China's Transition Occurring at a Critical Time
By Chris Maxey, Ryan Davis
November 13, 2012
Markets Fall Post-Election
Equity markets sank sharply in the days following the re-election of Barack Obama. The US blue chip indices suffered their worst two-day return of the year on Wednesday and Thursday. Ultimately, the S&P 500 and Dow Jones Industrial Average finished the week down 2.4% and 2.1%, respectively.
President Obama won a slight majority of the popular vote in Tuesday’s election, 50% to 48% for Mitt Romney, but more soundly defeated his opponent in the Electoral College. Obama won all but two of the so-called swing states, with his losses occurring in the historically Republican states of Indiana and North Carolina.
Congressional leadership remained split as Democrats retook the Senate and Republicans won a majority in the House. While the results in the house were expected, some observers saw an outside chance for Republicans to take control of the Senate. Ultimately, the party lost two seats to their rivals.
Tuesday’s results bring major implications for both investors and citizens, the most immediate being negotiations over the debt ceiling and fiscal cliff. Some preliminary statements by the President and Congressional leaders suggest compromise may be feasible, although much work remains to be done. The late-week sell-off was likely triggered by a combination of fears over an inability to find resolution on these issues, as well as the prospect of higher capital gains taxes in 2013.
Economic and corporate data took a backseat to the elections and political punditry last week, but there were a few important reports nonetheless.
Earnings among major companies were generally positive last week, with companies such as WellPoint, Time Warner, Kraft Foods, Macy’s, and Molson Coors Brewing Company surpassing analyst estimates. Still, very negative reports from J.C. Penny and Groupon offset some of this optimism. Overall, with the bulk of Q3 earnings season completed, approximately 70% of companies are beating estimates. This is in line with recent averages, although growth is still slightly negative at -0.1%. Revenue results have been far weaker, with just 40% of companies beating estimates.
On Monday, the Institute of Supply Management (ISM) released its monthly Non-Manufacturing Report on Business. The index slipped modestly from 55.1 to 54.2, but remained solidly in expansionary territory. Underlying trends in the report were not exceptional, as eight of the 10 component indices softened in October. New orders and business activity both declined sharply; at 54.8 and 55.4, however, both readings remain well above the 50-level which demarcates expansion/contraction.
One encouraging development in the NMI was a substantial 3.8 jump in the employment index. At 54.9, this index is also looking quite strong. Overall, the U.S. service economy appears healthier than the manufacturing sector. In ISM’s manufacturing update last week, the PMI edged up to 51.7, well below the NMI.
Consumer credit saw another robust gain in September, as debt outstanding grew $11.4 billion. This was down from August’s $18.4 billion level, but levels above $10 billion are generally quite strong. After contracting through 2009 and 2010, credit has expanded in all but two months in the past two calendar years.
Unfortunately, most of the recent credit growth is concentrated in student loans. Revolving credit, representing credit cards, actually contracted by $2.9 billion in September. This was the third such contraction in the past four months, although it has not shown up in consumer spending habits. Consumer savings rates have gone down as a result, as Americans continue to shun heavier debt loads, aside from educational expenses.
The U.S. trade deficit shrank to its lowest level in nearly two years in September. The trade balance of -$41.5 billion represented a contraction from August’s level of -$43.8 billion. The bulk of this improvement was seen in petroleum goods, where the deficit fell by nearly $2 billion. More encouragingly, exports saw a sharp recovery following a very weak August report. According to Econoday, gains were seen in every major category except automotive exports.
Finally, consumer sentiment improved from already strong levels to 84.9 for the first half of November. This is the best reading since the financial crisis, with a 91.3 level in consumers’ assessment of current conditions driving the headline rate. Expectations, while somewhat weaker, also improved in November. This data correlates with recent retail sales and personal spending data. Consumers appear more optimistic about the economy, despite continued weakness in the labor market.
China’s Transition Occurring At A Critical Time
While the presidential election in the U.S. was on the forefront of most investors’ minds, current events in China could be equally important to the global economy. China is going through a political transition at the same time as it seeks to rebalance its economy. Whether those efforts will be successful remains a great unknown.
As we mentioned last week, officials in China commenced the 18th national party congress to mark the official transition of power in that country. More than 2,200 delegates assembled to determine the leaders of the country for the next decade. Official announcements are expected on Thursday, one day following the end of the weeklong congress.
While the new leaders are unlikely to be a surprise, China is facing a number of important issues as this transition occurs. Global growth is slowing, major trade partners are contracting and social unrest is on the rise.
The good news for party leaders is that economic growth appears to have bottomed out in recent months. Indicators such as industrial production rose 0.8% in October, while retail sales increased 1.3%. On a year-over-year basis, retail sales are up 14.5%.
One of the biggest priorities for incoming leaders will be to figure out a way to continue transitioning the country into a consumer-demand based economy.
The challenge is what is happening outside the country. Recent trade figures showed a 2.7% YTD decline in trade with European partners and a 1.8% drop in trade with Japan. Somewhat surprisingly, though, was a 9.1% increase in trade between China and the U.S. As long as the American economy remains in a state of slow, steady growth, China will benefit. If we jump off the fiscal cliff and see a sudden slowdown in the U.S. economy, China may be prone to the ill effects.
Officials are also aware that persistent inflation has left many common citizens in an unhappy spot. After peaking last year at roughly 6%, inflation began to subside as the economy slowed. Through October, consumer prices were up 1.8% in the past 12 months, while producer prices are actually down 2.8% in the same period.
China’s new leaders will be required to tackle an aggressive agenda during the next decade. Transitioning the economy towards a retail-oriented, consumption base will be difficult in its own right. Officials will also be tasked with maintaining close relations with the U.S. and ensuring that any economic malaise in the U.S. does not cause deterioration in the Chinese economy.
the week ahead
There are several important economic reports next week for investors to watch. On Tuesday, the NFIB Small Business Optimism index is released, followed by PPI and retail sales on Wednesday. On Thursday, more inflation data is on tap with the CPI. Several important manufacturing series are also scheduled, including the Empire State Manufacturing and Philly Fed Surveys, as well as industrial production on Friday.
The Federal Open Market Committee releases minutes from its October 23-34 policy meeting on Wednesday. Traders and economists will scrutinize these transcripts for any clues in the FOMC’s first meeting following the announcement of QE3. The most important decision is the impending conclusion of Operation Twist, whereby the Fed purchases $45 billion of long-term Treasuries per month. Many observers believe the Fed will leave these purchases open-ended.
Bond markets will be closed on Monday in observance of Veteran’s Day, although equity markets will open.
Central bank activity is limited this week, with only Chile scheduled to meet. However, an important Eurogroup meeting takes place on Monday, in which the primary topic is expected to be Greece and its latest bailout program.
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