Equity Markets Enjoying the Spring Weather

US equity indices rallied for the sixth consecutive week with the Dow Jones Industrial Average rising 0.6% and the S&P 500 index increasing by 1.4%.

 

Despite a number of concerns about the fiscal situation in Greece, equity markets remained resilient.  Economic data showed some divergence over the past week as retailers reported a 9.1% jump in sales during the month of March.  Consumer credit on the other hand resumed its downward spiral, falling $11.5bln in February. 

 

Following January’s gain of $10.6bln, there was optimism building that consumers were once again feeling confident to tap into various sources of credit.  That proved to be fleeting with revolving credit (i.e. credit cards) tumbling by $9.5bln.  As we mentioned previously, a rebalancing of the consumer balance sheet was a painful but inevitable process.  

 

 

 

Source: Haver Analytics

 

With the end of the Federal Reserve mortgage purchase program officially upon us, mortgage rates are gradually inching higher.  The latest Freddie Mac Primary Mortgage market Survey found that the average rate on a 30-year fixed mortgage is now at 5.21%, up from 5.08% in the prior week.  The removal of support by the Fed is not the only reason rates are rising and strong job growth in the March employment report offered confidence in the future trajectory of the economy. 

 

At the same time, though, Americans are increasingly less enthused about the advantages of homeownership.  A survey by Fannie Mae found that 70% of individuals thought homeownership was a “safe investment” down from 83% in 2003.  Interestingly, 53% of people actually feel it is the homeowner’s fault, not the mortgage lenders, in entering into loans greater than they could afford.  Perhaps personal accountability isn’t dead after all. 

 

Is An Undervalued Renminbi Truly the Problem?

Coinciding with a visit to China by US Treasury Secretary Timothy Geithner, the perceived undervaluation of the Chinese Renminbi reemerged as a favored whipping post last week.  The prevailing school of thought is that a stronger Yuan will stimulate demand for US exports, thereby providing a natural source of growth for the US economy.  If only it were so simple. 

 

Taking a step back, it has long been the belief of politicians and some economists that China is artificially undervaluing its currency to boost foreign demand for Chinese goods.  To satiate that criticism, China gradually appreciated its currency from a ratio of 8.11 Yuan to the dollar to 6.83 between 2005 and 2008. 

 

Never the satisfied bunch, 130 members of Congress decided last month would be an opportune time to write Mr. Geithner to encourage stricter sanctions against China unless that country agreed to strengthen its currency.  Some within the economics community went as far as calling the Yuan undervalued by 40%. 

 

There are several problems with this simplistic thesis.  Politicians feel that an appreciation of the Yuan will encourage Chinese consumers to purchase American goods, but a 2008 report from the Congressional Budget Office (CBO) found that between 2005 and 2008, when the Yuan appreciated by 19% relative to the dollar, the price of goods imported from China only went up 2.5%.  Furthermore, US imports from China continued to rise during that time, going from 14.5% to 16%. 

 

Source: Congressional Budget Office

 

Second, Goldman Sachs estimates China’s gross savings rate is roughly 51% of GDP, with households accounting for 22%, corporations at 18% and government savings representing the final 11%.  With a savings rate that high, there is simply no reason to believe that Chinese consumers have any interest in spending money on goods, regardless of where they come from. 

 

That trend is ever so slowly changing, as Chinese consumers enter a phase of higher consumption, but it will take years for that trend to truly take hold.    

 

Source: CLSA

 

In the event China elected to revalue the Yuan by 40% overnight, there would be two primary implications.  The first and most detrimental would be a sudden acceleration of inflation in the US.  As estimated by the CBO, a 20% revaluation of the Yuan would result in an average price increase of 7% to 11% in Chinese imports.  Second, global growth would experience a swift slowdown as a dependency on China to fuel future growth would dissipate. 

 

There is a degree of ignorance from US politicians in this whole argument and as pointed out in the Financial Times over the weekend “often overlooked is the fact that the renmimbi is only pegged to the US dollar, so its undervaluation against other currencies, if it exists, is the direct result of the dollar’s own devaluation.”  Inherent to China’s dollar peg is implicit support for the US dollar at times when other parties are net sellers. 

 

It would be convenient to assume that a revaluation of the Yuan would lead to a readjustment of the US trade balance, but the likelihood is that production would merely shift to the next lowest cost country.  Academic reports on gains in Chinese imports in the early 90s show that imports from China came at the expense of other countries and  what politicians fail to recognize is that many manufacturers in the US import production inputs from China, directly affecting their ability to remain competitive. 

 

Admittedly, China has provided a competitive enhancement to its manufacturing industries by pegging the Yuan to the US dollar, but we struggle to understand how that is different from the $20bln annual subsidy provided to farmers by the US government. 

 

One economist recently called the Yuan undervaluation “blatant protectionism” but as Chinese Premier Wen Jiabao recently offered “I can understand that some countries want to increase their share of exports.  What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports.  This kind of practice I think is a kind of trade protectionism.” 

 

While China is unlikely to undertake a sudden revaluation of the Yuan, it is apparent that officials will have to gradually appreciate the currency in order to stem the tide of populist anger.  Presently, the Yuan is allowed to float within a narrow band and we are likely to see a gradual widening of that band in the coming months.

 

Revaluation of the Yuan long ago turned into a political rather than economic debate.  Even the CBO was quick to point out that the undervalued Yuan “is expected to have no medium or long-run effect on aggregate US employment or unemployment.”

 

Politicians are either unable to comprehend or unwilling to admit that structural problems in

the US economy are not the result of some questionable currency undervaluation.  A strengthening of the Yuan is inevitable at this point, but Chinese officials will make the process very deliberate and entirely on their own terms. 

The Week Ahead

There will be plenty to digest this week, from the beginning of 1st quarter earnings reports to a number of important economic releases both domestically and abroad.

 

The earnings cycle begins again as Alcoa reports first quarter earnings after the close on Monday.  Thomson Reuters is reporting that analysts expect earnings to be up 37% over the past 12 months.  Other notable companies to report include CSX, JP Morgan, Advanced Micro Devices, General Electric and Bank of America.  

 

Important economic releases within the US include the consumer price index, retail sales, capacity utilization and housing starts.  Improvement in auto sales is expected to provide support to headline retail sales, while inflation is expected to remain subdued on account of weakness in the housing markets.  The Federal Reserve will release the Beige Book on Wednesday, providing a detailed look at regional economic activity. 

 

China will also release a number of economic indicators on inflation, GDP growth and industrial production on Wednesday. 

 

On the geopolitical front, politicians from Brazil, China, India and Russia are meeting for 2 days in Brasilia on Thursday and Friday.  The BRIC countries are hoping to increase their presence on the global political stage.   That evening, the first of three debates between the leading political parties in the UK will take place. 

 

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