1-25-2010

Sometimes Black Swans Wear White Hats

The black swan theory refers to the existence of rare unexpected events of large magnitude. We’ve talked about it before. We might be going through a black swan event right now. This Black Swan, however, may be wearing a white hat. No one forecast the collapse of the United States mortgage banking system and the devastating effect it would have on the world economy. No one also forecast that from the depths of a serious worldwide recession, China would pull the world economy back to recovery. 

China has led the world out of recession. China is now growing a little faster than the Chinese government wants in order to keep domestic inflation in tow. Some investors in the United States have theorized that the Chinese economy is a bubble that will burst. They point to the unprecedented explosion of capital spending in China over the last decade. They theorize that commercial real estate is so overbuilt in China that there will be an empty office space for every man, woman and child in China. They liken the Chinese expansion to the soviet expansion under Khrushchev.  They hypothesize the demise of the value of all commodity and industrially- related companies. This is a lot of rubbish. The Chinese have brought hundreds of millions of people into their productive work force from rural and nomadic existence over the last thirty years. They have created cities and companies and respond quickly to the needs of their population, altering their strategic plans as they progress. However, free market advocates damn all central planned economies, regardless of outcomes. Also, the demand for infrastructure that is supported by commodities and industrial goods is also rising in other economies that have emerged. 

The United States has, unfortunately, allowed their education system to atrophy and bolstered entitlements to a very high percentage of GDP. We led the world into a recession when the financial derivative instruments we created in an un-regulated free market proved faulty. We had to drop interest rates to zero and create enormous financial bailouts to stabilize our economic decline.  Despite enormous fiscal stimulus, we are still just emerging from the recession and unemployment is still high.

The Chinese attacked the recession with more effective fiscal stimulus and are in the admirable position of possessing a huge $2 Trillion surplus from their trade with the United States over the last two decades. They quickly emerged from recession and now need to slow down bank credit. They also find themselves in the unattractive position of having their currency pegged to the dollar at a time when the U.S. is  maintaining zero interest rates to stimulate our economy. This is extremely problematic for the Chinese. If the dollar that the Yuan is pegged to was stronger, the Chinese would not have to worry so much about growth causing inflation. It is precisely because they are outperforming the U.S. so broadly that inflation is such an issue with their currency pegged. There is little chance of the dollar running away to the upside when our fiscal deficits are so big, our economy is weak, and our interest rates are zero. 

We are experiencing a rare unexpected event of large magnitude. A country whose economy is somewhere between one third and one half the size of the U.S. economy, depending on how you measure it, is assuming the economic leadership role in the world. The U.S. has been the world’s economic engine since World War II, and it is now stepping aside as China takes on that role. It is highly likely that China will decide to increase the value of the Yuan relative to the Dollar this year. It is most likely that they will remove the peg sometime in the next decade. The peg was most important when the vast majority of Chinese production was targeted at export to the United States. The Chinese experience holding dollar-denominated assets through the last business cycle, along with the growing percentage of Chinese production that will be targeted at domestic consumption, will change this. 

In past market cycles, we have often seen the stock market begin a new bull market in anticipation of a recovery from a recession. Most of our recessions were ended with V shaped recoveries. The market often corrected when the rate of growth in the rebound phase off the bottom slowed. Guess what, the Chinese have had a V-shaped recovery!   They are now forcing a slowdown in their growth rate and stock markets last week had a correction. 

We are having a hard time recognizing that we aren’t driving the train anymore, but we’re not! Markets will be taking their lead from China. That’s because China is leading the world. Some investors think this is bad. It’s not bad; it’s very good. What would be bad is if the world economy was still dependent on a partially crippled U.S. economy to pull everything along. 

The emergence of China into this leadership role was not anticipated by anyone two years ago. The effect of China taking the lead is very profound.  The facts are, though, that the impact of this black swan event is positive and, indeed, gives the U.S. unexpected room and time to build a self-sustaining recovery of its own. 

 

Fred S. Fraenkel
Vice Chairman and
Chairman of Investment Policy
Beacon Trust Company

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