Just a Fleshwound?

Do the falls of January show that the global economy is mortally wounded? Or is this merely a pause in an ongoing rally?

Three major stories developed in January that have been linked to the market falls. The "Volcker plan" in the US; the travails of Greece (plus other countries on the EU periphery); and, attempts by the central bank of China to slow down the pace of lending to the economy.

Out of these, the Volcker plan is likely the least important in driving markets in the near future. The objective of the plan is to limit the activities of US financial institutions and thereby reduce future systemic risks to the financial system. (That it also fulfils a more populist agenda of being seen to be tough on the banking industry no doubt helps its appeal.).

However, the situations regarding Greece (plus Spain and Portugal) and China deserve more immediate attention.

In January, a number of high profile claims that China was a bubble waiting to burst ("like Dubai times 1,000, or worse") were echoed by comments from Chinese officials about overheating housing markets and a move by China's central bank to increase bank reserve requirements and thereby dampen growth in lending.

Suddenly, China bears seemed to find their voices en masse. Comparisons were made between China today and Japan in 1989. And China matters. A huge reason for the comparatively mild slowdown in global economic activity in late 2008 / early 2009 (compared to what was often anticipated at the time) was down to the fact that China's economy kept going. This helped to power Asia (and by extension, the west) through the worst of the downturn.

Or perhaps the worst of the downturn so far...

The bears' case is that China's growth has been driven largely by unsustainable levels of government and private investment - that the sheer scale of this investment means that much of it is being wasted on 'bridges to nowhere'.

They cite a splurge in bank lending, evidenced by very high residential property prices in key cities and high vacancy rates in recently completed office towers, a 72% year on year increase in car purchases, a 10.7% increase in GDP, booming industrial production and retail sales.

But the reality is that whilst certain markets - notably residential property in key cities - could easily suffer significant falls, the Chinese economy as a whole does not show the sort of overheating apparent in 2007 when the Chinese stock market was obviously in a bubble situation. (Here is an article I wrote on the subject.). At the time, every man and his dog were setting up trading accounts to get in on the market. The rise in the Shanghai Composite in the two years to May 07 significantly eclipsed the rise in the NASDAQ in the two years prior to the TMT crash.

In comparison, the fundamentals of the Chinese economy look relatively sound today.

Yes, the Shanghai Composite could easily fall (or rise) dramatically in the short term. Yes, residential properties in key cities look overpriced. But many residential properties are bought without mortgages and for those involving mortgages the loan to value ratio is typically low. Consumer debt is very low - the typical household has debt totalling only 35% of its disposable income. Compare that to 130% for Japanese households in 1990 and to 169% for UK, 140% for US and 213% for Icelandic households in the run up to the credit crunch! On this basis it would appear that there is a far stronger case for likening the US / UK to Japan in 1989.

It is true that some investment spending will be wasted. But some investment spending, no matter how badly required, is always wasted. The reality is that China needs a high level of investment spending. And, unlike much of the stimulus in the US (which was paid to bankers and people looking to purchase new cars and properties), investment into infrastructure in China stands a very good chance of further boosting China's ability to grow over the longer term.

From an economic standpoint, China would appear to represent a far more solid economic positive in the medium to long term than do the economies of the UK, US and EU nations.

Maximum Drawdown for 2009

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