession in homebuilding activity has only just begun. While residential construction expenditures – the ongoing progression of homebuilding projects – have declined at a 14% average annual rate in the two middle quarters of 2006, this has unwound only 27% of the record run-up that occurred over the past decade.
This limited decline should hardly be surprising – construction activity almost never turns on a dime. In most cases – Thailand being a notable exception in 1997 – builders tend to complete the pipeline of previously initiated projects even as the outlook sours for new construction. That tends to support employment in the homebuilding sector long after the demand underpinnings of the cycle have turned. The latest trends in the US labor market bear that out. Since peaking in February 2006, employment in the homebuilding sector – namely, residential building and residential special trade contractors, combined – has contracted by a mere 2.8%; this reverses only 12% of the outsize run-up in hiring that occurred in these industries since early 2001. In other words, the homebuilding sector is still basically staffed for the boom. As existing projects are completed, I suspect there will be a sharp fall-off of headcount in this once frothy industry – with important implications for the state of the overall labor market, income generation, and personal consumption.
The employment response of the homebuilding sector is a microcosm of a key macro characteristic of the US economy – that the hiring shoe is typically the last to fall in a cyclical adjustment. Understandably, companies take the high fixed costs of hiring and firing quite seriously; distrustful of forecasts of the future and more sensitive to their own reality checks, businesses are slow to rehire in an upturn and equally reluctant to reduce headcount in a downturn. Current employment trends reflect just such a recognition lag. The disconnect comes when financial markets treat the lags as a counter-trend. That has certainly been the case in the aftermath of the past two labor market reports – weak preliminary estimates of hiring in both September and October, accompanied by massive upward revisions to earlier months.
In my view, either one of two explanations to the data-analytics disconnect is possible: The GDP is dead wrong and will be revised sharply upward from the sluggish 2.1% average annual pace of the two middle quarters of 2006, or it will just be a matter of time before this growth-recession-like outcome elicits the typical lags of the hiring response. My sympathies are with the latter line of reasoning. I do not believe that the same risk-averse US businesses that have been hoarding cash and holding back on capex for the past six years are suddenly throwing caution to the wind and loading up on high-cost labor at precisely the point when the cyclical debate is more contentious than ever.
Key macroeconomic issues: Chinese policy
Halfway around the world, there is another very important disconnect – Beijing’s response to a runaway Chinese investment boom. For the fifth time this year, the People’s Bank of China has followed the conventional counter-cyclical stabilization script and tightened monetary policy in an effort to cool off a white-hot economy. The latest action – a third increase in bank reserve ratios in 2006 – follows two earlier increases in overnight lending rates.
This approach is not working. Bank lending growth for new renminbi loans held at 15.2% y-o-y in September – down only fractionally from July’s peak 16.3% increase; moreover, total loan creation in the first nine months of this year has now exceeded the central bank’s full-year target by 10%. Yes, the growth rate of fixed investment is receding a bit – decelerating from a peak comparison of 33% y-o-y in the second quarter of 2006 to 24% in the third period. But for a sector that rose to 45% of GDP in 2005 and could well climb to 50% this year, there is nothing comforting about a 24% growth outcome. It still speaks of a China that is headed toward massive capacity overhangs, with attendant risks of deflation.
There are two dimensions of the China disconnect – the first being a policy strategy that is at odds with the structure of the Chinese economy. The central bank has not achieved policy traction, in large part, because its actions do not filter down to the provincial and village levels; consequently, the autonomous lending practices of local branches are not influenced heavily by adjustments made by the People’s Bank of China at the national level. That China’s four large banks have long been in excess reserve positions further complicates the monetary control exercise. Moreover, with State ownership still controlling at least 35% of Chinese GDP directly and a considerably larger portion indirectly through government ownership of unlisted shares, macro control remains very much in the hands of China’s modern-day central planners – namely, the National Development and Reform Commission. The NDRC issued a series of administrative edicts earlier this year aimed at targeting investment excesses in several overheated sectors – aluminum, cement, steel, coal, glass and other building materials, motor vehicles, and residential property. Yet the latest trends in bank lending and investment underscore a profound lack of meaningful progress in the all-important area of Chinese macro control.
A second aspect of the China disconnect comes in the form of its implications for the rest of Asia and the broader global economy. This goes back to the decoupling debate that I recently addressed (see: Can exporters wean themselves off the US consumer). Once again, the unflinching vigor of the Asian economy is being taken for granted. The same is true of the commodity super-cycle. In my view, these conclusions are highly conditional on the Chinese growth outcome. If Beijing finally delivers on the slowdown front, I suspect there will be a quick and severe markdown of the economic outlook for Asia and the commodity complex.
The case for a cooling off of the Chinese economy remains compelling: Ever-mounting imbalances in an investment- and export-led economy raise the odds of the dreaded hard landing that would seriously threaten the most important objective of China’s reforms – social stability. Ultimately, the questions boil down to determination, leadership, and control. In that vein, the internal politics of China may well hold the key. The recent arrest of Chen Liangyu, Secretary of the Shanghai Communist Party and member of the Politburo, sends a strong signal that Beijing is getting more serious about challenging the regional fragmentation of its centralized cooling off campaign.
At the same time, the resurfacing of Ma Kai, Chairman of the NDRC and China’s head central planner, sends an equally strong signal that macro control by administrative edict is likely to intensify. Recent tax increases (effective November 1) on selected Chinese commodity exports – namely, alumina, copper, coal, and steel – up the ante in this regard. In China, the disconnect boils down to making the macro call on the basis of the efficacy of countercyclical stabilization policies or the administrative edicts of central planning. My vote remains with the latter. I continue to believe that the Chinese leadership is about to up the ante on its cooling-off campaign.
Disconnects always seem to have a way of coming full circle in resolving the macro debate. This is where the analytical approach has the advantage over the data-dependent approach. The risk, of course, is that we get the analytics wrong – or that old relationships are rendered inoperative by new developments. Notwithstanding those risks, I still think it pays to focus on America’s post-housing bubble shakeout and on the staying power of the Chinese investment boom as the two most important moving pieces in the global economy. If both of these engines slow, as I suspect, a year from now the world will be in a very different place than it is today.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum