False contractions?

PORTFOLIO POINT: The economic signals suggest that talk of a global meltdown is exaggerated. The global economy has not lost much momentum, and some key regions are growing strongly.

When you sit back and read through a newspaper, most of the headlines and analysis on the economy is very much about a slowing in global growth.

The fact that this has been associated with a sharp drop in bulk commodity prices, comparatively sluggish Chinese data, mine closures in Australia, and the announcement of a number of domestic job cuts throughout industry and the public service heightens the anxiety. But all the noise around a drop-off in global growth momentum is misleading, and there are two key reasons for this.

1. Austerity is much exaggerated, and the ECB’s decision to buy bonds presents a turning point for the European crisis.
2. Global growth momentum isn’t anything like what all the headlines would have you believe.

Determining what is actually going on is no easy task. There is just so much rot. So I’ll be honest in stating that I am always instantly sceptical when I hear talk of a slowing.

But that’s not because of some permanently bullish bias. I’m not one of the big global investment houses trying to convince you of my world view so that I can somehow fleece you of money. I, like you, am a retail investor; like you, just trying to figure out what is. No, my scepticism stems from the fact that pessimism on actual economic growth has been proven wrong time and again – recall US double dip fears in 2010 and 2011, and incessant talk of a Chinese hard landing.

The situation in Europe has been quite different obviously. The crisis appears never ending and the region is actually flirting with recession. Officially they’ve just avoided it, but for all intents and purposes they are in a recession. No one disputes this. What people dispute is how large and how long this downturn will end up being, and the answer boils down to what you think caused it. Have a look at chart 1 below.

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The chart shows that growth really turned down quiet sharply in the December quarter. Prior to that growth had been holding up quite well, considering the fact that growth in Europe isn’t really that strong even at the best of times (decade average is only 1.2% annualised). Ask anyone what lays behind this slowdown and they’ll tell you without hesitation that it’s austerity, and that’s understandable. We hear a lot about it and big figures get thrown around – people are on the streets protesting.

You may be surprised by chart 2 below then. The fact is that to date, government spending hasn’t really been cut overall. In Greece, maybe, Spain, sure – but for the rest of Europe it is largely same-old. At best you might be able to say that the growth rate in spending has tapered off a little, but it certainly hasn’t been cut. More to the point, recent announcements actually do little to change that scenario.

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So far, European austerity announcements since the second half of 2011 have summed to something like €150 billion to €200 billion, usually over three or four years. At best one-third to one-half are made up of spending cuts. So, for instance France has pledged to cut around €30-40 billion mostly through revenue measures, rather than spending cuts. Spain’s got a bit of both, or about €65 billion in budget cuts over 2 ½ years split between spending cuts and tax increases. Italy for its part has made negligible cuts, but then again its budget was already in primary surplus prior to the ‘crisis’.

Anyway the point is that you’ve got something like €50 billion per year being cut from the budget of which, my back of the envelope calculations suggest, at best half are spending measures. €25 billion per year in spending cuts. However, European government expenditure amounts to some €6 trillion per year. Consequently to suggest in some way that €25 billion, or 0.4% of expenditure, is in some way severe austerity, austerity which has caused a European recession, is disingenuous in the extreme.

So why is Europe in a recession then? Well we know it’s not austerity, and we know that European households don’t have excessive debt, so they’re not deleveraging (again, refer to my note of May 7 Europe’s Untold Riches). Moreover, we know there was no investment glut or inventory overhang. It makes sense to me, with all that in mind, that this recession was driven by a surge in risk aversion (because of flare-up sovereign debt concerns) and this had two key effects. Firstly, it dampened private-sector demand, especially investment and on the supply side, it led to a tightening in financial conditions – over and above that brought about by Basel III requitements. Look at table 1 below.

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You can see the sharp deterioration in credit growth from late 2011 and, of course, as chart 3 below shows, this coincided with a sharp spike in Italian and Spanish government bond yields.

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This is why ECB’s decision to buy bonds is so pivotal and why ultimately I, and Europe’s leaders, are confident that the downturn will be light.

Austerity is not driving this recession, so if you contain those yields, bring them down, then concerns over another financial crisis will abate. In turn confidence will rebound. Remember the essential problem with Italy and Spain isn’t that they are insolvent – in a rational market they can easily afford to service their debt. Spain has a comparatively low debt-to-GDP ratio and Italy already ran a primary budget surplus prior to the ‘crisis.

This then brings us to the more important issue of growth elsewhere around the globe. On balance, when I look at the data it shows that global growth momentum isn’t anything like what all the headlines would have you believe. Look at the table below. Europe, as discussed, is slow right now. China too is slowing.

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Context as always is important though. Consider that Chinese growth isn’t that much different from last year, as Table 2 shows. Average growth in Q1 and Q2 was 9.3% in 2011. Average growth in 2012 has been 7.9%. If that was Australia, that would be the same as a slowdown in growth from say 4% to 3.4%. Virtually meaningless in other words.  

More broadly you can see for yourself all the talk about the global economy slowing is overdone. For the major regions, growth is actually stronger in the US and Japan (compared to last year) and by a good margin. Similarly growth in the ASEAN-5, which is of equal importance to Europe and the US in terms of its contribution to growth, is generally stronger. For the BRICS, it’s true to say that growth is weaker overall, but you can see the slowdown is modest. Only for the NIAEs is growth significantly weaker – although looking at growth rates on an annualised basis shows a pretty decent turn around over the 1H of 2012. So it may be the case they are past the worst. Time will tell.

As to those Chinese export numbers? I’ll admit I’m confused as they appear to be inconsistent with strong, albeit weaker GDP growth.

Moreover, when I look at US imports from China I’m not getting any sense that weak US demand is something that is driving the apparent slump in Chinese exports. Again, chart 4 may show US imports from China have slowed, but growth rates are still quite strong – 8% this latest year and since 2009, imports from China are 42% higher. That is a significant increase. I don’t think that because imports year to date are so far only 8% higher is all that material, coming after such strong growth. Numbers bounce around after all. Imports into the EU are so far flat, but again that follows two very strong years of growth and, of course, they are in a recession.

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So notwithstanding the slowing in Chinese trade statistics, I’m just not convinced we should be worried about China. People say China may experience its weakest growth since 2009. But think about how different the world is compared to then.

1. Unlike 2009, the world is not undergoing a financial crisis;
2. Growth in both the US and the EU (even with its recession) is far stronger than what it was in 2009. US economic growth is around trend, while in 2009 we were seeing growth rates of -7% and -9%;
3. Growth in the BRICS and ASEAN5 remains strong - generally.

Last, but not least, we have to consider a point I’ve made before and that is, even when China slows, growth is still very strong.

In summary then, the global economy has not really lost much momentum. European growth prospects are much improved following the ECB’s decision to buy bonds. China is still slowing, but not a lot and growth remains strong. Moreover, some key regions of the world are still showing very strong growth rates, which have in some cases accelerated.