Summary: Despite Europe hogging all the headlines in the financial world, there are significant developments that are happening in USA and China that are impacting our daily investment decisions. These impacts have to be studied and analysed in case an investor has to make decisions regarding his/her future. Ignoring these will be highly risky….

 

Context Of This Article

With an intention to make sense of the world we are living in and how it is shaping our present and immediate future, I am writing this article. This is the second article in the series of 3 articles on:

1. Just what is happening in Europe? (It is posted here)

1. What are the major themes in the world economy right now?
   •   I argue that other than Europe what happens in US and China has got a big bearing on our immediate future
2. Given all of the above, what is in store for an Indian investor

In my article in Europe, I had mentioned that good days are still some way ahead for Europe and that is a bad thing for the rest of the world. Already since there we are seeing that there have been conflicts of interest between Germany and rest of Europe on how to address this situation and we do not see an end in sight. The delay is causing heartburn for Germany itself as it is not able to sell its bonds as “safe haven” investments in the wider market.

I believe this status quo will continue for some more months to come. Broadly, we will only see intermittent flashes of light but no proper sunlight for some time to come.

Apart from Europe, India is also impacted by other world events. Some impact more than others. Below, I am mentioning what are those events and how they are going to shape the future of macroeconomic variables that shape our country.

What are the major themes other than Europe that are shaping our immediate future and why are they important?

The answers, in short, are US and China. If one looks at the world stage and considers investors as the producers of the plays that are performed on that stage, then one would realize that these producers look at US, Europe and China as the three biggest draws in any act. What happens to any of these is what guides the investors’ decisions.

It is important to understand this psyche of investors. It is because the real bulk of investments that happen in Indian equity markets happen through the foreign investors and no matter how much we beat our chests singing songs about the resilience of Indian economy, it will fall on deaf ears.

And we cannot fault those investors for that behavior. The resilience of our economy depends on how we get our money, what we do about it and how we are able to sell the eventual produce to the rest of the world. If the rest of the world is not doing well then we cannot borrow money from them at rates we want, we cannot buy raw materials from them at the rates we want and we cannot sell our produce back to them at the rates we want. When these rates change the same things that made us resilient in the first place will makes us depressed now.

It is for the same logic that we need to know what are the signals that US and China are giving us and what that means in terms of investment variable in the coming months.

So what’s happening in US?

Over the past few months we have seen a multitude of stories emerging regarding the American economy. Many of these are conflicting in nature. These are:

1. High deficit of US economy
2. US A’s credit rating downgrade by S&P a few months ago
3. Great results by IT firms a couple of quarters ago
4. Great turnaround by Citibank from its loss making financials from a couple of years ago.
5. Occupy Wall street movement due to lack of jobs
6. The breakdown of the so called “super committee” that was to reduce the US deficit
7. A slow uptrend in the customer confidence for its retail sector
8. A persistent lack of improvement in its housing sector

Depending on how one wants to slice and dice these stories together, it is possible to present either a dark or a rosy picture of the US economy for the audience. I believe that the truth lies somewhere in between. Below, I am trying to present a picture on how all the above news items fit one large jigsaw puzzle.

Some context first…

That USA has a high budget deficit is not a point worth any debate. The country has consistently borrowed more than it was producing and that has been its de-facto economic policy for decades now. That has brought its financials to a state where it is impossible for things to continue the way they are.

About 5 years ago, the world learnt that a lot of financial organizations had gambled on investments that were inherently speculative in nature. When government realized this these organizations were punished. This punishment was severe in nature and that dried up the entire credit flow in the country and that brought the country into recession. To prevent recession, the country as a whole borrowed some more from the rest of the world and helped those firms who had little fault in causing the recession to begin with.

Now 3 years after the last recession, a lot of American companies have better financials. They are making profits and that is actually exhibited by the continuous improvements in the results of companies in banking/IT/Retail segments.

However, one must realize that the crisis of 5 years ago was inherently financial in nature. It was caused due to incorrect investment decisions by banks/organizations and ended when the government helped these banks/organizations financially. What I am implying is that basically we had a situation where a bad situation (of high deficit) was worsened due to bad behavior exhibited by a lot of key players in the economy and the problem became so severe that the core of the solution presented was aimed at punishing those with bad behavior. Now we are at a stage where the bad behavior has been addressed and the companies are back to the levels of decent profitability, and the original painful issue of budget deficit has resurfaced.

I believe that even if we had no recession 3-4 years ago, we would still be at the same situation with respect to America’s finances as we are now. This is because, as mentioned earlier, the policy of borrowing from the world was the basic go-to plan for generations of leaders. As mentioned, that could not go on forever.

Back to present…

So as we stand today, we have a situation where America wants to plan for a future where it wants to lessen its expenditures and improve its production (in order to reduce deficit) but at the same time does not want to change itself (due to a behavior that has been imbibed over generations). As you and I know, old habits die hard. Along with this, there is an immediate memory of the recession that just went by and so folks are afraid on how painful it can get for all if they don’t change the situation immediately.

To make these improvements, their polity is suggesting a wide range of measures. Some are saying that they should tax the rich, while others are saying that the government should bring in a lot of cuts in areas such as defense and social security.  Their two political parties, Republicans and Democrats have their own points of view that are as polarized as… well North Pole and South Pole.  In the middle of this, the citizens are on the street as they don’t see anything happening on the ground. No one is trying to convince citizens that this day was inevitable and that is adding fuel to fire.

A few months ago Americans realized that they have to rein in the debt levels so that they don’t default on future payments. If they don’t do so, it will be catastrophic. The country held the most secure AAA credit rating in the world. That meant that if you invest with them, you will definitely get your money back, and then some more. If an AAA carrying agency defaults then in financial parlance there is no guarantee that anything else is secure.  When this default crisis arrived, they formed a committee comprising a group of politicians who debated on how to rein in the debt levels. Those politicians did as all politicians do. They did nothing… The country was unable to show enough signs that they were serious in changing their borrowing habits, and that led one ratings agency to strip them off the AAA credit rating.

Once Americans had to take it on their chin that theirs is not the most respected economy in the world anymore they realized that they have to make changes before things become any worse for them. They knew that they had to reduce their budget deficits to a level that is manageable. For this they constituted a super committee that comprised of politicians from both ends of the spectrum with an aim that this committee should come up with a mutually agreeable plan to but the budget deficit in the coming years. This committee did what all committees do… they went in with a bang and finished with a whimper! As a consequence this deal went nowhere and the whole aspect of whether they will be able to manage their deficit is under scrutiny.

So where does that land us with America?

I think the answer to this question can be obtained when we ask ourselves these set of questions:

• Is USA going to default in its debt payments?
  • Not for the mid-term future, unless it does not rein in budget deficit.

• Does US have to reduce its budget deficits?
  • Yes

• Is reducing government spending on various programs the only way to do this?
  • Not the only way, but it is going to be the most important part of any alternative

• Will this reduction in government spending cause a lot of heartburn among Americans?
  • Yes

• Is this going to have negative impact on American businesses?
  • Yes, it will be so on two counts. One, the small businesses that depend on general economic situation (like investment on infrastructure) will be impacted. Two, the customers will not feed that confident about their future and so big businesses will not be able to extract much business from them.

• Does the failure of super committeemean that the government will be unable to rein in budgets?
  • No. The mandate of the committee was to get to an agreeable solution on what needs to be done to reduce deficit. Since they could not reach an agreement, automatic budget cuts on various schemes will come into effect.
  • Does the failure of super committeemean that the government will be unable to rein in budgets?
    • No. The mandate of the committee was to get to an agreeable solution on what needs to be done to reduce deficit. Since they could not reach an agreement, automatic budget cuts on various schemes will come into effect.

• Does the failure of super committeemean that the government will be unable to rein in budgets?
  • No. The mandate of the committee was to get to an agreeable solution on what needs to be done to reduce deficit. Since they could not reach an agreement, automatic budget cuts on various schemes will come into effect. This will start from Jan 1 next year.

• So psychologically where does that leave the country?
  • Scarred. The present generation is guaranteed not to have a life that is better than their parents. However, they will also have to bear the cuts unwillingly, and that will be even more painful.

So where does that leave us with America? In the context of above points, I believe we should brace ourselves for a prolonged period of near zero growth of the American economy. That means that the businesses in that country will not grow their interactions with the rest of the world. Due to the prevailing political situation, it may even be so that their businesses contract their relationship with the rest of the world. That would mean lesser no. of discretionary investments in the public and private sector and so any country or company that relies heavily on American business cannot look at growing purely on the basis of existing relationships.

So what’s happening in China?

China is a study in contrast. As compared to USA, China is an export lead country. While America has budget deficit, China has budget surplus. In other words, it has lent its money to more countries than borrowed from them. Moreover, China happens to be the largest borrower of American debt. In other words, America owes a lot to China.

So how will China react? If we happen to go by the user comments on various blogs detailing this issue, the world seems to be in a status of fear w.r.t. Chinese dominance. Some folks say that China is capable of buying all that America has to offer. Personally, I believe that nothing can be farther from the truth.

Let’s look at from the point of view of China. It is an export lead economy and a growth lead economy. In other words, its business depends on what orders it gets from the rest of the world and it takes its economic decisions on the basis of a certain amount of estimated growth in its business. That is unlike USA that has to plan its economy for near zero growth. What this means is that for China it will be catastrophic if it does not get the orders it needs to sustain its business and it does not grow to the extent it has planned for. That is because otherwise it will have a huge unemployment issue on its hands and if that happens then the level of unrest may be hard for them to counter.

 Apart from this, Chinese have this habit of making sure that their currency is undervalued as compared to rest of the world so that their products remain competitive. If their customers don’t do well, then no matter how competitive the products are these products will not be bought. That will be a double whammy on top of the above described unemployment. The moment these two factors kick in, the level of earnings in Mainland China will reduce and the citizens and firms will not be able to pay back the loans they owe on housing/business. That will mean that a credit issue will arise in the country and the government will have to bail them out. So the money that many think will be spent in buying Europe and USA will actually be spent in bailing out their own country.

Remember what our grandparents used to say…. We should be cautious anytime we get too much too soon. I am sure Chinese grandparents said the same things and their Chinese off-springs have clearly not forgotten that.

If we accept that health of its customers and growth in business is paramount for Chinese, then we need to look at who those customers are. Surprise, surprise…. They are Europe (20%) and USA (18%). Essentially, nearly 40% of the business that Chinese get is actually obtained from the two most troubled regions in the world. If those two become sick, Chinese will go on a sneezing spree. We are already seeing signs that this has already started happening.

Will it actually bring things to a standstill in China? I think not. Actually, China is at a situation where it is growing faster than its own comfort levels. What I mean is that its unemployment is at an already low levels and so finding incremental labor is a tough and expensive proposition. That is eroding the price advantage that the Chinese have, no matter what games they play with their currency. Some amount of slow down, as a consequence, is good for them as it gives them breathing space. However, in a marathon one cannot pause too many times!

I am not an expert on Chinese politics and economy. I happen to read more news on US than China and like most of us around; I tend to look at Chinese data with a small degree of skepticism.  Due to these limitations, what I believe is that if I have to make sense of anything that is related to China, I have to look at the broad figures and not on the month economic figures. Under that assumption, I believe that there is no option for China but to slow down. It will be happy to do so for some months to come, but eventually it will start sweating as well.

So where does that land us with China?

I think the answer to this question can be obtained when we ask ourselves these set of questions:

• Is there is any other way for China so that it does not have to slow down?
  • I’m Afraid not.

• So it has to report lower levels of growth than what it is reporting right now?
  • Yes.

• Are you sure?
  • Hmmm… Yes.

•  Does that mean that its manufacturing engine will have to go slow on its production?
  • Yes.

• What does that mean for the rest of the world?
  • Commodity prices will go down.

• That’s good news right?
  • Not exactly… for primary economies (the ones that generate a lot of money based on commodity sales… For e.g. Australia) this is bad news. These economies sell their minerals to other countries to make metals/other products and now they will get less money in return. For other manufacturing economies, this will give them an opportunity to develop their own capabilities but whether they will be able to do that is going to be dependent on their own national character.

So where does that leave us with China? In the context of above points, I believe we should brace ourselves for a prolonged period of lower growth for the Chinese economy. They will still grow faster than the rest of the world, but at a slower rate than their immediate past. Due to their manufacturing lead character, this means that the prices of raw materials needed for that manufacturing will go down on account of lower requirements from Chinese. In other words, we will see a gradual reduction in the prices of commodities in the coming months. This news is not consistently good for the rest of the world. For primary economies i.e. the ones that generate a lot of money based on commodity sales (for e.g. Australia) this is bad news. These economies sell their minerals to other countries to make and now they will get less money in return. For other manufacturing based economies, this will give them an opportunity to develop their own capabilities but whether they will be able to do that is going to be dependent on their own national character. For countries like India which are Agriculture/Service based, this means that the input costs are lower and so the cost of imports are going to be lower.

Bottom-line: What are the overall trends we will see in the coming months?

Broadly, I believe we will see the following trends:

• Near zero growth in USA with an impetus on protectionism towards American economic interests
• Lower growth in China with reducing commodity prices the world over
• A general sense of negativity among the smaller economies and large but primary economies which will paint a grim picture of the world
• Reducing purchasing power within the citizens of these countries that will threaten deflation, at some points in time. To counter these, the governments will take even more protectionist measures.
• Housing industry in all these countries will be the worst effected as it is dependent on credit to home owners (which will dry up) and paying capacity of home buyers (which will reduce).

In the next article, I will mention how the above trends impact the Indian economy and the investment decisions of an Indian investor.