On the Road to Japan, YTD Equity Performance, Why China Real Estate, Oil

The continued weak performance of  the US and European economies, under a backdrop of deleveraging  and  insufficient demand,  invokes comparisons to Japan as a guide to what might be expected over the course of this decade in the western developed world.  Gerard Minack from Morgan Stanley  has written  an interesting note which  highlights the similarities, and some differences, in the growth path of the three economies which  provides  an useful tool to  analyse  potential future scenarios for the US and European economies. 

To summarise:

-The first  clear similarity  is that the three economies have suffered from a bursting of a credit bubble and are now dealing with the aftermath – an extended period of deleveraging.  This process is made more difficult with a declining trend in nominal GDP growth (as the attached chart illustrates by making comparisons between the US and Europe and Japan at the same stages of Japan's cycle-a theme repeated in the comparisons  below).

-The second-similarity is that fiscal stimulus works –  Japan used fiscal stimulus repeatedly during the 1990s, having a subsequent positive impact  on private spending (see chart below) . The sharper initial recovery in the US and Europe was due to a more aggressive initial fiscal stimulus in response to a larger initial downturn.

-It is the change in the cyclically-adjusted budget balance which provides the fiscal stimulus – and  in this regard the US stimulus has been the most aggressive with the budget balance falling by 6% of GDP  within a two year period, compared with about 3% for Japan and Europe (see chart below).

- However, US and Europe started with a weaker initial budget balance (a deficit versus a surplus in Japan) and a higher public debt than Japan and  therefore now have less room.  US and Europe are under pressure to tighten fiscal policy (Europe has already started )  and this could turn out to be the key differentiating factor from Japan (see chart below).

-Monetary policy has been much more aggressive in the US and Europe versus Japan, but  deleveraging has blunted its effectiveness.  Long-term bond yields are following a similar declining pattern as in Japan, and it has been dangerous to call a trough in yields .   It is debatable whether  this is due to central bank action or investor fears about a Japan like scenario unfolding, but the impact on equity prices has been somewhat limited.

-Unconventional monetary policy by the way of Quantitative Easing, was  also followed more aggressively by the US and  Europe than Japan (see chart below) . While these actions  were effective in dealing with the initial liquidity stresses, they were less effective in stimulating economic growth and the US actually suffered steeper declines in money velocity (the speed with which money circulates in the economy)  than Japan.

-Inflation has also increased more in the US and Europe than Japan as they experienced more rapid economic recoveries, after declining more rapidly during the initial phase as their economies contracted more (see chart below).

-Another reason behind the sharper rise in inflation in the US and Europe was the V-shaped recovery in emerging markets which lead to higher commodity prices. As global growth now falters, inflation could follow the downward trajectory in Japan.

-The current slow-down is more worrisome than in 2010 and 2011, as OECD leading indicators have fallen more rapidly (see chart below), with the scope for more aggressive policy action being limited due to zero-bound interest rates and the  fiscal contraints mentioned earlier.

-Meanwhile, equity markets in the US have mirrored the swings in the economic cycle which bear a striking similarlity to the swings in Japanese equity markets.

Interesting insights provided by making the comparisons for key economic and financial indicators  over the   phase of Japan's cycle.  Below trend growth  in the 1.5% area for the developed world over the course of thsisdecade seems very likely, particularly given that policy makers in Europe and the US  are reaching limits to further stimulative actions. This is particularly true of fiscal policy, which is more subject to the political divide in the  US and the north-south divide in  Europe.  As I have noted in previous newsletters, this implies that centrla banks will have to do much more of the heavy-lifting via more aggressive quantitative easing policies. While the impact of QE policies on markets and economic growth maybe  diminishing (see chart below) , its is (at this stage) the only game in town (and it works) and we  can expect more novel methods of QE down the road (purchase, directly or indirectly through  banks, of more risky assets).  We are likely to get the first glimpse of such action in the next month or so as the global slow-down, and a resurgence of European worries, forces the hands of centrla banks. The implications for investors is   to patiently wait for market corrections to  add to exposure, and ligthen-up when markets get  heady. This strategy is more  relevant for developed markets, while emerging markets remain on a secular uptrend – though with cyclical downswings along the way.

I thought it would be uuseful to take stock of the peformances of major  equity markets, and its interesting to note that  the Indian stock market is the best performing market this year in local currency terms (up 13.4%-see chart below) after being one of the worst performers last year. The return in US$ terms is also a very respectable 10.2% which would make it second only to the Nasdaq! (the penultimate page of The Economist has a table which provides YTD returns in local currencies and US$ for all  stock markets). China has underperformed, but I expect this to reverse during the second-half of this year as  China begins to stimulate more aggressively.  The Chinese real estate sector is likely to benefit signifcantly from the stimulus and valuations (see second chart below) are at historically attractive levels. Please note that, as the Mckinsey survey on urbanization noted last week, China is  expected to account for about a third of the global increase in building space over the course of the next 15 years, totalling $25 trillion!

Lastly, a comment on Oil.  There have been a lot of media attention on the impact of Shale oil on the oil markets, and while this  has important ramifications – with the US potentially acheiving oil sel-sufficiency by 2030, it still leaves the world with a oil supply gap  of 20 million b/d  by 2030 to be bridged by yet-to-be discovred resources (see chart below from a  Blackrock/Wood Mackenzie report). Recent research by the IMF predicts that growth in demand will put continual upward pressure on price, with the inflation-adjusted price of oil headed for $180/barrel by the end of the decade (see second chart below). According to their estimates, those price increases would be sufficient to keep global production increasing at about the same reduced rate we have seen since 2004.


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