beyondbrics

For equity markets, 2012 has got off to a flying start. It is almost as if the past year has been just a bad dream. But for Andy Xie, a Shanghai-based consultant and writer, investors are flying blind.

Xie is not afraid to stick his neck out and his assessments do not always stand up to close examination. A note he distributed on Monday contains some sweeping statements. But a lot of it rings alarmingly true.

Here’s how he sets out his stall:

The fundamentals for the global economy remain dire. The west is mired in debt troubles, declining competitiveness, and unsustainable social overheads. The east is struggling to build up robust consumer demand to balance its manufacturing prowess. So far the world’s leaders have used liquidity and fiscal measures to prop up demand on the margin, without addressing structural problems. The global leaders continue to treat the global economy as a car with a drained battery rather than a bad engine.

Nothing too startling there, perhaps. But Xie’s warning about “the east” is based on a gloomy outlook for China. He thinks the world’s manufacturing powerhouse is in for a long pause.

He says much of China’s recent growth is due to a domestic bubble. That will surprise those who thought exports had played a big part, too. But his prognosis, though tentative, is worrying:

Unlike the western economies, China can restructure its economy to create another growth cycle. The wage level is still low by international standards. Hence, making the supply side more efficient can increase China’s market share in the world. The household debt level is low. There is no problem turning labor income into consumption.

However, China is not showing the resolve to restructure its economy. The resolve must begin with a meaningful tax cut that redistributes Rmb 1 trillion to the household sector. The Chinese government has consistently shown its preference for increasing its share in the economy. This is a political phenomenon. It requires political reforms to change. It doesn’t look coming. Hence, China’s economy may experience slow growth for years to come.

He is less tentative on the impact on commodity prices.

The emerging economies have done well in the past decade, mainly due to rising commodity prices. And that is due to a tenfold increase in China’s fixed asset investment (FAI) in a decade. The odds are that China’s FAI will stagnant or even decline in some years in the next decade. Commodity prices may reverse.

I’m bullish on energy and agriculture, because both are not recyclable. As China shifts to consumption, the demand for both will continue to rise. But, for industrial metals, the story could be very negative. Iron ore price has risen tenfold in the past decade. It is likely to spiral down in the next decade. Countries like Brazil will likely slow down.

Countries like Brazil have also done well because governments used the crises of the 1990s to push through reforms that have only recently borne fruit. But it was the commodities boom that really brought that fruit within reach.

Strong domestic economies and low reliance on trade (Brazilian exports are worth less than 15 per cent of GDP, for example) suggest exporters could ride out a slowdown in China – especially if demand for agricultural commodities remains strong. But commodities play a bigger role than trade figures alone suggest – by driving investment, for example. Xie’s warnings should be heeded.

Getting back to global markets:

The risk appetite is now rising. We have seen several such episodes in the past three years. None lasted. The driving force for the risk-on trade is the [US Federal Reserve's] threat to depreciate money through its policy. It’s the fear of paper money rather than optimism for the future that drives such rallies in risk assets.

The risk-on trade is pushing hot money into emerging markets and at least keeping it there. So some vulnerable currencies like the Indian rupee and Brazilian real have bounced. But, economic fundamentals will come back to haunt such trades. Declining commodity prices will worsen the balance of payments for countries like Brazil and India. When the trade data hit market confidence, the rally will reverse.

Is confidence in India and Brazil the result of a fear of paper money? That seems a sweepingly harsh assessment of countries with enormous in-built growth potential. But the world, as Xie puts it, is a dangerous place and big emerging markets are not immune to its dangers.

Of course, analysts have argued for years that fundamentals would come back to haunt countries like Brazil – and those countries have done pretty well regardless. Xie’s closing remark – “This muddling-through equilibrium will blow up in everyone’s face when inflation causes social turmoils” – sounds over-egged. Social turmoil in Brazil? But ignore some of Xie’s hyperbole and the message remains a sobering one.

Related reading:
The bulls return, but for how long? FT
The Short View: A return to normality? FT
Andy Xie: China shouldn’t aid eurozone, beyondbrics