"Kee" Points with Jim Kee, Ph.D.

Inflection points: Correlation (things moving together) isn’t causation (one causing the other), but it is amazing how many global economic statistics -like global trade volume growth or commodity prices - correlate with the Chinese economy. Since the Great Recession, I have been of the view (I didn’t originate it) that Chinese leaders, though communist, were much more pragmatic than many in the West believed. But beginning a few years ago it became apparent that the time had come to take seriously the predictions of a fairly profound slowdown. In fact, many experts today (e.g. consulting firms like McKinsey & Co.) view China’s economy as really being comprised of multiple trillion-dollar sub-economies, some booming and some declining. I think that’s the way to think about China going forward, i.e. less a one-dimensional engine of growth and more a hodge-podge of sub-economies, some of which are globally competitive and some of which are “fit for the scrap heap” (McKinsey & Co.).

 

Growing concerns: There are other concerns about China that weren’t significant 10 years ago. One is the huge increase in debt there, which has quadrupled since 2007. The concern is that many loans (over half) are linked in some way to China’s real estate market, widely believed to be overheated. Now, he Chinese government has the capacity to bail out the financial system if the need should arise, but going forward a key challenge for Chinese policy makers will be constraining debt growth without constraining economic growth (McKinsey & Co.)

 

As an aside, high public and private indebtedness characterizes most of the developed world, and that tends to correlate with (again, not necessarily causing) lower future growth. One way out of this predicament is economic growth through fiscal policy reform (simpler, clearer, and more permanent rules, regulations, and taxes), but few countries are making any substantial progress in this direction. Because of this I feel that Europe’s debt problems (and probably Japan’s) will be back in the headlines for years to come. Other, more novel proposals for dealing with debt, include asset sales (e.g. military bases, public parks, licenses and access), one-time taxes on wealth, and better debt-restructuring programs

 

Related to this, the United Kingdom will hold an “in-out” vote or referendum on June 23rd of this year, which will determine whether they leave the European Union. You probably already know this but the United Kingdom is part of the 28-country European Union but did not adopt the euro as its currency, so it is not part of the 19-country European Monetary Union. The referendum is not surprising, as many have been arguing for some time that the UK has more in common with the United States than it does with the European Union. The consensus, I would say, is that while the UK will not leave the European Union, it will be pretty close. On this I have no basis to disagree, though I do think that there is a greater chance of a UK exit than, say, a Greek exit(!). Interestingly (and drawing from Kee Points of 4 or 5 years ago), when you have a monetary or fiscal union and one of the weakest countries exits, it can leave the remaining union stronger. But when one of the strongest countries exits, it makes the remaining union weaker and increases incentives for other strong countries to leave because the weaker (or subsidized) countries now have a greater proportional drag.

 

Back to China: More recently and more worrisome for China is that, in defending the stock market, the government has made the financial system more fragile and more dependent on Chinese stocks (Capital Ideas, University of Chicago). For example, in an effort to support the stock market, authorities in China have encouraged or forced (in the case of state-owned enterprises) insurance companies, banks, and securities firms to buy stocks while restricting selling. This causes financial institutions in China to be much more sensitive to stock market movements than they would be otherwise, hence the assertion of increased fragility.

 

Of course, a key question is how all of this affects the US economy. The US is less internationally-oriented then other large economies (i.e. Germany, Japan, China), meaning that international trade (exports and imports) is a smaller percentage of the total economy. That means that the US in general is less sensitive to global events than the rest of the world. But global events do impact US stocks in two ways. First, they can impact sales and profits, as many US companies do business overseas. Second, they can impact how much investors are willing to pay for these sales and profits. For example, big global shocks often cause a “risk-off” attitude among global investors, meaning they are willing to pay less for a given stream of expected earnings. Financial economists call this a rise in the discount rate (the rate at which future flows are discounted) or a rise in the “equity risk premium.” Of course, shocks can be positive as well, and this week is a good example: There is some hope that OPEC and non-OPEC will reach an agreement on oil output that can result in an oil price that stabilizes the oil producing regions. That would be good news or a “positive shock,” lowering the equity risk premium or discount rate and lifting stock prices. That is always an important point for investors to keep in mind, i.e. not all shocks are bad shocks!