US demand and Chinese production

Retail spending in the US recovered in September. However, industrial output continues to lag. The shift in manufacturing overseas means that much of the increase in demand in the US was probably met by overseas production, particularly in China. Whether this trend persists is uncertain, as inflation threatens to force a slowdown in China.

According to a US Commerce Department last Friday, retail sales in the US rose 1.5 percent last month, the biggest increase since March. The increase was led by a 4.2 percent increase in sales by vehicle dealers. Excluding sales of motor vehicles, sales increased by 0.6 percent, still the biggest advance since May and up from a 0.2 percent increase in August.

There is little sign of a similar pickup in the industrial sector. According to a Federal Reserve report on the same day, industrial production in the US rose just 0.1 percent in September. This followed a 0.1 percent decline in August, which was revised downward from an initially-reported 0.1 percent increase. Production at utilities saw a big jump of 5.4 percent, but manufacturing output fell 0.3 percent while mining output dropped 2.3 percent.

The lacklustre performance of the industrial sector is consistent with the weak job figures of the past few months, especially in manufacturing. There is little mystery to it. As the latest issue of BusinessWeek pointed out in an article by Michael J Mandel titled "Jobs: The Lull Will Linger", increase in demand for goods in the US has only boosted jobs in other countries.

Retail sales rose by a strong $62 billion over the past year, measured in 2000 dollars. But guess what? Imports of consumer goods, motor vehicles, and foods and beverages rose by exactly that amount. So rather than creating 100,000 or more manufacturing jobs in the US, that $62 billion in spending only hiked job growth elsewhere.

There is also little mystery as to exactly where the jobs have gone. China has accounted for most of the increase in global manufacturing output, while India is fast becoming a powerhouse in services outsourcing.

And according to Morgan Stanley economist Daniel Lian, developed economies like the US have probably felt the brunt of the rise of China's manufacturing capability in terms of lost jobs and investment in recent years, rather than other emerging economies, as has often been believed.

In a report in the Global Economic Forum on 8 October, he stated that from 1994 to 2003, China increased its share of the global manufactured export market from 2.2 percent to 5.3 percent. Greater China -- including China, Taiwan and Hong Kong -- increased its share from 8.1 to 10.1 percent. The five main ASEAN countries -- Indonesia, Malaysia, Philippines, Singapore and Thailand, often believed to have borne the brunt of the rise of China -- have in fact maintained their collective share at 4.4 percent. South Korea and Mexico saw their shares rise from 2.1 percent to 2.5 percent and from 1.2 percent to 1.9 percent, respectively. Brazil saw a slight decline in its global share, falling from 0.8 percent to 0.7 percent.

Lian's conclusion: "I think China may, in fact, have gained global manufacturing shares from advanced industrialized countries, as there are no other large manufacturing-intensive emerging economies to be hollowed out."

However, China's expansion in manufacturing may be headed for a slowdown, at least temporarily. The Chinese government has been trying to cool its fast-growing economy for the past few months, fearing that rising inflation and speculative excess may lead to a hard landing ahead.

Indeed, signs of bottlenecks are already appearing. On 7 October, Lian's Morgan Stanley colleague Andy Xie warned in an article in the Global Economic Forum:

[T]he erosion of real wages for Chinese factory workers is causing a supply backlash. Food and energy account for a large share of the expenditures of the factory workers in China. The reduction of their real wages is so severe that migrant workers are unwilling to move to the coast.

China's export sector has managed to meet demand despite labor shortage, which is due to spare capacities in the system. The spare capacities would be exhausted. As time goes on, even the existing workers may decide to leave, as they could not save enough from their wages to send home. The way out, I suspect, is that the export factories in China would have to raise wages to attract sufficient migrant workers. That would mean that the US import prices for Chinese goods have to rise, which has a big impact on the US retail prices.

BusinessWeek also arrived at a similar conclusion. In an article titled " Is China Running Out Of Workers?" in the latest issue, Dexter Roberts and Frederik Balfour wrote:

A recent survey by the Labor & Social Security Ministry found that the Pearl River Delta of which the city is a part needs 2 million more laborers. Other major export manufacturing regions, including parts of Fujian province, across from Taiwan, and Zhejiang, bordering Shanghai, are also facing shortages. "It's a serious situation if you're a manufacturer, because now you have got to compete on wages," says Jonathan Anderson, Chief Asia Economist at UBS Securities in Hong Kong...

The implication of the labor shortage: sharply rising wages that could push up an inflation rate that already tops 5% on the mainland. That could translate into higher prices for Chinese exports that would push up inflation around the world.

The potential slowdown in China has become apparent to markets. Last week, metal prices had their biggest drop in 16 years on Wednesday. On the London Metal Exchange, copper for three months' delivery fell 11 percent while nickel fell by 16.7 per cent. The fall in metal prices triggered falls in the equity markets as well. Oil prices, though, stayed high, NYMEX light sweet crude oil hitting a new high of around US$55 a barrel.

There is no certainty yet that the Chinese economy will slow down, have a hard landing or a soft landing. With so much of the world's manufacturing output dependent on it, however, you can be sure that many people around the world will be watching it closely.

Disappointing job growth may hurt US dollar

Last Friday, the US Labor Department reported disappointing job growth in September, something that seems to be becoming a habit. It now looks increasingly likely that the value of the US dollar must fall to both redress the current account deficit as well as revitalise job creation in the United States.

The US Labor Department report shows that payrolls grew by just 96,000 in September. Economists had predicted net job growth of about 150,000 in September. The unemployment rate held at 5.4 percent as 221,000 job seekers dropped out of the labor pool.

Government hiring provided 37,000 net new jobs. Job growth was strong in various service sector categories such as professional and business services, financial services and leisure and hospitality. But growth was weighed down by losses in manufacturing, retail and information services. The manufacturing sector shed 18,000 net jobs in September and has lost 2.7 million jobs overall since President George Bush took office.

August payrolls were revised down to 128,000 from the 144,000 reported last month. July's payrolls were revised up by 12,000 to 85,000.

The Labor Department estimated that payrolls for the year ended March 2004 could be 236,000 higher than previously estimated. It also thinks that the four hurricanes striking Florida and other coastal states in the past two months appear "to have held down employment growth, but not enough to change materially" the national jobs picture.

The weakness in job growth, especially in manufacturing, is a reminder that the strength of the US dollar remains a headwind in output and job creation, as I had pointed out in "Weaker dollar may help US economy but is no panacea". It reinforces the point made by Dallas Fed President Robert McTeer on Thursday at an event hosted by Market News International, when he said that the US current account deficit can only be corrected by a weaker US dollar. "Over time, there is only one direction for the dollar to go -- lower," he said in response to a question.

And it looks increasingly likely that that will happen. A 6 October report from economics and market research firm Forecast provides some evidence that suggests that Asian central banks, the biggest buyers of US Treasuries and, hence, the biggest supporters of the US dollar, have already started diversifying their reserves.

In the report, Forecast research director Alan Ruskin, points out that most of the big Asian central bankers have seen "a widening gulf between their reserves growth and the respective purchases of Treasuries and Agencies". The biggest gap is seen in the Chinese data that shows 12-month rolling net purchases of Treasuries and Agencies of just US$25bn compared to reserve growth of US$113bn over the same period (the latter figure excludes $45 billion injected in bank bail-outs).

Ruskin also highlights that other countries with growing gaps between their reserve growth and the purchases of Treasuries and Agencies over the same period include South Korea, where reserves were up US$35 billion over a period when purchases of Treasuries and Agencies were US$10.5 billion, and Singapore, where reserves rose US$13 billion compared to Treasury and Agency purchases of US$3 billion.

While these figures do not provide a complete picture, they suggest that the Asian central banks are diversifying their foreign reserves away from the US dollar. With diminished purchases of US assets from this important source of US dollar support, the currency looks likely to be headed for a decline.

One that American workers, especially in the manufacturing sector, may welcome with a sigh of relief.

Explaining the fall in bond yields

In the wake of three hikes in the federal funds rate by the Federal Reserve, yields on 10-year Treasuries have fallen in the United States, much to the surprise of many economists. Many economists have been searching for an explanation for this divergence, but in a globalised economy, the search for an explanation needs to be global as well.

The divergence between the federal funds rate and 10-year yields had become obvious by 21 September, when the Federal Reserve raised the federal funds rate to 1.75 percent, the third increase since June this year. Over roughly the same period, US 10-year Treasury bond yields, which had hit a high of about 4.9 percent in June, fell to 4 percent.

Since the federal funds rate normally underpins all other interest rates, many economists have wondered why yields for 10-year Treasuries have fallen in the face of rising federal funds rate.

The simple reason is that the federal funds rate affects the availability of short term funds and therefore, directly affects short term interest rates, but longer duration interest rates are affected by other factors like inflation and GDP growth.

This in turn leads to the obvious question: Are bond investors seeing low inflation or low economic growth? Recent evidence suggests both are real possibilities.

The inflation rate in the US for the year to August 2004 was 2.7 percent. However, excluding food and energy, the inflation rate is 1.7 percent.

Oil prices have risen considerably this year, with NYMEX crude oil hitting a record US$50 a barrel last week. However, the rise in oil prices have not resulted in any sustained rise in consumer prices. In fact, Avery Shenfeld, senior economist at CIBC World Markets Inc. in Toronto, suggested to Bloomberg: "If anything, high energy prices pushed core inflation lower by forcing companies to resort to discounting merchandise as consumers had to spend more to fill up their gas tanks."

High oil prices may also aggravate the economic slowdown that had started in the second quarter of this year. The economy grew at a 3.3 percent annual pace in the second quarter, slower than the 4.5 percent rate in the first three months.

That slowdown may have had a significant effect on restraining prices. "When total wages and salaries in the economy are growing slowly, consumers just don't have the spending power to cover high prices," said Shenfeld.

And despite Federal Reserve chairman Alan Greenspan's repeated comments that the economy is regaining "traction", evidence that the economy is re-accelerating is far from clear.

The Conference Board's index of leading economic indicators has declined for three consecutive months, falling by 0.3 percent in August to 115.7. In July, the index had fallen by 0.3 percent and in June, by 0.1 percent.

Last week, the Conference Board reported that its consumer confidence index for September fell to 96.8 from a revised 98.7 the previous month. The Conference Board's present situation index fell to 95.5 from 100.7 in August while the expectations index was virtually unchanged at 97.6 compared with 97.3 in August.

Indicators in manufacturing are also unclear. Durable goods orders were down 0.5 percent in August, but excluding transportation equipment, orders were up 2.3 percent. And on Friday, the index of manufacturing activity compiled from the Institute of Supply Management's survey of manufacturers' purchasing managers came in at 58.5 for September, a slight drop from the 59.0 reading in August.

And Mark Gilbert, a columnist for Bloomberg, has recently pointed out a dichotomy:

According to indexes compiled by Credit Suisse Group, the 40- basis point premium available on the most actively traded U.S. corporate bonds maturing in one to four years is the lowest in the five years the index has been in existence, and less than half its average in that period... For corporate debt of all maturities, spreads are about 90 basis points, compared with a five-year average of 144 basis points. Among Eurobonds, the current 40 basis-point spread compares with a five-year average of 70 basis points and a high of about 130 basis points reached two years ago.

If lower Treasury yields imply lower economic growth, why is the risk premium on corporate debt shrinking?

Maybe in looking for an explanation for the fall in interest rates, economists have been looking at the wrong places. Gilberts suggested: "Maybe the oft-cited Treasury buying by Asian central banks, rather than the economic outlook, is the real driver of the 10-year yield."

In a recent e-mail exchange between Morgan Stanley's chief economist Stephen Roach and Pacific Investment Management Co.'s chief investment officer William Gross -- published on 30 September in the Global Economic Forum -- the two discussed Asian central banks' role in keeping US interest rates low.

Roach wrote: "Lacking consumption growth, any currency-related hit to exports is a serious threat. So Asian central banks buy American bonds, which then support US asset markets."

Gross agreed, saying that the "Chinese and the Japanese are foolishly standing in the way [of a correction in the bond market], purchasing US Treasuries at the rate of $300 billion a year to prevent their own currencies from appreciating." He thinks that the Chinese are unpredictable and have their own domestic priorities, and would do "anything to prevent their products from losing what would still be an overwhelming pricing advantage".

Gross wrote that for bond yields to rise, the Chinese and the Japanese must play their part. "The world has changed a lot in the past decade," he wrote, "and a new pair of financial studs has displaced yours truly and others from their number one power ranking."