Global stock markets have been falling recently as the world slowly comes to realize that the U.S. financial contagion is spreading throughout Europe and Asia. Perhaps the most striking example of the global slowdown can be seen in deceleration of Chinese exports to the U.S. From 2003-2007 Chinese grew about 26% annually, but in the second quarter of 2008 the annual growth rate was only 8% according to Morgan Stanley. As you can see by the chart above, Developing Asia (China, Korea, Singapore, etc.) has become increasingly dependant on exports. As the U.S. consumer began to pull back, unable to tap their home equity for more money, the Chinese shifted their export focus to Europe and Japan. But now these economies are falling into recession as well.
In Europe, the broad Dow Jones Stoxx index of 600 companies declined 2.1 percent in afternoon trading. In Paris, the CAC-40 index lost 2.2 percent , while the FTSE-100 in London shed 2.1 percent. In Frankfurt, the DAX was off 1.8 percent. Fears about the economic outlook compounded the pessimism in Europe.
“The economic outlook is increasingly worrying,” said Andreus Hürkamp, chief strategist at Commerzbank in Frankfurt. “That’s the main reason why the euro is falling.” A report last week showed that gross domestic product in the euro area fell 0.2 percent in the second quarter. Separate data showed the German and French economies shrank.
For years our politicians and business leaders have preached the benefits of globalization, as world economic growth and trade hit new highs. We are now going to experience the downside as a global business cycle of interconnected economies slides into a worldwide recession that I think could last into 2010. The effects of this slowdown will be geopolitical, cultural and obviously economic.
Before I delve into what I think is to come, I want to spend a minute on how we got here. Last month, I wrote a post called Return to the Mean which had a fairly simple thesis–Bubbles always burst, returning us to normal levels. The most salient chart was of consumer spending as a percentage of GDP. It started soaring in the Reagan era and eventually moved from 62% up to the current 73%. As the U.S. continued to hollow out it’s manufacturing base, we relied more on consumption to fuel our $13 trillion economy. Our need for hyper-growth was fueled not by our income but by an asset impairment and debt based revenue scheme. And in that scheme we had a willing co-conspirator in the Asian economies, happy to loan us money to keep buying their goods. And after 9/11 the Bush government hit the panic button, calling on Americans to go to the mall as their patriotic duty and borrowing ever greater sums from the Asians. This virtuous (or vicious) cycle is now ending. The consumer can’t use his home as an ATM machine and the Asians will have to throttle back their hyper growth in exports and generate domestic consumption.
So what are the implications? In the financial world it seems to me that the consensus expectations of 25% earnings growth for the non-financial component of the S & P 500 in the next year are wildly optimistic. As I’ve said before, I think high quality bonds are perhaps the best place to hide. From a geopolitical point of view, I would have to assume some risk in Asia of civil discontent. China has been growing at about 12% a year. If that slows down to 7% the ability of the government to continue to bring millions into the middle class will be severely challenged, especially if local inflation continues. Throughout Asia, aging populations without a real social safety net will require that dollar reserves be deployed to some sort of social security and health care system. Although Europe is much better prepared to deal with this problem, one can’t ignore the demographic nightmare in countries like Italy, brought on by a shrinking working age population to pay for a growing baby boomer retirement. Needless to say this same inter-generational conflict will play out in the U.S. as has been obvious on this blog. The redeployment of Asian dollar reserves to domestic concerns will mean that easy Asian money to finance U.S. military adventures will not be readily available.
But ultimately I think the cultural shift will be the most gut-wrenching for our country. Ever since Ronald Reagan pronounced that it was “Morning in America” we have lived in the warm and fuzzy illusion that there really was a “free lunch”. We could finance massive military build-ups; fight wars all over the world; cut taxes; get rid of pesky government regulators in food, drugs, banking, media and the environment; build billions of square feet of shopping malls throughout the country to keep this consumer machine growing at 3.5% a year. Well, guess what? There is no Free Lunch. Possibly the greatest failing of our politics since Reagan’s election is the unwillingness of our President to tell the truth about this unsustainable consumption/debt binge. Confronted with the credit crisis, what did we do? Send a $1200 check to every family so they could return to the mall. The Republicans have been the worst in preaching the free lunch, and though Clinton yielded to the Bond Ayatollahs in the early 90’s and cut the government debt, he never did anything to try to reorient the much larger consumer economy towards saving,investment and production and away from consumption and debt. Even though Al Gore “wrote the book” on the energy crisis, we never made any significant investment during the 90’s in alternative energy sources. Bush and Cheney were of course ten times worse.
Now we face an election in which two candidates are vying for the privilege of leading us out of this crisis. One of them, John McCain, living in a fantasy world of multiple mansions and private jets, still believes in the free lunch. He wants to keep the Bush tax cuts on the very rich, continue our military adventurism and thinks we can drill our way out of the energy crisis. By contrast, Obama has said there are “tough choices and many sacrifices” ahead for our country. But he too has been too willing to embrace short term solutions, believing that rapid economic growth is the solution to all of our problems. The transition to an economy that makes serious investments in infrastructure will be painful. I am aware that the obvious solutions to both our fiscal and over-consumption problems–like a $1 per gallon federal gas tax (a lot less than most European gas taxes) to fund alternative energy investment are political dynamite because of 38 years of Republican propaganda about taxes and the free lunch. But ultimately someone is going to have to tell the truth to the American people. Perhaps the coming global recession may provide the dose of reality an easily distracted public needs to face the truth. And in that moment, a realist like Barack Obama, may be just the right person to guide us through the coming crisis.