The Chinese model is nearing its end

George Magnus

The country is now going through a crisis of transition, unparalleled since Deng Xiaoping

August in China has been anything but the quiet month of myth. Developments in the equity and foreign exchange markets and even the appalling industrial accident in Tianjin might seem mere bad luck when considered individually. Together, however, they symbolise a slow-motion denouement of China’s economic and political model. The country is now going through a crisis of transition, unparalleled since Deng Xiaoping set out to put clear water between China’s future and the Mao era.

The signs are that it is not going so well. Rebooting the authority and primacy of the Communist party, the pursuit of often contentious reforms, financial liberalisation and rebalancing the economy while trying to sustain an unrealistic rate of growth are complex and mutually incompatible goals.

Deng’s task in a pre-industrial society without a middle class and social media was, in many ways, easier. Determined to avoid the concentration of power in one individual, he empowered government bodies and ministers, especially the State Council and the prime minister, and encouraged openness and a consensus-driven political model. This worked well enough until the 21st century, but gradually tended towards atrophy. The party succumbed to corruption and paid scant attention to citizens’ concerns about social, environmental and product safety.

The economy built up high levels of debt, overcapacity and an addiction to misallocated and credit-fuelled investment.

To address these serious problems, President Xi Jinping has turned the clock back. He has accumulated more power than any leader since Mao and consistently emphasised the Leninist need for “party purity” to avoid the fate of the Soviet Communist party. Among his first policies was an extralegal anti-corruption campaign that continues to this day. He has usurped the authority of government institutions by establishing party bodies, known as “small leading groups”, that are more numerous than ministries and hold sway over the most important functions of the state.
There was doubtless a strong case for some re-centralisation of power in China, especially to implement the party’s ambitious reforms. Yet while some reforms have made progress, many important ones affecting the role of the state in the economy and the introduction of market mechanisms have suffered from dilution and the opposition of vested interests. The clampdown on civil society, media, legal and non-governmental institutions has not helped. A strong central authority, perversely, has stifled important reforms, removed authority and accountability from those institutions responsible for carrying them out and produced conflicted decision-making.
That is why August’s events matter. Encouragement of the stock market was supposed to be a weathervane for market mechanisms and a more efficient allocation of capital. But equities suffered a relapse, following extraordinary support measures estimated at more than $150bn. T

The indices are still flirting with the nadir reached in early July. Caught between its roles as cheerleader and regulator, the government has shown a lack of trust in the very market forces it sought to introduce.

This month’s mini-devaluation of the renminbi was explained officially as an incremental change to China’s financial liberalisation, designed to help the currency’s admission later this year to the International Monetary Funds’s accounting unit, the Special Drawing Right. Yet the action was communicated poorly at best. Again, the authorities have been conflicted, torn between a strong renminbi policy to help rebalance the economy, and a softer one to respond to weakening growth.
Economic statistics this summer, especially for exports, manufacturing and investment, were disappointing, underscoring that weaker performance for the past four years has become impervious to stimulus measures, which this year already add up to more than 1 per cent of gross domestic product.

A central part of the challenge for China will be its ability to manage employment, a more politically sensitive indicator than GDP. The official unemployment rate, supposedly about 4 per cent over many years, is fiction. Current developments in investment and labour-intensive construction, the low registration for unemployment benefits among those without urban registration status, the weakness of the benefit system and the difficulties of finding suitable work for 7m graduates a year are among many reasons to believe that the jobless rate may not only be higher than the 6.3 per cent estimated by the International Labour Organisation but rising.

China’s economic transition was always going to be difficult, but developments this year suggest that things are not going according to plan. The centralisation of power is proving to be a double-edged sword for reform, the anti-corruption campaign is choking off initiative and growth and the economy cannot be kept on an unrealistic expansionary path by unending stimulus.

The time for accepting a permanently lower growth rate is drawing closer. It will test the legitimacy and reform appetite of China’s leaders in ways that will determine the country’s prospects for years to come.

The writer is an associate at Oxford university’s China Centre and a senior adviser
to UBS

China’s Complexity Problem

Stephen S. Roach

Communist Party of China leaders

NEW HAVEN – There are many moving parts in China’s daunting transition to what its leaders call a moderately well-off society. Tectonic shifts are occurring simultaneously on several fronts – the economy, financial markets, geopolitical strategy, and social policy. The ultimate test may well lie in managing the exceedingly complex interplay among these developments. Is China’s leadership up to the task, or has it bitten off too much at once?
Most Western commentators continue to over-simplify this debate, framing it in terms of the proverbial China hard-landing scenarios that have been off the mark for 20 years. In the wake of this summer’s stock-market plunge and surprising devaluation of the renminbi, the same thing is happening again. I suspect, however, that fears of an outright recession in China are vastly overblown.
While the debate about China’s near-term outlook should hardly be trivialized, the far bigger story is its economy’s solid progress on the road to rebalancing – namely, a structural shift away from manufacturing and construction activity toward services. In 2014, the services share of Chinese GDP hit 48.2%, well in excess of the combined 42.6% share of manufacturing and construction. And the gap is continuing to widen – services activity grew 8.4% year on year in the first half of 2015, far outstripping the 6.1% growth in manufacturing and construction.
Services are in many respects the infrastructure of a consumer society – in China’s case, providing the basic utilities, communications, retail outlets, health care, and finance that its emerging middle class is increasingly demanding. They are also labor-intensive: in China, services require about 30% more jobs per unit of output than do capital-intensive manufacturing and construction.
Largely for that reason, China’s employment trends have held up much better than might be expected in the face of an economic slowdown. Urban job growth averaged slightly more than 13 million in 2013-14 – well above the ten million targeted by the government. Moreover, the data from early 2015 suggest that urban hiring remains near the impressive pace of recent years – hardly the labor-market stress normally associated with economic hard landings or recessions.
Services are also the ingredient that makes China’s urbanization strategy so effective. Today, approximately 55% of China’s population lives in cities, compared to less than 20% in 1978.
And the share should rise to 65-70% over the next 15 years. New and expanding cities sustain growth through services-based employment, which in turn boosts consumer purchasing power by trebling per capita income relative to that earned in the countryside.
So, despite all the handwringing over a Chinese crash, the rapid shift toward a services-based economy is tempering downside pressures in the old manufacturing-based economy. The International Monetary Fund stressed the same conclusion in its recent Article IV consultation with China, noting that labor income is now expanding as a share of GDP, and that consumption contributed slightly more than investment to GDP growth in 2014. That may seem like marginal progress, but it is actually quite rapid relative to the normally glacial pace of structural change – a process that began in China only in 2011 with the enactment of the 12th Five-Year Plan.
Alas, there is an important catch. While progress on economic rebalancing is encouraging, China has put far more on its plate: simultaneous plans to modernize the financial system, reform the currency, and address excesses in equity, debt, and property markets. Meanwhile, the authorities are also pursuing an aggressive anti-corruption campaign, a more muscular foreign policy, and a nationalistic revival couched in terms of the “China Dream.”
The interplay among these multiple objectives may prove especially daunting. For example, the confluence of deleveraging and the bursting of the equity bubble could create a self-reinforcing downward spiral in the old manufacturing economy that shakes consumer confidence and offsets the emerging dynamism of the new services economy. Similarly, military adventures in the South China Sea could damage China’s links to the rest of the world long before it is able to count on domestic demand for economic growth.
Ironically, China’s juggling act may prove even more difficult for the authorities to pull off in a market-based, consumer-oriented system. Caught in the transition from China’s tightly controlled, state-directed model, the government seems to be waffling – for example, by stressing a decisive shift to markets, only to intervene aggressively when equity prices plummet.

Likewise, it is embracing more of a market-based foreign-exchange regime while guiding the renminbi lower.
Add to that a stop-start commitment to reform of state-owned enterprises and China could inadvertently find itself mired in something comparable to what Minxin Pei has long called a “trapped transition,” in which the economic-reform strategy is stymied by the lack of political will in a one-party state.
Under President Xi Jinping’s leadership, there is no lack of political will in today’s China. The challenge is to prioritize that will in a way that keeps China on the course of reform and rebalancing. Any backtracking on these fronts would lead China into the type of trap that Pei has long feared is inevitable.
Economic development has always been a daunting challenge. As warnings about the “middle-income trap” underscore, history is littered with more failures than successes in pushing beyond the per capita income threshold that China has attained. The last thing China needs is to try to balance too much on the head of a pin. Its leaders need to simplify and clarify an agenda that risks becoming too complex to manage.

Markets Insight

August 26, 2015 5:32 am

Currency storms create investment opportunities

Mohamed El-Erian

In the market washouts, good names get flushed out with the bad

The currency storm that has engulfed the emerging world has blown into other markets around the globe. It has put pressure on valuations, produced patches of illiquidity and, in some cases, is starting to spill over into the economic and policy spheres.
While these dislocations have caused investor pain and risk some accidents, they are also creating a few investment opportunities today and a lot more down the road.

On the economic front, many emerging economies are being buffeted by that unpleasant mix of lower global demand and less favourable international prices. They are operating in an environment characterised by slowing growth, with China’s deceleration compounding sluggishness in Europe and Japan; and, in the case of commodity producers, a sharp drop in export earnings.

Policy options facing these emerging economies are a lot less attractive now they have used up some of the impressive international reserves they had built up in recent years. Their ability to navigate the global downturn using just financing tools is now more limited. Yet, and especially for systemically important countries with heavy influence in market indices (such as Brazil, Russia and Turkey), timely policy adjustments — a mix of fiscal adjustment and pro-growth structural reforms — are inhibited by unsettled political conditions.

The withdrawal of foreign portfolio capital accentuates the challenges. “Crossover investors” — those who have invested in markets outside their comfort zone, now feel an urgency to retrench to their home markets in advanced economies. In addition to placing greater pressures on international reserves and asset prices, this robs emerging markets of operational liquidity, making dysfunctional occurrences more common.

The carnage has been particularly acute in the foreign exchange arena. The most tradeable emerging market currencies are at lows that are worse than those experienced in the darkest days of the global financial crisis.

Companies face mounting losses on account of a mismatch between their high foreign exchange liabilities and their lower foreign exchange earnings. Inflexible foreign exchange pegs, most recently those of Kazakhstan and Vietnam, are biting the dust. And all this is fuelling the classic overshoot whereby currencies depreciate well beyond what is warranted by fundamentals.
The deeper the disruptions and the longer they persist, the more likely they are to contaminate other asset classes. And that is exactly what has happened. Having undermined emerging market credit and local currency bond markets, the instability stretched to corporate bonds in the advanced economies, and even to the better-anchored equity markets, such as in the US.

The resulting volatility risks lasting for a while. Despite recent developments, some market prices are still quite decoupled from fundamentals, particularly when it comes to those that have relied on the largesse of central banks. Meanwhile, policy circuit breakers are less effective these days, given how long these institutions have been operating exceptional policy regimes

In the short run, this calls for caution in portfolio positioning, but not universally so. The combination of overshoots and contagion creates interesting individual investment opportunities. In the market washouts, good names get flushed out with the bad, especially as volatility-driven trading algorithms force certain investors to sell wherever they can. Fearing client redemptions, even asset managers with long-term orientations scramble to accumulate cash, often in any way they can.

Most of the resulting trade opportunities are concentrated in “relative trades”, that is, investors using generally disrupted markets to buy the fundamentally well-anchored names and selling those whose weak fundamentals are likely to get weaker. And the most important distinguishing characteristics here are large balance sheet cushions, significant operational flexibility and a record of sound management.

Over the longer term, the opportunities will migrate to the asset class level as long-term investors find outright asset class exposure available at relatively cheap levels. This is particularly likely to be the case in emerging markets currencies, local bonds and external debt, where patience is likely to be handsomely rewarded.

Mohamed El-Erian is chief economic adviser to Allianz and chair of President Barack Obama’s Global Development Council

Moving Toward a Geopolitical Marketplace

By Jay Ogilvy

This column frames a question to which I do not have the answer. Or think of it as a historical agenda: How can we bring the logic of free market exchange into the domain of geopolitical conflict?

Why would we want to do such a thing? It's not simply a matter of substituting gold for guns, or nonviolent exchange for violent exchange. The question I am posing is not based on some utopian hope for perpetual peace. The distinction I want to focus on is the difference between zero-sum conflict and positive-sum Exchange.

The Zero-Sum Nature of Landmasses

With rare exceptions like landfill extensions or China's artificial islands in the South China Sea, the quantity of land on this Earth is fixed. Whatever territory one country gains, another must lose; any exchanges are thus zero sum. This is not so in the marketplace. The butcher comes to market to sell meat and buy bread, voluntarily. The baker comes to market to sell bread and buy meat, voluntarily. Both are beneficiaries of the voluntary exchange. Both return home better off than when they left home; theirs was a positive-sum Exchange.

This mutually beneficial interaction in the marketplace was not always so. When bands of hunter-gatherers strayed into one another's territory, there was a decent chance they would come to blows over limited prey. What one band killed and ate, another could not. Later in our evolution, some people satisfied their needs by enslaving others and coercing their labor.

What is Global Affairs?
Eventually, by fits and starts, we learned how to trade both labor and goods. Because few of our trades are as simple as a bilateral exchange between butcher and baker, we invented money, a medium of exchange. The butcher could sell to the baker and buy from the tailor. The baker could sell to the tailor and buy from the butcher. The tailor could sell to the butcher and buy from the baker, and all in various increments rather than in fixed lots. And once again, all would come to market voluntarily and return home happy with their purchases.

Is there a way of bringing this logic to geopolitics? What would be the currency, the medium of exchange? Could we move beyond bilateral conflict to a mutually beneficial multilateral exchange?

The Humility of the Market

The genius of the market, as opposed to centrally planned economies, is its humility when it comes to understanding what consumers want. Central planners are arrogant in assuming that they know what people want — how many tractors or hairdryers need to be shipped to which towns and with what frequency. Centrally planned economies make themselves stupid by denying themselves the information about consumer preferences that voluntary choices in the marketplace provide.

By analogy, and still working to frame the question, is our current geopolitical system stupid to the extent that it presumes to know what different countries want?

When we look at, say, the conflict in Ukraine, we see what appears to be a zero-sum standoff: What Russia gains, Ukraine loses, and vice versa. Like central planners, we presume that we know what each country wants: more territory, more control.

But isn't it possible that, like shoppers, different countries want different things? And if so, might there be a way to create a multilateral "market" that succeeds in allowing positive-sum exchanges?

Moving to another vexed part of the world, the Middle East, it is becoming increasingly obvious that borders need to be redrawn. Iraq is a mess and should probably be partitioned into a Shiite south, Sunni northwest and Kurdish northeast. The distribution of Pashtun tribes follows no national borders but sprawls across parts of Afghanistan and Pakistan. Syria has utterly lost its integrity as a state. Might there be a way to redraw some of those borders in a way that would be beneficial to all parties?

A Potential Misunderstanding

As I write these words, I can hear some realpolitikers mumbling, "This Ogilvy is impossibly naive.

Doesn't he know that there will always be war? There will always be violence as different countries compete over scarce resources." To which I reply: Yes, there will always be war, just as in the shadows of the marketplace there will always be crime that forces its victims to involuntarily part with their possessions. I'm not asking, like Rodney King, "Can't we all just get along?" I'm not assuming the universal spread of Christian love and cheek turning. I'm trying to imagine a mechanism, somewhat like the marketplace, that is based on dual premises: first, that not all countries share the same rank ordering of preferences, and second, that there might be a way for every country, through some medium of exchange, to get more of what it wants and less of what it doesn't want.

As in the economic marketplace, almost no one will get everything they want in the geopolitical "market" I'm trying to imagine. And perceived wrongs, slights, insults and envies will always lead to violence that will occasionally escalate to warfare.

But just imagine, by analogy with a multilateral marketplace including the butcher, baker, tailor and candlestick maker, might there be something Russia wants that China can provide; something China wants that Japan can provide; something Japan wants that the United States can provide; and something the United States wants that Russia can provide? (You could fill in the names of other countries, and eventually extend the list to each and every country on Earth, as the mechanisms of such a geopolitical marketplace mature.)

So the main point I'm making in posing this question — setting this historical agenda — is not that we should all be nice; quite the contrary. In The Wealth of Nations, Adam Smith observes that self-interest makes the economic world go 'round:
"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."

The same can be said of the geopolitical arena. If we move away from the primitive world of bilateral, zero-sum conflicts to a complex, multilateral system made up of countries that differ in their perceptions of their self-interests, then it might just be possible to develop a system that generates positive-sum results.

This is not a utopian vision. To draw again on the analogy of the economic marketplace, just as there are and always will be inequities between the rich and poor, so too will there be relative winners and losers in the geopolitical domain. But just as the aggregate sum of wealth generated in the global marketplace has increased manyfold in the past two centuries, following millennia of grinding poverty for nearly everyone, I have to think it possible that a comparable breakthrough in geopolitical relations might be possible. If only we could orchestrate our political relationships to move from the primitive world of bilateral, zero-sum exchange to a multilateral, positive-sum system that recognizes differing interests.

The Cap-and-Trade Model

We can draw yet another analogy between innovation in economic exchange and innovation in geopolitics when we examine cap-and-trade systems for reducing pollution. In a cap-and-trade system, potential polluters are allocated, based on historical data, a cap on what they can emit. Those who reduce their emissions below that cap then receive credits that they can sell to those who exceed their cap. When I first heard about cap-and-trade, I thought it was crazy. What, sell rights to pollute?!
At first glance, it seemed strange. But after doing the math, anyone can see that if the system devotes more resources to cleaning up the worst polluters and less resources to those who are already running relatively clean, then the system as a whole will be cleaner, and for less investment than would have been required without a cap-and-trade market in place. Rather than leaving cleanup to individual entities acting on their own, or to government bureaucrats exercising command-and-control regulation, cap-and-trade creates a truly systemic solution that produces more bang per buck, a positive sum.

Prior to the 1980s, cap-and-trade, or "emissions trading" as it was then called, was unknown.

As Richard Conniff put it in an August 2009 article in Smithsonian Magazine,
"[T]he Environmental Defense Fund (EDF) had begun to question its own approach to cleaning up pollution, summed up in its unofficial motto: "Sue the bastards." During the early years of command-and-control environmental regulation, EDF had also noticed something fundamental about human nature, which is that people hate being told what to do. So a few iconoclasts in the group had started to flirt with marketplace solutions: give people a chance to turn a profit by being smarter than the next person, they reasoned, and they would achieve things that no command-and-control bureaucrat would ever suggest."

Where are the iconoclasts in the realm of geopolitics? Is there anyone who can answer the question I'm posing? What might be the mechanisms for bringing free market logic into the geopolitical realm? What might be the medium of exchange, a currency other than bullets? I can't help but believe that we are as babies, or hunter-gatherers, or at best, mere adolescents in geopolitics, as geopolitically challenged as economists prior to Adam Smith.

But I don't have the answer to my question, just the suggestion of a historical agenda.

Getting Technical

Time to Buy Stocks? Not Until There Is Real Fear

Stocks have suffered plenty but not enough for contrarians to feel confident about getting back in.

By Michael Kahn

Updated Aug. 26, 2015 6:40 p.m. ET

No doubt, there is fear in the investing community. And many sentiment indicators suggest there is indeed enough of it to set the environment for a bottom in the stock market. But it takes more than just elevated chatter and bearish opinion to show that the market is truly washed out and ready to begin the healing process.
What we need is to see investors stampede to the exit doors.
And while I loathe the expression, we need to see them toss out the baby with the bath water.

We need to see stocks of elite companies that fundamental analysts love being sold along with the junk as the stock market becomes psychological poison.
That is not quite what is happening now; this is why I think it is not over yet.
Indicators from Investors Intelligence and the American Association of Individual Investors do show rather high levels of bearishness, even enough to suggest to contrarians that the worst is over. But these are surveys of advisors and individuals, respectively, and only tell us what people are thinking.
I find it more useful to know what they are doing with their money, and for that there are other indicators to use.
For example, the percentage of New York Stock Exchange stocks above their 200-day moving averages is at roughly 15%. That is indeed low but not as low as it was after bear markets in 2002 and 2008, and even after the last major correction in 2011 when it was in single digits.
As for new 52-week lows, Monday’s temporary 1,000-point drop on the Dow Jones Industrial Average skewed the data but as of Wednesday afternoon there were only 232 new lows on the NYSE. That is not very much at all.
These two indicators tell us whether the majority of stocks are being sold hard. When they reach extreme levels we can surmise that everything that could be sold already has been sold. Supply dries up and any spark can get the market rallying again.
We are not there yet.
And even a more obscure indicator called the bullish percent index (BPI) is far from an extreme low. This indicator measures the percent of NYSE stocks currently on buy signals based on the point-and-figure charting style. The details are not important here other than to understand that it looks at price patterns to determine if a stock is bullish or bearish. No opinion, just price action.
Right now, the BPI tells us that about 30% of NYSE stocks are still on buy signals. That is nowhere close to the low levels at the bottom of the last two bear markets or even the 1998 and 2011 corrections. In other words, there are plenty of stocks still in good shape.
With volatility so high and short-term conditions so oversold, nobody can rule out a bounce: One that lasts more than just a few hours unlike the ones we’ve seen this week. There is no shortage of pundits calling stocks bargains for the long haul, which also suggests sentiment is not too terrible, so anything goes in this wild and wooly market.
But the long-term chart of the Standard & Poor’s 500 shows no such oversold conditions (see Chart). Any of a number of popular momentum indicators show weakness but not at an extreme. Plus, this index, the benchmark for the domestic market, is about to have its own moving average death cross, about three weeks after the much publicized cross in the Dow.


Standard & Poor’s 500

Whether this is a true bear market or not, with the seasonally scary months of September and October on the horizon, today’s bargains may become tomorrow’s steals.

World shipping slump deepens as China retreats

Ports across the world suffer worst hit since the Lehman crisis as emerging markets wilt, but trade may not matter so much to global GDP any longer

By Ambrose Evans-Pritchard

stranded cargo vessel Rena grounded on the Astrolabe Reef, on October 12, 2011 in Tauranga, New Zealand.

Shipping has been hit by the gathering storm in global trade Photo: Getty
World shipping has fallen into a deep slump over the late summer, dashing hopes of a quick recovery from the global trade recession earlier this year and heightening fears that the six-year economic expansion may be on its last legs.

Freight rates for container shipping from Asia to Europe fell by over 20pc in the second week of August, even though trade volumes should be picking up at this time of the year. The Shanghai Containerized Freight Index (SCFI) for routes to north European ports crashed by 23pc in five trading days.
The storm in the shipping industry comes as the New York state manufacturing index for July plummeted to a recessionary low of minus 14.9, the lowest since the Great Recession and one of the steepest one-month drops ever recorded.


The new shipments component fell to -13.8, and new orders to -15.7. A similar drop occurred in 2005 and proved to be a false alarm but the latest fall comes at a delicate moment for the world economy.
There is now a full-blown August storm sweeping through global markets. The Bloomberg commodity index dropped to a fresh 13-year low on Monday and the MSCI index of emerging market equities touched depths not seen since August 2009.

A closely-watched gauge of emerging market currencies has fallen for the eighth week – the longest run of unbroken declines since the beginning of the century - led by the Malaysian Ringgit, the Russian rouble and the Turkish lira.

Asian currencies have dropped against the dollar over the last year
China’s surprise devaluation last week continues to send after-shocks through skittish global markets, already on edge over a likely rate rise by the US Federal Reserve in September - though this is now in doubt.

The currency move was widely taken as a warning that the Chinese economy is in deeper trouble than admitted so far, a menacing prospect for exporters of raw materials and for trade competitors in Asia. It threatens to transmit a fresh deflationary impulse through the global system.

The great worry is that companies in emerging markets will struggle to service $4.5 trillion of US dollar debt taken out in the boom years when quantitative easing by the Fed flooded the world with cheap money, much of it at irresistible real rates of 1pc. This is up from $1 trillion in 2002.

The monetary cycle has gone into reverse since the Fed ended QE in October 2014 and cut off the flow of fresh liquidity. While the first rate rise in eight years has been well-telegraphed, nobody knows for sure what will happen once tightening starts in earnest.

This stress-test could prove even more painful if China really has abandoned its (crawling) dollar peg and is seeking to protect export margins by driving down its currency.

The yuan has risen by 60pc against the Japanese yen and 105pc against the rouble since mid-2012. Yet China nevertheless has a trade surplus of 6pc of GDP.

Data from the Port of Hamburg released on Monday show much damage this currency surge may be doing to Chinese companies. Axel Mattern, the port’s chief executive, said a 10.9pc drop in trade with China was the chief reason why volumes of container cargoes passing through the port fell 6.8pc in the first six months.

“During the first six months of the years the euro was on average 19 percent lower than the yuan, making purchase of Chinese goods costlier for European importers,” he said.

If so, this is grist to the mill of those arguing that China timed its switch to a market-driven exchange rate in order to disguise what is really “currency warfare”, or a beggar-thy-neighbour strategy as it used to be known. The Chinese central bank has dismissed such claims as “nonsense”. It has intervened to stabilize the yuan over the last three days.

The port of Hamburg said trade with Russia collapsed by 36pc, the latest evidence that the rouble crash and deepening recession has forced Russian consumers to cut back drastically on purchases of imported cars and heavy goods.

The Dutch CPB index of world trade fell in both April and May in absolute terms, culminating five months of dire shipping activity. It had been widely-assumed that the worst was over.

World trade has slumped

Yet more recent data from Container Trades Statistics shows that global volumes fell 3.1pc in June from the already depressed levels the month before. This has come as shock: the period from June to August is typically the strongest time of the year, boosted by pre-shipments for the Christmas season.

What is even more disturbing is that fresh port data from Asia suggest that the downturn dragged on into July, and may even have deteriorated.

Singapore – the world’s second largest entrepot – saw a 13.3pc contraction in container volumes from a year earlier, the worst performance since the sudden-stop in trade after the Lehman crisis.
The growth in cargo shipments for all the major ports in East Asia (that have reported so far) fell to a new cycle-low of 0.6pc in July, according to tracking data collected by Nomura. “The clock is ticking on the third quarter. We remain sceptical of those trying to “call a bottom”,” it said.

It is still unclear how much of this weakness reflects recessionary conditions, and how much stems from a more benign shift in the structure of the global economy.

China’s reliance on imported components for its export industry has fallen to 35pc from 75pc in 1992 as the country moves up the technology ladder. The Communist Party is deliberately weaning the economy off heavy industry and mass production, shifting to a more mature service economy that relies less of trade.

At the same time, the US and Europe have been “re-shoring” manufacturing plant from China as Asian labour costs rise, reversing the process of globalisation.

These changes mean that the “trade-intensity” of the global economy is falling. The trade share of world GDP was 40pc in 1990. It rose to a peak of 61pc in 2011, and has since drifted down to below 60pc.

A recent study by the International Monetary Fund said the expansion of global supply chains driven by the US and China in the early 2000s is “exhausted”.

The implication is that trade is no longer the pulse of the global economy. Other indicators are less worrying.

Both credit and key measures of the money supply are rising briskly in Europe, the US, and latterly in China as well, pointing to a recovery later this year. These forces may prove to be more powerful in the end. `

The Fed Is Spooking the Markets Not China

By: Peter Schiff

Fasten your seat belts, this ride is getting interesting. Last week the Dow Jones Industrial Average was down more than 1,000 points, notching its worst weekly performance in four years. The sell-off took the Dow Jones down more than 10% from its peak valuations, thereby constituting the first official correction in four years. One third of all S&P 500 companies are already in bear market territory, having declined more than 20% from their peaks. Scarier still, the selling intensified as the week drew to a close, with the Dow losing 530 points on Friday, after falling 350 points on Thursday. The new week is even worse, with the Dow dropping almost 1,100 points near the open today before cutting its losses significantly.

However, no one should expect that this selling is over. The correction may soon morph into a full-fledged bear market if the Fed makes good on its supposed intentions to raise interest rates this year. Have no illusions, while most market observers are quick to blame the sell-off on China, this market was given life by the Fed, and the Fed is the only force that will keep it alive.

The Dow has now blown through the lows from October 2014, when fears over life without quantitative easing and zero percent interest rates had caused the markets to pull back about 5%.

Back then when market fear began spreading, St. Louis Fed President James Bullard publically issued a few choice words which reassured the markets that the Fed stood ready to reignite the QE engines if the economy really needed a fresh dose of stimulus. By the end of the year the Dow had rallied 10%.

Amid last week's carnage, Mr. Bullard was at it once again. But instead of throwing the market a much needed life preserver, he threw it an unwanted anchor. He offered that the economy was still strong enough to warrant a rate increase in September. He was careful to say, however, that the Fed is still "data dependent" and will therefore base its decision on information that will come out over the next three weeks. So after nearly seven years of zero percent interest rates, the most momentous decision the Fed has made since the Great Recession will be dictated by a few weekly data points that have yet to emerge. Haven't seven years of data provided them enough information already? What's next? Will they have to check the five-day forecast to insure that there will be no rain before they pull the trigger?

As I have been saying for years, the Fed has always known that the fragile economy created through stimulus might prove unable to survive even the most marginal of rate increases. But in order to instill confidence in the markets, it has pretended that it could. Wall Street has largely played along in the charade, insisting that rate increases were justified by an apparently strengthening economy and needed to restore normalcy to the financial markets.

But the recovery Wall Street had anticipated never arrived, and traders who had earlier demanded that the Fed get on with the show, have now panicked that the rate hikes are about to occur in the face of a weakening economy. As a result, we are seeing a redux of the 2013 "taper tantrum" when stocks sold off when the Fed announced that it would be winding down its QE purchases of bonds.

The question now is how much further the markets will have to fall before the Fed comes to the rescue by calling off any threatened rate increase? What else could pull the markets out of the current nose dive?

Think about where we are. Stock valuations are extremely high and earnings are falling and the economy is clearly decelerating. The steady march upward in stock prices has been enabled by a wave of cheap financing and share buybacks. There are very few reasons to currently suspect that earnings, profits, and share prices will suddenly improve organically. This market is just about the Fed. After one of the longest uninterrupted bull runs in history, bearish investors have learned the hard way that they can't fight the Fed. So why should they now expect to win when the Fed is posturing that its about to embark on a tightening cycle?

If the Fed were to do what it pretends it wants to do (embark on a tightening campaign that brings rates to about 2.0% in 18 months), and in the process ignore the carnage on Wall Street, I believe we would see a consistent sell off in which most of the gains made since 2009 would be surrendered.

After all, how much of those gains came from bona fide improvements in the economy? It was all about the twin props of Quantitative Easing and zero percent interest rates. The Fed has already removed one of the props, and it's no accident that the markets have gained no ground whatsoever in the eight months since the QE program was officially wound down.

As the market considers a world without the second prop, a free fall could ensue. Now that we have broken through the October 2014 lows, there is very little technical support that should come in to play. A free fall in stocks could be an existential threat to an already weak economy.

It should be clear the Janet Yellen-controlled Fed would not want to risk such a scenario. This is why I believe that if the sharp sell off in stocks continues, we will get a clear signal that rate hikes are off the table.

Of course, even if it does throw us that bone, the Fed will pretend that the weakness was unexpected and that it does not come from within (but is caused by external forces coming from China and Europe). Using that excuse, it will attempt to prolong the bluff that its delay is just temporary. For now at least Wall Street is happy to play along with the blame China game.

This ignores the fact that China has had much bigger sell offs in recent weeks that did not lead to follow-on losses on Wall Street. I think the problems in China are the same problems confronting other emerging economies, namely the fear of a Fed tightening cycle that would weaken U.S. demand, depress commodity prices while simultaneously sucking investment capital into the United States, and away from the emerging markets, as a result of higher domestic interest rates and the strengthening dollar.

But if a temporary halt in rate hike rhetoric is not enough to stem the tide, a more definitive repudiation may be needed. Such an admission should finally open some eyes on Wall Street about the true nature of the economy and the unjustified strength of the U.S. dollar. That already may be happening. The dollar index closed at 95 on Friday...down from a high of 98 two weeks prior. On Monday, the index blew through the 93.50 support level and dropped more than 3% in just one day, down to intraday low of 92.6. Who knows where it stops now?

Gold is rallying in the face of the crisis and has moved quickly back to $1,160, up around $80 in just two weeks. The bounce in gold must be causing extreme angst on Wall Street. Just two weeks ago, amid widening conviction that gold would fall below $1,000, it was revealed that hedge funds, for the first time, held net short positions on gold. Those trades are not working out. With the major currencies and gold now strengthening against the dollar, the greenback has had some success against far lesser rivals like the Thai baht and the Kazakhstan tenge. But these victories against currencies largely tied to commodities may be the last fights the dollar wins for a while, especially if Janet Yellen finally comes clean about the Fed's inherent dovishness. Those currencies now falling the farthest may be the biggest gainers if the Fed shelves rate increases.

Some still cling to the belief that the Fed will deliver one or two token 25 basis point rate increase before year end. But this could expose the Fed to a bigger catastrophe than doing nothing at all. If it actually raises rates, and the crisis on Wall Street intensifies, further weakening an already slowing economy, the Fed would have to quickly reverse course and cut back to zero. This would put the Fed's cluelessness and impotency into very sharp focus. From its perspective anything is better than that. If it does nothing, and the economy continues to slow, ultimately "requiring" additional stimulus, it will at least appear that its caution was justified.

Unfortunately for the Fed, it won't be able to get away with doing nothing for too much longer.

Events may soon force it to show its hand. Then perhaps some may notice that the Fed is holding absolutely nothing and has been bluffing the entire time. 

Productivity paradox deepens Fed’s rate-rise dilemma

Gillian Tett

 Slowdown flies in the face of popular belief that the western world is undergoing a technology boom

Brace yourself to hear the phrase “data dependent” — a lot — over the next month. With this week’s release of the US Federal Reserve minutes reinforcing expectations of a rate rise, perhaps as soon as September, Fed officials are at pains to stress that any final decision will depend on the macroeconomic data; and thus be “data dependent”.
But as the Fed keeps tossing around those “D” words, a certain irony hangs in the air. In a corner of the data world — productivity — the picture looks so baffling it is hard to see how anyone could depend on those numbers.

And while this data fog has not yet attracted much public debate, the mystery could complicate the Fed’s policy challenge — not least because it makes it hard to tell how fast the economy can grow before it needs more rate hikes.

To understand the issue, take a look at some numbers assembled by Alan Blinder, an economics professor at Princeton and a former vice-chairman of the Fed. Mr Blinder calculates that in the period between 1995 and 2010, productivity in the US economy grew on average by 2.6 per cent each year.
That meant the potential trend growth rate in the US economy, or the speed at which the economy could grow sustainably ignoring capacity issues, was roughly 3 per cent. (The trend rate is usually calculated by adding population growth and productivity increases.) However, since 2010, overall average productivity increases have tumbled to just 0.65 per cent; indeed, over the past year private sector labour productivity, excluding farming, has grown by a paltry 0.3 per cent according to the quarterly data series.

This is peculiar on many levels. For one thing, the trend flies in the face of the popular belief that the western world is undergoing a technology boom. After all, the internet revolution has given us mobile phones with the computing power of 1970s rockets, while analysts such as the Oxford Martin school are now predicting that digitalisation has become so powerful that it will replace half of all US jobs in the next couple of decades.

In what adds to the sense of mystery, the Fed itself seems to be using a very different understanding of productivity. Recent projections from Fed policy board members, for example, imply they think potential “trend growth” in the economy is around 2.15 per cent. That implies productivity growth of around 1.75 per cent.

While this week’s minutes revealed that the Fed has recently “trimmed projected rates of productivity gains and potential output growth”, it is far from clear how big this “trim” is — or why the Fed’s numbers have recently been so at odds with statistics. “The Fed is clueless about the trend rate of growth of productivity,” Mr Blinder concludes. “Just like everyone else.”

One explanation may be that statisticians cannot keep pace with technological trends; they might be missing part of the output generated by, say, smartphones. Another possible problem is that the last decade’s credit boom made finance seem more productive than it really was before 2007, which makes the post-crisis data look far worse.

A further factor is that corporate investment has recently been weak, while there is a growing skills gap in America’s workforce. This would normally be expected to lower productivity.

Then there is another, even more intriguing related issue: a technology time lag. As Mr Blinder notes, if you look at the productivity figures in a wider context, there are two other notable points. First, America is not the only country where productivity has tumbled; this is seen in places such as the UK too. Secondly, this is not the first time such a swing has occurred: back in the 1970s and 1980s there was another slump after an earlier boom. This might be just a coincidence. But what is striking about the 1970s was that it was also a period of dramatic technological change; the onset of the computing era.
And while logic might suggest that innovation should boost productivity, the problem with new technology, as economists such as Andrew McAfee of MIT point out, is that it takes time for companies to harness. So, just as it took a couple of decades before computers raised US productivity trends, it might take time before the economy is truly boosted by today’s smartphones.

If this theory turns out to be correct (as I suspect it is), it suggests that eventually those productivity numbers should rise sharply. The problem, however, is that it could take several years. Until then, better keep watching the productivity numbers — if nothing else, because they show that central banking is an art, not a science; especially when the time comes to change course.

The Real Demographic Challenge

Adair Turner

bangladesh railway slums

LONDON – The United Nations’ latest population projections suggest that Japan’s population could fall from 127 million today to 83 million by 2100, with 35% of the population then over 65 years old. Europe and other developed economies are aging as well, owing to low fertility rates and increasing longevity.
But those who warn that huge economic problems lie ahead for aging rich countries are focused on the wrong issue. Population aging in advanced economies is the manageable consequence of positive developments. By contrast, rapid population growth in many poorer countries still poses a severe threat to human welfare.
In 2008, the UN projected the world’s population reaching 9.1 billion by 2050 and peaking at about ten billion by 2100. It now anticipates a population of 9.7 billion in 2050, and 11.2 billion – and still rising – by 2100, because fertility rates in several countries have fallen more slowly than expected (in some, notably Egypt and Algeria, fertility has actually risen since 2005).

While the combined population of East and Southeast Asia, the Americas, and Europe is projected to rise just 12% by 2050 and then start falling, sub-Saharan Africa’s population could rise from 960 million today to 2.1 billion by 2050 and almost four billion by 2100. North Africa’s population will likely double from today’s 220 million.
Such rapid population growth, on top of even faster increases over the last 50 years, is a major barrier to economic development. From 1950 to 2050, Uganda’s population will have increased 20-fold, and Niger’s 30-fold. Neither the industrializing countries of the nineteenth century nor the successful Asian catch-up economies of the late twentieth century ever experienced anything close to such rates of population growth.
Such rates make it impossible to increase per capita capital stock or workforce skills fast enough to achieve economic catch-up, or to create jobs fast enough to prevent chronic underemployment. East Asia has gained a huge demographic dividend from rapid fertility declines: in much of Africa and the Middle East, the dividend is still missing.
In some countries, sheer population density also impedes growth. India’s population may stabilize within 50 years; but, with the number of people per square kilometer 2.5 times that of Western Europe and 11 times that of the contiguous United States, disputes over land acquisition for industrial development create serious barriers to economic growth. In much of Africa, density is not a problem, but in Rwanda competition for land, driven by high and rising density, was among the root causes of the 1994 genocide. By 2100, Uganda’s population density could be more than twice India’s current level.
The demographic challenges facing advanced economies are slight in comparison. Greater longevity poses no threat to economic growth or pension-system sustainability as long as average retirement ages rise accordingly. Population stabilization reduces pressure on environmental assets such as unspoiled countryside, which people value more as their incomes increase.
To be sure, rapid population decline would create difficulties. But if writers like Erik Brynjolfsson and Andrew McAfee are right that information technology will create new opportunities to automate jobs, gradual population decline could help offset falling demand for labor, which otherwise would generate unemployment and/or rising inequality.
On the other hand, increased automation could be a huge barrier to economic development for countries still facing rapid population growth. By making it possible to manufacture in almost workerless factories in advanced economies, automation could cut off the path of export-led growth that all of the successful East Asian economies pursued. The resulting high unemployment, particularly of young men, could foster political instability. The radical violence of ISIS has many roots, but the tripling of the population of North Africa and the Middle East over the last 50 years certainly is one of them.
Continued high unemployment throughout Africa and the Middle East, and political instability in many countries, may in turn make unrealistic the UN’s projection that Europe’s population will fall from 730 million today to 640 million by 2100. With Africa’s population likely to increase by more than three billion over the next 85 years, the European Union could be facing a wave of migration that makes current debates about accepting hundreds of thousands of asylum seekers seem irrelevant.
The UN assumes net migration from Africa of just 34 million over the century – only 1% of the population increase. The actual figure could be many times that.
As a result, Europe’s population – unlike, say, that of East Asia or even the Americas – may well continue to rise throughout the century. This, some will say, will help “solve Europe’s aging problem.” But, given that the aging “problem” is overstated and solvable by other means, mass migration may instead undermine Europe’s ability to reap the benefits of a stable or gently falling population.
Both increased longevity and falling fertility rates are hugely positive developments for human welfare. Even in the highest-fertility countries, rates have fallen – from six or more children per woman in the 1960s to 3-4 today. The sooner fertility rates reach two or below, the better for humanity.
Achieving this goal does not require the unacceptable coerciveness of China’s one-child policy. It merely requires high levels of female education, the uninhibited supply of contraceptives, and freedom for women to make their own reproductive choices, unconstrained by the moral pressure of conservative religious authorities or of politicians operating under the delusion that rapid population growth will drive national economic success. Wherever these conditions prevail, and regardless of supposedly deep cultural differences – in Iran and Brazil as much as in Korea – fertility is now at or below replacement levels.
Sadly, this is not true in many other places. Ensuring that women are educated and free is by far the most important demographic challenge facing the world today. Worrying about the coming population decline in advanced countries is a meaningless diversion.

jueves, agosto 27, 2015




Forking hell

A spat exposes unwieldy governance at the digital currency

“FEDERAL Reserve deeply split. Renegade group of board members to create separate American dollar.” Such a headline seems highly unlikely, but this in essence is what is happening in the land of Bitcoin, a digital currency. On August 15th two of its main developers released a competing version of the software that powers the currency. With no easy way to resolve feuds, some are warning that this “fork” could result in a full-blown schism.

The dispute is predictably arcane. The bone of contention is the size of a “block”, the name given to the batches into which Bitcoin transactions are assembled before they are processed.

Satoshi Nakamoto, the crypto-buff who created the currency before disappearing from view in 2011, limited the block size to one megabyte. That is enough to handle about 300,000 transactions per day—suitable for a currency used mainly by geeks, as Bitcoin once was, but nowhere near enough to satisfy the growth aspirations of its boosters. Conventional payment systems like Visa and MasterCard can process tens of thousands of payments per second if needed.

By how much and when to increase this limit has long been a matter of a heated debate within the Bitcoin community. Overlapping cabals of “core maintainers” and “main developers” serve as de facto keepers of the currency, especially in Mr Nakamoto’s continued absence. Now one camp wants to increase block sizes, and do it soon. Otherwise, they argue, the system could crash as it runs out of capacity as early as next year. Transactions could take hours to confirm and fees could rocket, warns Mike Hearn, a leading Bitcoin developer. “Bitcoin would survive,” he wrote in a blog post in May, “but it would have lost critical momentum.”

The rival faction, supported by other heavyweight developers, frets that rushing to increase the block size would turn Bitcoin into more of a conventional payment processor. The system currently relies on thousands of independent “nodes”, computers dotted across the world that check whether transactions are valid and keep tabs on who owns which bitcoins. Increasing the block size could make the whole edifice so unwieldy as to dissuade nodes from participating, so hastening a recent decline in users. The result would be a more centralised system, prompting angst among Bitcoin purists who fret concentration could undermine the currency.

The dispute is as ideological as it is technical. The Bitcoin community has a process to settle such controversies, but it is by design slow and produces decisions only when everybody is happy.

Frustrated that the discussion has kept dragging on, Mr Hearn and Gavin Andresen, another Bitcoin grandee, decided to press the issue by organising a referendum of sorts: they have called on “miners”, specialised nodes that assemble the blocks and mint new bitcoins, to install their new version, called “Bitcoin XT”. Once at least 75% of the blocks are processed by XT, but no earlier than January, it will upgrade to a block size of a maximum of eight megabytes (and double that limit every two years). The nodes that then still run the old “Bitcoin Core” software would find themselves excluded from the system.

Predictably, this move has increased the temperature of the debate. On discussion sites such as Reddit, moderators have censored mentions of XT because they see it as an effort to undermine the Bitcoin community. Comments purportedly made by Mr Nakamoto warning that a fork would lead him to “declare Bitcoin a failed project” have been widely dismissed as a hoax.

Despite all the sound and fury, a genuine split is still unlikely. Like doves and hawks at an old-fashioned central bank, the two sides will probably agree on some sort of compromise, perhaps at two fun-sounding “Bitcoin Scalability Workshops” scheduled for later this year. And even if miners get to decide by using the version they like, this would probably not lead to a Bitcoin split. Once it becomes clear which version is likely to prevail, all miners will have an incentive to join the winning side.

Already, 13% of nodes have jumped on the dissident XT bandwagon, albeit few miners.

Whether majority rule is the best way to run a system with Bitcoin’s pretensions is an entirely different question.

China’s Weak Yuan Temptation Could Prove Irresistible

By Shen Hong  

Next time China makes a major easing move, it can defend the yuan or let it slide slightly. Next time China makes a major easing move, it can defend the yuan or let it slide slightly. Photo: European Pressphoto Agency

It took just three days for Beijing to stabilize the yuan after it unleashed a surprise regime change in currency policy. The current peace might provide a false sense of security, especially if more monetary easing is in store.

After the People’s Bank of China jumped into currency markets to put a floor on the plunging yuan, officials promised stability going forward. In theory, China could stick to its guns and prevent more depreciation. But now that it has cracked the door open on its exchange-rate policy, the more Beijing conducts monetary easing, the more temptation it will have to let the yuan depreciate in tandem.

Under China’s de facto fixed exchange rate system, when capital flowed out, the central bank defended the exchange rate by buying yuan with foreign reserves. But when the central bank buys yuan, it is essentially shrinking the money supply, which is hardly what policy makers want in a slowing economy. By letting the outflows happen without intervening in the currency, the central bank can keep domestic money supply flush.

This matters because outflows have been persistent—and could pick up as interest rates fall further.

By one measure, the central bank and financial institutions sold nearly 250 billion yuan of foreign currencies in July, during the worst of the stock-market meltdown. Some of that outflow may be virtuous outbound investment and tourism spending, not necessarily pernicious capital flight, but it makes the central bank’s job difficult all the same.

To counteract the outflows, the PBOC this week provided banks 240 billion yuan ($37.5 billion) in short-term lending. If outflows continue—and the economy fails to respond to the cuts already in the system—more durable easing measures such as a cut to bank reserve-requirement ratios seem likely.

Next time it makes such a big easing move, however, China now faces a decision that it chose not to consider in the past. It can defend the currency by spending reserves to buy yuan to keep it stable. Or it can let the currency slide a bit. The latter choice has the potential to make the easing more effective.

Beijing likely remains squeamish when it comes to letting the currency fall too much and too quickly, so it won’t give up on currency intervention completely. A sharp fall in the yuan could make the capital outflow problem worse.

But at the next round of easing, China’s instinct may be to use its new flexibility on the currency to make the easing moves work better. That means that the current currency quiet is only temporary. Investors should be prepared.

Review & Outlook 

Two-Track Europe

Reforming countries are growing, while most of the rest are not. 

                                       Photo: Getty Images

Economic growth in the eurozone slowed to 0.3% in the second quarter from 0.4% in the previous quarter, according to data released Friday. After a few months of optimism fueled by a depreciating currency, this is the latest warning that most of Europe is returning to its familiar anemic state.

The positive spin is that things could have been worse. Europe has muddled through a seven-month Greek crisis without falling into recession. Credit for this generally goes to European Central Bank President Mario Draghi, whose ultralow interest rates and program to purchase €60 billion ($66.56 billion) of sovereign bonds every month have ostensibly bolstered the bloc’s resilience. That’s damning Europe’s economies with faint praise if monetary heroics are required merely to stagnate.

The bigger story is the slow growth beyond Greece. The most worrying news comes from Germany, whose exporters were supposed to be the biggest beneficiaries of the cheap euro Mr. Draghi has engineered. German growth in the second quarter edged up a tenth of a percentage point, to 0.4%, largely thanks to net exports. But growth at this stage of the post-2012 recovery is lagging the rebounds from recessions in 1996 and 2009, Capital Economics notes. Net exports aren’t driving the rapid recovery many had hoped for when the euro devaluation got underway.

German industrial production has been sluggish, having increased 0.1% in the second quarter compared to 0.5% in the first. The main German bright spot continues to be lower global oil prices, which offset the inflationary effects of having to pay more euros for imports and allow German households to continue shopping. In any case it’s becoming clear that a German export-led boom isn’t going to revive the rest of the eurozone.

The latest data also show that other large eurozone economies aren’t reviving themselves. After a 0.7% quarterly growth surprise three months ago, France notched a big, fat zero in the latest quarter. Italy managed only 0.2% growth. In both places the picture is similar to Germany, only worse, with lagging business optimism and industrial production.

Europe’s politicians, as ever, will blame outside forces. China’s slowdown is hurting exports, and it would help if the U.S. were growing faster than 2%. But too many European leaders have squandered the opportunity from low interest rates and rising optimism to press ahead with pro-growth economic reforms. Even those who understand the need, such as French Prime Minister Manuel Valls, are struggling against political systems resistant to even modest reforms.

What’s coming into focus is the extent to which Europe is developing a two-track economy. The brightest spots in last week’s data release were Spain, which accelerated to 1% growth in the second quarter, the U.K. (0.7%), and Eastern European economies such as Poland (0.9%) and Latvia (1.2%), some of which aren’t euro members but all of which have undertaken pro-market reforms.

These countries are evidence that European economies can grow when they create the conditions that encourage investment and business creation. The question now is whether the political class and voters in lagging Europe will get the message or be content with little or no economic growth.

Timing Gold Is A Fool's Errand

"I don't agree with you Jodie... Gold is in a bear market... too early to put some money in the yellow metal..." is a comment from the article recently posted by the Economic Times asking the question,

"Where do you see the gold prices making a bottom as every fundamental turns unfavorable for gold?"

We love your comments expressing your opinions about where the market is and where it's going, just as much as we love to share the history lessons told through our indices.

Let's pretend today is sometime in the middle of 1981. President Reagan just established the Gold Commission that rejected returning the U.S. to a gold standard. The Fed raised rates to 20%, and inflation fell. But that created a recession. Gold investors lost about half their asset values. They wondered, "Has gold reached its bottom?"

1981 Gold

To understand the answer to this question, investors might consider the underpinnings of the prior bull run of over 400% that started when Nixon took the dollar off the gold standard in 1973. Inflation tripled, the dollar crashed, and after years of erratic monetary policy, investors piled into gold as a safe haven. The perfect environment for gold ended, and investors wondered about the future of gold without these supports.

For the next 20 years, gold lived through mostly expansionary periods. Even as investors abandoned gold for stocks, gold didn't fall much further.

2001 Gold

Not until September 11, 2001 did fear ripple through the market, triggering the flight to safety into gold again. The drivers of inflation and a weak dollar that supported gold through the 1970s bull run were back. These factors, plus the global financial crisis and worries about government reform led gold to a record high. Such forces, in addition to the growing popularity of the gold ETF as a new way for investors to access gold sent gold soaring more than 600% over the next ten years until August 2011.

As worries eased, investors fled gold once again. However, many in this sell-off have no memory of the 65% drop that happened in 1981-82. Currently, gold has only lost 45% since its peak four years ago, but the majority of the loss happened in 2013, when gold dropped 28% - the most since 1981.

Source: S&P Dow Jones Indices
(Source: S&P Dow Jones Indices)

It is difficult to predict where the bottom is, but the last time gold dropped this much, it took over 25 years to recover. It certainly diminishes the importance of identifying the bottom, even if the bottom has been reached.

Gold would need to drop another 40% from current levels in order to match the 1981-82 drawdown, so it wouldn't be surprising to see it fall further. Investors need to look to underpinning fundamentals again to understand gold. Poor economic data from China, inflation under control, low interest rates, plus gold's diminished status of a safe haven are not promising.

Investors continue to flee, as evidenced by recent record outflows. If interest rates rise again, that may help gold futures, since the collateral return increases, but there may be outflows in lieu of income-producing securities.

Since most single factors like inflation, interest rates, jewelry demand, oil prices, geopolitics, and U.S. dollar strength don't alone move gold, they are unreliable indicators of gold's prices.

However, one statistic that is pretty solid through time is that gold is uncorrelated to the stock market. On average, the 12- month correlation is zero, but even on short intervals of rolling 90 days, the correlation doesn't ever exceed 0.6.

Gold 500 Correl

Once again, timing gold doesn't necessarily matter. Gold is not always owned for high returns, but instead, serves to protect against a drop in other assets, like stocks. It has held up in times of inflation, and may hedge against other risks, like geopolitical risks, that hurt stocks. Investors looking for diversification and capital preservation may use gold in a portfolio framework at any time. Now is as good of a time as any to invest in gold, given its recent drawdown and the strong stock market performance over the past several years.