Sunday, July 29, 2007

The US slowdown – and what does it mean for Asia?

I have been in the bear camp for some time regarding US growth and stock prices so last week was a little bit of vindication for me. My view was basically that housing is a big nasty broadbased shock to the economy which will take more than a year at least to play out AND that the tremendous amount of leverage in global asset markets – both explicit (LBOs) and embedded (CDOs, CDSs, etc.) mean the upside is limited but the downside – should the real economy slow – is significant. Before looking at the implications of whatever is going on in the US, first let me give you my views of what IS going on in the US.

I think the risk of an outright recession is high and growing (let’s call it 60% over the next 12 months). Looking at Q2 GDP released on Friday, the character of a slowdown is pretty easy to see. Consumer spending does seem to finally be slowing and with housing in (cliché alert) freefall, is likely to get worse. That’s my bet regardless of whether gas prices rise or fall. Remember that the average American household isn’t saving enough and so the secular trend (given babyboomer retirements) has to be for increased savings and lower spending. Business investment won’t bail us out because they aren’t spending much now (in the US anyway) and will slam on the breaks at the first sign of slower growth. Trade may help a bit but is way too small to offset slower consumer spending. Government spending is above trend due to the ‘bonus’ of higher property taxes but now this will go the other direction and so the trend here, over time, will be somewhat slower. By the way, I don’t buy the argument that a low US unemployment rate is indicative of a “solid” employment situation. The last few months of significant growth in construction jobs is fishy as hell. I’m betting that both construction and finance see job losses in the months ahead. The other reason not to be comforted by a low unemployment rate is that the denominator isn’t growing. The participation rate has gone down a bit and this leads one to consider a rather scary secular trend: slower labor force growth. If the unemployment rate is low because of increased retirement and fewer available workers, and not because of significant increased job growth – this ain’t good for consumer demand, instead it’s bad for the long term inflation outlook. Cue the Fed to keep rates higher than they might otherwise. Growth may be slowing but the Fed will still have to remain wary on the inflation front due to secular trend of labor shortage and higher wages (a global problem btw).

Looking at the global picture, I’m not much more optimistic. Yes, Europe and Japan are no longer completely and utterly stagnent but neither seem likely to take over as the engine of global growth. How about all those emerging markets which the folks at Goldman keep telling us have no where to go but up? Won’t Brazil, Russia, and Chindia take over as global growth engines? Hah. Not a chance. Brazil and Russia are growing above their long term trend BECAUSE OF global demand (for energy and other commodities) and have made little progress in diversifying their economies such that domestic demand will accelerate independently of a global slowdown. Chindia is a slightly different story but I’ll come to that in a moment.

Lastly, one has to factor in the effect of a slowing in the real global economy on risk appetite, leverage, and liquidity. This is an unknown factor. Will pockets of ugliness in one sector (US housing) have little effect elsewhere because of the miracle drug of securitization? Will a handful of hedge fund blowups cause anything other than fewer new BMWs and Fifth avenue penthouse renovations? Maybe, maybe not but the risk is all downside in my opinion.

So… what does this mean for India, China? In very big picture terms, I think you have to consider the effect of lower real demand and lower global risk appetite and liquidity. Regarding the former, I think India and China can weather a US induced global slowdown reasonably well. Dispite the popular notion that both are highly reliant on exports, the truth is that neither are as remotely exposed as the other Asian tigers were in the past. Why? Because they both have pretty large and fast growing domestic economies. So unless there is a severe recession in the US, and Europe and/or Japan slows as well, I don’t see slower export demand as a big enough hit to Chindia to cause growth rates to fall by more than a percent or two. Actually one could argue that slower external demand is just what they need given concerns about overheating and supply constaints in both countries. It’s the other factor, capital flows, that seem a bigger worry to me and here the two countries diverge in terms of consequences.

Assuming a significant US slowdown or outright recession combined with lower US stock prices, obviously Asian stock markets decline – probably by more. Global investors will look to take some money out and local punters will be willing to pay less for the same amount of earnings. In terms of capital inflows from private equity investors, it is important to note that the aggregate amounts actually have not been large to date. Total investment by PE investors (domestic and foreign) is running at a pace of around $10 billion per year for both China and India – a huge increase but insignificant for the whole economy. China has seen $60 billion or so of FDI per year, what will happen to this? Well, for one thing not a lot of it (or less than you may think) is from US MNCs. I don’t have the numbers at hand but my recollection is that less than a ¼ of Chinese FDI is from the US (I will post a correction if I’ve got that wrong). I wouldn’t be surprised to see FDI slowing somewhat but I think this may be more of a secular trend as Chinese costs rise and outward FDI increases – though some US companies may use the fact of a slower global economy to reduce planned investment in China (it’s been my bet for sometime that off-shoring by US companies to China was likely to slow anyway due to zooming costs and increased concerns about product quality). Finally, to complete the case for China’s insulation from a global capital risk reduction pullback, is the fact that Beijing is rolling in it. They didn’t actually need our dosh in the first place (just wanted the know-how that came with it). Conclusion: the Chinese economy will be fine and stock market, after the initial knee-jerk selloff, will also be okay.

India is a different story in terms of capital flows. India runs a mamoth trade deficit (5%ish of GDP) which is only balanced by inflows by NRIs and foreign investors. It seems likely that at the margin, foreigners will take some money off the table in India and this could – worse case – cause a balance of payments crisis in India. I know, sounds farfetched now but anyone who’s watched India for more than 10 years won’t laugh. If global asset markets are bad enough to cause foreign investors to take meaningful amounts of money out of India (public equity or private equity) than it will be nail-biting time in Mumbai. Unlike China, India desperately needs foreign capital in order to create a modern infrastructure. Their ability to do this was by no means a certainly under the best of circumstances. Doing so with significantly less foreign capital at their disposal becomes… questionable. And then one starts looking to lower one’s longer term potential growth rate for India (in addition to staying up nights worrying about the possibility of a currency crisis. The odds may be low but they won’t be 1%, they’ll be 10-20%). Stay tuned.

No comments: