China’s central bank has been engaging in policies designed to slow inflation over the past several months. The central bank has raised interest rates several times, and it has increased reserve and capital requirements at the nation’s banks. The goal is to slow the pace of economic growth and thereby slow the rapid increase in prices. We suspect the government is especially concerned about the cost of food for its 1.2 billion citizens, most of whom are below what we would consider the poverty level.
Chinese regulatory action is clearly a risk not only for investors in Chinese stocks, but also for investors in US stocks. With each new data point, it is becoming clearer that the recovery in the US will not be a normal one. The sub-par recovery in the US is being driven by a number of factors: 1) weak employment growth; 2) the housing market appears to be double-dipping; 3) state and municipal governments are in terrible fiscal shape; 4) consumer debt levels are still very high; 5) retirement savings are inadequate; 6) energy prices are surging; and 7) the supply of credit remains constrained. Given all these issues, the US recovery has become highly dependent on the surging growth in developing economies such as China. US companies are increasingly targeting these high growth markets for exports as the US consumer works to get his financial house in order. Essentially, with only modest economic growth domestically, investors are borrowing growth from more vibrant economies and markets. We expect the process of deleveraging by the US consumer will take a period of years, so our ability to tap demand in overseas markets will be of utmost importance for quite a while.
The conventional wisdom (held by the Fed, among others) is that inflation is not an issue in the US because our consumers spend only a small portion of their income on food & energy. According to an annual study by the Bureau of Labor Statistics, about 17% of the average consumer’s total annual expenditures are for food and gasoline. Housing is by far the largest expense for most US consumers at 34.4% of total annual expenditures, on average. At the same time, labor is a much higher cost in the production of goods and services in the US relative to developing economies. Therefore, the logic goes, as long as labor costs are well contained, more widespread inflationary pressures in our economy will be avoided. It is hard to argue that wage inflation is in our future with unemployment at 9.0%.
By contrast, consumers in China and other emerging markets are much more sensitive to surging commodity costs. A much higher portion of the average consumer’s income is spent on food, and commodities prices are much more important to the total cost of production of goods and services. Therefore, the central banks and governments of these countries are likely to increasingly implement measures to avoid continued spikes in food and energy prices. The risk is that these measures go too far and wind up crushing the fabulous growth rates that these countries have enjoyed for many years. If this were to happen, growth in the US would undoubtedly languish as well.
We also suspect that the Chinese government and central bank is concerned about real estate bubbles. Recent initiatives to raise reserve and capital requirements and curb lending suggest that the government would like to reduce the speculative real estate purchases that have led to massive increases in property values. Perhaps the Chinese have learned a lesson from our experience here in the US, where Greenspan’s low-rate policy contributed to a housing bubble of astronomical proportions. In any case, the authorities are walking a fine line as they try to carefully let some air out of a bubble without causing a massive correction.
Whether the Chinese government is acting to curb real estate bubbles or to slow commodity price inflation, the effect is the same. If successful, tighter monetary policy and stricter bank lending standards are likely to slow growth materially. If these policies are not successful, we might have even bigger problems on our hands as commodity prices continue to surge and housing develops into a much bigger problem.
A potential slowdown in the emerging markets is a risk factor that every U.S. investor needs to monitor closely. U.S. blue chip multi-national companies are uniquely suited to navigate such a slowdown and to ultimately emerge as stronger companies once growth returns.