THE FED AND THE MARKETS

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2 THE US ECONOMY Annual % change in quarter, unless noted otherwise 213 THE FED AND THE MARKETS Percent, unless noted otherwise Q1 Q2 Q3 Now Jul 31 Real GDP Fed funds target rate -¼% -¼% Memo: Excluding government Fed funds futures n.a..1 Final sales m Libor Consumption yr Treasury note Inventory Change ($ bn ar) y Treasury note Nonfarm Inventories Farm Inventories US dollar/euro Real GDI Yen/US dollar Real compensation Real pretax profits End- Aggregate hours worked Now 213 Nonfarm payrolls Ave. mon. change ( ) Wilshire 5 16,797 18,121 Industrial production % oya Manufacturing output P/E² Unemployment (% at q. end) Historical ave Chain PCE prices (% oya¹) S&P 5 1,68 1,695 Food (% oya¹) % oya Energy (% oya¹) Core (% oya¹) CPI (% oya¹) Core CPI (% oya¹) Petroleum (WTI, $ per barrel) Notes: bold figures are Chase forecasts; ar refers to annual rate. ¹ Change from 12 months earlier as of the last month of the quarter. ² Versus after-tax earnings, excluding the high multiples of the late 199s. Sources: US Department of Commerce; Federal Reserve Board. RECAP OF LAST WEEK S ECONOMIC NEWS Fed views on asset purchases (Summary of Economic Projections, not the formal FOMC Minutes): About half of [the FOMC] participants indicated that it likely would be appropriate to end asset purchases late this year. That s half of the 19 discussants but only three (possibly five) of the 12 members who vote on policy decisions. That accounts for the disconnect often sensed between the broad Committee discussions and the Fed Chairman s more cautious position. Taperers to the market: Pay no attention to the Q2 GDP report to be released on July 31. Maybe the 14 th comprehensive revision to the National Income Accounts released at the same time will bring GDP figures back in the game. It would help to know how employment has been growing almost 2 percent annually. Don t say productivity: that s a cop out. The federal deficit is down to 4.4 percent of GDP from 1 percent in 29. That s what happens to cyclical deficits as the economy recovers. It s the structural deficit, what lies in the future when the economy is back on its feet, that is the issue. The debate suffers when we try to solve the wrong problem. THIS WEEK S ECONOMIC CALENDAR Retail sales (good), CPI (energy kick but tame core), housing (ok), jobless claims (ignore until August), industrial production (slow), Bernanke s congressional testimonies on the state of the economy (he values continuity). ECONOMIC FOCUS: Slower Chinese Growth Is A Good Thing Here they go again. China is slowing. Trouble? No. A slowing Chinese economy is constructive, for China and for the global economy. Perversely, it will boost global demand. APPENDIX: Economic and Market Forecasts Weekly Insights on Markets and the Economy Commercial Banking 2

3 ECONOMIC FOCUS: Slower Chinese Growth Is A Good Thing Summary: China s economy is slowing down. That is a natural evolution for a fast-growing emerging economy. Perhaps Europe s stall has sped what was underway already. China s leaders aim for a more moderate 7.5 percent growth rate over the next phase and there could be moments when growth deviates from that. A slower Chinese economy doesn t threaten the struggling global economy. For one thing, China s economy may have grown to be the second largest economy, but it is heavily dependent on her role as an assembly point. It is a conduit for business. So, the size of her GDP exaggerates the significance of her demand for the global economy. For another, China s unique ability to build the infrastructure first that it can grow into as it modernizes has put enormous temporary pressure on prices of raw materials and commodities and that has been a challenge for the rest of the world. Slower Chinese growth will bring relief on that front. Third, China s supercharged development has outpaced her ability to spend and invest the resources she is earning in international trade. As a result, China s trade surplus has widened enormously. In the aggregate, that means global saving has expanded and global demand not kept pace. As China s development matures, these imbalances will ease and that will help to lift global demand. BECAUSE IT S A NATURAL EVOLUTION China s economy has been downshifting from the overdrive growth rates of the last decade (see the figure on the following page). Europe s economic stall almost certainly has accelerated this natural transition that has been under way for China s rapidly emerging economy Chinese exports to Europe represent a significant percentage of her economy. Chinese leaders have been casting the slowdown in a favorable light and that is appropriate. They have targeted annual growth of 7.5 percent over the next decade. The Chinese Finance Minister Lou Jiwei even said that the economy could grow a little slower than that, and that the government could tolerate growth as slow as 6.5 percent to 7 percent this year. Although the gradual moderation in China s growth rate is natural and benign, it is raising concerns in the financial markets that a slowergrowing Chinese economy might retard the ongoing global economic recovery. In part that s because observers assume that the rapid development of emerging economies has been an important antidote for recessions in the developed economies. And in part there s a worry that, with the Chinese economy having grown so much larger in recent decades, it has become an important component of global economic activity so that a slowdown would have an important impact on global demand. These concerns seem to be reflected in the Shanghai stock market index, which has fallen back to year-end levels, compared with the steady rise in the US stock market to new records (page 5). Weekly Insights on Markets and the Economy Commercial Banking 3

4 SLOWING NATURALLY, WITH A LITTLE ADDED DRAG FROM EUROPE Real GDP growth in selected regions (percent change from four quarters earlier) Forecasts China India 5 4 All others Global (shaded grey region) US Japan Sources: US Department of Commerce; J.P. Morgan; Chase. Updated through 213 Q1. 28-member European Union Nonetheless, a growth moderation in a developing economy like China s, particularly when the central government has the resources and the authority to manage activity, has a different implication for future economic activity than a slowdown in a fully developed, market-based economy. It may be more useful to think of the moderation in China s growth as more akin to growing pains. An economy that is modernizing as rapidly as China, that has ambitions to industrialize and urbanize in a much shorter span of time than was the case for today s developed economies during the Industrial Revolution from the mid-17s to the early 19s, is bound to run into bottlenecks and to generate excesses along the way. In that regard, many are tempted to blame developments like China s housing excesses, the dark cities, for the slowdown. However, in contrast to the US housing debacle, China s housing excesses have to be evaluated in the context of future needs. There is no connection between the US housing bubble and the Chinese housing excesses. Why? If China s government Weekly Insights on Markets and the Economy Commercial Banking 4

5 MAKING CHINESE INVESTORS NERVOUS S&P 5 ( =1) Dow Jones Shanghai Index (December 31, 1993 =1) 2,5 5 S&P 5 (left scale) 45 2, , , 2 Dow Jones Shanghai Index (right scale) 15 hopes to move 26,, people from the villages to urban areas over the next decade or so by the way, that urbanization occurred over the one hundred years between the mid-18s and the mid-19s a massive investment in infrastructure first is needed. This is bound to create dark city impressions that can be easily misinterpreted as the aftermath of a speculative binge (see Leaving the Land, China s Great Uprooting: Moving 25 Million Into Cities, New York Times, June 15, 213). Ultimately, the Chinese government hopes to fully integrate 7 percent of the country s population (roughly 9 million of her 1.4 billion people) into city living by 225. Such an ambitious plan can t possibly be accomplished in a straight line Sources: NBER-designated recession bar; US Department of Labor; JPMorgan Chase & Co. Updated through July 12, 213. BECAUSE CHINA IS STILL A CONDUIT At the same time, the size of China s GDP likely overstates her importance in aggregate demand. China s economy has climbed to the rank of Number Two measured by the size of GDP. Nonetheless, much of China s economic growth has been built up around her comparative advantage as an assembly point for global Weekly Insights on Markets and the Economy Commercial Banking 5

6 CHINA IS MORE OF A CONDUIT THAN A DEMAND POWERHOUSE US exports to and imports from China (billions of dollars over the most recent 12 months) production. That is, China is largely a conduit for components that are brought in, assembled, and then exported US goods imports from China US goods exports to China Source: US Department of Commerce. Updated through May That theme is evident in US trade with China: the US imports $4 billion of merchandise from China, far more than it exports. China imports only $1 billion annually from the US (see the illustration on this page that highlights US exports to and imports from China). That is a lot more than it used to be and China represents the fastestgrowing market for US exports, but China s demand remains relatively modest relative to global demand. Moreover, the $1 billion of US merchandise exports to China likely consists of components that are used in China s export activity. The best measure of China s importance as a source of growth is China s imports, which remain modest, in line with her living standard. As China continues to transform her export-based economy into better balance, with more domestic demand, and as China s living standard rises, Chinese consumers will become a much more important source of aggregate global demand. Weekly Insights on Markets and the Economy Commercial Banking 6

7 RELIEF FROM COMMODITY PRESSURE Selected commodity price indexes (1967 = 1) 7 CRB spot commodities 6 Reuters/Jefferies CRB commodities futures index Source: Knight Ridder; Reuters-Jeffries. Updated through June BECAUSE IT EASES COMMODITY PRESSURES China s eye-popping development pace, and her political ability to macro-manage her economic modernization agenda, has generated enormous demand for raw materials, more so than for most other developing economies. China s development is unique, because her government is able to build the infrastructure raw materials intensive in anticipation of development needs, in contrast to the more typical build-it-after-the-need-is-evident approach for most others. This has created significant challenges for others, including the developed economies. Surely it is a key reason why petroleum prices have remained at the high end of the historical ranges even though the developed economies of Europe, the US, and Japan economies that comprise almost half of the world s GDP have suffered major contractions. For this reason, some moderation in China s growth would be expected to ease the pressure on global commodity prices, as seems to be evident this year. And that will bring some relief to others. Weekly Insights on Markets and the Economy Commercial Banking 7

8 AND BECAUSE IT WILL BOOST GLOBAL DEMAND Perversely, slower Chinese growth is likely to boost global aggregate demand. Say again? China s decision to develop on the fast track by opening her borders to the international business community allow outsiders to come to China and build export facilities rather than to grow organically enables her to industrialize much faster than the developing economies did during the first Industrial Revolution. China seems to aspire to do in decades what took the developed economies the better part of 2 years to accomplish. China can do this catch up with the help of the international business community. One of the challenges of this fast-track approach, however, is that it leads to enormous international trade imbalances. The ballooning US trade imbalance in the last decade was widely misinterpreted as a sign the US was living beyond its means importing more than it was exporting when in fact it was the opening up of China that was the driver. The massive widening of China s trade deficit with the US and other developed economies meant that China was exporting far more that it could buy, because her consumers did not enjoy living standards yet that could support stronger imports. China is spending huge sums investing in infrastructure, but still cannot spend all of the resources that she earns in international trade with Europe and the United States. That trade surplus that China, or her Asian partners, earn represents national saving. An expansion in Asia s trade surplus with the developed economies means that their saving national saving is up and, symmetrically, that aggregate demand is temporarily depressed. And with China s focus on investment in commodity-intensive infrastructure a larger share of global demand is concentrated in the materials sector and less in goods and services produced in the developed economies. With that key implication of international trade imbalances in mind, a gradual moderation in China s growth rate as the country matures implies that the imbalances in global saving versus global demand will begin to moderate somewhat. In that case, global demand will begin to rise and global saving fall back, easing headwinds for the global economy. STILL EARLY DAYS FOR CHINA S DEVELOPMENT China s growth slowdown is not the beginning of the end of the boom the country has been enjoying for the past several decades. It merely represents a transition to a more balanced phase of growth. There are several reasons to believe that China s economic development will continue to move forward. For one, China remains relatively open to the international business community, which is eager not only to take advantage of the country s advantages as a source of low costs of production but because businesses see significant consumer Weekly Insights on Markets and the Economy Commercial Banking 8

9 JUST THE OPENING ACT FOR CHINA China s relative living standard (ratio of Chinese real GDP per capita to US real GDP per capita) opportunities as the country s living standard rises. In other words, China can continue to depend on outside help to hasten her modernization. Second, the rapid advances the country is making has the potential to be socially disruptive, because some will benefit more than others. The leadership seems guided by a desire to minimize social tensions and that implies that, having chosen to move forward as rapidly as possible, the country must continue to growth to minimize social instabilities. Third, as much progress as China has made in the last few decades, she still has a far distance to go to achieve the living standards enjoyed in the developed economies. China s living standard has climbed to about 25 percent of that in the US. From that perspective, China, and for that matter many of the newly emerging economies, can expect to continue to grow rapidly for the next several decades * Based on 25 US dollars, PPP basis. Source: US Department of Commerce;. Updated through 213 Q1. Weekly Insights on Markets and the Economy Commercial Banking 9

10 APPENDIX 1. GLOBAL ECONOMIC FORECAST Annualized percent change over the quarter Percent change over the four quarters of each year Real GDP 4Q12 1Q13 2Q13 3Q13 4Q Potential Growth Global Nafta Canada Mexico United States Europe EU Germany France Italy Spain United Kingdom Asia Japan China India Other Brazil Note: bold figures related to the US are Chase forecasts and figures for other economies are J.P. Morgan forecasts. Global and National Economic Outlook Commercial Banking 1

11 APPENDIX 2. US ECONOMIC FORECAST Annualized percent change over the quarter Percent change over the four quarters of each year Chase Forecasts 4Q12 1Q13 2Q13 3Q13 4Q Steady State Real GDP Memo: ex. Government Consumers Business investment Unemployment (period end) Official unemployment rate to 5. Unemployed 16- to 45-yr x olds (percent of cohort)¹ Inflation (PCE prices) Food Energy Core Petroleum ($/bbl, WTI, eop) $88.3 $93.1 $95.8 $95 $9 $88.3 $9 $75 $75 $75 FOMC Forecasts² Long term Real GDP 2. to to to to 3. Unemployment 6.9 to to to to 6. PCE inflation.8 to to to Core PCE inflation 1.1 to to to 2.3 Note: bold figures are forecasts. ¹ Inverse of the employment-to-population ratio for those 16 to 45 years of age that is, the percent of those 16 to 45 years of age who are unemployed. ² FOMC forecast range as of June 19, 213. Global and National Economic Outlook Commercial Banking 11

12 APPENDIX 3. MEDIUM-TERM US INTEREST RATE OUTLOOK Percent per annum FOMC Meeting FOMC Meeting: Jul 3-31 Sep Oct Dec Jan Mar Apr 29-3 Jun Jul 29-3 Sep Oct Fed funds target rate -¼% -¼% -¼% -¼% -¼% -¼% -¼% -¼% -¼% -¼% -¼% Fed funds futures month Libor y Treasury note y Treasury note Note: bold figures are Chase forecasts. Global and National Economic Outlook Commercial Banking 12

13 APPENDIX 4. LONG-TERM MARKET OUTLOOK Percent per annum at period end Chase Forecasts 4Q12 1Q13 2Q13 3Q13 4Q Steady State Federal funds target rate month Libor year Treasury note year Treasury note US dollar / Euro Yen / dollar Wilshire 5 14,995 16,598 16,992 17,275 17,597 14,82 14,995 18,622 19,767 19,767 2,961 S&P 5 1,426 1,569 1,66 1,628 1,648 1,527 1,426 1,648 1,744 1,852 1,963 Petroleum ($/bbl, WTI, eop) $88.3 $93.1 $95.8 $8 $ $88.3 $75 $75 $75 $75 $75 FOMC appropriate federal funds rate target¹ 3Q12 4Q12 1Q13 2Q13 3Q Long term Median Low High Note: bold figures are forecasts. ¹ The appropriate target rate at the end of the year shown. Figures are as of the June 19, 213 FOMC meeting. Global and National Economic Outlook Commercial Banking 13

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