Market Commentary
by Byron Wien

Around the World in Twenty Days

In my opinion, the three most important international issues facing investors right now are: Will China have a hard landing?  How will political and economic events play out in the Middle East?  And will the European Union hold together for at least another year and begin the process of structural change?  Of equal importance are the three most important domestic questions:  Who will win the November presidential election and what will it mean for the future of the U.S. economy?  Will the “fiscal cliff” plunge the economy back into a recession?  And will QE3 stimulate the economy enough to bring the unemployment rate down?  The answers to the domestic questions will become clearer over the next several months, but I spent most of September on a three-week trip to China, the Middle East and Europe trying to get a better understanding how the three international issues would develop over the next year.

Several days in China are not nearly enough time to get a thorough sense of what’s happening there, but I did have an opportunity to explore the key issues with some knowledgeable local observers.  Real estate is no longer the primary problem.  The empty cities, see-through office buildings and unsold condominiums have been partially absorbed in the twenty major urban areas, and construction has slowed.  The government has restricted land sales to developers, cut back on speculation by limiting the purchase of apartments for investment purposes and restrained bank lending for real estate projects.  There are still pockets of excess, but the fear that empty or unsold real estate would bring the whole economy down has diminished.  What is now the focus of concern is the fall-off in manufacturing activity.  The purchasing manager survey has dropped below 50 for several months, indicating the economy is contracting, and other measures show similar weakness.  Exports are slowing, inventory is accumulating, some plants are closing and workers are being laid off.

Most Western analysts, including myself, have believed that China would experience a “soft landing” and grow at about a 7% real rate, but after my visit I think the underlying growth rate, partially revealed by electricity consumption, may be softer.  It is still likely to be much faster than any developed country, but might be disappointing to Chinese policy makers because it may be only enough to result in limited job creation and thus increase the possibility of social unrest.  The cyclical industries are suffering the most.  Their volumes are down, their costs are increasing and their margins are being squeezed, causing profit disappointments.  This is reflected in the Chinese stock market, which is hovering near new lows.  China is also importing fewer raw materials, which is having an impact throughout the immediate region as well as in Brazil and Australia.  The cyclical industries are capital-intensive; therefore, cutbacks in the workforce have been limited so far, but these industries, largely state-owned enterprises, have not been hiring either. 

To address the rate of growth below 7%, policy makers will engage in a vigorous program of fiscal and monetary stimulus to pick up the pace of economic activity, and they have the resources to do it.  The important point is that China is a larger economy now and rapid growth is harder to achieve.  This is likely to be a continuing problem, particularly with Europe in recession and the United States growing slowly.  The positive aspect of this is that inflation is subdued.  It was a problem when China was growing at more than 10%, but inflation is running at only about a 3% rate now.

Two years ago the Chinese Five-Year Plan outlined a program to rebalance the economy.  In the last twelve years, as a result of government policy, the consumer portion of Gross Domestic Product (GDP) has declined from 45% to 35%.  The goal is to raise consumer spending back to something approaching its former level.  China has a high savings rate because of its minimal social programs; young people save for the education of their children and older ones save for healthcare and retirement.  The government has tried measures to stimulate consumer spending but these have not been particularly effective.  Clearly retailers around the world haven't given up on the Chinese consumer, however.  I spoke at a shopping center conference in Shanghai where 400 to 500 attendees were expected and 1200 signed up.

The approaching leadership change in China is the subject of much discussion.  Two factors make it especially important.  The economic slowdown puts a heavy burden on the new regime to improve growth, and the Bo Xilai corruption incident increases the emphasis on reform.  There had been concern that the new leaders were going to be more conservative than the previous team, but the current expectation is that they will be more progressive because that is what the population is demanding.  Right now, the government is in limbo in spite of the economic slowdown.  The leadership seems to be waiting for the new team to take over next year before decisive action is taken.  The 18th Party Congress, which will decide when Xi Jinping and Li Keqiang will be installed as President and Premier, is scheduled to meet November 8, 2012.

China’s activism in pursuing its interests in the South China Sea made me wonder whether the country wanted to have a greater role in geopolitical affairs.  The feeling among those I spoke with was that China would continue to focus on its internal problems even though it is now the second largest economy in the world.  The lukewarm reaction to Angela Merkel’s visit with the Chinese leadership to discuss China’s possible role in providing support for easing Europe’s sovereign debt problems is indicative of the current insular view. Economic problems have increased nationalism and decreased the desire for greater international influence.

I went from China to the Middle East, where I visited Dubai, Riyadh, Kuwait and Abu Dhabi.  Money continues to flow into the region from China, India and Europe.  The building boom in Dubai has subsided and some (but not all) of the office space and condominiums have become occupied.  Abu Dhabi stepped in to prevent its fellow emirate from financial calamity in the 2008–09 financial crisis.  The Middle East shares many of the worries of the developed world, but in that region some of them seem more immediate.  If Iran goes on to develop nuclear weapons capability, people expect an arms race throughout the region.  If Israel were to strike Iran to slow its nuclear program, the price of oil would soar and the whole area would be destabilized by anti-Western attitudes and Iran’s likely retaliation.

The protests from North Africa to Pakistan caused by an anti-Islamic film produced in the United States are indicative of the latent resentment toward the West that exists in the region.  Tribal allegiances are intense throughout the Middle East and Sunni suspicion of the long-term objectives of Shiite-led countries like Iran and Syria surfaces frequently.  The recent riots over the film may also be indicative of concern about Western imperialism.  In the meantime, the price of oil remains high and investors from troubled areas throughout Asia and elsewhere seek refuge and opportunity in the area, but a mood of caution prevails.  Abu Dhabi’s decision to slow down its ambitious cultural program may be a sign of that.  The emirate had plans to build a branch of the Louvre that would be designed by Jean Nouvel, a Guggenheim facility designed by Frank Gehry and a performance arts center designed by Pritzker–prize winner Zaha Hadid.  All appear to have been placed on hold for the time being.  In Saudi Arabia and elsewhere you see many buildings whose construction has been suspended. 

The other cloud that hangs over the Middle East, in addition to the Iranian nuclear weapons threat, is the conflict in Syria.  Several months ago most observers there believed the Assad regime was about to fall, but now they are less sure.  Support from Iran, China and Russia has enabled Bashar al-Assad to endure, but everyone is saddened to see the violence there.  This has resulted in hundreds of thousands of refugees leaving the country, settling mostly in Jordan and Turkey.  You can only come to live in Dubai if you have a job, and only the most educated and talented Syrians have been able to seek employment there. 

While events in Iran and Syria have an effect on the overall mood of the region, most of the people there go on about their business without being preoccupied by geopolitical concerns.  Saudi Arabia and Abu Dhabi are thriving, and there is plenty of opportunity everywhere because of the high price of oil.  That is what the expatriates working in the region came for, and if conditions change, they are prepared to leave.  The indigenous population is used to uncertainty, and if adverse conditions develop, they will deal with it as they have in the past.  A possible reversal in the price of oil as a result of diminishing demand, new supply and conservation is not given serious consideration.  Most think increasing demand as a result of the rising standard of living in the developing world will offset the effects of increasing supply in North America.  The economists on the ground in the region expect the real growth rate to continue at about 10%.

I left the Middle East for Europe where I had an opportunity to talk not only with some large investors, but also with more than a dozen chief executives of large banks from Asia, the Americas and Europe in a roundtable setting where I was the keynote speaker.  There were two views held by the participants that surprised me.  The first was the almost universal agreement that Barack Obama would be given a second term by the electorate in the coming November election and the second was that the European Central Bank, Germany and various other institutions that had been set up to deal with the sovereign debt crisis would be successful in holding the European Union together and keeping the euro as the continent’s basic currency.  They were even optimistic that there could be some movement toward structural change, including a banking union and fiscal convergence.  Deposit insurance might be harder to achieve and it continued to present a potential problem.

One of the reasons for their optimism was that the European Central Bank still had many policy options at their disposal.  So far it has only provided funds for the continent’s banks by buying their holdings of bonds issued by the weaker sovereign countries.  They have not provided funds to the governments themselves, which they are prepared to do if the countries meet certain objectives in terms of fiscal discipline.  After Antonis Samaras, the Greek Prime Minister, visited Berlin at the end of August, Angela Merkel said she was “waiting for the troika report” before deciding what Germany should do about Greece.  This report by the European Central Bank, the European Commission and the International Monetary Fund will be a result of a fact-finding mission which began at the beginning of September and is expected to conclude that Greece should remain in the European Union.  Merkel appears to agree with the view of France’s François Hollande that the implications of a Greek departure from the Union would be severe and every effort should be made to keep Greece in even if the country has trouble meeting the “conditions” of financial support.  Samaras wants to extend the deadline for imposing $15 billion in austerity measures and tax increases from 2014 to 2016.  Greece needs to do this to get $42 billion in financial aid from international institutions.  Without this the country could run out of money to keep operating and it could face financial collapse.  The financial aid is also needed to recapitalize the banks that have been crippled by the country’s economic crisis. 

It will not be easy for Greece to take the measures necessary to cut the budget.  They include reducing pensions and public sector salaries, raising the retirement age to 67 from 65 and laying off 15,000 public sector employee.  Self-employed workers and businesses will face a flat tax of 30% and the elimination of a tax-free threshold.  It isn’t all bad news however: the minimum taxable income for salaried workers will be raised from $6500 to $9100 and the top personal income tax will be reduced to 35% from 40% for those who pay it.

The budget problems are not confined to Greece.  Spanish Prime Minister Mariano Rajoy has proposed $17 billion in budget cuts and tax increases as part of a plan to cut the deficit by $85 billion through 2014, which would bring the deficit to 4.5% of GDP from 9% in 2011.  Rajoy also has to deal with the attempt by the relatively wealthy Catalonia (Barcelona) region to become more independent.  Spain has asked for $130 billion in aid from the European Union and Germany, and the Netherlands and Finland have expressed doubt that the country’s troubled banks can remain viable without a bailout.  Over in Italy Mario Monti, who is generally viewed as making important positive moves in improving Italy’s economy, has stated that he would seek another term if next April’s elections didn’t produce a clear winner.

A year ago I was convinced that Germany and the other stronger countries in the European Union wanted to do whatever was necessary to hold the Union together, but  Angela Merkel, who had to play a critical role, then faced significant political risks in taking a leadership position and seemed ambivalent about doing so.  Since then Merkel has become bolder in expressing her support for keeping the Union, including Greece, intact and her political position has improved, in my opinion.  If Greece were to leave the Union and default on its debts to Germany, the cost would be approximately $80 billion and it would be incurred immediately.  That would be a serious political blow to Merkel and a big hit to Germany’s finances.  What’s more, the “domino theory” would come into play, and if the other weak countries defaulted the cost would run into hundreds of billions.  Jens Weidmann, head of the Bundesbank and a sometime critic of Merkel’s, now supports keeping Greece in the Union, but Finance Minister Wolfgang Schäuble believes that a Greek exit may be necessary for continued German popular support of the European project.

When I arrived in Europe a few weeks ago I thought the European Union would remain intact for another year while the European Central Bank bought bonds of the weaker countries from the banks to ensure their sustainability.  I thought that a restructuring in 2013 was likely, with either the stronger countries keeping the euro and the weaker countries going back to their national currencies or vice versa.  I now think that there is a clear resolve to keep the Union together.  There are risks in this approach to be sure, but the benefits of the Union have been great and the costs of dissolution are huge.  Europe is suffering a mild recession this year, but if the European Union endures, its chances for modest growth next year and beyond are good.  The biggest risk as both large investors and bankers see it is that the budget cuts result in strikes and social unrest, but there is a general feeling that the disorder from austerity measures can be contained.  Any break-up of the Union is likely to result in greater chaos.

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