US 4Q GDP, chip inventory and renminbi revaluation

A few titbits that I am putting together in this post.

First, US fourth quarter real GDP grew at an annual rate of 3.1 percent, down from the third quarter's 4.0 percent.

Meanwhile, technology research firm iSuppli Corp reported that excess semiconductor inventories fell 38 percent to US$1 billion in the fourth quarter of 2004. Nevertheless, the firm warned that "with semiconductor sales growth slowing in 2005, the surplus remains an issue of concern to the worldwide electronics industry".

Finally, Brad Setser -- responding to arguments suggesting that a renminbi revaluation is not an issue -- puts together a fine case for why renminbi revaluation is in fact desirable. Excerpts:

[B]ooming China should be running a trade deficit right now. China imports lots of commodities, and it is in the midst of an absolutely enormous investment boom... Had savings stayed constant, China's trade balance would have swung into a substantial deficit... Morris Goldstein estimates that China's cyclically adjusted trade surplus is close to 5% of GDP. Moreover, given China's ongoing ability to attract the FDI needed to safely finance trade deficits, there is no reason why its trade should be in balance...

... The Asian NICs plus China -- and emerging Asia more broadly -- runs a substantial current account surplus. That is not the way the world has to work -- very fast growing regions often run trade and current account deficits... It is hard to see how the US can reduce its current account deficit if emerging Asia does not reduce its surplus, it is hard to see how emerging Asia reduces its surplus if China does not revalue. The "China is part of Asia and the Asian value added chain" argument STRENGTHENS the case for a renminbi revaluation as part of a broader Asian revaluation.

[T]he most important channel for adjustment would be indirect.. [S]lower Chinese reserve accumulation and reduced Chinese demand for US assets would tend to raise US interest rates, reduce US consumption (increase US savings) and lead to the eventual adjustment in the current account. Don't forget about the capital market channel.

As usual, good stuff from Setser.

Deflation is back

Signs of deflation have been mounting in recent months. The latest data suggest that deflation is back -- at least in Asia.

Japan's consumer price index (CPI) fell 0.5 percent in December from the previous month, according to the Ministry of Internal Affairs and Communications. Core CPI, though, was up 0.1 percent. Year-on-year, overall CPI rose 0.2 percent but core CPI fell 0.2 percent.

However, in a more current indication of inflation, the metropolitan Tokyo core CPI fell 0.9 percent in January from the previous month, the ministry reported. Year-on-year, the Tokyo area core CPI fell 0.5 percent, the 63rd straight monthly decline.

In other news from Japan, industrial production fell 1.2 percent in December, while spending by salaried workers' households was down 3.8 percent from a year earlier in December as well as from a month earlier.

While Japan's unemployment rate did fall in December, some economists point out that that could be partly because of a shrinking labor force in Japan.

Further signs of deflation came from Singapore. Yesterday, the Department of Statistics, Singapore reported that the consumer price index for the city-state fell 0.1 percent in December over the previous month. This was due mainly to lower costs of transport and communication as well as cheaper clothing.

Next in line for deflation could be Hong Kong and -- if the renminbi peg is changed or removed -- China.

There are no signs of deflation in the US, though. The latest figures for durable goods orders in the US show a 0.6 percent rise in December. Excluding transportation, orders rose 2.1 percent. Orders were especially strong for computers and electronic products, which rose 6.4 percent.

Singapore manufacturing turned up in December

Singapore's manufacturing slowdown appears to have been arrested, at least for December.

Monthly Manufacturing Performance - December 2004
Manufacturing output for December went up by 31.7% compared to December 2003. This high growth was due mainly to a substantial increase in output by the biomedical manufacturing and transport engineering clusters. Excluding the biomedical manufacturing cluster, December's output increased by 7.4% over December 2003. The three-month moving average for total manufacturing output grew by 14.1%. The seasonally adjusted month-on-month growth for December was 19.4%. Total manufacturing output for 2004 grew by 13.9% over 2003.

The strong performance in December has led some economists to think that Singapore's economic growth for 2004 will turn out to be higher than the 8.1 percent previously forecast.

The outlook going forward, however, remains uncertain. With the electronics sector still slowing, Singapore's manufacturing is becoming increasingly dependent on the volatile biomedical sector.

The problem for investors is that while there are many electronics stocks listed on the Singapore stock exchange, there are very few biomedical stocks. The stock market is more likely to be affected by the fate of the electronics sector than that of the biomedical sector.

Nevertheless, I am relatively sanguine about electronics stocks in Singapore, at least relative to the rest of the market. Much of the gloom in the sector has been discounted, with the Electronics Index having fallen 7 percent last year, and falling further in 2005 so far, both in contrast to gains in the broader market. Top electronics stock Venture Corporation, for example, currently trades at a price-earnings ratio of about 16 -- at the low end of its historical trading range.

I suspect that if electronics stocks suffer again in 2005, the broader market may not be spared this time.

Economic news from around the world

Recent news flow suggests that the world economy remains relatively resilient.

China's National Bureau of Statistics (NBS) reported yesterday that the economy grew 9.5 percent in 2004 compared with 9.3 percent in 2003. The government's efforts at slowing down the economy hasn't borne much fruit, although fixed-asset investment did slow slightly last year to 25.8 percent compared with 26.7 percent in 2003, while industrial output grew 11.5 percent in 2004 compared to 17 percent in 2003.

Inflation, however, was strong last year, with consumer prices rising 3.9 percent, 2.7 percentage points more than the previous year, mainly due to surging food prices.

In other news yesterday, the Conference Board reported that its consumer confidence index edged up to 103.4 in January from 102.7 in December. This is its second consecutive month of improvement.

In another sign of increasing confidence in the global economy, today, Germany's Ifo index of business confidence was reported to have risen to 96.4 in January from 96.2 in December. It is the strongest level for almost a year.

Earlier today, Japan's Ministry of Finance reported that its trade surplus in December fell a seasonally-adjusted 3.9 percent from the previous month to 949.7 billion yen. Exports decreased 5.6 percent to 5.04 trillion yen while imports fell 6.0 percent to 4.09 trillion yen.

For 2004 as a whole, Japan's trade surplus rose 17.9 percent to 12.01 trillion yen, with exports increasing by 12.2 percent to 61.18 trillion yen and imports rising by 10.8 percent to 49.17 trillion yen.

While this news may lend some support to the US dollar, new estimates for the US budget deficit is unlikely to.

US government officials now estimate that the budget deficit is likely to hit a record US$427 billion in the fiscal year of 2005, boosted by funding requirements for Iraq and the war on terrorism.

Property in Asia and US are good bets, says BT

A report in The Business Times suggests that property in Asia and the US are good investments for 2005.

The report by Neil Behrmann points out that faster growth compared to Europe should help US and Asian properties do well this year, although probably not as well as in 2004. According to Behrmann, estate agents think global shopping centres and other retail outlets "offer better value and growth than offices and industrial real estate". Behrmann also cites a Knight Frank report which states that the biggest prospect is in Asia, where retail real estate is expected to do well. For commercial property investment, Hong Kong, Shanghai, Singapore and major Australian cities are rated best.

Knight Frank, however, warns that the Indian property market is volatile, while some analysts fear that "the high euro and sharp slide in growth" among euro bloc countries may hamper investment prospects there.

Impact of profit warnings on share prices

Teh Hooi Ling writes in The Business Times that "Profit warnings hurt big boys less". Excerpt from the article:

Profit warnings are particularly bad news for small companies, but not necessarily so for big ones. Based on data in the last three years, big-cap counters which have issued profit warnings, on average went back to their pre-warning share price within five or six months, and ended up out-performing the STI by 5 percentage points. But few of the small stocks recovered to their pre-warning days within that same time frame. By the end of six months, they had fallen an average 19 per cent and had underperformed the UOB Sesdaq Index by 27 percentage points.

The article also mentions a study by George Bulkley and Renata Herrerias from the University of Exeter, UK, that had come up with similar findings. The two studied over 2,000 profit warnings by companies in the US between 1998 and 2000 and found that the impact of profit warnings is very much greater for small firms than large.

In addition, they found that companies that gave qualitative statements without any numbers suffered bigger price falls than those that gave quantitative warnings, possibly because the former implies potentially bigger disappointments.

Falls in British retails sales, US consumer confidence and stock prices

As many people had feared, Britain saw weak retail sales last month. Yesterday, Britain's National Statistics agency said retail sales were down 1.0 percent compared to November, the largest monthly decline since 1981.

The malaise may spread to the United States. The University of Michigan's consumer sentiment index for January reportedly fell to 95.8 from 97.1 in December. The consumer expectations index fell to 86.4 from 90.9 in December but the current conditions index rose to 110.4 from 106.7.

However, consumer confidence indicators do not correlate well with actual spending. Steve Stanley, chief economist at RBS Greenwich Capital, thinks that consumer spending may have grown by 4.5 percent in the fourth quarter. "Consumer spending was stellar in the second half of last year," he noted, "so the current levels of sentiment are certainly not an impediment to robust advances in actual outlays."

Furthermore, the Conference Board's index of leading indicators did rise last month.

Stock prices, of course, is one of the components of the leading index, and they had contributed to the rise last month. In January, though, stock prices in the US have fallen.

Mark Hulbert, in a recent commentary at CBS MarketWatch, noted a study by Michael J Cooper and John J McConnell of Purdue University and Alexei V Ovtchinnikov of Virginia Tech which shows that, apart from during the 1930s, January has a unique ability to predict what the market will do over the subsequent 11 months. This means that unless the market recovers its losses in the remaining week or so of January, 2005 may turn out to be a down year. Having said that, it may be reasonable to question -- as Hulbert does -- the significance of a finding which ignores the stock market performance during the 1930s.

On a more positive note, though, Hulbert noted in another commentary that sentiment among investment newsletters has become less bullish recently after the market pullback.

"That is definitely encouraging, from a contrarian point of view," he wrote. Not encouraging enough, though, to make him bullish. "I still don't think that [sentiment] has fallen enough to set up a very powerful rally... [O]ver the past five years, the stock market did not produce above-average returns following drops at least as large as the recent one."

US leading index continues to rise

The Conference Board's index of leading indicators rose for the second month in a row in December, which should ease concerns of an impending deceleration in the US economy.

The leading index increased 0.2 percent, the coincident index increased 0.3 percent and the lagging index remained unchanged in December.

The rise in the leading index in December brings it to 115.4, and follows November's revised 0.3 percent increase and October's 0.3 percent decline. In fact, until November, the leading index had posted five consecutive months of declines.

The Conference Board points out that the growth rate of the leading index in the second half of 2004 was below its long-term trend of 1.5 percent annually, but is not at a rate that has historically been associated with a recession. During the six-month span through December, the leading index decreased 0.9 percent, with six out of ten components advancing (diffusion index, six-month span equals sixty percent).

Malaysian ringgit

The Chinese renminbi is not the only pegged currency that is the subject of revaluation interest. Another such currency is the Malaysian ringgit, which is pegged at 3.80 ringgit to one US dollar.

Recently, Mahathir Mohamad, the former prime minister of Malaysia who had instituted the ringgit peg in 1998, suggested that it may be time to review the peg. "I feel the time has come for us to review because we have lost a lot as the value of our currency has fallen," he said.

However, the current prime minister, Abdullah Ahmad Badawi, has ruled out a change for the time being.

"There is no change at this point," he was quoted as saying by the official Bernama news agency in Malaysia. "If there comes a time when changes are required to be made for the benefit of the people, we would consider making the changes then."

Like China, Malaysia would want to implement any change in the currency regime at a time of its own convenience. And that would probably mean not giving speculators too many clues as to exactly when it would happen.

Insights from General Glut

General Glut has been saying some interesting things of late.

On the political side of the economy he says:

I've said before that the Dems need a strong moral argument in favor of Social Security. That moral argument rests upon social solidarity across the generations. For God's sake, that even a conservative argument -- at least it was back when there were such people in the United States before "conservative" became the label for nut-job libertarians, yahoo imperialists and money-grubbing ladder-climbers. Put the argument in the context of what we owe one another as members of the same society. We don't owe the aged an "opportunity," we owe them a safety net and a minimum guaranteed standard of living -- period.

The Los Angeles Times and now the Washington Post are getting in on a big story of the last thirty years -- the massive transfer of economic risk from capital to labor. Why can't the Dems use this stuff?? The vast majority of people don't want more risk for more "opportunity" -- the research shows it.

On the trade deficit, he thinks that while the US is losing its ability to export the traditional range of goods and services, it is compensating for this loss by effectively exporting housing.

[I]n fact housing has become rather easy to export thanks to the mortgage-backed security and US government agencies like Fannie Mae and Freddie Mac which create and sell them. In fact, exporting our houses is precisely part of the US strategy for financing the trade deficit... The goal seems to be to create or provide the context for the creation of expensive new assets with which the US can trade for goods and services. Thus the US sells the means of production and the means of reproduction to foreign capital for current consumption.

However, unlike the sale of goods and services, the sale of assets to foreigners involve the transfer of claims to future dividend, interest or rental income generated in the US. In other words, it will come back to haunt the US economy. It may not be sustainable long term.

Singapore's exports and renminbi revaluation

The International Enterprise Singapore has reported that Singapore's non-oil domestic exports grew 8.0 per cent on a year-on-year basis in December. However, on a month-on-month seasonally-adjusted basis, it increased by only 0.3 percent last month, after a 9.1 percent decline in November.

Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities in the months ahead, posted a 5.9 per cent decline on a month-on-month seasonally-adjusted basis in December, reversing the 4.1 per cent expansion in November 2004.

The trend seems to show that Singapore's exports have peaked and have started to decline. However, both government and private sector economists expect exports to pick up again in 2005.

A continued weakening of the US dollar, however, may upset this forecast, especially if renminbi revaluation fails to take place, allowing Chinese manufacturing to become even more competitive even as US demand flags with the weakening US currency.

And based on what was recently reported on the People's Daily Online, renminbi revaluation does seem unlikely to occur this year.

Fan Gang, director of the National Economic Research Institute China Reform Foundation, reportedly said at a recent seminar that the Chinese central government will not allow the renminbi to appreciate this year. He warned that a revaluation could bring unemployment shocks. He said that the market is speculating on a renminbi revaluation, but thinks that as long as speculation money stays in the market, the central government will not consider revaluation.

See also "China states stand on foreign exchange reserve".

Earnings growth may already be discounted

It's earnings reporting season again, so let's look at what is in store.

Standard & Poor's has projected full-year per-share earnings in excess of $60 for the S&P 500 under generally accepted accounting principles (GAAP) and operating earnings above $70. Operating earnings per share are seen rising 10 percent for the S&P 500, 15 percent for the S&P MidCap 400, and 20 percent for the S&P SmallCap 600. The second half is projected to show a slight improvement over the first.

In reporting these, Sam Stovall, chief investment strategist for Standard & Poor's, points out: "[E]quity valuations are not out of line. In fact, the S&P 500's GAAP p-e of 20.7 is a shade below its average of 21.5, dating back to 1984. But we note that the S&P 500 would have to decline 25% in order for its current p-e to equal the average p-e of 15.5 since 1935."

Meanwhile, Mark Hulbert reminds investors in a CBS MarketWatch commentary that fast-paced earnings growth is not necessarily bullish for the stock market as a whole.

In a commentary entitled "A cautionary tale about earnings", he points out:

Over the last eighty years, the S&P 500 has turned in some of its most mediocre showings during periods in which quarterly earnings were growing the fastest. In fact, but for the very worst quarters - ones in which earnings fell by more than 25% -- there was a perfectly inverse relationship: On average, the faster the earnings growth, the lower the S&P 500 return.

... [A]ccording to Martin Zweig, the fund manager and former newsletter editor who Ned Davis Research credits with noticing the phenomenon, is realizing that the stock market is a discounting mechanism, anticipating the future rather than merely keeping score on what's already happened.

This leads Hulbert to the following conclusion:

The stock market's current level may be close to discounting the earnings growth that will take place during the "up" phase of the current economic cycle - even if that growth lasts for another several quarters. If so, then the market fairly soon - if it has not already - will begin to acquire an increasingly negative tone as it progressively discounts what is likely to happen during the next "down" phase of the economy.

In addition, investors also may have to deal with the impact of stock options expensing, which is due to take effect in June this year. I discuss stock options expensing in the US and Singapore in "Companies react as stock options expensing takes effect".

US industrial output up in December as PPI falls

There was more good news on the US economic front on Friday, with industrial output growing last month while producer prices fell.

The Federal Reserve reported that output from US factories, mines and utilities rose 0.8 percent in December, more than analysts had expected. This helped output for the whole of 2004 to increase by 4.1 percent, the best annual showing in four years.

Manufacturing output rose 0.7 percent, utilities output rose 2.7 percent, while mining output climbed 0.4 percent.

Capacity utilisation hit 79.2 percent in December, the highest since January 2001.

On the same day, the US Labor Department reported that producer prices fell 0.7 percent in December. This is the biggest decline since April 2003. Excluding food and energy, producer prices rose 0.1 percent.

However, for the year as a whole, producer prices rose a steep 4.1 percent as oil prices jumped. It was the biggest calendar year gain since an oil price spike in 1990.

January producer prices may see further gains, after US crude oil futures rose to a six-week high of US$48.5 on Friday.

Andy Xie: Renminbi revaluation may harm, not help, US

Andy Xie of Morgan Stanley warns that a revaluation of the Chinese renminbi may do more harm than good to the US.

If China were to implement a significant revaluation of its currency, as some in the US are demanding, I believe inflation in the US would surge, which could help cause the US bond market to collapse. A major Chinese currency revaluation would shift jobs from China to other developing countries, not the US. Thus, a Chinese revaluation would harm, not benefit, the US.

Presumably, though, a renminbi revaluation would be accompanied by the revaluation of the other Asian currencies, so it's conceivable that there may still be some job gains by the US. Of course, that doesn't help with inflation in the US, though.

Xie has other insights into the US trade with China.

On average, each dollar the US pays for imports from China retails for US$3–4 in the US. Adding value to Chinese imports may account for 3–5% of US GDP. Four to eight million jobs in the US could be associated with adding value in the China trade. In contrast, for each dollar that China earns from exporting to the US, Hong Kong, Taiwan, or other foreign countries...China gets 50 cents. Thus, for each dollar from the China trade, the United States’ value-added is six to eight times China's... My rough calculation...is that corporate America earns 10% net profit from final sales of Chinese goods in the US. Total profits from the China trade for corporate America could have amounted to US$60–80 billion, or 10–15% of total S&P 500 profits, last year.

I have been saying that part of the reason for the rising productivity of the US and the rising profitability of US corporations has been the sourcing of goods from China. Xie puts figures into the latter's impact.

Xie also downplays the impact of China on the loss of US jobs.

The USSC [US-China Economic and Security Commission] report cites only a figure of 1.5 million [jobs lost] since 1989, or 1% of the US labor force over a period of 15 years. The US economy creates more jobs in one year, and normal economic restructuring would have shed far more jobs.

This, of course, is at odds with the view of most other economists (see "The impact of China on the world economy"), including his own colleague at Morgan Stanley, Daniel Lian (see "Sino Hollow").

It's not for nothing that Andy Xie has been called an iconoclast.

Japan's current account surplus shrinks, US retail sales up

Japan's current account surplus shrank in November for the first time in 17 months, its finance ministry said yesterday.

The merchandise trade surplus fell 35.2 percent to 753.2 billion yen as imports jumped 31.2 percent to 4.16 trillion yen while exports rose only 13.4 percent to 4.92 trillion yen. High oil prices was a major factor in the rise in imports. Crude oil imports jumped 54.4 percent to 202.6 billion yen from a year earlier while refined oil products rose 70.6 percent to 53 billion yen.

The capital and financial account posted an outflow from Japan of 1.41 trillion yen in November, against an inflow of 692.6 billion yen a year earlier. Japan's deficit in the services account widened by 6.0 percent to 296.4 billion yen.

Meanwhile, in the US, retail sales jumped a larger-than-expected 1.2 percent in December, according to the US Commerce Department. Excluding autos, retail sales rose 0.3 percent. In November, sales had risen 0.1 percent, while sales excluding autos had been up a revised 0.4 percent. For all of 2004, retail sales rose 8.0 percent from the year before, the biggest gain since 1999.

In other news yesterday, the Labor Department reported that the number of first-time claims for jobless benefits by Americans grew last week to 367,000, the highest since late September. However, the number of those continuing to file claims fell to their lowest level since mid-2001.

A separate Labor Department report showed that the price of goods imported into the United States fell by 1.3 percent in December, mainly due to a steep fall in the price of petroleum products.

China's record reserves may not mean renminbi revaluation

China's foreign reserve hits US$609.9 billion at the end of 2004 and the United States' trade deficit hits $60.3 billion in November. With China's trade surplus hitting a nine year high in December, you can be sure that there will be greater pressure on it to revalue the renminbi.

Andy Xie of Morgan Stanley, however, thinks that a renminbi revaluation is unlikely to work and is therefore unlikely to happen in 2005.

Revaluing the currency, in theory, gives more purchasing power to households by decreasing consumption prices. I seriously doubt that this would work. China's consumption weakness is due to 1) a labor surplus that keeps wages down, and 2) a low level of wealth due to a short history of market economics. Revaluation would not solve either problem.

Instead, Xie thinks a rise in China's interest rates in tandem with those in the US is the key.

If it raises interest rates gradually and keeps its exchange rate stable, the dollar would stabilize, commodity prices would decline, and the global economy might achieve a soft landing... The global economy is experiencing over-consumption in the US, over-investment in China, and massive speculation in financial markets. In my opinion, only if China and the US both raise interest rates gradually can the global economy achieve a soft landing.

In any case, General Glut thinks that the exchange rate of the US dollar has little impact on its trade deficit. He points out that the US trade deficit has continued to deteriorate even as the value of the US dollar has fallen in the past few years.

The point should not be overstated, though. It is true that the exchange rate is only one factor behind the deteriorating trade balance; the deteriorating US budget deficit of the past few years has also played a crucial role.

However, unless and until the budget makes a clear move towards surplus -- or at least a substantial narrowing of the deficit -- the trade balance will need all the help it can get from the US dollar.

Japanese outlook remains poor but other news mixed

The economic outlook for Japan remains poor. Its index of leading economic indicators stood at 30.0 for November, according to preliminary data issued by the Cabinet Office. This was the third straight month it was below the boom-bust line.

Things don't look much better in Germany. According to its Economy and Labour Ministry, industrial output fell by 1.7 percent in November, pulled down by declining activity in the key manufacturing, construction and energy sectors.

To offset that bad news, German investor confidence appears to have picked up. The ZEW economic research institute's economic expectations index rose by 12.5 points to plus 26.9 points in January, the sharpest rise since June 2003. ZEW president Wolfgang Franz, however, pointed out that the ZEW barometer remains below its historical average of plus 34.4 points.

In the corporate world, the technology sector has been in focus recently, with profit warnings from Advanced Micro Devices and ST Microelectronics being offset by better-than-expected profits from Intel in its fourth quarter.

In the meantime in consumer electronics, Creative Technology has raised its guidance for revenue growth for the three months ended in December. This is on strong sales of its MP3 players.

It looks like Apple's iPod is facing some stiff competition.

Australia and China's trade balances move in opposite directions

The trade balances reported by Australia and China yesterday showed contrasting performances.

Falling exports and rising imports pushed Australia's November trade deficit up 12 percent to a worse-than-expected A$2.66 billion (US$2.04 billion) on a seasonally-adjusted basis, according to the Australian Bureau of Statistics. It was the second highest deficit on record, and follows a revised deficit of A$2.37 billion in the balance for goods and services for October.

Exports in November were particularly disappointing, falling A$50 million from October to A$12.87 billion. The strong Australian dollar was obviously a drag on export performance.

China, in contrast, posted a trade surplus of US$11.08 billion in December, its biggest in nine years. Exports in December rose 32.7 percent from a year earlier. That compared with a rise of 45.9 percent in the year through November. Imports grew 24.6 percent in the year through December, compared with November's 38.5 percent increase.

For all of 2004, China had a surplus of US$31.98 billion, compared with about US$25 billion for all of 2003.

The latest trade figures from China will surely put pressure on the country to revalue the renminbi, and possibly increase calls for protectionist measures against it in developed countries.

Just yesterday, the US-China Economic and Security Review Commission released a report which asserted that 1.5 million American jobs had been displaced over the 1989-2003 period as a result of the growing trade deficit with China, which was affecting "an ever-broadening segment of US manufacturing, including advanced technology industries like semiconductors once thought immune to lower-wage Chinese competition".

China's widening impact has been noted before. See also "China's expanding influence" and "The impact of China on the world economy".

US markets at risk

Morgan Stanley's Richard Berner and David Greenlaw think that sustained interest rate rises in 2005 will have a greater impact on asset prices than on the economy.

The hawkish tilt to the inflation debate in December's FOMC minutes has raised concerns among market participants that Fed officials will abandon their measured tightening pace and put either risky assets or the economy or both in jeopardy. The time-honored fear, of course, is that when the Fed steps on the brake, someone always goes through the windshield; investors just don't know who that someone will be this time around...

... [W]hile there's an endgame in every tightening cycle, it's important to distinguish between market and economic risks. In our view, there's much more risk in markets than in the economy. That's both because there's a lot of good news in the price of risky assets, and because the Fed will welcome somewhat less favorable financial conditions to keep inflation down but will also aim at healthy economic growth.

This view is quite consistent with the view I expressed in my commentary yesterday titled "Poor start to 2005 for US equities", in which I quoted Mark Hulbert of CBS MarketWatch as saying: "The S&P 500's current P/E ratio is either 46 percent above historical norms or 50 percent above. Your conclusion in either case should be the same: Stocks aren't cheap."

Which leaves US stocks vulnerable to the risk of a weaker-than-expected economy as the Federal Reserve keeps its tightening bias.

Unemployment in Europe stays at 8.9 percent, higher than US

The euro-zone's seasonally-adjusted unemployment rate stood at 8.9 percent in November 2004, unchanged from October, according to Eurostat, the Statistical Office of the European Communities in a press release last Friday.

The unemployment rate in Europe has remained much higher than that in the US, whose unemployment rate is only 5.4 percent, which attests to the latter's job-creating prowess.

Larry Kudlow recently enthused over the 2.6 million American jobs created in 2004:

Mainstream economists continue to scoff at the economic power of lower marginal tax rates. But once again a supply-side experiment worked. For all of 2004, nonfarm job additions averaged just under 200,000 per month. At this rate, 2005 will be another banner year for employment and economic growth.

I would attribute the job creation to the economic recovery. Did lower marginal tax rates spur the recovery? Very probably. The real question is whether it could have been better and whether this is sustainable, bearing in mind the expected moderation in growth in 2005.

China's economic power not in its companies

BusinessWeek recently published an article on China's economic power. Excerpt:

Rethinking the China Threat
Everybody knows that China is the world's next economic superpower. Each year, it gets billions and billions of dollars in foreign investment, powering its booming economy. The Middle Kingdom has more cell-phone users than anywhere else on the planet, and soon it will be tops among Net surfers, too. American consumers can't get enough of the low-cost TVs, DVD players, mobile phones, computers, and other gizmos that come out of China's factories.

For believers in the China-rising story, the latest sign of ascendance was the December announcement that IBM, one of the most venerable names in U.S. industry, was selling its PC division to Lenovo, the No. 1 PC maker in China. Lenovo is owned in part by the Chinese government.

All the hype about the Lenovo-IBM deal and China's might obscures one problem: For a country that's about to become such a powerful threat to the U.S., China has a tough time producing world-class companies that can compete with the likes of America's Dell and Hewlett-Packard, or Japan's Sony or Asia's Samsung. Sure, China has Huawei Technologies and ZTE, both of them growing providers of low-cost, high-quality networking equipment. But when it comes to consumer electronics, Chinese outfits just aren't in the same ballpark.

... [A]mid all the hype about China being a threat to the U.S., it's worth remembering that many of the upstart's potential global champions have a long way to go before they can achieve their lofty ambitions.

China's economic power lies mainly in its cheap labour and the sheer size of its economy. These advantages are best exploited by serving as a workshop for foreign companies' products. As yet, China's domestic companies do not have the business sophistication nor the branding appeal to dominate world markets. Chinese workers taking away jobs is not the same as Chinese companies taking market share.

But that is not to say they won't. It just takes a lot more time.

Employment improving but consumer borrowing fell in Nov

The US Labor Department has reported that nonfarm payroll employment increased by 157,000 in December while the unemployment rate was unchanged at 5.4 percent.

Together with upward revisions in employment numbers for October and November, this helped boost the 2004 new jobs total to 2.2 million, the largest since 3.2 million were created in 1999 and a reversal from the 61,000 jobs lost in 2003. While the number of jobs created is not as high as in previous economic recoveries, it should be strong enough to keep the Federal Reserve on its tightening stance.

Speaking of the Fed, yesterday, it reported that consumers cut back on their borrowing in November by the largest amount on record. Consumer credit reportedly dropped by US$8.7 billion in November from the previous month, a 5 percent decline at a seasonally adjusted annual rate. The last time consumers trimmed their borrowing was in November 2003.

This may be a sign that monetary tightening is beginning to bite. Or that consumers are feeling their debt burden. Or it could be just a temporary blip, possibly due to consumers awaiting holiday discounts, as some economists seem to think.

In any case, with consumer spending -- much of it on credit -- so important to the US economy, the trend certainly bears watching.

Inflation fears persist

The US non-manufacturing ISM business activity index rose 1.8 points to 63.1 in December, indicating continued expansion.

What was noteworthy, I thought, was that the price index rose to 71.4 in December from 71.0 the previous month. The price index for its manufacturing counterpart had fallen in December, but to a still-high 72. Clearly, inflation fears persist.

This is consistent with the view of the Federal Open Market Committee -- as revealed in the minutes of the 14 December meeting released on Tuesday -- that interest rates "remained below the level it most likely would need to reach to keep inflation stable". Watch for further increases in the fed funds rate throughout the year.

Of course, this leads to the next question: Would long-term interest rates follow the fed funds rate up?

If Asian central banks continue to buy US dollars at the pace that Brad Setser thinks they have been, there is little guarantee of that.

Richard Berner on the life-cycle model of consumption

In a commentary in Morgan Stanley's Global Economic Forum, Richard Berner suggests -- among other things -- that the US personal saving rate may be about to rise.

[T]he saving rate may rise back to perhaps 4–6% by the end of the decade. Indeed, I think the rate may rise close to 3% by the end of 2006. The analytical framework behind this prediction is, of course, the so-called "life-cycle" model of consumption and saving, in which consumer spending is a function of both income and wealth... [E]stimates of the model consistently produce propensities to spend out of income that are 13–15 times larger than those from wealth, including housing wealth. Together with the lags in response to a change in wealth, these relationships imply a slow adjustment of the saving rate, consistent with the slow adjustment of consumers as they defend their lifestyles in the face of uncertainty.

... The steady, 600-basis-point decline in interest and dividend income as a share of disposable income since their peak in 1989 has reduced the saving rate because such income tends to be saved rather than spent. And the steady rise in the share of government transfers like Medicare has reduced the saving rate because such "income" is 100% spent rather than saved. Thus, Joel Prakken of Macroeconomic Advisers, LLC shows that these compositional effects have reduced the saving rate by about 200 bp since the mid-1980s, while the rise in wealth/income has reduced it by about 400 bp.

However, Berner also adds that this rise in thrift is unlikely to stop interest rates from rising this year. In fact, he thinks that "a faster rise in thrift would require a catalyst -- which, in my view, happens to be nothing less than a significant rise in interest rates".

Obviously, the decline in the US personal savings rate cannot continue indefinitely, and would probably, at some point in time, reverse. Where the world then finds compensating demand will be crucial for the continued expansion of the global economy.

Morgan Stanley reviews 2004 and previews 2005

Some insights from Morgan Stanley from the past few days.

Chief economist Stephen Roach looks back at 2004 and forward to 2005. As usual, he focuses on the global rebalancing theme. Some of his conclusions:

Adjustments in foreign exchange rates -- basically the decline in the US dollar -- is likely to usher in adjustments in other asset prices -- principally bond prices -- that would provide a more decisive impetus to global rebalancing.

Foreign buying of long-term US securities have allowed US interest rates to stay low. He doubts that they can stay low, noting: "There comes a point when private foreign portfolio investors demand to be compensated for taking outsized currency risk, and that compensation normally takes the form of higher real interest rates."

Foreign central banks may start to baulk at continuing to support the US currency. "There also comes a point when the offset from official capital inflows becomes politically and economically untenable," he wrote, addding that "it perpetuates trade imbalances, thereby raising protectionist risks, and it also leads to a loss of control over the domestic money supply, thereby stoking inflationary pressures".

US consumption has remained resilient. Sub-par income growth has been offset by increases in wealth -- most recently, that from property markets. If interest rates rise, "the long-awaited capitulation of the American consumer could well be at hand".

China has managed to cool its economy. Further downside is likely to be limited. Reform, especially of its currency regime, may be the main challenge for China in 2005.

Roach's colleague, Andy Xie, thinks that the US dollar's movement is the key to the performance of the global economy and financial assets.

When the dollar bottoms, I believe it will signal the peaking of all risk assets globally (e.g., Shanghai property, commodities, and emerging market debt). When the dollar bottoms will determine how 2005 pans out for financial investors. If the weak dollar drags through the whole year, 2005 would turn out to be similar to 2004 with risk assets remaining grossly overvalued and the global economy strong.

If the dollar reaches a convincing bottom in 2005, major reversals in asset markets could follow. The overvaluation of commodities and emerging market debt and stocks, for example, could correct quickly. A sharp slowdown in the emerging economies as well as the global economy would follow.

For my own review and outlook for 2004 and 2005, see "Stormy 2004 makes way for challenging 2005".

Global manufacturing picks up with more new orders

Over the last two days the purchasing managers' index for a number of countries have been compiled by JPMorgan and NTC Research into a global manufacturing PMI, which shows that manufacturing activity remains on track for further, if subdued, growth.

Global manufacturing PMI picked up slightly in December, as new orders rose at strongest pace in four months
At 53.6 in December, up from 53.2 a month earlier, the Global Manufacturing PMI -- a composite index produced by JPMorgan and NTC in association with ISM and IFPMM -- posted a reading above the no-change mark of 50.0 for the eighteenth successive month. The upturn remained broad-based, with all except one of the national manufacturing economies (Italy) registering an improvement. However, for the final quarter of 2004, the PMI pointed (on average) to an easing in the rate of growth from the joint-survey record high seen in Q2 2004 to the least marked since Q3 2003 (when the current upturn began). The majority of the national manufacturing economies, including the US, the Eurozone, Japan and China, recorded slower growth in Q4 2004 than in the previous quarter...

The table below is a summary of the changes in the sub-indices from the previous month.

	Nov	Dec	Change
Global PMI	53.2	53.6	+
Output	53.4	53.5	+
New Orders	53.9	56.5	+
Input Prices	71.8	68.4	-
Employment	52.0	50.5	-

The table below is a summary of the changes in some of the national or regional PMIs from the previous month.

	Nov	Dec	Change
US	57.8	58.6	+
Eurozone	50.4	51.4	+
Japan	51.3	50.6	-
UK	55.0	53.7	-
China	51.9	51.3	-
Australia	53.1	60.8	+
Singapore	50.3	51.8	+

As further evidence of the continued growth in manufacturing, US factory orders rose at the fastest rate in four months during November, according to the Commerce Department. Strong demand for new commercial aircraft pushed orders up by 1.2 percent in November, up from an upwardly-revised 0.9 percent orders gain in October. However, excluding transportation, factory orders were flat in November after rising 1 percent in October.

US manufacturing activity strong but not construction

There was mixed news on the US economic front.

The Institute for Supply Management said that its main index of industrial activity rose to 58.6 in December from 57.8 in November, indicating that manufacturing activity expanded in December for the 19th consecutive month. New orders increased to 67.4 in December from 61.5 in November, while new export orders expanded to 60 in December from 54.7 the month before. Offsetting these positives, the employment index dropped to 52.7 in December from 57.6 in November. The price index also fell, to 72 in December from 74 in the previous month.

Separately, the US Commerce Department reported that construction spending declined 0.4 percent in November, the first drop in 10 months. However, construction spending in October was revised to show a rise of 0.3 percent, compared with an initially-reported flat reading.

Overall, the US economy is still holding up well. The slowdown in construction, however, may signal the start of the end of the housing boom.

Bretton Woods Two and the impact on interest rates

A great thread on currencies and interest rates at Brad Setser's blog.

Bretton Woods Two Lives
The Fed has started to tighten, Greenspan said anyone who has not hedged their interest rate risk desires to lose money. Yet higher short-term rates have not led to higher long-term rates. In the jargon of the market, the yield curve has flattened.

Why is the yield on long-term Treasuries still so low?

My tentative answer: a surge in reserve financing in the fourth quarter from emerging economies largely made up for Japan's absence from the Treasury market. As central banks intervene in the foreign currency market to defend a fixed exchange rate or to prevent their currency from appreciating, they buy dollars -- dollars that are then invested in the US fixed income market, whether in Treasuries, Agencies or something else. That is the Bretton Woods two hypothesis: foreign central banks will finance the US trade deficit in order to keep their exchange rate from appreciating...

Sum up the estimated reserve accumulation of [China, Russia, India, Brazil, Korea and Taiwan] in the fourth quarter -- call my little grouping the BRICs plus the non-city state NICs -- and you get a total of $156 billion. Assume 75% of that increases, $117 billion, comes from an increase in their dollar assets, not valuation gains on their euros, yen and gold. The US current account deficit in q4 is likely to be around $175 billion. In other words, to find two-thirds of the financing the US needed in q4, you only really need to look at the balance sheets of six big financial institutions...

Does the surge in q4 reserve financing mean that the Bretton Woods two system is stable and sustainable, that rising reserve accumulation in the emerging world will finance a rising US current account deficit? Or is it evidence that the system is being stretched to its breaking point, and the People's Bank of China and the Bank of Korea are being asked to do too much, and to take on too large a share of financing the US deficit?

The scale of the financing these countries are providing the US is truly staggering. If my reserve accumulation numbers are correct, the central banks of six emerging economies added reserves at a $600 billion annual pace in q4, and added dollar reserves at annual pace of between $450 and $500 billion. That pace of reserve accumulation, should it continue, is enough to finance a large chunk of the United States' 2005 current account deficit, which is likely to be in the $750-800 billion range.

Europe complains that it alone bears the burden of currency adjustment v. the dollar. Emerging Asian central banks could just as well complain that they alone are stuck with the burden of financing the United States.

Most observers believe that "Bretton Woods two" is ultimately not sustainable. Even the Chinese authorities have acknowledged that some flexibility of the foreign exchange rate of the renminbi is desirable.

I think the more important question is how quickly the system unwinds, how painful the process will be and what are the possible steps to take to minimise the pain.

China's role in global rebalancing

Arthur Kroeber, managing editor of the China Economic Quarterly, provides an excellent perspective on China's role in the global balance of payments in an article in the Financial Times.

China's accumulation of reserves does not result from classic mercantilism... China held on to its US-dollar peg when the dollar was strong and rising, in 1998-2001, precisely the opposite of the mercantilist prescription. China's import growth has outstripped export growth every year but one since 1998, by an average of five percentage points. Between 1998 and 2003, China's total trade volume zoomed from 34 per cent to over 60 per cent of GDP. Yet during the same period, the trade surplus shrank, from 4.6 per cent to less than 2 per cent of GDP.

[S]ince the end of 2001, [China] has added over US$300bn to its foreign-currency holdings. But this has little to do with trade. Reserve accumulation results mainly from speculative short-term capital inflows... Chinese policy makers know that such inflows are highly volatile... So they are rightly sceptical of the notion that they should change their long-run currency regime simply in response to short-term capital movements.

Next, is it really true that China bears chief responsibility for the proposed adjustment?

According to economist Jonathan Anderson at UBS Securities, the US current account deficit will reach US$600bn this year. Against this, Japan, South Korea and Taiwan -- the three big mercantilist economies of East Asia -- will post a combined surplus of around US$230bn. Singapore and Malaysia, combined, will add another US$45bn. China, meanwhile, is heading for a surplus of around US$40bn.

These figures suggest that...China should be a significant but by no means the chief player. Indeed, one could more plausibly argue that the lead should be taken by Japan, which is a much bigger and more mature economy than China, and a bigger contributor both to the pile-up of foreign US dollar holdings and to exchange-rate distortions.

Japan could do far more than China to address the global financial imbalance, by opening its markets and stimulating domestic demand... The surplus savings of [Japan and continental Europe] are the result of economic policies deliberately designed to favour domestic producers and suppress domestic consumption. If those policies were dismantled, global imbalances would vanish, and sustainably so.

However, while it is true that China's role in the US current account deficit may have been exaggerated, it's also worthwhile to point out what Brad Setser has argued: "that booming China should be running a current account deficit of $50 billion (financed by FDI inflows) right now, not a current account surplus of $50 billion".

Seen in that light, even the relatively small surplus may be reflecting a significant imbalance in global flows.

Singapore economy returns to growth

Singapore's economy returned to growth in the fourth quarter, rising 2.4 percent on a quarter-on-quarter seasonally adjusted annualised basis, according to a Ministry of Trade and Industry press release.

The Singapore economy registered a moderation of growth in the fourth quarter of 2004. Advance estimates show that real gross domestic product (GDP) rose by 5.4 per cent in the quarter compared to the same period in 2003. On a quarter-on-quarter seasonally adjusted annualised basis, real GDP increased by 2.4 per cent, after declining by 3.0 per cent in the previous quarter.

The manufacturing sector is estimated to have expanded by a slower 9.5 per cent in the fourth quarter, mainly due to the slowdown in the electronics cluster... Activity in the construction sector...registered a smaller contraction of 7.4 per cent. Growth in the services-producing industries is estimated to be a lower 5.0 per cent as the pace of expansion eased in most major sectors...

For 2004 as a whole, the economy is estimated to have grown by 8.1 per cent in real terms. The manufacturing sector and services-producing industries expanded by 13.1 per cent and 7.5 per cent respectively, while the construction sector contracted by 6.3 per cent.

These are weak numbers and show an economy flirting with recession. Tomorrow's purchasing managers' index should give further clues on the direction of the economy.

Look where the money is going

One way to determine the possible direction of stock markets is to look at where money is flowing to.

Smartmoney.com recently quoted the following from Henry "Chip" Dickson, chief US strategist for Lehman Brothers: "The equity market performs best alongside a widening [steepening] yield curve, narrowing credit spreads, and when the yield curve is already positively sloped."

It is true that a positively-sloped and steepening yield curve tends to be good for the equity market. Unfortunately a steep curve is often followed by a flattening of the curve. Indeed, that is what happened in 2004.

Having said that, a mere flattening of the yield curve is not necessarily fatal to the stock market. The worst markets have tended to be those preceded by a flat or inverted (negatively-sloped) yield curve.

Incidentally, Smartmoney.com also quoted Dickson as saying that the redeployment of corporate cash could help boost equities in 2005. However, Paul Kasriel, director of economic research for The Northern Trust Company, wrote recently: "[C]orporations are not spending all of their after-tax after-dividend cash flow on capital equipment and inventories... What makes it especially unusual is that the cost of capital -- be it equity or debt capital -- is so low now. This suggests that the expected return on capital in the U.S. might be unusually low now."

In other words, the availability of so much corporate cash is not necessarily a good sign.

On China's search for oil and savings rate

More insights from Brad Setser on China:

Russia is to China as ...
Canada is to the United States? Large in area, scarcely populated, cold and a major supplier of natural resources to its large southern neighbor ... Well, not yet. Russia, I think, generally exports its energy to Europe, not to China. The pipelines flow west, not south and east. But that may be changing. It seems like the Yukos stake formerly held by western investors is being offered to China...

[T]he (hidden) battle between private US companies (and investors) and state owned Chinese companies for control over existing oil fields (or more precisely, for minority stakes in locally owned oil firms that have control over most countries domestic oil fields) is worth watching. The really high stake game, though, is for control over new oil fields which, with foregn investment, can be brought on line to meet the world's growing demand for energy -- not for control of the world's existing oil fields...

A (long) aside:... Compare slow growing Mexico to fast growing China and look for lessons... Mexico's comparatively low savings rate...generally translates into a low rate of investment. That alone probably explains a large share of the growth difference between Mexico and Asia. Putting all the emphasis on structural reform seems off when Asia's structural...are at least as big as Mexico's. If you can finance investment of well over 40% of GDP out of domestic savings, you are likely to grow fast, even if structural problems mean a large fraction of domestic savings is being invested inefficiently ... that, it seems to me, is the real lesson as Asia's post war miracle, and China's current economic miracle.

And in the comments, Brad adds the following points:

Geo-oil says the US gets supplied from Vennie and West Africa (almost as close to the US as to Europe, as the supertanker floats), and the rest of the world drinks in the Gulf, with a bit of Russian crude thrown in. Geo-politics, though, has the US troops sitting on or next to the gulf oil fields, and the US navy defending the sea lanes that take gulf oil to Singapore to be refined, and then up the South China Sea to the world's new industrial heartland.

An interesting mix. China has to trust us to assure the steady supply of their oil, even in a global supply shortage, or try to hedge their bets. The irony is that right now they seem more inclined to hedge their bets on oil than to hedge their exposure to the dollar ...

Which suggests, perhaps, that China's priorities may not always be aligned with those of the rest of the world. An interesting mix indeed.