Previous post: Monday 18th January 2010

Fast Boat to China
Investors endured a few volatile sessions in the markets last week following impressive Chinese trade data which led the country’s central bank to tighten liquidity. Initially, equity markets rallied strongly at the start of the week in response to economic data showing that China’s exports had risen 17.7% in December and imports by a massive 56%. However, news that the People’s Bank of China (PBoC) had started to rein in liquidity by increasing the bank reserve requirement ration sent markets into reverse. The PBoC also raised the yield on one-year central bank bills.

The Bank’s hand was forced following reports of a surge in lending by Chinese banks in the first week of this month – as much as £54bn in five frenzied days, according to The Daily Telegraph. Last year, banks were encouraged to increase lending following the government’s $586bn stimulus package which has succeeded in enabling the economy to achieve high levels of growth – back to where it was before the financial crisis. Suitably encouraged, Chinese banks went on a £900bn credit-creation binge in 2009 and were clearly intending to do the same this year until the Central Bank’s intervention.

The Chinese government is in a rather invidious position. On the one hand it needs to maintain high growth – the economy has averaged 10% over the past few decades, according to The Times – because a slowdown could lead to serious unemployment and social unrest as well as badly hitting its trading partners and commodity markets. Indeed, the World Economic Forum (WEF) said an abrupt slowdown in the world’s most populous nation was identified as the most likely of more than 36 threats to the world. On the other hand, if growth is too fast then it brings inflationary threats and a possible asset price bubble – the second economic threat according to the WEF. In December, property prices across China’s 70 largest cities surged at their fastest pace since 2008 – up by an average of 7.8%, according to data from the National Development and Reform Commission. The country also overtook the US as the world’s largest car market last year, with sales of 13.6m (compared to 10.4m in the US) – up some 46% on the previous year.

So the pressure is on the government to steer its way through a sea of potential problems and the situation is not being helped by the fact that it’s already huge foreign exchange reserves have burgeoned further in the last quarter of the year. The Financial Times reported that China’s reserves, by far the largest in the world, grew to $2,399bn last year as it continued to accumulate foreign exchange – the corollary of its policy to effectively peg its currency at an artificially low rate to the US dollar – and its trading partners accuse China of pursuing mercantilist policies. “The increasing risk of overheating and a fast rebound in CPI inflation combined with the stronger-than-expected recovery in exports will all result in rising pressure for renminbi appreciation in the coming months”, commented HSBC’s chief China economist Qu Hongbin. With the tightening unsettling investors, economists mulled over further possible moves, with UBS commenting “If the authorities value social stability over asset prices, more aggressive moves may be in store”.

Think Positive
Here in the UK the economic news was broadly positive and according to one of the country’s think-tanks, the National Institute for Economic and Social Research (NIESR), Britain will have emerged from its deepest recession since the Second World War when official data is released later this month. The NIESR forecast that the economy is likely to have grown by 0.3% in the last quarter of 2009 – equivalent to 1.2% in a full year: far from the strong bounce that is usually associated with deep recessions. Closer examination of the data shows that, whilst the services sector is growing and consumers are spending, manufacturing is still struggling and not rebounding to the extent expected, with production flat in November for the second consecutive month. Conversely, shopkeepers enjoyed their strongest December sales growth since 2005, according to the British Retail Consortium. In the housing market the picture is beginning to look a little more mixed, with house price falls in the North and West Midlands last month, whilst prices continued to rise in every other UK region. The South East has enjoyed the strongest growth and investment fund London Central Property said prices in the capital will have returned to pre-credit crunch levels by the end of the year.

With the consensus being weak and anaemic growth during 2010 for the UK, the one main theme to be gaining traction amongst economists is that Britain will be more reliant on the world economy and exports. One of the UK’s leading economic forecasters, The Ernst & Young ITEM Club, say that with the consumer completely ‘cashed-out’ and unable to fund a recovery, Britain will have to start selling into countries such as China to stand a chance of sustainable growth. This point was discussed in The Sunday Times by economist David Smith. He said that when world trade grows, experience shows that UK exports do well and the outlook is looking good for exporters. The Bank of England agrees and said last month that “The significant exchange-rate depreciation since the summer of 2007 should boost exports and reduce imports in the coming quarters”.

But although, on a trade-weighted basis, the pound has lost about 25% against rival currencies, British exporters are not making big inroads into foreign markets. The Times thought one possibility was that exporters are maintaining prices rather than using currency gains to become more competitive. “The foreign currency prices of our exports have not changed much over two years. Holding on to workers is expensive. Margins are being squeezed by labour cost” was the view of Barclays Capital’s chief economist Simon Hayes. But the CBI thinks it may be too early to expect a boost from the weakness in sterling, with growth in the UK’s main trading partners – Europe and America – only just emerging. “We don’t have the market share in developing countries of some of our competitors, such as Germany” the organisation said. And it seems that even Germany’s recovery has begun to stall – official data showed that GDP unexpectedly fell at an annualised rate of 5% in the final quarter as the country ceded its title to China as world exporter champion.

Setting Sun
Whilst China goes from strength to strength, its neighbour, Japan, just seems to become more sickly. After numerous false dawns, the Japanese economy has lurched from weak growth back into recession and last week Japanese machinery orders – a key driver of Asia’s second-largest economy – crumpled at what The Times described as a “shocking pace”, sliding to levels not seen since the late 1980s. Orders in November were 11.3% lower than the previous month and hit a 23-year low. The numbers cast a shadow over a fragile Japanese economic recovery and have led many to suspect that the government’s efforts to stimulate growth may be fast diminishing as a positive force. “The export-led recovery is struggling to spread over domestic private demand” said a senior Cabinet Office official. The central bank also issued data showing that wholesale prices fell by a record margin last year, with analysts taking the view that deflationary pressures are now anchored throughout the economy. But Julian Jessop of Capital Economics said it was not time to tear up 2010 forecasts for Japan, adding “For a start, although orders appear to have resumed their downward trend, even the core data are very erratic from month to month”.

In spite of the news, Tokyo had another good week with equities managing to gain 1.7% and in China the Shanghai Composite recovered earlier losses to end the week marginally higher. Elsewhere, equity markets proved resilient, with Wall Street ending only slightly lower. The US Federal Reserve’s so-called Beige Book report, which gathers together the economic views of the 12 Federal Reserve districts, showed conditions improving. US economic activity, whilst remaining at a low level, was improving modestly and beginning to broaden out to include wider swathes of the country. It said that home sales began increasing in most parts of the country as 2009 ended, especially for lower-priced homes. The Beige Book report will be used by US central bank policymakers when the federal open market committee meets later this month to decide whether to adjust monetary policy. Bond and equity markets are not anticipating any increase in interest rates whilst the recovery remains nascent.

Yield Hungry
The direction of interest rates is understandably important to many people and with interest rates at an historic 350 year low, whilst very beneficial to borrowers, this has impacted on returns from deposits, hurting savers. As the economy begins to recover the big question is when interest rates are likely to be increased? Well, in The Sunday Telegraph’s ‘The Markets’ column, the view was that it is unlikely anytime soon, arguing that recovery is far from assured. Unemployment is high, UK fiscal policy will tighten whoever wins the election, the debt overhang will snuff out any inflationary pressure and crucially, policymakers will not repeat the mistakes of 1930s America and 1990s Japan. So what choices are there for investors who are seeking income? The press focused on investing in equities and using managers such as Neil Woodford – The Sunday Times’ choice – to pick out those companies with a good track record of increasing dividends over the medium to long term. Mr. Woodford currently prefers to own more defensive stocks, such as pharmaceuticals like AstraZeneca and telecom stocks such as Vodafone, where yields are high and secure.

Away from equities, The Financial Times said that investors keen to profit from the fledgling recovery in prices for office space and shopping centres are buying into commercial property funds. For the last few months property funds have been popular with investors, following a long period when falling property values deterred them. Commercial property funds can yield up to 7% and, the paper said, appeal to income investors looking to diversify from fixed-income funds. Property is widely regarded as a ‘late-cycle’ investment as its performance tends to lag behind equities and bonds. So now, some analysts believe, conditions are ripe for buying-in. Although rental income is still falling in some areas, experts predict they will rise again as the economic recovery gathers pace. Also, the supply of new property is expected to drop sharply due to the number of projects being mothballed or aborted, which should support prices of existing properties. As ever, the best strategy is to ensure wide diversification of assets to reduce investment risk.

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