Balancing Acts

China has been the focus for the past several years in terms of the percentage of GDP allocated to consumption, investment, and net exports.  As has been discussed countless times in the business press and academic literature, China’s allocation to investment-related activities and net exports has leaped quite dramatically over the past decade at the expense of consumption, prompting calls from policymakers in the developed world for China to “rebalance” economically, or enact policies to strengthen the currency.  Oftentimes, political actors threaten China with retaliatory action to offset perceived trade balance injustices, as witnessed during the US presidential elections.

Generally, when economists total up GDP using an expenditures method, they derive total GDP from four sources: consumption, investment, government, and net exports.  Let’s take a quick look in the following charts where China stood coming into the year on each of the expenditure measures relative to GDP:

Source: World Bank

Source: World Bank

Source: World Bank

As you can see, the top-down investment driven model in China has pushed investment as a percentage of GDP up approximately 12 percentage points since the start of the new century to 48.4%.  Consumption has dropped approximately 11% points over the same time frame.  The allocation of GDP to net exports has increased by about 1.5%, though the contribution was much higher just ahead of the global economic and financial crisis.  Net exports have moderated as a percentage of GDEP as China’s currency has strengthened and US and European economic problems have stunted trade.  

What’s been worrisome to many in the pundit class, and some in the economics profession, is the fact that China’s numbers for investment as a percentage of GDP have reached levels unseen by other rapidly developing economies at similar stages of economic progress.  Japan, for instance, during its rapid rise juggled similar dynamics as the Chinese, but investment peaked at a level below 40% as a percentage of GDP.  The Economist performed a nice job addressing these concerns earlier this year by noting among other things that capital stock per capita in China still lags the US and other developing countries dramatically (see: http://www.economist.com/node/21552555).  Whether a positive, negative, or neutral condition, we’ll still argue that at some point the mix will need to change; it always has in other countries on a similar development track, and we have no reason to believe it won’t be the case for China.  As for the implications, we’ll handle those in a bit.

Before dealing with potential implications, let’s look at the US mix.  As you see in the charts following, the current composition and the trajectory over the past 10 to 15 years is almost a mirror image of China.

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

US consumption as a percentage of GDP has risen from the mid 60s during the 1990s to nearly 71% today, though it has recently begun to trail off.  Investment as a percentage of GDP in the US has fallen from near 18% at the turn of the century to approximately 13% today, off the lows of about 10.5% observed in 2009.  Finally, net exports as a percentage of GDP has fallen since the mid-90s, though the figure has improved substantially since the beginning of the financial crisis.  As we discussed last week, heading into the financial crisis the US faced a massive credit bubble and a massive savings deficit.  The deeply negative net exports number above, and the subsequent recovery is a crude visual representation of the dearth of savings heading into the crisis and the subsequent deleveraging/rebuilding of savings in the aftermath.  

Like the China example, it’s probably not too much of a stretch to think that the US will slowly rebalance away from a consumption driven economic model, to one that better balances investment and net exports.  

Perhaps we’re already seeing rebalancing on both fronts.  There’s been much discussion in China as they moved through the recent leadership transition about changing the predominant economic model towards one favoring consumption growth.  Wages in China continue to rise rapidly, narrowing the cost differential, all things considered, between China and the US.  Thus, in the US numerous articles are popping up discussing a new trend towards “insourcing” manufacturing capacity, a resurgence and focus on exporting, and increases in manufacturing employment.

So, now, what are the potential intermediate-term implications if the US and China, the two biggest economies in the world work in tandem to shift the economic mix demonstrated above over the coming years and decades.  Overall, it’s more nuanced than just saying it’s an absolute positive or negative for either country.  If the glide paths are relatively smooth for both countries, the overall impact doesn’t necessarily have to be particularly destructive or disruptive.  On the other hand, a dramatic short-term shift in the mix due to an unforeseen, dramatic political, economic, or market/currency move would be problematic.  Predicting where the countries will fall on the “glide path” is difficult.  Instead, it may be more instructive to focus on what an inevitable mix shift means for certain actors within the respective economies.  

Therefore, if there’s a strong likelihood that consumption growth is going to outpace GDP growth in China in coming years, and underwhelm relative to the rest of the economy in the US (and other developing economies) it may be safe to say that US-focused consumer discretionary companies should be shunned in favor of companies focused on selling into China and other emerging markets, as well as nascent consumer companies in China that focus on the urban consumers in their own country.  Similarly, US manufacturers with a strong export model and ability to satisfy Chinese demand could fare well.  Conversely, state-owned enterprises in China focused on the export sector, and the stakeholders there that have been enriched by these dynamics, will face increasing pressures in the future.  These broad conclusions may seem obvious in certain respects.  Looking at the US in particular, though, the consumer discretionary names in the S&P 500 still command a significant portion of investor mindshare.  The ratio of the S&P 500 consumer discretionary index level relative to the broader index is still over two standard deviations above the norm as the consumer index marks new all time highs.  While there’s been plenty of discussion about constrained consumers in the US, it’s not being reflected in market action.  In China, there’s been much talk about reducing the role of massive state-owned exporters in the economy and increasing opportunities for small and medium sized entrepreneurs.  At this point, there hasn’t been significant progress; maybe that will change in short order.  

Anatomy of a Deflating Credit Bubble

Amid a constant barrage of news about fiscal cliffs, and government deficits, and confidence deficits, and European meltdowns, and “muddle through” economies over the past few years, it’s easy to lose sight of an issue that’s played an instrumental part in the massive economic headwinds in the first place.  Ultimately, the severity of the 2008-2009 recession and the subsequent economic malaise, at least in relative terms to the economic rebounds we’ve seen during past post-war episodes, was attributable in major part to the massive reversal of a US consumer credit bubble that was decades in the making.

Look at the first chart below, which represent total household debt relative to disposable income in the US.  The chart is based on data provided by the Federal Reserve Bank from 1965 through Q3, 2012.  Between the mid 1960s until the early 1980s, debt as a percentage of disposable income remained relatively stationary.  From the early 1980s until 2007, households piled on debt at an ever-increasing pace relative to incomes.  Granted, the near parabolic move higher during the last stretches of the credit bubble was mainly attributable to mortgages outstanding, but the point remains the same.  Accelerating debt dynamics provided a turbo boost to economic growth, and probably masked underlying structural issues with US economic growth, especially from 2000, or so, to 2007.  The level of household debt relative to income peaked out at 129.4% in Q3:2007.  Since that time, it’s fallen to approximately 108%.  Further demonstrating the dynamic, below the first chart providing total household debt, we’ve also provided a chart based on data from the New York Fed which breaks debt out into individual consumer components such as auto loan debt, credit card debt, revolving home equity debt, and student loan debt.  As you can see, the ex-mortgage consumer credit categories have been in steady decline for the past several years as well (except for one category: student loans).  

Just as increasing use of credit provided a tailwind to US economic growth for years, the subsequent deleveraging among households has been an albatross. The aftermaths of massive credit bubbles aren’t pretty and are historically marked by years and years of substandard economic growth.  The event unfolding in the US seems to be unfolding according to the template outlined in the Rogoff and Reinhart book, This Time is Different.  Massive private sector credit bubbles prick, creating financial crises.  As governments work to offset the negative effects of the crisis, the debt baton is passed on to sovereigns/governments.  Ultimately, overburdened sovereigns dispense of obligations through various strategies, such as financial repression, monetizing/inflation, or default.  Whatever the trajectory, economic growth usually remains subdued for an extended period as economies adjust, rebalance, and digest; there’s very little policy makers can do.

Source: Federal Reserve

Source: Federal Reserve Bank of New York

Where do we stand in the overall process?  What’s amazing is the fact that the US finished 1999 and entered the 2000s with a household debt to disposable income ratio of approximately 91.5%, nearly 20 percentage points below the current level.  It’s obviously impossible to make definitely predictions on a debt trajectory from here, but it’s not unfathomable to think that total household debt will continue to work lower, especially considering the general aging of US society and other dynamics.  Maybe consumers will dedicate more of their disposable income to debt reduction, or perhaps institutions will write off more debt, such as mortgage balances.  Either way, the headwinds will probably continue.  

Atlanta Fed President Dennis Lockhart’s comments below, made during a speech in late 2011, succinctly describe the deleveraging process and the ongoing ill-economic effects associated with the aftermath of a credit bubble:

"It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.

…Rebalancing simply takes time. A 2010 report by McKinsey surveyed 32 international periods of deleveraging following financial crises and found that, on average, the duration of these episodes was about six and a half years. U.S. debt to GDP peaked in the first quarter of 2009. By that standard we are much closer to the beginning than the end of our deleveraging process."

If Lockhart is correct, the frustrations we’ve experienced over the past three years with the three steps forward, two steps back recovery will probably remain in place.  

Green Shoots in Global Performance?

Without a doubt, it’s been a frustrating few years for investors with a global orientation.  From the end of 2009 through yesterday (12/6/12), total return for the MSCI World has trailed that of the S&P by about 12.5 percentage points.  Of course, US stocks comprise nearly half of the MSCI World Index.  Isolate the ex-US component as represented by the EAFE, and the story is even more ugly.  EAFE returns have trailed over the past three years by nearly 25%!  In the 11 full quarters since the end of 2009, the MSCI World and EAFE have only outperformed the S&P 500 three times.  Here’s a table of quarterly returns:

	MSCI World	S&P 500	EAFE
Q1:10	3.37%	5.39%	0.98%
Q2:10	-12.47%	-11.43%	-13.69%
Q3:10	13.92%	11.29%	16.57%
Q4:10	9.08%	10.76%	6.67%
Q1:11	4.93%	5.92%	3.50%
Q2:11	0.66%	0.10%	1.80%
Q3:11	-16.50%	-13.87%	-18.92%
Q4:11	7.74%	11.82%	3.40%
Q1:12	11.73%	12.59%	11.00%
Q2:12	-4.85%	-2.75%	-6.93%
Q3:12	6.84%	6.35%	7.00%
Q4:12	1.04%	-1.37%	4.24%

A funny thing has happened of late.  For the first time since the end of ’09, the ex-US markets may outperform US markets for two consecutive quarters.  The EAFE and MSCI World as a whole outperformed slightly in Q3:2012.  Through yesterday, the EAFE has outperformed the S&P 500 by nearly 5.6 percentage points in the 4^th quarter.  Granted, there’s still plenty of time left in the month, but if things hold, this will mark the second biggest differential in performance between the EAFE and the S&P over the past three years (the biggest was an 8.4% point win by the S&P in Q4 of last year while Europe was struggling with most vicious news flow from the debt crisis).  

What factors have started to perk up global performance relative to the US?  Several issues could be at play.  First, from a news flow standpoint, though negative headline flow in Europe continues as the continent struggles with economic weakness and the ongoing political drama surrounding the debt crisis, the intensity has decreased.  Instead, global investors have found it’s the United States’ turn to absorb the brunt of negative headline flow as the President and Congress circle around the fiscal cliff issue.  Plus, the US economy remains sluggish and US earnings growth has been less than inspiring of late.  Second, the “herd” factor may be coming into play; individual and institutional investors entered 2012 with very negative sentiment towards ex-US markets.  Accordingly, equity investors have parked significant capital in US relative to ex-US markets.  As investors have voted with their feet in response to the debt crisis situation overseas, normalized multiples in overseas developed markets have become quite low relative to the United States, as we’ve discussed at several points this year.  Coming into November, the US held the highest multiple among all developed markets around the globe as illustrated by this chart from the World Beta Blog:

Source: World Beta Blog, www.mebanefaber.com

The US trades at approximately 21x.  In contrast, the European or Asian developed market with the highest normalized multiple is Hong Kong at 17x, decently below the US position.  The “Big 3” European markets, the UK, France, and Germany trade at 12.5x, 11.2x, and 13.4x respectively, far below the US.  Most emerging markets remain at low multiples.  Yes, economic/earnings and political conditions have been ugly overseas, especially in Europe.  Using multiples as a guide, it’s apparent that markets have priced in significant pain, meaning that hurdles are low.  When hurdles are low, it’s not particularly difficult to see a spark in performance with just the tiniest shift in news flow.  The opposite is true as well.  Hurdles are relatively high in the US and the tenor of news flow has been shifting, especially in earnings trajectory.  As we discussed recently, earnings news disappointed investors last quarter in the US, which we believe contributed significantly to weak performance.  Expectations are still reasonably optimistic for 2013 S&P 500 earnings.  Another round of earnings misses could result in P/E multiple compression in the US.

Sum it all up, and it could be time for global equities to gain a little bit of the spotlight relative to the US.  Global markets have underperformed US markets for quite some time.  We’ve said it before and it will continue to say it: multiples revert to the mean for various reasons over time.  It doesn’t necessarily happen quickly, and usually doesn’t happen in a neat, straight line.  But it happens.  There’s a wide chasm valuation-wise between US equities and global equities and that differential has developed over a long period of time.  We continue to expect that this course of events will reverse sooner rather than later.  Perhaps, the past two quarters of performance provide some indication that the ship is making its turn.  

We’ll leave you with one final visual representation of the performance differential between the S&P 500 the MSCI EAFE that shows where market currently stand and how the relationship has shifted over time.

Source: IronHorse Capital