Steps to take to keep investing simple. Plus how changes in China are having spillover effects for global economic growth and asset class returns.
In this episode you’ll learn:
- How flocks of birds move together.
- What are examples of simple things to focus on when investing.
- What is a maximum drawdown.
- Why it is important to step back and take a big picture view of the themes driving capital markets.
- How China’s transition to a consumer driven economy is having a spillover effect on other economies and asset classes.
Show Notes
Explaining Bird Flocks – Audubon
Rob Arnott on Long-term Return Expectations
World Bank – Global Economic Prospects – January 2016
IMF World Economic Outlook – January 2016
Peoples Bank Of China Governor Zhou Interview – FT Alphaville
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Summary Article
Why Global Economic Growth Is Slowing
Last year world economic growth is estimated to have slowed to between 2.4% and 3.1% from 2.6% to 3.4% in 2014 according to the World Bank and the International Monetary Fund.
That growth rate fell short of those organizations’ forecasts from just six months prior.
Economic growth measures the increase in global output, the monetary value of goods and services produced around the world. This output is known as gross domestic product or GDP.
GDP growth rate calculations can vary based on the currency exchange rate method used to convert the value of the world’s output into U.S. dollars. Given the recent strength of the U.S. dollar, using current market exchange rates results in a lower economic growth rate than using a more stable exchange rate based on purchasing power parity.
Purchasing power parity is a hypothetical currency exchange rate calculation that assumes a market basket of goods and services is worth the same from one country to the next.
Both the World Bank and the IMF report their growth numbers on a real, net of inflation basis.
The Impact of China
Why is growth slowing and will it continue?
That is a challenging question because in a world that is so interconnected, it is often difficult to point to one catalyst that is driving economic trends.
Still, if I was going to choose a catalyst, I’d select China. China is the largest or second largest economy in the world, depending on the calculation.
Economic growth in China is slowing as the country seeks to rebalance its economy to be more consumer driven.
For three decades, China grew their economy thirty times over by encouraging exports and infrastructure investments. It accomplished this by allowing businesses and local governments to borrow for capital projects at extremely attractive interest rates, well below the rate of inflation.
At the same time, the interest received by households on their bank savings was also below the inflation rate. That meant citizens were losing money every year after adjusting for inflation. As a result, Chinese households routinely saved twenty to thirty percent of their after-tax income for education, healthcare and retirement.
Of course, the ramp up of production and infrastructure investment meant that construction and factory jobs were abundant, which provided households with income that could be saved.
This pattern of encouraging infrastructure investment and exports by keeping interest rates and currency exchange rates artificially low has been phenomenally successful in growing the Chinese economy.
It has also led to corruption, over-investment in some areas, real estate bubbles, and bad debts that threaten the banking system.
China is now attempting to transition its economy so it is more consumer driven.
China and Commodities
In 2010, China consumed 53% of the world’s cement, 47% of its coal, 45% of its steel, and 47% of its pigs, according to data compiled by the investment firm GMO from various sources including Barclays Capital, Credit Suisse, Goldman Sachs, the IMF and the United Nations.
China is still a voracious consumer of commodities, but on the margin the growth in demand is slowing, and that is having a significant negative impact on commodity prices.
Oil prices have fallen over 75% in the past 400 days. Such a large price decline in oil and other commodities is a huge economic drag on commodity exporting nations such as Russia and Brazil, while it can be an economic tailwind for countries that import oil.
To date, the impact of lower oil prices has been a net negative for global economic growth as advanced economies, such as U.S., Europe, the UK and Japan, have seen their economic growth rates improve but not not enough to offset the slowdown in developing and commodity exporting economies.
Too Much Oil
The world is awash in oil. The year-over-year growth rate in the oil supply has been greater than the growth rate in oil demand since late 2014, a highly unusual situation, according to data from the U.S. Energy Information Administration.
The International Energy Agency estimates the supply of oil will exceed demand by one million barrels a day for a third successive year in 2016. Some analysts estimate current oil supply exceeds demand by two million barrels a day.
Oil’s share of global energy consumption has been in a steady decline due to an uptick in energy production from renewables and natural gas, according to data from BP compiled by TerraJoule. Oil now comprises 33% of energy consumption, down from 38% in the year 2000.
Most of the world's increased supply in oil is from the U.S. due to new extraction technologies and heavy investment.
At the same time, developed nations use of oil is declining, which means it is emerging market and developing nations that will have to increase their demand in order to soak up the excess supply.
Those are the same developing nations whose economic growth rates are slowing, both due to China’s economic rebalancing as well as slower export growth for developing economies due to falling commodity prices.
In the U.S., despite the more than 70% decline in oil prices, daily U.S. oil production increased 8% year-over-year in 2015, according to the Energy Information Administration.
Eventually, if oil prices remain low, U.S. oil production should slow as the number of active oil rigs has declined to 439 currently from close to 1600 in the third quarter of 2014, according to Baker Hughes.
No one knows where oil prices will bottom. Some analysts expect prices to fall below $20 a barrel before global supply and demand are brought into balance.
In the meantime, the economic pain from commodity price declines as a result of China’s economic rebalancing is larger than the benefits, resulting in slower world economic growth.
This is having spillover effects for a number of asset classes outside of commodities, including global stocks and non-investment grade bonds, as investors worry economic growth will get worse before it gets better.
