2nd Quarter 2004: Global Markets 2nd quarter 2004 - The China Story

By mid 2002, China made up 12% of world GDP - which is a marked improvement from having represented 3% some 22 years ago. It was already projected then that by the end of 2003 China would be the world's biggest consumer of platinum, copper, iron ore and aluminium. During 2003 the Chinese economy grew by 9.1% and at an annualised rate of 9.7% during the first quarter of 2004.

While all these statistics are impressive, there are now concerns that the Chinese economy may be "overheating". China's Premier, Wen Jiabao (appointed in March last year), warned during his tour of Europe in early May that "we are now under pressure of inflation." During the first quarter of this year, inflation increased by 2.8%. While this number is manageable, over the same period "factory gate prices" jumped by roughly 7%. There are reform measures currently being implemented by the Chinese authorities in an attempt to slow the Chinese economy down to more sustainable levels. "We cannot slam the brakes, we have to press the brakes gently" Premier Jiabao is quoted as having said recently. There are concerns, however, that these reforms may be difficult to implement.

Allan Zhang, who spent 14 years at the Chinese Foreign Trade Ministry, and who now heads up the China Business Centre in London for Pricewaterhouse Coopers, appears to be less than optimistic about these reforms. In his view "the central government is trying to cool down the economy, but that conflicts with local government officials who're keen to develop their economies. The local officials, basically they are paid by the local province….so the finance is not directly from the central coffers. Those local governments…have their own agenda." These comments stem from his view that Chinese officials focus on improving local growth, as they are apparently then "more likely to be promoted". Based on this view, it appears as if not only the economy is in need of reform - perhaps bureaucracy, too, will need to be addressed.

So the question that remains is whether the Chinese economic reformers can slow economic growth to sustainable levels or not. One of the hidden dangers, of course, is the possibility of "over correcting" and causing a slump in the Chinese economy. Only time will tell how this story will unfold.

Despite interest rates having been kept on hold during the quarter (at 1% and at their lowest level since 1962), there is now a growing concern that interest rate increases by the Federal Reserve are likely to take place sooner rather than later and almost certainly during the second half of this year. A falling dollar, rising commodity prices and an improvement in the job market (we have witnessed two consecutive months of higher payrolls and it has been estimated that some 708 000 new jobs were created between February and April this year - the April number brought the unemployment rate down to 5.6%) are some of the factors that are fuelling this view. Rising inflation is a consequence of the above factors (labour costs represent the biggest component of inflation), which is something that the Fed will need to monitor closely. We all recall how aggressively the Federal Reserve cut interest rates in 2001, following on from the recession which arose after the bursting of the TMT bubble in March 2000. Interest rates are cut in an attempt to boost the economy by making it attractive for corporates and businesses to borrow. Conversely, interest rates are increased when the authorities want to reign in growth and temper the economy - which then should ultimately keep inflation under control.

The wording of the statement at the most recent Fed meeting in May, following their unanimous decision to keep rates on hold incorporated some subtle changes, including the following extract "accommodation can be removed at a pace that is likely to be measured" which is a move away from their previous statement which stated that they would be "patient" about increasing rates. David Kelly, senior economist at Putnam Investments, commented as follows following their statement "this is a further advancement on the date at which the Fed starts to raise rates. I think this puts the odds of a
rate increase at their June 29 - 30 meeting at about 50 percent." As recently as the beginning of May, many forecasters were still of the opinion that interest rates were only likely to rise in August, at the very earliest.

Joel Naroff, president of Naroff Economic Advisors, expects that "the rate increases will start off slowly, but if inflation keeps accelerating, all bets are off afterward." Rising interest rates are generally not favourable for corporate profits or stock valuations. The prevailing uncertainly regarding interest rates has put markets under pressure in recent weeks. In addition, the alleged abuse of Iraqi detainees by American and British forces and other global security issues have also impacted negatively on investor sentiment. It is speculated that the upcoming elections in November may be the largest factor preventing the Fed from increasing rates too aggressively this year.

The economy, largely fuelled by consumer spending and renewed capital spending, grew by an annualised 4.2% in the first quarter of 2004.

Interest rates remained at 2% during the quarter under review. For some time now, there have been numerous calls for interest rates in the Eurozone to be reduced in an attempt to boost economic growth in the region - most notably from the German business community (the unemployment rate in Germany is currently at 9.8%). Following their most recent meeting, ECB President Jean-Claude Trichet said "we have not changed our assessment that the current stance of monetary policy remains in line with the maintenance of price stability over the medium term. We will continue to monitor the situation closely. On balance, there is currently no evidence challenging the assessment of continued, though modest, real GDP growth in the euro-area over the short term."

Inflation, which is currently benign at 1.7%, is expected to exceed 2% within the next few months. The rising oil price and recent Euro weakness are two of the main contributors to rising inflation.

While growth prospects for the Eurozone have increased, these forecasts are still well below the current forecasts of 4.6% for world growth.

Interest rates increased to 4.25% following an announcement shortly after the May meeting of the Bank of England. The announcement of the increase came as no
surprise as the Bank attempts to temper surging property prices and consumer debt levels. This is the third 25 basis point increase since November last year. Some analysts have stated that it is not impossible for rates to reach 5% by year end.

House prices have continued to rise unabated despite the recent interest rate increases. According to Halifax (the largest mortgage lender in the UK), house prices increased by 1.8% in April, with prices up by 19.1% on last year. Following the most recent meeting of the BOE, the chief economic advisor of the CBI is quoted at having stated that "business recognises that interest rates need to rise to a more neutral level over the next 12 months, so this rise is no surprise. Companies will be pleased that the Bank has continued its well-signalled, gradual approach."

Inflation in the UK, which is currently below its target level of 2%, is expected to rise above this target range within the next two years. A recent report stated that "UK business optimism and output are at their highest levels since the mid 1990's." Most economists are of the view that the "economy is on track to meet the growth targets of the Chancellor, Gordon Brown." Preliminary GDP data suggests that the economy grew at an annualised 3% during the first quarter of 2004.

Japan continues to benefit from increased investor confidence. Ongoing demand from China, Asia and the United States continues to provide support for Japanese exports. Exports have increased by some 13% in the last 12 months. The Governor of the Bank of Japan, Toshihiko Fukui, has warned however, that any recovery this year is unlikely to continue at the vigorous pace of the past number of months. Imports, which have continued to rise almost in line with exports, could be the reason for this word of caution from the Governor as it is almost impossible to control these import costs. On this subject, Soichi Okuda of Sumitomo stated that "Imports were higher than expected, but if you take out that factor, it's clear that exports remain the main driver of Japan's economic recovery."

April 28th marked the first anniversary of the recovery that has been underway on the Nikkei 225. Although coming off of a very low point, this index has recovered by some 60%, which has been the best return for this period for any major equity market. Restructuring has been evident among the larger companies in both the manufacturing and service industries. In addition, consumer spending appears to be improving. It has been reported that unemployment levels reached three-year lows in March. The one factor that could dampen investor sentiment about the region going forward is how investors react to current attempts to moderate the pace of growth in China with a view to reducing growth to more sustainable levels.

No changes were made to the Repo Rate and the Prime Lending Rate during the quarter under review. These rates therefore remain at 8% and 11.5%, respectively. Failing any marked changes to the current economic environment, we are still of the opinion that domestic interest rates have bottomed for this cycle. The question now being asked by most economists is when we can expect the first domestic interest rate increase to take place? We have already witnessed three interest rate increases in the United Kingdom and it appears as if the United States may be closer to increasing rates than most analysts had expected. Jac Laubscher, chief economist of Sanlam, doesn't believe that domestic interest rates are a one-way bet at the moment. In an article that appeared on the www.iafrica.co.za website on the 20th May, it states that he is of the opinion that it is possible for domestic rates to remain on hold during 2004, with the possibility of further cuts in 2005. This view is based on several factors, including "smaller-than-expected impact of oil prices on local inflation; a peak in local and global growth cycles in 2005; relatively sluggish domestic growth in 2004 and the SARB's own forecast of inflation remaining below the 6 percent upper band of the inflation target through 2005-06".

The Rand depreciated to above R7 to the US Dollar during the quarter, but showed renewed strength when it was announced that South Africa had won the bid to host the 2010 FIFA World Cup. The benefits of this success for South Africa are far reaching in that, according to an article in the Business Day, this event could provide a R21,3 billion boost to the domestic economy. According to Grant Thornton's projections referred to in this article, hosting this event could increase direct spending by R12,7 billion and create more than 150 000 jobs. Upgrading stadiums is likely to cost R2,3 billion. In addition, the SA Revenue Service is likely to benefit by some R7,2 billion. While this is very encouraging news for the domestic economy as a whole, it is likely to be some time before these benefits flow through. The Rand ended the quarter at R6.55, R7.99 and R12.02 to the US Dollar, Euro and Sterling, respectively.

The price of Brent crude oil increased sharply during the quarter to end the period at $37.01 (recent levels in excess of $40 will be remembered from 1990 when Kuwait was invaded by Iraq), from $33.24 per barrel at the end of the previous quarter (end February 2004). There are many theories relating to the possible cause for the dramatic increase in the oil price, however, it is the economic principle of supply and demand that appears to be the main driver. Continued political instability and attacks on oil facilities in the Middle East have raised supply concerns. Also, demand from the world's largest consumer of oil, the United States, as well as from China remains high. Forecasts by the International Energy Agency for global oil demand growth for 2004 have been increased to 1.95 million barrels per day.

It has been speculated that increased consumption alone does not account for the rising demand. The rising demand may largely be attributable to oil being stockpiled (especially by governments such as China, the United States and India) as a precaution against potential interruptions to the oil supply.

Purnamo Yusgiantoro, president of OPEC, has indicated that member states still need to agree on increasing output. OPEC is scheduled to meet in Beirut on June 3rd to discuss this issue. In the meantime, following a meeting of the G7 countries in New York on May 22nd, Saudi Arabia pledged to pump an extra 800 000 barrels of oil per day. Recent figures released from the Middle East Economic Survey indicate that already 2.5 million barrels in excess of the OPEC daily quota of 23 million barrels are being pumped. The major fear of a surging oil price is the threat it poses to global growth.

In contrast to oil, the gold price declined over the quarter - ending the quarter at $395 an ounce, from $398.90 an ounce at the end of February 2004. In our last article, we stated that a weak US Dollar, together with low short-term global interest rates (more specifically in the US), were providing support for the gold price. However, we have already witnessed the impact of a recent US Dollar rally on the gold price. In addition, interest rates in the United States are almost certainly set to rise during the second half of this year. Could these possibly be signs that the current rally in the gold price is running out of steam?

We are of the opinion that global markets will prove challenging during 2004 - interest rates are likely to start rising in the USA during the second half of the year, China appears to be "overheating" and certain global property market valuations are looking "stretched". But the news is not all negative. On the contrary, the global recovery has remained intact to date and there no longer appear to be concerns about deflation. China, while possibly "overheating" is still likely, together with Japan, to provide some good news in 2004. Europe has picked up momentum recently, be it very slowly, and growth in the United States for the first quarter of 2004 was an annualised 4.2%. In summary, we believe that because of certain macroeconomic factors that are currently very sensitive (global interest rates, elections, oil and gold price movements, inflation rather than deflation, etc) volatility is likely to prevail in global markets during the course of this year. As cautioned in our last report, because the robust returns of the past twelve months are unlikely to be repeated over the next twelve, it is important that we modify our expectations going forward.

QUARTERLY QUOTE
"An economist is an expert who will know tomorrow why the things he predicted yesterday did not happen today"
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This report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.