Investors should be cautiously optimistic on China and the U.S., but expect scant positive news out of the Eurozone, said Nathan Sheets, global head of international economics at Citigroup, in Toronto yesterday.
Sheets, who spent 18 years on the Federal Reserve Board and served as advisor to Ben Bernanke, said he’s “not expecting growth in China to accelerate significantly beyond 7.5%,” adding this pace is likely the new normal for the Asian powerhouse.
China’s rise over the last several decades has been fuelled in part by shifting labour from the countryside to the city. This “demographic mobilization has now reached a point of diminishing returns,” though there are still about “100-to-150 million workers left to mobilize,” Sheets explains.
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China’s days of 10% growth are probably over, “but its ability to be an important engine of growth will continue at least to the end of the decade.”
Sheets suggests the next 12-to-18 months should provide “continued confirmation” that China’s 7.5% growth rate is sustainable.
“There will be reduced uncertainty about whether China is going to overheat and create a financial crisis, and about whether there will be a hard landing that brings growth down to 3%-to-4%,” he said.
U.S. on the mend
The recovery south of the border has been softer than in past business cycles, with growth hitting only 2% at the high end. A typical rebound in previous cycles hit 4%-to-4.5%, Sheets notes.
“This is a violation of what Milton Friedman called the ‘pull the string’ theory of the business cycle. He looked at U.S. cycles over a 100-year period, and concluded the farther the economy fell, the faster it bounced back. If we were following this pattern, we should be at 4% or 5%, not 2%.”
Sheets says the lackluster recovery is a result of housing market and unemployment woes stemming from the financial crisis.
“The good news is there’s increasing evidence these headwinds have been abating over the last six-to-nine months,” Sheets says, adding the housing market is now a “tailwind for recovery.”
He also notes U.S. households are getting their balance sheets in order.
“Rising house prices help on the asset side, but the liability side is improving as well. The household-debt-to-disposable-income ratio peaked at about 135% as the crisis emerged. Over the last five-to-six years households have steadily brought it down to about 110%. There’s still some work to be done but I’m confident,” Sheets says.
Bank lending is another positive signal. Business loans are up, though consumer loans are still a little soft. But he expects the credit markets “will heal over the next few years.”
The labour market has improved, but the numbers aren’t as rosy as some headlines make them out to be, says Sheets.
Unemployment is down to 7.75% from a crisis peak of 10%. “But the Fed’s medium-term equilibrium unemployment rate—the so-called ‘natural rate’ of unemployment—is between 5.5% and 5.75%. So we’re still a solid 2% too high, which is roughly three million workers.”
Using broader measures of unemployment the picture is even worse; for instance, including people working part-time because they can’t find full-time work. On this basis, Sheets says the true jobs deficit is closer to five million.
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“This insight into how far we are from labour market equilibrium has made the Fed aggressive, and willing to make a long-term commitment to low rates.”
Sheets suggests a key piece of the puzzle is the mood in the corner offices of the country’s major corporations. When will they feel comfortable enough to significantly increase hiring and investment?
On the plus side, they’re flush with cash and have limited debt. And the manufacturing sector has a major competitive advantage thanks to a new natural gas extraction technique, according to Sheets.
Until 2008, natural gas prices in the U.S., Europe, and Japan were fairly even. “But with the emergence of fracking in the U.S., a cost advantage has opened up in our favour,” he explains, adding manufacturers of plastics, chemicals and fertilizers have benefitted most.
On the minus side, corporations have two main worries. The first is whether there’s enough demand for the added output of new hires. The second is the regulatory, tax and fiscal landscape.
Sheets notes some progress has been made on the fiscal front, but suggests the hardest part remains.
“Entitlements and health care expenditures must be addressed, but there’s very little appetite” for a major overhaul, he says.
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Despite the U.S.’s fiscal troubles, Sheets expects growth of 3%-to-4% in the second half of this year.
Eurozone woes to continue
Eurozone GDP will contract over the next few years, Sheets suggests, adding he is particularly worried about the political situation.
“Take Italy. It’s had zero growth over the last decade, but it needs 1.5% per year for it’s debt to be sustainable. To achieve this it needs structural reforms—exactly the kind Mario Monti was trying to implement. But it just had an election, and the people said they don’t like reform.”
Sheets says Italy could be the source of “very troubling disruptions in Europe” if the lack of support for reform persists, adding this worst-case scenario would unfold over years rather than months.
“But with political support for reform, the ECB’s backstop will be sufficient,” he concludes.
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