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Economy

India versus China: A race that looks like it is already won. Why India could be a powerhouse

By | Economy | No Comments

It should not come as a controversial statement (at least within the context of this article) that the world is set to suffer from a slowing-population problem as well as an ageing population problem.

We are already seeing the growth rates slow drastically across key economies, which is mostly due to a combination of a falling birth rate (less people choosing to raise large families) and a slowing death rate (people living longer). The migration rate also plays an important role, although is variable depending on the country in question.

India is a stand-out over the next 15 years

Overall, India remains well placed in absolute terms, with their population expected to grow at approximately 1.0% for the 2016-2030 period. To put the importance of this in context, China appears set to see its population growth slow to just 0.2% as a consequence of their historical one-child policy (the change in policy is not expected to help for decades), and worse still, is set to fall nominally in 2026. Australia remains quite small and nimble on a global scale, and despite an overall population increase from 7.4 million in 1945 to close to approximately 25 million today, is expected to continue growing close to 0.9%pa over the coming 15 years.

India versus China is looking like a one-sided issue

The population trend between China and India is remarkable, although needs to be considered in the context of household spending if it is to impact economic growth.

In India, the population trend is one of the best globally, which works very well given the structure of the economy, whereby household spending accounts for 58.0% of GDP (more than Australia but less than the USA). It could also be argued that India are set for greater household effectiveness, especially given the low GDP per capita baseline (relative to mature economies) and an intense focus on education standards. On this basis, it seems to be a glaring opportunity for Australia to redirect its exports; however, this won’t be without challenges as India is far more self-reliant than China and does not have the same need for iron ore or coal.

China on the other hand, has a far worse population trend despite the scrapping of the one-child policy. However, it is also important to realise China are far less reliant on household spending to drive economic growth. In fact, Chinese household spending accounts for only 37.4% of GDP, meaning a falling population may have a smaller impact if trade continues to grow. There is also scope to grow GDP per capita by a significant margin, which could add to total GDP beyond the concerning population trend.

Deeper analysis of the working population

An added advantage for India is that they have a young population. This means more workers and less retirees, which by extension implies a greater ability to earn more income and hence increase household spending. There are many ways to explain this concept, but one of the most important from an investors perspective is to view the ‘prime’ working population, defined by 45-64 year olds. Some people are calling this the “peak spender theory”.

 

What can we learn from the above?

Based on this evidence, a falling population growth rate could have substantial implications for the future economy. A living example is Japan, where a falling population has created the “lost decade(s)” despite some of the strongest growth rates in GDP on a per capita basis. For many of the key economies, including the USA and China, this falling population growth rate could have material implications and be deep-rooted as a structural headwind to long-term growth.

Whether this causes an economic disaster is a much harder question. On face value, there is enough evidence to suggest that falling population growth rates are severe enough to substantially increase the risk of an economic demise. This logic follows the path that lower growth increases the risk of periodic recessions and hence creates potential for social unrest and debt-fuelled policies (we are already seeing this in the USA, Europe and Japan).

However, there is insufficient evidence to suggest the inevitability of an economic demise on the basis of population trends alone. On this note, it is important to reiterate the difference between a falling population and a falling growth rate in the population. The latter is far less severe, which would explain the difference between Japan (which has suffered a falling population), versus the USA (a slowing growth rate).

 

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Evidence for the long-term: economic growth could increase until 2026 then slow thereafter

By | Economy, Headline Article | No Comments

If Brexit and Donald Trump have taught us anything, the world is getting tired of the slow growth status-quo. According to exit-polls from the USA election, the biggest reason for voter dissatisfaction is the state of the economy.

While it is not exactly clear what voters expect to see from the economy (unemployment is near cyclical lows and both economies have been recession free for several years), what is clear is that people are desperate for greater wage growth and GDP growth at a household level.

Therefore, we are digging under the hood of this economic concern by looking deeper into the population statistics. What we find is not particularly favourable in absolute terms, although we find that Australia and India are better placed than most. As a part of this analysis, we conclude Donald Trump is pushing uphill to “double the growth rate” as he suggests.

Is there a link between the population and economy?

The real economy relies heavily on population growth; both logically and practically. There are many ways we can verify this importance, however one of the best ways is to illustrate it over the very long-term by showing the 20-year trend of the economy, household spending and population growth. This is an effective method because it massages out economic cycles and shows that all three are intricately linked and generally mean-reverting in the long-term. Below is the case for Australia, showing a strongly aligned relationship.

The unemployment rate will be a critical factor to household spending in the short-term, however is generally seen to be cyclical. Therefore, while an unemployment spike is very likely to coincide with an economic downturn, over the very long-term it gets largely massaged out as excess capacity shifts in waves. Similarly, household savings could have a material impact in the medium term, as people spend more or save more depending on the state of the economy. However, in the very long-term this can also be expected to remain somewhat cyclical.

Employment considerations should be contemplated more broadly though. With an ageing population and extended life expectancies, we can anticipate that the percentage of the elderly workers will increase (as in the case of Japan). We may also see a higher percentage of individuals enter the workforce (especially in countries with a low female participation rate), which could provide further upside. These factors all materially impact the growth outlook.

What does it mean going forward? Why slow-growth may be the new-normal after 2026.

Using population and peak spender logic, we can illustrate the “population effect” and the added “ageing population effect” as per the chart below. This uses the Australian Bureau of Statistics expected population projection (accounting for expected changes in birth rates, death rates and an estimate of net migration) and is adjusted for the “peak spender theory” in the dark blue dotted line. We find the ageing population is expected to support the Australian economy in the short-term but will slow thereafter.

 

Take it as a grain of salt

While our analysis is a brave attempt to provide clarity and logic to an uncertain dynamic, it should not be considered a guarantee by any means. It must be understood there is significant scope for error. To provide full transparency on the scope for error as we see it, below are some of the points worth considering.

First and foremost, the entire premise of this analysis is that the economy and household spending are intricately linked. If this breaks down, the accuracy of the analysis breaks down. While we are confident in the link remaining to some extent (there appears no logical reason it wouldn’t), the reality is that household spending accounts for 55% of GDP which leaves 45% unaccounted for. Therefore, if we see a period of structural change in the remaining 45%, GDP could move markedly from the population trend.

There are also significant risks to any changes in what we’ve labelled as “household effectiveness”. The pace of innovation and technological development continues to drive progress at a household level, but our assumption this will continue at approximately 2% has inherent scope for error. Whether it is 1%, 2% or 5% is anyone’s guess in a world of robots and driverless cars.

The projection data is also subject to potential error, as birth rates or migration rates could change between now and 2100. There are also event risks, such as a world war that could materially impact both population numbers and household spending. A major asset market crash could have a similar impact and interrupt the trend significantly to the downside.

Lastly, from a technical perspective we have considered GDP in real terms throughout our analysis, meaning inflation has been discounted. The reason is that the relationship between population change and inflation is complex, due to the interaction between money supply and the velocity of money. Withstanding this, any period of hyper-inflationary or deflationary conditions could create further inaccuracies.

 

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IMG_0801 (480x640)Drawing attention to the outlook and big themes present in the economy is always a healthy perspective. Below are a number of key themes to think about as you monitor your portfolios as a long-term investor:

  • Baby boomer industries to thrive. The percentage of people aged over 60 years old in the Western World is rising at an unprecedented rate. It therefore makes sense to focus on industries which profit from this sector. Any company which derives sustainable profits from wellness and good health could have appeal. Healthcare, consumer staples, recreation/travel and utilities are all areas of focus, although beware of stretched valuations in some of these popular sectors.
  • Asian outbound tourism to grow. A rapidly growing middle-class in China, India and other emerging economies means greater demand for tourism and luxury goods. Chinese outbound tourism is now bigger than the USA with 83 million people travelling, up eight-fold since 2000. This won’t stop here, so it is worthwhile comprehending how you can profit from this trend.
  • Technology will advance beyond mobile and tablets. Only 20 years ago, Google didn’t exist, Nokia phones weren’t yet popular, CD players were yet to hit their peak and Kodak cameras with film were in their prime. It is dangerous to predict the future of technology, except to expect that it will move fast and unpredictably. Steady profits rarely come from this space, so long-term investors are better to think about companies that won’t be disrupted by technology than those who provide it.
  • A combination of high debt levels and rapid credit growth will be unsustainable. The world of rapid credit growth and excessive debt is not sustainable and appears more likely to deleverage or stagnate. In other words, you will probably want to think about whether your investments can thrive in a world of shrinking or stagnating debt. High earnings growth from traditional banking in western markets may be difficult.
  • The need for infrastructure will grow. The global population will continue to rise, even if at a slightly lower percentage, and infrastructure investment will be required. It is worthwhile thinking about the companies that can reduce the burden of increasing traffic and make steadily growing profits by doing so.
  • Food sustainability will become a global issue. With increasing food demand and less land per capita than ever before, a rising middle-class in emerging markets and greater education on the climate implications of food production, we will likely see a movement towards more sustainable food sources.  
  • Geopolitical tensions will remain. Islam is the fastest growing religion in the world and acts of terrorism are increasing. Unfortunately, 10 years henceforth will probably still have geopolitical issues which will cause ongoing volatility.
  • European political tensions will be ongoing. Having one monetary policy stance for 17 countries is problematic and it will be a miracle if the Greek economy fully recovers whilst remaining in the European Union.
  • Clean energy will gain traction. Climate change is a long-term issue that will attract further investment. However competition will be rampant and political intervention could cause disruptions.
  • Bonds to probably disappoint. Bond yields that are currently negative in real terms appear to have almost no option but to go up eventually, and as they do, prices must fall. If nothing else, don’t expect double-digit growth out of bonds.
  • Shares will likely rise, albeit with volatility. Industries will rise and fall, companies will boom and bust, but tomorrow’s companies will generally be more profitable than yesterday’s. The support of a generally growing population and productivity gains means there is every reason to think that shares will rise over the long-term.
  • The labour force will become more educated but less active. Hours worked per person continues to fall, whilst education standards gradually improve. Technology will be a key driver of the future workforce.
  • Quantitative easing is an area to watch. It is the unconventional monetary policy that every distressed economy seems to be reverting to. Unless we start to see consequences such as inflation, this will continue to be the stimulus of choice.
  • Budget deficits are a long-term challenge. With ageing populations, the social welfare system will come under increased strain both locally and globally. This will create ongoing political tension.
  • Commodities are not dead. Withstanding any major improvements in clean energy or future supply, scarce commodities should move higher as global energy demands grow. The Chinese only have 85 cars per 1,000 people, compared to the USA who have approximately 797 cars per 1,000 people. Steel demand is also expected to grow 65% in the next 15 years. In other words, low-cost producers of commodities could still make substantial profits.

The themes above are intended to be thought-provoking rather than strictly predictive. Hopefully some or all of the points resonate with you in thinking about an advancing world. We also warn that investing based on themes requires meticulous care as the underlying investments can be overpriced and leave you exposed. It is worthwhile using Warren Buffett’s wisdom in this regard, “only buy something that you’d be perfectly happy to hold if the market shut down for 10 years”.

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IMG_1116 (640x477)What does it take to identify an impending recession? Obviously, this is an extremely complex question. However, there are at least 10 factors that have had a strong historical track-record of identifying recessions, and below we outline ten metrics to add to your watch-list:

  • Household spending – The amount of money households spend on everyday goods and services is the number one determinant of economic growth. It represents more than half of GDP at 55.7% and is thus a directly attributable indicator and of significant importance to any GDP insight. Household spending changes tend to change instantaneously with the rate of economic growth, however given that consumer confidence tends to go in cycles it is still a useful tool to foresee future recessionary risks.
  • Business investment – Technically called ‘private fixed capital formation’, business investment is a direct line in the GDP calculation and thus has a direct effect on recessionary conditions. Business investment accounts for 20% of GDP so it’s thus seen to be a very important component and indicator for future recessions. Apart from its direct impact, it is also a clear signal of business confidence which has flow on effects for future GDP results.
  • Dwelling formation – Dwelling formation refers to the activities involved in new and used private houses, including alterations and renovations. It now accounts for 5.3% of the entire economy and is thus seen to be strongly correlated with the overall economic growth rate. Similar to household spending, it is seen to be an indicator of consumer confidence and thus has the ability to act as a leading indicator for economic growth. An encouraging signal involves a positive and/or growing rate.
  • Corporate earnings – Corporate earnings refer to the aggregate profitability of businesses and is a data series produced to gauge the health of the corporate sub-set of the economy. If the average company is highly profitable, it makes sense that the overall economy will be expanding. With this logic, we can see a strong correlation between the current status of corporations and the future growth rate of the country. The risk of recession is seen to increase when corporate profitability is deteriorating on average.
  • Yield curve – The yield curve simply refers to the difference in ‘borrowing rates’ on 10 year bonds versus 5 year bonds. If the 10-year bond pays a higher rate than the 5-year bond, this is seen to be normal, however when the opposite occurs it is seen to be the markets way of pricing for a recession. Across the globe, there has been a very strong long-term connection between the shape of the yield curve and the risk of recession. The link in Australia has been relatively weak but remains an insightful measure of risk.
  • Historical GDP growth – It makes intuitive sense that the risk of recession is higher if the economic growth rate is off a lower base. For example, it would seem highly unlikely for a recession to occur from a base of 5% or more, but would be far more plausible to slide into recession from a growth rate of 2% or less. This momentum effect is a powerful force behind economic growth, and for this reason the historical GDP growth rate can be an insightful measure for future recessionary risks.
  • Worker productivity – The driving force behind an economy is the workforce. The more people work, or the more efficient they become, the stronger the economy tends to be. There are many useful measures to track workplace productivity, however the most useful measure tends to be the total number of hours worked as this factors in population growth and demographic changes. A low and/or falling work ethic increases the risk of recession, whilst a growing rate is a positive sign for the future economy.
  • Retail sales – Retail sales is a vital component of household spending and is a very useful measure of the future direction of the economy. If consumers aren’t shopping and money isn’t passing through people’s hands, the economy is unlikely to be growing with conviction.
    If retail sales are falling, there is a reasonably high likelihood that a recession could be impending as consumer confidence becomes dented. History has shown that this connection with GDP is strong.
  • Housing starts – The process to build a house begins with a housing approval or ‘housing start’. This commitment is a clear sign of confidence that the economy will hold up, and marks the commencement of a long list of transactions that eventually push the economy forward. The new housing starts data is subject to volatility, however, if more people are committing to build a new home, more people are signalling their confidence in the economy. This reduces the risk of a future recession.
  • Employment growth – Similar to the workforce productivity indicator, the employment rate is of vital importance for the future prospects of the economy. The total employment growth figure is a more useful measure than the unemployment rate because it accounts for new additions to the workforce. While the employment growth figure tends to have a strong instantaneous correlation with GDP, the indicator has also proven to be an effective measure for future recessionary risks.

Of course, this list is not conclusive and there are an array of other important economic fundamentals that will impact the likelihood of a recession. In reality, there is no such thing as a perfect model, simply because the economy is so dynamic.

Creating a view from the data

Despite the limitations, an individual that wants any form of success should be trying to formulate a view based on the “known-known’s” while acknowledging the inability to predict the future with any precision. On this basis, the Investing Times opens up this research to help its readers, and produces a global recession risk report that is freely available to the public via the link below. This is a value-add service at no cost that covers at least five of the major global economies.

To give readers an idea of what to expect, the chart below is a historical view of the “recession trackers” ability in Australia, with a strong connection between the leading indicators and the future GDP growth rate.

Recession tracker performance

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IMG_0174 (640x480)China is undoubtedly important to the global economy and with embedded signs of rising bad debts, there are enormous concerns surrounding China’s ongoing stability.

Since 2005, China has accounted for approximately 40% of total global growth with the economy growing five-fold in just 15 years. However, jitters are now apparent and the past six months has seen the biggest test for emerging markets since the Asian crisis of 1997. A combination of three key factors are being cited; enormous growth in shadow-banking, bubbling asset markets and indebted local governments.

But just how likely is a financial crisis in China? What is their debt position in comparison to other countries and/or history? And what should an investor need to know in order to make educated decisions in related markets?

The Debt Expansion is Fearsome

A scary and newsworthy chart often put forward by media outlets shows the rapid growth in total debt across China. There are many versions of these articles, however even highly respected news outlets such as the Wall Street Journal (WSJ) and Bloomberg have caused stir with headlines such as “China’s Debt Bomb” and “A Debt Balloon With Nowhere to Go But Down”.

Of course, they are intended to inform their audience, but they also use such headlines to sell newspapers. Therefore, it is important to obtain a balanced view of the data.

The reality shows two important but contradictory points. Firstly, China’s debt has ballooned relative to history on both a nominal basis and in comparison to the size of their economy. In this sense, both the WSJ and Bloomberg are correct. However secondly, this debt expansion was from a very low base which means China is still in line with global peers on both a relative and absolute basis.

A Global Comparison

China’s total debt – accumulated by households, corporates and central/local governments – reportedly rose from 121% of GDP in 2000 to 158% in 2007 and 282% in 2014. This 161% expansion in debt looks unhealthy, but looks considerably worse in absolute terms.

Nominal GDP in China is estimated to have grown approximately 474% in the fourteen years to 2014, meaning the nominal total debt position has increased over 12x from around US$2.1 trillion to $28.2 trillion.

In comparison, no other country has ever encountered the same debt expansion on both a relative and nominal level. However, before everyone runs for the hills it is important to also illustrate the debt position of other key economies that many consider “perfectly safe”.

For example, the latest total debt figures – including public, corporate and household debts – show China has 282% estimated total debt to GDP, the USA has 269%, Germany has 258% and Australia has 274%. Relatively, all four countries have less debt than Japan’s governmental debt level alone.

Therefore, even after factoring in the misunderstood shadow banking, the Western World faces very similar levels of total debt as China according to the Bank of International Settlements. On this basis, China appears to be on track. The only problem is whether they can handle the next inevitable bad debt cycle.

IMG_0153 (640x480)Bad Debt cycles explained

It would be imprudent to brush off China’s debt expansion, including the shadow banking, on the basis of a global comparison. There are many valid reasons to be cautious about China’s debt expansion. Firstly, the composition of the debt is considerably different to its Western peers, with a much greater portion of higher risk corporate debt (especially lower grade non-financial corporate debt). In China, corporate debt represents 67% or two thirds of total debt compared to Australia which has less than half in corporate debt (47%) and the USA which has only 38%.

This debt composition is important on many levels, no less because it affects the speed and severity of any financial crisis, should it occur, plus it tends to lack the same levels of regulation and hence attracts riskier lending. This is a major risk for an economy known for volatility.

Bad and Doubtful Debts

Using the analogy of an individual that over-leverages on debt, it can be universally agreed upon that the greater the amount of debt relative to assets or income, the greater the risk of a severe collapse. For example, a couple earning $200,000pa with a $2 million home and a $1.8 million debt faces severe risk if either the asset or income falls. On the contrary, it also provides the greatest opportunity for growth if the asset value grows at a rate greater than the interest expense. On a country level, this is no different, and for China a high debt level creates this leverage.

The lesson from the “PIGS crisis” in Europe (the debt crisis of Portugal, Ireland, Greece and Spain) was that the real risk of a financial crisis comes from two sources; rising interest costs, typically beyond 7%, or a spike in bad and doubtful debts.

At present, the effective borrowing rate for China, assessed via its bond yield, is healthy at approximately 2.88%. Therefore, the real risk would be a spike in bad and doubtful debts, which is a key dataset to watch.

Will we see a spike in bad debts?

Whether we will see a spike in bad debts in China will relate to the ability of corporate China to meet its debt obligations. In the current environment, this is heavily reliant on three issues; 1) the overall exposure to resource-related debt, 2) whether the property market stabilises to constrain defaults, and 3) whether Chinese capital outflows can be constrained. In many ways, this is no different to the Western World, with the possible exception of capital outflows.

The biggest difference between China and its global peers is the historical analysis of bad debt cycles, with Chinese downturns far more severe and worrisome than Western counterparts. For example, a commonly cited downturn was the 1997 Asian debt crisis, which reportedly wiped more than 10% of bank assets in China. To put this in perspective, a similar episode today based on current Chinese debt levels would create a financial crisis up to 3.5x bigger than the 2007 crisis in the USA. This is scary stuff.

What to do?

It would seem contradictory to expect and/or fear a financial crisis in China without expecting something similar elsewhere in the indebted Western World. In reality, the backdrop of high debt and high asset prices are a common theme among many of the world’s most important economies.

Regardless of whether you think a crisis will occur, it is reasonable to worry about the impact a Chinese financial crisis would have on the global economy (including share-markets), particularly because of its size and historical volatility. Emerging market bond spreads are one way to monitor proceedings, as this is the markets way of telling us the risk of corporate debt, which China happens to have a lot of. Asset prices are another area to monitor, as a sharp fall in either property or equities could be an obvious trigger for a rise in defaults and the commencement of a bad debt cycle.

Patrick Hess from the European Central Bank said it well, when he was quoted as saying, “a domestic financial crisis is not unlikely to happen in China, and very likely to spread globally, should it indeed happen. To implement all the reforms necessary to avert a Chinese crisis is almost a “mission impossible,” or at least very difficult in the complex Chinese policymaking context, which involves a high degree of institutional overlap, conflicting goals and interests, and political bargaining. Even such a strong leader like Xi Jinping cannot change this context”.

At present, it could be plausibly stated that China faces its greatest debt-related risk since the 2007 GFC and possibly since the 1997 Asian Crisis, with capital outflows and asset values showing weakness. For now, Xi Jinping seems to be aware of the risks and we have seen the introduction of numerous reforms in recent times to counter or reduce these risks, and property values appear to have commenced a mild recovery.

Recent economic data shows the debt-train continues in China as it continues stimulating to avoid further capital outflows. However, rather ironically, the more China borrows the greater the risks become. In summary, investors should exercise a high degree of vigilance and monitor Chinese developments very closely.

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