On Friday Oct 28, The Commerce Department delivered an impressive headline US inflation-adjusted annual GDP growth rate of 2.9%. Stocks roared when market first opened. After paltry GDP growth in the first and second quarter of 0.8% and 1.4% respectively, could the US economy have finally rid the slow growth malady and ready to re-assert its full potential? On closer inspection, consumption growth which normally accounts for 70% of the economy only contributed half as much this quarter; both business equipment and residential construction contracted during the period. Stocks traded off later in the day as the curious facts spread. Aren’t consumption, capital spending and housing at the very heart of US economy? Then how can the economy grew so fast with its most important elements suffering?
At the risk of sounding like a Dan Brown novel, to uncover the mystery of the surging American economy, we must now travel to Zhangjiagang City, Jiangsu Province, the People’s Republic of China. It is home to China’s largest private steel maker, Shagang Group. As China’s economy slows and transforms from an investment driven growth to a consumption led model, the demand for steel is sagging. Faced with its money losing steel operation and little prospect for growth, Shagang have branched out to speculating in the stock, commodity and real estate markets. After losing money in 2015, Shagang is making profit again thanks to the performance of the wealth management products it had bought. Across China, tens of thousands of firms large and small and millions of individuals rich and poor have bought into these wealth management products, some with guaranteed double-digit return promises. In turn, these wealth management firms, taking advantage of China’s loose monetary policy have speculated on stocks, bonds, real estate and commodities. In 2015, apartment homes in Shenzhen surged 50%; during the first quarter of 2016, the price of iron ore also swelled 50%; then came May, it was soybean meal’s turn for a speculative rise of 40%.
With a strong US dollar and generally weak global economy, export growth in the United States have been hard to come by. Yet during the third quarter, it contributed a mighty 1.2% of the 2.9% GDP growth. This anomaly was caused by a 10% annualized export growth of agriculture products, mainly shipment of soybean from inventory. Indeed, the arbitrage opportunities provided by China’s commodity exchange may very well be the reason for this abrupt event. Without the 1.2% contribution, third quarter GDP would come in below 2% which would have been in line with the previous two quarters’ experiences.
The Unite State 10-year Treasury bond yield have risen from just below 1.4% in July to 1.8% in late October. It is no doubt influenced by the Federal Reserve’s pending interest hike in December. Friday’s strong GDP report seems to justify it as well. Released also on Friday was the Fed’s preferred inflation measure, the Personal Consumption Expenditure. The core PCE which exclude food and energy reached 1.7%, its highest level in two years.
Each generation of economists seems to fixate on the problems of its time. When I first entered the investment world in the early 90’s, the nickname of bond vigilante aptly summed up the collective spirit of the bond market. Any whiff of inflation was met by rising bond yield and alarmed Fed officials as the inflationary world of the early 80’s was still fresh on the minds of investment professionals and Fed governors alike. Today central bankers of the world are openly cheering for the appearance of inflation as prolonged disinflationary environment has become the norm. With such mind set, the pace of interest rate rise in the US will be slow even at the risk of a bit higher inflation.
Despite strong headline GDP growth, much of economic growth remain fragile and propped up by artificial means. Despite headline inflation risk, low interest will remain the policy for much of the world. With both stocks and bonds trading at elevated levels, how should an investor structure one’s portfolio in such an environment? I hope to shed some light to this question in my next post.