April 13, 2014 7:07 pm

Slowdown puts 1bn middle class at risk

The Fragile Middle

Almost a billion people in the developing world are at risk of slipping out of the ranks of a nascent middle class, according to FT analysis, raising questions about the durability of the past 30 years’ remarkable march out of poverty.

Rising inequality and slower global growth raise issues for businesses that have been investing heavily in emerging markets.

One of the biggest questions confronting governments is what slower growth will mean for the creation of a solid middle class in countries such as China and India, which many are counting on to drive the global economy in the 21st century.

The IMF last week warned that the world could face years of below-par growth, while economists from the World Bank also cautioned that growth of developing economies was likely to average 2-2.5 percentage points less than that seen before the 2008 global financial crisis.

The Asian Development Bank has defined the entry point to the new middle class as the $2 per day poverty line, adjusting for purchasing power, while other economists have argued that a more robust definition begins at $10 per day.

But analysis by the FT of World Bank income distribution data from 122 developing countries since the 1970s makes clear that most of the millions who have risen out of poverty in recent decades are sitting in what is best described as a “fragile middle” between those two lines.

There were 2.8bn people40 per cent of the world’s population living on $2-$10 a day in the developing world in 2010, the most recent year for which data are available. That makes the fragile middle the world’s biggest income group.

Moreover, many of those lifted out of poverty remain in an even tighter band only just above the $2 per day line. There were 952m people earning $2-$3 a day in the developing world in 2010, according to the FT analysis, a vulnerable segment that has grown more quickly than any other across the income spectrum.

FT Series: The Fragile Middle

Data Graphic
Fragile middle
Data show 2.8 billion people in the developing world sit just above the poverty line, at risk of slipping back as emerging market economies slow

The FT analysis also showed a strong correlation between poverty reduction and growth, with the relationship tending to be stronger among countries with higher GDP growth rates. Across the so-called Bric and Mint countries, India, China and Indonesia exhibited the strongest relationships between GDP growth and a reduction in the share of their population earning less than $2 per day since the late 1970s. These three countries also had the highest average annual real terms growth over the same period, each growing 5.5 per cent or more.

One of the things that concerns development economists is that, even before economies began to slow, the “churn” between those below and those immediately above the poverty line remained high. According to the World Bank, in countries such as Indonesia more than half of those below the poverty line were above it the year before.

The International Labor Organisation said it was already seeing the effect of slow growth in emerging economies, with the number of workers worldwide in extreme poverty declining only 2.7 per cent in 2013, one of the slowest rates seen over the past decade.

In an interview, Kaushik Basu, the World Bank’s chief economist, warned that many of those people who had emerged from poverty in recent years remainedvery vulnerable” to slipping back. He also said the world economy faced risks, including the possibility that China’s growth could slow even more than it has already, something that would have big repercussions for the developing world.

Even if that risk did not materialise, Mr Basu said, current growth would not be enough to return to the sort of poverty reduction seen in recent decades.

To make up for that, he said, “governments need to do more, much more, in terms of structural reforms in developing countries”.

The risk if they did not, he said, was the stalling of decades of progress in the fight against poverty and in the creation of a middle class deemed so vital to the future of the global economy.

Copyright The Financial Times Limited 2014.

A Weak Dollar Environment

Apr. 13, 2014 8:21 AM ET

by: Joseph Calhoun

The U.S. Dollar index exhibits the classic characteristics of a downtrending asset: Declining 50 and 200 day moving averages with the 50 solidly below the 200. Momentum indicators (MACD, PMO) both on sell signals.

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A longer-term view shows the index on the edge of support:

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A break of the 78-79 support level would open the way to a return to the lows. A very long-term view on the monthly chart shows some reason for optimism as the index has built a base over the last few years:

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Unfortunately this dollar stability of the last few years is somewhat of a mirage. Other indicators of the value of the dollar, such as gold and general commodity indexes, have been much more volatile. Regardless, from a technical perspective, all these charts point to a return to the weak dollar environment we experienced from 2002 to 2008. The reasons for renewed weakness are hard to pinpoint (as always) but I've always viewed currency values as measures of growth expectations. Interest rate differentials do play a role but not as much as most suppose.

Fear of weaker growth can be seen rather starkly in the Treasury market:

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The long term Treasury ETF (TLT) has been rallying rather hard since the beginning of the year defying the market expectation of the opposite as the Fed tapers its QE program. Of course, anyone who bothered to look at what happened after the end of previous iterations of QE isn't surprised by this development but the expectation that the last QE finally did the trick and moved the economy to a self sustaining expansion is, I guess, hard to kill. The popular, mainstream view of the economy since before the end of last year is that recent weakness is a function of a hard winter, but if that were true one would expect to see the bond market start to reflect better growth expectations as the weather warms. That may yet happen but there is no evidence of it yet.

The weaker dollar also shows up in other assets. A weak dollar has a direct and fairly immediate influence on commodity prices:

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A broad measure of commodity prices, the CRB index, has been moving higher as the dollar has moved lower and bond prices have moved higher. It is somewhat contradictory to see commodity prices moving higher even as the bond market prices in lower growth and inflation but the value of the dollar has a large and immediate influence on the dollar price of globally traded commodities.

Despite a recent correction, gold has also been tracking the movements in the dollar. Gold could also be reacting to renewed expectations of weaker growth and further Fed action but there is no way to know the minds of all the participants in the gold pits.

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I am not a technician and don't invest or trade based solely on chart patterns, but they are an easy way to get a high level view of what is happening in the markets. Often one finds that the market is sending an entirely different message than the one being proffered by the denizens of the sell side. In this case, the dollar index and the bond market seem to be saying that U.S. economic growth is suspect while all the talking heads on CNBC keep talking about a re-acceleration. Who you gonna believe? Wall Street or your lyin' eyes?

A weak dollar, no matter the cause, has implications for investors. Global capital flows move markets and currency trends tend to get reinforced. Momentum isn't just about stocks and trends in currencies tend to persist and overshoot. The dollar fell pretty steadily from 2002 to 2008 until we reached a point where the imbalances were too large and had to be corrected. If this is the beginning of a new downtrend, a look back at that previous period may be instructive.

A fairly obvious implication is that foreign stocks tend to outperform during periods of dollar weakness. This makes sense as the flip side of weak dollar is a strong foreign currency which adds to an investor's performance. In the previous weak dollar period, the EAFE outperformed the S&P 500 by over 60%:

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Emerging market stocks reacted even more positively:

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Commodities and gold also tend to outperform in weak dollar periods but the correlation is not as strong. It seems that dollar weakness has a strong influence at first but then fades somewhat as commodity producers respond:

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Foreign stocks are not yet outperforming their U.S. cousins but they have at least held their own and the EFA:SPY chart has built a base:

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Emerging markets, although they have outperformed very recently, haven't yet broken their downtrend:

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It does seem contradictory for foreign stocks to outperform if the message of the dollar index is weaker growth expectations in the U.S. Much of global growth is dependent on U.S. growth, especially in emerging markets, and it is hard to see how foreign economies and markets might outperform if U.S. growth declines further than it already has. I've never bought the decoupling thesis and if U.S. growth falls to recessionary levels, the rest of the world will feel the pain. It may be though that the message is one about relative growth rather than absolute growth rates. One thing we do know is that foreign markets are generally cheaper than the U.S., so shifting a larger portion of one's portfolio to non U.S. stocks would seem prudent regardless of the direction of the dollar.

I don't know yet whether this is the beginning of a new trend for the dollar but it certainly bears watching. Investing during a weak dollar period is different than a stable or strong dollar environment. Generally with a weak dollar, one would want to favor foreign stocks and hard assets such as real estate and commodities or commodity producers. Stable and strong dollar periods are generally favorable to U.S. stocks and negative for real assets.

If this is the beginning of a new trend lower for the dollar, a lot of investors are going to have to adjust to the new environment. That may explain the recent weakness in U.S. stocks as much as anything else as traders try to anticipate the emerging new trend. Another possibility is that the talking heads on CNBC are right, the U.S. economy is about to take off and all this will get reversed in short order. Nah

April 13, 2014 8:04 pm

This could be the moment for Greece to default

It not in recession nor is it recovering. It has collapsed. But there is another story

A Greek national flag flies from the roof of Athens University near statues of the ancient Greek philosophers Socrates, left, and Plato, right, in Athens, Greece, on Tuesday, May 22 2012. Syriza's opposition to the terms of Greece's financial-aid program doesn't mean the country would have to abandon the euro if the party forms a government after June 17 elections, party leader Alexis Tsipras said. Photographer: Angelos Tzortzinis/Bloomberg©Bloomberg

While the financial world is celebrating the Greek return to the bond markets, I am asking myself this question: is this a good time for Greece to default on its foreign debt? It is not a subject of polite conversion in Brussels or Athens. Nor does it appear to be a popular subject for investors’ conferences.

For the first time since the crisis Greece is in a position to default. It has a primary budget surplusbefore interest payments. The European Commission has forecast the primary surplus to reach 2.7 per cent of gross domestic product this year, rising to 4.1 per cent in 2015. The Greek current account registered a first surplus. Greece is no longer dependent on foreign investors.

Of course, just because you are in a position to default does not mean that you should. So how should one think about this?

Greece is probably now close to the bottom of its economic slump, which started six years ago. Between 2008 and 2013 real GDP shrank by 23.5 per cent and investment by 58.4 per cent. The most recent labour force survey showed unemployment at 26.7 per cent in January. The rate of youth unemployment in 2013 stood at 60.4 per cent. Bank loans to businesses were down at an annual rate of 5.2 per cent in February. Non-performing loans have reached a level of 38 per cent of the total. Bank deposits are shrinking.

More shocking than those relative changes are statistics that put the data in perspective. Yanis Varoufakis, a Greek political economist, recently produced a long list, of which I found the following most striking: of 2.8m Greek households, 2.3m have tax debts they cannot service; pensions are the main source of income for 48.6 per cent of families; and 3.5m employed people have to support 4.7m unemployed or inactive people. The Greek economy is not in recession. Nor is it recovering. It has collapsed.

But there is another storythat of the bond salesman – who says Greece is the biggest rebound story in modern times. Piraeus and Alpha, respectively the second and fourth- largest banks, managed to raise equity capital of almost €3bn between them. Last year, it was mostly the hedge funds who took a gamble on the country. More traditional investors have been piling in since. Last week’s five-year sovereign bond issue attracted €21bn in offers from more than 600 mostly international investors.

If I can discern any strategy in the official eurozone policy towards Greece, I would describe it this way: let’s generate a massive financial investment bubble and hope some of the money trickles down into the real economy eventually. With a debt ratio projected to rise to 177 per cent of GDP this year, Greece does not attract much real investment on the ground from overseas right now. Nor can it generate domestic investment because of its broken banking system.

If the government could auction off its stake in the banks, it could use the funds to create a “bad bank” to take over the non-performing loans. Once the European Central Bank has concluded this year’s stress tests, a reinvigorated banking sector could start lending to a lean and reformed economy. Problem solved.

But it would take quite a bubble to get to that point. The reason Greece was able to attract so much interest in last week’s bond issue was a combination of the promise of a high yield and the maturity profile of existing Greek debt. Official loans – from eurozone member states and the International Monetary Fundmake up 80 per cent of the total debt. Greece will not start to repay this until 2023. In other words the country is solvent in the short run. But long-run solvency is far from certain.

And this brings us back to the fundamental problem: who in their right mind is going to make a long-term investment in a country with unsustainable long-run debt? I find it hard to see how one could generate an investment boom unless and until that official debt is forgiven, or defaulted on. The cleanest way to do this would be through a debt conference, but the creditor countries do not want to hear about it.

Now contemplate the alternative. Greece defaults on all its foreign debt. It establishes a new currency that would immediately devalue. To lock in the competitive gain – to turn it into a real devaluationwould require a central bank with a credible inflation target and sufficiently deregulated labour and product markets. This is not a soft option, and would require a lot more structural reforms than Athens has so far undertaken.

While such a scenario would freak out foreign investors when it happened, they could be relied upon to forget it quickly, and come back quickly. After all, the probability of a default is lowest right after you have defaulted. At that point, a reformed Greece should be very attractive to foreign investors, not just financial investors.

I am not advocating exit. Greek voters and foreign investors should however know that Greece is now in a position where there is a choice.

Copyright The Financial Times Limited 2014