China’s Productivity Slide Reflects Unbalanced Growth…

In a note on China’s medium term prospects in February 2011, I noted that: ‘…China has largely followed the pattern of extensive (i.e. input driven) growth similar to that experienced by the Soviet Union from 1946-65, Brazil from 1964-1980 or Japan from 1960-73 when GDP grew by 10% a year (and recall that Japan in its boom years was often admired as ‘central planning that works’) Both the Soviet Union and Japan gradually ran out of growth as that model suffered the impact of a declining labour force and marginal productivity of capital.’ As that view has become consensus over the past three years, the implications have undermined GEM assets, as the country’s growth ‘glide path’ has continued to descend, and indeed sparked periodic investor panic. Fears of a deeper slowdown in China as reflected in the latest PMI data were certainly one factor behind the latest GEM selloff, particularly for commodity exporters, but a threatened default of the RMB 3bn ICBC trust product this week has been avoided via yet another opaque rescue deal. ICBC told investors that they could sell their rights in the product to an unidentified buyer while China Credit Trust announced that it had agreed to sell the shares it had acquired in the insolvent coal miner behind the original loan. We may never find out who these mysterious ‘third parties’ were, but this was an officially sanctioned bailout driven by fears of a systemic crisis in the wider shadow finance system. However, the cost of delaying financial reform is less the feared Lehman style collapse than ever slowing productivity and GDP growth trends, as diminishing returns become entrenched.

Productivity is the key to long term per capita real income growth and China’s progress since the early 1990s has been impressive – it has overtaken Thailand within Asia for instance, in terms of productivity relative to the US (and Thailand’s structural problems on that score were covered in an October note). However at barely over 7% y/y in 2013 on Conference Board data, China has seen a steadily declining productivity growth trend from well over 10% before the 2009-12 investment and credit surge; overall productivity growth last year was the slowest in over a decade while total factor productivity growth (i.e. efficiency gains from technical know-how etc.) stalled, compared to 3.1% annual growth from 2007 to 2011 and 0.6% growth in 2012. With productivity at less than a fifth of US levels, restoring this ‘catch up’ productivity momentum is crucial to sustaining even mid-single digit GDP growth rates through end decade. China bears claim that with aggregate credit/GDP now well over 200%, the majority of trust loans cannot be repaid, will eventually require substantial bailouts and lead to a collapse in the banking system and a wider economic crisis. Even if the assets are cash generative, huge liquidity risks exist given the known duration mismatch between trust loans and their underlying investments, echoing the genesis of the US subprime and Eurozone peripheral crisis. The key difference of course is that China remains a largely closed financial system, and as noted many times only its domestic bank depositors can make a ‘margin call’ on the system, a process that has started as they seek higher yields in wealth management products/money market funds, now far easier to access thanks to new online financial sector entrants such as Alibaba and Tencent.

It is unclear when the recently announced shadow banking audit will finish, but it needs to be swift and mark a decisive turning point in the on-going trust/WMP saga – the ‘pretend and extend’ policy of rolling over maturing debt seems to be the default (or rather no default) option until its outcome. Once regulators know the extent of shadow banking activities and how interconnected the formal banking sector is to the shadow banking sector, managed defaults have to be finally allowed to impose appropriate credit risk and begin to adjust trust/WMP investment practices. In the meantime, ever more credit growth will be absorbed in extending existing loan duration, exacerbating the impact of a steadily deteriorating capital-output ratio on trend GDP and productivity. Something will have to give, which may well be the now very fully valued RMB.

US Workforce Trends Confuse Investors…

We think that today’s labour force participation rate is about right, given observed demographic trends’ – James Bullard, St. Louis Fed President

We’ve seen a burst of volatility in the wake of the US December payrolls data, which ran contrary to just about every piece of bullish recent data and looks like an anomaly in what is a very noisy series. The slump in the labour force participation rate to 62.8% was the most interesting aspect, and it’s a sustained downtrend which has confused many observers. However, it was predicted pre-crisis by demographic models, including research done by the Fed itself. Over the past five years, the US labour force has grown only 0.2% annually, a fraction of the 1% plus pre-crisis trend. In principle, there are roughly 10m potential workers ‘missing’ from the data. If they were to suddenly reappear and actively look for a job, the unemployment rate would be closer to 11%.  The share of Americans either working or actively seeking work in December was the lowest level since 1977, before the female participation rate began to soar through the 1980s and 1990s. 

 As I’ve highlighted previously, the trend is largely structurally demographic rather than cyclically economic. Much of the decline was eminently predictable; indeed a 2006 paper by Fed economists accurately predicted that participation would fall to 62.9% by 2014. There is far too much focus on the demand side of the equation i.e. employment growth, and too little on the supply of labour which is slumping because of demographics and the end of Mexican immigration (the latter partly because of the high tech fence now blocking the border). Meantime, the US economy generated 2.2m new jobs last year, an impressive outcome set against substantial fiscal headwinds and the ever growing impact of productivity boosting technology in the service sector, adding to a similar gain in 2012.

For the Fed and investors, the question is how much of this downshift is cyclical (the still weak employment market discouraging potential workers) versus structural (i.e. demographic trends).  If the same trends in employment/population growth were in place as pre-recession, total employment would by now be about 6m higher. Between 1960 and 2000, the proportion of Americans in the workforce surged from 59% to a peak of 67.3% of the population before dropping to the current 62.8%. Recent studies have validated the 2006 predictions (and of all the data economists torture into submission, demographic trends are invariably give the most reliable answers). According to an analysis last November by an economist at the Philadelphia Fed, the aging of the American population accounts for most of the decline in labour force participation since 2000.

The head of the SF Fed pointed out back in September that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures derived from other sources such as private employment surveys/job openings etc. While I’d expect the participation rate to bottom on a cyclical basis in Q1, and gradually pick up by a point by year-end, the fact remains that there is less slack in the US labour market than widely assumed on a ‘mean reversion’ basis for the participation rate because of structural headwinds.

For example, teenagers are spending longer in education, and male participation rates for most age groups have been declining continuously for several decades (possibly because of the evolution of the economy away from manual blue collar occupations, notably in manufacturing). The downtrend accelerates during recessions but only partially reverses during subsequent recoveries. It is very difficult for the Fed to distinguish between a permanent, structural change in the participation rate and one which will be reversed if there is a stronger recovery in the jobs market, but recent comments suggest they are leaning toward the former explanation. If the CBO/Fed estimates of the non-inflationary unemployment rate (NAIRU) are right at about 5.5%, then labour market slack will be pretty much eliminated within a couple of years even with a slight pick-up in participation, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance.

Is Emerging Market Debt Attractive Again?

Selectively, yes – after last year’s sharp FX adjustments, the macro risks such as deficit funding cover, excessive consumer credit growth and deteriorating terms of trade which were overlooked by the bullish consensus a year ago now look adequately discounted for many countries. The World Bank, in a report released this week warned that: ‘In a disorderly (QE) adjustment scenario…nearly a quarter of developing countries could experience sudden stops in their access to global capital. For some countries, the effects of a rapid adjustment in global interest rates and a pullback in capital flows could trigger a balance of payments or domestic financial crisis.’  As the ‘Great Unwind’ from the extraordinary monetary policies of recent years begins in the US (and possibly the UK but not anytime soon in Europe while Japan will open the floodgates wider), blood curdling warnings like this are commonplace. Aside from the ever prescient BIS, such caution was very rare a year ago as indiscriminate retail inflows drove spreads versus Treasuries to historically low levels, particularly in ASEAN markets and IB strategists led the cheer leading. Emerging market fixed income ended up posting its third negative annual performance since 1998, driven by rising US Treasury yields from May as tapering entered the investor lexicon and caused a sudden reversal in ‘hot money’ portfolio inflows.

After a deep correction through H2, EM hard currency corporate bonds outperformed sovereign debt, returning a negative 0.6% versus -5.3% for the full year, boosted by shorter duration and correlation with stronger performance in global investment grade and high yield credit. EM corporate bond spreads, (as measured by the JPM Corporate EMBI index), are now flat to USD sovereign debt which translates into a narrowing of almost 70bps since the beginning of 2013.Therefore, asset allocation from EM sovereigns in both hard and local currency toward EM corporates was one of the key calls in 2013, as was avoiding industrial commodity exposure at both sovereign and corporate levels. Local currency debt delivered a negative total return of -9% mostly attributable to the FX component, while the carry, i.e. the additional return due to higher local interest rates, compensated for the back-up in yields. Despite the volatility from mid-year, GEM bond sales hit a record high, reaching $506bn from 2012’s previous record of $488bn, with EM corporate issuers accounting for $345bn.

Back in the May 17th 2012 note looking at EM debt, I noted that: ‘A structural re-rating of EM sovereign debt has driven borrowing costs to record lows for many countries (and who would have bet back in 2008 on Philippines 20-year local currency paper yielding well under Spanish?), enhancing their fiscal flexibility to withstand further macro volatility. Going forward, there is limited upside from further spread compression and we are likely to see greater dispersion in EM debt performance driven by diverging macro fundamentals. Indeed, stress testing a GEM equity or credit portfolio for sustained industrial commodity deflation remains a worthwhile exercise, as China’s diminishing role as ‘buyer of last resort’ impacts relative terms of trade and thus credit risk for resource exporters.’ That’s pretty much how things played out last year, with the terms of trade losers like Indonesia hardest hit by a re-pricing of credit and FX risk as current accounts reflected sliding commodity prices and unsustainable consumer spending booms.

Having seen growth squeezed by tighter policy and consumer import trends softening in recent months after sharp currency falls, an eventual narrowing of current account deficits in countries such as Brazil, India and Indonesia should see the FX selloff abate if not reverse, helping portfolio inflows to gradually resume. Local currency EM yields rose by 135 bps in 2013 to 6.85%, driven by currency weakness (South Africa), monetary policy tightening (Brazil, Indonesia), fiscal deterioration and inflation risk (Brazil), political and external account concerns (Turkey, Thailand from Q4), as well as a higher floor from US yields. This year, EM debt will be less about global macro risk and more country specific. No fewer than 12 major emerging market countries have presidential and/or parliamentary elections this year, including Brazil, India, Indonesia, South Africa, Turkey and Thailand. Aside from politics, the FX outlook is key; on a real effective exchange rate basis (trade weighted and adjusted for relative inflation rates) several EM currencies look good value and now that the Fed has provided clarity on its exit strategy  there is scope for the capital flow environment to turn more positive for EM assets, particularly if Treasury yields can be contained sub 3%  and Japanese retail interest in the EM carry trade resumes. Inflows into local equities and corporate bonds should be boosted by improving relative data momentum between GEM and particularly Asia and DM. The oversold Indonesia Rupiah would likely be the biggest beneficiary, with the Philippines peso also likely to bottom; prospects for the Thai baht hinge on the political crisis fizzling out although even a delayed election with an end to disruption would see a short covering rally.

I had a 60 productivity adjusted target versus the USD on the Indian rupee back in September amid the panic that drove it almost to 70, but it looks range bound near-term ahead of elections and with recent output and inflation data uninspiring. Turkey remains the most worrying situation which could spread contagion across other emerging markets if the political crisis escalates, given its dependence on foreign portfolio flows to cover near-term deficit funding. As noted recently, the sharp decline in industrial commodity prices since 2011 looks set to level out for several metals this year as supply deficits loom in 2015/16 so the countries most exposed offer the greatest prospects for a ‘relief’ rally.  Valuations for local currency debt look selectively attractive (in Indonesia, for instance) on the basis of the currency adjustment seen in 2013 and yields now adequately discounting macro risks.  Overall, if 2013 was the year when EM debt investors adjusted credit risk perceptions for current account funding risks and weak industrial and precious metal prices, energy may prove the key current account terms of trade risk this year for countries like Malaysia, if abating Iranian geopolitical tensions and the surge in US supply see global oil prices fall toward $90/barrel. 

2014 Outlook Hinges on US Wage and Capex Recovery…

There is an unusually tight consensus for the developed world outlook this year, hinging on the likelihood that the G-3 economies are headed toward synchronized growth although recall that the consensus a year ago only expected a 10% return on US equities (rather than the 32% total return the S&P generated) and was oblivious to the looming gold collapse, surge in global tech valuations and EM deficit risks. The global economy is indeed seeing improved developed world momentum into Q1, based largely on corporate spending and the manufacturing sector as reflected in the December JPM global PMI – capex plays remain a preferred theme for structural as much as cyclical reasons, as covered in the recent ‘Internet of Things’ note. As expected, China’s credit and infrastructure led acceleration which peaked back in Q3 is now rolling over, while FX volatility remains high across GEM, driven as much recently by political risk (Turkey, Thailand – India as an AAP/Congress coalition looms?) as weak deficit and growth fundamentals.

A benign outlook has been broadly priced into global developed market equities (and particularly US) with the trailing PER ratio rising to 16.6x from 13.8x at the end of 2012, largely because of multiple expansion as the implied equity risk premium has reverted to historical norms (at just sub 5% in the US), which was the basis of my 1800 S&P target a year ago. On that analysis, US equities look fully valued and it’s notable that 94 S&P constituents have issued negative guidance for Q4 and only 13 positive. The most persistent and significant valuation anomalies globally lie in (highly correlated) emerging markets and materials, where the consensus is weakest but net bearish.

The biggest macro risks in 2014 stem from China’s $1.2trn local government refinancing amid persistently tight liquidity and the Fed losing control of the bond market, with accelerated growth reflected in a spike in 10-yr yields beyond 3.5% amid a surge in outflows. I’ve always been convinced that depressed Treasury yield levels were less a function of Fed QE than extreme investor risk aversion and that is true more or less globally (less in the case of Japan given the relative scale of BOJ activity). It’s remarkable that we haven’t seen a meaningful correction in US equities over the past 18mths, and now that the earnings yield gap has largely closed (versus BAA bonds) equities will become much more sensitive to bond market volatility. We are likely to see a sixth straight year of positive total returns for the S&P 500, but with a 10-15% pullback in H1.

A target of 1950, based on a 16x PER and projected 2015 EPS of $123 represents a return of just 7%, almost all of which represents earnings growth. An issue being widely overlooked is that US companies would in a faster growth environment finally have to divert cash flows from buybacks ($500bn last year) and dividend hikes to wages and capex and as covered in recent notes, buybacks have been a key support for US equities. Since the start of the current bull market in Q1 2009 through Q3 last year, share buybacks have totalled $1.6trn and dividends $1.2trn. Indeed, the $207bn total of US share buybacks plus dividends in Q3 was just shy of the $233bn record in Q3 2007 although corporate cash flow rose to a record annualized high of $2.3trn during Q3. About 84% of S&P earnings were paid out in dividends and buybacks in 2013. Overall, it’s crucial that the benefits of growth and ultra-loose monetary policy now switch from Wall Street to ‘Main Street’ to sustain S&P revenue growth via domestic aggregate demand as EM growth falters and signs of that process starting are worth watching in coming months in the employment and investment data.