U.S. stocks finished flat on very light volume following the biggest weekly drop for the S&P 500 in more than month.  Only 3.2 billion shares traded on the New York Stocks Exchange composite volume, compared to the daily average of 5.4 billion. 

Disappointing GDP growth in Japan added to concerns about the slowing global recovery and set a negative tone at the onset of trading.  Much media attention was given to the fact that China surpassed Japan to become the second-largest economy in the world, which I will touch on in more depth in the full Daily Insight.

Manufacturing in the New York region expanded less than forecast in August.  A key driver for GDP over the last five quarters, manufacturers make up 11% of the economy and had benefitted from expanding world trade, inventory restocking, and stronger corporate spending for new equipment. As inventory rebuilding slows and export demands peak, the manufacturing sector is beginning to cool off.  This is not to say that manufacturing will be a drag on the economy, but rather less of an addition.

The National Association of Home Builders Confidence Index showed builders’ confidence dropped to the lowest since March 2009. Low confidence among homebuilders is not very surprising given three years of declining demand and, more recently, the expiration of a government tax incentive for homebuyers.  With mounting foreclosures adding to inventory and a stagnant labor market, a housing recovery will take a long time to develop.

Also weighing on sentiment was the Federal Reserve’s bank loan survey results, which showed a lack of demand from businesses and households even as banks eased credit standards and terms in the second quarter.  While survey results suggest that lending conditions are beginning to ease, this really only accounts for companies with annual sales of $50 million or more.  Smaller businesses are having difficulty obtaining credit. 

U.S. bonds rallied as data showed global demand for long-term American financial assets rose in June and the Federal Reserve prepared to buy Treasuries this week to keep borrowing costs low.  Yields on 10-year Treasuries dropped to the lowest level in more than 16 months. 

Technology shares outperformed for the entire session as Dell’s acquisition of storage equipment maker 3Par sparked excitement.  Materials also outperformed on higher copper and gold prices.

Market Activity for August 16, 2010

China is #2

Perhaps garnering more attention than Japan’s disappointing GDP growth was the fact that China surpassed Japan as the world’s second-largest economy last quarter.  There is no denying China’s increasingly important role in the global economy.  Last year, China overtook the U.S. as the biggest automobile market and Germany as the largest exporter.  They also have substantial influence over global commodity prices as they are the world’s biggest buyer of iron ore and copper, and the second-biggest importer of crude oil.  Additionally, China is the biggest foreign investor in U.S. Treasuries, which has an entirely different set of economic implications.

Their breakneck economic growth has been impressive, but China is now at a crossroads.  For the past 30 years, China has emulated the export-driven growth model that made Japan a major economic force in the 1980s.  But slowing global growth and reduced consumption in the U.S. and Europe mean that China can no longer lean so heavily on its exports for economic growth.  Instead they must focus on increasing domestic consumption.  China’s domestic consumption is a mere 35% of GDP, the lowest of any major economy, down from 45% a decade ago. 

Also complicating Chinese export growth is the rising wages among their factory workers. Chinese government data shows that wages in manufacturing-dominated regions have risen 20% to 25% this year alone. Rising wages may hurt exports, but could play an important role for China’s transition to a more consumer-driven economy.  It doesn’t take a genius to understand that consumers will spend more when their wages are higher. Of course, I’m oversimplifying a bit.  Eventually higher wages will affect the country’s competitiveness in the manufacturing.  As wages rise, companies may move their plants out of China and into countries with cheaper labor.  This means that China will have to increase its supply of skilled workers.  That requires a stable workforce, which stays with its employers long enough to be worth investing in. Some of China’s residency laws discourage this – that will have to change.

But if higher wages in China can increase their domestic consumer spending, then it would be a very welcome development with so many developed nations craving a global rebalancing.  Higher Chinese wages have a similar effect to a stronger exchange rate in that they would shrink China’s trade surplus and boost its spending.  This, in turn, could help foreign companies and the workers they have laid off.

This all sounds pretty easy, right?  The truth is that China is still a developing nation and these transformations may or may not come to fruition.  Yes, it’s the second-largest economy in the world and on pace to pass the U.S. in roughly 20 years, but they face many risks and are just as susceptible to economic weakness as the rest of the world. 

Have a great day!

Peter Lazaroff, Investment Analyst

Phone: 636-449-4900