Trade Growth Expands, Defying Protectionist Fears

An interesting analysis talking point is the cyclical improvement in the global economy spurred by the emerging markets. The chart below shows the improvement in global trade. Everything the mainstream economists and investors said about the global economy last year was wrong. They misunderstood the trade weakness, saying it caused by politics. If you think that a change in metrics is caused by politics, the implication is that it is a long-term trend. Tariffs explained alternately can be described as rules which make it prohibitively expensive to trade. If they were put in place on a mass scale, the economists would be right. However, they were mainly perceived or imagined threats caused by President Trump’s surprise election and Brexit.

The cyclical slowdown in trade combined with anti-trade rhetoric made some think the protectionism was causing the weakness. Now that President Trump’s actions didn’t spur a global move toward protectionism, the economy was allowed to have a cyclical return to normal growth. The chart breaks down where the growth is coming from. The purple bar, which is the Eurozone, is seeing a large expansion in growth. China is also seeing an expansion in growth. That’s why the chart on the right breaks down the nominal fixed asset investment in China. As you can see, there has been a big increase in infrastructure investment. That’s the Chinese One Road, One Belt policy which aims to expand land and sea trade routes.

Although China has seen decelerating growth, last quarter beat expectations as GDP was up 6.9%. That’s above the 6.5% growth rate expected. The chart below shows the revision to the IMF’s projections to Chinese GDP growth. As you can see, the growth rate is a few tenths higher in the 2017 projection in the next few years. You may think this looks great, but it’s actually a bad thing because China is issuing more debt to pay for growth. Debt is borrowing from future consumption to pay for current growth. That’s bad because eventually a country can’t keep borrowing.

The disaster that is the Chinese debt situation can be seen in the chart below. As you can see, the 2017 expectation for debt to GDP growth is even higher than the 2016 estimate. There’s little doubt that debt can increase in the near term, but in the long term both projections are probably unrealistic. There’s not a real chance that the debt to GDP ratio will go up forever. This is like the government’s GDP forecasts which never predict a recession. This prediction isn’t valuable in the sense of accuracy, but it is worth looking at it because it’s a hypothetical. If everything continues the way it is now, that’s what would happen to the debt to GDP ratio.

The IMF recommends that China slow its credit growth and increase its consumption growth. The chart below shows the spending in China on social programs compared to the OECD average. China is underfunding pensions, education, and healthcare. Improving this investment is easier said than done because China must develop the tools to properly administer the consumer goods. China has been trying for a few years to go from a production economy to a service economy. In the long term, it would make sense to switch from manufacturing because manufacturing will be automated. China switching from manufacturing is like Iran diversifying by investing in solar technology since oil won’t be relied upon at some point in the future. Iran is investing in renewables. The question it faces is how it can export the new energy it creates. With China, changing its economy while having a debt to GDP ratio at 242% is like doing a cartwheel on a tightrope. It won’t be easy.

The chart on the left is from June, so don’t get the idea that inflation has been ramping. If anything, this chart shows that as early as two months ago, the OECD was still predicting a rise in inflation. That didn’t occur. The reason why I put this slide in this article is to show the chart on the right. It shows the market based expectations for interest rates. Expectations for America are up while they are stagnant for Japan and Europe. I think the changes in these estimates where the American rate expectations fall and expectations for Japan and Europe rise will cause the dollar to weaken further. The U.S. inflation is disappointing, putting off rate hikes, while growth in Europe and Japan is beating expectations. The latest Japanese GDP report crushed expectations, causing some investors to rethink their entire macroeconomic opinions. Q2 GDP growth was 1.0% which was above the expectation for 0.6%. On a seasonally adjusted run rate basis, GDP grew 4.0% which beat expectations for 2.5%. Furthermore, Q1 GDP was revised up to 1.5% beating expectations for 1.0% growth.

On the one hand, global growth will boost America’s economy and allow other countries to catch up to the U.S. in terms of rate hikes. On the other hand, the Fed won’t be able to count on the other countries’ central banks to provide liquidity if volatility sprouts when the Fed starts the unwind in Q4 2017 and really ramps it up in 2018. This is beginning to look like an all or nothing scenario. That means more risk is about to hit the market. Don’t get lulled into a sleep because the initial reaction to the unwind isn’t a crash. I think the volatility will come in the spring of next year

Conclusion

Global growth is improving thanks to emerging markets, particularly China. China is investing infrastructure as it is the tried and true way to spur its economy. It has its ‘election’ this fall. Obviously, China doesn’t have a democracy, but the government wants the changing of leadership to go smoothly so some stimulus has been added. Besides China, Japan and Europe are heating up. This has monetary policy implications which we will be focused on in the next few months. The faster the economic growth, the faster the ECB takes away its monetary stimulus. The taper in October/November could be higher than expectations.

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