Growth "Conundrums"

We had some very upbeat reports lately on the global recovery gaining momentum and avoiding the double dip. The IMF in its latest report even lifted the outlook from 4,3% (April) to 4,6%. Developing nations will continue to cushion the relative weak developed performance with Europe posting a 1% growth this year. In fact, according to the IMF, a European sovereign debt explosion is the sole weak link in the further overall bright business cycle outlook. For the US, 3% is still in the cards whilst Japan will post a 2,4% growth rate (!). The most positive surprise will come from Brazil (forecast upgraded by 1,6% to 7,1%) and China (10,5% instead of 10%). Though we don't want to sound like Dr Doom and wish the world economy all the best of luck in realizing this scenario, there are some very disturbing indicators questioning this particular roadmap.

In the case of the US, there are still a lot of unresolved questions in the healing process of the real estate market. According to CoreLogic, more than 1 in 7 homeowners with loans in excess of a million USD are in delinquency mode. So the housing bust which began among the working class, has progressed to the suburban middle class and upper class. Looking at the composition of unemployment in the US, the numbers aren't reassuring either. Duration of unemployment has become a structural weakness and hits levels by far not seen during previous recessions : over the past 40 years, it peaked 3 times at 20 weeks, we now register a level of 35 weeks. Other labour market signs - eg 600,000 people stopped looking for work and older employed (65+) outnumbering young employees (16-19) for the first time since 1948 - just prove that this has not been an ordinary recession. Q1 growth was revised down at 2 occasions and stood at 2,8% annualized growth. With the inventory built-up almost completed, it is hard to imagine where the growth driver in the coming quarters will come from to reach 3% for the entire year. Finally, looking at the Alcoa numbers released yesterday, some interesting forward "guidance" numbers came from its capital expenditure lay-outs in Q2 : its capex in Q2 2010 was the second lowest number over the past 4 years (213 mio USD), only beaten by the Q4 2009 number (208 mio USD). In the period Q1 07 - Q4 08, the average quarterly capex stood at +/- 850 mio USD.

Another important observation is that despite the quantitative easing efforts of the FED - buying up distressed assets from commercial banks for an amount of 1,250 bio USD - the transmission mechanism of banks towards the private sector seems to fail : Credit standards are tight, the deleveraging of the US private sector continues :

But there are some other disturbing evolutions amongst which the Baltic Dry index :

The Baltic Dry - a freight price index of dry bulk goods such as iron ore - is a "real" indicator. 90% of international tradable goods go by sea. Most cost in the shipping industry are fixed, depreciation and overheads are a given. The only cost over which management of any business has control in the short term are variable cost, which in the case of shipping are wages and the price of oil. The chart above shows that there's a fairly good correlation between the price of oil and freight tariffs. Over the past couple of weeks, we see however that the Baltic Dry (peak 12,000 Q1 08) has plunged from 4,000 to the current level of 1,840. This is the 32nd sequential daily decline and the longest drop in 9 years. The Baltic Dry also decoupled from the price of crude which since the start of June more or less stabilized in the range 72- 75 USD/barrel. So we could have a business cycle effect on freight prices because "people don't book freighters unless they have cargo to move". If it is a business cycle slowing sign, who is responsible ?

Our usual suspect here should be China - the world's third largest economy - and the looming problems in the construction sector/real estate. The Statistics Bureau earlier reported that Q1 2010 investment in property leaped 35% on a yearly base with prices up 11,7% in March (other unofficial sources claim prices up more than 20%). Another interesting statistic is the ratio house price / household income. This ratio stands at 3,09 in the US, 4,74 in the UK and 6,3 in Australia. In China, estimates now point to a ratio of 9. So why should people buy a house priced 9 times their income ? Probably because you believe that the probability of selling the house at a profit is higher than of living in it in the long term. So prices have been driven by so-called "flippers", the same kind which created the 1925 Florida real estate bust and more recently in the US in general. Finally, looking at two construction sensitive commodities, ie copper and zinc, their price evolution from their 2010 peaks says enough : copper -18% and zinc -27%.

So a further cooling in the Chinese market is a danger going forward. It is also in line with recent steps taken by the Chinese government since April to stop the real estate frenzy, reiterated today by government officials. With this in mind, a 9,5% or 10% growth rate for the Chinese economy might seem very optimistic. If housing price declines should come into play over the coming 12 months - most pessimistic forecasts take -20% into account - a wealth effect will come into play as well with effects on consumer sentiment, just as was the case in the US, based upon the false pre-condition that asset prices can only go up.