FEBRUARY ECONOMIC REPORT / SIMON HUNT STRATEGIC SERVICES ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

February Economic Report

by Simon Hunt

This will be a shortened version of our usual monthly economic reports, since we have posted several short notes on the economic and financial markets.

This year is likely to be a year of surprises. Global economic growth will disappoint. The intrusion of governments into all matters financial, economic and even personal is a cause for uncertainty associated with policy risks; and markets hate uncertainty. It is these policy risks which could have the biggest impact on the potential global recovery in the economy and financial markets.

2010 should also be the year when many countries from the USA to the UK to China will experience the first moves towards policy tightening and the gradual withdrawal of financial and monetary stimulus. Moves by China to begin tightening monetary policy, even though they are only tinkering with the problem of excess liquidity, are a leading indicator to world markets of this changing environment. The consequences of this tightening are not yet visible, but could well become far reaching.

One outcome of China's fiscal and monetary largesse has been growing consumer inflation, whether fully seen in official data or not. What has been experienced on the ground by exporting companies, as we have been warning for several months, has been an increase in wages because of a shortage of skilled workers. Many never returned to their factories after last year's CNY. One factory reports (to a friend) that they are short of 17% of their normal labour force and this sort of rate is probably indicative across many coastal exporting companies.

The impact has been twofold: production has been hit and wages have had to be increased. Yesterday, Jiangsu province raised its monthly minimum wage by 13% to RMB960 (US$140). Wages for skilled labour are rising far more. This move by the province is an official recognition of what companies have been experiencing for many months.

The plight of exporting companies has consequences, too, for the RMB. China is under pressure to revalue its currency. Exporters are suffering from severe margin pressures. They are experiencing rising wages, rising raw material prices and increases in electricity and water rates etc. At the same time, credit for many of these companies remains exceptionally tight, so much so, that exporters are asking their foreign customers to open LCS, not at point of shipment, but at point of order placement.

There are a number of consequences resulting from the inflation of costs being experience by exporters. First, there will be the political result. Beijing will resist foreign pressure to revalue its currency - the earliest would be the second half of this year. Second, exporters will be raising their prices after the CNY, on average by around 10%, but for some goods substantially more. Third, buyers of Chinese goods knew well in advance that prices would be rising; they knew too that freight rates were being raised; so they have probably bunched orders up before prices rose. This dynamic together with the modest inventory replenishment being seen in the USA (though not yet evident in west coast US ports) and elsewhere has been the reason for higher level of Chinese and other Asian export business.

There is also another dynamic at work here. Across many manufacturing sectors in Asia business has been boosted by the need to replenish inventory within the supplier chain. This had been rundown to almost zero levels for balance sheet reasons in 2008's 4th quarter and last year's first quarter. This round of inventory replenishment has about now run its course. What lies behind this development will determine the course of the global economy in the first half of this year.

From what we hear, the news will not be encouraging.

China's industrialisation has been nothing short of miraculous - stunning - yet there remain many pitfalls ahead. It has successfully, at least in the short-term, grown its economy whilst most of the rest of the world has suffered the pains of recession. However, by throwing so much fiscal and monetary stimulus at the economy, it risks seeing rising inflation to levels above those of official forecasts (3-4%). Inflation in the Austrian sense is already rampant. Average land prices rose by 106% last year, though even more in many large cities; the stock market exploded; investment in commodities soared, not just by merchants, but by institutions and individuals; and manufacturing, caught in this speculative frenzy, started to produce for inventory. Certainly, our observation from visits last year was that China's economy had far too much speculative froth; that too much of the fiscal stimulus and bank lending were directed into speculation and not into the real economy; and that the seeds were being sown for a nasty reaction post 2010.

We also noted, confirmed by discussions which our associate had with senior people in Beijing that economic success was breeding arrogance in the country, a theme which we have found also. In its dealings with foreign countries, China has become far more assertive, stretching from US arms sales to Taiwan, to the disputed borders between India and China, to its "obstreperous stance it took in the Copenhagen climate change conference last December", to its truculence over the alleged hacking of Google and other foreign companies and to trade issues.

The real question is whether these are tactics of divergence from the government's real problem of how to take the speculation out of the economy in order to create the foundation for sustainable growth, in other words to cause some domestic pain. We don't buy that argument.

We suspect that China has grown sufficiently powerful through its trade, through the rest of the world's perception that the world depends on China's economy and because of its huge foreign exchange reserves for it to finally ditch Deng Xiaoping's words, "Keep a low profile and hide your claws" whilst building up your strength.

The West's response to China's undisputed rise in power and influence will be all-important. The history of empires suggests that America will not allow its global superpower status to be handed over willingly. There are bound to be geopolitical clashes over the coming decade, whether over the Middle East, Taiwan, Japan etc. These will be an intrinsic part of the global transition from a unilateral world to a world dominated by two powers.

In the meantime, trade will be the central issue, a theme which we have focused on for a long time, so will not express again our thinking beyond concluding that the trend is now towards manufacturing being based close to points of final consumption, rather than in some distant country or region like China and Asia.

This is both a political and economic conclusion. Pete Peterson, for instance, calls for business leaders to re-enact the non-partisan Committee for Economic Development that was formed in the midst of WW11 by folks like Paul Hoffman, Bill Benton and Marion Folsom, or something along those lines, in order to try and solve the nation's structural problems, ranging from rising budget deficits, the $60 trillion in unfunded government liabilities and promises, to the growing intrusion of government into business and finance.

Part of this coming revolution will surely be to bring back within American borders much of the manufacturing capacity needed for its own economy, rather than having that capacity located offshore. Government has begun this process by wielding a stick, threatening to curtail many of the financial benefits and tax breaks that US companies currently enjoy from their offshore operations. The next stage will be to offer the carrot - by granting tax and other incentives for US multinationals to make that move.

This relocation of capacity will not happen on its own: it will be an integral part of the US using its scientific and engineering prowess to produce state-of-the art products, whether by the development of intelligent cars, telemedicine, smart robots, artificial intelligence and other devices. In short, it will be a combination of America's power of technology and the political and economic forces pulling manufacturing back home which will revolutionaries the global economy with similar developments to be seen in Europe and Japan. It will not be just competition by price, but competition by quality and design which will allow America to reemerge as a dynamic economic power sometime by the end of the 2010s.

First, though, there must be the Schumpeterian destruction of outdated plant and the financial system which then allows a return to traditional ratios of capital structures with a focus on long-term investment. It is this destruction which always occurs in the Winter of the K-Wave, probably starting around 2012/13 in a succession of down-waves which don't terminate until circa 2018. This does not mean that the entire period is one long depression, but that recoveries are relatively short within an overall downturn.

In summary, global economic recovery will disappoint as set out below:-

• Growth will slow in the first half of this year

• It should recover late this year with a modest recovery likely in 2011.

• The seeds of the next credit crisis have been sown by soaring government debt and monetary largesse. It may well be the need for a huge issuance of government loans that will cause the next credit crisis, starting around 2012 and reaching its apex in 2013.

• A new global recession, part of the ongoing depression, will begin that year and last at least two years.

• The world is unlikely to begin a new period of sustainable growth until 2018 at the earliest.

Until then markets will remain volatile and should be traded rather than now making long-term investments.